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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] Annual Report pursuant to section 13 or 15(d) of the Securities
Exchange Act of 1934 for the fiscal year ended December 31, 1997 or
[ ] Transition report pursuant to section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from ________ to ________
Commission file number 0-22019
SPECIALTY CARE NETWORK, INC.
(Exact name of registrant as specified in its charter)
Delaware
(State or other jurisdiction of 62-1623449
incorporation or organization) (I.R.S. Employer Identification No.)
44 Union Boulevard, Suite 600
Lakewood, Colorado 80228
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (303) 716-0041
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
None None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.001 per share
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No __
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in the definitive proxy statement incorporated
by reference in Part III of this annual report on Form 10-K or any amendment to
this annual report on Form 10-K. __
As of March 20, 1998, the aggregate market value of the Common Stock held by
non-affiliates of the registrant was $185,265,605. Such aggregate market value
was computed by reference to the closing sale price of the Common Stock as
reported on the Nasdaq National Market on such date. For purposes of making this
calculation only, the registrant has defined "affiliates" as including all
directors and beneficial owners of more than five percent of the Common Stock of
the Company.
As of March 20, 1998 there were 17,736,393 shares of the registrant's Common
Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement for the Registrant's 1998 Annual
Meeting of Stockholders to be filed within 120 days after the end of the fiscal
year covered by this Annual Report on Form 10-K -- Part III.
1
TABLE OF CONTENTS
PART I
Item 1. Business............................................................ 3
Item 2. Properties..........................................................23
Item 3. Legal Proceedings...................................................23
Item 4. Submission of Matters to a Vote of Security Holders.................23
PART II
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters...............................................26
Item 6. Selected Financial Data.............................................27
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations.........................................27
Item 7A Quantitative and Qualitative Disclosures About Market Risk..........32
Item 8. Financial Statements and Supplementary Data.........................32
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure...............................32
PART III
Item 10. Directors and Executive Officers of the Registrant..................33
Item 11. Executive Compensation..............................................33
Item 12. Security Ownership of Certain Beneficial Owners and Management......33
Item 13. Certain Relationships and Related Transactions......................33
PART IV
Item 14. Exhibits, Financial Statement Schedules,
and Reports on Form 8-K...........................................34
Index to Financial Statements and Schedules..................................F-1
This Report contains forward-looking statements that address, among other
things, the Company's affiliation and expansion strategy, projected capital
expenditures, liquidity, proposed specialties of physicians with whom the
Company intends to affiliate, possible third-party payor arrangements, cost
reduction strategies, possible effects of changes in government regulation and
availability of insurance. These statements may be found under "Item 1-
Business," "Item 1-Risk Factors," and "Item 7-Management's Discussion and
Analysis of Financial Condition and Results of Operations" as well as in the
Report generally. Actual events or results may differ materially from those
discussed in forward-looking statements as a result of various factors,
including difficulties in affiliating with additional practices, inability to
integrate and manage successfully assets and personnel related to affiliations
with musculoskeletal practices, changes in reimbursement practices of third
party providers, change in mix of patients served by the Affiliated Practices,
insufficient capital resources, competition, changes in the regulatory
environment and other factors discussed below including without limitation those
discussed in "Item 1-Risk Factors" and matters set forth in the Report
generally.
Unless the context indicates otherwise, the terms "Specialty Care Network,"
"SCN" and "Company" refer to Specialty Care Network, Inc. References to
practices affiliated with the Company (the "Affiliated Practices") include
predecessors of those practices.
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PART I
Item 1. Business.
General
Specialty Care Network is a physician practice management company that
focuses on musculoskeletal care, which is the treatment of conditions relating
to bones, joints, muscles and related connective tissues. The Company currently
provides comprehensive management services under exclusive, long-term agreements
to 153 physicians practicing through 21 Affiliated Practices at 47 clinic
locations in 10 states. In addition, the Company manages two outpatient surgery
centers, three physical therapy centers and one occupational medicine operation.
Specialty Care Network seeks to affiliate with premier orthopaedic physician
groups in targeted markets as the first step in developing an integrated
musculoskeletal provider network.
Under the service agreements between the Company and its Affiliated
Practices (the "Service Agreements"), the Company provides management,
administrative and development services to the Affiliated Practices. The
Company's affiliated physicians are trained in a variety of musculoskeletal
disciplines, including general orthopaedics, joint replacement surgery, sports
medicine, spinal care, hand and upper extremity care, foot and ankle care,
pediatric orthopaedic, physiatry, podiatry, occupational medicine, neurosurgery,
plastic surgery, rheumatology, trauma and adult neurology. In addition, certain
of the Company's Affiliated Practices are now providing ancillary services,
including magnetic resonance imaging, orthotics and radiology.
The Company was incorporated in December 1995 and commenced its physician
practice management services in November 1996.
Industry Overview
Physician Practice Management Industry. The Health Care Financing
Administration ("HCFA") estimated that national health care spending in 1995 was
approximately $988 billion, with approximately $202 billion of such expenditures
directly attributable to physician services and an additional $600 billion under
physician direction. Moreover, HCFA projects that national health care spending
will be nearly $1.5 trillion in 2000. This spending growth has occurred in an
environment where managed care payors have consolidated and have become more
aggressive in negotiations with providers. The resulting emphasis on cost
containment, the consolidation of the health care market in general, the
increased market share of managed care companies and the gradual transfer of
risk from payors to providers have precipitated significant changes in the way
physicians organize themselves. The Company believes that, among other factors,
these market pressures have caused physicians to affiliate with physician
practice management companies that provide comprehensive operational and
financial support.
Musculoskeletal Market Overview. Expenditures for musculoskeletal care in
the United States are significant, with total direct costs associated with the
delivery of musculoskeletal care exceeding $60 billion in 1988, according to the
American Academy of Orthopaedic Surgeons ("AAOS"). Of this amount, approximately
$7 billion represented fees paid for physician services. The remaining amount
represented charges for hospital stays, prosthetics, supplies and related
diagnostic therapies and other ancillary services.
The spectrum of musculoskeletal care ranges from acute procedures, such as
spinal or hip surgery after trauma, to the treatment of chronic conditions, such
as arthritis and back pain. There are a number of subspecialties of
orthopaedics, including adult reconstructive (joint replacement) surgery, spinal
care, sports medicine, foot and ankle care, hand and upper extremity care,
pediatrics, oncology and trauma care. Although the orthopaedic surgeon
represents the primary musculoskeletal provider, musculoskeletal care is also
provided by a variety of medical and surgical specialists, including
neurosurgeons, neurologists, plastic surgeons, physiatrists, rheumatologist,
occupational medicine physicians, podiatrists and primary care physicians, as
well as rehabilitative therapists. The American Medical
3
Association estimates that in 1996 there were approximately 22,500
orthopaedic surgeons, 5,700 physiatrists, 3,500 rheumatologist, 3,000
occupational medicine physicians, 11,400 neurologists and 4,900 neurosurgeons.
The payor mix for musculoskeletal care is diverse, with managed care
enrollees representing an increasing percentage of patients. According to data
from a 1996 AAOS survey, the largest percentage of patients is managed care,
including fee-for-service and capitation (26%), followed by private pay (23%),
Medicare (21%) and workers compensation (17%). Almost 84% of orthopaedic
surgeons indicated they received patients from managed care sources. The AAOS
survey indicates that the percentage of total managed care patients has
increased from 12% in 1988 to 26% in 1996. Over the same period, patients from
private pay sources declined from 39% to 23%. The distribution of patients from
other sources remained relatively constant over this period. According to the
AAOS, the 65-and-over age group accounts for approximately 25% of
musculoskeletal cases. Given the aging of the U.S. population, the Company
believes that demographic trends will increase the need for musculoskeletal
care.
Affiliated Practices
Specialty Care Network seeks to affiliate with premier musculoskeletal
groups in targeted markets throughout the United States. The Company evaluates
potential affiliation candidates based on a variety of factors, including: (i)
physician credentials and reputation; (ii) competitive market position; (iii)
specialty and subspecialty mix of physicians; (iv) historical financial
performance and growth potential; (v) commitment to providing comprehensive
musculoskeletal care and developing an integrated disease management model; and
(vi) recognition of the need for outside managerial, financial and business
expertise to position effectively for managed care and capitation. The Company
believes that it is an attractive affiliation partner to musculoskeletal groups
because of its physician-oriented heritage and governance structure, the depth
and experience of its management team, and its corporate philosophy and service
agreement structure, which emphasize parallel incentives among physicians and
the Company.
Specialty Care Network currently provides comprehensive management services
under exclusive, long-term agreements with 153 physicians practicing through 21
Affiliated Practices at 47 clinic locations in 10 states. Management believes
that ancillary services represent a significant expansion opportunity for a
majority of the Affiliated Practices, and the Company intends to pursue
aggressively the addition of ancillary services where appropriate.
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The table below sets forth certain information regarding the Affiliated
Practices, all of whose physicians are board certified or board eligible:
Musculoskeletal Ancillary
Affiliated Practices Principal Office Physicians Subspecialties Services(1) Offices
- -------------------------------- ------------------ ------------- ------------------ ----------------- -----------
Reconstructive Orthopaedic
Associates, II, P.C. ("ROA") Philadelphia, PA 9 5 MRI, Orthotics 2
3B Orthopaedics, P.C. ("3B
Orthopaedics") Philadelphia, PA 6 3 -- 3
Princeton Orthopaedic
Associates, II, P.A. ("POA") Princeton, NJ 14 7 Outpatient 3
Surgery,
Rehabilitation
Therapy
Greater Chesapeake Orthopaedic
Associates, LLC ("GCOA") Baltimore, MD 8 5 Orthotics 2
The Orthopaedic & Sports
Medicine Center, II, P.A..,
("OSMC") Annapolis, MD 10 6 -- 3
Riyaz H. Jinnah, M.D., P.A. Baltimore, MD 1 -- -- 1
Mid-Atlantic Orthopaedic
Specialists/Drs. Cirincione,
Milford, Stowell and
Amalfitano, P.C. ("MAOS") Hagerstown, MD 5 1 -- 2
Vero Orthopaedics II, P.A. ("VO") Vero Beach, FL 7 6 -- 1
Ortho-Associates, P.A. d/b/a
Park Place Therapeutic
Center ("PPTC") Plantation, Fl 14 4 MRI, 2
Rehabilitation
Therapy
Medical Rehabilitation
Specialists II, P.A. ("MRS") Tallahassee, FL 2 1 -- 1
Northeast Florida Orthopaedic
Sports Medicine and
Rehabilitation II, P.A.
("NFOSM") Jacksonville, FL 2 2 Rehabilitation 1
Therapy
Orthopaedic Associates of
West Florida, P.A. Clearwater, FL 9 5 Bone Density 2
- ----------------
(1) Includes ancillary services provided by the Affiliated Practices with
respect to which the Company receives a fee.
5
Musculoskeletal Ancillary
Affiliated Practices Principal Office Physicians Subspecialties Services(1) Offices
- -------------------------------- ------------------ ------------- ------------------ ----------------- -----------
Steven P. Surginer, M.D., P.A., II Marianna, FL 1 -- -- 1
TOC Specialists, P.L. ("TOC") Tallahassee, FL 17 7 Outpatient 4
Surgery,
Rehabilitation
Therapy, Orthotics
Floyd Jaggears, M.D., P.C. Thomasville, GA 1 -- -- 1
Southeastern Neurology
Group II, P.C. ("SNG") Portsmouth, VA 12 2 -- 5
Orthopaedic Surgery Centers,
P.C. II ("OSC") Portsmouth, VA 10 6 -- 6
Associated Orthopaedic &
Sports Medicine, P.A. ("AOSM") Plano, TX 5 1 Outpatient 1
Surgery,
Rehabilitation
Therapy
Orthopaedic Institute of
Ohio ("OIO") Lima, OH 8 3 Outpatient 2
Surgery,
Rehabilitation
Therapy
The Specialists Orthopaedic
Medical Corporation ("SMC") Fairfield, CA 12 6 Outpatient 4
Surgery,
Rehabilitation
Therapy
- ----------------
(1) Includes ancillary services provided by the Affiliated Practices with
respect to which the Company receives a fee.
Management Information Systems
The Company believes that its management information systems provide
meaningful assistance to the Affiliated Practices. The Company has developed
proprietary financial systems that have been installed at the Company's
headquarters and at each of the Affiliated Practices. The electronic interfaces
between payroll, general ledger, banking, accounts payable and accounts
receivable applications enable the Company to capture, analyze and report
centrally financial data from the various Affiliated Practice locations and
provide analyses of financial data on a fully integrated basis. In addition, the
internally developed purchase order application enables the Company to monitor
daily practice inventory purchases from order to receipt, to centrally control
the disbursement of funds and to identify economies in purchasing.
The Company believes that an important factor in the successful management
of musculoskeletal disease is the creation of a treatment-specific outcomes
database from which treatment modalities can be derived. Therefore, the Company,
in conjunction with affiliated physicians who specialize in specific orthopaedic
subspecialties, is in the process of gathering clinical information designed to
facilitate the development of a proprietary clinical outcomes database to enable
the Affiliated Practices to analyze clinical outcomes at the practitioner and
practice levels on a
6
standardized basis. The Company has established standards at the Affiliated
Practices for gathering clinical and financial information such as personal
patient data, physician and procedure identifier codes, payor class and amounts
charged and reimbursed. Information is being gathered from patient encounters in
areas such as incidence rates (the number of specified procedural, diagnostic
and medical events during a defined period with respect to a particular patient
population), utilization (frequency of patient care and activity relating to the
patient) and quality of care (monitoring and evaluation of patient outcomes).
This information should assist physicians in developing clinical protocols,
measuring outcomes, ensuring that standards of quality are met and determining
the most cost-effective course for treating patients. The Company intends to use
this data, together with data derived from its financial information systems, to
produce comprehensive financial and clinical reports to be used in connection
with the negotiation, structuring and pricing of managed care contracts.
Operations
Management Services. Specialty Care Network assists in strategic planning,
preparation of operating budgets and capital project analysis. The Company
coordinates group purchasing of supplies, inventory and medical and malpractice
insurance for the practices. In addition, the Company assists the Affiliated
Practices in physician recruitment by introducing physician candidates to the
practices and advising the practices in structuring employment arrangements. The
Company also provides or arranges for a variety of additional services relating
to the day-to-day non-medical operations of the practices, including (i)
management and monitoring each practice's billing levels, invoicing procedures
and accounts receivable collection by payor type, (ii) accounting, payroll and
legal services and records and (iii) cash management and centralized
disbursements.
These management services are designed to reduce the amount of time
physicians must spend on administrative matters, thereby enabling the physicians
to dedicate more of their efforts toward the delivery of health care services.
The Company's capital resources and assistance in preparation of budgets and
capital project analyses are intended to facilitate the development of ancillary
musculoskeletal services, such as outpatient surgery, outpatient imaging, pain
management, rehabilitation therapy and orthotics. Comprehensive administrative
support is designed to facilitate more effective billing and collections and, as
the Company grows, to generate economies of scale in effecting purchases.
Practice Services. Specialty Care Network employs most of the Affiliated
Practices' non-physician personnel. These non-physician personnel, along with
additional personnel at the Company's headquarters, manage the day-to-day
non-medical operations of each of the Affiliated Practices, including, among
other things, provision of secretarial, bookkeeping, scheduling and other
routine services. Under the Service Agreements, the Company must provide
practice facilities and equipment to the Affiliated Practices; consequently, the
Company entered into lease agreements for the practice facilities utilized by
the Affiliated Practices, many of which are owned by physician owners of the
Affiliated Practices, and the Company also purchased the equipment utilized by
each of the Affiliated Practices.
Payor Contracting. An increasing portion of the Affiliated Practices' net
revenue is derived from managed care payors. Although rates paid by managed care
payors are generally lower than fee for service rates, managed care payors can
provide access to large patient volumes. Currently, the Company performs
analyses of the Affiliated Practices' markets to develop managed care
contracting strategies and meets with principal payors in these markets to
enhance and establish relationships between the Affiliated Practices and such
payors.
Specialty Care Network seeks to negotiate both fee-for-service and
capitated contracts on behalf of the Affiliated Practices. Under capitated
arrangements, providers deliver health care services to managed care enrollees
and bear all or a portion of the risk that the cost of such services may exceed
capitated payments. Capitated contracts involve various forms of risk-sharing.
Providers may accept risk only with respect to the costs of physician services
required by a patient (i.e., professional fee capitation) or for all of the
medical costs required by a patient including professional, institutional and
ancillary services (i.e., global capitation). Managed care companies'
arrangements with providers can be further segmented into episode of care and
per member per month capitation. Under specified episode of care capitation,
providers deliver care for covered enrollees with a specified medical condition,
or who require a particular
7
treatment, on a fixed fee basis per episode. Under per member per month
capitation, the providers receive fixed monthly fees per covered enrollee and
assume the financial responsibility for the incidence of medical conditions
requiring procedures specified in the contract.
The Company, on behalf of certain of its Affiliated Practices, has
negotiated "Episode of Care" or package pricing arrangements with several major
health maintenance organizations and workers compensation carriers. These
arrangements cover several surgical procedures, including hip replacement,
spinal fusion, laminectomy, discectomy, anterior cruciate ligament repair,
arthroscopy and foot and ankle procedures.
Governance and Quality Assurance
Specialty Care Network's current governance structure promotes physician
participation in the management of the Company, with six affiliated physicians
currently serving on the Company's ten person Board of Directors. In addition,
the Company is establishing a Physician Advisory Board that is designed to serve
as a liaison to the Company for these practices that are not otherwise
represented on the Board of Directors. Moreover, each Affiliated Practice has a
Joint Policy Board whose membership includes an equal number of representatives
from the Company and the Affiliated Practice. The Joint Policy Boards have
responsibilities that include developing long-term strategic objectives,
developing practice expansion and payor contracting guidelines, promoting
practice efficiencies, identifying and recommending significant capital
expenditures and facilitating communication and information exchanges between
the Company and each of the Affiliated Practices.
Contractual Agreements with Affiliated Practices
The Company has entered into long-term Service Agreements with each of the
Affiliated Practices to provide management and administrative services. The
following is intended to be a general summary of the form of Service Agreement
employed by the Company. The actual terms of the individual Service Agreements
may, and typically do, vary in certain respects from the description below as a
result of negotiations with the individual practices and the requirements of
state and local laws and regulations.
Responsibilities of the Company. Pursuant to the Service Agreements, the
Company, among other things, (i) acts as the exclusive manager and administrator
of non-physician services relating to the operation of the Affiliated Practices,
subject to matters for which the Affiliated Practices maintain responsibility or
which are referred to the Joint Policy Boards of the Affiliated Practices, (ii)
on behalf of the Affiliated Practices bills patients, insurance companies and
other third-party payors and collects, on behalf of the Affiliated Practices,
the fees for professional medical and other services rendered, including goods
and supplies sold by the Affiliated Practices, (iii) provides or arranges for,
as necessary, clerical, accounting, purchasing, payroll, legal, bookkeeping and
computer services and personnel, information management, preparation of certain
tax returns, printing, postage and duplication services and medical transcribing
services, (iv) supervises and maintains custody of substantially all files and
records (medical records of the Affiliated Practices remain the property of the
Affiliated Practices), (v) provides facilities and equipment for the Affiliated
Practices, (vi) prepares, in consultation with the Joint Policy Boards and the
Affiliated Practices, all annual and capital operating budgets for the
Affiliated Practices, (vii) orders and purchases inventory and supplies as
reasonably requested by the Affiliated Practices, (viii) implements, in
consultation with the Joint Policy Boards and the Affiliated Practices, local
public relations or advertising programs and (ix) provides financial and
business assistance in the negotiation, establishment, supervision and
maintenance of contracts and relationships with managed care and other similar
providers and payors. Most employees providing such services were employed by
the Affiliated Practices prior to affiliation with the Company.
Responsibilities of the Affiliated Practices. Under the Service Agreements,
the Affiliated Practices retain the responsibility for (i) hiring and
compensating physician employees and other medical professionals, (ii) ensuring
that physicians have the required licenses, credentials, approvals and other
certifications needed to perform their duties and
8
(iii) complying with certain federal and state laws and regulations applicable
to the practice of medicine. In addition, the Affiliated Practices maintain
exclusive control of all aspects of the practice of medicine and the delivery of
medical services.
Service Fee. Under the Service Agreements, the Company collects fees from
the Affiliated Practices on a monthly basis generally equal to the following:
(i) a percentage (the "Service Fee Percentage") ranging from 20%-50% of the
Adjusted Pre-Tax Income of the Affiliated Practices, which is defined generally
as revenue of the Affiliated Practices related to professional services less
amounts equal to certain clinic expenses of the Affiliated Practices, not
including physician owner compensation or most benefits to physician owners
("Clinic Expenses," as defined more fully in the Service Agreements) and (ii)
amounts equal to Clinic Expenses. Generally, for the first three years following
the affiliation the portion of service fee described under clause (i) is subject
to a fixed dollar minimum (the "Base Service Fee"); which generally was
determined by applying the respective Service Fee Percentage to the Adjusted
Pre-Tax Income for each Affiliated Practice for the 12 months prior to
affiliation. In addition, with respect to its management (and, in certain
instances, ownership) of certain facilities and ancillary services associated
with certain of the Affiliated Practices, the Company receives fees based on a
percentage of net revenue or pre-tax income related to such facilities and
services.
Accounts Receivable. Under the Service Agreements, each Affiliated Practice
agrees to sell and assign to the Company, and the Company agrees to buy, all of
the Affiliated Practice's accounts receivable each month during the existence of
the Service Agreement. The purchase price for such accounts receivable generally
equals the gross amounts of the accounts receivable recorded each month less
adjustments for contractual allowances, allowances for doubtful accounts and
other potentially uncollectible amounts based on the Affiliated Practice's
historical collection rate, as determined by the Company. However, the Company
and certain Affiliated Practices are currently making periodic adjustments so
that amounts paid by the Company for the accounts receivable are adjusted
upwards or downwards based on the Company's actual collection experience. While
the Company believes, based on its discussions with the other Affiliated
Practices, that this arrangement is acceptable to them, the Company cannot
assure that this arrangement will be effected in all cases.
Period Covered by Service Agreement. The Service Agreements have initial
terms of forty years, with automatic extensions (unless specified notice is
given) of additional five-year terms.
Termination of Service Agreement. The Service Agreements may be terminated
by either party if the other party (i) files petition in bankruptcy or other
similar events occur or (ii) defaults on the performance of a material duty or
obligation, which default continues for a specified term after notice. In
addition, the Company may terminate the agreement if the Affiliated Practice's
Medicare or Medicaid number is terminated or suspended as a result of some act
or omission of the Affiliated Practice or physicians, and the Affiliated
Practice may terminate the agreement if the Company misapplies funds or assets
or violates certain laws. Upon termination of a Service Agreement by the
Affiliated Practice for one of the reasons above, the Affiliated Practice is
required to purchase and assume the assets and liabilities related to the
Affiliated Practice at the fair market value thereof. Upon termination of the
Service Agreement by the Company for one of the reasons set forth above, the
Company has the option to require the Affiliated Practice to purchase and assume
the assets and liabilities related to the Affiliated Practice, in which event
the purchase price for such assets is equal to the unamortized amount of
intangible assets reflected on the books of the Company as of the last day of
the month prior to termination of the Service Agreement plus the then book value
of all remaining assets (including the Affiliated Practice's accounts
receivable) of the Company related to the Affiliated Practice. The Service
Agreement generally may also be terminated by the Affiliated Practice on the
tenth anniversary if all of the owners of the Affiliated Practice elect to do
so. In such event, the Affiliated Practice generally must purchase the practice
assets from the Company for a purchase price calculated in the same manner as
when the Service Agreement is terminated by the Company.
Advance Notice of Termination. Under the Service Agreements, each physician
owner must give the Company twelve months notice of an intent to retire from the
Affiliated Practice. If a physician gives such notice during the first five
years of the agreement, the physician must also locate a replacement physician
or physicians acceptable to the Joint
9
Policy Board and pay an amount based on a formula relating to any loss of
service fee for the first five years of the term. In addition, a physician
leaving a practice during the first five years of the term is required to pay
the Company or return to the Company an amount of cash or stock equal to
one-third of the total consideration received by such physician in connection
with the Company's affiliation with the practice. The agreement generally also
provides that after the fifth year, no more than 20% of the physician owners at
the Affiliated Practice may retire within a one-year period.
Non-Competition Provisions. The Affiliated Practices and the physician
owners of the Affiliated Practices generally agree not to compete with the
Company in providing services similar to those provided by the Company under the
Service Agreements, and the physician owners also generally agree not to compete
with an Affiliated Practice within a specified geographic area. Non-competition
restrictions generally apply to physician owners during their affiliation with
Affiliated Practices and for three years thereafter. In addition, the Service
Agreements generally require the Affiliated Practice to enter into
non-competition agreements with all physicians in the Affiliated Practice.
Non-competition restrictions generally apply to physician employees during their
affiliation with the Affiliated Practice and for two years after any termination
of employment. The Service Agreements generally require the Affiliated Practices
to pursue enforcement of the non-competition agreement with physicians or assign
to the Company the right to pursue enforcement. In addition, the Service
Agreements generally require the Company to obtain the consent of an Affiliated
Practice or the particular Joint Policy Board in order to affiliate with, or
enter into a management service agreement with, other practices or physicians
located within the same geographic area in which the physician owners have
agreed not to compete.
Insurance. The Affiliated Practices are responsible for obtaining
professional liability and worker's compensation insurance for the physicians
and other medical employees of the Affiliated Practices, as well as general
liability umbrella coverage. The Company is responsible for obtaining
professional liability and worker's compensation insurance for employees of the
Company and general liability and property insurance for the Affiliated
Practices.
Indemnification. The Service Agreements contain indemnification provisions,
pursuant to which the Company indemnifies the Affiliated Practices for damages
resulting from negligent acts or omissions by the Company or its agents,
employees or stockholders. In addition, the Affiliated Practices indemnify the
Company for any damages resulting from any negligent act or omissions by any
affiliated physicians, agents or employees of the Affiliated Practice, other
than damages resulting from claims arising from the performance or
nonperformance of medical services.
Other Agreements. Effective July 1997, three affiliated physicians
discontinued practicing with ROA. The Company entered into an agreement (the "3B
Agreement") pursuant to which two of the physicians, together with the third
physician, who was not part of the agreement, established an independent
practice, 3B Orthopaedics, which will enter into a new service agreement with
the Company. The Company is currently negotiating a new service agreement with
3B Orthopaedics. The aggregate Base Service Fee for ROA and 3B Orthopaedics
generally will be equal to ROA's current Base Service Fee. Pending the execution
of a new service agreement with 3B Orthopaedics, the three physicians remain
subject to the Service Agreement with ROA. The parties have agreed that in the
event additional issues arise in the process of completing definitive
agreements, and such issues are not resolved, then such issues will be submitted
to binding arbitration.
Third Party Reimbursement
A significant amount of the revenues of the Affiliated Practices are
derived from government and private third party payors. The health care industry
is experiencing a trend toward cost containment as third party payors seek to
impose lower reimbursement and utilization rates and negotiate reduced capitated
payment schedules with service providers. For the year ended December 31, 1997,
the net practice revenue from Medicare constituted approximately 22% of the
aggregate net practice revenue of the Affiliated Practices. The federal
government has implemented a resource-based relative value scale ("RBRVS")
payment methodology under Medicare for physician services and other outpatient
services furnished incident to a physician's service. RBRVS is a fee schedule
that, except for certain geographical and other adjustments, pays similarly
situated physicians the same amount for the same services. The RBRVS is adjusted
each year and is subject to increases or decreases at the discretion of
Congress. To date, the implementation of RBRVS has reduced payment rates for
certain of the procedures historically provided by the Affiliated Practices.
Moreover, the Balanced Budget Act of 1997 (the "1997 Budget Act") contains
provisions that may
10
have the effect of reducing Medicare reimbursement for services
historically provided by the Affiliated Practices, including orthopedic surgical
procedures and rehabilitation services such as physical therapy and
comprehensive outpatient rehabilitation services. These or further changes in
the Medicare fee schedule payment methodology could have an adverse effect on
the business of the Company and Affiliated Practices.
Physician reimbursement rates paid by private third party payors, including
those that provide Medicare supplemental insurance coverage, are more often
still based on established charges. However, RBRVS types of payment systems are
increasingly being adopted by certain private third party payors and may become
a predominant payment methodology. Wider spread implementation of such payment
systems may result in reduced payments from private third party payors and could
indirectly reduce revenue to the Company. Although more private third party
payors are adopting RBRVS-type reimbursement or other managed care-type
restrictions on reimbursement, such rates still are generally higher than
Medicare payment rates. However, further reductions in reimbursement levels or
other changes in reimbursement for health care services could have a material
adverse effect on the Affiliated Practices and, as a result, on the Company.
These reductions could result from changes in current reimbursement rates or
from a shift in clinical protocols to non-surgical solutions to orthopedic
conditions. There can be no assurance that the Company will be able to offset
successfully any or all of the payment reductions that may occur. Even absent
more widespread adoptions of RBRVS or managed care-type payment restrictions, a
change in the patient mix of any of the Affiliated Practices that results in a
decrease in patients covered by private third party payors could have a material
adverse effect on the Affiliated Practices and, as a result, on the Company.
Government Regulation and Supervision
The delivery of health care services has become one of the most highly
regulated of professional and business endeavors in the United States. Both the
federal government and the individual state governments are responsible for
overseeing the activities of individuals and businesses engaged in the delivery
of health care services. Federal law and regulations are based primarily upon
the Medicare program and the Medicaid program, each of which is financed, at
least in part, with federal funds. State jurisdiction is based upon the state's
interest in regulating the quality of health care in the state, regardless of
the source of payment.
The Company believes its operations are in material compliance with
applicable laws; however, the Company has not received or applied for a legal
opinion from counsel or from any federal or state judicial or regulatory
authority to this effect, and many aspects of the Company's business operations
have not been the subject of state or federal regulatory interpretation. The
laws applicable to the Company and the Affiliated Practices are subject to
evolving interpretations, and therefore, there can be no assurance that a review
of the Company or the Affiliated Practices by a court or law enforcement or
regulatory authority will not result in a determination that could have a
material adverse effect on the Company or the Affiliated Practices. Furthermore,
there can be no assurance that the laws applicable to the Company or the
Affiliated Practices will not be amended in a manner that could have a material
adverse effect on the Company or the Affiliated Practices.
The federal health care laws apply in any case in which the Company is
submitting a claim on behalf of an Affiliated Practice that is providing an item
or service that is reimbursed under Medicare, Medicaid or most other
federally-funded health care programs. The principal federal laws include those
that prohibit the filing of false or improper claims for federal payment, those
that prohibit unlawful inducements for the referral of business reimbursable
under federally-funded health care programs and those that prohibit the
provision of certain services by a provider to a patient if the patient was
referred by a physician with which the physician or his immediate family have
certain types of financial relationships.
False and Other Improper Claims. The federal government is authorized to
impose criminal, civil and administrative penalties on any person or entity that
files a false claim for reimbursement from Medicare or Medicaid or other
federally-funded programs. Criminal penalties are also available in the case of
claims filed with private insurers if the government can show that the claims
constitute mail fraud or wire fraud, or violate state false claims prohibitions.
11
While the criminal statutes are generally reserved for instances involving
fraudulent intent, the criminal and administrative penalty statutes are being
applied by the government in an increasingly broad range of circumstances. The
government has taken the position, for example, that a pattern of claiming
reimbursement for unnecessary services violates these statutes if the claimant
should have known that the services were unnecessary. The government has also
taken the position that claiming reimbursement for services that are substandard
is a violation of these statutes if the claimant should have known that the care
was substandard. Severe sanctions under these statutes, including exclusion from
Medicare, Medicaid or other federally-funded programs, have been applied even in
situations that have not resulted in a criminal conviction. Moreover, the
Department of Health and Human Services recently issued new documentation
guidelines applicable to Medicare claims filed by physicians for evaluation and
management services involving examination of "single-organ systems," including
the musculoskeletal system.
The Company believes that its billing activities on behalf of the
Affiliated Practices are in material compliance with such laws, but there can be
no assurance that the Company's activities will not be challenged or scrutinized
by governmental authorities. A determination that the Company or the Affiliated
Practices have violated such laws could have a material adverse impact on the
Company.
Federal Anti-kickback Laws. A federal law commonly known as the
"Anti-kickback Law" prohibits the knowing or willful offer, solicitation,
payment or receipt of anything of value (direct or indirect, overt or covert, in
cash or in kind) which is intended to induce the referral of patients covered
under Medicare, Medicaid and most other federally-funded health care programs,
or the ordering of items or services reimbursable under those programs. The law
also prohibits remuneration that is intended to induce the recommendation of, or
the arranging for, the provision of items or services reimbursable under those
programs. The law has been broadly interpreted by a number of courts to prohibit
remuneration that is offered or paid for otherwise legitimate purposes if the
circumstances show that one purpose of the arrangement is to induce referrals.
Even bona fide investment interests in a health care provider may be questioned
under the Anti-kickback Law if the government concludes that the opportunity to
invest was offered as an inducement for referrals. The penalties for violations
of this law include civil monetary penalties, criminal sanctions, exclusion from
further participation in federally-funded health care programs (mandatory
exclusion in certain cases), and the ability of the Secretary of Health and
Human Services to refuse to enter into or terminate a provider agreement, and
debarment from participation in other federal programs.
In part to address concerns regarding the implementation of the
Anti-kickback Law, the federal government in 1991 published regulations that
provide exceptions or "safe harbors," for certain transactions that will not be
deemed to violate the Anti-kickback Law. Among the safe harbors included in the
regulations were provisions relating to the sale of physician practices,
management and personal services agreements, office and equipment rental
agreements and employee relationships. Subsequently, regulations were published
offering safe harbor protection to additional activities, including referrals
within group practices consisting of active investors. Proposed amendments
clarifying the existing safe harbor regulations were published in 1994. If any
of the proposed regulations are ultimately adopted, they would result in
substantive changes to existing regulations. The failure of an activity to
qualify under a safe harbor provision, while potentially leading to greater
regulatory scrutiny, does not render the activity illegal.
There are several aspects of the Company's relationships with physicians to
which the Anti-kickback Law may be relevant. In some instances, for example, the
government may construe some of the marketing and managed care contracting
activities of the Company as arranging for the referral of patients to the
physicians with whom the Company has a Service Agreement. In addition, the
Company owns an interest in West Central Ohio Group, Ltd. ("WCOG") which owns
and operates an ambulatory surgery center. The remaining interests are owned by
physicians. These physicians will perform surgery in the ambulatory surgery
center. The government may scrutinize the distributions from WCOG to the
physicians to determine if they are payments for the referral of patients to the
ambulatory surgery center, in which case these payments could fall within the
purview of the Anti-kickback Law. Although the investments in the Company by
physicians and the Service Agreements between the Company and the Affiliated
Practices do not qualify for protection under the safe harbor regulations, the
Company does not believe that these activities fall within the type of
activities the Anti-kickback Law was intended to prohibit and is not aware of
any legal challenge or proceeding pending against
12
similar physician practice management activities under the Anti-kickback
Law. A determination that the Company has violated the Anti-kickback Law would
have a material adverse effect on the Company.
The Stark Self-Referral Law. The Stark Self-Referral Law (the "Stark Law")
prohibits a physician from referring a patient to a health care provider for
certain designated health services reimbursable by Medicare or Medicaid
(including physical therapy, diagnostic imaging services, orthotics and
prosthetics), if the physician or an immediate family member has a financial
relationship with that provider, including an investment interest, a loan or
debt relationship or a compensation relationship. In addition to the conduct
directly prohibited by the law, the statute also prohibits schemes that are
designed to obtain referrals indirectly that cannot be made directly. The
penalties for violating the law include (i) a refund of any Medicare or Medicaid
payments for services that resulted from an unlawful referral, (ii) civil fines
and (iii) exclusion from the Medicare and Medicaid programs.
On January 9, 1998, the Health Care Financing Administration (the "HCFA")
issued proposed rules (the "Proposed Regulations") regarding the Stark Law as it
relates to designated health services other than clinical laboratory services.
The Proposed Regulations contemplate that designated health services may be
provided by a physician's practice or by any other corporation, including an
entity that owns the operation providing the designated health services. A
corporation that merely owns the components of a health services operation, such
as the building that houses the facility or the medical equipment used at the
facility, would not be deemed to own the operation. It is not clear, however,
whether and to what extent the provision of management services by the Company
to the Affiliated Practices and the receipt of a service fee based on net
patient revenues would cause the Company to be deemed to own the operation. In
addition, the Proposed Regulations would apply to an entity that does not bill
under its own Medicare number but receives payment for the services from the
billing entity as part of a so-called "under arrangements" agreement (a term of
art under the regulations relating to certain hospital arrangements) or similar
agreements. It is not clear whether the term "similar agreements" would apply to
the Company's arrangements with the Affiliated Practices. If the Company is
deemed to "own the operation" or to be engaged in an arrangement similar to an
"under arrangements" agreement, it would be deemed a provider of the services
addressed by the Proposed Regulations.
Regardless of whether the Proposed Regulations are adopted, because the
Company provides management services related to those designated health services
provided by physicians affiliated with the Affiliated Practices, there can be no
assurance that the Company will not be deemed the provider for those services
for purposes of the Stark Law, and accordingly, the recipient of referrals from
physicians affiliated with the Affiliated Practices. Such referrals will be
permissible only if (i) the financial arrangements under the Service Agreements
with the Affiliated Practices meet certain exceptions in the Stark Law, (ii) the
ownership of stock in the Company by the referring physicians meets certain
investment exceptions under the Stark Law and (iii) there are no other financial
arrangements between the Company and a referring physician which are not covered
by an exception under the Stark Law. The Company believes that the financial
arrangements under the Service Agreements qualify for applicable exceptions
under the Stark Law; however, there can be no assurance that a review by courts
or regulatory authorities would not result in a contrary determination. In
addition, the Company will not meet the Stark Law exception related to
investment interest until the Company's stockholders' equity exceeds $75
million. Furthermore, the Proposed Regulations provide that in order to meet the
investment interest exception criteria the investment has to be in securities
which at the time they were obtained could be purchased on the open market. This
regulatory change would prohibit referral relationships between physicians and
an entity in which such physician (or a family member) own stock or options if
such stock or options were acquired prior to the time that the entity was
publicly held. Physicians affiliated with certain practices that affiliated with
the Company prior to its initial public offering received stock and options that
were not publicly traded. If the Company were to be deemed a provider of
designated health services, these physicians would not be covered by the
investment interest exception under the Proposed Regulations. In addition, the
Company owns an interest in an entity which owns a facility which will provide
designated health services as an ambulatory surgery center and the Company may
own similar interests in other entities in the future. A determination that the
Company has violated the Stark Law would have a material adverse effect on the
Company.
State Anti-Kickback Laws. Many states have laws that prohibit payment of
kickbacks in return for the referral of patients. Some of these laws apply only
to services reimbursable under state Medicaid programs. However, a number
13
of these laws apply to all health care services in the state, regardless of
the source of payment for the service. Based on court and administrative
interpretation of federal anti-kickback laws, the Company believes that these
laws prohibit payments to referral sources where a purpose for payment is for
the referral. However, the laws in most states regarding kickbacks have been
subjected to limited judicial and regulatory interpretation and therefore, no
assurances can be given that the Company's activities will be found to be in
compliance. Noncompliance with such laws could have an adverse effect upon the
Company and subject it and physicians affiliated with the Affiliated Practices
to penalties and sanctions.
State Self-Referral Laws. A number of states have enacted self-referral
laws that are similar in purpose to the Stark Law but which impose different
restrictions. Some states, for example, only prohibit referrals when the
physician's financial relationship with a health care provider is based upon an
investment interest. Other state laws apply only to a limited number of
designated health services. Some states do not prohibit referrals, but require
only that a patient be informed of the financial relationship before the
referral is made. The Company believes that its operations are in material
compliance with the self-referral laws of the states in which the Affiliated
Practices are located.
Fee-Splitting Laws. Many states prohibit a physician from splitting with a
referral source the fees generated from physician services. Other states have a
broader prohibition against any splitting of a physician's fees, regardless of
whether the other party is a referral source. In most states, the Company
believes that it is not considered to be fee-splitting when the payment made by
the physician is reasonable reimbursement for services rendered on the
physician's behalf.
The Company will be reimbursed by physicians on whose behalf the Company
provides management services. The compensation provisions of the Service
Agreements have been designed to comply with applicable state laws relating to
fee-splitting. There can be no certainty, however, that, if challenged, the
Company and its Affiliated Practices will be found to be in compliance with each
state's fee-splitting laws. A determination in any state that the Company is
engaged in any unlawful fee-splitting arrangement could render any Service
Agreement between the Company and an Affiliated Practice located in such state
unenforceable or subject to modification in a manner adverse to the Company.
The Florida Board of Medicine recently ruled in a declaratory statement
that payments of 30% of a physician group's net income to a practice management
company in return for a number of services including the physician practice
management company's expanding the practice by increasing patient referrals
through the creation of preferred provider networks, affiliation with other
networks, and negotiation of managed care contracts constituted fee-splitting
and could subject the physicians to disciplinary action. This order only applies
to the physician practice management company and the physicians asking for the
declaratory statement. The Florida Board of Medicine has agreed to stay
implementation of the order pending appeal of the decision by the physician
practice management company to a Florida court. Although the terms and
conditions of the Company's Service Agreements in Florida are distinguishable
from the agreements subject to the declaratory statement, an adverse decision by
the Florida court on this issue could require the Company to modify its Service
Agreements with the Affiliated Practices located in Florida or render such
agreements unenforceable.
Corporate Practice of Medicine. Most states prohibit corporations from
engaging in the practice of medicine. Many of these state doctrines prohibit a
business corporation from employing a physician. States differ, however, with
respect to the extent to which a licensed physician can affiliate with corporate
entities for the delivery of medical services. Some states interpret the
"practice of medicine" broadly to include activities of corporations such as the
Company that have an indirect impact on the practice of medicine, even where the
physician rendering the medical services is not an employee of the corporation
and the corporation exercises no discretion with respect to the diagnosis or
treatment of a particular patient.
The Company intends that, pursuant to its service agreements, it will not
exercise any responsibility on behalf of affiliated physicians that could be
construed as affecting the practice of medicine. Accordingly, the Company
believes that its operations do not violate applicable state laws relating to
the corporate practice of medicine. Such laws and legal doctrines have been
subjected to only limited judicial and regulatory interpretation with respect to
practice management
14
companies, and there can be no assurance that, if challenged, the Company
would be considered to be in compliance with all such laws and doctrines. A
determination in any state that the Company is engaged in the corporate practice
of medicine could render any Service Agreement between the Company and an
Affiliated Practice located in such state unenforceable or subject to
modification in a manner adverse to the Company.
Antitrust Laws. The federal antitrust laws (principally the Sherman Act,
the Clayton Act and the Federal Trade Commission Act) are designed to maintain
market competition. Those laws address both structural issues (market share
through merger, acquisition or otherwise) and conduct issues (contracts or
combinations in restraints of trade). The Federal Trade Commission and the
Department of Justice have addressed competitive issues in the health care
industry through their Statements of Enforcement Policy in Health Care issued in
1996. Those statements address both structural issues and conduct issues, both
of which could apply to various aspects of the business of the Company,
particularly in areas where the Company provides management services to
practices that could be deemed to be in the same market. While the Company
believes that it is in compliance with all such laws, there is no assurance that
in the future its operations will not become the focus of inquiry and potential
challenge. Responding to such challenges could result in substantial costs to
the Company and the Affiliated Practices, and an adverse determination could
have a material adverse effect upon the Company.
Insurance Licensure Laws. All states have established licensure
requirements to regulate the business of insurance and the operation of HMOs.
Some states have also established separate licensure requirements for
provider-sponsored managed care networks (also known as "provider-sponsored
organizations," or "PSOs") and for other managed care entities such as
third-party administrators, utilization review agents, and marketing agents who
solicit memberships or policies in managed care plans. A person who fails to
obtain the appropriate insurance license may be subject to civil and criminal
penalties in certain states. While licensure requirements for insurers, HMOs and
PSOs would not generally apply to companies that provide only management
services to physician providers and that do not otherwise engage in the
financing or delivery of health care services, there is little uniformity in how
the states interpret the scope of their respective laws and regulations.
Therefore, although the Company believes that its operations do not violate
insurance licensure laws for insurers, HMOs and PSOs in the states where it
currently does business, there can be no assurance that regulatory authorities
of such states would not apply these laws to require licensure of the Company as
an insurer, as an HMO, or as a PSO. Compliance with such laws could result in
substantial costs to the Company. In addition, practices affiliated with the
Company may require licensure as PSOs under separate statutory requirements for
PSOs or, if such practices enter into capitated or other risk-assumption
arrangements, under requirements relating to HMOs or insurers. See "Provider
Risk Assumption," below.
Finally, to the extent that the Company's management services for physician
networks involve "administrator," "utilization review," or marketing functions,
as those terms are defined by various states, the Company may need to obtain
separate licensure as a third-party administrator, as a utilization review
agent, or as an HMO or insurance marketing agent. There can be no assurance that
such state laws would not be interpreted in a manner that would deem the Company
to be in violation of these laws unless it obtained such licenses and incurred
additional costs. If the Company were to be deemed to be in noncompliance with
these laws or with insurance licensure laws generally, it would be materially
adversely affected.
In Florida, a new "fiscal services intermediary law," effective July 1,
1997, requires entities performing "fiduciary or fiscal intermediary services"
on behalf of health care professionals who contract with HMOs to register with
the Department of Insurance and to obtain a fidelity bond in the minimum amount
of $10 million. "Fiduciary or fiscal intermediary services" means
"reimbursements received or collected on behalf of health care professionals for
services rendered, patient and provider accounting, financial reporting and
auditing, receipts and collections management, compensation and reimbursement
disbursement services, or other related fiduciary services pursuant to health
care professional contracts with health maintenance organizations." The Company
believes that its management services for physician practices fall within this
definition and intends to take appropriate steps to register or otherwise to
comply with the new provisions.
15
Provider Risk Assumption. Even in the absence of a separate licensure or
regulatory scheme for PSOs, many states have taken the position that when
provider networks assume risk, e.g., by accepting capitation payments in return
for providing or arranging a specified set of health care services, they are
engaging in the "business of insurance" and therefore require licensure as an
insurer or an HMO. The degree of consensus among the states on this issue varies
depending on whether the risk being assumed is "direct" risk or "downstream"
risk. As outlined in a policy statement adopted by the National Association of
Insurance Commissioners ("NAIC") in December of 1997, "direct" risk arrangements
involve agreements whereby a PSO agrees directly with individuals, employers or
other unlicensed groups to assume all or part of the risk for health care
expenses or service delivery. Downstream risk arrangements are contractual
arrangements between licensed entities, such as HMOs and insurers, and
subcontracting provider entities (organizations or individuals) under which the
provider entity or person assumes all or part of the licensed entity's risk.
A consensus exists among state insurance regulators that entities which
enter into direct risk arrangements should be required to obtain the appropriate
regulatory license. By contrast, a consensus does not exist with respect to
"downstream" risk arrangements. Although the NAIC has observed that the vast
majority of states do not require licensure of subcontractor provider entities,
many states question whether having a licensed entity, i.e., an HMO or insurer,
involved in a downstream arrangement adequately addresses consumer protection
concerns. Consequently, an increasing number of states are adopting laws to
regulate downstream risk through various mechanisms, including, in some
instances, licensure.
In many states, therefore, practices affiliated with the Company will be
precluded from entering into capitated or episode of care contracts directly
with employers, individuals and other unlicensed groups, or even indirectly as a
subcontractor of a licensed HMO or insurance company, unless they qualify to do
business as HMOs or insurance companies under applicable insurance laws and
regulations. These laws may require capital requirements and adherence to other
safety and soundness requirements. Full compliance with such laws and
regulations could result in substantial costs to the Company and the Affiliated
Practices. The inability to enter into capitated or other risk-assumption
arrangements, or the cost of complying with certain laws that would permit
expansion of risk-based contracting activities, would have a material adverse
effect on the Company.
Managed Care Contracting Laws. An increasing volume of state regulation is
directed to controlling the terms of contracts between managed care payors and
managed care providers. Certain of these laws and regulations can affect the
composition of a managed care network. For example, so-called "any willing
provider" regulations require that insurers, managed care organizations, and
other health plans give all providers membership on their provider panels under
certain circumstances. Other laws and regulations are aimed at protecting health
care consumers, including laws that prohibit managed care plans from restricting
a physician's ability to communicate all available treatment options to a
patient and from providing financial incentives to physicians for limiting
covered services, and laws that require health care providers to "hold harmless"
health care consumers for the cost of any covered services for which the
consumer has already paid the applicable premium or charge. There can be no
assurance that such laws would not be interpreted in a manner adverse to the
Company. A determination that the Company or its Affiliated Practices are not in
compliance with such laws could have a material adverse effect on the Company.
Physician Incentive Plan Rule. On March 27, 1996, the United States
Department of Health and Human Services issued final regulations concerning
physician incentive plans operated by certain prepaid health care organizations.
The regulations prohibit a prepaid health care organization that contracts with
the Medicare or Medicaid programs from operating a physician incentive plan that
directly or indirectly makes specific payments to a physician or physician group
as an inducement to reduce or limit medically necessary services furnished to a
specific enrollee of the organization. Moreover, the regulations require such an
organization to provide adequate stop-loss protection to a physician or
physician group if the organization's system for compensating physicians does
not provide certain limitations on the amount of physician compensation that is
put at risk for referrals made by the physician. These regulations may affect
the operations of the Company and Affiliated Practices, including contractual
arrangements with prepaid health care organizations. There can be no assurance
that these regulations will not have an adverse effect on the business of the
Company and Affiliated Practices.
16
Employee Leasing Services. Several states have enacted legislation
prohibiting the provision of "employee leasing services" without a license. The
Company is in the process of evaluating the application of such laws to its
provision of non-physician personnel to physician practices under its Service
Agreements, and intends to seek licensure where appropriate. There can be no
assurance that, if the Company seeks to obtain a license in a particular state,
the Company's application will be approved. Failure to obtain a license to
provide employee leasing services where required may result in civil or criminal
penalties and may affect the Company's ability to provide personnel in
accordance with the terms of the Service Agreements, which could have a material
adverse effect on the Company.
Competition
Specialty Care Network competes with numerous entities that seek to
affiliate with musculoskeletal practices. Several companies that have
established operating histories and greater resources than the Company are
pursuing the acquisition of the assets of general and specialty practices and
the management of such practices. Physician practice management companies and
some hospitals, clinics and HMOs engage in activities similar to the activities
of the Company. There can be no assurance that the Company will be able to
compete effectively with such competitors, that additional competitors will not
enter the market, or that such competition will not make it more difficult to
affiliate with, and to enter into agreements to provide management services to,
practices on terms beneficial to the Company.
Affiliated Practices will compete with local musculoskeletal care service
providers as well as some managed care organizations. The Company believes that
changes in governmental and private reimbursement policies and other factors
have resulted in increased competition for consumers of medical services. The
Company believes that the cost, accessibility and quality of services provided
are the principal factors that affect competition. There can be no assurance
that the Affiliated Practices will be able to compete effectively in the markets
that they serve. The inability of the Affiliated Practices to compete
effectively would materially adversely affect the Company.
Further, the Affiliated Practices compete with other providers for managed
musculoskeletal care contracts. The Company believes that trends toward managed
care have resulted in increased competition for such contracts. Other practices
and management service organizations may have more experience than the
Affiliated Practices and the Company in obtaining such contracts. There can be
no assurance that the Company and the Affiliated Practices will be able to
successfully acquire sufficient managed care contracts to compete effectively in
the markets they serve. The inability of the Affiliated Practices to compete
effectively for such contracts could materially adversely affect the Company.
Employees
As of December 31, 1997, the Company had 841 employees, of whom 44 were
located at the Company's headquarters and 797 were located at the offices of the
Affiliated Practices. The Company believes that its relationship with its
employees is good.
Corporate Liability and Insurance
The provision of medical services entails an inherent risk of professional
malpractice and other similar claims. However, the Company does not influence or
control the practice of medicine by physicians or have responsibility for
compliance with certain regulatory and other requirements directly applicable to
physicians and physician groups. Nevertheless, as a result of the relationship
between the Company and the Affiliated Practices, the Company may become subject
to some medical malpractice actions under various theories, including successor
liability. There can be no assurance that claims, suits or complaints relating
to services and products provided by Affiliated Practices will not be asserted
against the Company in the future. The Company's medical professional liability
insurance provides coverage of up to $5 million per incident, with maximum
aggregate coverage of $5 million per year. The Company's general liability
insurance provides coverage of up to $5 million per incident, with maximum
aggregate coverage of $5 million per year. The Company believes that such
insurance will extend to professional liability claims that may be asserted
against employees of the Company that work on site at Affiliated Practice
locations. In addition, pursuant to
17
the Service Agreements, the Affiliated Practices are required to maintain
comprehensive professional liability insurance. The availability and cost of
such insurance have been affected by various factors, many of which are beyond
the control of the Company and Affiliated Practices. The cost of such insurance
to the Company and Affiliated Practices may have a material adverse effect on
the Company. In addition, successful malpractice or other claims asserted
against the Affiliated Practices or the Company that exceed applicable policy
limits would have a material adverse effect on the Company.
Risk Factors
Limited Operating History. The Company has conducted physician practice
management operations only since November 1996, when it affiliated with five
practices. Several other affiliations occurred during 1997 and additional
affiliations are anticipated as part of the Company's growth strategy. There can
be no assurance that the Company will be able to integrate and manage
successfully the assets and personnel of, or provide services profitably to, its
affiliated practices. In addition, there can be no assurance that the Company's
establishment of affiliation arrangements will not result in a loss of patients
by any of the Affiliated Practices or other unanticipated adverse consequences.
Moreover, there can be no assurance that the Company's personnel, systems and
infrastructure will be sufficient to permit effective and profitable management
of Affiliated Practices or to implement effectively the Company's strategies.
Risks Associated with Affiliation and Expansion Strategy. A primary element
of the Company's growth strategy is to acquire certain assets of, and affiliate
through service agreements with, selected musculoskeletal practices in targeted
markets. The Company's strategy also involves assisting Affiliated Practices in
recruiting physicians and, to the extent permitted by applicable law, either
developing or contracting with facilities that provide ancillary services such
as outpatient surgery, outpatient imaging, pain management, rehabilitation
therapy and orthotics, and contracting with associated providers. Identifying
appropriate physician group practices, individual physicians and ancillary
facilities and proposing, negotiating and implementing economically attractive
affiliations with such practices, physicians and facilities can be a lengthy,
complex and costly process. The failure of the Company to identify and effect
additional affiliations would have a material adverse effect on the Company. In
addition, the Company is a party to a credit facility that places certain
limitations upon the number of affiliations the Company can effect in any year
and the terms of any future affiliations. Moreover, there can be no assurance
that future affiliations, if any, will contribute to the Company's profitability
or otherwise facilitate the successful implementation of the Company's overall
strategy.
The Company's ability to expand is also dependent upon the health care
regulatory environment, which is subject to change. There can be no assurance
that application of current laws or changes in legal requirements will not
adversely affect the Company or its ability to expand. See "Risk Factors --
Extensive Government Regulation" and "Government Regulation and Supervision" in
this Item.
Dependence on Affiliated Practices and Physicians. The Company's operations
are entirely dependent on its continued affiliation through the Service
Agreements with the Affiliated Practices and on the success of the Affiliated
Practices. One of the Affiliated Practices, Reconstructive Orthopaedic
Associates II, P.C. ("ROA"), contributed approximately 22%, of the fees
(excluding fees relating to the reimbursement of clinic expenses and fees
relating to physicians formerly practicing with ROA who formed 3B Orthopaedics,
P.C. ("3B Orthopaedics") on July 1, 1997) paid to the Company by all of the
Affiliated Practices during 1997. Although, in most instances absent a default
by the Company, the termination of a service agreement by an Affiliated Practice
prior to the end of its stated term and particularly during the early years of
the contract would require the Affiliated Practice to make a significant payment
to the Company, the termination of any of the Service Agreements with any of the
Affiliated Practices could have a material adverse effect on the Company. For a
description of the Service Agreements, see "Business -- Contractual Agreements
with Affiliated Practices" in this Item. For a discussion of circumstances under
which a service agreement may be rendered unenforceable, see "Government
Regulation" in this Item.
18
Some of the Affiliated Practices derive, and other practices with which the
Company may affiliate may derive, a significant portion of their revenue from a
limited number of physicians. There can be no assurance that the Company or the
Affiliated Practices will maintain cooperative relationships with key members of
a particular Affiliated Practice. In addition, there can be no assurance that
key members of an Affiliated Practice will not retire, become disabled or
otherwise become unable or unwilling to continue practicing their profession
with an Affiliated Practice. The loss by an Affiliated Practice of one or more
key members would have a material adverse effect on the revenue of such
Affiliated Practice and possibly on the Company. Neither the Company nor the
Affiliated Practices maintains insurance on the lives of any affiliated
physicians for the benefit of the Company. The loss of revenue by any Affiliated
Practice could have a material adverse effect on the Company.
An Affiliated Practice that accounts for less than two percent of the
Company's total Base Service Fees sent a letter to the Company in March 1998
alleging that the Company has defaulted under several provisions of the Service
Agreement and that it intends to exercise its termination rights under the
agreement if the alleged defaults are not cured within 60 days. The Company
believes it is fulfilling its obligations under the Service Agreement and is
seeking to amicably resolve the matter. Although the Company does not believe
that a termination or restructuring of the Service Agreement would, over the
long term, have a material adverse effect on the Company, any such termination
or restructuring could adversely affect operating results in the period in which
it occurs.
Risk of Changes in Payment for Medical Services. The health care industry
is experiencing a trend toward cost containment as government and private
third-party payors seek to impose lower reimbursement and utilization rates and
negotiate reduced payment schedules with service providers. Further reductions
in payments to health care providers or other changes in reimbursement for
health care services could have a material adverse effect on the Affiliated
Practices and, as a result, on the Company. These reductions could result from
changes in current reimbursement rates or from a shift in clinical protocols to
non-surgical solutions to musculoskeletal conditions. There can be no assurance
that the Company will be able to offset successfully any or all of the payment
reductions that may occur.
The federal government has implemented, through the Medicare program, a
resource-based relative value scale ("RBRVS") payment methodology for physician
services and other outpatient services. RBRVS is a fee schedule that, except for
certain geographical and other adjustments, pays similarly situated physicians
the same amount for the same services. The RBRVS is adjusted each year and is
subject to increases or decreases at the discretion of Congress. To date, the
implementation of RBRVS has reduced payment rates for certain of the procedures
historically provided by the Affiliated Practices. Further reductions could
significantly affect the Affiliated Practices, each of which derives a
significant portion of its revenue from Medicare. Moreover, the Balanced Budget
Act of 1997 may result in further reductions in Medicare reimbursement,
particularly for surgical services. For the year ended December 31, 1997, the
net revenue from Medicare constituted approximately 22% of the aggregate net
revenue of the Affiliated Practices. Payment systems similar to RBRVS have also
been adopted by certain private third-party payors and may become a predominant
payment methodology. Wider-spread implementation of such programs would reduce
payments from private third-party payors, and could indirectly reduce revenue to
the Company.
Physician reimbursement rates paid by private third-party payors, including
those that provide Medicare supplemental insurance, are most typically based on
established provider charges and, although more private payors are adopting
RBRVS-type reimbursement or other managed care-type restrictions on
reimbursement, such rates still are generally higher than Medicare payment
rates. A change in the payor mix of any of the Affiliated Practices could have a
material adverse effect on the Affiliated Practices and, as a result, on the
Company. See "Government Regulation and Supervision" in this Item.
Extensive Government Regulation. The delivery of health care, including the
relationships among practitioners such as physicians and other clinicians, is
subject to extensive federal and state regulation. Much of this regulation,
particularly in the area of patient referral, is complex and open to different
interpretations. While the Company believes that its operations are conducted in
material compliance with applicable laws, there can be no assurance that a
review of such operations by federal or state judicial or regulatory authorities
will not result in a determination that the Company or one of its Affiliated
Practices has violated one or more provisions of federal or state law. Any such
determination could have a material adverse effect on the Company.
The federal and state laws to which the Company and its Affiliated
Practices are subject cover a broad range of activities. Among other things,
these laws (i) prohibit the filing of false or other improper medical claims,
(ii) prohibit "kickback" and similar activities intended to induce patient
referrals or the ordering of reimbursable items or services,
19
(iii) prohibit physicians from making referrals to health care providers
with which the physicians have a financial relationship, (iv) prohibit
fee-splitting under certain circumstances and (v) prohibit corporations from
engaging in the practice of medicine. In addition, a variety of laws of general
applicability, including antitrust, insurance, environmental, occupational
safety, employment, medical leave, and civil rights laws, have a restrictive
effect on the operations and activities of the Company and its Affiliated
Practices. Violations of the laws to which the Company and its Affiliated
Practices are subject can result in severe adverse consequences, including civil
or criminal penalties (such as imprisonment and fines), exclusion from
participation in Medicare and Medicaid programs or other federally funded health
care programs, and censure or delicensing of physician-violators. See "Business
- -- Government Regulation and Supervision."
In addition to extensive existing government health care regulation, in the
recent past there have been numerous initiatives on the federal and state levels
for comprehensive or incremental reforms affecting the payment for and
availability of health care services. While it is uncertain what legislative
proposals will be enacted in the future, many of the proposals under
consideration, including those that would reduce Medicare and Medicaid payments
or impose additional prohibitions on ownership by health care providers, could
have a material adverse effect on the Company if they are enacted. See "Risk
Factors -- Risks Associated With Affiliation and Expansion Strategy," "Risk
Factors --Risk of Changes in Payment for Medical Services" and "Government
Regulation and Supervision" in this Item.
Health care also is subject to the application of the federal and state
antitrust laws that address both market concentration and conduct within a
market that may be deemed to restrain trade. Federal antitrust concerns address
market share, which is dependent on frequently contested assessments of the
nature of the product or service market and the scope of the geographic market.
Although the Company believes that it is not in violation with the antitrust
laws, future enforcement interpretations or initiatives could subject it to
investigational oversight and potential challenge, which could have a material
adverse effect on the Company.
Several states have enacted legislation prohibiting the provision of
"employee leasing services" without a license. The Company is in the process of
evaluating the application of such laws to its provision of non-physician
personnel to physician practices under its Service Agreements, and intends to
seek licensure where appropriate. There can be no assurance that, if the Company
seeks to obtain a license in a particular state, the Company's application will
be approved. Failure to obtain a license to provide employee leasing services
where required may result in civil or criminal penalties and may affect the
Company's ability to provide personnel in accordance with the terms of the
Service Agreements, which could have a material adverse effect on the Company.
Dependence on Information Systems. The Company's success is largely
dependent on its ability to implement new information systems and to interface
these systems with the Affiliated Practices' existing practice management,
financial and clinical information systems. In addition to their integral role
in helping the Affiliated Practices realize operating efficiencies, such systems
are critical to negotiating, pricing and managing capitated managed care
contracts. The Company will need to continue to invest in, and administer,
sophisticated management information systems to support these activities. The
Company may experience unanticipated delays, complications and expenses in
implementing, integrating and operating such systems. Furthermore, such systems
may require modifications, improvements or replacements as the Company expands
or if new technologies become available. Such modifications, improvements or
replacements may require substantial expenditures and may require interruptions
in operations during periods of implementation. The failure to implement
successfully and maintain adequate practice management, financial and clinical
information systems would have a material adverse effect on the Company. See
"Risk Factors -- Risks Associated with Managed Care Contracts" and "Operations"
in this Item.
The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. In other words,
date-sensitive software may recognize a date using the "00" as the year 1900
rather than the Year 2000. This could result in system failures or
miscalculations causing disruptions of operations, including, among others, a
temporary inability to process transactions, send invoices, or engage in similar
normal business activities.
The Company has initiated an internally-managed Year 2000 program designed
to ensure that there is no adverse effect on the Company's core business
operations and transactions with customers, suppliers and financial
institutions. The Company has determined that it will need to modify or replace
some portions of the practice management systems at its Affiliated Practices so
that the systems will function properly with respect to dates in the year 2000
and beyond. The cost of these Year 2000 initiatives is not expected to be
material to the Company's results of operations or financial position. However,
the Company seeks to expand its business through additional affiliations, and
there can be no assurance that systems at practices that affiliate with the
Company in the future will be Year 2000 compliant or, if not Year 2000
compliant, will be converted on a timely basis. The Company also has initiated
discussions with its significant suppliers to determine whether those parties
will be subject to the Year 2000 issue where their systems interface with the
Company's systems or otherwise have an impact on Company operations. The Company
is assessing the extent of which its operations are vulnerable should its
suppliers fail to remediate properly their computer systems.
While the Company believes its planning efforts are adequate to address its
Year 2000 concerns with respect to its internal systems and those of its
Affiliated Practices, there can be no guarantee that the systems of other
entities on which the Company's systems and operations rely will be converted on
a timely basis. The failure of such other entities to remediate any Year 2000
issue on a timely basis could have a material adverse effect on the Company.
Need for Additional Funds. The Company's affiliation and expansion strategy
will require substantial capital, and the Company anticipates that it will, in
the future, seek to raise additional funds through debt financing or the
issuance of equity or debt securities. There can be no assurance that sufficient
funds will be available on terms acceptable to the Company, if at all. If equity
securities are issued, either to raise funds or in connection with future
affiliations, dilution to the Company's stockholders may result, and if
additional funds are raised through the incurrence of debt, the Company may
become subject to restrictions on its operations and finances. Such restrictions
may have
20
an adverse effect on, among other things, the Company's ability to pursue its
affiliation strategy. The Company's bank credit facility places certain
limitations on the number of affiliations the Company can effect in any year and
the terms of the future affiliations. See "Item 7 -- Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Liquidity and
Capital Resources."
Risks Associated with Managed Care Contracts. As an increasing
percentage of patients enter into health care coverage arrangements with managed
care payors, the Company believes that its success will be, in part, dependent
upon the Company's ability to negotiate contracts with HMOs, employer groups and
other private third-party payors on behalf of practices affiliated with the
Company. The inability of the Company to enter into satisfactory arrangements
with such payors in the future on behalf of practices affiliated with the
Company could have a material adverse effect on the Company.
In certain instances, the Company has assisted certain of its Affiliated
Practices in negotiating contracts providing a fixed global fee for each episode
of care covering hip replacement, spinal fusion, laminectomy, discectomy,
anterior cruciate ligament repair, arthroscopy and foot and ankle procedures.
Certain Affiliated Practices also have other capitated fee arrangements that
existed prior to affiliation with the Company. The Company has been successful
in negotiating per member per month increases in certain of these existing
capitated arrangements for certain Affiliated Practices. The Company anticipates
that its Affiliated Practices may enter into additional contracts based on
capitated and global fee arrangements in the future. Under an episode of care
contract, the payor pays the surgeon a global fee which encompasses all services
required for that episode of care. To the extent the surgeon, with the Company's
assistance, manages the costs and utilization of the resources required to
provide the care, the surgeon typically earns additional compensation over and
above the normal professional fees. Other types of fee arrangements that may be
entered into include a capitated fee arrangement under which a provider agrees
to provide its specialty services to a defined population of members for a fixed
fee. The fee is normally negotiated on a per member per month basis. Health care
providers under these contracts or arrangements bear the risk, generally subject
to certain loss limits, that the aggregate costs of providing medical services
will exceed the premiums received. To the extent that patients or enrollees
covered by such contracts require more frequent or more extensive care than
anticipated, there could be a material adverse effect on a practice affiliated
with the Company, and, therefore, on the Company. In the worst case, revenue
negotiated under these contracts would be insufficient to cover the costs of the
care provided. Any such reduction or elimination of earnings to the Affiliated
Practices could have a material adverse effect on the Company. See "Payor
Contracting" in this Item.
Several states have adopted regulations prohibiting physicians from
entering into capitated payment or other risk sharing contracts except through
HMOs or insurance companies. In addition, some states have subjected physicians
and physician networks to applicable insurance laws and regulations which
provide for, among other things, minimum capital requirements and other safety
and soundness requirements. The inability of practices affiliated with the
Company to enter into capitated or episode of care arrangements or the costs of
compliance with insurance laws and regulations would have a material adverse
effect on the Company. See "Government Regulation and Supervision - Insurance
Laws" in this Item.
Generally, there is no certainty that the Company and practices
affiliated with the Company will be able to establish or maintain satisfactory
relationships with managed care and other third-party payors, many of which
already have existing provider structures in place and may not be able or
willing to change their provider networks. In addition, any significant loss of
revenue by the practices affiliated with the Company as a result of the
termination of third-party payor contracts or otherwise would have a material
adverse effect on the Company.
Competition. Competition for affiliation with additional musculoskeletal
practices is intense and may limit the availability of suitable practices with
which the Company may be able to affiliate. Several companies with established
operating histories and greater resources than the Company, including physician
practice management companies and some hospitals, clinics and HMOs, are pursuing
activities similar to those of the Company. There can be no assurance that the
Company will be able to compete effectively with such competitors, that
additional competitors will not enter the market or that such competition will
not make it more difficult and costly to acquire the assets of, and provide
21
management services to, musculoskeletal medical practices on terms beneficial to
the Company. The Company also believes that changes in government and private
reimbursement policies, among other factors, have resulted in increased
competition among providers of medical services to consumers. There can be no
assurance that the Company's Affiliated Practices will be able to compete
effectively in the markets they serve. See "Competition" in this Item.
Dependence Upon Key Personnel. The Company is dependent upon the ability
and experience of Kerry R. Hicks, its President and Chief Executive Officer, and
its other executive officers and key personnel for the management of the Company
and the implementation of its business strategy. The Company currently has
employment contracts with each of its executive officers. Because of the
difficulty in finding adequate replacements for such personnel, the loss of the
services of any such personnel or the Company's inability in the future to
attract and retain management and other key personnel could have a material
adverse effect on the Company.
Potential Liability and Insurance; Legal Proceedings. The provision of
medical services by physicians entails an inherent risk of exposure to
professional malpractice claims and other similar claims. While the Affiliated
Practices generally maintain malpractice insurance, there can be no assurance
that any claim asserted against any of the Affiliated Practices or any other
practice that may affiliate with the Company in the future will be covered by,
or will not exceed the coverage limits of, applicable insurance. A successful
malpractice claim against any practice affiliated with the Company, even if
covered by insurance, could have a material adverse effect on such practice and,
as a result, on the Company.
The Company does not engage in the practice of medicine; however, the
Company could be implicated in professional malpractice and similar claims, and
there can be no assurance that claims, suits or complaints relating to services
delivered by practices affiliated with the Company (including claims with regard
to services rendered by a practice prior to its affiliation with the Company)
will not be asserted against the Company in the future. Although the Company has
attempted to address this risk by maintaining insurance, there can be no
assurance that any claim asserted against the Company for professional or other
liability will be covered by, or will not exceed the coverage limits of, such
insurance. The Company's medical professional liability insurance provides
coverage of up to $5.0 million per incident, with maximum coverage of $5.0
million per year. The Company's general liability insurance provides coverage of
up to $5.0 million per incident, with maximum coverage of $5.0 million per year.
The availability and cost of professional liability insurance have been
affected by various factors, many of which are beyond the control of the
Company. There can be no assurance that the Company will be able to maintain
insurance in the future at a cost that is acceptable to the Company, or at all.
Any claim made against the Company not fully covered by insurance could have a
material adverse effect on the Company. See "Corporate Liability and Insurance,"
in this Item.
Risks Related to Purchase of Receivables. The Service Agreements provide
that the Company will acquire each Affiliated Practice's accounts receivable
each month. The purchase price for such accounts receivable generally equals the
gross amounts of the accounts receivable recorded each month, less adjustments
for contractual allowances, allowances for doubtful accounts and other
potentially uncollectible amounts based on the practice's historical collection
rate, as determined by the Company. The Company generally also bears the
collection risk with respect to outstanding receivables acquired in connection
with an affiliation. To the extent that the Company's actual collections are
less than the amounts paid for the receivables, or if payment of receivables is
not made on a timely basis, the Company could be materially adversely affected.
See "Item 7 -- Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources" and "Contractual
Agreements with Affiliated Practices" in this Item.
Possible Volatility of Stock Price. The market price of the Company's
Common Stock may fluctuate substantially in response to variations in the
Company's operating and financial results, changes in earnings estimates by
securities analysts, general economic and market conditions, and other factors.
Variations in the Company's operating and financial results may be caused by the
timing of practice affiliations and by the timing and volume of musculoskeletal
procedures, among other things. See Item 5 -- "Market for Registrant's Common
Stock and Related Stockholder Matters."
22
Item 2. Properties
The Company has a five-year lease for its approximately 12,000 sq. foot
headquarters facility in Lakewood, Colorado, which expires on March 15, 2001.
The Company has entered into leases for the facilities utilized by the
Affiliated Practices for annual lease payments of approximately $5.9 million.
Several of the leases involve properties owned by physician owners of the
Affiliated Practices.
Item 3. Legal Proceedings
Currently, no legal proceedings are pending against the Company. However,
there can be no assurance that claims will not be asserted against the Company
in the future. The Company may become subject to certain pending claims as the
result of successor liability in connection with the assumption of certain
liabilities of the Affiliated Practices; nevertheless, the Company believes it
is unlikely that the ultimate resolution of such claims will have a material
adverse effect on the Company.
The Company has been advised that the Department of Health and Human
Services is conducting an inquiry regarding Reconstructive Orthopaedic
Associates, Inc., a practice whose assets were acquired through merger with the
Company, and physicians formerly associated with that practice, including
Richard H. Rothman, M.D., Ph.D., Chairman of the Board of the Company, and
Robert E. Booth, Jr., M.D., a director of the Company. The inquiry appears to be
concerned with the submission of claims for Medicare reimbursement by the
practice prior to the affiliation of ROA with the Company. The Department of
Health and Human Services has not contacted the Company in connection with the
inquiry.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
23
Executive Officers of the Registrant
The following table sets forth certain information concerning the
executive officers of the Company:
NAME AGE POSITION
Kerry R. Hicks........................... 38 President, Chief Executive Officer
Patrick M. Jaeckle....................... 39 Executive Vice President - Finance/Development,
Secretary and Director
Michael E. West.......................... 38 Senior Vice President - Operations
D. Paul Davis............................ 40 Senior Vice President - Finance
Peter A. Fatianow........................ 34 Vice President - Development
David G. Hicks........................... 39 Vice President - Management Information Systems
Timothy D. O'Hare........................ 45 Vice President - Payor Operations
KERRY R. HICKS, a founder of the Company, has served as President and Chief
Executive Officer and as a director of the Company since its inception in
December 1995. From 1985 to March 1996, Mr. Hicks served as Senior Vice
President of LBA Health Care Management ("LBA"), a developer of health care and
management information services. LBA provided management consulting services
(including orthopaedic projects) to medical centers to support the purchasing,
planning, marketing and delivery of health care. Mr. Hicks was principally
responsible for developing LBA's orthopaedic product line and its information
systems. LBA's orthopaedic product line established quality and cost benchmarks
and developed clinical protocols and patient care algorithms intended to enhance
both the quality and effectiveness of the delivery of orthopaedic care.
PATRICK M. JAECKLE, a founder of the Company, has served as Executive Vice
President - Finance/Development and as a director of the Company since its
inception in December 1995. From February 1994 to March 1996, Dr. Jaeckle served
as director of health care corporate finance at Morgan Keegan & Company, Inc.,
a regional investment banking firm. Prior to February 1994, Dr. Jaeckle was a
member of the health care investment banking groups at both Credit Suisse First
Boston Corporation (from June 1992 to February 1994) and Smith Barney, Inc.
(from May 1991 to June 1992). Dr. Jaeckle holds an M.B.A. degree from Columbia
Business School, a D.D.S. degree from Baylor College of Dentistry and a B.A.
degree from The University of Texas at Austin.
MICHAEL E. WEST has served as Senior Vice President - Operations since
August 1997. From 1990 to July 1997, Mr. West served as a consultant for Medical
Group Services, LLC, a health care practice management firm. Mr. West received a
B.B.A. in accounting and management from James Madison University. He is a
certified public accountant.
D. PAUL DAVIS has served as Senior Vice President - Finance since June 1997
and served as Vice President of Finance from March 1996 until June 1997. He also
served as the Company's controller from March 1996 until September 1997. From
January 1993 to March 1996, Mr. Davis served as Vice President of Finance for
Surgical Partners of America, Inc. From April 1987 to January 1993, he served
as Chief Financial Officer for Anesthesia Service Medical Group, Inc. Mr. Davis
received a B.S. degree in Accounting from the University of Utah. He is a
certified public accountant and a certified management accountant.
PETER A. FATIANOW has been Vice President - Development of the Company
since March 1996. From July 1994 to February 1996, Mr. Fatianow worked at Morgan
Keegan & Company, Inc., most recently as an Associate Vice President in health
care corporate finance. From July 1992 to July 1994, Mr. Fatianow was a member
of the health care investment banking group at Credit Suisse First Boston
Corporation in New York. Mr. Fatianow received a B.S. degree in Business
Management with an emphasis in Finance from Brigham Young University.
DAVID G. HICKS has served as Vice President - Management Information
Systems of the Company since March 1996. From November 1994 to March 1996, Mr.
Hicks worked as Manager of Information Technology for the Association
24
of Operating Room Nurses, responsible for information technology
maintenance and development. From February 1993 to November 1994, he served as
Manager of Information Systems Administration for Coors Brewing Company, and
from January 1982 to February 1993, Mr. Hicks served as Manager of Internal
Systems for Martin Marietta Data Systems. Mr. Hicks received a B.S. degree in
Management Information Systems from Colorado State University.
TIMOTHY D. O'HARE has been Vice President - Payor Operations since August
1996. From May 1994 to July 1996, Mr. O'Hare served as Executive Director of
Kaiser Foundation HealthPlan of North Carolina, where his responsibilities
included the negotiation of capitated and incentive contracts with hospitals,
physician hospital organizations and physician group practices. From April 1987
to May 1994, Mr. O'Hare served as Vice President/Executive Director of CIGNA
Health Care of North Carolina. From March 1986 to April 1987, Mr. O'Hare served
as Vice President of Operations for Preferred Health Network. Mr. O'Hare
received a B.S. degree from Virginia Polytechnic Institute and State University
and a M.H.A. degree from Virginia Commonwealth University.
Kerry R. Hicks and David G. Hicks are brothers.
25
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Since February 7, 1997, the Common Stock has been quoted on the Nasdaq
Stock Market under the symbol "SCNI." The following table sets forth the high
and low sales prices for the Common Stock for the quarters indicated as reported
on the Nasdaq Stock Market.
High Low
---- ---
Year Ending December 31, 1997
First Quarter(1)............................... $10 5/8 $ 8
Second Quarter................................. 12 1/2 7 5/8
Third Quarter.................................. 13 3/4 10 7/8
Fourth Quarter................................. 14 10 3/4
(1) Represents trading of the Common Stock from February 7, 1997 through March
31, 1997.
The Company has never paid or declared any cash dividends and does not
anticipate paying any cash dividends in the foreseeable future. The Company
currently intends to retain any future earnings for use in its business. The
Company's credit facility with a bank prohibits the payment of any dividends
without written approval from the bank.
On November 16, 1997, the Company acquired, through a merger and asset
purchases, the assets of certain physician practices, a related surgery center
and physical therapy facilities in Fairfield, California. In connection with the
transactions, the Company issued an aggregate of 226,181 shares of Common Stock
to the physician owners of the practice and the owners of both the surgery
center and physical rehabilitation centers.
The Company effected the foregoing transactions in reliance on the
exemption from registration provided under Sections 4(2) under the Securities
Act of 1933 (the "Act"). The Company believes that the transactions complied
with the requirements of Rule 506 under the Act.
26
Item 6. Selected Financial Data
Statement of Operations Data
Year Ended Year Ended Period Ended
December 31, 1997 December 31, 1996 December 31, 1995
----------------- ----------------- -----------------
Revenue:
Service fees $ 45,966,531 $ 4,392,050 $ --
Other 3,689,390 -- --
------------ ------------ ----------
49,655,921 4,392,050 --
Costs and expenses:
Clinic expenses 31,644,618 2,820,743 --
General and administrative expenses 7,861,015 3,770,263 --
------------ ------------ ----------
Total expenses 39,505,633 6,591,006 --
Income (loss) from operations 10,150,288 (2,198,956) --
Other:
Interest income 536,180 11,870 --
Interest expense (942,144) (90,368) --
------------ ------------ ----------
Income (loss) before income taxes 9,744,324 (2,277,454) --
Income tax (expense) benefit (3,873,926) 506,071 --
------------ ------------ ----------
Net income (loss) $ 5,870,398 $ (1,771,383)
============ ============ ==========
Net income (loss) per common share (basic)(1) $ 0.38 $ (0.16) $ --
============ ============ ==========
Weighted average number of common shares
used in computation (basic)(1) 15,559,368 11,422,387 --
============ ============ ==========
Net income (loss) per common share (diluted)(1) $ 0.37 $ (0.14) $ --
============ ============ ==========
Weighted average number of common
share and common share equivalents
used in computation (diluted) 16,071,153 12,454,477 --
============ ============ ==========
Balance Sheet Data
December 31, 1997 December 31, 1996 December 31, 1995
----------------- ----------------- -----------------
Working capital (deficit) $ 21,924,386 $ 7,637,724 $(27,894)
Total assets 140,301,650 16,013,125 40,684
Total long-term debt 33,885,141 5,142,450 --
(1) The 1996 net income (loss) per share and weighted average share amounts have
been restated to comply with Statement of Financial Accounting Standards
No. 128, Earnings Per Share.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operation
General
Specialty Care Network is a physician management company that focuses on
musculoskeletal care, which is the treatment of conditions relating to bones,
joints, muscles and related connective tissues. The Company was incorporated in
1995 but did not conduct any significant operations until November 1996, when it
affiliated with the five practices (the "Initial Affiliated Practices")
following a series of transactions by which the Company acquired substantially
all of the assets and certain liabilities of the predecessors to the Initial
Affiliated Practices (the "Initial Affiliation
27
Transactions"). Thereafter, the Company affiliated with 16 additional
practices that have an aggregate of 92 physicians. In addition, the Company has
assisted the Affiliated Practices in recruiting orthopaedic and other
musculoskeletal physicians to join the Affiliated Practices. Prior to their
affiliations with the Company, the Affiliated Practices were established
businesses engaged in the provision of musculoskeletal care as separate,
independent entities (other than 3B Orthopaedics, whose physicians were formerly
part of ROA). The Affiliated Practices currently conduct business as separate
entities obtaining services from the Company pursuant to Service Agreements with
the Company.
The Company has entered into Service Agreements with the Affiliated
Practices, pursuant to which the Company, among other things, provides
facilities and management, administrative and development services, and employs
most non-physician personnel, in return for specified service fees. Such fees
are payable monthly and generally consist of the following: (i) service fees
based on a percentage (The "Service Fee Percentage") ranging from 20% to 50% of
the Adjusted Pre-Tax Income of the Affiliated Practices (defined generally as
revenue of the Affiliated Practices related to professional services less
amounts equal to certain clinic expenses of the Affiliated Practices, not
including physician owner compensation or most benefits to physician owners
("Clinic Expenses" as defined more fully in the Service Agreements)) and (ii)
amounts equal to Clinic Expenses. Generally, for the first three years following
affiliation, the portion of the service fee described under clause (i) is
subject to a fixed dollar minimum (the "Base Service Fee"), which generally was
determined by applying the respective Service Fee Percentage to Adjusted Pre-Tax
Income for each Affiliated Practice for the 12 months prior to affiliation. The
annual base service fees for all of the current Affiliated Practices are
approximately $19 million in the aggregate. In addition, with respect to its
management (and, in certain instances, ownership) of certain facilities and
ancillary services associated with certain of the Affiliated Practices, the
Company receives fees based on a percentage of net revenue or pre-tax income
related to such facilities and services.
Net revenue of the Company consists of service fees (including
reimbursement of Clinic Expenses) paid by the Affiliated Practices pursuant to
the Service Agreements. Significant factors that influence revenue of the
Affiliated Practices include patient volume, number of physicians, specialty and
subspecialty mix, payor mix and associated ancillary services. The Company
assists the Affiliated Practices by providing management, capital and other
resources required to develop new ancillary services, by assisting in the
recruitment of additional physicians and by assisting in the procurement of
managed care contracts.
The operating expenses incurred by the Company include the salaries, wages
and benefits of personnel (other than physician owners and certain technical
medical personnel), supplies, expenses involved in administering the clinical
practices of the Affiliated Practices and depreciation and amortization of
assets. The Company will seek to reduce certain operating expenses, as a
percentage of net revenue, through purchase discounts, economies of scale and
standardization of best practices. The negotiated amounts of the Company's
Service Fee Percentages with Affiliated Practices also will affect the Company's
operating expenses, measured as a percentage of net revenue. In addition to the
operating expenses discussed above, the Company incurs personnel and
administrative expenses in connection with its corporate offices, which provide
management, administrative and development services to the Affiliated Practices.
Accounting Treatment
The acquisition of the assets and assumption of certain liabilities of the
predecessors to the Initial Affiliated Practices (the "Predecessor Practices")
were accounted for by the Company at the transferors' historical cost basis. The
Common Stock issued in exchange for those assets was recorded by SCN at the
Predecessor Practices' historical cost. The beginning net assets of
approximately $5.5 million recorded by the Company with respect to the Initial
Affiliation Transactions reflect, in the opinion of management, adjustments
necessary to present these balances in conformity with generally accepted
accounting principles. In accordance with Staff Accounting Bulletin No. 48, the
physician owners of the Predecessor Practices were deemed to function as
promoters in the Initial Affiliation Transactions. Cash consideration given in
those acquisitions has been treated for accounting purposes as a dividend from
SCN to the physician owners who received cash.
28
The acquisition of assets in 1997 in connection with the Company's
affiliation with the other Affiliated Practices was accounted for by the
purchase method. Future acquisitions will most likely be accounted for by the
purchase method.
Cost of obtaining Service Agreements ("Service Agreement Intangible
Assets") are amortized over the life of the agreements, which are generally
forty years. The Company reviews its long-lived assets quarterly, including
Service Agreements and goodwill, pursuant to the provisions of Statement of
Financial Accounting Standards No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of. Intangible assets
associated with each Affiliated Practice are reviewed separately because the
operations and cash flows of each Affiliated Practice are independent of each
other. The evaluation of the recoverability of long-lived assets, including
Service Agreement Intangible Assets, is significantly affected by estimates of
future cash flows from each of the Company's Affiliated Practices. If estimates
of future cash flows from operations decrease in the future, the Company may be
required to write down the carrying value of its long-lived assets. Any such
write-down could have a material adverse effect on the Company's results of
operations. Intangible and other long-lived assets are allocated to each
Affiliated Practice based on the specific identification methodology.
The Company accounts for its stock-based compensation arrangements using
the intrinsic value method under the provisions of Accounting Principles Board
Opinion No. 25, Accounting for Stock Issued to Employees ("APB No. 25"). In
1995, Financial Accounting Standards Board Statement No. 123, Accounting for
Stock-Based Compensation ("FASB No. 123"), was issued, whereby companies may
elect to account for stock-based compensation expense using a fair market value
based method or continue measuring compensation expense using the intrinsic
value method prescribed in APB No. 25. Currently, the Financial Accounting
Standards Board has added to its agenda a project regarding certain APB No. 25
issues including such items as incorporating the FASB No. 123 grant date
definition into APB No. 25, readdressing the criteria under which broad-based
plans qualify for noncompensatory accounting and defining what constitutes
employees. The resolution of these issues could result in the revision of the
Company's accounting for stock-based compensation arrangements.
Results of Operations
Year Ended December 31, 1997
During 1996, the Company was in its start-up phase and, consequently, the
1996 results are not comparable with the 1997 results.
For 1997, the Company had service fees revenues of approximately $46.0
million, including reimbursement of clinic expenses. Of this amount,
approximately $17.6 million in service fees were derived from practices that
affiliated with the Company during 1997. The Company also generated other
revenues totaling approximately $3.7 million, which consist mainly of business
consulting fees, medical director fees and miscellaneous revenue, of which
approximately $.5 million is derived from ongoing operations and may be deemed
recurring.
During 1997, the Company incurred costs and expenses totaling approximately
$39.5 million, of which approximately $7.9 million are general and
administrative expenses, principally comprised of personnel and administrative
expenses relating to the provision of services to the Affiliated Practices. In
addition, approximately $1.2 million of such expenses constitutes amortization
expense relating to the costs and expenses incurred in the Service Agreement
Intangible Asset.
In 1997, the Company incurred approximately $942,000 of interest expense on
weighted average outstanding debt of approximately $14.7 million. At the end of
1997, outstanding indebtedness on the Company's bank line of credit was
approximately $33 million.
29
Year Ended December 31, 1996
Prior to November 12, 1996, the Company had not entered into any service
agreements and, consequently, generated no revenue. For the period from
January 1, 1996 through October 31, 1996, the Company incurred a pre-tax loss of
approximately $2.9 million, reflecting management salaries, business start-up
expenses and travel, legal and accounting costs associated with the Initial
Affiliation Transactions. For the period from November 1, 1996 through December
31, 1996, the Company generated net revenue, including reimbursement of clinic
expenses, of approximately $4.4 million and pre-tax income of approximately
$611,000. The income tax benefit reflected in the Company's statement of
operations differs from amounts currently payable because certain revenue and
expenses are reported differently in the statement of operations than they are
for tax filing purposes. For the year ended December 31, 1996, the Company's
effective tax rate was (22.2%). See "Liquidity and Capital Resources" below for
additional information.
The following table presents certain statement of operations data for the
year ended December 31, 1996, for the ten months ended October 31, 1996, during
which the Company did not conduct any significant operations and devoted most of
its efforts toward completing the Initial Affiliation Transactions, and for the
two months ended December 31, 1996, which includes operations following the
affiliation with the Initial Affiliated Practices on November 12, 1996.
Ten Months Two Months Twelve Months
Ended Ended Ended
October 31, 1996 December 31, 1996 December 31, 1996
-------------------- ---------------------- ---------------------
Revenue:
Service fees $ -- $ 4,392,050 $ 4,392,050
Other -- -- --
----------- ----------- -----------
-- 4,392,050 4,392,050
Costs and expenses:
Clinic expenses -- 2,820,743 2,820,743
General and administrative expenses 2,845,973 924,290 3,770,263
----------- ----------- -----------
2,845,973 3,745,033 6,591,006
Income (loss) from operations (2,845,973) 647,017 (2,198,956)
Other:
Interest income 6,070 5,800 11,870
Interest expense (48,760) (41,608) (90,368)
----------- ----------- -----------
Income (loss) before income taxes ($2,888,663) $ 611,209 $(2,277,454)
=========== =========== ===========
Liquidity and Capital Resources
During 1996, the Company financed its operations with private placements of
convertible debt and equity and with bank borrowings. The Company received net
proceeds from private placements of convertible subordinated debt and equity in
an aggregate amount of approximately $2.5 million. SCN utilized bank borrowings
under a credit facility with a bank (the "Credit Facility") of approximately
$1.7 million to effect the Initial Affiliation Transactions in November 1996.
In February and March 1997, the Company received net proceeds from its
initial public offering of approximately $22.2 million. Approximately $5.6
million of the proceeds were utilized to repay all outstanding borrowings under
the Credit Facility. The Company utilized $16.4 million of the proceeds of the
offering and approximately $29 million under the Credit Facility in connection
with its affiliation with additional practices subsequent to the Company's
initial public offering.
30
In November, 1997, the Credit Facility was restated to permit maximum
borrowings of $75 million, subject to certain limitations. The Credit Facility
may be used (i) to fund the cash portion of affiliation transactions and (ii)
for the development of musculoskeletal focused surgery centers and other
ancillary service capabilities. The Company can elect to borrow on the Credit
Facility at a floating rate based on the prime rate plus an adjustable
applicable margin, if any, of up to 0.75% or at a rate based on LIBOR plus an
adjustable applicable margin of 1.00% to 2.25% (in each case, the amount of the
margin is based on the Company's ratio of funded debt to consolidated cash flow
(as defined)). At December 31, 1997, the Company had $33 million outstanding
under the Credit Facility, and the effective rate of interest under the Credit
Facility was approximately 7.6% per annum. The Credit Facility is secured by
substantially all of the assets of the Company and contains several affirmative
and negative covenants, including covenants limiting the Company's ability to
incur additional indebtedness, limiting the Company's ability to and restricting
the terms upon which the Company can affiliate with physician practices in the
future, prohibiting the payment of cash dividends on, and the redemption or
repurchase of, the Company's Common Stock and requiring the maintenance of
certain ratios and stockholders equity. The per annum commitment fee on the
unused portion of the Credit Facility is a maximum of .35% per annum if the
Company's leverage coverage (the ratio of funded debt to consolidated cash flow)
is equal to or greater than 2.50, subject to incremental reduction to a
minimum of .20% per annum if the Company's leverage coverage is less than 1.00.
In connection with The Specialists Orthopaedic Medical Corporation
affiliation transactions, the Company agreed to make a $750,000 loan to
Specialist-SCN LLC, a California limited liability company (the "LLC Company").
The LLC Company was organized on November 7, 1997 pursuant to an operating
agreement by and among the LLC Company, the Company and four physicians. The
Company has a 50% membership interest in the LLC Company. The physicians who own
50% membership interests in the LLC Company have severally guaranteed up to
$375,000 of any loan obligations of the LLC Company to the Company. The LLC
Company intends to purchase land necessary for the development for an orthopedic
hospital which will be operated by the LLC Company.
In connection with the Initial Affiliation Transactions and one other
affiliation transaction, the Company loaned funds to certain physician owners of
the relevant Affiliated Practices. As of December 31, 1997, the Company had
loans outstanding of approximately $915,000 to certain of these physician
owners. The loans bear interest at a floating rate based on prime plus 1.25% and
generally mature at the earlier of the date on which any shares of Common Stock
held by the physicians (i) are sold pursuant to a registration statement filed
with the Commission or (ii) may otherwise be sold pursuant to Rule 144 under the
Securities Act of 1933. The loans are secured by a portion of the Common Stock
owned by the physician owners.
Pursuant to the Service Agreements with the Affiliated Practices, the
Company purchases, subject to adjustment, the accounts receivable of the
Affiliated Practices monthly and anticipates that it will have a similar
obligation under service agreements entered into in the future. The purchase
price for such accounts receivable generally equals the gross amounts of the
accounts receivable recorded each month, less adjustments for contractual
allowances, allowances for doubtful accounts and other potentially uncollectible
amounts based on the practice's historical collection experience, as determined
by the Company. However, the Company and certain Affiliated Practices are
currently making periodic adjustments so that amounts paid by the Company for
the accounts receivable are adjusted upwards or downwards based on the Company's
actual collection experience. While the Company believes, based on its
discussions with the other Affiliated Practices, that this arrangement is
acceptable to them, the Company cannot assure that this arrangement will be
effected in all cases. The Company generally bears the collection risk with
respect to outstanding receivables acquired in connection with an affiliation.
The Company expects to use working capital to fund its obligation to purchase,
subject to adjustment, the accounts receivable on an ongoing basis. No
adjustments will be made to reflect financing costs related to the carrying of
such receivables by the Company.
In connection with its Affiliation Transactions, the Company recorded
deferred income taxes associated with book and tax temporary differences in
accordance with Statement on Financial Accounting Standards No. 109. These
liabilities are principally attributable to the temporary differences associated
with identifiable intangible assets and the assumption by the Company of certain
cash basis net assets of the Predecessor Practices. At December 31, 1997, the
deferred taxes related to these items were approximately $31.1 million and $3.1
million,
31
respectively. The deferred taxes associated with identifiable intangible assets
are payable over the amortizable life of the intangible asset while those
related to the cash basis net assets are payable over a four-year period
commencing in the year of affiliation. Based on current levels of operation, it
is anticipated that 1998 cash payments to taxing authorities will exceed income
tax expense reflected on the Company's statement of operations by approximately
$2.2 million. Additional acquisitions of practice assets will most likely
increase the estimate significantly.
Management believes that funds available under the Company's line of credit
and cash flow from operations will be sufficient to fund the Company's
operations at its current level for at least the next twelve months. However,
the Company anticipates that it will require additional funds to finance capital
expenditures relating to expansion of its business. The Company expects that
capital expenditures during 1998 will relate primarily to (i) affiliations with
additional practices, if any, (ii) the development of ancillary facilities,
(iii) expansion and replacement of medical and office equipment for the
Affiliated Practices and (iv) the purchase of equipment for expansion of its
corporate offices. The Company anticipates that, in order to fund expansion of
its business, it may incur from time to time additional short- and long-term
bank indebtedness and may issue equity or debt securities, the availability and
terms of which will depend on market and other conditions. There can be no
assurance that sufficient funds will be available on terms acceptable to the
Company, if at all. If funds are unavailable when needed, the Company may be
compelled to modify its expansion plans.
Year 2000
The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. In other words,
date-sensitive software may recognize a date using the "00" as the year 1900
rather than the Year 2000. This could result in system failures or
miscalculations causing disruptions of operations, including, among others, a
temporary inability to process transactions, send invoices, or engage in similar
normal business activities.
The Company has initiated an internally-managed Year 2000 program designed
to ensure that there is no adverse effect on the Company's core business
operations and transactions with customers, suppliers and financial
institutions. The Company has determined that it will need to modify or replace
some portions of the practice management systems at its Affiliated Practices so
that the systems will function properly with respect to dates in the year 2000
and beyond. The cost of these Year 2000 initiatives is not expected to be
material to the Company's results of operations or financial position. However,
the Company seeks to expand its business through additional affiliations, and
there can be no assurance that systems at practices that affiliate with the
Company in the future will be Year 2000 compliant or, if not Year 2000
compliant, will be converted on a timely basis. The Company also has initiated
discussions with its significant suppliers to determine whether those parties
will be subject to the Year 2000 issue where their systems interface with the
Company's systems or otherwise have an impact on Company operations. The Company
is assessing the extent of which its operations are vulnerable should its
suppliers fail to remediate properly their computer systems.
While the Company believes its planning efforts are adequate to address its
Year 2000 concerns with respect to its internal systems and those of its
Affiliated Practices, there can be no guarantee that the systems of other
entities on which the Company's systems and operations rely will be converted on
a timely basis. The failure of such other entities to remediate any Year 2000
issue on a timely basis could have a material adverse effect on the Company.
Item 7A. Quantitative and Qualitative Disclosure About Market Risk
Not applicable.
Item 8. Financial Statements and Supplementary Data
See pages F-1 through F-52 and page S-1 of this document.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
Not applicable.
32
PART III
Item 10. Directors and Executive Officers of the Registrant
This information (other than the information relating to executive officers
included in Part I) will be included in the Company's Proxy Statement relating
to its Annual Meeting of Stockholders which will be filed within 120 days after
the close of the Company's fiscal year covered by this report, and is hereby
incorporated by reference to such Proxy Statement.
Item 11. Executive Compensation
This information will be included in the Company's Proxy Statement relating
to its Annual Meeting of Stockholders, which will be filed within 120 days after
the close of the Company's fiscal year covered by this report, and is hereby
incorporated by reference to such Proxy Statement.
Item 12. Security Ownership of Certain Beneficial Owners and Management
This information will be included in the Company's Proxy Statement relating
to its Annual Meeting of Stockholders, which will be filed within 120 days after
the close of the Company's fiscal year covered by this report, and is hereby
incorporated by reference to such Proxy Statement.
Item 13. Certain Relationships and Related Transactions
This information will be included in the Company's Proxy Statement relating
to its Annual Meeting of Stockholders, which will be filed within 120 days after
the close of the Company's fiscal year covered by this report, and is hereby
incorporated by reference to such Proxy Statement.
33
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) 1. Financial Statements.
The financial statements listed in the accompanying Index to Financial
Statements and Financial Statement Schedules at page S-1 are filed as part of
this Form 10-K.
2. Financial Statement Schedules.
The following financial statement schedule is filed as part of this Form
10-K:
Schedule II - Valuation and Qualifying Accounts.
All other schedules have been omitted because they are not applicable, or
not required, or the information is shown in the Financial Statements or notes
thereto.
3. Exhibits.
The following is a list of exhibits filed as part of this annual report on
Form 10-K. Where so indicated by footnote, exhibits which were previously filed
are incorporated by reference.
Exhibit
Number Description
- ------ -----------
3.1 Amended and Restated Certificate of Incorporation (incorporated
by reference to Exhibit 3.1 to the Company's Registration
Statement on Form S-1 (File No. 333-17627))
3.2 Amended and Restated Bylaws (incorporated by reference to
Exhibit 3.2 to the Company's Registration Statement on Form S-1
(File No. 333-17627))
10.1+ 1996 Equity Compensation Plan, as amended on June 5, 1997, as
amended on July 25, 1997 and as amended on September 12, 1997
(incorporated by reference to Exhibit 4 to the Company's
Registration Statement on Form S-8 (File No. 333-36933)
10.2 Second Amended and Restated Revolving Loan and Security
Agreement dated as of November 21, 1997 among Specialty Care
Network, Inc., SCN of Princeton, Inc., NationsBank of Tennessee
N.A., AmSouth Bank, Banque Paribas, Key Corporate Capital Inc.
and NationsBank of Tennessee, N.A., as Agent
10.3+ Employment Agreement dated as of April 1, 1996 by and between
Specialty Care Network, Inc. and Kerry R. Hicks (incorporated by
reference to Exhibit 10.3 to the Company's Registration
Statement on Form S-1 (File No. 333-17627))
10.4+ Employment Agreement dated as of April 1, 1996 by and between
Specialty Care Network, Inc. and Patrick M. Jaeckle
(incorporated by reference to Exhibit 10.4 to the Company's
Registration Statement on Form S-1 (File No. 333-17627))
10.5+ Employment Agreement dated as of June 30, 1997 by and between
Specialty Care Network, Inc. and Michael E. West.
10.6+ Employment Agreement dated as of February 22, 1996 by and
between Specialty Care Network, Inc. and Paul Davis
(incorporated by reference to Exhibit 10.6 to the Company's
Registration Statement on Form S-1 (File No. 333-17627)).
10.6.1+ Amendment to Employment Agreement between Specialty Care
Network, Inc. and D. Paul Davis dated December 5, 1997.
10.7+ Employment Agreement dated as of March 1, 1996 by and between
Specialty Care Network, Inc. and Peter A. Fatianow (incorporated
by reference to Exhibit 10.7 to the Company's Registration
Statement on Form S-1 (File No. 333-17627)
34
10.7.1+ Amendment to Employment Agreement between Specialty Care
Network, Inc. and Peter A. Fatianow dated October 1, 1997.
10.8+ Employment Agreement dated as of March 1, 1996 by and between
Specialty Care Network, Inc. and David Hicks (incorporated by
reference to Exhibit 10.8 of the Company's Registration
Statement on Form S-1 (File No. 333-17627))
10.8.1+ Amendment to Employment Agreement between Specialty Care
Network, Inc. and David Hicks, dated December 2, 1997.
10.9 Merger Agreement dated November 12, 1996 by and among Specialty
Care Network, Inc. and Reconstructive Orthopaedic Associates,
Inc. (incorporated by reference to Exhibit 10.9 of the Company's
Registration Statement on Form S-1 (File No. 333-17627))
10.10 Service Agreement dated as of November 12, 1996 by and
between Specialty Care Network, Inc., Reconstructive Orthopaedic
Associates II, P.C. and Richard H. Rothman, M.D., Robert E.
Booth, Jr., M.D., Richard Balderston, M.D., Arthur R.
Bartolozzi, M.D., William J. Hozack, M.D., Michael G. Ciccotti,
M.D., Todd J. Albert, M.D., Alexander R. Vaccaro, M.D. and Peter
F. Sharkey, M.D. (incorporated by reference to Exhibit 10.10 of
the Company's Registration Statement on Form S-1 (File No.
333-17627))
10.16 Term Sheet by and among Reconstructive Orthopaedic Associates
II, P.C., Specialty Care Network, Inc., Robert E. Booth, Jr.,
M.D. and Arthur R. Bartolozzi, M.D. (incorporated by reference
to Exhibit 10.26 of the Company's Registration Statement on Form
S-1 (File No. 333-17627)).
21 Subsidiary of the Company (incorporated by reference to Exhibit
21 of the Company's Registration Statement on Form S-1 (File No.
333-17627)).
23 Consent of Ernst & Young LLP.
27.1 Financial Data Schedule for the year ended December 31, 1997.
27.2 Restated Financial Data Schedule for the year ended
December 31, 1996.
- --------------------
35
+ Constitutes management contract or compensatory plan or arrangement
required to be filed as an exhibit to this form.
(b) Reports on Form 8-K
No reports on Form 8-K were filed during the last quarter of the period
covered by this report.
36
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
SPECIALTY CARE NETWORK, INC.
Date: March 30, 1998 By /s/ Kerry R. Hicks
--------------------
Kerry R. Hicks
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Name Title Date
---- ----- ----
/s/ Richard H. Rothman Chairman of the Board of Directors March 30, 1998
- ---------------------------------------
Richard H. Rothman, M.D., Ph.D.
/s/ Kerry R. Hicks President and Chief Executive Officer March 30, 1998
- --------------------------------------- (Principal Executive Officer)
Kerry R. Hicks
/s/ Patrick M. Jaeckle Executive Vice President - March 30, 1998
- --------------------------------------- Finance/Development (Principal Financial
Patrick M. Jaeckle Officer)
/s/ D. Paul Davis Senior Vice President - Finance (Principal March 30, 1998
- --------------------------------------- Accounting Officer)
D. Paul Davis
/s/ James L. Cain Director March 30, 1998
- ---------------------------------------
James L. Cain, M.D.
/s/ Peter H. Cheesbrough Director March 30, 1998
- ---------------------------------------
Peter H. Cheesbrough
/s/ Richard E. Fleming, Jr. Director March 30, 1998
- ---------------------------------------
Richard E. Fleming, Jr., M.D.
/s/ Thomas C. Haney Director March 30, 1998
- ---------------------------------------
Thomas C. Haney, M.D.
/s/ Leslie S. Matthews Director March 30, 1998
- ---------------------------------------
Leslie S. Matthews, M.D.
/s/ Mats Wahlstrom Director March 30, 1998
- ---------------------------------------
Mats Wahlstrom
37
INDEX TO FINANCIAL STATEMENTS
Specialty Care Network, Inc. and Subsidiary:
Report of Independent Auditors .......................................F-2
Consolidated Balance Sheets ..........................................F-3
Consolidated Statements of Income ....................................F-5
Consolidated Statements of Stockholders' Equity ......................F-6
Consolidated Statements of Cash Flows ................................F-8
Notes to Consolidated Financial Statements ...........................F-10
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.):
Report of Independent Auditors .......................................F-36
Balance Sheets .......................................................F-37
Statements of Operations .............................................F-38
Statements of (Net Capital Deficiency) Stockholders' Equity ..........F-39
Statements of Cash Flows .............................................F-40
Notes to Financial Statements ........................................F-41
F-1
Report of Independent Auditors
Board of Directors and Stockholders
Specialty Care Network, Inc.
We have audited the accompanying consolidated balance sheets of Specialty Care
Network, Inc. and subsidiary (collectively the "Company") as of December 31,
1997 and 1996, and the related consolidated statements of income, stockholders'
equity, and cash flows for the years ended December 31, 1997 and 1996 and the
period from December 22, 1995 (date of incorporation) through December 31, 1995.
Our audits also included the financial statement schedule listed in the Index at
Item 14(a). These financial statements and the schedule are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Specialty Care
Network, Inc. and subsidiary at December 31, 1997 and 1996, and the consolidated
results of their operations and their cash flows for the years ended December
31, 1997 and 1996 and the period from December 22, 1995 (date of incorporation)
through December 31, 1995, in conformity with generally accepted accounting
principles. Also, in our opinion, the related financial statement schedule, when
considered in relation to the basic consolidated financial statements taken as a
whole, presents fairly in all material respects the information set forth
therein.
/s/ ERNST & YOUNG LLP
---------------------
Ernst & Young LLP
Denver, Colorado
March 20, 1998
F-2
Specialty Care Network, Inc. and Subsidiary
Consolidated Balance Sheets
December 31
1997 1996
---------------------------------
Assets
Cash $ 3,444,517 $ 1,444,007
Accounts receivable, net 25,957,367 10,418,175
Loans to physician stockholders 914,737 976,419
Prepaid expenses and inventories 796,903 285,218
------------ ------------
Total current assets 31,113,524 13,123,819
Property and equipment, net 5,276,219 1,889,070
Intangible assets, net of accumulated amortization of
$189,485 and $22,130 in 1997 and 1996, respectively 1,137,808 193,906
Prepaid offering costs -- 747,847
Management service agreements, net of accumulated
amortization of $1,210,391 100,732,431 --
Equity investment and other 922,022 --
Other assets 1,119,646 58,483
------------ ------------
Total assets $140,301,650 $ 16,013,125
============ ============
F-3
December 31
1997 1996
--------------------------------
Liabilities and stockholders' equity
Current portion of capital lease obligations $ 263,007 $ 140,151
Accounts payable 701,087 416,282
Accrued payroll, incentive compensation and related
expenses 1,350,825 1,065,881
Accrued expenses 2,171,130 879,619
Income taxes payable 944,632 1,229,275
Due to affiliated physician practices 2,885,602 1,087,057
Deferred income taxes 872,855 667,830
------------ ------------
Total current liabilities 9,189,138 5,486,095
Line-of-credit 33,000,000 4,177,681
Capital lease obligations, less current portion 885,141 964,769
Deferred income taxes 32,115,476 679,713
------------ ------------
Total liabilities 75,189,755 11,308,258
Commitments and contingencies
Stockholders' equity:
Preferred stock, $0.001 par value, 2,000,000
shares authorized, no shares issued or outstanding -- --
Common stock, $0.001 par value, 50,000,000
shares authorized, and 17,703,293 and
11,045,015 shares issued and outstanding in 1997
and 1996, respectively 17,703 11,045
Additional paid-in capital 60,995,177 6,465,205
Retained earnings (accumulated deficit) 4,099,015 (1,771,383)
------------ ------------
Total stockholders' equity 65,111,895 4,704,867
------------ ------------
Total liabilities and stockholders' equity $140,301,650 $ 16,013,125
============ ============
See accompanying notes.
F-4
Specialty Care Network, Inc. and Subsidiary
Consolidated Statements of Income
Years ended December 31,
1997 and 1996 and the period
from December 22, 1995 (date of
incorporation)
through December 31, 1995
1997 1996 1995
------------------------------------------------------------
Revenue:
Service fees $ 45,966,531 $ 4,392,050 $ --
Other 3,689,390 -- --
------------ ------------ --------
49,655,921 4,392,050 --
------------ ------------ --------
Costs and expenses:
Clinic expenses 31,644,618 2,820,743 --
General and administrative expenses 7,861,015 3,770,263 --
------------ ------------ --------
39,505,633 6,591,006 --
------------ ------------ --------
Income (loss) from operations 10,150,288 (2,198,956) --
Other:
Interest income 536,180 11,870 --
Interest expense (942,144) (90,368) --
------------ ------------ --------
Income (loss) before income taxes 9,744,324 (2,277,454) --
Income tax (expense) benefit (3,873,926) 506,071 --
------------ ------------ ---------
Net income (loss) $ 5,870,398 $ (1,771,383) $ --
============ ============ =========
Net income (loss) per common share
(basic) $ 0.38 $ (0.16) $ --
============ ============ =========
Weighted average number of common
shares used in computation (basic) 15,559,368 11,422,387 --
============ ============ =========
Net income (loss) per common
share (diluted) $ 0.37 $ (0.14) $ --
============ ============ =========
Weighted average number of common
shares and common share
equivalents used in computation
(diluted) 16,071,153 12,454,477 --
============ ============ =========
See accompanying notes.
F-5
Specialty Care Network, Inc. and Subsidiary
Consolidated Statements of Stockholders' Equity
Years ended December 31, 1997 and 1996 and the
period from December 22, 1995 (date of incorporation)
through December 31, 1995
Preferred Stock Common Stock Retained
$0.001 Par Value $0.001 Par Value Additional Earnings
---------------------- ------------------------ Paid-in (Accumulated
Shares Amount Shares Amount Capital Deficit) Total
------ ------ ------ ------ ------- --------- -----
Balances at December 22, 1995 -- $-- -- $ -- $ $ -- $ --
Shares issued in connection
with a private placement
memorandum -- -- 1,690,000 1,690 -- -- 1,690
-- ----- ---------- ---------- ------------ ------------ ------------
Balances at December 31, 1995 -- -- 1,690,000 1,690 -- -- 1,690
Purchase and retirement of
common stock in connection
with a severance agreement -- -- (425,000) (425) -- -- (425)
Shares issued to one of the
affiliated physician
practices -- -- 100,000 100 299,900 -- 300,000
Convertible debt and accrued
interest thereon converted
to common shares -- -- 2,020,900 2,021 2,220,018 -- 2,222,039
Shares issued in connection
with the acquisitions of
net assets of affiliated
physician practices -- -- 7,659,115 7,659 5,483,159 -- 5,490,818
Dividends paid to physician
owners as promoters -- -- -- -- (1,537,872) -- (1,537,872)
Net loss -- -- -- -- -- (1,771,383) (1,771,383)
-- ----- ---------- ---------- ------------ ------------ ------------
Balances at December 31, 1996 -- -- 11,045,015 11,045 6,465,205 (1,771,383) 4,704,867
Shares issued in connection
with an initial public
offering of common stock,
including the underwriters'
overallotment -- -- 3,208,338 3,208 22,188,283 -- 22,191,491
Shares and other equity
instruments issued in
connection with the
acquisitions of net assets
of affiliated physician
practices -- -- 3,222,891 3,223 31,147,368 -- 31,150,591
Exercise of employee stock
options -- -- 227,049 227 265,160 -- 265,387
Tax benefit related to
employee stock options -- -- -- -- 717,140 -- 717,140
F-6
Specialty Care Network, Inc. and Subsidiary
Consolidated Statements of Stockholders' Equity (continued)
Preferred Stock Common Stock Retained
$0.001 Par Value $0.001 Par Value Additional Earnings
---------------------- ------------------------ Paid-in (Accumulated
Shares Amount Shares Amount Capital Deficit) Total
--------- ------------ ------------ ----------- --------------- ---------------- --------------
Non-cash compensation expense
related to employee stock
options -- $ -- -- $ -- $ 212,021 $ -- $ 212,021
Net income -- -- -- -- -- 5,870,398 5,870,398
========= ============ ============ =========== =============== ================ ==============
Balances at December 31, 1997 -- $ -- 17,703,293 $17,703 $60,995,177 $4,099,015 $65,111,895
========= ============ ============ =========== =============== ================ ==============
F-7
See accompanying notes.
Specialty Care Network, Inc. and Subsidiary
Consolidated Statements of Cash Flows
Years ended December 31, 1997 and 1996 and the
period from December 22, 1995 (date of incorporation)
through December 31, 1995
1997 1996 1995
---- ---- ----
Operating activities
Net income (loss) $ 5,870,398 $ (1,771,383) $ --
Adjustments to reconcile net income (loss) to net
cash (used in) provided by operating activities:
Non-cash compensation expense related to
employee stock options 212,021 -- --
Depreciation 965,492 136,216 --
Amortization 1,377,746 22,130
Interest on convertible debentures -- 52,039 --
Deferred income tax benefit (1,279,497) (1,735,346) --
Changes in operating assets and liabilities,
net of the effects of the non-cash
acquisitions of net assets of affiliated
physician practices:
Accounts receivable (9,313,152) (2,066,190) --
Prepaid expenses and inventories and
other assets (1,572,849) (204,911) --
Accounts payable (88,566) 49,764 29,584
Accrued payroll, incentive compensation
and related expenses 212,621 982,982 --
Accrued expenses (419,582) 850,035 --
Income taxes payable 432,497 1,229,275 --
Due to affiliated physician practices, net 1,798,545 1,087,057 --
------------ ------------ ------------
Net cash (used in) provided by operating activities (1,804,326) (1,368,332) 29,584
Investing activities
Purchases of property and equipment (1,568,795) (354,595) --
Increases in intangible assets (1,111,257) (186,452) (29,584)
Equity investment and related advances (922,022) -- --
Acquisitions of physician practices, net of cash
acquired (44,452,105) -- --
------------ ------------ ------------
Net cash used in investing activities (48,054,179) (541,047) (29,584)
Financing activities
Proceeds from initial public offering, net of
current period offering costs 22,939,338 -- --
Proceeds from line-of-credit agreement 35,500,000 4,177,681 --
Proceeds from convertible debentures -- 2,170,000 --
Principal repayments on line of credit agreement (6,677,681) -- --
F-8
Specialty Care Network, Inc. and Subsidiary
Consolidated Statement of Cash Flows (continued)
1997 1996 1995
---- ---- ----
Financing activities (continued)
Principal repayments on capital lease obligations $ (229,711) $ (33,422) $ --
Initial capital contributions -- -- 1,690
Retirement of common stock -- (425) --
Capital contribution from one physician practice -- 300,000 --
Prepaid offering costs -- (747,847) --
Dividends paid to promoters -- (1,537,872) --
Exercise of employee stock options 265,387 -- --
Advances from officers and stockholders -- (9,410) 9,410
Principal payments from loans to physician
stockholders 1,026,419 -- --
Loans to physician stockholders (964,737) (976,419) --
------------- ------------- -------------
Net cash provided by financing activities 51,859,015 3,342,286 11,100
------------- ------------- -------------
Net increase in cash 2,000,510 1,432,907 11,100
Cash at beginning of period 1,444,007 11,100 --
------------- ------------- -------------
Cash at end of period $ 3,444,517 $ 1,444,007 $ 11,100
============= ============= =============
Supplemental cash flow information
Interest paid $ 910,000 $ 38,329 $ --
============= ============= =============
Income taxes paid $ 4,720,926 $ -- $ --
============= ============= =============
Supplemental schedule of noncash investing
and financing activities
Effects of the acquisitions of net assets of
affiliated physician practices:
Assets acquired $ 110,952,707 $ 10,761,466 $ --
Liabilities assumed (2,429,726) (2,187,759) --
Income tax liabilities assumed (32,920,285) (3,082,889) --
Less: Cash paid for acquisitions (44,452,105) -- --
------------- ------------- -------------
$ 31,150,591 $ 5,490,818 $ --
============= ============= =============
Conversion of convertible debentures and accrued
interest thereon into common stock $ -- $ 2,222,039 $ --
============= ============= =============
F-9
See accompanying notes
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements
December 31, 1997
1. Description of Business
Specialty Care Network, Inc. and subsidiary (collectively the "Company") is a
physician practice management company that focuses on musculoskeletal care,
which is the treatment of conditions related to bones, joints, muscles and
related connective tissues. Specialty Care Network, Inc. was incorporated on
December 22, 1995. Commencing on November 12, 1996, the Company began providing
comprehensive management services under long-term management service agreements
with five physician practices in various states. As of March 20, 1998, the
Company is affiliated with 153 physicians in 21 practices located in ten states.
The Company also manages two outpatient surgery centers, three physical therapy
centers and one occupational medicine operation. See Note 10 for further details
of the Company's acquisition activity and the underlying long-term service
arrangements with physician practices.
2. Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include Specialty Care Network, Inc. and
its wholly-owned subsidiary, SCN of Princeton, Inc. All significant intercompany
balances and transactions have been eliminated in consolidation. The Company
uses the equity method of accounting to account for investments in entities in
which it exhibits significant influence, but not control, and does not have an
ownership interest in excess of 50%.
Principles of Acquisition Accounting
The accompanying financial statements give effect to the acquisitions of
substantially all of the assets of five physician practices on November 12,
1996, through asset purchases, a share exchange and a merger, at their
historical cost basis in accordance with the accounting treatment prescribed by
Securities and Exchange Commission Staff Accounting Bulletin No. 48, Transfers
of Nonmonetary Assets by Promoters or Shareholders. In connection with all
subsequent affiliations with physician practices, a substantial portion of the
consideration paid to the physician owners of the practice is restricted
securities and cash, and is allocated to the management service agreement (the
"Service Agreements"). Hereinafter, all physician practices that have affiliated
with the Company, including the initial five physician practices, are referred
to collectively as the "Affiliated Practices." The Company also recognizes the
income tax effects of temporary
F-10
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
2. Summary of Significant Accounting Policies (continued)
differences related to all identifiable acquisition intangible assets, including
the Service Agreements. Such Service Agreements are amortized over the term of
the underlying agreements, which is generally forty years.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and footnotes. Although
these estimates are based on management's knowledge of current events and
actions they may undertake in the future, actual results could differ from those
estimates.
Revenue Recognition and Accounts Receivable
Service fee revenue is recognized based upon the contractual arrangements of the
underlying long-term Service Agreements between the Company and the Affiliated
Practices. See Note 10 for further discussion of such contractual arrangements,
including certain guaranteed minimum management fees.
Other revenue consists primarily of business consulting fees and other
miscellaneous income.
Accounts receivable represents amounts due from patients and other independent
third parties for medical services provided by the Affiliated Practices and
management fee revenue earned by the Company. Under the Service Agreements, each
Affiliated Practice agrees to sell and assign to the Company, and the Company
agrees to buy, all of the Affiliated Practices' accounts receivable each month
during the existence of the Service Agreement. The purchase price for such
accounts receivable generally equals the gross amounts of the accounts
receivable each month less adjustments for contractual allowances, allowances
for doubtful accounts and other potentially uncollectible amounts based on the
Affiliated Practice's historical collection rate, as determined by the Company.
However, the Company and certain of the Affiliated Practices are currently
making periodic adjustments so that amounts paid by the Company for the accounts
receivable are adjusted upwards or downwards based on the Company's actual
collection experience. The Company generally bears the collection risk with
respect to accounts receivable acquired in connection with an affiliation
transaction.
F-11
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
2. Summary of Significant Accounting Policies (continued)
Earnings Per Share
In 1997, Statement of Financial Accounting Standards No. 128 ("SFAS No. 128"),
Earnings Per Share, was issued. SFAS No. 128 replaced the calculation of primary
and fully diluted earnings per share with basic and diluted earnings per share.
Unlike primary earnings per share, basic earnings per share excludes any
dilutive effects of options, warrants and convertible securities. Diluted
earnings per share is very similar to fully diluted earnings per share under the
previous method of reporting earnings per share. All earnings per share amounts
for all periods have been presented, and where appropriate, restated to conform
to SFAS No. 128 requirements.
Financial Instruments
The carrying amounts of financial instruments as reported in the accompanying
balance sheets approximate their fair value primarily due to the short-term
and/or variable-rate nature of such financial instruments.
Property and Equipment
Property and equipment are stated at cost, including assets acquired from the
Affiliated Practices. Equipment held under capital leases is stated at the
present value of minimum lease payments at inception of the related lease. Costs
of repairs and maintenance are expensed as incurred. Depreciation is computed
using the straight-line method over the estimated useful lives of the underlying
assets. Amortization of capital lease assets and leasehold improvements are
computed using the straight-line method over the shorter of the lease term or
the estimated useful lives of the underlying assets. The estimated useful lives
used are as follows:
Computer equipment and software 3-5 years
Furniture and fixtures 5-7 years
Leasehold improvements 5 years
F-12
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
2. Summary of Significant Accounting Policies (continued)
Intangible Assets
Intangible assets, which are stated at cost, primarily consist of deferred debt
issuance costs of $1,297,709 and $186,452 at December 31, 1997 and 1996,
respectively, that are being amortized on a straight-line basis over a
three-year period.
Pursuant to the provisions of Statement of Financial Accounting Standards No.
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of, the carrying value of long-lived assets, including
management service agreements, is reviewed quarterly to determine if any
impairment indicators are present. If it is determined that such indicators are
present and the review indicates that the assets will not be recoverable, based
on undiscounted estimated cash flows over the remaining amortization and
depreciation period, the carrying value of such assets is reduced to estimated
fair market value. Impairment indicators include, among other conditions, cash
flow deficits; an historic or anticipated decline in revenue or operating
profit; adverse legal, regulatory or reimbursement developments; accumulation of
costs significantly in excess of amounts originally expected to acquire the
asset; or a material decrease in the fair market value of some or all of the
assets.
The Company reviews its long-lived assets separately for each physician practice
because the cash flows and operations of each individual physician practice is
largely independent of each other and of other aspects of the Company's
business. Intangible and other long-lived assets are allocated to each physician
practice based on the specific identification methodology. During the years
ended December 31, 1997 and 1996, no impairment charges were recognized by the
Company.
The evaluation of the recoverability of long-lived assets, including management
service agreements, is significantly affected by estimates of future cash
flows from each of the Company's market areas and individual physician
practices. If estimates of cash flows from operations decrease in the future,
the Company may be required to write down its long-lived assets. Any such
write-down could have a material adverse effect on the Company's results of
operations.
F-13
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
2. Summary of Significant Accounting Policies (continued)
Stock-Based Compensation
The Company accounts for its stock-based employee compensation arrangements
under the provisions of Accounting Principles Board Opinion No. 25, Accounting
for Stock Issued to Employees ("APB No. 25"). In 1995, Statement of Financial
Accounting Standards No. 123, Accounting for Stock-Based Compensation ("SFAS No.
123"), was issued, whereby companies may elect to account for stock-based
compensation using a fair value based method or continue measuring compensation
expense using the intrinsic value method prescribed in APB No. 25. SFAS No. 123
requires that companies electing to continue to use the intrinsic value method
make pro forma disclosure of net income and net income per share as if the fair
value based method of accounting had been applied.
Estimated Malpractice Professional Liability Claims
The Company and its affiliated physician practices are insured with respect to
medical malpractice risks on either an occurrence-rate or a claims-made basis.
Management is not aware of any claims against it or its affiliated physician
practices which might have a material impact on the Company's financial position
or results of operations.
Reclassifications
Certain amounts in the 1996 and 1995 consolidated financial statements have been
reclassified in order to conform to the current presentation.
Future Accounting Pronouncements
Reporting Comprehensive Income
Statement of Financial Accounting Standards No. 130 ("SFAS No. 130"), Reporting
Comprehensive Income, was issued in June 1997. SFAS No. 130 establishes
standards for reporting and display of comprehensive income and its components
(e.g., revenue, expenses, gains, losses, etc.) in a full set of general purpose
financial statements. This new accounting pronouncement requires that all items
that are required to be recognized under accounting standards as components of
comprehensive income be reported in a financial statement that is displayed with
the same prominence as other financial statements and display the accumulated
balance of other comprehensive income separately from retained earnings and
additional paid-in capital in the equity section of
F-14
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
2. Summary of Significant Accounting Policies (continued)
the balance sheet. SFAS No. 130 is effective for the Company's year ending
December 31, 1998. Management is currently evaluating the potential impact on
the Company's financial statement presentation; however, the impact is not
expected to be material.
Segment Reporting
Also in June 1997, Statement of Financial Accounting Standards No. 131 ("SFAS
No. 131"), Disclosures about Segments of an Enterprise and Related Information,
was promulgated. SFAS No. 131 establishes standards for the way that public
business enterprises report information about operating segments in annual
financial statements and requires that those enterprises report selected
information about operating segments in interim financial reports issued to
shareholders. It also establishes standards for related disclosures about
products and services, geographic areas, and major customers.
This new accounting pronouncement requires that a public business enterprise
report financial and descriptive information about its reportable operating
segments. Operating segments are components of an enterprise about which
separate financial information is available that is evaluated regularly by the
chief operating decision maker in deciding how to allocate resources and in
assessing performance. Generally, financial information is required to be
reported on the basis that it is used internally for evaluating segment
performance and deciding how to allocate resources to segments.
SFAS No. 131 is effective for the Company's year ending December 31, 1998.
Management is currently evaluating the potential impact on the Company's
footnote disclosures; however, the impact is not expected to be material.
F-15
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
3. Accounts Receivable and Management Fee Revenue
Accounts receivable consisted of the following:
December 31
1997 1996
----------- ----------
Gross patient accounts receivable purchased
from the affiliated physician practices $48,922,686 $25,564,645
Less allowance for contractual adjustments
and doubtful accounts 26,225,860 15,719,542
----------- -----------
22,696,826 9,845,103
Management fees, including reimbursement of
clinic expenses 3,260,541 573,072
----------- -----------
$25,957,367 $10,418,175
=========== ===========
Management fee revenue, exclusive of reimbursed clinic expenses, was
approximately $14.3 million and $1.6 million for the years ended December 31,
1997 and 1996, respectively. One of the Affiliated Practices exceeded 20% of the
1997 and 1996 totals.
An integral component of the computation of management fees earned by the
Company is net patient revenue of the Affiliated Practices. The Affiliated
Practices recognize net patient revenue for medical services at established
rates reduced by allowances for doubtful accounts and contractual adjustments.
Contractual adjustments arise due to the terms of certain reimbursement and
managed care contracts. Such adjustments represent the difference between
charges at established rates and estimated recoverable amounts and are
recognized by the Affiliated Practices in the period the services are rendered.
Any differences between estimated contractual adjustments and actual final
settlements under reimbursement and managed care contracts are reported as
contractual adjustments in the year the final settlements are made. Net patient
revenue is not recognized as revenue in the accompanying financial statements.
The Company's affiliated physician practices derived approximately 21.9% and
22.6% of their net revenue from services provided under the Medicare program for
the years ended December 31, 1997 and 1996, respectively. Laws and regulations
governing the Medicare program are complex and subject to interpretation. The
Company believes that the Affiliated Practices are in compliance, in all
material respects, with all applicable laws and regulations. See Note 11 for
discussion of an
F-16
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
3. Accounts Receivable and Management Fee Revenue (continued)
ongoing Department of Health and Human Services inquiry regarding the
predecessor of Reconstructive Orthopaedic Associates II, P.C. Such laws and
regulations can be subject to future government review and interpretation.
Violation of such laws could result in significant regulatory action including
fines, penalties and exclusion from the Medicare program. Other than the
Medicare program, no single payor provided more than 10% of aggregate net clinic
revenue or 5% of accounts receivable as of and for the years ended December 31,
1997 or 1996. Accordingly, concentration of credit risk related to patient
accounts receivable is limited by the diversity and number of providers,
patients and payors.
4. Property and Equipment
Property and equipment consist of the following:
December 31
1997 1996
---------- -----------
Furniture and fixtures $5,386,107 $2,639,418
Computer equipment and software 1,983,477 1,110,657
Leasehold improvements and other 1,227,720 381,271
---------- ----------
8,597,304 4,131,346
Accumulated depreciation and amortization 3,321,085 2,242,276
---------- ----------
Net property and equipment $5,276,219 $1,889,070
========== ==========
Included in the above are assets recorded under capital leases which consist of
the following:
December 31
1997 1996
---------- ----------
Furniture and fixtures $ 1,536,411 $1,372,557
Computer equipment 178,693 145,661
----------- ----------
1,715,104 1,518,218
Accumulated amortization 983,603 882,846
----------- ----------
Net assets under capital leases $ 731,501 $ 635,372
=========== ==========
F-17
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
4. Property and Equipment (continued)
At December 31, 1997, the Company had equipment purchase commitments aggregating
approximately $2.8 million. Such equipment will be used primarily to provide
ancillary services at the Affiliated Practices.
5. Debt
Convertible Debentures
In connection with private placements in 1996, the Company raised $2.17 million
of short-term unsecured convertible debt. The proceeds thereof were utilized to
fund the Company's start-up and its organizational phase until certain net
assets of the original five Affiliated Practices were acquired on November 12,
1996.
Contemporaneous with the acquisitions of these physician practices, the holders
of the debentures converted the unpaid principal amounts plus any accrued
interest thereon (calculated at 5.0%), into the Company's common stock at the
conversion ratio of $1.00 ($1,920,332) and $3.00 ($301,707) of debenture
principal and accrued interest for one share of common stock. The following
table summarizes the conversions:
Accrued
Principal Interest Total
--------- ---------- ----------
Stockholders of the Company $ 640,000 $ 18,153 $ 658,153
Physician practices and
related stockholders 1,530,000 33,886 1,563,886
---------- ---------- ----------
$2,170,000 $ 52,039 $2,222,039
========== ========== ==========
Line-of-Credit
On November 1, 1996, the Company entered into a $30 million Revolving Loan and
Security Agreement (the "Credit Facility") with a bank, which provided certain
amounts necessary to effectuate the acquisitions of the five original Affiliated
Practices and related transactions. Through October 31, 1997, the Credit
Facility interest rates ranged from approximately 7.2% to 7.4%, primarily based
on a LIBOR rate plus an applicable margin.
In November 1997, the Credit Facility was restated to permit maximum borrowings
of $75 million, subject to certain limitations. The Credit Facility may be used
(i) to fund the
F-18
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
5. Debt (continued)
cash portion of affiliation transactions, and (ii) for the development of
musculoskeletal focused surgery centers. The Company can elect to borrow on the
Credit Facility at a floating rate based on the prime rate plus an adjustable
applicable margin of 0% to 0.75% or at a rate based on LIBOR plus an adjustable
applicable margin of 1.0% to 2.25%. At December 31, 1997, the Company had $33
million outstanding under the Credit Facility at an effective rate of interest
of approximately 7.6% per annum. The Credit Facility is secured by substantially
all of the assets of the Company and contains several affirmative and negative
covenants, including covenants limiting the Company's ability to and restricting
the terms upon which the Company can affiliate with physician practices in the
future, prohibiting the payment of cash dividends on, and the redemption or
repurchase of, the Company's common stock and requiring the maintenance of
certain ratios and stockholders' equity. The per annum commitment fee on the
unused portion of the Credit Facility is 0.25% per annum, subject to reduction
to a minimum of 0.20% per annum if the Company's leverage coverage (a ratio of
funded debt to consolidated cash flow) is less than 1.00.
6. Common Stock
At December 31, 1996, 1,180,000 and 85,000 shares of certain outstanding
nontransferable common stock were held by current employees and former
employees, respectively. Pursuant to the common stock subscription agreements
and a related Stockholders Agreement, executed by the Company and its employees,
all unvested shares became vested as a result of the initial public offering of
the Company's common stock.
During the year ended December 31, 1996, the Company issued an additional
100,000 shares of common stock to one of its affiliated practices at $3.00 per
share.
On February 6, 1997, the Company's initial public offering of its common stock
became effective. In connection therewith, 3,208,338 shares of common stock were
issued at $8.00 per share, including 208,338 common shares issued upon exercise
of the underwriters' overallotment option.
F-19
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
6. Common Stock (continued)
As of December 31, 1997, the Company had the following common shares reserved
for future issuance:
Stock Option Plans 3,998,966
Warrants in connection with one of the Affiliated Practice
acquisitions (Note 10) 544,681
Shares which may be released as additional consideration for one of
the Affiliated Practice acquisitions (Note 10) 113,393
---------
Total shares reserved for future issuance 4,657,040
=========
7. Stock Option Plans
On March 22, 1996, the Company adopted the 1996 Incentive and Non-Qualified
Stock Option Plan (the "Plan") pursuant to which nontransferable options to
purchase up to 5,000,000 shares of common stock of the Company were available
for award to eligible directors, officers, advisors, consultants and key
employees. On January 10, 1997, the Board of Directors voted to terminate the
Plan. The exercise price for incentive stock options awarded during the year
ended December 31, 1996 was not less than the fair market value of each share at
the date of the grant and the options granted thereunder were for a period of
ten years. Options, which are generally contingent on continued employment with
the Company, may be exercised only in accordance with a vesting schedule
established by the Company's Board of Directors. Of the 553,500 shares
underlying the option grants approved during the year ended December 31, 1996 at
an exercise price of $1.00 per share, 3,500 shares underlying the grant options
remain outstanding and exercisable at December 31, 1997. The other 550,000
options were forfeited or exercised during 1997.
On October 15, 1996, the Company's Board of Directors approved the 1996 Equity
Compensation Plan (the "Equity Plan"), which provides for the granting of
options to purchase up to 2,000,000 shares of the Company's common stock. The
total number of shares authorized under the Equity Plan increased to 4,000,000
in 1997. Both incentive stock options and non-qualified stock options may be
issued under the provisions of the Equity Plan. Employees of the Company and any
future subsidiaries, members of the Board of Directors and certain advisors are
eligible to participate in this plan, which will terminate no later than October
14, 2006. The granting and vesting of options under the Equity Plan are provided
by the Company's Board of Directors or a committee of the Board of Directors
(currently the Compensation Committee).
F-20
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
7. Stock Option Plans (continued)
Pro forma information regarding net income and earnings per share is required by
SFAS No. 123 and has been determined as if the Company had accounted for its
employee stock options under the fair value method of that accounting
pronouncement. The fair value for options awarded during the years ended
December 31, 1997 and 1996 were estimated at the date of grant using an option
pricing model with the following assumptions: risk-free interest rate over the
life of the option of 6.0%; no dividend yield; and expected two to eight year
lives of the options. The estimated fair value for these options was calculated
using the minimum value method in 1996 and may not be indicative of the future
impact since this model does not take into consideration volatility and the
commencement of public trading in the Company's common stock on February 7,
1997. The Black-Scholes model was utilized to calculate the value of the options
issued during 1997. The volatility factor utilized in 1997 was 0.47.
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions, including the expected stock price volatility. Because
the Company's stock options have characteristics significantly different from
those of traded options, and because changes in the subjective input assumptions
can materially affect the fair value estimate, in management's opinion, the
existing models do not necessarily provide a reliable single measure of the fair
value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options' vesting period. Because compensation
expense associated with an award is recognized over the vesting period, the
impact on pro forma net income as disclosed below may not be representative of
compensation expense in future years.
F-21
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
7. Stock Option Plans (continued)
The Company's pro forma information as is follows:
1997 1996
---- ----
Pro forma net income (loss) $5,354,571 $(1,815,272)
Pro forma net income (loss) per common
share (basic) $ 0.34 $ (0.16)
Pro forma net income (loss) per common
share (diluted) $ 0.33 $ (0.15)
A summary of the Company's stock option activity, and related information for
the years ended December 31 is as follows:
1997 1996
------------------------------ ------------------------------
Weighted- Weighted-
Average Average
Options Exercise Price Options Exercise Price
-------------- -------------- --------------- --------------
Outstanding at Beginning of Year 1,758,748 $ 5.25 -- $ --
Granted
Exercise price equal to
fair value of common stock 1,073,751 12.07 603,500 1.41
Exercise price greater than
fair value of common stock 160,000 10.00 726,658 8.00
Exercise price less than
fair value of common stock -- -- 428,590 6.00
Exercised (227,049) -- --
Forfeited (400,443) -- --
---------- ---------
Outstanding at End of Year 2,365,007 9.57 1,758,748 5.25
========== =========
Exercisable at End of Year 231,537 $7.38 3,500 $1.00
========== ===== ========= =====
1997 1996
---- ----
Weighted-Average Fair Value of Options:
Exercise price equal to fair value of
common stock $ 4.62 $ 0.19
Exercise price greater than fair value
of common stock 4.35 0.99
Exercise price less than fair value of
common stock -- 2.75
F-22
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
7. Stock Option Plans (continued)
Exercise prices for options outstanding and the weighted-average remaining
contractual lives of those options at December 31, 1997 are as follow:
Options Outstanding Options Exercisable
------------------------------------------------- -----------------------------
Weighted-
Average Weighted- Weighted-
Remaining Average Average
Range of Number Contractual Exercise Number Exercise
Exercise Prices Outstanding Life Price Exercisable Price
- --------------------------------------------------------------------- -----------------------------
$1.00 3,500 8.22 $ 1.00 3,500 $ 1.00
$6.00 475,590 8.93 6.00 59,200 6.00
$8.00 654,166 8.93 8.00 168,837 8.00
$9.00-$9.99 128,500 9.39 9.69 - -
$10.00-$12.99 683,364 9.55 11.31 - -
$13.00-$13.25 419,887 10.00 13.25 - -
---------------- ----------------
$1.00-$13.25 2,365,007 9.33 9.57 231,537 7.38
================ ================
F-23
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
8. Leases
The Company is obligated under operating and capital lease agreements for
offices and certain equipment. In some circumstances, these lease arrangements
are with entities owned or controlled by physician stockholders who are also
equity holders of the Affiliated Practices. Certain leases are subject to
standard escalation clauses and include renewal options. Future minimum payments
under noncancelable capital and operating leases with lease terms in excess of
one year are summarized as follows for the years ending December 31:
Capital Operating
Leases Leases
-------------------- ------------------
1998 $ 365,016 $ 6,039,700
1999 323,560 6,027,588
2000 306,917 5,691,266
2001 227,464 5,337,597
2002 194,629 4,299,698
Thereafter -- 25,247,435
-------------------- -----------------
Total minimum lease payments 1,417,586 $52,643,284
==================
Less amount representing interest 269,438
--------------------
Present value of net minimum lease payments 1,148,148
Less current portion 263,007
--------------------
Long-term portion $ 885,141
====================
Rent expense for the years ended December 31, 1997 and 1996 under all operating
leases was approximately $4,800,000 and $400,000, respectively. Approximately
$4,600,000 and $355,000, respectively, of such amounts were charged directly
to the Affiliated Practices as clinic expenses.
9. Income Taxes
The Company is a corporation subject to federal and certain state and local
income taxes. The provision for income taxes is made pursuant to the liability
method as prescribed in Statement of Financial Accounting Standards No. 109,
Accounting for Income Taxes. The liability method requires recognition of
deferred income taxes based on temporary differences between the financial
reporting and income tax bases of assets and liabilities, using currently
enacted income tax rates and regulations.
F-24
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
9. Income Taxes (continued)
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities at December 31, 1997 and 1996
are as follows:
1997 1996
------------------ ---------------
Deferred tax assets:
Deferred start-up expenditures $ 718,491 $ 796,949
Property and equipment, net 209,244 236,481
Accrued liabilities 386,030 35,497
Stock option compensation 85,698 -
------------------ ---------------
1,399,463 1,068,927
------------------ ---------------
Deferred tax liabilities:
Management service agreements 31,125,220 -
Net cash basis assets assumed
in physician practice affiliations 3,079,428 2,346,434
Prepaid expenses 183,146 70,036
------------------ ---------------
34,387,794 2,416,470
------------------ ---------------
Net deferred tax liability $32,988,331 $1,347,543
================== ===============
The income tax expense (benefit) for the years ended December 31, 1997 and 1996
is summarized as follows:
1997 1996
------------------ ---------------
Current:
Federal $4,074,033 $ 971,192
State 1,079,390 258,083
------------------ ---------------
5,153,423 1,229,275
------------------ ---------------
Deferred:
Federal (991,430) (1,362,954)
State (288,067) (372,392)
------------------ ---------------
(1,279,497) (1,735,346)
------------------ ---------------
Total $3,873,926 $ (506,071)
================== ===============
F-25
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
9. Income Taxes (continued)
The income tax expense (benefit) differs from amounts currently payable because
certain revenue and expenses are reported in the statement of income in periods
that differ from those in which they are subject to taxation. The principal
differences relate to business acquisition and start-up expenditures that are
capitalized for income tax purposes and expensed for financial statement
purposes, and the amortization of certain cash basis net assets included in
taxable income in periods subsequent to the date of affiliation with physician
practices.
A reconciliation between the statutory federal income tax rate of 34% and the
Company's 39.8% and (22.2%) effective tax rates for the years ended December 31,
1997 and 1996, respectively, is as follows:
1997 1996
----------------- -----------------
Federal statutory income tax rate 34.0% (34.0)%
State income taxes, net of federal benefit 5.1 (2.8)
Nondeductible business acquisition and other costs 0.7 11.5
Miscellaneous - 3.1
---------------- -----------------
Effective income tax rates 39.8% (22.2)%
================= =================
10. Physician Practice Net Asset Acquisitions
Effective November 12, 1996, the Company acquired substantially all of the
assets, including accounts receivable and fixed assets, and certain liabilities,
including current trade payables, accrued expenses and certain capital lease
obligations, of five physician practices. The physician owners, functioning as
promoters, effectively contributed these assets and liabilities in exchange for
an aggregate of 7,659,115 shares of common stock of the Company and $1,537,872
in cash. Upon closing, the Company, under signed agreements, assumed all risks
of ownership related to these net assets.
F-26
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
10. Physician Practice Net Asset Acquisitions (continued)
The following table summarizes certain financial information related to this
transaction for the five original Affiliated Practices:
Common Stock Cash
Consideration Consideration
Paid by the Paid by the
Company Company
--------------------- -------------------
(Shares)
Reconstructive Orthopaedic Associates, Inc. 3,169,379 $1,537,872
Princeton Orthopaedic Associates, P.A. 1,196,793 -
Tallahassee Orthopedic Clinic, P.A. 1,072,414 -
Greater Chesapeake Orthopaedic Associates, LLC 1,568,922 -
Vero Orthopaedics, P.A. 651,607 (1) -
(1) Excludes non-qualified stock options to purchase an additional 50,000
shares of the Company's common stock at $6.00 per share, which fully vest
on November 12, 1998.
During 1997, the Company acquired substantially all of the assets and certain
liabilities of additional physician practices through a combination of asset
purchases and mergers as detailed in the table below:
- ----------------------------------------------------------------------------------------------------------
Affiliation Affiliated Acquisition Headquarters Number of
Date Practice(1) Type Location Physicians
- ----------------------------------------------------------------------------------------------------------
March 1997 Medical Rehabilitation Merger Tallahassee, Florida 4
Specialists II, P.A.; Riyaz H. Baltimore, Maryland
Jinnah, M.D., P.A.; Floyd Thomasville, Georgia
R. Jaggears, M.D., P.C., II
April 4, 1997 The Orthopaedic and Sports Merger Annapolis, Maryland 10
Medicine Center, II, P.A.
July 1, 1997 Southeastern Neurology Group Asset Portsmouth, Virginia 12
II, P.C. Purchase/
Merger
July 1, 1997 Orthopaedic Surgery Centers, Merger Portsmouth, Virginia 10
P.C. II
July 3, 1997 Associated Orthopaedics & Merger Plano, Texas 5(2)
Sports Medicine, P.A.
F-27
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
10. Physician Practice Net Asset Acquisitions (continued)
- ----------------------------------------------------------------------------------------------------------
Affiliation Affiliated Acquisition Headquarters Number of
Date Practice(1) Type Location Physicians
- ----------------------------------------------------------------------------------------------------------
July 3, 1997 Associated Arthroscopy Asset Plano, Texas 5(2)
Institute, Inc. Purchase
July 3, 1997 Access Medical Supply, Inc. Asset Plano, Texas 5(2)
d/b/a Associated Physical Purchase
Therapy
July 3, 1997 Allied Health Services, P.A. Asset Plano, Texas 5(2)
d/b/a Associated Occupational Purchase
Rehabilitation
July 7, 1997 Ortho-Associates, P.A. d/b/a Asset Plantation, Florida 14
Park Place Therapeutic Center Purchase
July 16, 1997 Mid-Atlantic Orthopaedic Merger Hagerstown, Maryland 5
Specialists\Drs. Cirincione,
Milford, Stowell, and
Amalfitano, P.C.
August 29, 1997 Northeast Florida Orthopaedic, Merger Orange Park, Florida 2
Sports Medicine and
Rehabilitation II, P.A.
August 29, 1997 Steven P. Surgnier, M.D., P.A., Asset Marianna, Florida 1
II Purchase
September 1, 1997 Orthopaedic Associates of West Merger Clearwater, Florida 9
Florida, P.A.
September 10, 1997 Orthopaedic Institute of Ohio, Merger Lima, Ohio 8
Inc.
November 14, 1997 The Specialists Orthopaedic Merger/ Fairfield, California 12(3)
Medical Corporation Asset
Purchase
November 14, 1997 The Specialists Surgery Center Asset Fairfield, California 12(3)
Purchase
(1) The Affiliated Practices listed are successors to those entities acquired
by the Company through mergers.
(2) Associated Orthopaedics & Sports Medicine, P.A., Associated Arthroscopy
Institute, Inc., Access Medical Supply, Inc. and Allied Health Services,
P.A. are related entities which include five physicians in total.
(3) The Specialists Orthopaedic Medical Corporation and The Specialists Surgery
Center are related entities which include twelve physicians in total.
- --------------------------------------------------------------------------------
F-28
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
10. Physician Practice Net Asset Acquisitions (continued)
Total consideration for the 1997 merger and asset acquisitions was 3,222,891
shares of the Company's common stock and $44,452,105 in cash. As part of the
consideration in three of the mergers, the Company issued an aggregate of 13,322
shares of common stock and paid an aggregate of $189,000 in cash to an
individual who served as a consultant to three of the predecessors to the
Affiliated Practices. This individual subsequently became Senior Vice President
of Operations of the Company in August 1997. Furthermore, the Company granted
one physician associated with Orthopaedic Surgery Centers, P.C. II the right,
until June 30, 1998, to require the Company to re-purchase 74,844 shares of
common stock issued to such physician in the merger at a purchase price equal to
$11.21 per share. Additionally, in connection with the asset purchase of
Ortho-Associates, P.A. d/b/a Park Place Therapeutic Center, the Company issued
to the physician owners warrants to purchase, in the aggregate, 544,681 shares
of common stock at an exercise price of $14.69 per share. The Company also has
an escrowed deposit of approximately $900,000 in cash and 113,393 shares which
may be released as additional consideration for one of the Company's physician
practice acquisitions. Although management does not believe the additional
consideration will be paid, the cash amount has been included in other assets as
a restricted deposit.
Effective September 10, 1997, the Company acquired, by purchase from the
physician owners of Orthopedic Institute of Ohio, Inc., one-half of the
outstanding membership interests of West Central Ohio Group, Ltd., an Ohio
limited liability company ("WCOG"). WCOG constructed an orthopaedic institute in
Lima, Ohio (the "Institute"). The Institute began operations in February 1998.
In connection with the acquisition, the Company paid $400,000 in cash for its
investment in WCOG. Included in equity investment and other in the accompanying
financial statements is the $400,000 investment in WCOG and $522,022 in advances
to WCOG. Additionally, the Company has agreed to pay an amount equal to 25% of
WCOG's first $6,000,000 of net income as contingent consideration. The Company's
obligation to pay this contingent consideration will terminate in September
2002.
In connection with The Specialists Orthopaedic Medical Corporation affiliation
transactions, the Company agreed to make a $750,000 loan to Specialist-SCN LLC,
a California limited liability company (the "LLC Company"). The LLC Company was
organized on November 7, 1997 pursuant to an operating agreement by and among
the LLC Company, the Company and four physicians. The Company has a 50%
membership interest in the LLC Company. The physicians who own 50% membership
interests in the
F-29
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
10. Physician Practice Net Asset Acquisitions (continued)
LLC Company have severally guaranteed up to $375,000 of any loan obligations of
the LLC Company to the Company. The LLC Company intends to purchase land for the
development of an orthopedic hospital which will be operated by the LLC Company.
Concurrent with its 1997 and 1996 acquisitions, the Company simultaneously
entered into long-term service agreements with the Affiliated Practices.
Pursuant to the terms of the Service Agreements, the Company, among other
things, provides facilities and management, administrative and development
services, in return for service fees. Such fees are payable monthly and consist
of the following: (i) service fees based on a percentage ranging from 20%-50% of
the adjusted pre-tax income of the Affiliated Practices (generally defined as
revenue of the Affiliated Practices related to professional services less
amounts equal to certain clinic expenses but not including physician owner
compensation or most benefits to physician owners) plus (ii) reimbursement of
certain clinic expenses. Typically, for the first three years following
affiliation, the portion of the service fees described under clause (i) is
specified to be the greater of the amount payable as described under clause (i)
above or a fixed dollar amount (the "Base Service Fee"), which was generally
calculated by applying the respective service fee percentage of adjusted pre-tax
income of the predecessors to the Affiliated Practices for the twelve months
prior to affiliation. The aggregate annual Base Service Fee for all of the
Affiliated Practices is approximately $19 million. In addition, with respect to
its management of certain facilities and ancillary services associated with
certain of the Affiliated Practices, the Company receives fees ranging from
2%-8% of net revenue or pre-tax income.
The Service Agreements have terms of forty years, with automatic extensions
(unless specified notice is given) of additional five-year terms. A Service
Agreement may be terminated by either party if the other party (i) files a
petition in bankruptcy or other similar events occur or (ii) defaults on the
performance of a material duty or obligation, which default continues for a
specified term after notice. In addition, the Company may terminate the
agreement if the Affiliated Practice's Medicare or Medicaid number is terminated
or suspended as a result of some act or omission of the Affiliated Practice or
the physicians, and the Affiliated Practice may terminate the agreement if the
Company misapplies funds or assets or violates certain laws.
Upon termination of a Service Agreement by the Company for one of the reasons
set forth above, the Company generally has the option to require the Affiliated
Practice to purchase and assume the assets and liabilities related to the
Affiliated Practice at the fair
F-30
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
10. Physician Practice Net Asset Acquisitions (continued)
market value thereof. In addition, upon termination of a Service Agreement by
the Company during the first five years of the term, the physician owners of the
Affiliated Practice are required to pay the Company or return to the Company an
amount of cash or stock of the Company equal to one-third of the total
consideration received by such physicians in connection with the Company's
affiliation with the practice.
Under the Service Agreements, each physician owner must give the Company twelve
months notice of an intent to retire from the Affiliated Practice. If a
physician gives such notice during the first five years of the agreement, the
physician must also locate a replacement physician or physicians acceptable to a
Joint Policy Board and pay the Company an amount based on a formula relating to
any loss of service fee for the first five years of the term. Furthermore, the
physician must pay the Company an amount of cash or stock of the Company equal
to one-third of the total consideration received by such physician in connection
with the Company's affiliation with the practice. Typically, the agreement also
provides that after the fifth year no more than 20% of the physician owners at
an Affiliated Practice may retire within a one-year period.
11. Commitments and Contingencies
The Company has entered into employment agreements that provide key executives
and employees with minimum base pay, annual incentive awards and other fringe
benefits. The Company expenses all costs related to the agreements in the period
that the services are rendered by the employee. In the event of death,
disability, termination with or without cause, voluntary employee termination,
change in ownership of the Company, etc., the Company may be partially or wholly
relieved of its financial obligations to such individuals. However, under
certain circumstances, a change in control of the Company may provide
significant and immediate enhanced compensation to the employees possessing
employment contracts. At December 31, 1997, the Company was contractually
obligated for the following base pay compensation amounts (summarized by years
ending December 31):
1998 $1,323,167
1999 1,357,000
2000 1,357,000
2001 570,334
2002 75,000
----------------
$4,682,501
================
F-31
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
11. Commitments and Contingencies (continued)
The Company and Reconstructive Orthopaedic Associates II, P.C. (the successor to
Reconstructive Orthopaedic Associates, Inc.) have been advised that the
Department of Health and Human Services is conducting an inquiry regarding
Reconstructive Orthopaedic Associates, Inc. and physicians formerly associated
with that practice, including two of the Company's directors. The inquiry
appears to be concerned with the submission of claims for Medicare reimbursement
by the practice. The Company has not been contacted by the Department of Health
and Human Services in connection with the inquiry.
The Company may become subject to certain pending claims as the result of
successor liability in connection with the assumption of certain liabilities of
the Affiliated Practices; nevertheless, the Company believes it is unlikely that
the ultimate resolution of such claims will have a material adverse effect on
the Company.
12. Related Party Transactions
In connection with the acquisitions of the five original Affiliated Practices
and one other Affiliated Practice, the Company loaned funds to certain
physician owners of the relevant Affiliated Practices. Advances thereunder,
which aggregated $914,737 and $976,419 at December 31, 1997 and at December 31,
1996, respectively, and bear interest at the prime lending rate plus 1.25%
are collateralized by 83,101 shares of the Company's common stock owned by the
individual physicians. Interest income related to physician advances was
$102,508 and $7,231 for the years ended December 31, 1997 and 1996,
respectively.
F-32
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
13. Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per
share for the years ended December 31, 1997 and 1996.
1997 1996
------------------- -------------------
Numerator for both basic and diluted earnings per share:
Net income (loss) $ 5,870,398 $ (1,771,383)
=================== ===================
Denominator:
Weighted average shares outstanding 15,559,368 1,450,138
Cheap stock shares:
Conversion of convertible debentures
and interest thereon - 2,020,900
Dividends paid to promoters - 192,234
November 12, 1996 affiliation transactions
assumed to be outstanding since
January 1, 1996 - 7,659,115
Employee stock options 118,761 -
Shares issued to one of the Affiliated
Practices - 100,000
------------------- -------------------
Denominator for basic net income (loss) per
common share--weighted average shares 15,678,129 11,422,387
Effect of dilutive securities:
Employee stock options 393,024 1,032,090
------------------- -------------------
Denominator for diluted net income (loss) per
common share--adjusted weighted average
shares and assumed conversion 16,071,153 12,454,477
=================== ===================
Net income (loss) per common share (basic) $ 0.38 $ (0.16)
=================== ===================
Net income (loss) per common share (diluted) $ 0.37 $ (0.14)
=================== ===================
For additional disclosures regarding employee stock options, puts and warrants
see Notes 7 and 10.
F-33
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
13. Earnings Per Share (continued)
Options to purchase 419,887 shares of common stock at $13.25 were outstanding
during 1997 but were not included in the computation of diluted earnings per
common share for 1997 because the options' exercise price was greater than the
average market price of the common shares and, therefore, the effect would be
antidilutive. Options to purchase 44,936 shares of common stock at $11.25 were
outstanding during 1997 but were not included in the computation of diluted
earnings per share because the options' exercise price was greater than the
average market price of the common shares and, therefore the effect would be
antidilutive.
Warrants to purchase 544,681 shares of common stock at $14.69 were outstanding
during 1997 but were not included in the computation of diluted earnings per
share because the warrants' exercise price was greater than the average market
price of the common shares and, therefore the effect would be antidilutive.
See Note 10 for discussion of the contingent shares issuable as additional
consideration for one of the Company's practice acquisitions. These shares were
not included in the computation of diluted earnings per share because the
necessary conditions for issuance had not been satisfied.
Pursuant to Securities and Exchange Commission Staff Accounting Bulletin No. 83
("SAB No. 83") and staff policy, common and common share equivalents issued
prior to the Company's initial public offering for nominal consideration are
presumed to have been issued in contemplation of the public offering, even if
antidilutive, and have been included in the calculations of net income (loss)
per common share as if these common and common equivalent shares were
outstanding for the period immediately preceding the Company's initial public
offering of common stock. Pursuant to Securities and Exchange Commission Staff
Accounting Bulletin No. 98, which modifies certain of the provisions of SAB No.
83, the treasury stock method for measuring the dilutive effect related to
nominal issuances of stock options and warrants is no longer permitted.
Accordingly, the above calculations assume that common shares are outstanding
from the date of the stock option grant to the date of the Company's initial
public offering, if the corresponding option strike price is deemed to be
nominal consideration.
F-34
Specialty Care Network, Inc. and Subsidiary
Notes to Consolidated Financial Statements (continued)
13. Earnings Per Share (continued)
The Company used a portion of the proceeds from the initial public offering of
its common stock to repay borrowings under the Company's Credit Facility. If
shares issued to repay amounts outstanding under the Company's Credit Facility
were outstanding for the years ended December 31, 1997 and 1996, the net income
(loss) per common share would not have changed from the amount reported.
14. Employee Benefit Plan
Effective May 1, 1997, the Company adopted an employee benefit plan covering
substantially all employees of the Company, most affiliated physicians and other
employees of the affiliated physician practices. Participants must have attained
age 21 and completed one year of service with either the Company or one of the
Affiliated Practices in order to participate in the plan. The plan is designed
to qualify under Section 401(k) of the Internal Revenue Code of 1986, as
amended. The plan includes a matching contribution equal to up to 4% of eligible
employee salaries and a discretionary defined contribution (5.5% in 1997).
Expense under this plan, including the 5.5% discretionary contribution,
aggregated approximately $711,000 for 1997, of which approximately $654,000 was
charged directly to the affiliated physician practices as clinic expenses.
F-35
Report of Independent Auditors
Board of Directors
Reconstructive Orthopaedic Associates II, P.C.
We have audited the accompanying balance sheets of Reconstructive Orthopaedic
Associates II, P.C. (successor to Reconstructive Orthopaedic Associates, Inc.)
as of December 31, 1997 and 1996, and the related statements of operations, (net
capital deficiency) stockholders' equity and cash flows for each of the three
years in the period ended December 31, 1997. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Reconstructive Orthopaedic
Associates II, P.C. (successor to Reconstructive Orthopaedic Associates, Inc.)
as of December 31, 1997 and 1996, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 1997, in
conformity with generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
---------------------
Ernst & Young LLP
Denver, Colorado
February 13, 1998
F-36
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Balance Sheets
December 31
1997 1996
----------------------------------------
Assets (See Note 2)
Current assets:
Cash $ 109,362 $ 52,031
Due from Thomas Jefferson University 102,000 303,600
Due from Specialty Care Network, Inc. 424,290 1,314,462
Other accounts receivable 46,594 -
Prepaid expenses 11,993 -
----------------------------------------
Total current assets 694,239 1,670,093
Other assets 4,733 25,714
----------------------------------------
Total assets $ 698,972 $1,695,807
========================================
Liabilities and (net capital deficiency)
stockholders' equity
Current liabilities:
Accounts payable $ 136,256 $ 170,746
Accrued compensation and benefits 212,103 -
Due to Thomas Jefferson University 46,594 39,674
Due to Specialty Care Network, Inc. 623,159 850,498
----------------------------------------
Total current liabilities 1,018,112 1,060,918
Commitments and contingencies
(Net capital deficiency) stockholders' equity:
Class A voting common stock, $1.00 par value,
1,000 shares authorized, 510 shares outstanding 510 510
Class B nonvoting common stock, $1.00 par value,
1,000 shares authorized, 490 shares outstanding 490 490
Additional paid-in capital 199,204 199,204
(Accumulated deficit) retained earnings (492,569) 434,685
Treasury stock (340 Class A common shares and
100 Class B common shares), at cost (26,775) -
----------------------------------------
Total (net capital deficiency) stockholders' equity (319,140) 634,889
----------------------------------------
Total liabilities and (net capital deficiency)
stockholders' equity $ 698,972 $1,695,807
========================================
See accompanying notes.
F-37
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Statements of Operations
Year ended December 31
1997 1996 1995
--------------------------------------------------------------
(See Note 2)
Net patient revenue $14,999,469 $16,732,168 $16,906,641
Other revenue 1,117,126 1,006,600 584,145
--------------------------------------------------------------
Total revenue 16,116,595 17,738,768 17,490,786
Operating expenses:
Physician compensation 6,267,170 10,187,408 9,288,516
Salaries and benefits 1,014,916 3,057,694 3,874,636
Supplies, general and
administrative expenses 1,275,145 3,970,963 2,792,588
Depreciation and amortization - 114,339 133,450
Management fee to Specialty
Care Network, Inc. 8,546,776 1,453,874 -
--------------------------------------------------------------
Total operating expenses 17,104,007 18,784,278 16,089,190
--------------------------------------------------------------
(Loss) income from operations (987,412) (1,045,510) 1,401,596
Interest income 60,158 70,497 59,121
Interest expense - (13,333) (555)
--------------------------------------------------------------
Net (loss) income $ (927,254) $ (988,346) $ 1,460,162
==============================================================
See accompanying notes.
F-38
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Statements of (Net Capital Deficiency) Stockholders' Equity
(Accumulated
Number Additional Deficit)
of Common Paid in Retained Treasury
Shares Stock (1) Capital Earnings Stock Total
----------- ------------- ------------ ---------------- -------------- -------------
(See Note 2)
Balances, January 1, 1995 1,000 $1,000 $ - $2,744,489 $ (25,013) $2,720,476
Net income - - - 1,460,162 - 1,460,162
Dividends paid - - - (40,000) - (40,000)
----------- ------------- ------------ ---------------- -------------- -------------
Balances, December 31, 1995 1,000 1,000 - 4,164,651 (25,013) 4,140,638
Net loss - - - (1,423,031) - (1,423,031)
Purchase of treasury stock (660) - - - (141,700) (141,700)
Sale of treasury stock 660 - - - 141,700 141,700
Dividends paid - - - (297,260) - (297,260)
Net assets transferred to
Specialty Care Network, Inc. - - - (2,270,143) - (2,270,143)
----------- ------------- ------------ ---------------- -------------- -------------
Ending capitalization at
November 11, 1996 of
Reconstructive Orthopaedic
Associates, Inc. (predecessor) 1,000 $1,000 $ - $ 174,217 $ (25,013) $ 150,204
=========== ============= ============ ================ ============== =============
Beginning balances at November
12, 1996 of remaining
predecessor assets
transferred to
Reconstructive Orthopaedic
Associates II, P.C.
(successor) - $ - $150,204 $ - $ - $ 150,204
Sale of stock of successor 1,000 1,000 49,000 - - 50,000
Net income - - - 434,685 - 434,685
----------- ------------- ------------ ---------------- -------------- -------------
Balances, December 31, 1996 1,000 1,000 199,204 434,685 - 634,889
Acquisition of 440 common shares
pursuant to a separation - - - - (26,775) (26,775)
agreement
Net loss - - - (927,254) - (927,254)
=========== ============= ============ ================ ============== =============
Balances, December 31, 1997 1,000 $1,000 $199,204 $ (492,569) $ (26,775) $(319,140)
=========== ============= ============ ================ ============== =============
(1) Includes Class A and Class B common stock for Reconstructive Orthopaedic
Associates II, P.C.
See accompanying notes.
F-39
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Statements of Cash Flows
Year ended December 31
1997 1996 1995
---------------------------------------------------------
(See Note 2)
Operating activities
Net (loss) income $(927,254) $ (988,346) $1,460,162
Adjustments to reconcile net (loss) income to
net cash provided by operating activities:
Depreciation and amortization - 114,339 133,450
Gain on sale of assets - (40,440) -
Changes in assets and liabilities:
Accounts receivable - 2,238,906 (1,664,688)
Inventories - 19,100 6,100
Due from Thomas Jefferson University 201,600 (303,600) 57,716
Due from Specialty Care Network, Inc. 890,172 (1,314,462) -
Other accounts receivable (46,594) - -
Prepaid expenses (11,993) 122,793 124,359
Other assets 20,981 (6,742) (16,695)
Accounts payable (34,490) (8,689) 120,017
Accrued compensation and benefits 212,103 (45,730) (36,071)
Accrued profit sharing contribution - (245,819) 85,421
Other accrued expenses - (2,863) 1,975
Due to Thomas Jefferson University 6,920 39,674 -
Due to Specialty Care Network, Inc. (227,339) 850,498 -
---------------------------------------------------------
Net cash provided by operating activities 84,106 428,619 271,746
Investing activities
Sales of furniture, fixtures and equipment - 92,025 -
Purchases of furniture, fixtures and equipment - (47,733) (240,426)
---------------------------------------------------------
Net cash provided by (used in) investing activities - 44,292 (240,426)
Financing activities
Proceeds from short-term borrowings - - 570,000
Repayment of short-term borrowings - (570,000) (550,000)
Proceeds from long-term debt - 200,000 -
Principal payments on long-term debt - (49,823) -
Purchases of treasury stock (26,775) (141,700) -
Proceeds from sale of treasury stock - 141,700 -
Proceeds from sale of common stock - 50,000 -
Dividends paid - (297,260) (40,000)
---------------------------------------------------------
Net cash used in financing activities (26,775) (667,083) (20,000)
---------------------------------------------------------
Net increase (decrease) in cash 57,331 (194,172) 11,320
Cash at beginning of year 52,031 246,203 234,883
---------------------------------------------------------
Cash at end of year $ 109,362 $ 52,031 $ 246,203
=========================================================
Supplemental schedule of noncash
investing and financing activities
Assets transferred to Specialty Care Network, Inc. $ - $2,548,412 $ -
Liabilities transferred to Specialty Care
Network, Inc. - (278,269) -
---------------------------------------------------------
$ - $2,270,143 $ -
=========================================================
See accompanying notes.
F-40
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Notes to Financial Statements
December 31, 1997
1. Description of the Business
Reconstructive Orthopaedic Associates II, P.C. (successor to Reconstructive
Orthopaedic Associates, Inc.) is an orthopaedic physician practice which serves
Philadelphia, Pennsylvania and its surrounding communities. Reconstructive
Orthopaedic Associates II, P.C. and Reconstructive Orthopaedic Associates, Inc.
(collectively the Company) is/was a professional corporation incorporated under
the laws of the State of Pennsylvania.
2. Summary of Significant Accounting Policies
Basis of Presentation
As discussed in Note 8, Reconstructive Orthopaedic Associates, Inc. (the
Predecessor Practice) entered into an agreement on November 12, 1996, with
Specialty Care Network, Inc. (SCN) whereby SCN acquired substantially all the
net assets of the Predecessor Practice. Concurrent with the acquisition, the
physician shareholders of the Predecessor Practice, who functioned as promoters
in that transaction, formed Reconstructive Orthopaedic Associates II, P.C. (the
Successor Practice) and entered into a long-term service agreement with SCN
under which SCN provides management and administrative services to the Successor
Practice. That transaction reflects a disposition of certain net practice assets
to SCN with no significant change in the operations or ownership between the
Predecessor and Successor Practices and has accordingly been treated for
financial statement presentation purposes as a continuation of the business.
The accompanying financial statements of the Company as of and for the years
ended December 31, 1997 and 1996 have been prepared on the historical basis of
accounting. SCN's acquisition of the Predecessor Practice's net assets was
accounted for using historical cost in accordance with Securities and Exchange
Commission Staff Accounting Bulletin No. 48 and related interpretations. The
remaining net assets of the Predecessor Practice at the transaction date were
transferred at historical cost to the Successor Practice.
Additionally, the accompanying financial statements contemplate the effectuation
of the proposed amendments to the affiliation agreement between SCN and the
Company on substantially the same terms and conditions as described in Note 9
herein.
F-41
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Notes to Financial Statements (continued)
2. Summary of Significant Accounting Policies (continued)
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amounts of revenue and expenses during the
reporting period. Actual results could differ from those estimates.
Revenue Recognition
Net patient revenue is recorded at established rates as services are rendered,
net of provisions for bad debts and contractual adjustments. Contractual
adjustments arise due to the terms of certain reimbursement and managed care
contracts. Such adjustments represent the difference between charges at
established rates and estimated amounts to be reimbursed to the Company and are
recognized when the services are rendered. Any differences between estimated
contractual adjustments and actual final settlements under reimbursement
contracts are recognized when final settlements are made.
Under the long-term service agreement with SCN, the Successor Practice agreed to
sell and assign to SCN, and SCN agreed to buy, all of the Successor Practice's
accounts receivable each month during the existence of the service agreement.
The purchase price for such accounts receivable generally equals the gross
amount of the accounts receivable each month, less adjustments for contractual
allowances, allowances for doubtful accounts and other potentially uncollectible
amounts based on historical collection rates, as determined by SCN. However, SCN
and the Successor Practice are currently making periodic adjustments so that
amounts paid by SCN for the accounts receivable are adjusted upwards or
downwards based on SCN's actual collection experience. SCN bears the collection
risk with respect to accounts receivable acquired from the Predecessor Practice
in connection with the initial affiliation transaction.
F-42
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Notes to Financial Statements (continued)
2. Summary of Significant Accounting Policies (continued)
Furniture, Fixtures and Equipment
Furniture, fixtures and equipment were stated at cost. Depreciation and
amortization were determined using the straight-line method over the estimated
useful lives of the assets. The estimated useful lives used were as follows:
Computer equipment and automobiles 5 years
Furniture, fixtures and equipment 7 years
Leasehold improvements 15 years
All furniture, fixtures and equipment at November 11, 1996 were transferred to
SCN (see Note 8).
Financial Instruments
The carrying amounts of financial instruments (e.g., accounts receivable,
certain liabilities, etc.) as reported in the accompanying balance sheets
approximate fair value.
Estimated Medical Professional Liability Claims
Effective December 1, 1996, the Company is insured for medical professional
liability claims through a claims-made commercial insurance policy. Prior to
such date the Company maintained an occurrence-based commercial insurance
policy.
Income Taxes
The Company is a Subchapter S corporation under the Internal Revenue Code and
the Commonwealth of Pennsylvania tax statutes and, accordingly, is not taxed as
a separate entity. The Company's taxable income or loss is allocated to each
stockholder and recognized as taxable income on their individual federal and
state tax returns.
The estimated aggregate permanent and temporary differences between the tax
bases and reported amounts of the Company's net assets is approximately $365,000
at December 31, 1997.
F-43
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Notes to Financial Statements (continued)
2. Summary of Significant Accounting Policies (continued)
Reclassifications
The accompanying 1996 and 1995 financial statements include certain
reclassifications in order to conform to the current period presentation.
3. Accounts Receivable and Net Patient Revenue
As further discussed in Note 8, the Predecessor Practice entered into an
acquisition transaction with SCN. In conjunction therewith, as part of the
acquisition of substantially all net practice assets, the outstanding net
patient accounts receivable of the Predecessor Practice were transferred to SCN.
Concurrently, the Successor Practice entered into a long-term service agreement
with SCN. Pursuant to the terms of this agreement, SCN purchases from the
Successor Practice, on a monthly basis, the patient revenue charges, net of a
historically-based contractual discount. At December 31, 1997 and 1996, the
Company had a receivable from SCN for December's patient charges of $787,481 and
$1,314,462, respectively, which is net of contractual discounts of $1,418,792
and $2,218,771. Additionally, at December 31, 1997, approximately $363,000
offsets the amounts due from SCN relating to adjustments for previously
purchased 1997 patient revenue charges.
Net patient revenue consists of the following:
Year ended December 31
1997 1996 1995
------------------- ------------------- ------------------
Gross patient revenue $42,293,644 $47,708,533 $39,124,045
Less contractual adjustments and
uncollectibles 27,294,175 30,976,365 22,217,404
------------------- ------------------- ------------------
$14,999,469 $16,732,168 $16,906,641
=================== =================== ==================
Revenue from the Medicare program accounted for approximately 28%, 28% and 34%,
of the Company's net patient service revenue for the years ended December 31,
1997, 1996 and 1995, respectively. Laws and regulations governing the Medicare
program are complex and subject to interpretation. Management of the Company
believes that it is in compliance with all applicable laws and regulations.
F-44
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Notes to Financial Statements (continued)
3. Accounts Receivable and Net Patient Revenue (continued)
See Note 7 for discussion of an ongoing Department of Health and Human Services
inquiry regarding the Predecessor Practice. Such laws and regulations can be
subject to future government review and interpretation. Violation of such laws
could result in significant regulatory action, including fines, penalties and
exclusion from the Medicare program. Other than the Medicare program, no single
payor provided more than 10% of net patient revenue for the years ended December
31, 1997, 1996 or 1995.
4. Lines of Credit and Note Payable
In 1995, the Company had a $700,000 line of credit with Mellon Bank. The
outstanding balance of $570,000 was paid in September 1996. Simultaneously, the
line of credit was terminated.
In February 1996, the Company entered into a long-term note payable with Mellon
Bank for $200,000 with principal due in monthly installments of $5,556 plus
interest at a rate of 8.25%. Pursuant to the terms of the acquisition agreement
(see Note 8), SCN assumed the outstanding liability of $150,177 at November 11,
1996.
The Company has an uncollateralized $300,000 line of credit with Mellon Bank
that expires on March 1, 1998. The entire amount was available at December 31,
1997. Managment intends to renew the line of credit on substantially the same
terms and, in connection therewith, negotiations with the bank are ongoing.
Interest expense, as disclosed in the accompanying statements of operations,
reasonably approximates the cash paid for interest during such years.
5. Employee Benefit Plans
The Predecessor Practice had a profit sharing plan that covered substantially
all of its employees. Eligible employees could contribute up to 15% of their
compensation. The Predecessor Practice contributed a discretionary amount that
was allocated proportionally based upon the salaries of the participating
employees. The profit sharing plan expense was $255,750 and $247,894 for the
years ended December 31, 1996 and 1995, respectively. This plan was discontinued
as of the November 12, 1996 acquisition of the
F-45
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Notes to Financial Statements (continued)
5. Employee Benefit Plans (continued)
net assets of the Predecessor Practice by SCN. The Successor Practice has not
adopted a new profit sharing plan.
Effective May 1, 1997, SCN adopted an employee benefit plan covering
substantially all employees of the Company, including physicians and those who
have attained age 21 and completed one year of service with the Company. The
plan is designed to qualify under Section 401(k) of the Internal Revenue Code of
1986, as amended. The plan includes a Company matching contribution equal to up
to 4% of eligible employee salaries and a discretionary defined contribution
(5.5% in 1997). Expense under this plan, including the 5.5% discretionary
contribution, aggregated $113,392 for 1997.
6. Other Revenue
In July 1995, the Company entered into a two year agreement with Thomas
Jefferson University Hospital (the Hospital), a division of Thomas Jefferson
University, whereby the Company provides administrative, supervisory, teaching
and patient care services for the Hospital's Department of Orthopaedic Surgery.
Effective July 1, 1997, the agreement was extended for an additional five year
term. The Hospital provides the Company with compensation for its employees
providing such services in the amount of $607,200 per annum prior to July 1,
1997 and $865,000 per annum subsequent to such date. Approximately $202,000 of
the then outstanding accounts receivable was allocated to the Successor Practice
as part of the November 12, 1996 SCN transaction.
Also in July 1995, the Company entered into a two year agreement with Jefferson
Medical College (the College), a division of Thomas Jefferson University,
whereby the Company provided educational services to the College's medical
students and residents for an annual fee of $400,000.
Effective April 1, 1997, the Company, the Hospital and the College entered into
a five year agreement whereby one of the Company's physicians, as specifically
identified in the underlying agreement, will serve as co-director of the
College's Spinal Cord Injury Center, as well as perform other clinical,
administrative and teaching services associated with the care of acute spinal
cord injury patients. The Hospital will provide the Company with compensation
for the physician providing such services in the amount of $408,000 per annum,
plus an additional amount based on the physician's performance, as
F-46
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Notes to Financial Statements (continued)
6. Other Revenue (continued)
determined in accordance with criteria established by the College; however, no
such additional amount has been recorded in the accompanying financial
statements as of and for the year ended December 31, 1997.
7. Commitments and Contingencies
The Company leases its office facilities on an annual basis. Rent expense for
the years ended December 31, 1997, 1996 and 1995 totaled $109,506, $308,000 and
$121,139, respectively. Additionally, the Company reimburses SCN for rent
expense incurred by SCN on the Company's behalf. Such amounts for the years
ended December 31, 1997 and 1996 were $504,868 and $62,000, respectively.
The Company is committed to certain renovations to its primary office facility
in the aggregate amount of approximately $60,000. The Company expects that such
costs will be reimbursed by SCN and subsequently charged back to the Company
through depreciation and amortization under the SCN management fee arrangement.
The Company and SCN have been advised that the Department of Health and Human
Services is conducting an inquiry regarding the Predecessor Practice and
physicians formerly associated with that practice, including two of SCN's
directors. The inquiry appears to be concerned with the submission of claims for
Medicare reimbursement by the practice. Management does not believe that the
final resolution of this matter will have an adverse impact on the Company's
results of operations or financial position.
The Company is party to legal proceedings and potential claims arising in the
ordinary course of its business, including malpractice claims in excess of
available insurance coverage. The ultimate legal and financial liability of the
Company with respect to such ongoing litigation cannot be estimated with any
certainty but, in the opinion of management, the Company has adequate legal
defenses, reserves or malpractice insurance coverage with respect to those
matters so that the ultimate resolution will not have a material adverse effect
on the Company's financial position, results of operations or cash flows.
F-47
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Notes to Financial Statements (continued)
8. Acquisition of Net Assets by Specialty Care Network, Inc.
Effective November 12, 1996, the Predecessor Practice entered into an agreement
with SCN whereby SCN acquired substantially all of the net assets of the
Predecessor Practice. Pursuant to the terms of the agreement the transaction was
structured whereby the physician stockholders of the Predecessor Practice,
functioning as promoters, exchanged the common stock of the Predecessor
Practice, which was dissolved, for 3,169,379 common shares of SCN and $1,537,872
of cash. In addition, as part of this transaction, those physician stockholders
concurrently transferred certain assets of the Predecessor Practice into the
Successor Practice (a newly formed entity) and entered into a long-term service
agreement with SCN to provide ongoing clinical services. That transaction
reflected a disposition of certain net practice assets to SCN with no
significant change in the operations and ownership between the Predecessor and
Successor Practices and has accordingly been treated for financial statement
presentation purposes as a continuation of the business.
Initial Service Agreement
Concurrent with the aforementioned transaction, the Successor Practice entered
into a long-term service agreement (the Initial Service Agreement) with SCN.
However, see Note 9 for discussion of subsequent proposed amendments to the
Initial Service Agreement related to the separation of three physicians from the
Company. Pursuant to the terms of the forty-year service agreement, SCN, among
other things, provides facilities and management, administrative and development
services, in return for a service fee. Such fee is payable monthly and consists
of the following: (i) a service fee based on 33% of the adjusted pre-tax income
of the Company (generally defined as revenue of the Company related to
professional services less amounts equal to certain clinic expenses but not
including physician owner compensation or most benefits to physician owners)
plus (ii) reimbursement of certain clinic expenses. For the first three years
following affiliation, however, the portion of the service fees described under
clause (i) is specified to be the greater of the amount payable as described
under clause (i) above or a fixed dollar amount (the "Base Service Fee"), which
was generally calculated by applying the service fee percentage to the adjusted
pre-tax income of the Predecessor Practice for the twelve months prior to
affiliation. For the years ended December 31, 1997 and 1996, management fee
expenses, exclusive of clinic expense reimbursement, were $3,113,667 and
$680,124, respectively. The amount due to SCN at December 31, 1997 and 1996 is
$710,319 and $850,498, respectively.
F-48
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Notes to Financial Statements (continued)
8. Acquisition of Net Assets by Specialty Care Network, Inc. (continued)
The Initial Service Agreement has a term of forty years, with an automatic
extension (unless specified notice is given) of an additional five-year term.
The Initial Service Agreement may be terminated by either party if the other
party (i) files a petition in bankruptcy or other similar events occur or (ii)
defaults on the performance of a material duty or obligation, which default
continues for a specified term after notice. In addition, SCN may terminate the
agreement if the Company's Medicare or Medicaid number is terminated or
suspended as a result of some act or omission of the Company, and the physicians
and the Company may terminate the agreement if SCN misapplies funds or assets or
violates certain laws.
Upon termination of the Initial Service Agreement by SCN for one of the reasons
set forth above, SCN has the option to require the Company to purchase and
assume the assets and liabilities related to the Company at the fair market
value thereof. In addition, upon termination of the Initial Service Agreement by
SCN during the first five years of the term, the physician owners of the Company
are required to pay SCN or return to SCN an amount of cash or stock of SCN equal
to one-third of the total consideration received by such physicians in
connection with SCN's affiliation with the Company.
Under the Initial Service Agreement, each physician owner must give SCN twelve
months notice of an intent to retire from the Company. If a physician gives such
notice during the first five years of the agreement, the physician must also
locate an acceptable replacement physician and pay SCN an amount based on a
formula relating to any loss of service fee for the first five years of the
term. Furthermore, the physician must pay SCN an amount of cash or stock of SCN
equal to one-third of the total consideration received by such physician in
connection with SCN's affiliation with the Company. The agreement also provides
that after the fifth year no more than 20% of the physician owners of the
Company may retire within a one-year period.
Non-competition provisions
The Company and the physician owners of the Company generally agree not to
compete with SCN in providing services similar to those provided by SCN under
the Initial Service Agreement, and the physician owners also generally agree
with SCN not to compete with an affiliated practice of SCN within a specified
geographic area.
F-49
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Notes to Financial Statements (continued)
8. Acquisition of Net Assets by Specialty Care Network, Inc. (continued)
Non-competition restrictions generally apply to physician owners during their
affiliation with the Company and for three years thereafter. In addition, the
Initial Service Agreement requires the Company to enter into non-competition
agreements with all its physicians. After the fifth year of the term of the
Initial Service Agreement, physician owners of the Company may be released from
the non-competition provisions upon payment of certain amounts to SCN, which may
be paid in the form of SCN's common stock. The Initial Service Agreement
generally requires the Company to pursue enforcement of the non-competition
agreement with physicians or assign to SCN the right to pursue enforcement.
9. Separation Agreement
Pursuant to a Separation Agreement (the Agreement), dated June 9, 1997, between
the stockholders of the Company, the Company and doctors Booth, Bartolozzi and
Balderston (collectively the 3B Group), the three aforementioned physicians
redeemed their 440 shares of stock in the Company for approximately $26,800 and
formed a new Pennsylvania professional corporation in order to practice
medicine. The stock redemption amount approximated the net book value per common
share on June 30, 1997 (i.e., the date of separation).
The net patient revenue attributable to doctors Booth Bartolozzi and Balderston
for the years ended December 31, 1996 and 1995 was approximately $6,907,394 and
$7,440,575, respectively. The similar amount for the six months ended June 30,
1997 was approximately $4,506,477. The Company's individual physician
compensation is generally determined by the net patient revenue generated by the
physician, less an allocation of clinic and corporate expenses.
Pursuant to proposed amendments to the Initial Service Agreement, SCN, the
Company and the 3B Group will amend the original service agreement with the
Company so that the aggregate Base Service Fee for the Company and the 3B Group
will be equal to the Company's original Base Service Fee. Additionally, in the
event that the Base Service Fee of either (but not both) of the practices for
the twelve months ended October 31, 1997 is more than the service fee (the
Percentage-Based Service Fee) that would result from the application of the
Service Fee Percentage to the practice's Adjusted Pre-Tax Income (a Base Fee
Deficit), the other practice will offset against the deficit the amount, if any,
by which its Percentage-Based Service Fee exceeds its Base Service Fee.
Thereafter, if
F-50
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Notes to Financial Statements (continued)
9. Separation Agreement (continued)
any deficit remains, (i) SCN will forgive one-third of the remaining Base Fee
Deficit, up to $120,000, (ii) the practice that did not have the Base Fee
Deficit will pay one-third of the remaining Base Fee Deficit, up to $120,000 and
(iii) the practice with the Base Fee Deficit will pay to SCN all additional
remaining Base Fee Deficit. If both practices have a Base Fee Deficit, (i) the
3B Group will pay one-third of the Company's Base Fee Deficit, up to $120,000,
(ii) SCN will forgive one-third of the Company's Base Fee Deficit, up to
$120,000, (iii) the Company will pay the remainder of the Base Fee Deficit and
(iv) the 3B Group will pay to SCN the entire amount of its Base Fee Deficit.
During the twelve months ending October 31, 1998, the proposed amendments
indicate that up to two-thirds of the Company's Base Service Fee Deficit may be
forgiven by SCN, up to $240,000.
The parties have agreed that in the event additional issues arise in the process
of completing definitive agreements, or amendments to existing agreements, and
such issues are not resolved, then such issues will be submitted to binding
arbitration.
10. Stockholders' Equity
The Successor Practice maintains two classes of common stock. Class A common
stock and Class B common stock have equal rights and privileges, except that the
holders of the Class B common stock are not entitled to vote upon matters
submitted to a vote of the stockholders, except for those matters required by
law. However, the Shareholders' Agreement, which governs the contractual rights
and privileges of the stockholders, requires the conversion of all Class B
nonvoting common shares into Class A voting common shares upon the occurrence of
certain events. The separation agreement discussed in Note 9 creates
circumstances whereby conversion will occur, but the legal stock conversion has
not yet been effectuated at December 31, 1997. Management believes that the
appropriate common stock conversion will transpire in 1998.
Stockholders are generally prohibited from selling and/or transferring their
common shares without the unanimous written consent of all the other
stockholders. Moreover, the individual stockholders and the Company maintain
rights of first refusal pursuant to any common stock dispositions. The purchase
price for disposition purposes shall at all times be the book value of such
shares as determined by reference to the most recent financial statements.
F-51
Reconstructive Orthopaedic Associates II, P.C.
(successor to Reconstructive Orthopaedic Associates, Inc.)
Notes to Financial Statements (continued)
10. Stockholders' Equity (continued)
Exclusive of shares held as treasury stock, there are 170 Class A common shares
and 390 Class B common shares held by physician stockholders at December 31,
1997.
11. Year 2000 Issue (Unaudited)
The Company and SCN have developed plans to modify their information
technologies to be ready for the year 2000 and the Company has begun converting
critical data processing systems. The Company currently expects the project to
be substantially complete by mid 1999. An estimate of the year 2000 internal
costs, exclusive of the costs to upgrade and replace systems in the normal
course of business, is not currently available; however, the Company does not
expect this project to have a significant effect on operations. As of December
31, 1997, no significant amounts have yet been expensed thereunder. The Company
will continue to implement systems with strategic value though some projects may
be delayed due to resource constraints.
F-52
Specialty Care Network, Inc. and Subsidiary
Schedule II -- Valuation and Qualifying Accounts
Balance at Charged to Charged to Balance at
Beginning Costs and Other End
Description of Period Expenses Accounts Deductions of Period
----------- ----------- ------------ ------------- ------------ ------------
Year ended December 31, 1997
Reserves and allowances deducted
from asset accounts:
Allowance for contractual
adjustments and doubtful
accounts $15,719,542 $ 100,380 $87,199,182(1) $(84,589,217)(3) $26,225,860
(1,542,354)(4) 9,338,327(2)
Year ended December 31, 1996
Reserves and allowances deducted
from asset accounts:
Allowance for contractual
adjustments and doubtful
accounts $ -- $ -- $11,264,784(1) $(11,085,869)(3) $15,719,542
15,540,627(2)
(1) Contractual adjustments recognized in the purchase of monthly net accounts
receivable balances for the periods presented.
(2) Acquired in conjunction with acquisition of affiliated physician practices.
(3) Represents actual amounts charged against the allowance for the periods
presented.
(4) Recoveries of amounts previously reserved, included in other revenue in the
consolidated financial statements.
S-1