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U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

For the fiscal year ended August 31, 2003

Commission file number: 000-21574

DYNACQ HEALTHCARE, INC.

(Formerly Dynacq International, Inc.)

(Exact name of registrant as specified in its charter)

TELEPHONE NUMBER: (713) 378-2000

INTERNET WEBSITE: WWW.DYNACQ.COM

Securities registered pursuant to Section 12(b) of the Exchange Act: None

Securities registered pursuant to Section 12(g) of the Exchange Act: Common Stock

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 ¨ No x

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 or information statement incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ¨

The aggregate market value of the voting and non-voting common equity stock held by non-affiliates of the registrant as of February 27, 2004 was $33,748,333. As of June 30, 2004, registrant had 14,852,072 shares of common stock outstanding, all of one class.

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EXPLANATORY NOTE

We are filing this annual report on Form 10-K in order to reflect the audited consolidated financial statements for the year ended August 31, 2003, the restatement and re-audit of our financial statements for the fiscal year ended August 31, 2002, the restatement of our 2001 financial statements, and the restatement of our selected financial information for fiscal years 1999 and 2000. All financial data in this report reflects the effects of the restatements. See “Recent Developments” below as well as “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 2 to the Consolidated Financial Statements included in this report for details relating to these restatements. As a result of these restatements, investors should not rely upon the Company’s previously filed financial statements for the fiscal years ended August 31, 1999 through 2002.

PART I

This annual report on Form 10-K contains forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. Such forward-looking statements relate to future events or future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements, including the risks and uncertainties described in “Risk Factors” below. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. You must read the following discussion of the results of our business and our operations and financial condition in conjunction with our consolidated financial statements, including the notes, included in this Form 10-K filing.

General

Dynacq Healthcare, Inc., a Delaware corporation, is a holding company which through its subsidiaries develops and manages general acute hospitals that provide specialized general surgeries. The Company’s strategy is to develop and operate general acute hospitals designed to handle specialized general surgeries such as bariatric, orthopedic and neuro spine surgeries. The Company’s hospitals include operating rooms, pre- and post-operative space, intensive care units, nursing units, and modern diagnostic facilities. The Company normally does not participate in any managed care contracts nor does it receive a substantial amount of reimbursement from Medicare or Medicaid. Except for emergency room patients, the surgeries are typically pre-certified by the insurance carriers. The bulk of the surgeries are either covered by workers’ compensation insurance or by commercial insurers on an out-of-network health plan basis, and are relatively complex surgeries. The Company believes that, as a result, the per-procedure revenue generated by the Company is comparatively higher than the per-procedure revenue generated by other hospitals. The Company’s facilities are designed to handle complex orthopedic and general surgeries, such as spine and bariatric surgeries.

During the fiscal year ended August 31, 2003 the Company expanded its hospitals from one to three. Other key events in fiscal year 2003 include:

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The Company was incorporated in Nevada in June 1989. In November 2003, the Company reincorporated in Delaware and changed its name from Dynacq International, Inc. to Dynacq Healthcare, Inc. The terms “Company,” “Dynacq,” “our” or “we” as used herein refer to Dynacq Healthcare, Inc. and its affiliates unless otherwise stated or indicated by context. The term “affiliates” means direct and indirect subsidiaries of Dynacq Healthcare, Inc. and partnerships and joint ventures in which subsidiaries are partners, general or limited partners or members.

The Company, through its affiliates, owns or leases 100% of the real estate and owns or leases 100% of the equipment in its facilities. The Company maintains a majority ownership and controlling interest in all of its operating entities. As of August 31, 2003, the Company owned the following percentages of its facilities:

Recent Developments

Change in Independent Auditors

Ernst & Young LLP resigned as the Company’s independent auditor effective December 17, 2003. In conjunction with Ernst & Young’s resignation, Ernst & Young advised us that it had identified material weaknesses relating to our internal controls. Please read “Item 9A. Controls and Procedures” for further details. On January 19, 2004, the Audit Committee of the Board of Directors engaged the registered public accounting firm of Killman, Murrell & Company, P.C. as the Company’s new independent auditors for the fiscal year ended August 31, 2003.

SEC Investigation

On December 18, 2003, we received a notice of an informal investigation from the Fort Worth, Texas District Office of the Securities and Exchange Commission requesting our voluntary assistance in providing information regarding reporting of our financial statements, recognition of costs and revenue, accounts receivable,

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allowances for doubtful accounts and our internal controls. We have been cooperating fully with the continuing informal SEC investigation.

SEC Review

Beginning in October 2003, the Division of Corporation Finance of the SEC has been commenting upon Dynacq’s periodic filings.

Restatement of Financial Statements for the Fiscal Years 1999-2002

On April 6, 2004, we announced that in connection with the ongoing review by the Securities and Exchange Commission’s Division of Corporation Finance of our periodic reports, we would restate our financial statements for the fiscal years ended August 31, 2001 and 2002. We have restated and obtained a re-audit of our financial statements for the fiscal year ended August 31, 2002, restated our 2001 financial statements, and restated the selected financial information for fiscal years 1999 and 2000. The re-audit and restatements of the financial statements produced adjustments to previously reported amounts. These adjustments are described in Note 2 to the consolidated financial statements.

The restated financial statements reflect reductions in net income for the fiscal years ended August 31, 2001 and 2002, to approximately $7.7 million and $14.8 million, respectively, which is 30% and 4% less than the previously reported net income, and increases of approximately 11% and 4%, respectively, in the previously reported stockholders’ equity. The reductions in previously reported net income are primarily the result of adjustments for the noncash expensing of stock options issued to non-employees and the related income tax effect.

As part of the audit adjustments, the restated financial statements reflect an increase in stockholders’ equity at August 31, 2000 of 19% due to the correction of the over-accrual of income tax liabilities prior to August 31, 2000. Retained earnings reflect an increase at August 31, 2000 of 11%, consisting of a 24% increase related to the overstatement of income tax liabilities offset by a 13% noncash charge for stock options issued to non-employees prior to August 31, 2000.

None of the restatements has reduced previously reported net revenue, cash flows from operating activities or stockholders’ equity.

Due to the restatements and re-audit, investors should not rely on the Company’s previously issued financial statements for the fiscal years ended August 31, 1999, 2000, 2001 and 2002. Net revenue and net income for the fiscal year ended August 31, 2003, are approximately $90 million and $21 million, respectively, as we stated on December 1, 2003.

Delisting of Common Stock from Nasdaq National Market

On January 21, 2004, we announced that a hearing had been scheduled for February 5, 2004 before the Nasdaq Listing Qualifications Panel (the “Panel”) to review the recent Nasdaq Staff Determination to delist our common stock for failure to comply with certain NASD Marketplace Rules. We requested the hearing in response to a December 2003 Staff Determination that our securities were subject to delisting from the Nasdaq National Market for failure to comply with the filing requirements for continued listing set forth in NASD Marketplace Rule 4310(c)(14), due to our failure to file an Annual Report on Form 10-K for the fiscal year ended August 31, 2003. On January 15, 2004, the Company received notice of an additional Staff Determination that due to our failure to timely file periodic reports, as well as public interest concerns based on the apparent lack of internal controls, we no longer qualified for inclusion in the Nasdaq Stock Market under Nasdaq Marketplace Rules 4300 and 4330(a)(3), which provide broad discretionary authority to deny continued listing of securities in order to maintain the quality of, and the public’s confidence in, the Nasdaq Stock Market.

On April 15, 2004, we announced that the Panel had notified us that our common stock would be delisted from the Nasdaq National Market as of the opening of business on Friday, April 16, 2004. The Panel acknowledged (a) the reports of the special counsel to the audit committee, which found that there were “no questionable, improper/fraudulent actions or practices relating to the potential sale of account receivables” and that there were “no internal control and/or accounting weaknesses other than” one episode of lack of communication among our officers in connection with a proposed transaction, (b) recently adopted internal control procedures which limit the chief executive officer’s authority to enter into contracts in excess of $250,000 and require greater involvement by the

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general counsel in the use of outside counsel and assignment of projects, and (c) resolution to the satisfaction of the Securities and Exchange Commission of certain concerns with respect to public filings, concluding that public interest considerations did not warrant delisting of our common stock. The Panel also acknowledged the significant amounts of time and resources expended by us in an effort to complete the audit committee investigation and the 2003 audit so as to remedy the filing delinquencies. However, in a determination delivered to us on April 14, 2004, the Panel indicated that in light of the length of the ongoing delinquency in our SEC filings and the Panel’s belief that we had failed to offer a definitive plan to fully remedy the filing delinquency within a reasonable period of time, the Panel had determined to deny our request for a further exception to the filing requirements and to delist our common stock.

Following the delisting, our common stock has been quoted on the National Quotation Service Bureau (the “Pink Sheets”) for unsolicited trading. However, our common stock is not eligible for quotation on the OTC Bulletin Board because we do not have publicly available financial statements that are as of a date within six months of the possible quote. Once we have released the required financial statements, our common stock could become eligible for quotation on the OTC Bulletin Board if a market maker makes an application to have the shares quoted and such application is approved by the Nasdaq Compliance Unit. The Company is currently making every effort to file its quarterly reports on Form 10-Q for the first three quarters of fiscal 2004, as soon as possible.

We are making every effort to make our remaining late SEC filings as soon as possible, but have not yet filed our quarterly reports on Form 10-Q for the periods ended November 30, 2003, February 29, 2004 and May 31, 2004. Once we have become current in our SEC filings, we will explore the listing alternatives available to us. However, we cannot assure you that an active trading market will exist for our common stock.

Changes in Directors and Executive Officers

On January 21, 2004, we announced the election of James G. Gerace as a new independent director and a member of our Audit Committee. Mr. Gerace, a graduate of Texas A&M University, is a Certified Public Accountant and mediator with more than 30 years of professional experience at public accounting firms, performing audits, tax planning and related services. He has served on the board of directors of several banks and savings and loan associations. Mr. Gerace was appointed Chairman of the Audit Committee in February 2004.

In July 2003, James N. Baxter was appointed an executive vice president for investor relations. In September 2003, Irvin T. Gregory, who had served as the Company’s Executive Vice President and Chief Development Officer since October 2001, resigned but remained with the Company in a market research capacity until January 2004. He subsequently elected to leave the Company at the conclusion of his employment agreement on January 31, 2004 to pursue his personal investments and business ventures. In December 2003, Tammy Danberg-Farney was appointed Executive Vice President, General Counsel. In January 2004, Richard D. Valentine was appointed Director of Operations and Development. In February 2004, Sarah C. Garvin resigned from her position as Executive Vice President and Chief Operating Officer of the Company in order to pursue a career as a healthcare management consultant focusing on project development. She continues to assist the Company on a consulting basis. Chiu M. Chan, Chief Executive Officer of the Company, is serving as acting Chief Operating Officer until a replacement can be secured.

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Loss of Key Physicians

During the period August 2003 to May 2004 six physicians who had accounted for over 54% of our gross revenues in fiscal 2003 departed from the Pasadena Facility or substantially reduced their surgeries for various reasons. While the Company has added additional physicians in the fourth quarter of fiscal year 2004, the loss of these physicians resulted in a significant reduction in net patient revenues for the first three quarters of fiscal year 2004. While we believe that we will be able to continue to attract and retain additional physicians, the potential loss of physicians who provide significant net patient revenues for the Company will adversely affect our results of operations.

During the fourth quarter of fiscal year 2004, the Pasadena Facility added six physicians to its medical staff: three orthopedic spine surgeons, two general and vascular surgeons and one bariatric surgeon. In addition, one of its bariatric surgeons who had been out for personal reasons returned in late June of 2004.

Unaudited and Unreviewed Financial Information

We expect to file quarterly reports on Form 10-Q for the fiscal quarters ended November 30, 2003, February 29, 2004, and May 31, 2004 as soon as practicable. We expect net income for the quarters ended November 30, 2003, and February 29, 2004, to be approximately $1.2 million and $700,000, respectively, or 75% and 83% lower than the comparable periods in fiscal 2003. The reduction in net income for the fiscal quarter ended November 30, 2003 includes a non cash charge of approximately $624,000 related to stock options previously issued to an employee which were amended in the first quarter of fiscal 2004. Based on unaudited financial statements, which have not been reviewed by our independent auditor but which have been prepared based on the same accounting policies underlying our previously reported and now restated financial statements, we expect a net loss of approximately $2.2 million for the quarter ended May 31, 2004, compared to net income of $6.3 million in the comparable period of fiscal 2003. We expect net revenues of approximately $47.7 million and a net loss of approximately $300,000 for the nine months ended May 31, 2004, compared to $64.7 million and net income of $15.7 million, respectively, in the comparable period in fiscal 2003. These lower results were negatively impacted by operating expenses incurred in the start up of our new Garland facility with minimal offsetting revenue, by a lower level of activity in our Pasadena Facility and by increased legal and auditing fees. Additionally, several long-time members of the physician staff at the Pasadena Facility ceased or reduced their surgeries in that facility at various times during the first three quarters of fiscal 2004. We have been engaged in efforts to recruit new physicians to the staff. While we have added several new physicians to the staffs of each of the three hospitals, including the return of some who had left earlier, we do not currently expect our financial results to improve in the near future.

Any failure to attract and retain physicians on the staff of our hospital could have an adverse impact on our financial situation. We may not be able to improve our financial condition and may incur substantial losses in the future.

Industry Background

The development of proprietary general acute care hospital networks occurred during the 1970s. During the past 20 years, freestanding outpatient surgery centers were developed to compete with these general hospitals for outpatient procedures. Freestanding outpatient surgery centers allowed surgeons to perform outpatient procedures in specialized facilities, designed to improve efficiency and enhance patient care. The Company believes that its operational model allows surgeons to perform inpatient procedures at facilities that provide similar efficiencies as those provided at outpatient surgery centers. The Company believes that the development and acquisition of general acute hospitals focusing on an evolving combination of surgical specialties, such as orthopedics and bariatrics, will continue to aid in the delivery of quality medical care while resulting in profitable operations.

General acute hospitals specializing in specific complex surgical procedures are designed with the goal of improving both physician and facility efficiency. The surgeries performed are primarily non-emergency procedures that are electively scheduled and therefore allow for the full efficiency available through block time/scheduling. Given the opportunity to utilize multiple operating rooms for pre-determined periods of time, the surgeons are able to schedule their time more efficiently and therefore increase the number of surgeries they can perform within a given amount of time. The facility receives the benefit of consistent staffing patterns and greater facility utilization. In addition, the Company believes that, due to the relatively small size of its facilities, many surgeons choose to perform surgeries in the Company’s facilities because their patients prefer the comfort of a more personal atmosphere and the convenience of simplified admission and discharge procedures.

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Pasadena Facility

At August 31, 2003, the Company owned, through its subsidiaries, 91.5% partnership interest in the Pasadena Facility operating entity, and 8.5% was owned by Halcyon, L.L.C., a third party physician group. The Company purchased an additional 3.5% interest on September 15, 2003, thereby increasing its ownership to 95.0%. The remaining 5% interest was purchased in December 2003, thereby increasing its ownership to 100%. The limited partnership was restructured as of June 2004 and since that date the Company has owned 93% percent of this operating entity and the remaining interest is primarily owned by physicians and by other healthcare professionals. The Pasadena Facility’s primary areas of practice include orthopedic surgery, and general surgery, such as spine and bariatric surgeries, and represents approximately 84% of the Company’s fiscal 2003 net patient service revenues. Through its affiliates, the Company owns 100% of the real estate and owns or leases 100% of the equipment and in turn leases the land, hospital facility and equipment to the operating hospital entity. In November 2002, Vista Healthcare, Inc. ceased to operate and surrendered its license. The Pasadena Facility modified its hospital license and leased the space previously occupied by the Ambulatory Surgery Center.

Baton Rouge Facility

In January 2003, the Company opened its second hospital—the Baton Rouge Facility. This facility’s primary areas of practice include bariatric surgery, orthopedic surgery, general surgery, pain management and cosmetic surgery. At August 31, 2003, the Company owned 97% of the operating hospital entity and a physician group owned the remaining 3%. The Company purchased the remaining 3% interest in April 2004, thereby increasing its ownership to 100% of this operating entity. The limited liability company was restructured in June 2004 and since that date the Company has owned 90% percent of this operating entity, and physicians and other healthcare professionals primarily own the remaining 10% interest. The Baton Rouge Facility contributed 12% of net patient revenues in fiscal year 2003. Through its affiliates, the Company owns 100% of the real estate and owns or leases 100% of the equipment and in turn leases the land, hospital facility and equipment to the operating hospital entity.

Garland Facility

In August 2003, the Company, through its subsidiaries, acquired the total assets of a 113-bed hospital (which is now licensed for 79 beds), a medical office building and 22.7 acres of land in the Dallas-Fort Worth area for approximately $8.5 million (comprising of approximately $6.7 million for land and building and $1.7 million for medical equipment and furniture and fixtures), including the assumption of approximately $2.9 million of liabilities. The Company has completed renovations at that facility, with six surgical suites, and started performing surgical procedures in late November 2003. The principal types of surgery to be performed at this facility are expected to be orthopedic surgery, bariatric surgery, general surgery and pain management. As of July 2004, the Company owned 92% of this operating entity, and the remaining interests are primarily owned by physicians and by other healthcare professionals. Through its affiliates, the Company owns 100% of the real estate and owns or leases 100% of the equipment and in turn leases the land, hospital facility and equipment to the operating hospital entity.

West Houston Facility

Vista Surgical Center West (the “West Houston Facility”) was established in March 2001 and is a satellite ambulatory surgical center to the Pasadena Facility and is located in west Houston. The West Houston Facility houses two operating rooms. This facility’s primary areas of practice include orthopedic surgery, general surgery and pain management. The facility also houses Vista Fertility Institute which provides invitro fertilization services to couples who have been unable to conceive through other means. The operating entity is a wholly owned subsidiary of the Company and subleases the premises from a physician who practices there. For fiscal year 2003, the West Houston Facility represented approximately 4% of the Company’s net patient service revenues.

Business Growth Strategy

The Company has focused on developing and expanding its surgical services hospitals. The Company’s current business strategy involves:

Creating and maintaining relationships with quality surgeons;

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Creating and Maintaining Relationships with Quality Surgeons

Since physicians provide and influence the direction of healthcare, we have developed our operating model to encourage physicians to affiliate with us and to use our facilities in accordance with their practice needs. Our strategy is to focus on the development of physician partnerships and facilities that will enhance their practices in order to provide high quality healthcare in a friendly environment for the patient. We seek to attract new physicians to our facilities in order to grow or to replace physicians who retire or otherwise depart from time to time. In order to attract new physicians and maintain existing physician relationships, the Company affords them the opportunity to purchase interests in the operating entities of the facilities. By doing so, the physician becomes more integrally involved in the quality of patient care and the overall efficiency of facility operations.

Attracting and Retaining Key Personnel

We place the utmost importance on attracting and retaining key personnel to be able to provide quality facilities to attract and retain top quality physicians. Attracting and retaining the appropriate corporate personnel and quality senior executives is also an important goal of management and essential in expanding our operations.

Further Refining Hospital Design

We believe we attract physicians because we design our facilities, and adopt staffing, scheduling and clinical systems and protocols to increase physician productivity and promote their professional success. We constantly focus our attention on providing physicians with quality facilities designed to improve the physicians’ and their patients’ satisfaction.

Addition of New Capabilities to Existing Hospitals

Our overall strategy is to develop and operate hospitals designed to handle complex surgeries. Currently, some of our more complex surgeries include spine and bariatric surgeries for which we have added more operating rooms and surgical equipment. The Company continues to explore the possibility of adding other types of surgical procedures which would fit our business model.

New Opportunities and Market Expansion

An integral part of our future plans is the acquisition and development of additional hospitals. As opportunities are identified, we plan to acquire and develop additional hospitals using one of three methods: 1) new construction, which generally requires two years to complete; 2) acquisition of assets and renovation, which generally requires four to six months to complete; 3) long-term leases, which is generally less capital-intensive and requires the least amount of time to commence business operations. Criteria examined when exploring new markets include:

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International Development Opportunities

Our Board of Directors has ratified and approved negotiations for the potential long-term lease of land and procurement of a hospital license for a hospital to be constructed in Shanghai, China. The proposed hospital would be owned by a joint venture company controlled by Dynacq, with several local joint venture partners. While certain approvals from the Beijing and Shanghai governments have been obtained, other required approvals have not. No assurance can be given that the required approvals will be obtained or that the proposed joint venture hospital project can be achieved at all, or if so, on terms deemed favorable to us. The Company is currently negotiating the lease and has made an earnest money deposit of $640,000.

Marketing

Our marketing efforts are directed primarily at physicians and other healthcare professionals, who are principally responsible for referring patients to our facilities. We market our facilities to physicians by emphasizing the high level of patient satisfaction with our hospitals, the quality and responsiveness of our services, and the practice efficiencies provided by our facilities. We believe that providing quality facilities creates a positive environment for patients and physicians. The Company, through its subsidiaries, also has agreements with outside organizations that offer marketing, pre-authorization and follow up support services to prospective bariatric and orthopedic patients in areas serviced by the Pasadena, Garland, and Baton Rouge Facilities. These facilities receive bariatric and orthopedic referrals from other sources and the organizations also refer clients to other area hospitals.

Competition

Presently, the Company operates in the greater Houston, Texas, Baton Rouge, Louisiana, and Dallas-Fort Worth, Texas metropolitan markets. In each market, the Company competes with other providers, including major acute care hospitals. These hospitals may have various competitive advantages over the Company, including their community position, capital resources, surgeon partnerships, and proximity to surgeon office buildings. The Company also encounters competition with other companies for acquisition and development of facilities and for strategic relationships with surgeons.

There are several large publicly-held companies, and numerous privately-held companies, that acquire and develop freestanding private hospitals and outpatient surgery centers. Many of these competitors have greater financial and other resources than the Company. The principal competitive factors that affect the Company’s ability and the ability of its competitors to acquire or develop private hospitals are experience and reputation, and access to capital. Further, some surgeon groups develop surgical facilities without a corporate partner. The Company can provide no assurance that it will be able to successfully compete in these markets.

Government Regulation

Overview

All participants in the healthcare industry are required to comply with extensive government regulation at the federal, state and local levels. Under these laws and regulations, hospitals must meet requirements for licensure and qualify to participate in government programs, including Medicare and Medicaid. These requirements relate to the adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, hospital use, rate-setting, compliance with building codes and environmental protection laws. There are also extensive regulations governing a hospital’s participation in government programs. These laws and regulations are extremely complex and, in many instances, the industry does not have the benefit of significant regulatory or judicial interpretation.

In the event of a determination that we violated applicable laws, rules or regulations or if changes in the regulatory framework occur, we may be subject to criminal penalties and/or civil sanctions and our hospitals could lose their licenses and/or their ability to participate in government programs. In addition, government regulations frequently change and when regulations change, we may be required to make changes in our facilities, equipment, personnel and services so that our hospitals remain licensed and qualified to participate in these programs. One or more of these outcomes could be material to our operations. We believe that our hospitals are in substantial compliance with current applicable federal, state and local regulations and standards.

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State Workers’ Compensation Commissions

A significant amount of our net revenue results from Texas workers’ compensation claims and to a lesser extent, currently from Louisiana workers’ compensation claims. As such, we are subject to the rules and regulations of the Texas and Louisiana’s Workers’ Compensation Commissions (“TWCC” and “LWCC”, respectively).

The Texas Administrative Code provides the specific methodology and procedure for the payment and denial of medical bills by third party payers for medical services to injured workers in Texas. Specifically, for inpatient surgical services, reimbursement is predicated upon the Acute Care Hospital Inpatient Fee Guideline. In April 2004, the TWCC adopted a new Fee Guideline for Ambulatory Surgical Centers which will become effective as of September 1, 2004. Reimbursement for services not identified in an established fee guideline are reimbursed at a “fair and reasonable” rate. “Fair and reasonable” is not a defined term and the only requirement placed upon an outpatient facility is to bill charges at a “usual and customary” level. Our outpatient and ambulatory surgical center facilities bill for services provided to its workers’ compensation patients at its usual and customary level and pursues reimbursement for these services at a “fair and reasonable” rate. Due to the soon to be effective Ambulatory Surgical Center guidelines, it is anticipated that the number of medical fee disputes filed with the commission may increase during the first twelve months after implementation of this new guideline. As of now, the new fee guideline only affects Ambulatory Surgery Centers and therefore only the West Houston Facility will be affected at this time. The TWCC provides the Medical Dispute Resolution process to request proper reimbursement for services pursuant to the Texas Labor Code and the Texas Administrative Code. For example, if a third party payer does not provide the Company proper reimbursement for a claim, we request reconsideration of that payment amount. After that request, if the third party payer has not provided proper reimbursement, we file a request for Medical Dispute Resolution with the TWCC.

The TWCC then reviews the claim to determine if additional payment is warranted pursuant to the statutory and regulatory guidelines and/or fee guidelines implemented by the TWCC. The TWCC then issues a finding and decision, which the non-prevailing party may then appeal to the State Offices of Administrative Hearings. At that point, the parties can pursue an administrative hearing to determine if proper reimbursement was made for services provided to an injured worker. Although this entire process is lengthy, we request optimal reimbursement for services rendered based upon the utilization of this administrative process. Our Company effectively pursues all avenues of reimbursement allowed under the law as mandated by the legislature and state administrative agencies.

The Louisiana Administrative Code provides the specific methodology and procedure for the payment and denial of medical bills by third party payers for medical services to injured workers. Specifically, for inpatient surgical services, reimbursement is predicated upon the hospital reimbursement schedule. In addition, there is also a reimbursement guideline for outpatient services.

We cannot predict the course of future legislation or changes in current administration of the Texas Labor Code and/or Texas Administrative Code or the Louisiana Administrative Code. We expect that there may be changes in the future, but we are unable to predict their impact on our operations.

Licensure, Certification and Accreditation

Our hospitals are subject to periodic inspection by governmental and other authorities to assure continued compliance with the various standards necessary for licensing and accreditation. Moreover, in order to participate in the Medicare and Medicaid programs, each of our hospitals must comply with the applicable regulations of the United States Department of Health and Human Services relating to, among other things, equipment, personnel and standards of medical care, as well as comply with all applicable state and local laws and regulations. We believe that all of our hospitals are in substantial compliance with such regulations and laws and, as such, are certified for participation in the Medicare and Medicaid programs.

We believe that our hospitals are in substantial compliance with current applicable federal, state and local regulations and standards. However, the requirements for licensure, certification and accreditation are subject to change. Consequently, in order for our hospitals to remain licensed, certified and accredited, it may be necessary from time-to-time for us to make material changes in our facilities, equipment, personnel and/or services.

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Professional licensure

Healthcare professionals at our hospitals are required to be individually and currently licensed or certified under applicable state law and may be subject to numerous Medicare and Medicaid participation and reimbursement regulations. We take steps to ensure that all independent physicians and our employees and agents have the necessary licenses and certifications, and we believe that our employees and agents comply with all applicable state licensure laws.

Corporate practice of medicine and fee-splitting

Some states, including Louisiana and Texas, have laws that prohibit unlicensed persons or business entities, including corporations, from employing physicians. Some states also have adopted laws that prohibit direct or indirect payments or fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violations of these restrictions include loss of license, civil and criminal penalties, and rescission of the business arrangements. These laws vary from state to state, are often vague and in most states have seldom been interpreted by the courts or regulatory agencies. We have attempted to structure our arrangements with healthcare providers to avoid the exercise of any responsibility on behalf of the physicians utilizing our hospitals that could be construed as affecting the practice of medicine and to comply with all such applicable state laws. However, we cannot assure you that governmental officials charged with responsibility for enforcing these laws will not assert that we, or the transactions in which we are involved, are in violation of these laws. These laws may also be interpreted by the courts in a manner inconsistent with our interpretations.

Healthcare Program Regulations

Participation in any federal or state healthcare program, including the Medicare and Medicaid programs, is heavily regulated by statute and regulation. If a hospital fails to substantially comply with the numerous conditions of participation in the Medicare and Medicaid programs or performs certain prohibited acts, the hospital’s participation in the federal or state healthcare programs may be terminated, civil or criminal penalties may be imposed under certain provisions of the Social Security Act, or both.

Anti-kickback Statute

Among the provisions of the Social Security Act is a section known as the Anti-Kickback Statute. The Medicare and Medicaid Anti-Fraud and Abuse Amendments to the Social Security Act, or the Anti-kickback Statute, prohibits providers and others from soliciting, receiving, offering or paying, directly or indirectly, any remuneration with the intent of generating referrals or orders for services or items covered by a federal healthcare program. Courts have interpreted this statute broadly. Violations of the Anti-kickback Statute may be punished by a criminal fine of up to $25,000 for each violation, imprisonment up to five years, or both, civil money penalties of up to $50,000 per violation and damages of up to three times the amount of the illegal kickback and/or exclusion from participation in federal healthcare programs, including Medicare and Medicaid.

The Office of Inspector General at the Department of Health and Human Services (the “OIG”), among other regulatory agencies, is responsible for identifying and eliminating fraud, abuse and waste in federal healthcare programs. The OIG carries out this mission through a nationwide program of audits, investigations and inspections. In order to provide guidance to healthcare providers, the OIG has from time to time issued “Special Fraud Alerts” that do not have the force of law, but identify features of arrangements or transactions that may indicate that the arrangements or transactions violate the Anti-kickback Statute or other federal healthcare laws. The OIG has identified several incentive arrangements, which, if accompanied by inappropriate intent, constitute suspect practices, including: (a) payment of any incentive by the hospital each time a physician refers a patient to the hospital, (b) the use of free or significantly discounted office space or equipment in facilities usually located close to the hospital, (c) provision of free or significantly discounted billing, nursing or other staff services, (d) free training for a physician’s office staff in areas such as management techniques and laboratory techniques, (e) guarantees which provide that, if the physician’s income fails to reach a predetermined level, the hospital will pay any portion of the remainder, (f) low-interest or interest-free loans, or loans which may be forgiven if a physician refers patients to the hospital, (g) payment of the costs of a physician’s travel and expenses for conferences, (h) coverage on the hospital’s group health insurance plans at an inappropriately low cost to the physician, (i) payment for services (which may include consultations at the hospital) which require few, if any, substantive duties by the physician, (j) purchasing goods or services from physicians at prices in excess of their fair market value, or (k) certain

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“gainsharing” arrangements, the practice of giving physicians a share of any reduction in a hospital’s costs for patient care attributable in part to the physician’s efforts. The OIG has encouraged persons having information about hospitals who offer the above types of incentives to physicians to report such information to the OIG.

As authorized by Congress, the OIG has published final safe harbor regulations that outline categories of activities that are deemed protected from prosecution under the Anti-kickback Statute. Currently there are statutory exceptions and safe harbors for various activities, including the following: investment interests, space rental, equipment rental, practitioner recruitment, personal services and management contracts, sale of practice, referral services, warranties, discounts, employees, group purchasing organizations, waiver of beneficiary coinsurance and deductible amounts, managed care arrangements, obstetrical malpractice insurance subsidies, investments in group practices, freestanding surgery centers, and referral agreements for specialty services. Compliance with a safe harbor is not mandatory. The fact that a particular conduct or a business arrangement does not fall within a safe harbor does not automatically render the conduct or business arrangement illegal under the Anti-kickback Statute. Such conduct and business arrangements, however, may lead to increased scrutiny by government enforcement authorities.

The safe harbor regulations with respect to investment interests establish two instances in which payments to an investor in a venture will not be treated as a violation of the Anti-Kickback Statute. The first safe harbor is for investment interests in public companies that have total assets exceeding $50 million and whose investment securities are registered pursuant to the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The second safe harbor or “small entity” safe harbor is for investments in entities as long as the following criteria are met: (i) no more than 40% of the total investment interests of each class of investment interests are held in the previous fiscal year or previous 12-month period by investors who are in a position to make or influence referrals to, furnish items or services to, or otherwise generate business for the entity; (ii) the terms on which an investment interest is offered to a passive investor (e.g., a shareholder or limited partner) who is in a position to make or influence referrals to, furnish items or services to, or otherwise generate business for the entity are no different than the terms offered to other passive investors; (iii) the terms on which an investment interest is offered to an investor who is in a position to make or influence referrals to, furnish items or services to, or otherwise generate business for the entity are not related to the previous or expected volume of referrals, items or services furnished or amount of business otherwise generated from that investor to the entity; (iv) there is no requirement that a passive investor, if any, make referrals to, be in a position to make or influence referrals to, furnish items or services to, or otherwise generate business for the entity as a condition for remaining as an investor; (v) the entity must not market or furnish the entity’s items or services to passive investors differently than to non-investors; (vi) no more than 40% of the gross revenues of the entity in any fiscal year or twelve-month period comes from referrals or business otherwise generated from investors; (vii) the entity or individual acting on behalf of the entity must not loan funds to or guaranty a loan for an investor who is in a position to make or influence referrals to or otherwise generate business for the entity if the investor uses any part of such loan to obtain the investment interest; and (viii) the amount of payment to an investor in return for the investment interest is directly proportional to the amount of the capital investment (including the fair market value of any pre-operational services rendered) of that investor.

We have a variety of financial relationships with physicians who refer patients to our hospitals. Physicians own interests in certain of our hospitals and may also own our stock. We also have medical directorship agreements with some physicians. Although we believe that our arrangements with physicians have been structured to comply with the current law and available interpretations, we cannot assure you that regulatory authorities will not determine that these arrangements violate the Anti-kickback Statute or other applicable laws. Also, the states in which we operate have adopted anti-kickback laws, some of which apply more broadly to all payers, not just to federal healthcare programs. Many of these state laws do not have safe harbor regulations comparable to the federal Anti-kickback Statute and have only rarely been interpreted by the courts or other government agencies. If our arrangements were found to violate any of these anti-kickback laws we could be subject to criminal and civil penalties and/or possible exclusion from participating in Medicare, Medicaid, or other governmental healthcare programs such as workers’ compensation programs.

Stark Law

The Social Security Act also includes certain provisions commonly known as the “Stark Law.” This law prohibits physicians, absent an exception, from referring Medicare and Medicaid patients to entities with which they or any of their immediate family members have a financial relationship if these entities provide certain designated health services that are reimbursable by Medicare, including inpatient and outpatient hospital services. Sanctions for violating the Stark Law include denial of payment, refunding amounts received for services provided pursuant to

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prohibited referrals, civil monetary penalties of up to $15,000 per prohibited service provided, and exclusion from the Medicare and Medicaid programs. The statute also provides for a penalty of up to $100,000 for a circumvention scheme that has the principal purpose of assuring referrals and that, if directly made, would violate the Stark law. There are exceptions to the self-referral prohibition for many of the customary financial arrangements between physicians and providers, including employment contracts, leases and recruitment agreements. There is also an exception for a physician’s ownership interest in an entire hospital, as opposed to an ownership interest in a hospital department.

On March 26, 2004, the Centers for Medicare and Medicaid Services (“CMS”) issued final “Phase II” regulations to clarify parts of the Stark Law and some of the exceptions thereto. These regulations concluded the second phase of a two-phase process. The Phase I regulations largely went into effect on January 4, 2002, except for one provision interpreting the requirement in many Stark Law exceptions that a physician’s compensation must be “set in advance.” The Phase II Regulations became effective on July 26, 2004 and created seven new exceptions. There have been few enforcement actions, and therefore, there is little indication as to how courts will interpret and apply the Stark Law; however, enforcement is expected to increase.

We believe we have structured our financial arrangements with physicians to comply with the statutory exceptions included in the Stark Law and the regulatory exceptions. In particular, we believe that our physician ownership arrangements meet the Stark whole hospital exception. On March 19, 2004, the CMS announced its implementation of a moratorium on physician investment in and referrals to certain specialty hospitals enacted by Congress as part of the Medicare Prescription Drug, Improvement and Modernization Act of 2003. Congress and CMS define specialty hospitals as primarily or exclusively engaged in the care and treatment of one of the following categories: (i) patients with a cardiac condition, (ii) patients with an orthopedic condition or (iii) patients receiving a surgical procedure. The moratorium became effective on December 8, 2003 and expires on June 8, 2005. Congress specifically excluded from the moratorium, hospitals that were in operation before or under development as of November 18, 2003. In determining whether a specialty hospital was “under development” as of November 18, 2003, the CMS considers whether all of the following occurred prior to November 18, 2003: (i) architectural plans were completed, (ii) funding was received, (iii) zoning requirements were met, and (iv) necessary approvals from appropriate state agencies were received. In cases where all of these steps were not completed prior to November 18, 2003, the CMS will make a case-by-case determination as to whether the specialty hospital was “under development” and will consider any other evidence that would indicate the under development status. To request a case-specific determination regarding whether a specialty hospital was under development as of November 18, 2003, an interested party can request a written opinion from the CMS. During the 18-month moratorium, the Medicare Payment Advisory Commission, in consultation with the Comptroller General of the United States, will conduct a study to determine, in addition to other things, the financial impact of physician-owned specialty hospitals on local full-service community hospitals. We cannot predict the results of this study or the action that Congress may take in response to the study.

The Stark Law may also be amended in ways that we cannot predict at this time, including possible changes to the current physician ownership and compensation exceptions. We cannot predict whether any other law or amendment will be enacted or the effect they might have on us.

State Anti-Kickback and Physician Self-Referral Laws

Many states, including those in which we do or expect to do business, have laws that prohibit payment of kickbacks or other remuneration in return for the referral of patients. Some of these laws apply only to services reimbursable under state Medicaid programs. However, a number of these laws apply to all healthcare services in the state, regardless of the source of payment for the service. Based on court and administrative interpretations of the federal Anti-kickback Statute, we believe that the Anti-kickback Statute prohibits payments only if they are intended to induce referrals. However, the laws in most states regarding kickbacks have been subjected to more limited judicial and regulatory interpretation than federal law. Therefore, we can give you no assurances that our activities will be found to be in compliance with these laws. Noncompliance with these laws could subject us to penalties and sanctions and have a material adverse effect on us.

A number of states, including those in which we do or expect to do business, have enacted physician 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 healthcare provider is based upon an investment interest. Other state laws apply only to a limited number of designated health services. Some states do

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not prohibit referrals, but require that a patient be informed of the financial relationship before the referral is made. We believe that our operations are in material compliance with the physician self-referral laws of the states in which our hospitals are located.

HIPAA and The Balanced Budget Act of 1997

The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) broadened the scope of certain federal fraud and abuse laws by adding several criminal provisions for healthcare fraud offenses that apply to all health benefit programs. HIPAA also added a prohibition against incentives intended to influence decisions by Medicare beneficiaries as to the provider from which they will receive services. In addition, HIPAA created new enforcement mechanisms to combat fraud and abuse, including the Medicare Integrity Program and an incentive program under which individuals can receive up to $1,000 for providing information on Medicare fraud and abuse that leads to the recovery of at least $100 of Medicare funds. Federal enforcement officials now have the ability to exclude from Medicare and Medicaid any investors, officers and managing employees associated with business entities that have committed healthcare fraud, even if the officer or managing employee had no knowledge of the fraud. HIPAA was followed by The Balanced Budget Act of 1997, which created additional fraud and abuse provisions, including civil penalties for contracting with an individual or entity that the provider knows or should know is excluded from a federal healthcare program.

Other Fraud and Abuse Provisions

The Social Security Act also imposes criminal and civil penalties for making false claims and statements to Medicare and Medicaid. False claims include, but are not limited to, billing for services not rendered or for misrepresenting actual services rendered in order to obtain higher reimbursement, billing for unnecessary goods and services, and cost report fraud. Criminal and civil penalties may be imposed for a number of other prohibited activities, including failure to return known overpayments, certain gainsharing arrangements, and offering remuneration to influence a Medicare or Medicaid beneficiary’s selection of a healthcare provider. Like the Anti-kickback Statute, these provisions are very broad. Careful and accurate coding of claims for reimbursement, as well as accurately preparing cost reports, must be performed to avoid liability.

The Federal False Claims Act and Similar State Laws

A factor affecting the healthcare industry today is the use of the Federal False Claims Act and, in particular, actions brought by individuals on the government’s behalf under the False Claims Act’s “qui tam,” or whistleblower, provisions. Whistleblower provisions allow private individuals to bring actions on behalf of the government alleging that the defendant has defrauded the federal government.

When a defendant is determined by a court of law to be liable under the False Claims Act, the defendant may be required to pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each false claim submitted. There are many potential bases for liability under the False Claims Act. Liability often arises when an entity knowingly submits a false claim for reimbursement to the federal government. The False Claims Act defines the term “knowingly” broadly. Thus, although simple negligence will not give rise to liability under the False Claims Act, submitting a claim with reckless disregard to its truth or falsity constitutes a “knowing” submission under the False Claims Act and, therefore, will qualify for liability.

In some cases, whistleblowers and the federal government have taken the position that providers who allegedly have violated other statutes, such as the Anti-kickback Statute and the Stark Law, have thereby submitted false claims under the False Claims Act. Certain states in which we operate have adopted their own false claims provisions as well as their own whistleblower provisions whereby a private party may file a civil lawsuit in state court.

Health Information Security and Privacy Practices

The Administrative Simplification Provisions of HIPAA also require certain organizations, including us, to implement very significant and potentially expensive new computer systems and business procedures designed to protect each patient’s individual healthcare information. HIPAA requires the Department of Health and Human Services to issue rules to define and implement patient privacy and security standards. Among the standards that the Department of Health and Human Services adopted pursuant to HIPAA are standards for the following:

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On August 17, 2000, the Department of Health and Human Services finalized the transaction standards. The Administrative Simplification and Compliance Act extended the date by which we must comply with the transaction standards to October 16, 2003, provided we submit a compliance plan to the Secretary of Health and Human Services by October 16, 2002. We submitted a compliance plan by October 16, 2002. The transaction standards require us to use standard code sets established by the rule when transmitting health information in connection with some transactions, including health claims and health payment and remittance advices. We are now in substantial compliance with the standards.

On December 28, 2000, the Department of Health and Human Services published a final rule establishing standards for the privacy of individually identifiable health information. This rule was amended May 31, 2002 and August 14, 2002. These privacy standards apply to all health plans, all healthcare clearinghouses and many healthcare providers, including healthcare providers that transmit health information in an electronic form in connection with certain standard transactions. We are a covered entity under the final rule. The privacy standards protect individually identifiable health information held or disclosed by a covered entity in any form, whether communicated electronically, on paper or orally. These standards not only require our compliance with rules governing the use and disclosure of protected health information, but they also require us to impose those rules, by contract, on any business associate to whom such information is disclosed. A violation of the privacy standards could result in civil money penalties of $100 per incident, up to a maximum of $25,000 per person per year per standard. The final rule also provides for criminal penalties of up to $50,000 and one year in prison for knowingly and improperly obtaining or disclosing protected health information, up to $100,000 and five years in prison for obtaining protected health information under false pretenses, and up to $250,000 and ten years in prison for obtaining or disclosing protected health information with the intent to sell, transfer or use such information for commercial advantage, personal gain or malicious harm. The compliance date for the privacy rule was April 14, 2003.

On February 20, 2003, the Department of Health and Human Services issued a final rule that establishes, in part, standards for the security of health information by health plans, healthcare clearinghouses and healthcare providers that maintain or transmit any health information in electronic form, regardless of format. We are an affected entity under the rule. These security standards required affected entities to establish and maintain reasonable and appropriate administrative, technical and physical safeguards to ensure integrity, confidentiality and the availability of the information. The security standards were designed to protect the health information against reasonably anticipated threats or hazards to the security or integrity of the information and to protect the information against unauthorized use or disclosure. Although the security standards do not reference or advocate a specific technology, and affected entities have the flexibility to choose their own technical solutions, we expect that the security standards will require us to implement significant systems and protocols. The compliance date for the initial implementation of the standards set forth in the security rule is April 20, 2005.

In April 2003, the Department of Health and Human Services published an interim final rule that establishes procedures for the imposition, by the Secretary of Health and Human Services, of civil monetary penalties on entities that violate the administrative simplification provisions of HIPAA. This was the first installment of the enforcement rule. When issued in complete form, the enforcement rule will set forth procedural and substantive requirements for imposition of civil monetary penalties. The act also provides for criminal penalties for violations. We have established a plan and committed the resources necessary to comply with the act. At this time, we anticipate that we will be able to fully comply with the act’s regulations that have been issued and with the proposed regulations. Based on the existing and proposed regulations, we believe that the cost of our compliance with the act will not have a material adverse effect on our results of operations.

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Emergency Medical Treatment and Labor Act

All of our hospitals are subject to the Emergency Medical Treatment and Labor Act (“EMTALA”). This federal law requires any hospital that participates in the Medicare program to conduct an appropriate medical screening examination of every person who presents to the hospital’s emergency department for treatment and, if the patient is suffering from an emergency medical condition, to either stabilize that condition or make an appropriate transfer of the patient to a facility that can handle the condition. The obligation to screen and stabilize emergency medical conditions exists regardless of a patient’s ability to pay for treatment. There are severe penalties under EMTALA if a hospital fails to screen or appropriately stabilize or transfer a patient or if the hospital delays appropriate treatment in order to first inquire about the patient’s ability to pay. Penalties for violations of EMTALA include civil monetary penalties and exclusion from participation in the Medicare program. In addition, an injured patient, the patient’s family or a medical facility that suffers a financial loss as a direct result of another hospital’s violation of the law can bring a civil suit against the hospital.

Although we believe that we are currently in substantial compliance with the requirements of EMTALA, we cannot predict any modifications that the CMS will implement in the future. On May 13, 2004, the CMS issued revised interpretive guidelines for surveyors investigating EMTALA complaints. We cannot predict whether we will be in compliance with any new requirements or interpretive guidelines.

In December 2002, the Pasadena Facility was notified by the CMS that it had allegedly violated EMTALA requirements. The Texas Department of Health (“TDH”) conducted an investigation and reported to the CMS that appropriate corrective actions had been taken. As a result of TDH’s findings, the CMS notified the facility in January 2003 that its eligibility for Medicare participation remained in effect, but, as required by §1867(d) of the Social Security Act, the matter would be forwarded to the Quality Improvement Organization (“QIO”) to review the case and report its findings to the OIG for a possible assessment of a civil monetary penalty. The facility met with the QIO on October 3, 2003. As of this date, there has been no report issued by the QIO or any response received from the OIG. The Company does not anticipate that it will incur any material liability that would have an adverse effect on the Company’s operations, cash flows, or financial condition as a result of this proceeding.

The company is in the process of interviewing individuals with strong regulatory backgrounds to fill the position of Regulatory Compliance Officer. This individual(s) will be responsible for ensuring that the company’s facilities remain in compliance and good standing with both state and federal agencies. The company expects to fill this position(s) by the end of the fourth quarter of fiscal 2004.

Healthcare Reform

As one of the largest industries in the United States, healthcare continues to attract significant legislative interest and public attention. In recent years, various legislative proposals have been introduced or proposed in Congress and in some state legislatures that would affect major changes in the healthcare system, either nationally or at the state level. Many states have enacted or are considering enacting measures designed to reduce their Medicaid expenditures and change private healthcare insurance. We cannot predict the course of future healthcare legislation or other changes in the administration or interpretation of governmental healthcare programs and the effect that any legislation, interpretation, or change may have on us.

Certificate of Need

Some states require state approval for construction and expansion of healthcare facilities, including findings of need for additional or expanded healthcare facilities or services. Certificates of need, which are issued by governmental agencies with jurisdiction over healthcare facilities, are sometimes required for capital expenditures exceeding a prescribed amount, changes in bed capacity or services and certain other matters. Following a number of years of decline, the number of states requiring certificates of need is once again on the rise as state legislators are looking at the certificate of need process as a way to contain rising healthcare costs. Currently, we do not operate in any state that requires a certificate of need. Should we desire to expand our operations to any jurisdiction where a certificate of need will be required, we are unable to predict whether we will be able to obtain any such certificate of need.

Conversion Legislation

Many states have enacted or are considering enacting laws affecting the conversion or sale of not-for-profit hospitals. These laws, in general, include provisions relating to attorney general approval, advance notification and community involvement. In addition, state attorneys general in states without specific conversion legislation may exercise authority over these transactions based upon existing law. In many states there has been an increased interest in the oversight of not-for-profit conversions. We may effect a conversion of a not for profit hospital in the future and accordingly, the adoption of conversion legislation and the increased review of not-for-profit hospital

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conversions may increase the cost and difficulty or prevent our completion of transactions with not-for-profit organizations in certain states in the future.

Environmental Regulation

Our hospital operations generate medical waste that must be disposed of in compliance with federal, state and local environmental laws, rules and regulations. These operations, as well as our purchases of hospitals, also are subject to compliance with various other environmental laws, rules and regulations. We believe that the cost of such compliance will not have a material effect on our future capital expenditures, earnings or competitive position.

Insurance

The Company maintains various insurance policies that cover each of its facilities. Specifically, the Company maintains medical malpractice insurance coverage in Texas. The Company has claims-made malpractice coverage and has purchased tail coverage effective through August 12, 2004. The Company in Louisiana is a member of the Louisiana Patient Compensation Fund and purchases insurance through the Louisiana Patient Compensation Fund for medical malpractice. In addition, all physicians granted privileges at the Company’s facilities are required to maintain medical malpractice insurance coverage. The Company also maintains general liability and property insurance coverage for each facility and flood coverage for the Baton Rouge Facility. The Company also maintains workers’ compensation coverage for the Baton Rouge Facility, but does not currently maintain worker’s compensation coverage in Texas. In regard to the Employee Health Insurance Plan, the Company is self insured with specific and aggregate re-insurance with stop loss levels appropriate for the company’s group size. Coverages are maintained in amounts management deems adequate.

Employees

As of June 26, 2004, the Company employed approximately 328 full-time employees and 74 part-time employees, which represents approximately 338 full time equivalent (“FTE”) employees.

Available Information

We file proxy statements and annual, quarterly and current reports with the U.S. Securities and Exchange Commission (SEC). You may read and copy any document that we file at the SEC’s public reference room located at 450 Fifth Street N.W., Washington, D.C. 20549. You may also call the SEC at 1-800-SEC-0330 for information on the operation of the public reference room. Our SEC filings are also available to you free of charge at the SEC’s website at http://www.sec.gov. We also maintain a website at http://www.dynacq.com that includes links to our SEC filings, including our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports. These reports are available on our website without charge as soon as reasonably practicable after such reports are filed with or furnished to the SEC. Information contained on our website is not part of this report.

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Risk Factors

The value of an investment in Dynacq Healthcare, Inc. will be subject to significant risks that are inherent in our business and the industry in which we operate, and some of which are specific to our Company. If any of the matters described in the risk factors listed below were to occur, our business and financial results could be adversely affected in a material way. This could cause the trading price of our common stock to decline, perhaps significantly. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties, including those that are not presently known or that we currently believe are immaterial, may also adversely affect our business, financial condition or results of operations.

Because we are not current in our periodic SEC filings, we are in default under our reducing revolving line of credit.

We currently have approximately $6.0 million outstanding under our reducing revolving line of credit, which includes a covenant requiring us to timely file our periodic reports with the Securities and Exchange Commission. Because we did not timely file this annual report on Form 10-K and have not yet filed our quarterly reports on Form 10-Q for the fiscal quarters ended November 30, 2003, February 29, 2004 and May 31, 2004, we are in default under the terms of the line of credit. On April 16, 2004, the financial institution submitted to us a notice of default. Since we did not cure the default within 10 days, we are now in default under the line of credit. To this date, the financial institution has not taken any further action. Our indebtedness under our line of credit is secured by substantially all of our assets. If we are unable to repay all outstanding balances, the financial institution could proceed against our assets to satisfy our obligations under the line of credit.

The cash that we generate from our business may not be sufficient to meet our financial obligations or to fund our capital requirements. As a result, we may require additional capital for, among other purposes, implementing our business growth strategy, purchasing equipment and establishing new facilities. We may not be able to obtain additional capital on acceptable terms, if at all. If we are unable to obtain sufficient additional capital in the future, our business could be adversely affected by reducing our ability to increase revenues and profitability. If we are unable to generate sufficient cash flow from operations in the future to repay our indebtedness and to meet our other commitments, we will be required to adopt one or more alternatives, such as refinancing, selling material assets or operations or seeking to raise additional debt or equity capital. These actions may not be effected on a timely basis or on satisfactory terms or at all, and these actions may not enable us to continue to satisfy our capital requirements. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

Our former and current independent auditors have advised us that they have identified material weaknesses in our internal controls.

In conjunction with Ernst & Young’s resignation, Ernst & Young advised us that it had identified material weaknesses relating to our internal controls. In a letter dated December 23, 2003, Ernst & Young advised us that a material weakness existed as a result of inadequate communication lines and internal controls relating to the authorization, recognition, capture and review of transactions, facts, circumstances and events that may have a material impact on the Company’s financial reporting process. Ernst & Young has also advised us that a material weakness existed as a result of a lack of supervision, review and quality control related to the accounting for income taxes, noting errors in the computation of income taxes. Further, our current independent auditors have orally advised the audit committee that they have identified what they consider to be material weaknesses in our internal controls with respect to: