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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2001
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number 1-10989
VENTAS, INC.
(Exact name of registrant as specified in its charter)
Delaware 61-1055020
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
4360 Brownsboro Road
Suite 115
Louisville, Kentucky 40207-1642
(Address of principal executive offices) (Zip Code)
(502) 357-9000
(Registrant's telephone number, including area code)
------------------------
Securities registered pursuant to Section 12(b) of the Act:
Name of Each Exchange
Title of Each Class: on which Registered:
Common Stock, par value $.25 per share New York Stock Exchange
Preferred Stock Purchase Rights New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
------------------------
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment of this
Form 10-K. [_]
As of March 15, 2002, there were 69,062,380 shares of the Registrant's
common stock, $.25 par value ("Common Stock"), outstanding. The aggregate market
value of the shares of Common Stock of the Registrant held by non-affiliates of
the Registrant, based on the closing price of such stock on the New York Stock
Exchange on March 15, 2002, was approximately $844 million. For purposes of the
foregoing calculation only, all directors and executive officers of the
Registrant have been deemed affiliates.
Certain portions of the Registrant's annual report to stockholders for the
fiscal year ended December 31, 2001 are incorporated by reference into Parts I
and II of this Annual Report on Form 10-K.
Certain portions of the Registrant's definitive proxy statement relating to
the annual meeting of stockholders to be held on May 14, 2002 are incorporated
by reference into Part III of this Annual Report on Form 10-K.
CAUTIONARY STATEMENTS
This Form 10-K includes forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended (the "Securities Act") and
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"). All statements regarding Ventas, Inc. (the "Company" or "Ventas") and its
subsidiaries' expected future financial position, results of operations, cash
flows, funds from operations, dividends and dividend plans, financing plans,
business strategy, budgets, projected costs, capital expenditures, competitive
positions, growth opportunities, expected lease income, continued qualification
as a real estate investment trust ("REIT"), plans and objectives of management
for future operations and statements that include words such as "anticipate,"
"if," "believe," "plan," "estimate," "expect," "intend," "may," "could,"
"should," "will," and other similar expressions are forward-looking statements.
Such forward-looking statements are inherently uncertain, and stockholders must
recognize that actual results may differ from the Company's expectations. The
Company does not undertake a duty to update such forward-looking statements.
Actual future results and trends for the Company may differ materially
depending on a variety of factors discussed in the Company's filings with the
Securities and Exchange Commission (the "Commission"). Factors that may affect
the plans or results of the Company include, without limitation, (a) the ability
and willingness of Kindred Healthcare, Inc. ("Kindred") and certain of its
affiliates to continue to meet and/or honor its obligations under its
contractual arrangements with the Company and the Company's subsidiaries,
including without limitation the lease agreements and various agreements (the
"Spin Agreements") entered into by the Company and Kindred at the time of the
Company's spin-off of Kindred on May 1, 1998 (the "1998 Spin Off"), as such
agreements may have been amended and restated in connection with Kindred's
emergence from bankruptcy on April 20, 2001 (the "Kindred Effective Date"), (b)
the ability and willingness of Kindred to continue to meet and/or honor its
obligation to indemnify and defend the Company for all litigation and other
claims relating to the healthcare operations and other assets and liabilities
transferred to Kindred in the 1998 Spin Off, (c) the ability of Kindred and the
Company's other operators to maintain the financial strength and liquidity
necessary to satisfy their respective obligations and duties under the leases
and other agreements with the Company, and their existing credit agreements, (d)
the Company's success in implementing its business strategy, (e) the nature and
extent of future competition, (f) the extent of future healthcare reform and
regulation, including cost containment measures and changes in reimbursement
policies and procedures, (g) increases in the cost of borrowing for the Company,
(h) the ability of the Company's operators to deliver high quality care and to
attract patients, (i) the results of litigation affecting the Company, (j)
changes in general economic conditions and/or economic conditions in the markets
in which the Company may, from time to time, compete, (k) the ability of the
Company to pay down, refinance, restructure, and/or extend its indebtedness as
it becomes due, (l) the movement of interest rates and the resulting impact on
the value of the Company's interest rate swap agreements and the ability of the
Company to satisfy its obligation under one of these agreements to post cash
collateral if required to do so, (m) the ability and willingness of Atria, Inc.
("Atria") to continue to meet and honor its contractual arrangements with the
Company and Ventas Realty, Limited Partnership ("Ventas Realty") entered into in
connection with the Company's spin off of its assisted living operations and
related assets and liabilities to Atria in August 1996, (n) the ability and
willingness of the Company to maintain its qualification as a REIT due to
economic, market, legal, tax or other considerations, including without
limitation, the risk that the Company may fail to qualify as a REIT due to its
ownership of Kindred common stock, (o) the outcome of the audit being conducted
by the Internal Revenue Service for the Company's tax years ended December 31,
1997 and 1998, (p) final determination of the Company's taxable net income for
the year ended December 31, 2001, (q) the ability and willingness of the
Company's tenants to renew their leases with the Company upon expiration of the
leases and the Company's ability to relet its properties on the same or better
terms in the event such leases expire and are not renewed by the existing
tenants and (r) the limitations on the ability of the Company to sell, transfer
or otherwise dispose of its common stock in Kindred arising out of the
securities laws and the registration rights agreement the Company entered into
with Kindred and certain of the holders of the Kindred common stock. Many of
such factors are beyond the control of the Company and its management.
Kindred Information
Kindred is subject to the reporting requirements of the Commission and is
required to file with the Commission annual reports containing audited financial
information and quarterly reports containing unaudited financial information.
The information related to Kindred provided in this Form 10-K is derived from
filings made with the Commission or other publicly available information, or has
been provided by Kindred. The Company has not verified this information either
through an independent investigation or by reviewing Kindred's public filings.
The Company has no reason to believe that such information is inaccurate in any
material respect, but there can be no assurance that all such information is
accurate. The Company is providing this data for informational purposes only,
and the reader of this Form 10-K is encouraged to obtain Kindred's publicly
available filings from the Commission.
2
TABLE OF CONTENTS
PART I
Item 1. Business .................................................................................... 4
Item 2. Properties .................................................................................. 36
Item 3. Legal Proceedings ........................................................................... 41
Item 4. Submission of Matters to a Vote of Security Holders ......................................... 41
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters ....................... 42
Item 6. Selected Financial Data ..................................................................... 42
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ....... 42
Item 7A. Quantitative and Qualitative Disclosures About Market Risk .................................. 42
Item 8. Financial Statements and Supplementary Data ................................................. 42
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure ........ 42
PART III
Item 10. Directors and Executive Officers of the Registrant .......................................... 43
Item 11. Executive Compensation ...................................................................... 43
Item 12. Security Ownership of Certain Beneficial Owners and Management .............................. 43
Item 13. Certain Relationships and Related Transactions .............................................. 43
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K ............................. 43
3
PART I
Item 1. Business
General
Ventas, Inc. ("Ventas" or the "Company") is a Delaware corporation that
elected to be taxed as a real estate investment trust ("REIT") under the
Internal Revenue Code of 1986, as amended (the "Code"), for the year ended
December 31, 1999. The Company believes that it has satisfied the requirements
to qualify as a REIT for the years ended December 31, 2000 and 2001. The Company
intends to continue to qualify as a REIT for federal income tax purposes for the
year ending December 31, 2002 and subsequent years. It is possible that
economic, market, legal, tax or other considerations may cause the Company to
fail, or elect not, to continue to qualify as a REIT. The Company owns a
geographically diverse portfolio of healthcare related facilities which
consisted of 44 hospitals, 216 nursing facilities and eight personal care
facilities in 36 states as of December 31, 2001. The Company and its
subsidiaries lease these facilities to healthcare operating companies under
"triple-net" or "absolute-net" leases. Kindred Healthcare, Inc. and its
subsidiaries (collectively, "Kindred") lease 210 of the Company's nursing
facilities and all of the Company's hospitals as of December 31, 2001. The
Company conducts substantially all of its business through a wholly owned
operating partnership, Ventas Realty, Limited Partnership ("Ventas Realty") and
an indirect, wholly owned limited liability company, Ventas Finance I, LLC
("Ventas Finance"). The Company operates in one segment which consists of owning
and leasing healthcare facilities and leasing or subleasing such facilities to
third parties. See "Note 2--Summary of Significant Accounting Policies" to the
Consolidated Financial Statements included in the Company's annual report to
stockholders for the fiscal year ended December 31, 2001, which is incorporated
herein by reference (the "Annual Report").
The Company was incorporated in Kentucky in 1983 as Vencare, Inc. and
commenced operations in 1985. The Company changed its name to Vencor
Incorporated in 1989 and to Vencor, Inc. in 1993. From 1985 through April 30,
1998, the Company was engaged in the business of owning, operating and acquiring
healthcare facilities and companies engaged in providing healthcare services.
On May 1, 1998, the Company effected the 1998 Spin Off pursuant to which
the Company was separated into two publicly held corporations. A new
corporation, subsequently named Vencor, Inc. (which has since been renamed
Kindred Healthcare, Inc.), was formed to operate the hospital, nursing facility
and ancillary services businesses. Pursuant to the terms of the 1998 Spin Off,
the Company distributed the common stock of Kindred to stockholders of record of
the Company as of April 27, 1998. The Company, through its subsidiaries,
continued to hold title to substantially all of the real property and to lease
such real property to Kindred. At such time, the Company also changed its name
to Ventas, Inc. and refinanced substantially all of its long-term debt. For
financial reporting periods after and including the 1998 Spin Off, the
historical financial statements of the Company for financial reporting periods
prior to the 1998 Spin Off were assumed by Kindred, and the Company is deemed to
have commenced operations on May 1, 1998. In addition, for certain reporting
purposes under this Form 10-K and other filings, the Commission treats the
Company as having commenced operations on May 1, 1998. On September 13, 1999
(the "Petition Date"), Kindred filed for protection under chapter 11 of title 11
of the United States Code (the "Bankruptcy Code"). Kindred emerged from
proceedings under the Bankruptcy Code on April 20, 2001 (the "Kindred Effective
Date") pursuant to the terms of Kindred's plan of reorganization (the "Kindred
Reorganization Plan"). As a result of the Kindred bankruptcy proceedings, the
Company suspended the implementation of its original business strategy in 1999
and continued such suspension through 2001.
The Company's current business strategy is preserving and maximizing
stockholders' capital by means that include (a) the reduction of the amount of
the Company's indebtedness and a reduction of the average all-in cost of the
Company's indebtedness and (b) the implementation of a measured and disciplined
diversification and growth program to reduce the Company's dependence on
Kindred. The ability of the Company to pursue certain of these objectives may be
restricted by the terms of the Company's Amended and Restated Credit, Security,
Guaranty and Pledge Agreement dated January 31, 2000 (the "Credit Agreement").
Dependence on Kindred
The Company leases all of its hospitals and 210 of its nursing facilities
to Kindred under five master lease agreements (the "Master Leases"). For the
years ended December 31, 2001, 2000 and 1999, Kindred accounted for
approximately 98.8%, 98.6% (98.4%, net of write-offs) and 98.5% of the Company's
rental revenues, respectively. In addition, the Company owns 1,080,314 shares of
the outstanding common stock of Kindred. See "--Risk Factors--Any significant
decrease in the value of the 1,080,314 shares of Kindred common stock that the
Company owns, as well as the limitations on the Company's ability to sell,
transfer or otherwise dispose of such shares of
4
Kindred common stock, could have a material adverse effect on the Company's
ability to reduce its indebtedness and implement its business strategy."
Recent Developments Regarding Kindred
In order to govern certain of the relationships between the Company and
Kindred after the 1998 Spin Off and to provide mechanisms for an orderly
transition, the Company and Kindred entered into the Spin Agreements at the time
of the 1998 Spin Off. Except as noted below, each written agreement by and among
Kindred and the Company and/or Ventas Realty was assumed by Kindred and certain
of these agreements were simultaneously amended in accordance with the terms of
the Kindred Reorganization Plan.
The Company and Kindred also entered into certain agreements and
stipulations and orders both prior to and during the pendency of Kindred's
bankruptcy proceedings governing certain aspects of the business relationships
between the Company and Kindred prior to the Kindred Effective Date. These
agreements and stipulations and orders were terminated on the Kindred Effective
Date in accordance with the terms of the Kindred Reorganization Plan.
Set forth below is a description of the material terms of (a) the Kindred
Reorganization Plan, (b) certain of the Spin Agreements as assumed by Kindred
pursuant to the Kindred Reorganization Plan, including the terms of amendments
or restatements of such Spin Agreements, where applicable, (c) those Spin
Agreements and other agreements terminated under the Kindred Reorganization
Plan, and (d) new agreements entered into between the Company and Kindred in
accordance with the Kindred Reorganization Plan.
Summary of the Kindred Reorganization Plan
Under the terms of the Kindred Reorganization Plan, the Company, among
other things, (a) retained all rent paid by Kindred through the Kindred
Effective Date, (b) amended and restated its leases with Kindred, (c) received
1,498,500 shares of the common stock of Kindred together with certain
registration rights, (d) entered into new agreements relating to the allocation
of certain tax refunds and liabilities, and (e) settled certain claims of the
United States pertaining to the Company's former healthcare operations.
Master Leases
Under the Kindred Reorganization Plan, Kindred assumed its five
pre-existing leases with the Company and Ventas Realty (the "Prior Master
Leases"). The Prior Master Leases were then amended and restated into four
agreements styled as amended and restated master leases (collectively, the
"Amended Master Leases").
In connection with the consummation on December 12, 2001 of a $225 million
LIBOR based floating rate commercial mortgage backed securitization transaction
(the "CMBS Transaction"), Ventas Realty removed 40 skilled nursing facilities
(the "CMBS Properties") from Amended Master Lease No. 1 and placed the CMBS
Properties in a new fifth master lease with Kindred dated December 12, 2001 (the
"CMBS Master Lease"). Simultaneously with the closing of the CMBS Transaction,
Ventas Realty transferred the CMBS Properties and the CMBS Master Lease to
Ventas Finance, the borrower under the CMBS Transaction. The Amended Master
Leases and the CMBS Master Lease are collectively referred to as the "Master
Leases."
Each Master Lease is a "triple-net lease" or an "absolute-net lease"
pursuant to which Kindred is required to pay all insurance, taxes, utilities,
maintenance and repairs related to the properties. There are several renewal
bundles of properties under each Master Lease, with each bundle containing a
varying number of properties. All properties within a bundle have primary terms
ranging from 10 to 15 years commencing May 1, 1998, plus renewal options
totaling fifteen years.
Under each Master Lease, the aggregate annual rent is referred to as Base
Rent (as defined in each Master Lease). Base Rent equals the sum of Current Rent
(as defined in each Master Lease) and Accrued Rent (as defined in each Master
Lease). Kindred is obligated to pay the portion of Base Rent that is Current
Rent, and unpaid Accrued Rents, as set forth below. From May 1, 2001 through
April 30, 2004, Base Rent will equal Current Rent. Under the Master Leases, the
initial annual aggregate Base Rent is $180.7 million from May 1, 2001 to April
30, 2002. For the period from May 1, 2002 through April 30, 2004, annual
aggregate Base Rent, payable all in cash, escalates on May 1 of each year at an
annual rate of 3.5% over the Prior Period Base Rent (as defined in the Master
Leases) if certain Kindred revenue parameters are met. Assuming such Kindred
revenue parameters are met, Annual Base Rent under the Master Leases would be
$187.0 million from May 1, 2002 to April 30, 2003 and $193.6 million from May 1,
2003 to April 30, 2004. See "Note 3--Revenues from Leased Properties" and "Note
9--Transactions with Kindred" to the Consolidated Financial Statements included
in the Annual Report, which is incorporated herein
5
by reference.
Each Master Lease provides that beginning May 1, 2004, if Kindred
refinances its senior secured indebtedness entered into in connection with the
Kindred Reorganization Plan or takes other similar action (a "Kindred
Refinancing"), the 3.5% annual escalator will be paid in cash and the Base Rent
shall continue to equal Current Rent. If a Kindred Refinancing has not occurred,
then on May 1, 2004, the annual aggregate Base Rent will be comprised of (a)
Current Rent payable in cash which will escalate annually by an amount equal to
2% of Prior Period Base Rent, and (b) an additional annual non-cash accrued
escalator amount of 1.5% of the Prior Period Base
Rent which will accrete from year to year including an interest accrual at
LIBOR (as defined in the Master Leases) plus 450 basis points (compounded
annually) to be added to the annual accreted amount (but such interest will not
be added to the aggregate Base Rent in subsequent years). The Unpaid Accrued
Rent will become payable, and all future Base Rent escalators will be payable in
cash, upon the occurrence of a Kindred Refinancing. Under certain circumstances,
the Company's right to receive payment of the Unpaid Accrued Rent is subordinate
to the receipt of payment by the lenders of Kindred's senior secured
indebtedness. Upon the occurrence of a Kindred Refinancing, the annual aggregate
Base Rent payable in cash will thereafter escalate at the annual rate of 3.5%
and there will be no further accrual feature for rents arising after the
occurrence of such events.
Under the terms of the Master Leases, the Company has a one time right to
reset the rents under the Master Leases (the "Reset Right"), exercisable 5 years
after the Kindred Effective Date on a Master Lease by Master Lease basis, to a
then fair market rental rate, for a total fee of $5.0 million payable on a
pro-rata basis at the time of exercise under the applicable Master Lease. The
Reset Right under the CMBS Master Lease can only be exercised in conjunction
with the exercise of the Reset Right under Master Lease No. 1. The Company
cannot exercise the Reset Right under the CMBS Master Lease without the prior
written consent of the CMBS Lender if, as a result of such reset, the aggregate
rent for the CMBS Properties would decrease. See "--Risk Factors--Because
Kindred is the primary source of the Company's rental revenues, Kindred's
inability or unwillingness to satisfy its obligations under the Master Leases
would have a Material Adverse Effect on the Company" and "--Due to the Company's
dependence on Kindred's rental payments as the primary source of its rental
revenues, the Company may be negatively affected by enforcing its rights under
the Master Leases or by terminating a Master Lease."
Tax Allocation Agreement, Tax Stipulation and Tax Refund Escrow Agreement
The Tax Allocation Agreement, entered into at the time of the 1998 Spin Off
and described in more detail below, was assumed by Kindred under the Kindred
Reorganization Plan and then amended and supplemented by the Tax Refund Escrow
Agreement, also described below. The Tax Stipulation, entered into by Kindred
and the Company during the pendency of the Kindred bankruptcy proceedings, was
superseded by the Tax Refund Escrow Agreement.
The Tax Allocation Agreement provides that Kindred will be liable for, and
will hold the Company harmless from and against, (i) any taxes of Kindred and
its then subsidiaries (the "Kindred Group") for periods after the 1998 Spin Off,
(ii) any taxes of the Company and its then subsidiaries (the "Company Group") or
the Kindred Group for periods prior to the 1998 Spin Off (other than taxes
associated with the Spin Off) with respect to the portion of such taxes
attributable to assets owned by the Kindred Group immediately after completion
of the 1998 Spin Off and (iii) any taxes attributable to the 1998 Spin Off to
the extent that Kindred derives certain tax benefits as a result of the payment
of such taxes. Under the Tax Allocation Agreement, Kindred would be entitled to
any refund or credit in respect of taxes owed or paid by Kindred under (i), (ii)
or (iii) above. Kindred's liability for taxes for purposes of the Tax Allocation
Agreement would be measured by the Company's actual liability for taxes after
applying certain tax benefits otherwise available to the Company other than tax
benefits that the Company in good faith determines would actually offset tax
liabilities of the Company in other taxable years or periods. Any right to a
refund for purposes of the Tax Allocation Agreement would be measured by the
actual refund or credit attributable to the adjustment without regard to
offsetting tax attributes of the Company.
Under the Tax Allocation Agreement, the Company would be liable for, and
would hold Kindred harmless against, any taxes imposed on the Company Group or
the Kindred Group other than taxes for which the Kindred Group is liable as
described in the above paragraph. The Company would be entitled to any refund or
credit for taxes owed or paid by the Company as described in this paragraph. The
Company's liability for taxes for purposes of the Tax Allocation Agreement would
be measured by the Kindred Group's actual liability for taxes after applying
certain tax benefits otherwise available to the Kindred Group other than tax
benefits that the Kindred Group in good faith determines would actually offset
tax liabilities of the Kindred Group in other taxable years or periods. Any
right to a refund would be measured by the actual refund or credit attributable
to the adjustment without regard to offsetting tax attributes of the Kindred
Group. See "Note 8--Income Taxes" to the Consolidated Financial Statements
included in the Annual Report, which is incorporated by reference herein.
6
Prior to and during the Kindred bankruptcy proceedings, the Company and
Kindred were engaged in disputes regarding the entitlement to federal, state and
local tax refunds for the tax periods prior to and including May 1, 1998 (the
"Subject Periods") which had been received or which would be received by either
company. Under the terms of the Tax Stipulation, the companies agreed that the
proceeds of certain federal, state and local tax refunds for these Subject
Periods, received by either company on or after September 13, 1999, with
interest thereon from the date of deposit at the lesser of the actual interest
earned and 3% per annum, were to be held by the recipient of such refunds in
segregated interest bearing accounts.
On the Kindred Effective Date, Kindred and the Company entered into the Tax
Refund Escrow Agreement governing their relative entitlement to certain tax
refunds for the Subject Periods that each received or may receive in the future.
The Tax Refund Escrow Agreement amends and supplements the Tax Allocation
Agreement and supersedes the Tax Stipulation. Under the terms of the Tax Refund
Escrow Agreement, refunds ("Subject Refunds") received on or after September 13,
1999 by either Kindred or the Company with respect to federal, state or local
income, gross receipts, windfall profits, transfer, duty, value-added, property,
franchise, license, excise, sales and use, capital, employment, withholding,
payroll, occupational or similar business taxes (including interest, penalties
and additions to tax, but excluding certain refunds), for taxable periods ending
on or prior to May 1, 1998, or including May 1, 1998 and received on or after
September 13, 1999 ("Subject Taxes") must be deposited into an escrow account
with a third-party escrow agent.
The Tax Refund Escrow Agreement provides, inter alia, that each party must
notify the other of any asserted Subject Tax liability of which it becomes
aware, that either party may request that asserted liabilities for Subject Taxes
be contested, that neither party may settle such a contest without the consent
of the other, that each party has the right to participate in any such contest,
and that the parties generally must cooperate with regard to Subject Taxes and
Subject Refunds and will mutually and jointly control any audit or review
process related thereto.
The funds in the escrow account (the "Escrow Funds") may be released from
the escrow account to pay Subject Taxes and as otherwise provided therein.
The Tax Refund Escrow Agreement provides generally that Kindred and the
Company waive their rights under the Tax Allocation Agreement to make claims
against each other with respect to Subject Taxes satisfied by the Escrow Funds,
notwithstanding the indemnification provisions of the Tax Allocation Agreement.
To the extent that the Escrow Funds are insufficient to satisfy all liabilities
for Subject Taxes that are finally determined to be due (such excess amount,
"Excess Taxes"), the relative liability of Kindred and the Company to pay such
Excess Taxes shall be determined as provided in the Tax Refund Escrow Agreement.
Disputes under the Tax Refund Escrow Agreement, and the determination of the
relative liability of Kindred and the Company to pay Excess Taxes, if any, are
governed by the arbitration provision of the Tax Allocation Agreement.
Interest earned on the Escrow Funds or included in refund amounts received
from governmental authorities will be distributed equally to each of Kindred and
the Company on an annual basis and are accrued as interest income on the
Consolidated Statement of Operations. Any Escrow Funds remaining in the escrow
account after no further claims may be made by governmental authorities with
respect to Subject Taxes or Subject Refunds (because of the expiration of
statutes of limitation or otherwise) will be distributed equally to Kindred and
the Company.
Agreement of Indemnity--Third Party Leases
In connection with the 1998 Spin Off, the Company assigned its former third
party lease obligations (i.e., leases under which an unrelated third party is
the landlord) as a tenant or as a guarantor of tenant obligations to Kindred
(the "Third Party Leases"). Under the Kindred Reorganization Plan, Kindred
assumed and has agreed to fulfill its obligations under the Agreement of
Indemnity--Third Party Leases. There can be no assurance that Kindred will have
sufficient assets, income and access to financing to enable it to satisfy its
obligations under the Agreement of Indemnity--Third Party Leases or that Kindred
will continue to honor its obligations under the Agreement of Indemnity--Third
Party Leases. If Kindred does not satisfy or otherwise honor the obligations
under the Agreement of Indemnity--Third Party Leases, then the Company may be
liable for the payment and performance of such obligations. Under the Kindred
Reorganization Plan, Kindred has agreed not to renew or extend any Third Party
Lease unless it first obtains a release of the Company from liability under such
Third Party Lease. See "--Risk Factors--Kindred may not perform the obligations
it assumed in the 1998 Spin Off relating to indemnification of the Company and
the assumption of the defense of certain claims" and "Note 9--Transactions with
Kindred--Agreement of Indemnity--Third Party Leases" to the Consolidated
Financial Statements included in the Annual Report, which is incorporated by
reference herein.
Agreement of Indemnity--Third Party Contracts
7
In connection with the 1998 Spin Off, the Company assigned its former third
party guaranty agreements to Kindred (the "Third Party Guarantees"). Under the
Kindred Reorganization Plan, Kindred assumed and has agreed to fulfill its
obligations under the Agreement of Indemnity--Third Party Contracts. There can
be no assurance that Kindred will have sufficient assets, income and access to
financing to enable it to satisfy its obligations incurred in connection with
the Agreement of Indemnity--Third Party Contracts or that Kindred will continue
to honor its obligations under the Agreement of Indemnity--Third Party
Contracts. If Kindred does not satisfy or otherwise honor the obligations under
the Agreement of Indemnity--Third Party Contracts, then the Company may be
liable for the payment and performance of such obligations. See "--Risk
Factors---Kindred may not perform the obligations it assumed in the 1998 Spin
Off relating to indemnification of the Company and the assumption of the defense
of certain claims." and "Note 9--Transactions with Kindred--Agreement of
Indemnity--Third Party Contracts" to the Consolidated Financial Statements
included in the Annual Report, which is incorporated by reference herein.
Assumption of Certain Operating Liabilities and Litigation
In connection with the 1998 Spin Off, Kindred agreed in various Spin
Agreements to assume and to indemnify the Company for any and all liabilities
that may arise out of the ownership or operation of the healthcare operations
either before or after the date of the 1998 Spin Off. Under the Kindred
Reorganization Plan, Kindred assumed and agreed to perform its obligations under
these indemnifications. There can be no assurance that Kindred will have
sufficient assets, income and access to financing to enable it to satisfy its
obligations incurred in connection with the 1998 Spin Off or that Kindred will
continue to honor its obligations incurred in connection with the 1998 Spin Off.
If Kindred does not satisfy or otherwise honor the obligations under these
arrangements, then the Company may be liable for the payment and performance of
such obligations and may have to assume the defense of such claims. See "--Risk
Factors---Kindred may not perform the obligations it assumed in the 1998 Spin
Off relating to indemnification of the Company and the assumption of the defense
of certain claims." and "Note 9--Transactions with Kindred--Assumption of
Certain Operating Liabilities and Litigation" to the Consolidated Financial
Statements included in the Annual Report, which is incorporated by reference
herein.
Kindred Common Stock and Registration Rights Agreement
On the Kindred Effective Date, Ventas Realty received 1,498,500 shares of
the common stock in Kindred, representing not more than 9.99% of the issued and
outstanding common stock in Kindred as of the Kindred Effective Date. Based on
applicable laws, regulations, advice from experts, an appraisal, the trading
performance of the Kindred common stock at the applicable time and other
appropriate facts and circumstances, including the illiquidity and lack of
registration of the Kindred common stock when received and the Company's lack of
significant influence over Kindred, the Company determined that the value of the
Kindred common stock was $18.2 million on the date received by Ventas Realty.
The Kindred common stock received by Ventas Realty is subject to dilution from
stock issuances occurring after the Kindred Effective Date. The Kindred common
stock was issued to Ventas Realty as additional future rent in consideration of
the agreement to charge the base rent as provided in the Master Leases.
On the Kindred Effective Date, Kindred executed and delivered to Ventas
Realty and other signatories, a Registration Rights Agreement, which, among
other things, provides that Kindred must file a shelf registration statement
with respect to the Kindred common stock and to keep such registration statement
continuously effective for a period of two years with respect to such securities
(subject to customary exceptions). The shelf registration statement was declared
effective on November 7, 2001.
The Company disposed of 418,186 shares of Kindred common stock in the
fourth quarter of 2001 and recognized a gain of $15.4 million on the
dispositions. In connection with a registered offering of common stock by
Kindred, Ventas Realty exercised its piggyback registration rights, and sold
83,300 shares of Kindred common stock, recognizing a gain of $2.6 million. The
Company applied the net proceeds of $3.6 million from the sale of the 83,300
shares of Kindred common stock as a prepayment on the Company's indebtedness
under the Credit Agreement. The Company declared a distribution of 334,886
shares of Kindred common stock as part of the 2001 dividend, resulting in a gain
of $12.8 million. For every share of common stock of the Company that a
stockholder owned at the close of business on December 14, 2001, the stockholder
received 0.005 of a share of Kindred common stock and $0.0049 in cash (equating
to one share of Kindred common stock and $0.98 in cash for every two hundred
shares of common stock in the Company). For purposes of the 2001 dividend, the
Kindred common stock was valued in accordance with the Code and applicable
rulings and regulations on December 31, 2001 at $51.02 per share. See "--Risk
Factors--Any significant decrease in the value of the 1,080,314 shares of
Kindred common stock that the Company owns, as well as the limitations on the
Company's ability to sell, transfer or otherwise dispose of such shares of
Kindred common stock, could have a material adverse effect on the Company's
ability to reduce its indebtedness and implement its business strategy."
8
Terminated Agreements
The Participation Agreement and the Development Agreement, both executed in
connection with the 1998 Spin Off, were terminated on the Kindred Effective
Date. The Second Standstill Agreement and the Tolling Agreement, both entered
into by the Company and Kindred in April 1999, and the Tax Stipulation and the
Rent Stipulation were all terminated on the Kindred Effective Date and are of no
further force or effect.
Settlement of United States Claims
Kindred and the Company were the subject of investigations by the United
States Department of Justice regarding the Company's prior healthcare
operations, including matters arising from lawsuits filed under the qui tam, or
whistleblower, provision of the Federal Civil False Claims Act, which allows
private citizens to bring a suit in the name of the United States. See "Note
12--Litigation" to the Consolidated Financial Statements included in the Annual
Report, which is incorporated by reference herein. The Kindred Reorganization
Plan contains a comprehensive settlement of all of these claims by the United
States (the "United States Settlement").
Under the United States Settlement, the Company will pay $103.6 million to
the United States, of which $34.0 million was paid on the Kindred Effective
Date. The balance of $69.6 million bears interest at 6% per annum and is payable
in equal quarterly installments over a five-year term commencing on June 30,
2001 and ending in 2006. The Company made the first three quarterly installments
under the United States Settlement through December 31, 2001.
The Company also paid approximately $0.4 million to legal counsel for the
relators in the qui tam actions. In the fourth quarter of 2000, the Company
recorded the full amount of the obligation under the United States Settlement
for $96.5 million based on an imputed interest rate of 10.75%.
Recent Developments Regarding Liquidity
See the section entitled "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Recent Developments Regarding Liquidity" in
the Annual Report incorporated herein by reference for a discussion of the
Company's Credit Agreement and the CMBS Transaction.
Portfolio of Properties
The following table reflects the Company's portfolio of properties as of
December 31, 2001.
Percentage Number Number Number of
---------- ------ ------ ---------
Type of Facility of Portfolio(1) of Facilities of Beds/Units States (2)
- ----------------------------------------- --------------- ------------- ------------- ----------
Hospitals ................... 35.0% 44 4,033 21
Skilled Nursing Facilities .. 65.0% 216 27,952 31
Personal Care Facilities .... 00% 8 136 1
-------- ------ --------
Total. ............ 100.0% 268 32,121 36
======== ====== ========
(1) Based on percentage of rent earned by the Company for the year ended
December 31, 2001.
(2) The Company has properties located in 36 states operated by four different
operators.
Hospital Facilities
The Company's hospitals generally are long-term acute care hospitals that
serve medically complex, chronically ill patients. The operator of these
hospitals has the capability to treat 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. Chronic patients are often dependent on technology for continued life
support, such as mechanical ventilators, total parenteral nutrition, respiration
or cardiac monitors and dialysis machines. While these patients suffer from
conditions which require a high level of monitoring and specialized care, they
may not necessitate the continued services of an intensive care unit. Due to
their severe medical conditions, these patients generally are not clinically
appropriate for admission to a nursing facility or rehabilitation hospital.
9
Nursing Facilities
The Company's nursing facilities generally are skilled nursing facilities.
In addition to the customary services provided by skilled nursing facilities,
the operators of the Company's nursing facilities typically provide
rehabilitation services, including physical, occupational and speech therapies.
Personal Care Facilities
The Company's personal care facilities serve persons with acquired or
traumatic brain injury. The operator of the personal care facilities provides
services including supported living services, neurorehabilitation,
neurobehavioral management and vocational programs.
Competition
The Company competes for real property investments with healthcare
providers, other healthcare related REITs, real estate partnerships, banks,
insurance companies and other investors. Many of the Company's competitors are
significantly larger and have greater financial resources and lower cost of
capital than the Company. The Company's ability to compete successfully for real
property investments will be determined by numerous factors, including the
ability of the Company to identify suitable acquisition targets, the ability of
the Company to negotiate acceptable terms for any such acquisition, the
availability and cost of capital to the Company, and the restrictions contained
in the Credit Agreement. "--Risk Factors--The Company may encounter certain
risks and financing constraints when implementing the Company's business
strategy" and "Note 5--Borrowing Arrangements" to the Consolidated Financial
Statements included in the Annual Report, which is incorporated by reference
herein.
The operators of the Company's properties compete on a local and regional
basis with other healthcare operators. The ability of the Company's operators to
compete successfully for patients at the Company's facilities depends upon
several factors, including the quality of care at the facility, the operational
reputation of the operator, physician referral patterns, physical appearance of
the facilities, other competitive systems of healthcare delivery within the
community, population and demographics, and the financial condition of the
operator. Private, federal and state reimbursement programs and the effect of
other laws and regulations also may have a significant effect on the Company's
operators to compete successfully for patients for the properties.
Environmental Regulation
Under various federal, state and local environmental laws, ordinances and
regulations, a current or previous owner or operator of real property from which
there is a release or threatened release of hazardous or toxic substances or an
entity that arranges for the disposal or treatment of hazardous or toxic
substances at a disposal site may be held jointly and severally liable for the
cost of removal or remediation of certain hazardous or toxic substances that
could be located on, in or under such property or other affected property. Such
laws and regulations often impose liability whether or not the owner, operator
or otherwise responsible party knew of, or caused the presence of the hazardous
or toxic substances. The costs of any required remediation or removal of these
substances could be substantial, and the liability of a responsible party as to
any property is generally not limited under such laws and regulations and could
exceed the property's value and the aggregate assets of the liable party. The
presence of these substances or failure to remediate such substances properly
also may adversely affect the owner's ability to sell or rent the property, or
to borrow using the property as collateral. In connection with the ownership and
leasing of the Company's properties, the Company could be liable for these costs
as well as certain other costs, including governmental fines and injuries to
person or properties or natural resources. In addition, owners and operators of
real property are liable for the costs of complying with environmental, health,
and safety laws, ordinances and regulations and can be subjected to penalties
for failure to comply. Such ongoing compliance costs and penalties for
non-compliance can be substantial. Changes to existing or the adoption of new
environmental, health, and safety laws, ordinances, and regulations could
substantially increase an owner's or operator's environmental, health, and
safety compliance costs and/or associated liabilities. Environmental, health,
and safety laws, ordinances, and regulations potentially affecting the Company
address a wide variety of topics, including, but not limited to, asbestos,
polychlorinated biphenyls ("PCBs"), fuel oil management, wastewater discharges,
air emissions, radioactive materials, medical wastes, and hazardous wastes.
Under the Master Leases, Kindred has agreed to indemnify the Company against any
environmental claims (including penalties and clean-up costs) resulting from any
condition arising in, on or under, or relating to, the leased properties at any
time on or after the commencement date of the lease term for the applicable
leased property. Kindred also has agreed to indemnify the Company against any
environmental claim (including penalties and clean up costs) resulting from any
condition permitted to deteriorate, on or after the commencement date of the
lease term for the applicable leased property (including as a result of
migration from adjacent properties not owned or operated by the Company or any
of its affiliates other than
10
Kindred and its direct affiliates). There can be no assurance that Kindred will
have the financial capability or the willingness to satisfy any such
environmental claims. See "--Risk Factors--Kindred may not perform the
obligations it assumed in the 1998 Spin Off relating to indemnification of the
Company and the assumption of the defense of certain claims." If Kindred is
unable or unwilling to satisfy such claims, the Company may be required to
satisfy the claims. The Company has agreed to indemnify Kindred against any
environmental claims (including penalties and clean-up costs) resulting from any
condition arising on or under, or relating to, the leased properties at any time
before the commencement date of the lease term for the applicable leased
property.
The Company did not make any material capital expenditures in connection
with such environmental, health, and safety laws, ordinances, and regulations in
2001 and does not expect that it will have to make any such material capital
expenditures during 2002.
Governmental Regulation
General
The operators of the Company's properties derive a substantial portion of
their revenues from third party payors, including the Medicare and Medicaid
programs. Medicare is a federal program that provides certain hospital and
medical insurance benefits to persons age 65 and over, certain disabled persons
and persons with end-stage renal disease. Medicaid is a medical assistance
program jointly funded by federal and state governments and administered by each
state pursuant to which benefits are available to certain indigent patients. The
Medicare and Medicaid statutory framework is subject to administrative rulings,
interpretations and discretion that may affect the amount and timing of
reimbursements made under Medicare and Medicaid. The amounts of program payments
received by the Company's operators and tenants can be changed by legislative or
regulatory actions and by determinations by agents for the programs.
The Balanced Budget Act of 1997 (the "Budget Act") was intended to reduce
the increase in Medicare payments by $115 billion and reduce the increase in
Medicaid payments by $13 billion between 1998 through 2002 and made extensive
changes to the Medicare and Medicaid programs. The impact of these changes and
reductions has been only partially ameliorated by subsequent legislation. See
"--Healthcare Reform" below. In addition, private payors, including managed care
payors, increasingly are demanding discounted fee structures and the assumption
by healthcare providers of all or a portion of the financial risk. Efforts to
impose greater discounts and more stringent cost controls upon operators by
private payors are expected to continue. Further, on March 25, 1999, legislation
was passed that prevents nursing facility operators that decide to withdraw from
the Medicaid program from evicting or transferring patients who are residents as
of the effective date of withdrawal, and who rely on Medicaid to cover their
long-term care expenses. There can be no assurance that adequate reimbursement
levels will continue to be available for services to be provided by the
operators of the Company's properties, which currently are being reimbursed by
Medicare, Medicaid or private payors. Significant limits on the scope of
services reimbursed and on reimbursement rates and fees could have a material
adverse effect on these operators' liquidity, financial condition and results of
operations, which could affect adversely their ability to make rental payments
to the Company.
The operators of the Company's properties are subject to extensive federal,
state and local laws and regulations including, but not limited to, laws and
regulations relating to licensure, conduct of operations, ownership of
facilities, addition of facilities, services, prices for services and billing
for services. These laws authorize periodic inspections and investigations, and
identification of deficiencies that, if not corrected, can result in sanctions
that include loss of licensure to operate and loss of rights to participate in
the Medicare and Medicaid programs. Regulatory agencies have substantial powers
to affect the actions of operators of the Company's properties if the agencies
believe that there is an imminent threat to patient welfare, and in some states
these powers can include assumption of interim control over facilities through
receiverships. Extensive legislation and regulations also pertain to healthcare
fraud and abuse, including kickbacks, physician self-referrals and false claims.
Federal anti-kickback laws codified under Section 1128B(b) of the Social
Security Act (the "Anti-kickback Laws") prohibit certain business practices and
relationships that might affect the provision and cost of healthcare services
reimbursable under Medicare, Medicaid and other federal healthcare programs,
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 the Anti-kickback Laws include criminal penalties and civil
sanctions, including fines and possible exclusion from government programs such
as the Medicare and Medicaid programs. In the ordinary course of its business,
the operators of the Company's properties have been and are subject regularly to
inquiries, investigations and audits by federal and state agencies that oversee
these laws and regulations.
Pursuant to the Medicare and Medicaid Patient and Program Protection Act of
1987, the Department of Health
11
and Human Services ("HHS") periodically has issued regulations that describe
some of the conduct and business relationships permissible under the
Anti-kickback Laws ("Safe Harbors"). The fact that a given business arrangement
does not fall within a Safe Harbor does not render the arrangement per se
illegal. Business arrangements of healthcare service providers that fail to
satisfy the applicable Safe Harbor's criteria, however, risk increased scrutiny
and possible sanctions by enforcement authorities.
The operators of the Company's properties also are subject to the Ethics in
Patient Referral Act of 1989, commonly referred to as the Stark Law. In the
absence of an applicable exception, the Stark Law prohibits referrals by
physicians of Medicare and other government-program patients to providers of a
broad range of designated health services with which the physicians (or their
immediate family members) have ownership interests or certain other financial
arrangements. Initially, the Stark Law applied only to clinical laboratory
services and regulations applicable to clinical laboratory services were issued
in 1995. Earlier that same year, the Stark Law's self-referral prohibition
expanded to additional goods and services, including inpatient and outpatient
hospital services. In January 2001 the Centers for Medicare and Medicaid
Services ("CMS," formerly the Health Care Financing Administration) published a
final rule that it characterized as the first phase of what will be a two-phase
final rule, and most of the provisions of part one of this final rule became
effective on January 4, 2002. Although CMS has stated that it intends to publish
phase two shortly, it is unclear when this will occur.
Many states have adopted or are considering legislative proposals similar
to the federal referral prohibition, some of which extend beyond the Medicare
and Medicaid programs to prohibit the payment or receipt of remuneration for the
referral of patients and physician self-referrals regardless of whether the
service was reimbursed by Medicare or Medicaid. These laws and regulations are
extremely complex, and little judicial or regulatory interpretation exists. A
violation of such laws and regulations could have a material adverse effect on
these operators' liquidity, financial condition and results of operations, which
could affect adversely their ability to make rental payments to the Company.
Government investigations and enforcement of healthcare laws has increased
dramatically over the past several years and is expected to continue. The Health
Insurance Portability and Accountability Act of 1996 (Pub. L. 104-191)
("HIPAA"), which became effective January 1, 1997, greatly expanded the
definition of healthcare fraud and related offenses and broadened the scope to
include private healthcare plans in addition to government payors. HIPAA also
greatly increased funding for the Department of Justice, Federal Bureau of
Investigation and the Office of the Inspector General to audit, investigate and
prosecute suspected healthcare fraud. Private enforcement of healthcare fraud
also has increased due in large part to amendments to the civil False Claims Act
in 1986 that were designed to encourage private individuals to sue on behalf of
the government. These whistleblower suits by private individuals, known as qui
tam relators, may be filed by almost anyone, including present and former
patients and nurses and other employees. HIPAA also mandates the adoption by HHS
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. Final privacy regulations became effective in April
2001, with compliance required by April 2003. HIPAA's security regulations have
not yet been finalized. These actions could have a material adverse effect on
these operators' liquidity, financial condition and results of operations, which
could affect adversely their ability to make rental payments to the Company.
The Budget Act also provides a number of additional anti-fraud and abuse
provisions. The Budget Act contains new civil monetary penalties for an
operator's violation of the Anti-kickback Laws and imposes an affirmative duty
on operators to ensure that they do not employ or contract with persons excluded
from the Medicare and other government programs. The Budget Act also provides a
minimum ten-year period for exclusion from participation in federal healthcare
programs for operators convicted of a prior healthcare offense.
Some states require state approval for development and expansion of
healthcare facilities and services, including findings of need for additional or
expanded healthcare facilities or services. A certificate of need ("CON"), which
is issued by governmental agencies with jurisdiction over healthcare facilities,
is at times required for expansion of existing facilities, construction of new
facilities, addition of beds, acquisition of major items of equipment or
introduction of new services. The CON rules and regulations may restrict an
operator's ability to expand the Company's properties in certain circumstances.
In the event that any operator of the Company's properties fails to make
rental payments to the Company or to comply with the applicable healthcare
regulations, and, in either case, such operators or their lenders fail to cure
the default prior to the expiration of the applicable cure period, the ability
of the Company to evict that operator and substitute another operator or
operators may be materially delayed or limited by various state licensing,
receivership, CON or other laws, as well as by Medicare and Medicaid
change-of-ownership rules. Such delays and limitations could have a material
adverse effect on the Company's ability to collect rent, to obtain possession of
leased
12
properties, or otherwise to exercise remedies for tenant default. In addition,
the Company may also incur substantial additional expenses in connection with
any such licensing, receivership or change-of-ownership proceedings.
Long-Term Acute Care Hospitals
Substantially all of the Company's hospitals are operated as long-term
acute care hospitals ("LTACs"). In order to receive Medicare and Medicaid
reimbursement, each hospital must meet the applicable conditions of
participation set forth by HHS 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. Hospitals undergo periodic on-site certification surveys,
which generally are limited if the hospital is accredited by the Joint
Commission on Accreditation of Healthcare Organizations ("JCAHO") or other
recognized accreditation organizations. A loss of certification could adversely
affect a hospital's ability to receive payments from Medicare and Medicaid
programs, which could in turn adversely impact the operator's ability to make
rental payments under its leases with the Company.
An LTAC has an average length of stay greater than 25 days. Hospitals that
are certified by Medicare as LTACs are currently excluded from the prospective
payment system ("PPS") that applies to acute care hospitals. However, a PPS
system for LTACs is scheduled to be in place by October 1, 2002 and applicable
to cost report periods commencing on or after October 1, 2002. See "--Healthcare
Reform" below. Inpatient operating costs for LTACs are reimbursed under a
cost-based reimbursement system, subject to a computed target rate per discharge
for inpatient operating costs established by the Tax Equity and Fiscal
Responsibility Act of 1982 ("TEFRA"), as amended by the Budget Act and the
Medicare, Medicaid, and SCHIP Benefits Improvement and Protection Act of 2000
("BIPA"). Medicare and Medicaid reimbursements generally are determined from
annual cost reports filed by hospital operators that are subject to audit by the
respective agency (or their fiscal agents) administering the program. Under such
programs of cost-based reimbursement, costs which will be accepted for
reimbursement are defined and limited by statutes, regulations and program
policies relating to numerous factors, including necessity, reasonableness,
related-party principles and relatedness to patient care.
Nursing Facilities
The operators of the Company's nursing facilities generally are licensed on
an annual or bi-annual basis and certified annually for participation in the
Medicare and Medicaid programs through various regulatory agencies which
determine compliance with federal, state and local laws. These legal
requirements relate to the quality of the nursing care provided, 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 facilities.
The Budget Act established a prospective payment system for Medicare
skilled nursing facilities ("SNFs") for cost reporting periods beginning on or
after July 1, 1998. The payments received under the SNF prospective payment
system cover all services for Medicare patients, including ancillary services.
The rates for such services were first published in the Federal Register on May
12, 1998, after the consummation of the 1998 Spin Off. Although there has been
some payment relief under the Balanced Budget Refinement Act of 1999
("Refinement Act") and BIPA, there can be no assurance that the reimbursement
levels under the SNF prospective payment system will be sufficient to permit the
Company's operators to satisfy their obligations, including payment of rent
under their leases with the Company. See "--Healthcare Reform."
Healthcare Reform
Healthcare is one of the largest industries in the United States and
continues to attract much legislative interest and public attention. In an
effort to reduce federal spending on healthcare, in 1997 the Federal government
enacted the Budget Act, which contained extensive changes to the Medicare and
Medicaid programs intended to reduce the projected amount of increase in
payments under those programs by $115 billion and $13 billion, respectively,
between 1998 and 2002. Under the Budget Act, annual growth rates for Medicare
were to be reduced from over 10% to approximately 7.5% for the period between
1998 and 2002 based on specific program baseline projections from 1993 to 1997.
Virtually all spending reductions have and will come from healthcare operators
and changes in program components. For certain healthcare providers, including
hospitals, home health agencies, SNFs and hospices, implementation of the Budget
Act resulted in more drastic reimbursement reductions than had been anticipated.
In addition to its impact on Medicare, the Budget Act also afforded states more
flexibility in administering their Medicaid plans, including the ability to
shift most Medicaid enrollees into managed care plans without first obtaining a
federal waiver. Accordingly, the Medicare and Medicaid programs, including
payment levels and methods, are in a state of change and are less predictable
than before enactment of the Budget Act. Further Medicare reform legislation is
currently under consideration by Congress. See "Recent Developments Regarding
Government Regulations."
13
The Budget Act established a prospective payment system for skilled nursing
facilities ("SNF PPS") to be transitioned over a three-year period for cost
reporting periods beginning on or after July 1, 1998. Under the SNF PPS payment
methodology, payment amounts are based upon classifications determined through
assessments of individual Medicare patients in the skilled nursing facility,
rather than on the facility's reasonable costs. The SNF PPS features a case-mix
adjustment that utilizes data derived from a standardized clinical assessment
tool that assesses a patient's needs known as the Minimum Data Set, or MDS. For
SNF PPS purposes, the MDS data are used to classify SNF patients into one of 44
Resource Utilization Groups, Version III ("RUG-III") based on the medical
services and functional support the patient is expected to need. Each RUG-III
group is assigned an index score that factors the amount of staff time,
supplies, and services used, on average, for patients classified in that group.
The payments received under the SNF PPS are intended generally to cover all
inpatient services for Medicare patients, including routine nursing care, most
capital-related costs associated with the inpatient stay, and ancillary
services, such as respiratory therapy, occupational therapy, speech therapy and
certain covered drugs.
Under the SNF PPS, per diem payments are made to nursing home facilities
for each resident. Upon the expiration of the three-year transition period,
these per diem payments would be fully transitioned into the federal SNF PPS
rates. During the transition period, payments are based on a blended rate that
uses both a facility-specific rate and the federal rate. As a result of SNF PPS,
Medicare payments to SNFs dropped by 12.5% in 1999. Additionally, the SNF PPS
forced SNFs to make expensive administrative adjustments to implement the
payment system. Although there has been some payment relief (as described
below), there can be no assurance that the reimbursement levels under the SNF
PPS will be sufficient to permit the Company's operators to satisfy their
obligations, including payment of rent under their leases with the Company.
With respect to Medicaid, the Budget Act repealed the "Boren Amendment"
federal payment standard for Medicaid payments to hospitals and nursing
facilities effective October 1, 1997, giving states greater latitude in setting
payment rates for these providers.
The Budget Act also affected the payments made to LTACs by reducing the
amount of reimbursement for incentive payments established pursuant to the
TEFRA, for capital expenditures and bad debts, and for services to certain
patients transferred from an acute care hospital. In addition, the Budget Act
for the first time imposed a national ceiling limitation or "national cap" on
payments that may be made in each category of hospitals exempt from a
prospective payment system. LTACs constitute one such category. The Budget Act
also mandated the creation of a prospective payment system ("LTAC PPS") for
LTACs.
In response to widespread healthcare industry concern about the effects of
the Budget Act, the Federal government enacted the Refinement Act on November
29, 1999. The Refinement Act did not enact any fundamental changes in the
Medicare system, but rather reversed or delayed some of the reductions in
Medicare payment increases mandated by the Budget Act. It was estimated that in
the four to five fiscal years after its enactment, the Refinement Act would
return to healthcare providers approximately $16 billion of the $115 billion the
Budget Act was expected to cut from increases to the Medicare program. Specific
providers who received relief under the Refinement Act included SNFs, which
received temporary (effective April 1, 2000 to October 1, 2000) per diem payment
increases for certain high cost patients, and outpatient rehabilitation therapy
providers, which received a 2-year moratorium on a $1,500 annual cap on the
amount of physical, occupational and speech therapy provided to a patient.
Pursuant to BIPA, CMS extended the moratorium on the $1,500 annual cap to
December 31, 2002.
In its July 31, 2000 final rule ("Final Refinement Act Rule") refining the
SNF PPS, CMS announced increases in payment rates for fiscal year 2001. In its
earlier proposed rule, issued on April 10, 2000, CMS had detailed proposed
refinements to be made to the SNF PPS case-mix classification system that would
more adequately account for high cost cases. Specifically, the agency developed
new categories of service classifications for payment purposes and proposed to
increase reimbursement rates for higher cost cases using a new index system
based on patient clinical variables. The Final Refinement Act Rule postponed any
such refinements to the SNF PPS case-mix classification system, while retaining
two temporary remedies set forth in the Refinement Act: (a) a 4% increase in the
per diem reimbursement rates for all RUG-III groups in both fiscal years 2001
and 2002; and (2) an additional 20% increase in the per diem reimbursement for
fifteen RUG-III groups falling under the Extensive Services, Special Care,
Clinically Complex, High Rehabilitation and Medium Rehabilitation categories,
applicable to services furnished on or after April 1, 2000, until such time as
case-mix refinements are implemented.
Passed in December 2000, BIPA provided a certain degree of relief from the
projected impact of the Budget Act. Specifically, BIPA modified the impact of
the Refinement Act on SNF PPS payment rates, as implemented by the Final
Refinement Act Rule, in several important ways. First, BIPA revised the annual
market basket update factor upward from "market basket--1%" to (a) "market
basket" in fiscal year 2001, and (b) "market basket--
14
0.5%" in fiscal years 2002 and 2003. Second, BIPA temporarily increased the
nursing component of the federal SNF PPS rate by 16.6%, from April 1, 2001
through September 30, 2002. Finally, BIPA increased the per diem reimbursement
rates for fourteen rehabilitation-related RUG-III groups by 6.7%, from April 1,
2001 until such time as case-mix refinements are implemented pursuant to the
Refinement Act. To date, CMS has not promulgated the SNF PPS case-mix
refinements required by the Refinement Act. As a result, the temporary per diem
payment increases for specified RUG-III groups have been retained for an
unspecified period of time, with certain budget-neutral changes to the size and
allocation of such increases among different RUG-III groups. However, CMS has
indicated that the RUG-III refinements may be incorporated into a final rule
scheduled for release by July 31, 2002 and implementation in fiscal year 2003.
With respect to LTACs, BIPA mandated that HHS implement the LTAC PPS by
October 1, 2002. Unless the Secretary of HHS develops a system of
diagnosis-related groups ("DRGs") specifically refined for LTACs before that
date, the LTAC PPS will be implemented using the DRGs currently used for
inpatient stays in acute care hospitals (modified, if feasible, to account for
the resource usage of long-term care patients, as well as the most recently
available hospital discharge data). In the interim, LTACs continue to be
reimbursed on a reasonable cost basis, subject to a facility-specific target
amount, and subject also to a national cap. For cost reporting periods during
fiscal year 2001, BIPA raised the applicable national cap for LTACs by 2%. BIPA
also raised the target amount for LTACs by 25%, though this revised target
amount cannot exceed the wage-adjusted national cap.
On March 22, 2002, CMS published a proposed rule for LTAC PPS. The Company
is currently analyzing the proposed rule. The public will have 60 days from
March 22, 2002 to review the proposed rule and submit comments. In response to
comments submitted by the public and its own ongoing review of the proposed
rule, CMS may modify the proposed rule before it is adopted in final form. There
can be no assurance as to the content of the final rule for LTAC PPS, nor can we
predict its impact on the Company's tenants and operators.
There can be no assurance that the Budget Act, the Refinement Act, BIPA and
future healthcare legislation, or other changes in the administration or
interpretation of governmental healthcare programs will not have a material
adverse effect on the liquidity, financial condition or results of operations of
the Company's operators which could have a material adverse effect on their
ability to make rental payments to the Company.
Recent Developments Regarding Government Regulation
Recent legislation and implementing regulations set forth revised payment
mechanisms for skilled nursing facility and long-term care hospital services.
The precise overall economic impact of new laws and other recent developments is
under review by the long-term care industry and by the Company and its
operators.
In its annual update for 2002 ("2002 Final Rule"), CMS announced SNF
payment increases effective October 1, 2001. The 2002 Final Rule reflects an
update using a 2.8% market basket and is intended to implement both Refinement
Act and BIPA adjustments. The rule reflects the Refinement Act's and BIPA's
temporary increase to the per diem adjusted payment rates to certain RUG-III
groups, as well as BIPA's 16.6% adjustment to the nursing component of the
Federal rate. These increases are to continue until the implementation of
case-mix refinements. Also provided in the 2002 Final Rule is the Refinement
Act's 4% increase in the adjusted Federal rate for fiscal year 2002. There can
be no assurance that the give back provisions under the Refinement Act and BIPA
will continue after September 30, 2002.
The 16.6% temporary increase to the nursing home RUG-III groups and the 4%
add-on for all RUG-III groups provided under the Refinement Act and BIPA expire
on September 30, 2002. Expiring provisions are estimated to, on average, reduce
per beneficiary per diems by $57. Moreover, CMS has informally indicated that it
intends to complete refinements to the SNF PPS as part of the upcoming fiscal
year 2003 rulemaking. Under applicable law, when these revisions are
implemented, the 6.7% increase for rehabilitation patients and the 20% add-on
for medically complex patients authorized under the Refinement Act and BIPA will
expire.
LTACs, which are currently excluded from a prospective payment system, are
scheduled to transition to LTAC PPS by October 1, 2002. The new prospective
payment system for LTACs would apply to cost report periods beginning on or
after October 1, 2002. The Company believes that the new prospective payment
system would impact Kindred no sooner than September 1, 2003. As noted
previously, if HHS cannot implement a prospective payment system specific to
LTACs by October 1, 2002, it is required to instead implement a prospective
payment system based upon existing acute care hospital diagnosis-related groups
that have been modified where possible to account for resource usage of LTAC
patients. On March 22, 2002, CMS published a proposed rule for LTAC PPS. The
Company is currently analyzing the proposed rule. The public will have 60 days
from March 22, 2002 to review the proposed rule and submit comments. In response
to comments submitted by the public and its own ongoing review of the proposed
rule, CMS may modify the proposed rule before it is adopted in final form.
There can be no assurance as to the content of the final rule for LTAC PPS, nor
can we predict its impact on the Company's tenants and operators. The Company
believes that the new prospective payment system would impact Kindred no sooner
than September 1, 2003.
On November 20, 2001, CMS announced a proposed regulation ("Proposed
Regulation") to restrict the "upper-payment limit loophole" in Medicaid. The
Proposed Regulation revises a provision of an earlier regulation published on
January 12, 2001 that allowed states to make overall payments to public
non-state government owned or operated hospitals of up to 150 percent of the
estimated amount that would be paid under Medicare for the same
15
services. Under the Proposed Regulation, these payments would be limited to 100
percent of estimated Medicare payments, which is the limit for all other
hospitals. The resulting effect of the Proposed Rule is that states may
implement rate or service cuts to providers (including SNFs) to compensate for
reduced federal funding. To date, CMS has not issued the final regulations.
Approximately two-thirds of all nursing home residents are dependent on
Medicaid. Medicaid reimbursement rates, however, typically are less than the
amounts charged by the operators of the Company's properties. Moreover, rising
Medicaid costs and decreasing state revenues caused by the current recession
have prompted an increasing number of states to cut Medicaid funding as a means
of balancing their respective state budgets. Existing and future initiatives
affecting Medicaid reimbursement may reduce utilization of (and reimbursement
for) services offered by the operators of the Company's properties.
There can be no assurance that future healthcare legislation or changes in
the administration or implementation of governmental healthcare reimbursement
programs will not have a material adverse effect on the liquidity, financial
condition or results of operations of the Company's operators and tenants which
could have a material adverse effect on their ability to make rental payments to
the Company which, in turn, could have a material adverse effect on the
business, financial condition, results of operation and liquidity of the Company
and on the Company's ability to service its indebtedness and its obligations
under the United States Settlement and on the Company's ability to make
distributions to its stockholders as required to continue to qualify as a REIT
(a "Material Adverse Effect").
Federal Income Tax Considerations
The Company elected to qualify as a REIT for federal income tax purposes
for the year ended December 31, 1999. The Company believes that it has satisfied
the requirements to qualify as a REIT for the years ended December 31, 2000 and
2001. The Company intends to continue to qualify as a REIT for federal income
tax purposes for the year ended December 31, 2002 and subsequent years subject
to its ability to meet the minimum distribution requirements as discussed below.
The Company's continued qualification and taxation as a REIT will depend upon
its ability to meet on a continuing basis, through actual annual operating
results, distribution levels, and stock ownership, the various qualification
tests imposed under the Code. These tests are discussed below. No assurance can
be given that the actual results of the Company's operations for any particular
taxable year will satisfy such requirements. Although the Company believes it
has satisfied the requirements to continue to qualify as a REIT for years ended
December 31, 2000 and 2001 and although the Company currently intends to
continue to qualify as a REIT for the year ended December 31, 2002 and
subsequent years, it is possible that economic, market, legal, tax or other
considerations may cause the Company to fail, or elect not, to continue to
qualify as a REIT. For a discussion of the tax consequences of failing to
continue to qualify as a REIT, see "--Failure to Continue to Qualify," below.
The discussion of "Federal Income Tax Considerations" set forth herein is
not exhaustive of all possible tax considerations and is not tax advice.
Moreover, this summary does not deal with all tax aspects that might be relevant
to a particular stockholder in light of such stockholder's circumstances, nor
does it deal with particular types of stockholders that are subject to special
treatment under the Code, such as insurance companies, financial institutions
and broker-dealers. The Code provisions governing the federal income tax
treatment of REITs are highly technical and complex, and this summary is
qualified in its entirety by the applicable Code provisions, rules and Treasury
regulations promulgated thereunder, and administrative and judicial
interpretations thereof. The following discussion is based on current law, which
could be changed at any time, possibly retroactively.
Federal Income Taxation of the Company
If the Company continues to qualify for taxation as a REIT, it generally
will not be subject to federal corporate income tax on net income that it
currently distributes to stockholders. This treatment substantially eliminates
the "double taxation" (i.e., taxation at both the corporate and stockholder
levels) that generally results from investment in a corporation. Notwithstanding
its qualification as a REIT, the Company will be subject to federal income tax
in the following circumstances. First, the Company will be taxed at regular
corporate rates on any undistributed taxable income, including undistributed net
capital gains. Second, under certain circumstances, the Company may be subject
to the "alternative minimum tax" on its undistributed items of tax preference.
Third, if the Company has (i) net income from the sale or other disposition of
"foreclosure property" (which is, in general, property acquired by foreclosure
or otherwise on default of a loan secured by the property or property
repossessed by the Company upon dispossessing a tenant after a lease default)
that is held primarily for sale to customers in the ordinary course of business
or (ii) other non-qualifying income from foreclosure property, it will be
subject to tax at the highest corporate rate on such income. Fourth, if the
Company has net income from "prohibited transactions" (which are, in general,
certain sales or other dispositions of property (other than foreclosure
property) held primarily for sale to
16
customers in the ordinary course of business), such income will be subject to a
100% tax. Fifth, if the Company should fail to satisfy the 75% gross income test
or the 95% gross income test (as discussed below), and has nonetheless
maintained its qualification as a REIT because certain other requirements have
been met, it will be subject to a 100% tax on the product of (a) the gross
income attributable to the greater of the amount by which the Company fails the
75% or 95% gross income test, and (b) a fraction intended to reflect the
Company's profitability. Sixth, if the Company should fail to distribute during
each calendar year at least the sum of (i) 85% of its REIT ordinary income for
such year, (ii) 95% of its REIT capital gain net income for such year (other
than retained long-term capital gain the Company elects to treat as having been
distributed to stockholders), and (iii) any undistributed taxable income from
prior years, the Company would be subject to a non-deductible 4% excise tax on
the excess of such required distribution over the amounts actually distributed.
Seventh, if the Company should receive rents from a tenant deemed not to be fair
market value rents, or if the Company values its assets incorrectly, the Company
may be liable for valuation penalties. Finally, if the Company acquires any
asset from a C corporation (i.e., a corporation generally subject to full
corporate level tax) in a transaction in which the basis of the asset in the
Company's hands is determined by reference to the basis of the asset (or any
other asset) in the hands of the C corporation, and the Company recognizes gain
on the disposition of such asset during the 10-year period (the "Recognition
Period") beginning on the date on which such asset was acquired by the Company,
then, to the extent of such asset's "Built-in Gain" (i.e., the excess of the
fair market value of such property at the time of acquisition by the Company
over the adjusted basis of such asset at such time), such gain will be subject
to tax at the highest regular corporate rate (the "Built-in Gain Rules")).
The Company owns appreciated assets that it held on January 1, 1999, the
effective date of its REIT election. These assets are subject to the Built-in
Gain Rules discussed above because the Company was a taxable C corporation prior
to January 1, 1999. If the Company recognizes taxable gain upon the disposition
of any of these assets within the ten-year Recognition Period, the Company
generally will be subject to regular corporate income tax on the gain equal to
the lower of (a) the recognized gain at the time of the disposition and (b) the
Built-in Gain in that asset as of January 1, 1999. The total amount of gain on
which the Company can be taxed under the Built-in Gain Rules is limited to its
net built-in gain at the time it became a REIT, i.e., the excess of the
aggregate fair market value of its assets at the time it became a REIT over the
adjusted tax bases of those assets at that time. Some but not all of such
capital gains realized would be offset by the amount of any available capital
loss carryforwards. In connection with the sale of any assets, all or a portion
of such gain could be treated as ordinary income instead of capital gain and be
subject to taxation and/or the minimum REIT distribution requirements. See
"--Annual Distribution Requirements" below.
Requirements for Qualification
To continue to qualify as a REIT, the Company must continue to meet the
requirements discussed below, relating to the Company's organization, sources of
income, nature of assets and distributions of income to stockholders.
Organizational Requirements
The Code defines a REIT as a corporation, trust or association (i) that is
managed by one or more directors or trustees; (ii) the beneficial ownership of
which is evidenced by transferable shares or by transferable certificates of
beneficial interest; (iii) that would be taxable as a domestic corporation, but
for Sections 856 through 859 of the Code; (iv) that is neither a financial
institution nor an insurance company subject to certain provisions of the Code;
(v) the beneficial ownership of which is held by 100 or more persons during at
least 335 days of a taxable year of 12 months, or during a proportionate part of
a shorter taxable year (the "100 Shareholder Rule"); (vi) not more than 50% in
value of the outstanding stock of which is owned, directly or indirectly, by
five or fewer individuals (as defined in the Code to include certain entities)
during the last half of each taxable year (the "5/50 Rule"); (vii) that makes an
election to be a REIT (or has made such election for a previous taxable year)
and satisfies all relevant filing and other administrative requirements
established by the Internal Revenue Service that must be met in order to elect
and to maintain REIT status; (viii) that uses a calendar year for federal income
tax purposes; and (ix) that meets certain other tests, described below,
regarding the nature of its income and assets.
For purposes of the 5/50 Rule, an unemployment compensation benefits plan,
a private foundation or a portion of a trust permanently set aside or used
exclusively for charitable purposes generally is considered an individual. A
trust that is a qualified trust under Section 401(a) of the Code, however,
generally is not considered an individual and the beneficiaries of such trust
are treated as holding shares of a REIT in proportion to their actuarial
interests in such trust for purposes of the 5/50 Rule. Certain entities,
including entities that file Schedules 13 D, F or G with the Commission, are not
treated as a single owner under the 5/50 Rule. For purposes of the 5/50 Rule,
the beneficial owners of such entities are deemed to be the owners of the
Company's Common Stock. A REIT will be treated as having satisfied the 5/50 Rule
if it complies with certain regulations for ascertaining the ownership of its
stock and if
17
it did not know (or after the exercise of reasonable diligence would not have
known) that its stock was sufficiently closely held to cause it to violate the
5/50 Rule. See "--Annual Record Keeping Requirements" below.
In order to prevent a concentration of ownership of the Company's stock
that would cause the Company to fail the 5/50 Rule or the 100 Shareholder Rule,
the Company amended its Certificate of Incorporation on April 30, 1998 to
provide that, except with the consent of the Company's Board of Directors, no
holder (with certain exceptions) is permitted to own, either actually or
constructively under the applicable attribution rules of the Code, more than
9.0% of the Common Stock or 9.9% of any class of preferred stock issued by the
Company. Certain persons (an "Existing Holder") who owned stock in the Company
in excess of the foregoing limits on April 30, 1998 (the date that the
Certificate of Incorporation was amended) are not subject to the general
ownership limits applicable to other stockholders; rather, Existing Holders
generally are permitted to own up to the same percentage of the Company's
outstanding stock that they owned on April 30, 1998. No holder, however, is
permitted to own, either actually or constructively under the applicable
attribution rules of the Code, any shares of any class of the Company's stock if
such ownership would cause more than 50% in value of the Company's outstanding
stock to be owned by five or fewer individuals or would result in the Company's
stock being beneficially owned by fewer than 100 persons (determined without
reference to any rule of attribution).
Since the date of the 1998 Spin Off, Tenet Healthcare Corporation ("Tenet")
has owned approximately 12% of the Company's issued and outstanding Common Stock
and, therefore, is treated as an Existing Holder under the Company's Certificate
of Incorporation. Except as explained below, as an Existing Holder, Tenet is
generally permitted to own in excess of the ownership limits in the Company's
Certificate of Incorporation.
As permitted by its certificate of incorporation, the Company previously
granted waivers of the ownership limitations to certain stockholders of the
Company. These waivers initially permitted such stockholders to own over 10% of
the Common Stock of the Company but in no event more than 15% of the Common
Stock. These waivers have either been terminated in their entirety or have been
subsequently revised to restrict the ownership of Common Stock by any such
stockholder to less than 10% of the Company's issued and outstanding Common
Stock. The Company believes that no stockholder, other than Tenet, owns 10% or
more of the Company's issued and outstanding Common Stock, as measured by the
Code.
To qualify as a REIT, a corporation may not have (as of the end of the
taxable year) any earnings and profits that were accumulated in periods before
it elected REIT status. The Company believes that at December 31, 1999 it did
not have any accumulated earnings and profits that are attributable to periods
during which the Company was not a REIT, although the IRS would be entitled to
challenge that determination. For taxable years beginning after 2000 (and the
Company believes for the taxable year 2000), a distribution made to meet the
requirement that a REIT may not have non-REIT earnings and profits will be
treated, on a first-in, first-out basis, as made from earnings and profits.
Thus, such earnings and profits are deemed distributed first from earnings and
profits that would cause such a failure, starting with the earliest Company year
for which such failure would occur.
Section 856(i) of the Code provides that a corporation that is a "Qualified
REIT Subsidiary" will not be treated as a separate corporation for federal
income tax purposes, and all assets, liabilities, and items of income, deduction
and credit of a qualified REIT subsidiary will be treated as assets,
liabilities, and items of income, deduction, and credit of the REIT. A
"qualified subsidiary" is defined as any wholly owned corporate subsidiary of a
REIT. The Company currently has two qualified REIT subsidiaries, Ventas
Specialty I, Inc. and Ventas Finance I, Inc.
Pursuant to Treasury Regulations relating to entity classification (the
"Check-the-Box Regulations"), an unincorporated entity that has a single owner
is disregarded as an entity separate from its owner for federal income tax
purposes. The Company directly owns a 99% general partnership interest in Ventas
Realty and indirectly owns the remaining 1% limited partnership interest in
Ventas Realty through a wholly owned limited liability company. Under the
Check-the-Box Regulations, the limited liability Company, and therefore Ventas
Realty, is disregarded as an entity separate from the Company for federal income
tax purposes. Similarly, Ventas Specialty I, LLC and Ventas Finance I, LLC,
formed in connection with the CMBS Transaction, are also wholly owned, single
member limited liability companies that are disregarded for federal income tax
purposes.
In the case of a REIT that is a partner in a partnership, Treasury
regulations provide that the REIT will be deemed to own its proportionate share
of the assets of the partnership and will be deemed to be entitled to the income
of the partnership attributable to such share. In addition, the character of the
assets and gross income of the partnership will retain the same character in the
hands of the REIT for purposes of the income and asset tests described below. If
and when Ventas Realty were to admit a partner other than the Company, a
subsidiary of the Company, or an entity that is disregarded under the
Check-the-Box Regulations as an entity separate from the Company, the Company's
proportionate share of the assets and gross income of Ventas Realty would be
treated as
18
the assets and gross income of the Company for purposes of applying the
requirements described herein.
Income Tests
To continue to qualify as a REIT, the Company must satisfy certain annual
gross income requirements. First, at least 75% of the Company's gross income
(excluding gross income from prohibited transactions) for each taxable year must
consist of defined types of income derived directly or indirectly from
investments relating to real property or mortgages on real property (including
"rents from real property" (defined below)) and, in certain circumstances,
interest on certain types of temporary investment income. Second, at least 95%
of the Company's gross income (excluding gross income from prohibited
transactions) for each taxable year must be derived from such real property or
temporary investments, dividends, interest and gain from the sale or disposition
of stock or securities, or from any combination of the foregoing.
Substantially all of the Company's gross income is derived from leasing its
properties to Kindred under the Master Leases. Rents received or deemed received
by the Company under its leases (including the Master Leases) will qualify as
"rents from real property" in satisfying the gross income requirements described
above only if the Company's leases are respected as "true" leases for federal
income tax purposes and are not treated as service contracts, joint ventures, or
some other type of arrangement. The determination of whether the Company's
leases are true leases depends on an analysis of all the surrounding facts and
circumstances. In making such a determination, courts have considered a variety
of factors, including the following: (i) the intent of the parties, (ii) the
form of the agreement, (iii) the degree of control over the property that is
retained by the property owner (e.g., whether the lessee has substantial control
over the operation of the property or whether the lessee was required to use its
best efforts to perform its obligations under the agreement), and (iv) the
extent to which the property owner retains the risk of loss with respect to the
property (e.g., whether the lessee bears the risk of increases in operating
expenses or the risk of damage to the property) or the potential for economic
gains (e.g., appreciation) with respect to the property. Based upon advice of
counsel at the time the Master Leases were negotiated, the Company believes that
its leases should be treated as "true" leases for federal income tax purposes.
Investors should be aware, however, that there are no controlling Treasury
regulations, published rulings, or judicial decisions involving leases with
terms substantially the same as the Company's leases that discuss whether such
leases constitute true leases for federal income tax purposes. If the leases are
recharacterized as service contracts or partnership agreements, rather than true
leases, part or all of the payments that the Company receives from its tenants
would not be considered rent or would not otherwise satisfy the various
requirements for qualification as "rents from real property." In that case, the
Company likely would not be able to satisfy either the 75% or the 95% gross
income tests, and, as a result, would lose its REIT status.
Assuming that the Company's leases are "true" leases for tax purposes,
rents received by the Company will qualify as "rents from real property" for
purposes of the REIT gross income tests only if several additional conditions
are satisfied. First, the amount of rent generally must not be based in whole or
in part on the income or profits of any person. However, an amount received or
accrued generally will not be excluded from the term "rents from real property"
solely by reason of being based on a fixed percentage or percentages of receipts
or sales.
Second, amounts received from a tenant will not qualify as "rents from real
property" if the Company, or an owner of 10% or more of the Company, directly or
constructively is deemed to own 10% or more of the ownership interests in the
tenant (a "Related Party Tenant").
Third, if rent attributable to personal property, leased in connection with
a lease of real property, is greater than 15% of the total rent received under
the lease (based on the fair market values after 2000), then the portion of rent
attributable to such personal property will not qualify as "rents from real
property."
Finally, for rents received to qualify as "rents from real property," the
Company generally must not operate or manage the property or furnish or render
services to the tenants of such property, other than through an "independent
contractor" who is adequately compensated and from whom the Company derives no
income. The "independent contractor" requirement, however, does not apply to the
extent that the services provided by the Company are "usually or customarily
rendered in connection with the rental of space for occupancy only," which are
services of a type that a tax-exempt organization can provide to its tenants
without causing its rental income to be unrelated business taxable income
("UBTI"). In addition, the "independent contractor" requirement does not apply
to noncustomary services provided by the Company, the annual value of which does
not exceed 1% of the gross income derived from the property with respect to
which the services are provided (the "1% de minimis exception"). For this
purpose, such services may not be valued at less than 150% of the Company's
direct cost of providing the services. An "independent contractor" is defined as
an entity that does not own (directly or indirectly) more than 35% of the
Company's stock or an entity not more than 35% owned (directly or indirectly) by
persons who own more than 35% of the Company's stock. If any class of stock of
the Company or the person being tested as
19
an independent contractor is regularly traded on an established securities
market, only persons who directly or indirectly own 5% or more of such class of
stock shall be counted in determining whether the 35% ownership limitations have
been exceeded. Certain of the foregoing rules are modified if the Company forms
a taxable REIT Subsidiary. See "--Taxable REIT Subsidiary."
The Company does not believe that it has, and does not anticipate that it
will in the future, (i) charged/charge rent that is based in whole or in part on
the income or profits of any person (except by reason of being based on a fixed
percentage or percentages of receipts or sales consistent with the rule
described above), (ii) derived/derive rent attributable to personal property
leased in connection with real property that exceeds 15% of the total rents,
(iii) derived/derive rent attributable to a Related Party Tenant, or (iv)
provided/provide any noncustomary services to tenants other than through
qualifying independent contractors, except as permitted by the 1% de minimis
exception or to the extent that the amount of resulting nonqualifying income
would not cause the Company to fail to satisfy the 95% and 75% gross income
tests.
Related Party Tenant
The Company leases substantially all of its properties to Kindred and
Kindred is the primary source of the Company's rental revenues. Under the
Kindred Reorganization Plan, Ventas Realty received 1,498,500 shares of Kindred
common stock on the Kindred Effective Date. Under the Code, if the Company owns
10% or more of any class of Kindred's issued and outstanding voting securities
or 10% or more of the value of any class of Kindred's issued and outstanding
securities (the "10% securities test"), Kindred would be a Related Party Tenant.
As a Related Party Tenant, the Company's rental revenue from Kindred would not
qualify as "rents from real property" and the Company would lose its REIT status
because it likely would not be able to satisfy either the 75% or the 95% gross
income test. The Company's loss of REIT status would have a Material Adverse
Effect on the Company.
Since the Kindred Effective Date, Kindred has issued additional common
stock and Ventas Realty has disposed of 418,186 shares of its Kindred common
stock. As of January 22, 2002, the Company owned 1,080,314 shares of Kindred
common stock or not more than 6.2% of the issued and outstanding shares of
Kindred. Based upon applicable tax authorities and decisions and advice from the
Internal Revenue Service, the Company believes that for purposes of the 10%
securities test, its ownership percentage in Kindred has been and will continue
to be less than 9.99%.
A number of safeguards are in place to reduce the risk of the Company's
violation of the 10% securities test as a result of its ownership of Kindred
common stock including: (a) a provision in Kindred's corporate charter requiring
Kindred, at the Company's sole option, to purchase a portion of the Company's
Kindred common stock in the event Kindred proposes to enter into a transaction
which would cause the Company to violate the 10% securities test, and (b) the
Company's ability to sell the Kindred common stock to a third party or
distribute the Kindred common stock to its stockholders, subject to compliance
with the registration requirements of the Securities Act. See "-- Recent
Developments Regarding Kindred--Registration Rights Agreement."
The Company believes that the only greater than 10% stockholder of the
Company's Common Stock, as measured by the Code, is Tenet. Since the date of the
1998 Spin Off, Tenet has owned approximately 12% of the Company's issued and
outstanding Common Stock. Certain provisions under the Code provide that any
ownership interest in Kindred that Tenet may purchase may be attributed to the
Company. Any such attribution could cause to Company to violate the 10%
securities test and lose its REIT status unless under applicable laws, rules and
regulations or interpretations, the Company is otherwise deemed not to have
violated the 10% securities test. To reduce the likelihood of such an
occurrence, the Company has implemented certain protective measures. As part of
the Kindred Reorganization Plan, the Company negotiated for the inclusion of
Article Tenth of the Kindred Corporate Charter. Article Tenth of the Kindred
Corporate Charter, which became effective on the Kindred Effective Date, is
designed to prohibit Tenet from gaining beneficial ownership of any Kindred
common stock if such ownership when combined with the Company's ownership would
exceed 9.9% of any class of stock or all stock in the aggregate. If Tenet should
nevertheless violate this provision, either directly or as a result of the
attribution rules under the Code, any shares of the Kindred common stock so
purchased by or attributed to Tenet will automatically, without any action by
any party, become "Excess Stock" in Kindred and will be deemed to be owned by a
trust for the benefit of a third party and Tenet will have no legal title to
such "Excess Stock" in Kindred. Tenet would have the limited right to receive
certain distributions on and a certain portion of the proceeds of a sale of such
"Excess Stock" in Kindred.
In addition, under the Company's Certificate of Incorporation, under a
formal interpretation by the Board of Directors, if Tenet should purchase any
Kindred common stock while Tenet owns in excess of 10% of the Company's Common
Stock, then all of Tenet's holdings of the Company's Common Stock in excess of
9.9% will automatically become "Excess Shares" in the Company and will be deemed
to be owned by a trust for the benefit
20
of a third party and Tenet would have no legal title to such "Excess Shares" in
the Company. Tenet would have the limited right to receive certain distributions
on and a certain portion of the proceeds of a sale of such Excess Shares in the
Company.
While the Company believes that these and other safeguards which have been
instituted by the Company are adequate, there can be no assurances that such
safeguards will be adequate to prevent the Company from violating the 10%
securities test. If the Company should ever violate the 10% securities test, the
Company would lose its status as a REIT which would have a Material Adverse
Effect on the Company.
If the Company fails to satisfy one or both of the 75% or 95% gross income
tests for any taxable year, it may nevertheless continues to qualify as a REIT
for such year if it is entitled to relief under certain provisions of the Code.
These relief provisions generally will be available if the Company's failure to
meet such tests was due to reasonable cause and not due to willful neglect, the
Company attaches a schedule of the sources of its income to its return and any
incorrect information on the schedules was not due to fraud with intent to evade
tax. It is not possible, however, to state whether in all circumstances the
Company would be entitled to the benefit of these relief provisions. Even if
these relief provisions were to apply, a tax would be imposed with respect to
the excess net income.
Foreclosure Property
General
The foreclosure property rules permit the Company (by the Company's
election) to foreclose or repossess properties without being disqualified as a
result of receiving income that does not qualify under the gross income tests;
however, a corporate tax is imposed upon net income from "foreclosure property"
that is not otherwise "good REIT" income. Detailed rules specify the calculation
of the tax. The after tax amount increases the amount the REIT must distribute
each year.
"Foreclosure property" includes any real property and any personal property
incident to such real property acquired by bid at foreclosure or by agreement or
process of law after there was a default or a default was imminent on the leased
property. During a 90-day grace period, the Company may operate the foreclosed
property without an "independent contractor" or qualifying lessee. The 90-day
grace period will begin on the date the Company acquires possession of the
property.
To maintain foreclosure property treatment after the 90 day grace period,
the Company must cause the property to be managed by an "independent contractor"
(from whom the Company derives or receives no income) or lease the property
pursuant to a lease qualifying as a true lease for income tax purposes to an
unrelated third party. Ownership of the tenant must not be attributed to the
Company in violation of the related tenant rule of Section 856(d)(2)(B)
(relating to 10% or more owned tenants). If the property is leased to a third
party under a true lease, the foreclosure property rules are not then relevant.
Foreclosure property treatment will end on the first day on which the REIT
enters into a lease of the property that will give rise to income that is not
good rental income under Section 856(c)(3). In addition, foreclosure property
treatment will end if any construction takes place on the property (other than
completion of a building, or other improvement more than 10 percent complete
before default became imminent). Foreclosure property treatment is available for
an initial period of three years, provided that such treatment may be extended
up to six years.
Healthcare Properties
The Company is permitted to terminate leases of "qualified healthcare
properties" other than by reason of default or imminent default. In addition,
the Company may treat "qualified healthcare properties" as foreclosure property
at the time a lease comes to an end. Except as noted below, healthcare
foreclosure properties are subject to the foreclosure property tax and other
rules under the general foreclosure property rules.
The differences between this special healthcare rule and the general
foreclosure rule are that (i) the initial foreclosure property period is for two
rather than three years, although it may be extended for the same aggregate six
years, (ii) the lease may be terminated without requirement of default, and
(iii) income from the independent contractor is disregarded to the extent such
income is attributable to any lease of property in effect on the date of
acquisition or any lease of property entered into after such date if on such
date a lease of the new property from the REIT was in effect, and under the
terms of the new lease, the REIT receives no more than substantially the same
benefit in comparison to the lease previously in effect.
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A "qualified healthcare property" includes any real property and any
personal property incident to such real property which is a "healthcare
facility" or is necessary or incidental to the use of a healthcare facility. The
qualified healthcare facility may be operated by an independent contractor from
whom the REIT does not derive or receive any income other than certain
qualifying lease income from an independent contractor.
Asset Tests
At the close of each quarter of its taxable year, the Company must satisfy
two tests relating to the nature of its assets. First, at least 75% of the value
of the Company's total assets must be represented by cash or cash items
(including certain receivables), government securities, "real estate assets" or,
in cases where the Company raises new capital through stock or long-term
(maturity of at least five years) debt offerings, temporary investments in stock
or debt instruments during the one-year period following the Company's receipt
of such capital (the "75% asset test"). The term "real estate asset" includes
interests in real property, interests in mortgages on real property to the
extent the mortgage balance does not exceed the value of the associated real
property, and shares of other REITs. For purposes of the 75% asset test, the
term "interest in real property" includes an interest in land and improvements
thereon, such as buildings or other inherently permanent structures (including
items that are structural components of such buildings or structures), a
leasehold in real property and an option to acquire real property (or a
leasehold in real property). Second, of the investments not included in the 75%
asset class, the value of any one issuer's debt and equity securities owned by
the Company (other than the Company's interest in any entity classified as a
partnership for federal income tax purposes, or the stock of a qualified REIT
subsidiary) may not exceed 5% of the value of the Company's total assets (the
"5% asset test"), and the Company may not own more than 10% of any one issuer's
outstanding voting securities or 10% of the value of any one issuer's
outstanding securities, subject to limited "safe harbor" exceptions for certain
straight debt obligations (except for the Company's ownership interest in an
entity that is disregarded for federal income tax purposes, that is classified
as a partnership for federal income tax purposes or that is the stock of a
qualified REIT subsidiary) (previously defined as the "10% securities test"). In
addition, no more than 20% of the value of the Company's assets can be
represented by securities of Taxable REIT Subsidiaries (as defined below).
If the Company should fail to satisfy the asset tests at the end of a
calendar quarter except for its first calendar quarter, such a failure would not
cause it to fail to qualify as a REIT or to lose its REIT status if (i) it
satisfied all of the asset tests at the close of the preceding calendar quarter
and (ii) the discrepancy between the value of the Company's assets and the asset
test requirements arose from changes in the market values of its assets and was
not wholly or partly caused by an acquisition of nonqualifying assets. If the
condition described in clause (ii) of the preceding sentence were not satisfied,
the Company still could avoid disqualification by eliminating any discrepancy
within 30 days after the close of the calendar quarter in which it arose. The
Company intends to maintain adequate records of the value of its assets to
ensure compliance with the asset tests and to take such other actions as may be
required to comply with those tests.
The Company believes it has been and will continue to be in compliance with
the 10% securities test and the 5% asset test. However, there can be differing
opinions as to the methods of calculating compliance with these tests and as to
the value of the Company's assets (including the valuation of the Kindred common
stock) for purposes of these tests. Therefore, there can be no assurance the
Company is or will continue to be in compliance with either of these tests. If
the Company failed to satisfy either of these tests, the Company would lose its
REIT status. If the Company lost its status as a REIT, it would have a Material
Adverse Effect on the Company.
Taxable REIT Subsidiaries
The Company is permitted to own up to 100% of a "Taxable REIT Subsidiary."
To qualify as a taxable REIT subsidiary, both the Company and the subsidiary
corporation must join in an election to treat the subsidiary corporation as a
taxable REIT subsidiary. In addition, any corporation (other than a REIT or a
qualified REIT subsidiary) of which a taxable REIT subsidiary owns, directly or
indirectly, more than 35 percent of the vote or value is automatically treated
as a taxable REIT subsidiary.
A taxable REIT subsidiary can provide services to tenants of the Company's
properties (even if such services were not considered services customarily
furnished in connection with the rental of real property), and can manage or
operate properties, generally for third parties, without causing amounts
received or accrued directly or indirectly by the Company for such activities to
fail to be treated as rents from real property. However, rents paid to the
Company generally are not qualified rents if the Company owns more than 10% (by
vote or value) of the corporation paying the rents. Nevertheless, qualified
rents do include rents that are paid by taxable REIT subsidiaries and that also
meet a limited rental exception (where 90% of space is leased to third parties
at comparable rents) and an exception for rents from certain lodging facilities
(operated by an independent contractor).
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Moreover, the taxable REIT subsidiary cannot directly or indirectly operate
or manage a lodging or healthcare facility, subject to special rules for certain
lodging facilities.
Also, the taxable REIT subsidiary generally cannot provide to any person
rights to any brand name under which hotels or healthcare facilities are
operated, unless the rights are provided to an independent contractor to operate
or manage a lodging facility, if the rights are held by the taxable REIT
subsidiary as licensee or franchisee and the lodging facility is owned by the
taxable REIT subsidiary or leased to it by the Company.
The taxable REIT subsidiary cannot deduct interest in any years that would
exceed 50% of the taxable REIT subsidiary's adjusted gross income. If any amount
of interest, rent, or other deductions of the taxable REIT subsidiary for
amounts paid to the Company is determined to be other than at arm's length
(