Back to GetFilings.com
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.
2
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.
4
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