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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
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FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2002
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 001-14057
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KINDRED HEALTHCARE, INC.
(Exact name of registrant as specified in its charter)
Delaware 61-1323993
(State or other (I.R.S. Employer
jurisdiction of Identification Number)
incorporation or
organization)
680 South Fourth Street
Louisville, Kentucky 40202-2412
(Address of principal (Zip Code)
executive offices)
(502) 596-7300
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12(b) of the Act:
Name of Each Exchange on
Title of Each of Class which Registered
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None None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.25 per share
Series A Warrants to Purchase Common Stock
Series B Warrants to Purchase Common Stock
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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K ((S)229.405 of this chapter) is not contained herein, and
will not be contained, to the best of Registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment of this Form 10-K. [X]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [_]
As of January 31, 2003, there were 17,648,857 shares of the Registrant's
common stock, $0.25 par value, outstanding. The aggregate market value of the
shares of the Registrant held by non-affiliates of the Registrant, based on the
closing price of such stock on the Nasdaq on June 28, 2002, was approximately
$325,138,000. For purposes of the foregoing calculation only, all directors and
executive officers of the Registrant have been deemed affiliates.
Indicate by check mark whether the Registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [X] No [_]
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Proxy Statement for the Annual Meeting of
Shareholders to be held on May 22, 2003 are incorporated by reference into Part
III of this Form 10-K.
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TABLE OF CONTENTS
Page
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PART I
Item 1. Business............................................................................. 3
Item 2. Properties........................................................................... 42
Item 3. Legal Proceedings.................................................................... 42
Item 4. Submission of Matters to a Vote of Security Holders.................................. 45
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters................ 47
Item 6. Selected Financial Data.............................................................. 48
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 49
Item 7A. Quantitative and Qualitative Disclosures About Market Risk........................... 73
Item 8. Financial Statements and Supplementary Data.......................................... 73
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. 74
PART III
Item 10. Directors and Executive Officers of the Registrant................................... 74
Item 11. Executive Compensation............................................................... 74
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters.................................................................. 74
Item 13. Certain Relationships and Related Transactions....................................... 76
Item 14. Controls and Procedures.............................................................. 76
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K..................... 77
2
PART I
Item 1. Business
GENERAL
Kindred Healthcare, Inc. provides long-term healthcare services primarily
through the operation of nursing centers and hospitals. At December 31, 2002,
our health services division operated 285 nursing centers (37,376 licensed
beds) in 32 states and a rehabilitation therapy business. Our hospital division
operated 65 hospitals (5,385 licensed beds) in 24 states and an institutional
pharmacy business. All references in this Annual Report on Form 10-K to
"Kindred," "our Company," "we," "us," or "our" mean Kindred Healthcare, Inc.
and, unless the context otherwise requires, its consolidated subsidiaries.
On April 20, 2001 (the "Effective Date"), we emerged from proceedings under
Chapter 11 of Title 11 of the United States Code (the "Bankruptcy Code")
pursuant to the terms of our Fourth Amended Joint Plan of Reorganization (the
"Plan of Reorganization"). On March 1, 2001, the United States Bankruptcy Court
for the District of Delaware (the "Bankruptcy Court") approved our Plan of
Reorganization. In connection with our emergence, we changed our name to
Kindred Healthcare, Inc. See "- Our Reorganization."
From the filing for protection under the Bankruptcy Code on September 13,
1999 through the Effective Date, we operated our businesses as a
debtor-in-possession subject to the jurisdiction of the Bankruptcy Court.
Accordingly, our consolidated financial statements have been prepared in
accordance with the American Institute of Certified Public Accountants
Statement of Position 90-7, "Financial Reporting by Entities in Reorganization
Under the Bankruptcy Code" ("SOP 90-7") and generally accepted accounting
principles applicable to a going concern, which assume that assets will be
realized and liabilities will be discharged in the normal course of business.
In connection with our emergence from bankruptcy, we reflected the terms of
the Plan of Reorganization in our consolidated financial statements by adopting
the fresh-start accounting provisions of SOP 90-7. Under fresh-start
accounting, a new reporting entity is deemed to be created and the recorded
amounts of assets and liabilities are adjusted to reflect their estimated fair
values. For accounting purposes, the fresh-start adjustments have been recorded
in our consolidated financial statements as of April 1, 2001. Since fresh-start
accounting materially changed the amounts previously recorded in our
consolidated financial statements, a black line separates the post-emergence
financial data from the pre-emergence data to signify the difference in the
basis of preparation of the financial statements for each respective entity.
As used in this Form 10-K, the term "Predecessor Company" refers to us and
our operations for periods prior to April 1, 2001, while the term "Reorganized
Company" is used to describe us and our operations for periods thereafter.
On May 1, 1998, Ventas, Inc. ("Ventas") completed the spin-off of its
healthcare operations to its stockholders through the distribution of our
former common stock (the "Spin-off"). Ventas retained ownership of
substantially all of its real property and leases such real property to us. In
anticipation of the Spin-off, we were incorporated on March 27, 1998 as a
Delaware corporation. For accounting purposes, the consolidated historical
financial statements of Ventas became our historical financial statements
following the Spin-off. Any discussion concerning events prior to May 1, 1998
refers to our businesses as they were conducted by Ventas prior to the Spin-off.
On September 28, 1995, The Hillhaven Corporation merged into us. On March
21, 1997, we acquired TheraTx, Incorporated ("TheraTx"), a provider of
rehabilitation and respiratory therapy program management services to nursing
centers and an operator of 26 nursing centers. On June 24, 1997, we acquired a
controlling interest in Transitional Hospitals Corporation, an operator of 19
long-term acute care hospitals located in 13 states. We completed the merger of
our wholly owned subsidiary into Transitional on August 26, 1997.
3
This Annual Report on Form 10-K includes forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"). See "- Cautionary Statements."
RECENT DEVELOPMENTS
We operate 18 nursing centers in the state of Florida. As a result of
significantly increasing professional liability costs, these facilities
generated a pretax loss of approximately $68 million in 2002. In October 2002,
we announced our intentions to divest our nursing center operations in Florida.
On December 11, 2002, we entered into a non-binding letter of intent with
Senior Health Management, LLC ("SHM") to transfer the operations of our 18
skilled nursing facilities in Florida. Under the proposed transaction,
affiliates of Senior Health Properties-South, Inc. will sublease 16 of our 18
Florida facilities for an initial term of five years. The lease payments under
the subleases will be equal to the lease payments under the primary leases. We
will remain a primary guarantor under the primary leases. In addition, SHM's
designee will lease with an option to purchase the remaining two facilities we
own. SHM will enter into a management agreement with each of the subtenants and
tenants, as applicable, to manage the Florida facilities. Each of the
subtenants or tenants, as applicable, also will purchase certain personal
property assets related to the operations of the Florida facilities. We will
retain the working capital associated with all of our Florida facilities.
The parties continue to make progress in their negotiations of definitive
agreements related to the letter of intent but have not reached agreement at
this time. In addition to entering into a definitive agreement, the
consummation of a proposed transaction is subject to a number of material
conditions including, without limitation, the receipt of required approvals
from regulators, governmental entities and other third parties. We lease 15 of
the 18 Florida facilities from Ventas pursuant to the Master Lease Agreements
(as defined below). Although Ventas has previously publicly announced its
intention to work with us in facilitating a Florida exit strategy, Ventas has
informed us that it will object to the transaction unless it receives a
substantial and material consent fee and other lease concessions. We have
informed Ventas that this demand is improper. We believe that under the Master
Lease Agreements we have the ability to sublease 12 of these facilities without
Ventas's consent and that Ventas cannot unreasonably withhold its consent on
the remaining three facilities.
In addition, Ventas has informed the Florida licensure agency that it
believes the proposed sublease transaction is not permitted under its Master
Lease Agreements with us and has requested that the agency suspend further
processing of the necessary licensure applications for the change in ownership.
SHM and we have independently informed the Florida agency that Ventas's request
is improper and that it lacks the authority to make any such request. We
believe that the Florida agency is aware that it must continue to process the
change in ownership applications.
We are continuing to pursue the proposed sublease transaction and our
divestiture of the Florida facilities. If Ventas improperly interferes with the
completion of the proposed transaction or the divestiture of these facilities,
we will seek appropriate legal remedies against Ventas as well as damages for
the continuing losses sustained by us.
HEALTHCARE OPERATIONS
During 2002, we were organized into two operating divisions: the health
services division, which operates nursing centers and a rehabilitation therapy
business and the hospital division, which operates hospitals and an
institutional pharmacy business. We believe that the independent focus of each
division on the unique aspects and quality concerns of its business enhances
its ability to attract patients, improve operations and achieve cost
containment objectives.
4
HEALTH SERVICES DIVISION
Our health services division provides quality, cost-effective long-term care
through the operation of a national network of 285 nursing centers (37,376
licensed beds) located in 32 states and a rehabilitation therapy business as of
December 31, 2002. Through our nursing centers, we provide residents with
long-term care services, a full range of pharmacy, medical and clinical
services and routine services, including daily dietary, social and recreational
services. We also provide rehabilitation services, including physical,
occupational and speech therapies to our residents as well as to residents in
nursing facilities and other facilities operated by third parties.
At a number of our nursing centers, we offer specialized programs for
patients suffering from Alzheimer's disease and dementia. Within these nursing
centers, we provide quality care to these patients by dedicating to them
separate units run by teams of professionals that specialize in the unique
problems experienced by Alzheimer's and dementia patients. We believe that we
are a leading provider of nursing care to patients with Alzheimer's disease and
dementia, based on the specialization and size of our program for caring for
these patients.
We monitor and enhance the quality of care at our nursing centers through
the use of quality assurance and performance improvement committees as well as
family satisfaction surveys. Our quality assurance and performance improvement
committees oversee patient healthcare needs and patient and staff safety.
Physicians serve on these committees as medical directors and advise on
healthcare policies and practices. We conduct surveys of patients' families
periodically, and these surveys are reviewed by our performance improvement
committees at each facility to promote quality patient care. Substantially all
of our nursing centers are certified to provide services under the Medicare and
Medicaid programs. Our nursing centers have been certified because the quality
of our accommodations, equipment, services, safety, personnel, physical
environment and policies and procedures meet or exceed the standards of
certification set by those programs.
Health Services Division Strategy
Our goal is to become the provider of choice in the markets our health
services division serves, which we believe will allow us to increase our
patient census and enhance our payor mix. In addition, we have implemented
several initiatives to improve our quality and thereby enhance our
profitability. As appropriate, we may expand selectively our operations through
development and acquisition activities. The principal elements of our health
services division strategy are:
Providing Quality, Clinical-Based Services. The health services division is
focused on qualitative and quantitative clinical performance indicators with
the goal of providing quality care under the cost containment objectives
imposed by government and private payors. In an effort to continually improve
the quality of our services, we pursue aggressive plans to:
. hire and retain quality healthcare personnel by becoming the employer of
choice in the industry,
. establish improved processes to monitor and promote our patient care
objectives,
. integrate clinical advice of our chief medical officer and other
physicians into our operational procedures, and
. develop and enhance our internal training programs.
Enhancing Sales and Marketing Programs. We conduct our nursing center
marketing efforts, which focus on the quality of care provided at our
facilities, at the local market level through our nursing center
administrators, admissions coordinators and/or the facility-based sales and
marketing personnel. The marketing
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efforts of our nursing center personnel are supplemented by strategies provided
by our regional and district marketing staffs. In order to increase awareness
of our services and the provision of quality care, we:
. direct a targeted marketing effort at the elderly population, which we
believe is the fastest growing segment in the United States and which
will, therefore, provide the growth in our industry in the coming years,
and
. work to improve our relationships with local referral sources.
Increasing Operating Efficiency. The health services division continually
seeks to improve operating efficiency with a view to maintaining high-quality
care in an environment that demands an increasingly greater control of costs.
We believe that operating efficiency is critical in maintaining our position as
a leading provider of nursing center services in the United States. In our
effort to improve operating efficiency we have:
. centralized administrative functions such as accounting, payroll, legal,
reimbursement, compliance and human resources,
. developed a management information system to aid in financial reporting
as well as billing and collecting, and
. focused our efforts to hire and retain quality personnel.
Managing Efficient Delivery of Ancillary Services. We are dedicated to
providing quality nursing services to the residents in our facilities while at
the same time optimizing our operating efficiency. Our nursing centers
generally provide ancillary services, primarily rehabilitation services, to
their residents through the use of internal staff. We are continuing to refine
the delivery of ancillary services to external customers to maintain
profitability under the cost constraints of the prospective payment system.
Accordingly, over the last few years, the health services division terminated
many unprofitable external ancillary services contracts.
Expanding Selectively Through Acquisitions and Development Activities. We
believe that we have the strategic and financial ability to pursue
opportunities to expand our business through acquisitions and development
activities on a selective basis. We will evaluate development opportunities to
expand our operations, either through acquiring or leasing individual or small
portfolios of nursing facilities in selected markets or by managing the
operations of third parties. We also will evaluate opportunities to acquire
companies with operations in attractive markets.
6
Selected Health Services Division Operating Data
The following table sets forth certain operating data for the health
services division (dollars in thousands, except statistics):
Reorganized Company | Predecessor Company
------------------------- | -------------------------
Year Nine months | Three months Year
ended ended | ended ended
December 31, December 31, | March 31, December 31,
2002 2001 | 2001 2000
------------ ------------ | ------------ ------------
Nursing centers: |
Revenues................................. $ 1,854,131 $1,348,236 | $ 429,523 $ 1,675,627
Operating income......................... $ 226,284 $ 234,500 | $ 70,543 $ 278,738
Facilities in operation at end of period: |
Owned or leased........................ 278 282 | 278 278
Managed................................ 7 23 | 35 34
Licensed beds at end of period: |
Owned or leased........................ 36,573 36,926 | 36,469 36,466
Managed................................ 803 2,367 | 3,861 3,723
Patient days (a)......................... 11,383,328 8,583,270 | 2,804,982 11,580,295
Revenues per patient day (a)............. $ 163 $ 157 | $ 153 $ 145
Average daily census (a)................. 31,187 31,212 | 31,166 31,640
Occupancy % (a).......................... 84.7 84.9 | 85.2 86.1
Rehabilitation services: |
Revenues................................. $ 34,296 $ 27,451 | $ 10,695 $ 135,036
Operating income......................... $ 7,531 $ 8,112 | $ 690 $ 8,047
Other ancillary services: |
Operating income......................... $ 435 $ 508 | $ 250 $ 4,737
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(a) Excludes managed facilities.
The term "operating income" is defined as earnings before interest, income
taxes, depreciation, amortization, rent, corporate overhead, unusual
transactions and reorganization items. The term "licensed beds" refers to the
maximum number of beds permitted in the facility under its license regardless
of whether the beds are actually available for patient care. "Patient days"
refers to the total number of days of patient care provided for the periods
indicated. "Average daily census" is computed by dividing each facility's
patient days by the number of calendar days in the respective period.
"Occupancy %" is computed by dividing average daily census by the number of
licensed beds, adjusted for the length of time each facility was in operation
during each respective period.
Total assets of the health services division were $423 million and $393
million at the end of 2002 and 2001, respectively.
Sources of Nursing Center Revenues
Nursing center revenues are derived principally from the Medicare and
Medicaid programs and from private payment patients. Consistent with the
nursing center industry, changes in the mix of the health services division's
patient population among these three categories significantly affect the
profitability of our nursing center operations. Although Medicare and higher
acuity patients generally produce the most revenue per patient day,
profitability with respect to higher acuity patients is reduced by the costs
associated with the higher level of nursing care and other services generally
required by such patients.
7
The following table sets forth the approximate percentages of nursing center
patient days and revenues derived from the payor sources indicated:
Medicare Medicaid Private and other
--------------- --------------- ---------------
Patient Patient Patient
Period days Revenues days Revenues days Revenues
- ------ ------- -------- ------- -------- ------- --------
Year ended December 31, 2002....... 15% 33% 67% 48% 18% 19%
Nine months ended December 31, 2001 14 32 67 47 19 21
Three months ended March 31, 2001.. 15 31 66 47 19 22
Year ended December 31, 2000....... 13 28 67 49 20 23
For the year ended December 31, 2002, revenues of the health services
division totaled approximately $1.9 billion or 55% of our total revenues
(before eliminations).
Both governmental and private third party payors employ cost containment
measures designed to limit payments made to healthcare providers. Those
measures include the adoption of initial and continuing recipient eligibility
criteria which may limit payment for services, the adoption of coverage
criteria which limit the services that will be reimbursed and the establishment
of payment ceilings which set the maximum reimbursement that a provider may
receive for services. Furthermore, government reimbursement programs are
subject to statutory and regulatory changes, retroactive rate adjustments,
administrative rulings and government funding restrictions, all of which may
materially increase or decrease the rate of program payments to the health
services division for its services.
Medicare. The Medicare Part A program provides reimbursement for extended
care services furnished to Medicare beneficiaries who are admitted to nursing
centers after at least a three-day stay in an acute care hospital. Covered
services include supervised nursing care, room and board, social services,
physical, speech and occupational therapies, pharmaceuticals, supplies and
other necessary services provided by nursing centers.
The Balanced Budget Act of 1997 (the "Balanced Budget Act") established a
prospective payment system for nursing centers ("PPS") for cost reporting
periods beginning on or after July 1, 1998. Prior to the implementation of PPS,
nursing centers were reimbursed by Medicare based on the facility-specific,
reasonable direct and indirect costs of services provided to their patients.
All of our nursing centers adopted PPS on July 1, 1998. The payments received
under PPS cover all services for Medicare patients including all ancillary
services, such as respiratory therapy, physical therapy, occupational therapy,
speech therapy and certain covered pharmaceuticals.
Medicaid. Medicaid is a state-administered program financed by state funds
and matching federal funds. The program provides for medical assistance to the
indigent and certain other eligible persons. Although administered under broad
federal regulations, states are given flexibility to construct programs and
payment methods consistent with their individual goals. Accordingly, these
programs differ in many respects from state to state.
The health services division provides to eligible individuals
Medicaid-covered services consisting of nursing care, room and board and social
services. In addition, states may at their option cover other services such as
physical, occupational and speech therapies and pharmaceuticals. Prior to the
Balanced Budget Act, federal law, generally referred to as the "Boren
Amendment," required Medicaid programs to pay rates that were reasonable and
adequate to meet the costs incurred by an efficiently and economically operated
nursing center providing quality care and services in conformity with all
applicable laws and regulations. Despite the federal requirements,
disagreements frequently arose between nursing centers and states regarding the
adequacy of Medicaid rates. By repealing the Boren Amendment, the Balanced
Budget Act eased the restrictions on the states' ability to reduce their
Medicaid reimbursement levels for such services. Medicaid programs also are
subject to statutory and regulatory changes, administrative rulings,
interpretations of policy by the state agencies and certain government
8
funding limitations, all of which may materially increase or decrease the level
of program payments to nursing centers operated by the health services
division. We believe that the payments under many of these programs may not be
sufficient on an overall basis to cover the costs of serving certain patients
participating in these programs. In addition, budgetary pressures impacting a
number of states may further reduce Medicaid payments to our nursing centers
from current levels. Furthermore, the Omnibus Budget Reconciliation Act of
1987, as amended, mandates an increased emphasis on ensuring quality patient
care, which has resulted in additional expenditures by nursing centers.
Private Payment. The health services division seeks to maximize the number
of private payment patients admitted to its nursing centers, including those
covered under private insurance and managed care health plans. Private payment
patients typically have financial resources (including insurance coverage) to
pay for their monthly services and do not rely on government programs for
support.
We cannot assure you that payments under governmental and private third
party payor programs will remain at levels comparable to present levels or will
be sufficient to cover the costs allocable to patients eligible for
reimbursement pursuant to such programs. In addition, one or more of the
facilities operated by the health services division, or the provision of
services and supplies by the health services division, could fail to meet the
requirements for participation in such programs. We could be adversely affected
by the continuing efforts of governmental and private third party payors to
contain the cost of healthcare services. See "- Governmental Regulation -
Regulatory Changes" and "- Cautionary Statements."
9
Nursing Center Facilities
The following table lists by state the number of nursing centers and related
licensed beds we operated as of December 31, 2002:
Number of facilities
---------------------------------------------
Licensed Owned Leased from Leased from
State beds by us Ventas (2) other parties Managed Total
----- -------- ----- ----------- ------------- ------- -----
Alabama (1)....... 588 - 3 1 - 4
Arizona........... 823 - 5 1 - 6
California........ 2,262 4 11 3 1 19
Colorado.......... 695 - 4 1 - 5
Connecticut (1)... 983 - 8 - - 8
Florida (1)....... 2,543 2 15 1 - 18
Georgia (1)....... 1,053 1 5 1 - 7
Idaho............. 862 1 8 - - 9
Indiana........... 4,372 - 15 13 - 28
Kentucky (1)...... 2,055 1 12 4 - 17
Louisiana (1)..... 305 - - 1 1 2
Maine (1)......... 775 - 10 - - 10
Massachusetts (1). 4,181 - 31 3 3 37
Mississippi (1)... 125 - - 1 - 1
Missouri (1)...... 496 - - 3 - 3
Montana (1)....... 446 - 2 1 - 3
Nebraska (1)...... 163 - 1 - - 1
Nevada (1)........ 180 - 2 - - 2
New Hampshire (1). 512 - 3 - - 3
North Carolina (1) 2,764 - 19 4 - 23
Ohio (1).......... 2,005 - 11 4 - 15
Oregon (1)........ 254 - 2 - - 2
Pennsylvania...... 200 - 1 1 - 2
Rhode Island (1).. 201 - 2 - - 2
Tennessee (1)..... 2,669 - 4 12 - 16
Texas............. 443 - 1 1 - 2
Utah.............. 740 - 5 - 1 6
Vermont (1)....... 310 - 1 - 1 2
Virginia (1)...... 629 - 4 - - 4
Washington (1).... 993 1 9 - - 10
Wisconsin (1)..... 2,298 - 12 2 - 14
Wyoming........... 451 - 4 - - 4
------ -- --- -- - ---
Totals......... 37,376 10 210 58 7 285
====== == === == = ===
- --------
(1) These states have certificate of need regulations. See "- Governmental
Regulation - Federal, State and Local Regulation."
(2) See "- Master Lease Agreements."
Health Services Division Management and Operations
Each of our nursing centers is managed by a state-licensed administrator who
is supported by other professional personnel, including a director of nursing,
staff development professional (responsible for employee training), activities
director, social services director, business office manager and, in general,
physical, occupational and speech therapists. The directors of nursing are
state-licensed nurses who supervise our nursing staffs that include registered
nurses, licensed practical nurses and nursing assistants. Staff size and
composition
10
vary depending on the size and occupancy of each nursing center and on the type
of care provided by the nursing center. The nursing centers contract with
physicians who provide medical director services and serve on quality assurance
committees. We provide our facilities with centralized information systems,
human resources management, state and federal reimbursement assistance, state
licensing and certification maintenance, as well as legal, finance and
accounting, purchasing and facilities management support. The centralization of
these services improves efficiency and permits facility staff to focus on the
delivery of high quality nursing services.
Our health services division is managed by a divisional president and a
chief financial officer. Our nursing center operations are divided into four
geographic regions, each of which is headed by an operational vice president.
These four operational vice presidents report to the divisional president. The
clinical issues and quality concerns of the health services division are
managed by the division's chief medical officer and senior vice president of
clinical operations. District and/or regional staff in the areas of nursing,
dietary and rehabilitation services, state and federal reimbursement, human
resources management, maintenance, sales and financial services support the
health services division.
Quality Assessment and Improvement
Quality of care is monitored and enhanced by quality assurance and
performance improvement committees as well as family satisfaction surveys.
These committees oversee patient healthcare needs and patient and staff safety.
Additionally, physicians serve on these committees as medical directors and
advise on healthcare policies and practices. Regional and district nursing
professionals visit each nursing center periodically to review practices and
recommend improvements where necessary in the level of care provided and to
assure compliance with requirements under applicable Medicare and Medicaid
regulations. Surveys of patients' families are conducted from time to time in
which the families are asked to rate various aspects of service and the
physical condition of the nursing centers. These surveys are reviewed by
performance improvement committees at each facility to promote quality patient
care.
The health services division provides training programs for nursing center
administrators, managers, nurses and nursing assistants. These programs are
designed to maintain high levels of quality patient care.
Substantially all of our nursing centers are certified to provide services
under the Medicare and Medicaid programs. A nursing center's qualification to
participate in such programs depends upon many factors, such as accommodations,
equipment, services, safety, personnel, physical environment and adequate
policies and procedures.
Health Services Division Competition
Our nursing centers compete with other nursing centers and similar long-term
care facilities primarily on the basis of quality of care, reputation, their
location and physical appearance and, in the case of private patients, the
charges for our services. Some competitors are located in buildings that are
newer than those operated by us and may provide services that we do not offer.
Our nursing centers compete on a local and regional basis with other nursing
centers as well as with facilities providing similar services, including
hospitals, extended care centers, assisted living facilities, home health
agencies and similar institutions. The industry includes government-owned,
religious organization-owned, secular not-for-profit and for-profit
institutions. Many of these competitors have greater financial and other
resources than we do. Although there is limited, if any, price competition with
respect to Medicare and Medicaid patients (since revenues received for services
provided to such patients are based generally on fixed rates), there is
significant competition for private payment patients.
In addition, our health services division competes in the fragmented and
highly competitive ancillary services markets. Many nursing centers are
developing internal staff to provide these services, particularly in
11
response to the implementation of PPS. The primary competitive factors for the
ancillary services markets are quality of services, charges for services and
responsiveness to the needs of patients and families, and the facilities in
which the services are provided.
HOSPITAL DIVISION
Our hospital division primarily provides long-term acute care services to
medically complex patients through the operation of a national network of 65
hospitals (which includes three hospitals operated as general acute care
hospitals) with 5,385 licensed beds located in 24 states as of December 31,
2002. We opened our first long-term acute care hospital in 1985 and today
operate the largest network of long-term acute care hospitals in the United
States based on revenues. As a result of our commitment to the long-term acute
care business, we have developed a comprehensive program of care for medically
complex patients which allows us to deliver quality care in a cost-effective
manner. During 2002, the hospital division operated an institutional pharmacy
business, which focuses on providing a full array of institutional pharmacy
services to nursing centers and specialized care centers, including the nursing
centers we operate.
In addition to our long-term acute care hospitals, the hospital division
operates three hospitals as general short-term acute care hospitals. A number
of the hospital division's long-term acute care hospitals also provide
outpatient services. General acute care and outpatient services may include
inpatient services, diagnostic services, CT scanning, one-day surgery,
laboratory, X-ray, respiratory therapy, cardiology and physical therapy.
In our hospitals, we treat medically complex patients who suffer from
multiple systemic failures or conditions such as neurological disorders, head
injuries, brain stem and spinal cord trauma, cerebral vascular accidents,
chemical brain injuries, central nervous system disorders, developmental
anomalies and cardiopulmonary disorders. In particular, we have a core
competency in treating patients with pulmonary disorders. Medically complex
patients often are dependent on technology, such as mechanical ventilators,
total parental nutrition, respiratory or cardiac monitors and dialysis
machines, for continued life support. Approximately 50% of our patients may
require ventilator care during their length of stay. During 2002, the average
length of stay for patients in our long-term acute care hospitals was
approximately 40 days. Although the hospital division's patients range in age
from pediatric to geriatric, approximately 70% of these patients are over 65
years of age.
Our hospital division patients have conditions which require a high level of
monitoring and specialized care, yet may not need the services of a traditional
intensive care unit. Due to their severe medical conditions, these patients
generally are not clinically appropriate for admission to a nursing center and
their medical conditions are periodically or chronically unstable. By combining
selected general acute care services with the ability to care for medically
complex patients, we believe that our long-term acute care hospitals provide
their patients with high quality, cost-effective care.
Our long-term acute care hospitals employ a comprehensive program of care
for their medically complex patients which draws upon the talents of
interdisciplinary teams, including physician specialists. The teams evaluate
medically complex patients upon admission to determine treatment programs. Our
hospital division has developed specialized treatment programs focused on the
needs of medically complex patients. Where appropriate, the treatment programs
may involve the services of several disciplines, such as pulmonary medicine,
infectious disease and physical medicine.
Hospital Division Strategy
Our goal is to remain a leading operator of long-term acute care hospitals
in terms of both quality of care and operating efficiency. Our strategies for
achieving this goal include:
Maintaining High Quality of Care. The hospital division differentiates its
hospitals through its ability to care for medically complex patients in a
high-quality, cost-effective setting. We are committed to maintaining
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and improving the quality of our patient care by dedicating appropriate
resources to each facility and refining our clinical initiatives. In this
regard, we have taken the following measures to improve and maintain the
quality of care at our hospitals:
. established an integrated quality assessment and improvement program,
administered by our chief clinical officer, vice president of quality and
risk management and director of quality management, which encompasses
utilization review, quality improvement, infection control and risk
management.
. maintained a strategic outcomes program, which includes a concurrent
review of all of our patient population against quality screenings,
outcomes reporting and patient and family satisfaction surveys.
. implemented a program whereby our hospitals are reviewed by internal
quality auditors for compliance with standards of the Joint Commission on
Accreditation of Health Care Organizations (the "Joint Commission").
. committed to attracting the highest quality of professional staff within
each market. The hospital division believes that its future success will
depend in part upon its continued ability to hire and retain qualified
healthcare personnel.
. incorporated the clinical advice of our chief clinical officer, medical
advisory board and other physicians into our operational procedures.
. monitored licensure and certification compliance through a vice president
for quality and risk management.
Improving Operating Efficiency. The hospital division is continually
focused on improving operating efficiency and controlling costs while
maintaining quality patient care. Our hospital division seeks to improve
operating efficiencies and control costs by standardizing operations and
optimizing the skill mix of its staff based on the hospital's occupancy and the
clinical needs of its patients. The initiatives we have undertaken to control
our costs and improve efficiency include:
. managing labor costs by adjusting staffing to patient acuity and
fluctuations in census,
. centralizing administrative functions such as accounting, payroll, legal,
reimbursement, compliance and human resources,
. managing pharmacy costs through the use of formularies and evaluating
medical utilization through our pharmacy and therapeutic committees in
each hospital, and
. utilizing management information technology to aid in financial reporting
as well as billing and collecting.
Growing Through Business Development and Acquisitions. Our growth strategy
is focused on the development and expansion of our services:
. Hospital-in-Hospital. We look to partner with non-Kindred hospitals in
order to operate 30 to 40 long-term acute care hospital beds within the
partner hospital. Under such arrangements, we would lease space and
purchase a limited amount of ancillary services from our partners and
provide them with the option to discharge a portion of their clinically
appropriate patients into our care. During 2002, we opened two new
hospitals-in-hospitals with a total of 71 beds.
. Free-standing Hospitals. We seek to add free-standing hospitals in
certain strategic markets. We opened a new free-standing hospital in
Scottsdale, Arizona which contains 50 beds in May 2002.
. Growing Through Acquisitions. We seek growth opportunities through
strategic acquisitions in selected target markets. On April 1, 2002, we
acquired Specialty Healthcare Services, Inc. ("Specialty"), a private
operator of six long-term acute care hospitals with a total of 425 beds.
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Expanding Breadth of Industry Leadership. We are the leading provider of
long-term acute care to patients with pulmonary dysfunction. In addition, we
deliver other services in areas such as wound care, post surgical care, acute
rehabilitation and pain management. We intend to broaden our expertise beyond
pulmonary services and to leverage our leadership position in pulmonary care to
expand our market strength to other clinical services.
Increasing Higher Margin Commercial Volume. We typically receive
substantially higher reimbursement rates from commercial insurers than we do
from the Medicare and Medicaid programs. As a result, we work to expand
relationships with insurers to increase commercial patient volume. Each of our
hospitals employs case managers who focus on patient admissions and the
referral process.
Improving Relationships with Referring Providers. Substantially all of the
acute and medically complex patients admitted to our hospitals are transferred
to us by other healthcare providers such as general acute care hospitals,
intensive care units, managed care programs, physicians, nursing centers and
home care settings. Accordingly, we are focused on maintaining strong
relationships with these providers. In order to maintain these relationships,
we employ case managers who are responsible for coordinating admissions and
assessing the nature of services necessary for the proper care of the patient.
Case managers also are responsible for educating healthcare professionals from
referral sources as to the unique nature of the services provided by our
long-term acute care hospitals. Specifically, case managers train and educate
the staffs of referring institutions about long-term acute care hospital
services and the types of patients who could benefit from such services.
Selected Hospital Division Operating Data
The following table sets forth certain operating data for the hospital
division (dollars in thousands, except statistics):
Reorganized Company | Predecessor Company
------------------------- | -------------------------
Year Nine months | Three months Year
ended ended | ended ended
December 31, December 31, | March 31, December 31,
2002 2001 | 2001 2000
------------ ------------ | ------------ ------------
Hospitals: |
Revenues................................ $1,276,299 $822,935 | $271,984 $1,007,947
Operating income........................ $ 260,440 $157,613 | $ 54,778 $ 205,858
Facilities in operation at end of period 65 57 | 56 56
Licensed beds at end of period.......... 5,385 4,961 | 4,867 4,886
Patient days............................ 1,200,024 802,425 | 273,029 1,044,663
Revenues per patient day................ $ 1,064 $ 1,026 | $ 996 $ 965
Average daily census.................... 3,288 2,918 | 3,034 2,854
Occupancy %............................. 65.3 62.6 | 65.3 60.8
Pharmacy: |
Revenues................................ $ 257,782 $176,105 | $ 54,880 $ 204,252
Operating income........................ $ 23,531 $ 20,831 | $ 6,176 $ 7,421
Total assets of the hospital division were $581 million and $497 million at
the end of 2002 and 2001, respectively.
Sources of Hospital Revenues
The hospital division receives payment for its hospital services from third
party payors, including government reimbursement programs such as Medicare and
Medicaid and non-government sources such as commercial insurance companies,
health maintenance organizations, preferred provider organizations and
contracted providers. Patients covered by non-government payors generally will
be more profitable to the
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hospital division than those covered by the Medicare and Medicaid programs. The
following table sets forth the approximate percentages of the hospital patient
days and revenues derived from the payor sources indicated:
Medicare Medicaid Private and other
--------------- --------------- ---------------
Patient Patient Patient
Period days Revenues days Revenues days Revenues
- ------ ------- -------- ------- -------- ------- --------
Year ended December 31, 2002....... 70% 59% 11% 9% 19% 32%
Nine months ended December 31, 2001 67 57 13 9 20 34
Three months ended March 31, 2001.. 68 56 13 11 19 33
Year ended December 31, 2000....... 67 55 13 10 20 35
For the year ended December 31, 2002, revenues of the hospital division
totaled approximately $1.5 billion or 45% of our total revenues (before
eliminations).
Hospital Facilities
The following table lists by state the number of hospitals and related
licensed beds we operated as of December 31, 2002:
Number of facilities
-------------------------------------
Licensed Owned Leased from Leased from
State beds by us Ventas (2) other parties Total
----- -------- ----- ----------- ------------- -----
Arizona........... 159 - 2 1 3
California........ 801 4 6 1 11
Colorado.......... 68 - 1 - 1
Florida (1)....... 536 - 6 1 7
Georgia (1)....... 72 - - 1 1
Illinois (1)...... 545 - 4 1 5
Indiana........... 167 - 2 1 3
Kentucky (1)...... 374 - 1 - 1
Louisiana......... 168 - 1 - 1
Massachusetts (1). 86 - 2 - 2
Michigan (1)...... 400 - 2 - 2
Minnesota......... 92 - 1 - 1
Missouri (1)...... 227 - 2 - 2
Nevada (1)........ 144 1 1 - 2
New Mexico........ 61 - 1 - 1
North Carolina (1) 124 - 1 - 1
Ohio.............. 75 - - 1 1
Oklahoma.......... 59 - 1 - 1
Pennsylvania...... 229 - 2 3 5
South Carolina (1) 59 - - 1 1
Tennessee (1)..... 49 - 1 - 1
Texas............. 748 2 6 2 10
Washington (1).... 80 1 - - 1
Wisconsin......... 62 1 - - 1
----- - -- -- --
Totals......... 5,385 9 43 13 65
===== = == == ==
- --------
(1) These states have certificate of need regulations. See "- Governmental
Regulation - Federal, State and Local Regulation."
(2) See "- Master Lease Agreements."
15
Quality Assessment and Improvement
The hospital division maintains a strategic outcome program which includes a
concurrent review of all of its patient population against utilization and
quality screenings, as well as clinical outcomes data collection and patient
and family satisfaction surveys. In addition, each hospital has an integrated
quality assessment and improvement program administered by a director of
quality management which encompasses utilization review, quality improvement,
infection control and risk management. The objective of these programs is to
ensure that patients are admitted appropriately to our hospitals and that
quality healthcare is provided in a cost-effective manner.
The hospital division has implemented a program whereby its hospitals are
reviewed by internal quality auditors for compliance with standards of the
Joint Commission. The purposes of this internal review process are to (a)
ensure ongoing compliance with industry recognized standards for hospitals, (b)
assist management in analyzing each hospital's operations and (c) provide
consulting and educational programs for each hospital to identify opportunities
to improve patient care.
Hospital Division Management and Operations
Each of our hospitals has a fully credentialed, multi-specialty medical
staff to meet the needs of the medically complex, long-term acute patient. Each
of our hospitals offers a broad range of physician services including
pulmonology, internal medicine, infectious diseases, neurology, nephrology,
cardiology, radiology and pathology. In addition, each of our hospitals is
staffed with a multi-disciplinary team of healthcare professionals including: a
professional nursing staff trained to care for long-term acute patients,
respiratory, physical, occupational and speech therapists; pharmacists;
registered dietitians; and social workers.
Each hospital maintains a pre-admission assessment system to evaluate
clinical needs and other information in determining the appropriateness of each
patient referral. Upon admission, each patient's case is reviewed by the
hospital's interdisciplinary team to determine treatment programs. Where
appropriate, the treatment programs may involve the services of several
disciplines, such as pulmonary medicine, infectious disease and physical
medicine.
A hospital chief executive officer supervises and is responsible for the
day-to-day operations at each of our hospitals. Each hospital also employs a
chief financial officer who monitors the financial matters of each hospital,
including the measurement of actual operating results compared to budgets. In
addition, each hospital employs a chief operating officer to oversee the
clinical operations of the hospital and a director of quality management to
direct an integrated quality assurance program. We provide centralized services
in the areas of information systems design and development, training, human
resources management, reimbursement expertise, legal advice, technical
accounting support and purchasing and facilities management to each of our
hospitals. We believe that this centralization improves efficiency and allows
hospital staff to spend more time on patient care.
A divisional president and a chief financial officer manage the hospital
division. The operations of the hospitals are divided into four geographic
regions with each region headed by an operational vice president, each of whom
reports to the divisional president. During 2002, institutional pharmacy
operations were managed by a vice president who reported to the divisional
president. The clinical issues and quality concerns of the hospital division
are managed by the division's chief clinical officer.
Institutional Pharmacy Operations
Our institutional pharmacy operations are a leading provider of
pharmaceuticals and resident care products to the long-term industry. We
operated 30 institutional pharmacies at December 31, 2002 that serve
approximately 59,000 patients and residents of senior care facilities in 24
states. The facilities served by our institutional pharmacy operations include
skilled nursing facilities, assisted living facilities, psychiatric hospitals
and other institutional healthcare facilities.
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Our institutional pharmacy operations derive approximately 50% of their
revenues from state Medicaid programs and the balance from Medicare and other
third party payors. Beginning in 2003, the institutional pharmacy operations
will be operated as a separate operating division.
Hospital Division Competition
As of December 31, 2002, our hospitals were located in 42 geographic markets
in 24 states. In each geographic market, there are general acute care hospitals
which provide services comparable to those offered by our hospitals. In
addition, the hospital division believes that as of December 31, 2002 there
were approximately 300 hospitals in the United States certified by Medicare as
general long-term hospitals, some of which provide similar services to those
provided by the hospital division. Certain competing hospitals are operated by
not-for-profit, nontaxpaying or governmental agencies, which can finance
capital expenditures on a tax-exempt basis and receive funds and charitable
contributions unavailable to the hospital division.
Competition for patients covered by non-government reimbursement sources is
intense. The primary competitive factors in the long-term acute care business
include quality of services, charges for services and responsiveness to the
needs of patients, families, payors and physicians. Other companies have
entered the long-term acute care market with licensed hospitals that compete
with our hospitals. The competitive position of any hospital also is affected
by the ability of its management to negotiate contracts with purchasers of
group healthcare services, including private employers, managed care companies,
preferred provider organizations and health maintenance organizations. Such
organizations attempt to obtain discounts from established hospital charges.
The importance of obtaining contracts with preferred provider organizations,
health maintenance organizations and other organizations which finance
healthcare, and its effect on a hospital's competitive position, vary from
market to market, depending on the number and market strength of such
organizations.
Our institutional pharmacy services generally compete on price and quality
of the services provided. Several of the competitors of our pharmacy operations
are larger and more established service providers.
OUR REORGANIZATION
As a result of decreased Medicare and Medicaid reimbursement rates
introduced by the Balanced Budget Act and other issues associated with our
Company, we were unable to meet our then existing financial obligations,
including rent payable to Ventas and debt service obligations under our then
existing indebtedness. Accordingly, on September 13, 1999, we filed voluntary
petitions for protection under Chapter 11 of the Bankruptcy Code. From the date
of our bankruptcy filing until we emerged from bankruptcy on April 20, 2001, we
operated our businesses as a "debtor-in-possession" subject to the jurisdiction
of the Bankruptcy Court. On March 1, 2001, the Bankruptcy Court approved our
Plan of Reorganization. See note 2 of the notes to consolidated financial
statements.
Pursuant to our Plan of Reorganization, on the Effective Date of the Plan of
Reorganization:
. we issued to certain claimholders, including senior creditors and Ventas,
in exchange for their claims:
. an aggregate of $300 million of senior secured notes, bearing
interest at the London Interbank Offered Rate (as defined in the
agreement) plus 41/2%, which began accruing interest approximately
two quarters after the Effective Date,
. an aggregate of 15,000,000 shares of our common stock,
. an aggregate of 2,000,000 Series A warrants, and
. an aggregate of 5,000,000 Series B warrants,
17
. we entered into a new $120 million revolving credit facility to provide
us with working capital and to be used for other general corporate
purposes,
. we entered into amended and restated master lease agreements with Ventas
covering 210 of the nursing centers and 44 of the hospitals that we
operated,
. we entered into a registration rights agreement with Ventas and each
holder of 10% or more of our common stock following the exchange
described above, providing such holders with certain shelf, demand and
"piggy-back" registration rights, and
. our then existing senior indebtedness and debt and equity securities were
canceled.
As a result of the exchange described above, the holders of certain claims
acquired control of our Company and the holders of our pre-reorganization
common stock relinquished control.
In addition, in connection with our emergence from bankruptcy:
. we changed our name to Kindred Healthcare, Inc.,
. a new board of directors, including representatives of the principal
security holders following the exchange, was appointed, and
. effective April 1, 2001, we adopted fresh-start accounting in accordance
with SOP 90-7. This has resulted in the creation of a new reporting
entity for financial accounting reporting purposes and a revaluation of
our assets and liabilities to reflect their estimated fair values.
Because of the adoption of fresh-start accounting, amounts previously
recorded in our historical financial statements have changed materially.
As a result, our financial statements for periods after our emergence
from bankruptcy are not comparable in all respects to our financial
statements for periods prior to the reorganization.
MASTER LEASE AGREEMENTS
Under our Plan of Reorganization, we assumed our original master lease
agreements with Ventas and its affiliates and simultaneously amended and
restated the agreements into four new master leases (the "Master Leases").
Under the Master Leases, Ventas has a right to sever properties from the
existing leases in order to create additional leases, a device adopted to
facilitate its financing flexibility. In such circumstances, our aggregate
lease obligations remain unchanged. Ventas exercised this severance right with
respect to Master Lease No. 1 to create a new lease of 40 nursing centers (the
"CMBS Lease") and mortgaged these properties in connection with a securitized
mortgage financing. The CMBS Lease is in substantially the same form as the
other Master Leases with certain modifications requested by Ventas's lender and
required to be made by us pursuant to the Master Leases. The transaction closed
on December 12, 2001.
The following summary description of the Master Lease Agreements is
qualified in its entirety by reference to the Master Leases and the CMBS Lease
(collectively, the "Master Lease Agreements"), as filed with the Securities and
Exchange Commission (the "SEC").
Term and Renewals
Each Master Lease Agreement includes land, buildings, structures and other
improvements on the land, easements and similar appurtenances to the land and
improvements, and permanently affixed equipment, machinery and other fixtures
relating to the operation of the leased properties. There are several bundles
of leased properties under each Master Lease Agreement, with each bundle
containing approximately 7 to 12 leased properties. Other than the CMBS Lease,
which has only nursing center properties, each bundle contains both
18
nursing centers and hospitals. All leased properties within a bundle have base
terms ranging from 10 to 15 years beginning from May 1, 1998, subject to
certain exceptions.
At our option, all, but not less than all, of the leased properties in a
bundle may be extended for one five-year renewal term beyond the base term at
the then existing rental rate plus the then existing escalation amount per
annum. We may further extend for two additional five-year renewal terms beyond
the first renewal term at the greater of the then existing rental rate plus the
then existing escalation amount per annum or the then fair market value rental
rate. The rental rate during the first renewal term and any additional renewal
term in which rent due is based on the then existing rental rate will escalate
each year during such term(s) at the applicable escalation rate.
We may not extend the Master Lease Agreements beyond the base term or any
previously exercised renewal term if, at the time we seek such extension and at
the time such extension takes effect, (1) an event of default has occurred and
is continuing or (2) a Medicare/Medicaid event of default (as described below)
and/or a licensed bed event of default (as described below) has occurred and is
continuing with respect to three or more leased properties subject to a
particular Master Lease Agreement. The base term and renewal term of each
Master Lease Agreement are subject to termination upon default by us (subject
to certain exceptions) and certain other conditions described in the Master
Lease Agreements.
Rental Amounts and Escalators
Each Master Lease Agreement is commonly known as a triple-net lease or an
absolute-net lease. Accordingly, in addition to rent, we are required to pay
the following: (1) all insurance required in connection with the leased
properties and the business conducted on the leased properties, (2) certain
taxes levied on or with respect to the leased properties (other than taxes on
the net income of Ventas) and (3) all utilities and other services necessary or
appropriate for the leased properties and the business conducted on the leased
properties.
Under each Master Lease Agreement, the aggregate annual rent is referred to
as base rent. Base rent equals the sum of current rent and accrued rent. We are
obligated to pay the portion of base rent that is current rent, and unpaid
accrued rent will be paid as set forth below.
From the effective date of the Master Lease Agreements through April 30,
2004, base rent will equal the current rent. Under the Master Lease Agreements,
the annual aggregate base rent owed by us currently is $185.9 million. For the
period from May 1, 2001 through April 30, 2004, annual aggregate base rent
payable in cash will escalate at an annual rate of 31/2% over the prior period
base rent if certain revenue parameters are obtained. The Company paid rents to
Ventas approximating $184.3 million for the year ended December 31, 2002,
$135.6 million for the nine months ended December 31, 2001, $45.4 million for
the three months ended March 31, 2001, and $181.6 million for 2000.
Each Master Lease Agreement also provides that beginning May 1, 2004, the
annual aggregate base rent payable in cash will escalate at an annual rate of
2% (plus, upon the occurrence of certain events, an additional annual accrued
escalator amount of 11/2% of the prior period base rent) which will accrete
from year to year including an interest accrual at the London Interbank Offered
Rate plus 41/2% to be added to the annual accreted amount. This interest will
not be added to the aggregate base rent in subsequent years.
The unpaid accrued rent will become payable upon the refinancing of our
existing credit agreements or the termination or expiration of the applicable
Master Lease Agreement.
Reset Rights
During the one-year period commencing in July 2006, Ventas will have a
one-time option to reset the base rent, current rent and accrued rent under
each Master Lease Agreement to the then fair market rental of the leased
19
properties. Upon exercising this reset right, Ventas will pay us a fee equal to
a prorated portion of $5 million based upon the proportion of base rent payable
under the Master Lease Agreement(s) with respect to which rent is reset to the
total base rent payable under all of the Master Lease Agreements. The
determination of the fair market rental will be effectuated through the
appraisal procedures in the Master Lease Agreements.
Use of the Leased Property
The Master Lease Agreements require that we utilize the leased properties
solely for the provision of healthcare services and related uses and as Ventas
may otherwise consent. We are responsible for maintaining or causing to be
maintained all licenses, certificates and permits necessary for the leased
properties to comply with various healthcare regulations. We also are obligated
to operate continuously each leased property as a provider of healthcare
services.
Events of Default
Under each Master Lease Agreement, an "Event of Default" will be deemed to
occur if, among other things:
. we fail to pay rent or other amounts within five days after notice,
. we fail to comply with covenants, which failure continues for 30 days or,
so long as diligent efforts to cure such failure are being made, such
longer period (not over 180 days) as is necessary to cure such failure,
. certain bankruptcy or insolvency events occur, including filing a
petition of bankruptcy or a petition for reorganization under the
Bankruptcy Code,
. an event of default arising from our failure to pay principal or interest
on our senior secured notes or any other indebtedness exceeding $50
million,
. the maturity of the senior secured notes or any other indebtedness
exceeding $50 million is accelerated,
. we cease to operate any leased property as a provider of healthcare
services for a period of 30 days,
. a default occurs under any guaranty of any lease or the indemnity
agreements with Ventas,
. we or our subtenant lose any required healthcare license, permit or
approval or fail to comply with any legal requirements as determined by a
final unappealable determination,
. we fail to maintain insurance,
. we create or allow to remain certain liens,
. we breach any material representation or warranty,
. a reduction occurs in the number of licensed beds in a facility,
generally in excess of 10% (or less than 10% if we have voluntarily
"banked" licensed beds) of the number of licensed beds in the applicable
facility on the commencement date (a "licensed bed event of default"),
. Medicare or Medicaid certification with respect to a participating
facility is revoked and re-certification does not occur for 120 days
(plus an additional 60 days in certain circumstances) (a
"Medicare/Medicaid event of default"),
. we become subject to regulatory sanctions as determined by a final
unappealable determination and fail to cure such regulatory sanctions
within its specified cure period for any facility,
. we fail to cure a breach of any permitted encumbrance within the
applicable cure period and, as a result, a real property interest or
other beneficial property right of Ventas is at material risk of being
terminated, or
20
. we fail to cure the breach of any of the obligations of Ventas as lessee
under any existing ground lease within the applicable cure period and, if
such breach is a non-monetary, non-material breach, such existing ground
lease is at material risk of being terminated.
Remedies for an Event of Default
Except as noted below, upon an Event of Default under one of the Master
Lease Agreements, Ventas may, at its option, exercise the following remedies:
(1) after not less than ten days' notice to us, terminate the Master Lease
Agreement to which such Event of Default relates, repossess any leased
property, relet any leased property to a third party and require that we pay to
Ventas, as liquidated damages, the net present value of the rent for the
balance of the term, discounted at the prime rate,
(2) without terminating the Master Lease Agreement to which such Event of
Default relates, repossess the leased property and relet the leased property
with us remaining liable under such Master Lease Agreement for all obligations
to be performed by us thereunder, including the difference, if any, between the
rent under such Master Lease Agreement and the rent payable as a result of the
reletting of the leased property, and
(3) seek any and all other rights and remedies available under law or in
equity.
In addition to the remedies noted above, under the Master Lease Agreements,
in the case of a facility-specific event of default Ventas may terminate a
Master Lease Agreement as to the leased property to which the Event of Default
relates, and may, but need not, terminate the entire Master Lease Agreement.
Each of the Master Lease Agreements includes special rules relative to
Medicare/Medicaid events of default and licensed bed events of default. In the
event a Medicare/Medicaid event of default and/or a licensed bed event of
default occurs and is continuing (a) with respect to not more than two
properties at the same time under a Master Lease Agreement that covers 41 or
more properties and (b) with respect to not more than one property at the same
time under a Master Lease Agreement that covers 21 to and including 40
properties, Ventas may not exercise termination or dispossession remedies
against any property other than the property or properties to which the event
of default relates. Thus, in the event Medicare/Medicaid events of default and
licensed bed events of default would occur and be continuing (a) with respect
to one property under a Master Lease Agreement that covers less than 20
properties, (b) with respect to two or more properties at the same time under a
Master Lease Agreement that covers 21 to and including 40 properties, or (c)
with respect to three or more properties at the same time under a Master Lease
Agreement that covers 41 or more properties, then Ventas would be entitled to
exercise all rights and remedies available to it under the Master Lease
Agreements.
Assignment and Subletting
Except as noted below, the Master Lease Agreements provide that we may not
assign, sublease or otherwise transfer any leased property or any portion of a
leased property as a whole (or in substantial part), including by virtue of a
change of control, without the consent of Ventas, which may not be unreasonably
withheld if the proposed assignee (1) is a creditworthy entity with sufficient
financial stability to satisfy its obligations under the related Master Lease
Agreement, (2) has not less than four years experience in operating healthcare
facilities, (3) has a favorable business and operational reputation and
character and (4) has all licenses, permits, approvals and authorizations to
operate the facility and agrees to comply with the use restrictions in the
related Master Lease Agreement. The obligation of Ventas to consent to a
subletting or assignment is subject to the reasonable approval rights of any
mortgagee and/or the lenders under its credit agreement. We may sublease up to
20% of each leased property for restaurants, gift shops and other stores or
services customarily found in hospitals or nursing centers without the consent
of Ventas, subject, however, to there being no material alteration in the
character of the leased property or in the nature of the business conducted on
such leased property.
21
In addition, each Master Lease Agreement allows us to assign or sublease (a)
without the consent of Ventas, 10% of the nursing center facilities in each
Master Lease Agreement and (b) with Ventas's consent (which consent will not be
unreasonably withheld, delayed or conditioned), two hospitals in each Master
Lease Agreement, if either (i) the applicable regulatory authorities have
threatened to revoke an authorization necessary to operate such leased property
or (ii) we cannot profitably operate such leased property. Any such proposed
assignee/sublessee must satisfy the requirements listed above and it must have
all licenses, permits, approvals and other authorizations required to operate
the leased properties in accordance with the applicable permitted use. With
respect to any assignment or sublease made under this provision, Ventas agrees
to execute a nondisturbance and attornment agreement with such proposed
assignee or subtenant. Upon any assignment or subletting, we will not be
released from our obligations under the applicable Master Lease Agreement.
Subject to certain exclusions, we must pay to Ventas 80% of any
consideration received by us on account of an assignment and 80% (50% in the
case of existing subleases) of sublease rent payments (approximately equal to
revenue net of specified allowed expenses attributable to a sublease, and
specifically defined in the Master Lease Agreements), provided that Ventas's
right to such payments will be subordinate to that of our lenders.
Ventas will have the right to approve the purchaser at a foreclosure of one
or more of our leasehold mortgages by our lenders. Such approval will not be
unreasonably withheld so long as such purchaser is creditworthy, reputable and
has four years experience in operating healthcare facilities. Any dispute
regarding whether Ventas has unreasonably withheld its consent to such
purchaser will be subject to expedited arbitration.
GOVERNMENTAL REGULATION
Medicare and Medicaid
Medicare is a federal program that provides certain hospital and medical
insurance benefits to persons age 65 and over and certain disabled persons.
Medicaid is a medical assistance program administered by each state pursuant to
which healthcare benefits are available to certain indigent patients. Within
the Medicare and Medicaid statutory framework, there are substantial areas
subject to administrative rulings, interpretations and discretion that may
affect payments made under Medicare and Medicaid. A substantial portion of our
revenues are derived from patients covered by the Medicare and Medicaid
programs. See "- Health Services Division - Sources of Nursing Center Revenues"
and "- Hospital Division - Sources of Hospital Revenues."
Federal, State and Local Regulation
In the ordinary course of our business, we are subject regularly to
inquiries, investigations and audits by federal and state agencies that oversee
applicable healthcare regulations.
The extensive federal, state and local regulations affecting the healthcare
industry include, but are not limited to, regulations relating to licensure,
conduct of operations, ownership of facilities, addition of facilities,
allowable costs, services and prices for services, and the confidentiality and
security of health-related information. In particular, various laws including
antikickback, antifraud and abuse amendments codified under the Social Security
Act prohibit certain business practices and relationships that might affect the
provision and cost of healthcare services reimbursable under Medicare and
Medicaid, including the payment or receipt of remuneration for the referral of
patients whose care will be paid by Medicare or other governmental programs.
Sanctions for violating these antikickback, antifraud and abuse amendments
under the Social Security Act include criminal penalties, civil sanctions,
fines and possible exclusion from government programs such as Medicare and
Medicaid. The U.S. Department of Health and Human Services has issued
regulations that describe some of the conduct and business relationships
permissible under the antikickback amendments. The fact that a given business
arrangement does not fall within one of these safe harbors does not render the
arrangement per se illegal. Business arrangements of healthcare service
providers that fail to satisfy the applicable criteria, however, risk increased
scrutiny and possible sanctions by enforcement authorities.
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In addition, Section 1877 of the Social Security Act, which restricts
referrals by physicians of Medicare and other government program patients to
providers of a broad range of designated health services with which they have
ownership or certain other financial arrangements, was amended effective
January 1, 1995, to broaden significantly the scope of prohibited physician
referrals under the Medicare and Medicaid programs. Many states have adopted or
are considering similar legislative proposals, some of which extend beyond the
Medicaid program, to prohibit the payment or receipt of remuneration for the
referral of patients and physician self-referrals regardless of the source of
payment for the care. These laws and regulations are complex and limited
judicial or regulatory interpretation exists. We do not believe our
arrangements are in violation of these prohibitions. We cannot assure you,
however, that governmental officials charged with responsibility for enforcing
the provisions of these prohibitions will not assert that one or more of our
arrangements are in violation of such provisions.
The Balanced Budget Act also includes a number of antifraud and abuse
provisions. The Balanced Budget Act contains additional civil monetary
penalties for violations of the antikickback amendments discussed above and
imposes an affirmative duty on providers to ensure that they do not employ or
contract with persons excluded from the Medicare program. The Balanced Budget
Act also provides a minimum ten-year period for exclusion from participation in
federal healthcare programs for persons or entities convicted of a prior
healthcare offense.
The federal Health Insurance Portability and Accountability Act of 1996,
commonly known as "HIPAA," signed into law on August 21, 1996, amended, among
other things, Title XI of the U.S. Code (42 U.S.C. (S)1301 et seq.) to broaden
the scope of fraud and abuse laws to include all health plans, whether or not
they are reimbursed under federal programs. In addition, HIPAA also mandates
the adoption of regulations aimed at standardizing transaction formats and
billing codes for documenting medical services, dealing with claims submissions
and protecting the privacy and security of individually identifiable health
information. HIPAA regulations that standardize transactions and code sets
became final in the fourth quarter of 2000. These regulations require standard
formatting for healthcare providers, like us, that submit claims
electronically. We will be required to comply with HIPAA transaction and code
set standards by October 2003 since we have filed a plan with the U.S.
Department of Health and Human Services that demonstrates how we intend to
comply with the regulations by that deadline.
Final HIPAA privacy regulations were published in December 2000. These
privacy regulations apply to "protected health information," which is defined
generally as individually identifiable health information transmitted or
maintained in any form or medium, excluding certain education records and
student medical records. The privacy regulations seek to limit the use and
disclosure of most paper and oral communications, as well as those in
electronic form, regarding an individual's past, present or future physical or
mental health or condition, or relating to the provision of healthcare to the
individual or payment for that healthcare, if the individual can or may be
identified by such information. HIPAA provides for the imposition of civil or
criminal penalties if protected health information is improperly disclosed. We
must comply with the privacy regulations by April 14, 2003.
HIPAA's security regulations were finalized in February 2003. The security
regulations specify administrative procedures, physical safeguards and
technical services and mechanisms designed to ensure the privacy of protected
health information. We will be required to comply with the security regulations
by April 21, 2005.
We are currently evaluating the impact of compliance with HIPAA regulations,
but we have not completed our analysis or finalized the estimated costs of
compliance. We cannot assure you that our compliance with the HIPAA regulations
will not have an adverse affect on our financial position, results of
operations or liquidity.
We believe that the regulatory environment surrounding the long-term care
industry remains intense. State and federal governments continue to impose
extensive enforcement policies resulting in a significant number of
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inspections, citations of regulatory deficiencies and other regulatory
sanctions including terminations from the Medicare and Medicaid programs, bars
on Medicare and Medicaid payments for new admissions and civil monetary
penalties. Such sanctions could have a material adverse effect on our financial
position, results of operations and liquidity. We vigorously contest such
sanctions where appropriate; however, these cases can involve significant legal
expense and consume our resources.
Certificates of Need and State Licensing. Certificate of need, or CON,
regulations control the development and expansion of healthcare services and
facilities in certain states. Certain states also require regulatory approval
prior to certain changes in ownership of a nursing center or hospital. Certain
states that do not have CON programs may have other laws or regulations that
limit or restrict the development or expansion of healthcare facilities. We
operate nursing centers in 23 states and hospitals in 12 states that require
state approval for the expansion of our facilities and services under CON
programs. To the extent that CONs or other similar approvals are required for
expansion of the operations of our nursing centers or hospitals, either through
facility acquisitions, expansion or provision of new services or other changes,
such expansion could be affected adversely by the failure or inability to
obtain the necessary approvals, changes in the standards applicable to such
approvals or possible delays and expenses associated with obtaining such
approvals.
We are required to obtain state licenses to operate each of our nursing
centers and hospitals and to ensure their participation in government programs.
Once a nursing center or hospital becomes licensed and operational, it must
continue to comply with federal, state and local licensing requirements in
addition to local building and life-safety codes. All of our nursing centers
and hospitals have the necessary licenses.
Health Services Division
The development and operation of nursing centers and the provision of
healthcare services are subject to federal, state and local laws relating to
the adequacy of medical care, equipment, personnel, operating policies, fire
prevention, rate-setting and compliance with building codes and environmental
laws. Nursing centers are subject to periodic inspection by governmental and
other authorities to assure continued compliance with various standards,
continued licensing under state law, certification under the Medicare and
Medicaid programs and continued participation in the Veterans Administration
program. The failure to obtain, retain or renew any required regulatory
approvals or licenses could adversely affect nursing center operations
including its financial results.
Medicare and Medicaid and other Federal Regulations. The nursing centers
operated and managed by the health services division are licensed either on an
annual or bi-annual basis and generally are certified annually for
participation in Medicare and Medicaid programs through various regulatory
agencies that determine compliance with federal, state and local laws. These
legal requirements relate to the compliance with the laws and regulations
governing the operation of nursing centers including the quality of nursing
care, the qualifications of the administrative and nursing personnel, and the
adequacy of the physical plant and equipment. Federal regulations determine the
survey process for nursing centers that is followed by state survey agencies.
The state survey agencies recommended to the Centers for Medicare and Medicaid
Services ("CMS") the imposition of federal sanctions and impose state sanctions
on facilities for noncompliance with certain requirements. Available sanctions
include, but are not limited to, imposition of civil monetary penalties,
temporary suspension of payment for new admissions, appointment of a temporary
manager, suspension of payment for eligible patients and suspension or
decertification from participation in the Medicare and Medicaid programs.
We believe that substantially all of our nursing centers are in substantial
compliance with applicable Medicare and Medicaid requirements of participation.
In the ordinary course of business, however, the nursing centers periodically
receive statements of deficiencies from regulatory agencies. In response, the
health services division implements plans of correction to address the alleged
deficiencies. In most instances, the regulatory agency accepts the facility's
plan of correction and places the nursing center back into compliance with
24
regulatory requirements. In some cases, the regulatory agency may take a number
of adverse actions against the nursing center, including the imposition of
fines, temporary suspension of admission of new patients to the nursing center,
decertification from participation in the Medicaid and/or Medicare programs
and, in extreme circumstances, revocation of the nursing center's license.
The health services division also is subject to federal and state laws that
govern financial and other arrangements between healthcare providers. These
laws prohibit certain direct and indirect payments or fee-splitting
arrangements between healthcare providers that are designed to induce or
encourage the referral of patients to, or the recommendation of, a particular
provider for medical products and services. Such laws include the antikickback
amendments discussed above. These provisions prohibit, among other things, the
offer, payment, solicitation or receipt of any form of remuneration in return
for the referral of Medicare and Medicaid patients. In addition, some states
restrict certain business relationships between physicians and ancillary
service providers and some states prohibit business corporations from
providing, or holding themselves out as a provider of, medical care. Possible
sanctions for violation of any of these restrictions or prohibitions include
loss of licensure or eligibility to participate in reimbursement programs as
well as civil and criminal penalties. These laws vary considerably from state
to state.
In certain circumstances, federal law mandates that conviction for certain
abusive or fraudulent behavior with respect to one nursing center may subject
other facilities under common control or ownership to disqualification from
participation in the Medicare and Medicaid programs. In addition, some
regulations provide that all nursing centers under common control or ownership
within a state are subject to delicensure if any one or more of such facilities
are delicensed.
Hospital Division
Medicare and Medicaid and other Federal Regulations. The hospital division
is subject to various federal and state regulations. In order to receive
Medicare reimbursement, each hospital must meet the applicable conditions of
participation set forth by the U.S. Department of Health and Human Services
relating to the type of hospital, its equipment, personnel and standard of
medical care, as well as comply with state and local laws and regulations. We
have developed a management system to facilitate our compliance with these
various standards and requirements. Among other things, each hospital employs a
person who is responsible for an ongoing quality assessment and improvement
program. Hospitals undergo periodic on-site Medicare certification surveys,
which generally are limited in frequency if the hospital is accredited by the
Joint Commission. As of December 31, 2002, all of the hospitals operated by the
hospital division were certified as Medicare providers and 57 of such hospitals
also were certified by their respective state Medicaid programs. A loss of
certification could affect adversely a hospital's ability to receive payments
from the Medicare and Medicaid programs.
Since 1983, Medicare has reimbursed general short-term acute care hospitals
under a prospective payment system. Under the short-term prospective payment
system, Medicare inpatient costs are reimbursed based upon a fixed payment
amount per discharge using diagnosis related groups. The diagnosis-related
group payment under the short-term prospective payment system is based upon the
national average cost of treating a Medicare patient's condition. Although the
average length of stay varies for each diagnosis related group, the average
stay for all Medicare patients subject to the short-term prospective payment
system is approximately six days. An additional outlier payment is made for
patients with higher treatment costs. Outlier payments are only designed to
cover marginal costs. Accordingly, the short-term prospective payment system
creates an economic incentive for general short-term acute care hospitals to
discharge medically complex Medicare patients as soon as clinically possible.
Hospitals that are certified by Medicare as general long-term acute care
hospitals are excluded from the short-term prospective payment system. We
believe that the incentive for short-term acute care hospitals to discharge
medically complex patients as soon as clinically possible creates a substantial
referral source for our long-term acute care hospitals.
The Social Security Amendments of 1983 excluded certain hospitals, including
general long-term acute care hospitals such as we operate, from the short-term
hospital prospective payment system. A general long-term
25
acute care hospital has been defined as a hospital that has an average length
of stay greater than 25 days for all patients. Inpatient operating costs for
general long-term acute care hospitals have been reimbursed under the
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 discussed below, the Balanced
Budget Act made significant changes to the TEFRA provisions.
Prior to the Balanced Budget Act, Medicare operating costs per discharge in
excess of the computed target rate were reimbursed at the rate of 50% of the
excess, up to 10% of the computed target rate. Hospitals whose operating costs
were lower than the computed target rate were reimbursed their actual costs
plus an incentive. For cost reporting periods beginning on or after October 1,
1997, the Balanced Budget Act reduced the incentive payments to an amount equal
to 15% of the difference between the actual costs and the computed target rate,
but not to exceed 2% of the computed target rate. Costs in excess of the
computed target rate are still being reimbursed at the rate of 50% of the
excess, up to 10% of the computed target rate, but the threshold to qualify for
such payments was raised from 100% to 110% of the computed target rate.
Since the adoption of the Balanced Budget Act, a new provider will no longer
receive unlimited cost-based reimbursement for its first few years in
operation. Instead, for the first two years, it will be paid the lower of its
costs or 110% of the median of TEFRA's computed target rate for 1996, adjusted
for inflation. During this two-year period, new providers are not eligible to
receive TEFRA relief or the incentive payments discussed in the previous
paragraph.
As of December 31, 2002, all of our long-term acute care hospitals were
subject to TEFRA's computed target rate provisions. The reduction in TEFRA's
incentive payments has had a material adverse effect on our hospital division's
operating results. These reductions, which began between May 1, 1998 and
September 1, 1998 with respect to our hospitals, have had a material adverse
impact on hospital division revenues.
We also operate three hospitals as general acute care facilities that are
subject to the short-term acute care hospital prospective payment system and
are not subject to TEFRA's computed target rate provisions.
Medicare and Medicaid reimbursements generally are determined from annual
cost reports that we file, which are subject to audit by the respective agency
or fiscal intermediaries administering the programs. We believe that adequate
provisions for loss have been recorded to reflect any adjustments that could
result from audits of these cost reports.
Federal regulations provide that admission to and utilization of hospitals
by Medicare and Medicaid patients must be reviewed by peer review organizations
in order to ensure efficient utilization of hospitals and services. A peer
review organization may conduct such review either prospectively or
retroactively and may, as appropriate, recommend denial of payments for
services provided to a patient. The review is subject to administrative and
judicial appeals. Each of the hospitals operated by our hospital division
employs a clinical professional to administer the hospital's integrated quality
assurance and improvement program, including its utilization review program.
Peer review organization denials historically have not had a material adverse
effect on the hospital division's operating results.
The antikickback amendments discussed above prohibit certain business
practices and relationships that might affect the provision and cost of
healthcare services reimbursable under federal healthcare programs. Sanctions
for violating these amendments include criminal and civil penalties and
exclusion from federal healthcare programs. Pursuant to the Medicare and
Medicaid Patient and Program Protection Act of 1987, the U.S. Department of
Health and Human Services and the Office of the Inspector General specified
certain safe harbors that describe conduct and business relationships
permissible under the antikickback amendments. These safe harbor regulations
have resulted in more aggressive enforcement of the antikickback amendments by
the U.S. Department of Health and Human Services and the Office of the
Inspector General.
26
Section 1877 of the Social Security Act, commonly known as "Stark I," states
that a physician who has a financial relationship with a clinical laboratory
generally is prohibited from referring patients to that laboratory. The Omnibus
Budget Reconciliation Act of 1993 contains provisions, commonly known as "Stark
II," amending Section 1877 to expand greatly the scope of Stark I. Effective
January 1995, Stark II broadened the referral limitations of Stark I to
include, among other designated health services, inpatient and outpatient
hospital services. Under Stark I and Stark II, a "financial relationship" is
defined as an ownership interest or a compensation arrangement. If such a
financial relationship exists, the entity generally is prohibited from claiming
payment for services under the Medicare or Medicaid programs. Compensation
arrangements generally are exempted from Stark I and Stark II if, among other
things, the compensation to be paid is set in advance, does not exceed fair
market value and is not determined in a manner that takes into account the
volume or value of any referrals or other business generated between the
parties. These laws and regulations, however, are complex, and the industry has
the benefit of only limited judicial or regulatory interpretation. We believe
that business practices of providers and financial relationships between
providers have become subject to increased scrutiny as healthcare reform
efforts continue on federal and state levels.
Our institutional pharmacy operations are subject to regulation by the
various states in which business is conducted as well as by the federal
government. The pharmacies are regulated under the Food, Drug and Cosmetic Act
and the Prescription Drug Marketing Act, which are administered by the U.S.
Food and Drug Administration. Under the Comprehensive Drug Abuse Prevention and
Control Act of 1970, which is administered by the U.S. Drug Enforcement
Administration, dispensers of controlled substances must register with the Drug
Enforcement Administration, file reports of inventories and transactions and
provide adequate security measures. Failure to comply with such requirements
could result in civil or criminal penalties.
States generally require that a pharmacy operating within the state be
licensed by the state board of pharmacy. At December 31, 2002, we had the
necessary licenses for each pharmacy we operate. In addition, our pharmacies
are registered with the appropriate state and federal authorities pursuant to
statutes governing the regulation of controlled substances. In addition, we
believe we comply with all relevant requirements of the Prescription Drug
Marketing Act for the transfer and shipment of pharmaceuticals.
Joint Commission on Accreditation of Health Care Organizations. Hospitals
may receive accreditation from the Joint Commission, a nationwide commission
that establishes standards relating to the physical plant, administration,
quality of patient care and operation of medical staffs of hospitals.
Generally, hospitals and certain other healthcare facilities are required to
have been in operation at least six months in order to be eligible for
accreditation by the Joint Commission. After conducting on-site surveys, the
Joint Commission awards accreditation for up to three years to hospitals found
to be in substantial compliance with Joint Commission standards. Accredited
hospitals also are periodically resurveyed, at the option of the Joint
Commission, upon a major change in facilities or organization and after merger
or consolidation. As of December 31, 2002, all of the hospitals operated by the
hospital division were accredited by the Joint Commission. The hospital
division intends to seek and obtain Joint Commission accreditation for any
additional facilities it may purchase or lease and convert into long-term acute
care hospitals. We do not believe that the failure to obtain Joint Commission
accreditation at any hospital would have a material adverse effect on the
hospital division's results of operations.
Regulatory Changes
The Balanced Budget Act contained extensive changes to the Medicare and
Medicaid programs intended to reduce the projected amount of increase in
payments under those programs over a five-year period. Virtually all spending
reductions were derived from reimbursements to providers and changes in program
components. The Balanced Budget Act has affected adversely the revenues in each
of our operating divisions.
The Balanced Budget Act established PPS for nursing centers for cost
reporting periods beginning on or after July 1, 1998. All of our nursing
centers adopted PPS on July 1, 1998. During the first three years, the per
27
diem rates for nursing centers were based on a blend of facility-specific costs
and federal rates. Effective July 1, 2001, the per diem rates are based solely
on federal rates. The payments received under PPS cover substantially all
services for Medicare patients including all ancillary services, such as
respiratory therapy, physical therapy, occupational therapy, speech therapy and
certain covered pharmaceuticals.
The Balanced Budget Act also reduced payments made to our hospitals by
reducing TEFRA incentive payments, allowable costs for capital expenditures and
bad debts, and payments for services to patients transferred from a general
short-term acute care hospital. In addition, the Balanced Budget Act reduced
allowable costs for capital expenditures by 15%. These reductions have had a
material adverse impact on hospital revenues.
Under PPS, the ability to bill Medicare separately for ancillary services
provided to nursing center patients also has declined dramatically. Medicare
reimbursements to nursing centers under PPS include substantially all services
provided to patients, including ancillary services. Prior to the implementation
of PPS, the costs of such services were reimbursed under cost-based
reimbursement rules. The decline in the demand for ancillary services since the
implementation of PPS is mostly attributable to efforts by nursing centers to
reduce operating costs. As a result, many nursing centers have elected to
provide ancillary services to their patients through internal staff. In
response to PPS and a significant decline in the demand for ancillary services,
we realigned our former ancillary services division in 1999 by integrating the
physical rehabilitation, speech and occupational therapy businesses into the
health services division and assigning the institutional pharmacy business to
the hospital division. Our respiratory therapy and other ancillary businesses
were discontinued.
Various legislative and regulatory actions have provided a measure of relief
from the impact of the Balanced Budget Act. In November 1999, the Balanced
Budget Refinement Act (the "BBRA") was enacted. Effective April 1, 2000, the
BBRA (a) implemented a 20% upward adjustment in the payment rates for the care
of higher acuity patients, and (b) allowed nursing centers to transition more
rapidly to the federal payment rates. The BBRA also imposed a two-year
moratorium on certain therapy limitations for skilled nursing center patients
covered under Medicare Part B. Effective October 1, 2000, the BBRA increased
all PPS payment categories by 4% through September 30, 2002.
The 20% upward adjustment in the payment rates for the care of higher acuity
patients under the BBRA will remain in effect until a revised Resource
Utilization Grouping ("RUG") payment system is established by CMS. On April 23,
2002, CMS announced that it will further delay the establishment of a revised
RUG classification system. Accordingly, the 20% upward adjustment for certain
higher acuity RUG categories set forth in the BBRA will be extended until the
RUG refinements are enacted. Nursing center revenues associated with the 20%
upward adjustment approximated $38 million in 2002, $32 million in 2001 and $18
million in 2000.
In December 2000, the Medicare, Medicaid, and State Child Health Insurance
Program Benefits Improvement and Protection Act of 2000 ("BIPA") was enacted to
provide up to $35 billion in additional funding to the Medicare and Medicaid
programs over the next five years. Under BIPA, the nursing component for each
RUG category increased by 16.66% over the existing rates for skilled nursing
care for the period April 1, 2001 through September 30, 2002. BIPA also
provided some relief from scheduled reductions to the annual inflation
adjustments to the RUG payment rates through September 30, 2002.
BIPA also extended the two-year moratorium on outpatient therapy limitations
for skilled nursing center patients under the BBRA through December 31, 2002.
On February 7, 2003, CMS instructed fiscal intermediaries to apply the therapy
limitations for all outpatient rehabilitation services in a prospective manner
beginning with claims submitted for dates of service on or after July 1, 2003.
For each subsequent year, the therapy limitation will be effective for the
entire calendar year.
In addition, BIPA slightly increased payments for inpatient services and
TEFRA incentive payments for long-term acute care hospitals. Allowable costs
for bad debts also were increased by 15%. Both of these provisions became
effective for cost reporting periods beginning on or after September 1, 2001.
28
Our nursing centers received reimbursement under the BBRA (including amounts
related to the 20% upward adjustment discussed above) of approximately $51
million in 2002, $47 million in 2001 and $21 million in 2000. Revenues
associated with BIPA aggregated approximately $32 million in 2002 and $30
million in 2001.
As previously discussed, certain Medicare reimbursement provisions under the
BBRA and BIPA expired as scheduled on October 1, 2002. Accordingly, Medicare
reimbursement to our nursing centers declined by approximately $35 per patient
day or $15 million in the fourth quarter of 2002, resulting in a material
reduction in nursing center operating income.
On October 1, 2002, the provision under the Balanced Budget Act reducing
allowable hospital capital expenditures by 15% expired. As a result, hospital
Medicare revenues increased by approximately $2 million in the fourth quarter
of 2002.
On August 30, 2002, CMS issued final regulations for the new prospective
payment system for long-term acute care hospitals ("LTAC PPS") that became
effective on October 1, 2002. Because of our Medicare cost reporting periods,
this new payment system will not become effective for all but two of our
long-term acute care hospitals until September 1, 2003.
As anticipated, LTAC PPS is based on discharge-based diagnosis related
groups ("DRG") similar to the system used to pay short-term acute care
hospitals. While the clinical system which groups procedures and diagnoses is
identical to the prospective payment system for short-term acute care
hospitals, the new payment system utilizes different rates and formulas. Three
types of payments will be used in the new system: (a) short stay outlier that
will provide for patients whose length of stay is less than 5/6th of the
average length of stay for that DRG, a payment based upon the lesser of (1) a
per diem based upon the average payment for that DRG, (2) the estimated costs
plus 20%, or (3) the full DRG payment; (b) DRG fixed payment which provides a
single payment for all patients with a given DRG, regardless of length of stay,
cost of care or place of discharge; and (c) high cost outlier that will provide
a partial coverage of costs for patients whose cost of care far exceeds the DRG
reimbursement. For patients in the high cost outlier category, Medicare will
reimburse 80% of the costs incurred above the DRG reimbursement plus a fixed
cost outlier threshold of $24,450 per discharge.
The new system provides for an adjustment for differences in area wages
resulting from salary and benefit variations. There also are additional rules
for payment for patients who are transferred from a long-term care hospital to
another healthcare setting and are subsequently re-admitted to the long-term
care hospital. The LTAC PPS payment rates also are subject to annual
adjustments.
The new system maintains long-term acute care hospitals as a distinct
provider type, separate from short-term acute care hospitals. Only providers
certified as long-term acute care hospitals may be paid under the new system.
To maintain certification under the new payment system, the average length of
stay of Medicare patients must be at least 25 days. Under the previous system,
compliance with the 25-day average length of stay threshold was based on all
patient discharges.
As previously noted, the new system became effective for cost reporting
periods beginning after October 1, 2002. As an alternative to the immediate
adoption of LTAC PPS, long-term acute care hospitals may elect to phase in the
new system over five years. These phase-in provisions will enable providers to
make the necessary operational changes over the next several years to support a
smooth clinical and financial transition to the new payment system.
Our hospitals currently receive interim cash payments under TEFRA as a
result of submitting interim and final patient bills twice each month. Under
LTAC PPS, a provider will choose one of two methods of receiving interim cash
payments: (1) by billing each patient at the earlier of the time of discharge
or 60 days from the time of admission or (2) by electing a periodic interim
payment methodology which estimates the total annual LTAC PPS reimbursement by
hospital and converts that amount into a bi-weekly cash payment. Either payment
system may negatively impact the hospital division's operating cash flows in
2003.
29
We continue to review the extensive regulations associated with the new LTAC
PPS. Based upon our analysis to date, we believe that the new system should not
have a material impact on our hospital operating results but may negatively
impact operating cash flows in the short term. These preliminary estimates are
based upon current patient acuity and expense levels in our hospitals. These
factors, among others, are subject to significant change. Slight variations in
patient acuity could significantly change Medicare revenues generated under
LTAC PPS. In addition, our hospitals may not be able to appropriately adjust
their operating costs as patient acuity levels change. As a result of these
uncertainties, we cannot predict the ultimate impact of the new LTAC PPS on our
hospital operating results and we cannot assure you that such regulations or
operational changes resulting from these regulations will not have a material
adverse impact on our financial position, results of operations or liquidity.
In addition, we cannot assure you that the new LTAC PPS will not have a
material adverse effect on revenues from non-government third party payors.
There continue to be legislative and regulatory proposals that would impose
further limitations on government and private payments to providers of
healthcare services. By repealing the Boren Amendment, the Balanced Budget Act
eased existing impediments on the ability of states to reduce their Medicaid
reimbursement levels. Many states are considering or have enacted measures that
are designed to reduce their Medicaid expenditures and to make certain changes
to private healthcare insurance. In addition, budgetary pressures currently
impacting a number of states may further reduce Medicaid payments to our
nursing centers. Some states also are considering regulatory changes that
include a moratorium on the designation of additional long-term acute care
hospitals. Additionally, regulatory changes in the Medicaid reimbursement
system applicable to our hospitals and pharmacies have been enacted or are
being considered. There also are legislative proposals including cost caps and
the establishment of Medicaid prospective payment systems for nursing centers.
We could be affected adversely by the continuing efforts of governmental and
private third party payors to contain healthcare costs. We cannot assure you
that payments under governmental and private th