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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the transition period from             to             

Commission file number: 1-32203

Prospect Medical Holdings, Inc.

(Exact name of registrant as specified in its charter)

(310) 943-4500

(Registrant’s telephone number, including area code)

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 o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):  Yes o  No x

The number of shares of the issuer’s common stock, par value $0.01 per share, outstanding as of February 10, 2011 was 100, all of which are owned by Ivy Intermediate Holding Inc., a wholly-owned subsidiary of Ivy Holdings Inc.

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PROSPECT MEDICAL HOLDINGS, INC.

Index

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PART I—FINANCIAL INFORMATION

Item 1.  Financial Statements.

PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands)

(Unaudited)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

continued

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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PROSPECT MEDICAL HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2010

(Unaudited)

1. Organization

Prospect Medical Holdings, Inc. (“Prospect,” “Company” or the “Parent Entity”) is a Delaware corporation. Prior to the August 8, 2007 acquisition of Alta Hospitals System, LLC (“Alta”), which was previously known as Alta Healthcare System, Inc., the Company was primarily engaged in providing management services to affiliated physician organizations that operate as independent physician associations (“Medical Groups”) or medical clinics. Following the Alta acquisition and acquisition of a majority stake in Brotman Medical Center, Inc., a California corporation (“Brotman”), on April 14, 2009 (see Note 9), and as of December 31, 2010, the Company owns and operates five community-based hospitals in Southern California, and its operations are organized into three primary reportable segments: Hospital Services, Medical Group and Corporate as discussed below.

As further described in Note 4 below, effective December 15, 2010, after the receipt of stockholder approval at a special meeting of its stockholders, Prospect merged with, and into, Ivy Merger Sub Corp., an indirect wholly-owned subsidiary of Ivy Holdings Inc. (the “Ivy Merger”).  Following the Ivy Merger, all shares of Prospect’s common stock voluntarily ceased trading in the NASDAQ Global Market and were delisted.  All outstanding shares of Prospect are now owned by Ivy Intermediate Holding Inc., a wholly-owned direct subsidiary of Ivy Holdings Inc., which is owned by affiliates of Leonard Green & Partners, L.P., a private equity fund, and certain members of Prospect’s management.

Hospital Services Segment

We own and operate five hospitals in Los Angeles County, with a total of approximately 759 licensed beds served by 724 on-staff physicians at December 31, 2010. We acquired four community hospitals in Hollywood, Los Angeles, Norwalk and Van Nuys in connection with our acquisition of Alta. Our fifth hospital, in which we currently have a 78% ownership interest, is Brotman Medical Center, located in Culver City. All of our hospitals are accredited by Det Norske Veritas (“DNV”) Healthcare, Inc.

Our three community hospitals in Hollywood, Los Angeles and Norwalk offer a comprehensive range of medical and surgical services, including general acute care hospital services, pediatrics, obstetrics and gynecology, pediatric sub-acute care, general surgery, medical-surgical services, orthopedic surgery, and diagnostic, outpatient, skilled nursing and urgent care services. Our psychiatric hospital in Van Nuys provides acute inpatient and outpatient psychiatric services on a voluntary basis. Brotman offers a comprehensive range of inpatient and outpatient services, including general surgery, orthopedic, spine and neurosurgery, cardiology, diagnostic outpatient, rehabilitation, psychiatric and detox services. In addition, Brotman has an active emergency room that plays an integral part in providing emergency services to the West Los Angeles area.

The table below gives a brief overview of the Company’s hospitals and the locations they serve:

Admitting physicians are primarily practitioners in the local area. The Hospitals have payment arrangements with Medicare, Medi-Cal (the California version of Medicaid) and other third party payers, including some commercial insurance carriers, health maintenance organizations (“HMOs”) and preferred provider organizations (“PPOs”).

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Medical Group Segment

The Medical Group segment is a healthcare management services organization that provides management services to affiliated physician organizations that operate as independent physician associations (“Medical Groups”). The affiliated physician organizations enter into agreements with HMOs to provide HMO enrollees with a full range of medical services in exchange for fixed, prepaid monthly fees known as “capitation” payments. The Medical Groups contract with physicians (primary care and specialist) and other healthcare providers to provide enrollees with all medical services. Prospect currently manages the provision of prepaid healthcare services for its affiliated physician organizations in Southern California. The network consists of the following physician organizations as of December 31, 2010 (stand alone or individually referred to as, an “Affiliate”):

Prospect Medical Group, Inc. (“PMG”)

Prospect Health Source Medical Group, Inc. (“PHS”)

Prospect Professional Care Medical Group, Inc. (“PPCM”)

APAC Medical Group, Inc. (“APA”) (Inactive)

Genesis HealthCare of Southern California, Inc., A Medical Group (“Genesis”)

Prospect NWOC Medical Group, Inc. (“PNW”)

StarCare Medical Group, Inc. (“PSC”)

Santa Ana/Tustin Physicians Group, Inc. (“SATPG”) (Inactive)

AMVI/Prospect Medical Group (“AMVI/Prospect”)

Nuestra Familia Medical Group, Inc. (“Nuestra”)

Upland Medical Group, a Professional Medical Corporation (“UMG”)*

Pomona Valley Medical Group, Inc. (“PVMG”)*

*         PVMG and UMG are collectively referred to as the “ProMed Entities.”

These Affiliates are managed by the following two medical management company subsidiaries that are wholly-owned by Prospect:

Prospect Medical Systems, Inc. (“PMS”)

ProMed Health Care Administrators (“PHCA”)

All of the Affiliates are wholly-owned by PMG, with the exception of Nuestra, which is 62% owned by a nominee physician shareholder pursuant to an assignable option agreement described below, and AMVI/Prospect which is a 50/50 Joint Venture between AMVI Care Health Network, Inc. and SATPG. PMG is owned by the same nominee physician shareholder pursuant to a separate assignable option agreement. The results of all of these entities, with the exception of AMVI/Prospect, are consolidated in the accompanying unaudited condensed consolidated financial statements.

The AMVI Joint Venture was formed for the sole purpose of combining enrollment in order to meet minimum enrollment levels required for participation in the CalOptima Medicaid (Medi-Cal in California) program in Orange County, California. The joint venture ownership is set at 50/50 to prevent either party from exerting control over the other; however, AMVI and SATPG’s businesses are operated autonomously, and enrollees, financial results and cash flows are each separately tracked and recorded. In accordance with the joint venture partnership agreement, profits and losses are not split in accordance with the partnership ownership interest, but rather, are directly tied to the results generated by each separate portion of the business. Separate from any earnings the Company generates from SATPG’s portion of business within the joint venture, the Company also earns fees for management services PMS provides to SATPG’s partner in the joint venture. The Company accounts for SATPG’s interest in the joint venture partnership using the equity method of accounting. The Company includes in the unaudited condensed consolidated financial statements only the net results attributable to those enrollees specifically identified as assigned to the Company, together with the management fee that PMS charges for managing those enrollees specifically assigned to the other joint venture partner.

PMS has entered into an assignable option agreement with PMG and the nominee physician shareholder of PMG. Under the assignable option agreement, Prospect has an assignable option, obtained for a nominal amount from PMG and the nominee shareholder to designate the purchaser (successor physician) for all or part of PMG’s issued and outstanding stock held by the nominee physician shareholder (the “Stock Option”) in its sole discretion. The Company may also assign the assignable option agreement to any person. The assignable option agreement has an initial term of 30 years and is automatically extended for additional terms of 10 years each, as long as the term of the related management services agreement described below (the “Management Agreement”) is automatically extended. Upon termination of the Management Agreement with PMG, the related Stock Option would be automatically and immediately exercised. The Stock Option may be exercised for a purchase price of $1,000. Under these nominee shareholder agreements, Prospect has the unilateral right to establish or effect a change of the nominee, at will, and without the consent of the nominee, on an unlimited basis and at nominal cost throughout the term of the Management Agreement. In addition to the Management Agreement with PMG, Prospect, through one of its management company subsidiaries, has a management agreement with each Affiliate. The term of the Management Agreements is generally 30 years. PMG is the sole shareholder of SATPG, PHS, PPCM, PNW, PSC, APA, Genesis, PVMG, and UMG. Dr. Lipper is the nominee shareholder as to the 62% interest in Nuestra, pursuant to a separate assignable option agreement entered into with PMS, under which PMS has the same rights and powers as those described in this paragraph regarding the PMG agreement.

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The Company’s Affiliates have each entered into a Management Agreement and each Affiliate has agreed to pay a management fee to PMS or PHCA, as applicable (each of which is a wholly-owned subsidiary of Prospect). The fee is based in part on the costs to the management company and on a percentage of revenues the Affiliate receives (i) for the performance of medical services by the Affiliate’s employees and independent contractor physicians and physician extenders, (ii) for all other services performed by the Affiliates, and (iii) as proceeds from the sale of assets or the merger or other business combination of the Affiliates. The management fee also includes a fixed percentage fee for marketing and public relations services. The revenue from which this fee is determined includes medical capitation, all sums earned from participation in any risk pools and all fee-for-service revenue earned. Except in the case of Nuestra and AMVI/Prospect, the Management Agreements have initial terms of 30 years, renewable for successive 10-year periods thereafter, unless terminated by either party for cause. In the case of Nuestra, its Management Agreement has an initial 10 year term renewable for successive one year terms. In the case of AMVI/Prospect, its Management Agreement has a one year term with successive one year renewal terms. In return for payment of the management fee, Prospect (through PMS and PHCA) has agreed to provide financial management, information systems, marketing, advertising, public relations, risk management, and administrative support, including for utilization review and quality of care. At its cost, Prospect has assumed the obligations for all facilities, medical and non-medical supplies, and employment of non-physician personnel of its affiliated medical clinics.

The management fee earned by Prospect fluctuates based on the profitability of each wholly-owned Affiliate. Prospect is allocated a 50% residual interest in all profits after the first 8% of the profits or a 50% residual interest in the losses of the Affiliate, after deduction for costs to the management company and physician compensation. The remaining balance is retained by the Affiliates. Supplemental management fees are periodically negotiated where significant incremental efforts and expense have been incurred by Prospect on behalf of the Affiliates.

The Management Agreements are not terminable by the Affiliates except in the case of gross negligence, fraud or other illegal acts of Prospect, or bankruptcy of the Company.

Further, Prospect’s rights under the Management Agreements are unilaterally salable or transferable. Based on the provisions of the Management Agreements and the assignable option agreements with PMG, Prospect has determined that it has a controlling financial interest in the Affiliates, with the exception of Nuestra. Consequently, under applicable accounting principles, Prospect consolidates the revenues and expenses of all the Affiliates except AMVI/Prospect from the respective dates of execution of the Management Agreements. All significant inter-entity balances have been eliminated in consolidation. In the case of AMVI/Prospect, only that portion of the results which are contractually identified as Prospect’s are recognized in the consolidated financial statements, together with the management fee that the Company charges AMVI for managing AMVI’s share of the joint venture operations.

Prospect has also entered into management agreements with unaffiliated third parties to manage services to their HMO enrollees.

The Medical Group segment manages services for the following enrollees under contracts with various health plans (in thousands):

(1)                                  Represents members that we manage on behalf of third parties in exchange for a management fee.

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Corporate Segment

The Corporate segment reflects certain expenses incurred at Prospect Medical Holdings, Inc. (the “Parent Entity”) not specifically allocable to the Hospital Services or Medical Group segments. These include and are not limited to salaries, benefits and other compensation for corporate employees, financing, insurance, rent, operating supplies, legal, accounting, SEC compliance, and Sarbanes-Oxley compliance. The Company does not allocate interest expense, gain or loss on interest rate swaps and income taxes to the other reporting segments.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in conformity with U.S. Generally Accepted Accounting Principles (“GAAP”) for interim consolidated financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. In accordance with the instructions and regulations of the Securities and Exchange Commission (“SEC”) for interim reports, certain information and footnote disclosures normally included in financial statements prepared in conformity with U.S. GAAP for annual reports have been omitted or condensed. All adjustments (consisting of normal recurring adjustments) and disclosures considered necessary for fair presentation have been included in the accompanying unaudited condensed consolidated financial statements.

The unaudited results of operations for the three months ended December 31, 2010 are not necessarily indicative of the results to be expected for the full year. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the audited consolidated financial statements for the year ended September 30, 2010 and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on December 20, 2010.

The unaudited condensed consolidated financial statements include the accounts of the Company and its controlled subsidiaries, but not the accounts of its parent companies, Ivy Holdings Inc. and Ivy Merger Sub Corp. All intercompany accounts and transactions have been eliminated.

As discussed in Note 6, upon the consummation of the merger, the Company became an indirect, wholly-owned subsidiary of Ivy Holdings, and the Company’s common stock ceased trading on the NASDAQ Global Market and was delisted. In accordance with the senior secured notes’ indenture, the Company will continue to file with the SEC until such time that all of its outstanding registered debt has been repaid by the Company, the Company has complied with the Indenture requirements in order to terminate the filing of SEC reports, or a Second Supplemental Indenture that does not require filing with the SEC is in place.

Principles of Consolidation

The unaudited condensed consolidated financial statements include the accounts of the Company and all wholly owned and majority owned subsidiaries and controlled entities in accordance with the accounting guidance for consolidations. All adjustments considered necessary for a fair presentation of the results as of the date of, and for the interim periods presented, which consist solely of normal recurring adjustments, have been included. All significant intercompany balances and transactions have been eliminated in consolidation.

Stock Options and Restricted Stock

Prior to being terminated upon completion of the Ivy Merger, the Company had stock option and restricted stock agreements with certain directors, officers and employees. Share-based awards have generally been issued at or above the market price of the underlying stock.

Compensation costs for option awards are measured and recognized in the financial statements based on their grant date fair value, net of estimated forfeitures over the awards’ service period. The fair value of restricted stock grants are determined on the date of grant, based on the number of shares granted and the quoted price of the Company’s common stock. The Company used the Black-Scholes option pricing model and a single option award approach to estimate the fair value of stock options granted. Equity-based compensation is classified within the same line items as cash compensation paid to employees. Cash retained as a result of excess tax benefits relating to share-based payments is presented in the statement of cash flows as a financing cash inflow.

Prior to their cancellation in connection with the Ivy Merger, the Company’s equity awards vested based on continuous service and did not include performance or market vesting conditions. There are no liability awards that may be settled for cash.

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Restricted Cash

At December 31, 2010, restricted cash primarily represents amounts set aside pursuant to the Los Angeles Jewish Home for the Aging (“JHA”) loan agreements (see Note 8) for property taxes, maintenance and emergency room construction. As discussed in Note 8, as of December 31, 2010, Brotman is delinquent on these required deposits.

Restricted Investments

The Company is required to keep restricted deposits by certain HMOs for the payment of claims. Such restricted deposits are classified as a current asset in the accompanying unaudited condensed consolidated balance sheet, as they are restricted for payment of current liabilities.

Inventories

Inventories of supplies are valued at the lower of amounts that approximate the weighted average cost or market.

Goodwill and Other Intangible Assets

Goodwill and other intangible assets totaled approximately $194,409,000 and $195,409,000 at December 31, 2010 and September 30, 2010, respectively, and arose as a result of the ProMed, Alta and Brotman business acquisitions. Other intangible assets include customer relationships, covenants not-to-compete, trade names and provider networks. Goodwill represents the excess of the consideration paid and liabilities assumed over the fair value of the assets acquired, including identifiable intangible assets. In conjunction with these acquisitions, management of the Company has reviewed the allocation of the excess of the purchase consideration (including costs incurred related to the acquisitions) over net tangible and intangible assets acquired, and has determined that the goodwill is primarily related to the operating platforms acquired through the addition of the existing renewable HMO contracts in the case of ProMed and new business segments in the case of the Alta and Brotman acquisitions.

Goodwill and other intangible assets with indefinite useful lives are not amortized; rather they are reviewed annually for impairment for each reporting unit, or more frequently if impairment indicators arise. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. A two-step impairment test is used to identify potential goodwill impairment and to measure the amount of goodwill impairment loss to be recognized, if any. As further discussed in Note 10, the Company’s operations are organized into three reporting segments, within which there are four operating units, consisting of Alta, Brotman, ProMed and Prospect.

The Company tests for goodwill impairment in the fourth quarter of each year, or sooner if events or changes in circumstances indicate that the carrying amount may exceed the fair value. In evaluating whether indicators of impairment exist, the Company considers adverse changes in market value and/or stock price, laws and regulations, profitability, cash flows, ability to maintain enrollment and renew payer contracts at favorable terms, among other factors. The goodwill impairment test is a two-step process. The first step consists of estimating the fair value of the reporting unit based on a weighted combination of (i) the guideline company method that utilizes revenue or earnings multiples for comparable publicly-traded companies, and (ii) a discounted cash flow model that utilizes expected future cash flows, the timing of those cash flows, and a discount rate (or weighted average cost of capital, which considers the cost of equity and cost of debt financing expected by a typical market participant) representing the time value of money and the inherent risk and uncertainty of the future cash flows. If the estimated fair value of the reporting unit is less than its carrying value, a second step is performed to compute the amount of the impairment by determining the “implied fair value” of the goodwill, which is compared to its corresponding carrying value.

As discussed in Note 13, Brotman could potentially be a net payer under the Assembly Bill 1383 (“AB 1383”) as amended by the Assembly Bill 1653 (collectively “AB 1653”) by in excess of $4,000,000 through December 31, 2010. Brotman has been informed that, beginning February 14, 2011 withholds of its expected Medi-Cal payments in the amount of $65,000 per week are scheduled to start. Brotman management is contesting these withholds. Failure by management to successfully contest such withholds, however, could potentially be a triggering event that would require a specific impairment evaluation of Brotman’s intangibles. Such impairment evaluation would likely result in an impairment charge as early as the second quarter of fiscal 2011.

Due from/to Government Payers

Following the acquisition of a majority interest in Brotman, effective April 14, 2009, the Company consolidated Brotman’s estimated liability to the Centers for Medicare and Medicaid Services (“CMS”) arising out of outlier payments received for services provided by Brotman to Medicare eligible inpatients, primarily for the last four months of calendar year 2005 and all of calendar year 2006.

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While Brotman and Alta report financial statements on a fiscal year ending September 30, Medicare cost reports are filed on a calendar year basis. Acute care hospitals receive Medicare reimbursement payments pursuant to a prospective payment methodology primarily based on the diagnosis of the patient, but are entitled to receive additional payments, referred to as “outliers” for patients whose treatment is very costly. When Brotman acquired the hospital in 2005, CMS provided a ratio of cost to charges (the “RCC”) based on the statewide average. Payments received by Brotman on this basis were an interim estimate, subject to final determination upon auditing of Brotman’s cost reports. Brotman filed its Medicare cost reports, but determined that its outlier reimbursement for services provided in fiscal years 2005 and 2006 could be subject to adjustment based on certain outlier reconciliation rules. The Company believes that CMS has not conducted any outlier reconciliations under current regulations, has not formally notified Brotman of any pending reconciliation to be conducted regarding their cost reports and has not determined the amount of any liability at this point related to possible overpayments. As of December 31, 2010 and September 30, 2010, an estimated liability of $13,834,000 was included in each of the accompanying unaudited condensed consolidated balance sheets related to this matter.

Brotman and Alta have also accrued estimated third-party settlement net payables in the amount of $108,000 for filed cost reporting years and estimates for the three months ended December 31, 2010.  At September 30, 2010, estimated net receivables for cost reports not yet finalized were approximately $103,000.

The following is a summary of due from and due to governmental payers as of December 31 and September 30, 2010 (in thousands):

Revenues

Revenues by reportable operating segment are comprised of the following amounts (in thousands, unaudited):

The Company presents segment information externally the same way that Management uses financial data internally to make operating decisions and assess performance.  The Company’s operations are organized into three reporting segments: (i) Hospital Services, (ii) Medical Group, and (iii) Corporate (see Note 1).

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Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires Management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities at the dates, and for the periods, that the unaudited condensed consolidated financial statements are prepared. Actual results could materially differ from those estimates. Principal areas requiring the use of estimates include third-party settlements, receivables for medical services, allowances for contractual discounts and doubtful accounts, accruals for medical claims, impairment of goodwill, long-lived assets and intangible assets, valuation of interest rate swaps, share-based payments, professional and general liability claims and workers’ compensation claims, reserves for outcome of legislation and valuation allowances against deferred tax assets.

Recent Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board (“FASB”) issued guidance to amend the disclosure requirements related to recurring and nonrecurring fair value measurements. The guidance requires new disclosures on the transfers of assets and liabilities between Level 1 (quoted prices in active market for identical assets or liabilities) and Level 2 (significant other observable inputs) of the fair value measurement hierarchy, including the reasons and the timing of the transfers. Additionally, the guidance requires a roll forward of activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). Disclosures regarding transfers are required beginning January 1, 2010 and the Level 3 rollforward is to be disclosed in reporting periods beginning after December 15, 2010. Since the Company had no transfers between categories, the additional disclosures are not applicable for the periods presented.

In June 2009, the FASB issued revised guidance for the accounting of variable interest entities. This revised guidance replaces the quantitative-based risks and rewards approach with a qualitative approach that focuses on identifying which enterprise has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and has the obligation to absorb losses or the right to receive benefits from the entity that could be potentially significant to the variable interest entity. The accounting guidance also requires an ongoing reassessment of whether an enterprise is the primary beneficiary and requires additional disclosures about an enterprise’s involvement in variable interest entities. This accounting guidance is effective for the Company beginning in the first quarter of fiscal 2011. The adoption of this accounting guidance had no impact on the Company’s results of operations and did not have a material impact on the Company’s financial position.

In June 2009, the FASB issued revised guidance for the accounting of transfers of financial assets. This guidance eliminates the concept of a qualifying special-purpose entity, removes the scope exception for qualifying special-purpose entities when applying the accounting guidance related to the consolidation of variable interest entities, changes the requirements for derecognizing financial assets, and requires enhanced disclosure. This accounting guidance is effective for the Company beginning in the first quarter of fiscal 2011. The adoption of this accounting guidance had no impact on the Company’s results of operations and did not have a material impact on the Company’s financial position.

In August 2010, the FASB approved certain modifications to existing accounting standards that will directly affect health care entities in the future. The first change provides clarification to companies in the healthcare industry on the accounting for professional liability insurance. Specifically, it states that receivables related to insurance recoveries should not be netted against the related claim liability and such claim liabilities should be determined without considering insurance recoveries. The second change clarifies that disclosures regarding the level of charity care provided by a health care entity must (i) represent the direct and indirect costs of providing such services, and (ii) include a description of the method used to determine those costs. Additionally, disclosures about charity care must now include information regarding any related reimbursements received by a health care entity.

The modified accounting standards are required to be adopted for fiscal years that begin after December 15, 2010. Early adoption of such accounting standards is permitted. The charity care disclosure change must be applied on a retrospective basis; however, the accounting change for insurance recoveries may be applied on either a prospective or retrospective basis. The Company will adopt the modified accounting standards in the first quarter of fiscal year 2012 and is currently assessing the potential impact that the adoption will have on its condensed consolidated results of operations and condensed consolidated financial position.

Reclassification

Certain prior period amounts have been reclassified to conform to the current period presentation with no impact on the unaudited condensed consolidated net income (loss).

Subsequent Events

The Company’s unaudited condensed consolidated financial statements are considered issued when filed with the SEC.  Accordingly, the Company has evaluated subsequent events up to the filing date of this Form 10-Q with the SEC (see Note 15).

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3. Property, Improvements and Equipment

Property, improvements and equipment as of December 31 and September 30, 2010, consisted of the following (in thousands):

4.  The Ivy Merger

On August 16, 2010, the Company entered into an Agreement and Plan of Merger (the “Ivy Merger Agreement”) with Ivy Holdings Inc. (“Ivy Holdings”) and Ivy Merger Sub Corp. (“Merger Sub”), an indirect, wholly owned subsidiary of Ivy Holdings. On December 15, 2010 (the “Merger Effective Date”), at a special meeting of our stockholders, the adoption of the Ivy Merger Agreement was approved by the affirmative vote of a majority of our common stock outstanding as of the record date for the special meeting. In accordance with the Ivy Merger Agreement and the Delaware General Corporation Law on the Merger Effective Date, Merger Sub subsequently merged with and into the Company on December 15, 2010, and the Company became an indirect, wholly-owned subsidiary of Ivy Holdings (the “Ivy Merger”). Following the consummation of the merger, the Company’s common stock ceased trading on the NASDAQ Global Market and was delisted.

Pursuant to the Merger Agreement, at the Merger Effective Date:

·                  All outstanding options to purchase shares of the Company’s common stock were canceled and the holder of each such option received a cash payment equal to the excess of the $8.50 per share cash merger consideration over the exercise price of such option, multiplied by the number of shares subject to the option that are vested immediately prior to the Merger Effective Date, less any applicable withholding taxes and after giving effect to the determination of the Company’s compensation committee to accelerate the vesting of certain unvested options in connection with the Ivy Merger (see Note 5).

·                  Each outstanding warrant to purchase shares of our common stock was canceled and converted into the right to receive a cash payment equal to the excess of the $8.50 per share cash merger consideration over the exercise price of the warrant, multiplied by the number of shares subject to the warrant.

·                  Restrictions on each share of restricted stock issued under any of the Company’s equity incentive plans lapsed and each such share of restricted stock was converted into the right to receive the $8.50 per share merger consideration, less any applicable withholding taxes.

The Compensation Committee of the Board of Directors approved a contingent bonus in the amount of $1,235,000 paid to Samuel S. Lee, the Company’s Chief Executive Officer and Chairman of its Board of Directors, upon successfully completing the merger transaction. The Company’s controlling stockholders (the “Rollover Investors”), which were comprised of Mr. Lee, Mike Heather (the Company’s Chief Financial Officer), David R. Topper (the President of the Alta Hospitals Systems, LLC subsidiary) and Dr. Jeereddi A. Prasad (one of the Company’s directors and the President of ProMed Health Services Company), executed a voting agreement pursuant to which they agreed, subject to the terms thereof, to vote their shares of the Company’s common stock in favor of the approval and adoption of the Ivy Merger Agreement. The voting agreement provided the requisite stockholder approval for the merger.

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Pursuant to a contribution and subscription agreement, immediately prior to the completion of the merger, the Rollover Investors contributed a total of 6,227,824 shares of the Company common stock (the “Rollover Shares”) in exchange for shares of Ivy Holdings common stock. Following the completion of the merger, Messrs. Lee, Topper, Heather and Dr. Prasad beneficially own approximately 20.2%, 14.9%, 1.6% and 1.2%, respectively, of the outstanding common stock of Ivy Holdings (excluding any stock options that may be granted to the Rollover Investors pursuant to a management equity incentive plan that Ivy Holdings adopted in December 2010, as further discussed in Note 5).

The terms of the contribution and subscription agreement entitled Messrs. Lee and Topper, in their discretion, to offer other employees of the Company the ability to acquire shares of Ivy Holdings common stock on the same terms and conditions as the Rollover Investors. Immediately prior to the completion of the merger, a group of eleven employees of the Company (the “Additional Employee Investors”) contributed to Ivy Holdings approximately 136,765 shares of the Company’s common stock in exchange for shares of Ivy Holdings’ common stock. Following the completion of the merger, the Additional Employee Investors beneficially own a total of approximately 0.8% of the outstanding common stock of Ivy Holdings (excluding any stock options that may be granted to the Additional Employee Investors pursuant to a management equity incentive plan that Ivy Holdings adopted in December 2010, as further discussed in Note 5). In connection with the exercise of the Company’s stock options to be rolled into shares of Ivy Holdings, approximately $935,000 of stock subscriptions receivable was due from the Rollover and Additional Employee Investors at December 31, 2010.

The LGP Funds, affiliated investment funds of Leonard Green Partners, L.P., own the remainder of the common stock of Ivy Holdings not owned by the Rollover Investors and the Additional Employee Investors. As a result, at the Merger Effective Date, the Company, which became a wholly-owned subsidiary of Ivy Holdings, is 62% indirectly owned by the LGP Funds and 38% owned by the Rollover and Additional Employee Investors. As the change in control is less than 85%, no push down accounting is applicable. In connection with the merger, the Company also received a capital contribution of approximately $844,000 from the LGP Funds. In connection with such capital contribution and the acceleration of unvested options at the Effective Merger Date, additional paid-in capital totaling approximately $9,200,000 was recorded in the first quarter of the fiscal 2011 period.

Following the merger, each holder of the Company’s senior secured notes described in Note 8 below was entitled under the notes’ indenture to require the Company to repurchase all or a portion of the holder’s senior secured notes at a cash purchase price equal to 101% of the principal amount of the senior secured notes plus accrued and unpaid interest. Accordingly, following the Merger Effective Date, notice was provided to each holder of such notes advising the holder that it was entitled under the indenture, prior to January 14, 2011, to require the Company to purchase the senior secured notes held by the holder at a purchase price equal to 101% of the principal amount of the senior secured notes, plus accrued and unpaid interest to the date of purchase. In December 2010 and January 2011, a total of approximately $8,200,000 of the senior secured notes was tendered by note holders and was purchased by the Company in January 2011.  Given the expiration of the tender offer period, the $8,200,000 of the debt is classified as current as of December 31, 2010.  The remaining outstanding $151,800,000 in principal amount of senior secured notes have been reflected as non-current in the accompanying December 31, 2010 unaudited condensed consolidated balance sheet (refer to Note 8).

Following the announcement of the merger, two putative class action complaints were filed against the Company, each of the Rollover Investors, each of the special committee members, Ivy Holdings, the Merger Sub, and Leonard Green & Partners, L.P. These complaints, which were consolidated into a single action, allege generally that defendants breached their fiduciary duties, or aided and abetted others’ breaches of their fiduciary duties, in connection with the transaction with the Company by, among other things, authorizing the transaction for what plaintiffs claim to be inadequate consideration and pursuant to what plaintiffs claim to be an inadequate process and with inadequate disclosures.  The complaint seeks, among other relief, an injunction against the proposed merger, rescission of the merger or recessionary damages to the putative class if the merger is completed and an award of costs, including attorneys’ fees and experts’ fees.  On December 28, 2010, plaintiffs filed a motion for class certification which remains pending, and plaintiffs have indicated that they are planning to amend and update the complaint in light of the completion of the merger and to amend their motion for class certification.

On December 30, 2010, another lawsuit was filed in Delaware Chancery Court by six shareholders against the same defendants identified above.  The complaint alleges generally that the consideration offered to shareholders in connection with the transaction with the Company was inadequate in light of the revenue received under the one-time supplemental payments to certain medical facilities pursuant to AB 1653 (described in Note 13), and that defendants breached their fiduciary duties, or aided and abetted others’ breaches of their fiduciary duties by not obtaining a higher price in light of this additional revenue.

Defendants believe the claims alleged in both suits are without merit and intend to vigorously defend against the suits.

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In connection with the merger, in the three months ended December 31, 2010, the Company incurred a total of approximately $13,300,000 of merger-related expenses. The majority of these costs were expensed during the three months then ended in accordance with generally accepted accounting principles.

5. Equity-Based Compensation Plans

On August 13, 2008, the Company adopted the 2008 Omnibus Equity Incentive Plan (“2008 Plan”) to provide flexibility in implementing equity awards, including incentive stock options (“ISO”), non-qualified stock options (“NQSO”), restricted stock grants, stock appreciation rights (“SAR”) and performance based awards to employees, directors and outside consultants, as determined by the Compensation Committee of the Board of Directors (the “Committee”). In conjunction with the adoption of the 2008 Plan, effective August 13, 2008, additional equity awards under the Company’s 1998 Stock Option Plan (“1998 Plan”) were discontinued and new equity awards until the completion of the Ivy Merger were granted under the 2008 Plan. Remaining authorized shares under the 1998 Plan which were not subject to outstanding awards as of August 13, 2008, were canceled on August 13, 2008. The 1998 Plan remained in effect as to outstanding equity awards granted under the 1998 Plan prior to August 13, 2008. At the inception of the 2008 Plan, 4,000,000 shares were reserved for issuance under the 2008 Plan.

As a result of the Ivy Merger, both the 1998 Plan and the 2008 Plan were terminated and any unexercised options outstanding under the plans, the individual option agreements and any stock options issued outside of a plan were cancelled.  Any offerings of common stock upon exercise of any such options pursuant to their registration statements were terminated.

Effective December 15, 2010, the Board of Directors of Ivy Holdings adopted its 2010 Stock Option Plan that authorizes the issuance of options exercisable for up to 155,110 shares of the common stock of Ivy Holdings to employees, certain consultants and independent members of the boards of directors, of Ivy Holdings and its subsidiaries (including the Company and its subsidiaries). As of the date of the filing of this report on Form 10-Q, no options have been granted under the Ivy Holdings’ plan.

Stock Options Activity

The following table summarizes information about our stock options outstanding as of December 31, 2010 and activity during the three-month period then ended:

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of our common stock for those awards that have an exercise price currently below the quoted market price.

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A summary of the Company’s nonvested options and the changes during the periods ended December 31, 2010 and September 30, 2010 is presented as follows (in thousands, except weighted average grant date fair value):

As discussed in Note 4, in connection with the cancellation of the Company’s stock option plans, the vesting of certain unvested stock options was accelerated. As required under GAAP, cancellation of an award accompanied by the concurrent grant of a replacement award or other consideration should be accounted for as a modification of the stock option terms.  Thus incremental compensation cost, measured as the excess of the replacement award’s fair value over the fair value of the cancelled award (at the cancellation date), totaling approximately $1,400,000 was recorded in the three months ended December 31, 2010. The replacement awards are valued based on per share cash merger consideration of $8.50.

Unvested stock options that were not modified were cancelled, thus requiring the acceleration of the remaining unamortized stock based compensation totaling approximately $252,000, which was expensed in the three months ended December 31, 2010.

Stock-Based Compensation Expense

Stock-based compensation expense for all share-based payments in exchange for employee services (including stock options and restricted stock) is measured at fair value on the date of grant, estimated using an option pricing model and is recognized in the financial statements, net of estimated forfeitures over the awards requisite service period.

Compensation expenses for stock-based awards are measured and recognized in the financial statements, net of estimated forfeitures over the awards requisite service period. The Company uses the Black-Scholes option pricing model and a single option award approach to estimate the fair value of options granted. Estimated forfeitures will be revised in future periods if actual forfeitures differ from the estimates and will impact compensation cost in the period in which the change in estimate occurs. The determination of fair value using the Black-Scholes option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables, including expected stock price volatility, risk-free interest rate, expected dividends and projected employee stock option exercise behaviors. Equity-based compensation is classified within the same line items as cash compensation paid to employees. Cash retained as a result of excess tax benefits relating to share-based payments are presented in the statement of cash flows as a financing cash inflow.

Expected Term—The expected term of options granted represents the period of time that they are expected to be outstanding. The Company has adopted the “simplified method” of determining the expected term for “plain vanilla” options, as allowed under the Securities and Exchange Commission Staff’s shortcut approach. The “simplified method” states that the expected term is equal to the sum of the vesting term plus the contract term, divided by two. “Plain vanilla” options are defined as those granted at-the-money, having service time vesting as a condition to exercise, providing that non-vested options are forfeited upon termination and that there is a limited time to exercise the vested options after termination of service, usually 90 days, and providing the options are non-transferable and non-hedgeable.

Risk-Free Interest Rate—The Company bases the risk-free interest rate on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon issues with equivalent remaining terms.

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Expected Volatility—The Company estimates the volatility of the common stock at the date of grant based on the average of the historical volatilities of a group of peer companies. Since the Company’s shares did not become publicly traded until May 2005 and trading volume was limited, Management did not believe there was sufficient historical volatility data available to predict the stock’s future volatility. The Company has identified a group of comparable companies to calculate historical volatility from publicly available data for sequential periods approximately equal to the expected terms of the option grants. In selecting comparable companies, Management considered several factors including industry, stage of development, size and market capitalization.

Forfeitures—Share-based compensation is recognized only for those awards that are ultimately expected to vest. Compensation expense is recorded net of estimated forfeitures. Those estimates are revised in subsequent periods if actual forfeitures differ from those estimates. The Company used data since May 2005 to estimate pre-vesting option forfeitures.

Stock-based compensation expense for stock options recognized in the three months ended December 31, 2009 was approximately $520,000.

See above regarding the treatment of the cancellation of the Company’s stock option plans and the acceleration of the vesting of certain stock options in conjunction with the Ivy Merger.

Restricted Stock Award Activities

On August 15, 2008, the Company granted 200,000 shares of restricted stock to its Chief Financial Officer with a grant date fair value of $2.40 per share. On December 18, 2009, the Company granted an aggregate of 210,000 shares of restricted stock to its Chief Executive Officer and Chief Financial Officer. Compensation expense relating to restricted stock recorded in the three months ended December 31, 2009 was approximately $509,000. As discussed in Note 4, at the Merger Effective Date, the vesting of 33,334 restricted shares was accelerated. As required under GAAP, the modification of the terms required the revaluation at the date of modification and this resulted in approximately $209,000 of stock based compensation expense in the three months ended December 31, 2010.

On November 12, 2009, the Company granted an aggregate of 36,000 shares of fully-vested restricted stock to outside members of the Board of Directors. Approximately $144,000 of expense relating to these shares was included in general and administrative expense in the accompanying unaudited condensed consolidated financial statements during the three months ended December 31, 2009.

On November 10, 2010, the Company granted an aggregate of 18,000 shares of fully-vested restricted stock to outside members of the Board of Directors. Approximately $152,000 of expense relating to these shares was included in general and administrative expense in the accompanying unaudited condensed consolidated financial statements during the three months ended December 31, 2010.

6. Earnings per Share

The Company calculates basic net income (loss) per share by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding, after giving effect to potentially dilutive shares computed using the treasury stock method. Such shares are excluded if determined to be anti-dilutive.

The calculations of basic and diluted net income per share attributable to Prospect were as follows (in thousands, except share and per-share amounts, unaudited):

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The number of stock options and warrants excluded from the computation of diluted earnings per share due to being anti-dilutive were 1,434,537 and 475,774 shares, respectively, during the three months ended December 31, 2009.

Effective December 15, 2010, upon the consummation of the Ivy Merger, the Company became an indirect, wholly-owned subsidiary of Ivy Holdings, and the Company’s common stock ceased trading on the NASDAQ Global Market and was delisted. As such, the Company is no longer required to present earnings per share data in the fiscal 2011 reporting periods.

7. Related Party Transactions

The Company had an employment agreement with Dr. Terner that expired on August 1, 2008 and provided for base compensation (most recently $400,000 per year) and further provided that if the Company terminated Dr. Terner’s employment without cause, the Company would pay him $12,500 for each month of past service as the Chief Executive Officer, commencing as of July 31, 1996, up to a maximum of $1,237,500. Dr. Terner resigned as the Chief Executive Officer of the Company effective March 19, 2008 and resigned as Chairman of the Board of Directors effective May 12, 2008. In consideration of Dr. Terner’s resignation and other promises in his resignation agreement, the Company agreed to pay to his family trust the sum of $19,361.10 each month during the twelve-month period ending on April 30, 2009 and the sum of $42,694.45 each month during the twenty-four month period ending on April 30, 2011, for the total sum of $1,257,000, which amount was recorded as a general and administrative expense in the third quarter of fiscal 2008. In September 2009, the Company ceased making payments to Dr. Terner following its determination that Dr. Terner was not entitled to receive such payments. Subsequently, Dr. Terner filed a complaint against the Company seeking restoration of the payments. The Company and Dr. Terner are currently litigating this dispute.

On August 1, 2005 and subsequently amended on October 25, 2007, Prospect Medical Management, Inc. (now known as Prospect Hospital Advisory Services, Inc. (“PHAS”)), a subsidiary of the Company, entered into a consulting services agreement, to provide administrative, financial and management consulting services to Brotman for a monthly fee of $100,000 plus expenses. The agreement had an initial term of one year and automatically renewed for additional one-year terms unless terminated by either party with 90 days written notice. As discussed in Note 9, Brotman, which filed a voluntary petition for bankruptcy protection under Chapter 11 of the U. S. Bankruptcy Code on October 25, 2007, emerged from Chapter 11 bankruptcy proceedings on April 14, 2009 (the “Effective Date”). On the Effective Date, the Company increased its approximately 33.1% ownership stake in Brotman, to approximately 72% via an incremental investment of approximately $2.5 million. Beginning April 14, 2009, amounts earned under the agreement have been eliminated in consolidation.

Effective December 15, 2009, the Board of Directors of Brotman authorized certain designated officers to enter into an amendment to the consulting services agreement between Brotman and PHAS (“Amended and Restated Consulting Services Agreement”).  The Amended and Restated Consulting Services Agreement, which was executed on February 1, 2010, states inter alia, that effective April 14, 2009, PHAS shall be entitled to receive a monthly fee of 4.5% of Brotman’s net operating revenue.  To the extent Brotman does not have sufficient cash to make such cash payment, or is otherwise restricted in its ability to pay all amounts due by agreements applicable to Brotman or PHAS, then PHAS shall be entitled to receive shares of common stock of Brotman.  All amounts under this agreement are eliminated in consolidation.

On December 15, 2009, Brotman initiated a rights offering, whereby existing shareholders of Brotman could subscribe to purchase up to $5,500,000 of Brotman convertible subordinated promissory notes (the “Brotman Notes”).  The Brotman Notes are due three years from the date of issuance, bear interest at 15% per annum, and are convertible at the option of the holder into shares of Brotman at $3.34 per share.  PHAS exercised its right to purchase a portion of its pro rata (approximately 72%) share of the Brotman Notes and, effective January 7, 2010, purchased $3,500,000 of such Brotman Notes.

As a result of the rights offering, Culver Hospital Holdings, L.P. (“Culver”), a minority shareholder of Brotman, filed a shareholder complaint against Prospect, PHAS, Brotman, and each member of the Brotman Board of Directors.  The court granted a preliminary injunction that enjoins Prospect from taking the following actions: (1) acquiring Culver’s share of convertible promissory notes, (2) converting the Brotman Notes into shares of Brotman common stock, (3) converting Brotman’s debt owed to Prospect into shares of Brotman common stock, and (4) using the proceeds of the rights offering to repay debt that Brotman owes to Prospect. Prospect has filed a notice of appeal.

On November 4, 2010, Brotman commenced a new rights offering pursuant to which it offered all shareholders of record as of the close of business on the record date of October 31, 2010 the right to subscribe and purchase all or any portion of their proportionate share of the total 1,288,659 shares of its common stock offered at a price of $2.91 per share. The offering provided for an oversubscription period during which eligible record shareholders who fully subscribed during the initial offering period were entitled to purchase the remaining unsubscribed shares at the same price of $2.91 per share. The oversubscription period began with a mailing to qualified rights holders on November 4, 2010 and terminated on November 15, 2010. Following the consummation of this

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rights offering, PHAS, having participated in the amount of $3,065,000, increased its existing ownership stake in Brotman from approximately 72% to approximately 78%.

See Note 15 for discussion of February 2011 rights offering.

PMG, an affiliated physician organization of the Company, entered into a risk pool sharing agreement, dated May 1, 2005, with Brotman. Under the agreement, PMG and Brotman agreed to establish a Hospital Control Program (as defined) to serve HMO enrollees and earn incentive revenue or incur penalties by sharing in the risk for hospitalization based on inpatient services utilized. Risk pools are generally settled in the following year. All amounts earned under the agreement are eliminated in consolidation.

In connection with the above-described risk-sharing agreement, Prospect Medical Systems, Inc. (“PMS”) and Brotman entered into an Administrative Services Agreement, dated October 1, 2005, as amended on October 1, 2009, that provides for the administration by PMS of the payment of claims under such risk-sharing arrangement, with all administrative fees being eliminated in consolidation.

On August 31, 2005, PMG, entered into a joint marketing agreement with Brotman. The agreement is for an initial term of 20 years, renewable for successive five-year terms unless terminated by either party with 180 days written notice. During the term of this agreement, Brotman will contract exclusively with PMG with regard to full risk contracting with HMOs for all lines of business, including Medicare, Medi-Cal and commercial enrollees. Brotman will not merge into, consolidate with, or sell substantially all of its assets (unless the purchaser or surviving entity expressly assumes these managed care exclusivity arrangements), it will not alter such agreements without the consent of PMG, and it agrees to be bound by the exclusivity provision.

On March 1, 2010, Alta entered into an agreement with an HMO, pursuant to which, Alta would provide hospital, medical, and other healthcare services to approximately 2,000 senior HMO enrollees under a fixed capitation arrangement (the “Capitation Arrangement”). Concurrently, on March 1, 2010, Alta entered into a risk pool sharing agreement with PMG and Prospect Health Source Medical Group (“PHS”) and a management services agreement with PMS. Under the risk pool sharing agreement, Alta, PMG and PHS agreed to establish a Hospital Control Program (as defined) to serve the HMO enrollees, pursuant to which, PMG is allocated a 90% residual interest in the profit or loss, after deductions for costs to Alta hospitals. Under the management services agreement, PMS provides non-hospital and non-physician support activities that are required under the agreement with the HMO, in return for a monthly management fee of 10% of earned revenue (as defined).  All amounts earned under the risk pool sharing and management services agreements are eliminated in consolidation.

Certain officers of the ProMed Entities have ownership interests in a medical physician group that provides medical services on a fee-for-service basis. For the three months ended December 31, 2010 and 2009, the ProMed Entities paid medical claims to the group of approximately $3,600,000 and $3,300,000, respectively.

In connection with the Ivy Merger described in Note 4 above, on December 10, 2010, Prospect Green Management, LLC (“PGM”) was formed as a wholly owned subsidiary of the Company. PGM exists solely to enter into, and perform under, the Management Services Agreement, dated December 15, 2010 (the “LGP Management Agreement”), between PGM and Leonard Green & Partners, L.P. (“LGP”). Pursuant to the terms of the LGP Management Agreement, LGP provides to PGM and other subsidiaries of Ivy Holdings, (a) certain investment banking services, (b) management, consulting and financial planning services and (c) financial advisory and investment banking services in connection with major financial transactions from time to time. In consideration for the services provided by LGP under the LGP Management Agreement, PGM pays LGP an annual fee of $1,000,000, payable in monthly installments, and reimburses LGP for its related expenses up to $50,000 annually. If approved by the unanimous consent of the Board of Directors of PGM (which is comprised of the same members as the Boards of Directors of Ivy Holdings and the Company), additional customary fees may be due to LGP pursuant to the terms of the LGP Management Agreement for services rendered in connection with major transactions from time to time. For services rendered by LGP in connection with the consummation of the Ivy Merger, a one time structuring fee of $4,441,000 was paid by PGM to LGP.

Concurrent with the closing of the Ivy Merger on December 15, 2010, Ivy Holdings, Ivy Intermediate Holding Inc. (“Ivy Intermediate”) and the Company entered into a Tax Sharing Agreement. Following the consummation of the Ivy Merger, the Company is now a wholly owned subsidiary of Ivy Intermediate which is a wholly owned subsidiary of Ivy Holdings. Therefore, Ivy Holdings is now the parent of an affiliated group of corporations within the meaning of Section 1504(a) of the Internal Revenue Code of 1986. The Tax Sharing Agreement allows the Company to make payments to Ivy Holdings and/or Ivy Intermediate as necessary to fund their payment of any required taxes incurred due to such parent status.

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8. Long-Term Debt

Long-term debt consists of the following (in thousands):

Prospect’s Debt:

Senior Secured Notes

On July 29, 2009, the Company closed the offering of $160 million in 12.75% senior secured notes due 2014 (the “Notes”) at an issue price of 92.335%. The sale was executed in accordance with Rule 144A under the Securities Act of 1933 and Regulation S under the Securities Act of 1933. Concurrent with the issuance of the Notes, the Company entered into a three year $15 million revolving credit facility which was undrawn at closing and is still undrawn, with any future borrowings bearing interest at London Interbank Offered Rate (“LIBOR”) plus 7.00%, with a LIBOR floor of 2.00%.

The Company used the net proceeds from the sale of the Notes to repay all remaining amounts outstanding under its former $155 million senior secured credit facility, plus a prepayment premium of approximately $2.6 million. The Company reflected the prepayment premium, together with the write-off of approximately $560,000 of deferred financing costs related to its former credit facilities, as interest expense in the fourth quarter of fiscal 2009. Capitalized deferred financing costs and original issue discount related to the Notes is being amortized over the term of the related debt using the effective interest method.

The terms of the Notes are governed by an indenture among the Company, certain of its subsidiaries and affiliates (as guarantors), and U.S. Bank National Association (as trustee) (the “Indenture”). Interest is payable semi-annually in arrears on January 15 and July 15. The terms of the revolving senior secured credit facility are governed by the Credit Agreement, dated as of July 29, 2009, among the Company, Royal Bank of Canada (as administrative agent), Jefferies Finance LLC (as co-syndication agent) and the lenders party thereto (the “Credit Agreement”).

The Notes and the revolving senior secured credit facility are jointly and severally guaranteed on a senior secured basis by all of the Company’s restricted subsidiaries (as such term is defined in the Indenture) other than Brotman, Nuestra and certain immaterial subsidiaries. The Notes are secured pari passu with the revolving credit facility on a first priority basis by liens on substantially all of the Company’s assets and the assets of the subsidiary guarantors (other than accounts receivable) including all the mortgages on the Company and its subsidiary guarantors’ hospital properties (but excluding a pledge of, or mortgage on, the stock, properties or other assets of Brotman, AMVI/Prospect Medical Group and certain immaterial subsidiaries). The lenders under the revolving credit facility have a first priority lien on certain of the accounts receivable of the Company and the subsidiary guarantors while the holders of the Notes have a second priority lien on such collateral.

The Indenture requires the Company to offer to repurchase the Notes at 101% of their principal amount in the event of a change of control of the Company and at 100% of the principal amount with certain proceeds of sales of assets. The Indenture also contains certain covenants that, among other things, limit the Company’s ability, and the ability of its restricted subsidiaries to: pay dividends or distributions on capital stock or equity interests, prepay subordinated indebtedness or make other restricted payments; incur additional debt; make investments; create liens on assets; enter into transactions with affiliates; engage in other businesses; sell or issue capital stock of restricted subsidiaries; merge or consolidate with another company; transfer and sell assets; create dividend and other payment restrictions affecting subsidiaries; and designate restricted and unrestricted subsidiaries. The Credit Agreement contains a number of customary covenants as well as covenants requiring the Company to maintain a maximum consolidated leverage ratio, minimum fixed charge coverage ratio and a maximum consolidated total leverage ratio. As of December 31, 2010, the Company was in compliance with the financial covenants of the Indenture and Credit Agreement.

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Pursuant to its definitive Prospectus filed with the SEC a Form S-4 on October 26, 2009, the Company offered to exchange (the “Exchange Offer”) up to $160 million of its 12.75% Senior Secured Notes, Series B, due 2014 (the “Exchange Notes” and together with the Original Notes, the “Notes”) for an equal amount of the Notes issued on July 29, 2009 (the “Original Notes”). The Exchange Notes are substantially identical to the Original Notes, except that the offer and sale of the Exchange Notes have been registered under the Securities Act of 1933, as amended, and the Exchange Notes do not bear any legend restricting their transfer. The Exchange Offer was finalized on December 3, 2009, at which time $159 million of the $160 million aggregate principal amount of private notes had been tendered and accepted for exchange. Pursuant to a post-effective amendment to the form S-4 filed with the SEC on December 3, 2010, the Company removed from registration the Exchange Notes that were not issued because the corresponding Original Notes were not tendered for exchange.

The Notes will mature on July 15, 2014. Prior to July 15, 2012, the Company may redeem up to 35% of the original principal amount of the Notes at a redemption price equal to 112.75% of the principal amount of the Notes redeemed, plus any accrued and unpaid interest, with the proceeds of certain equity offerings. From July 15, 2012 until July 15, 2013, the Company may redeem all, or any portion, of the Notes at a redemption price equal to 106.375% of the principal amount of the Notes redeemed, plus any accrued and unpaid interest. After July 15, 2013, but before the maturity date of July 15, 2014, the Company may redeem all, or any portion, of the Notes at a redemption price equal to 100% of the principal amount of the Notes redeemed, plus any accrued and unpaid interest.

Following the Ivy Merger, each holder of the Company’s senior secured notes was entitled under the notes’ indenture to require the Company to repurchase all or a portion of the holder’s senior secured notes at a cash purchase price equal to 101% of the principal amount plus accrued and unpaid interest. Accordingly, following the effective time of the merger, notice was provided to each holder of such notes advising the holder that it was entitled under the indenture, prior to January 14, 2011, to require the Company to purchase the senior secured notes held by the holder at a purchase price equal to 101% of the principal amount of the senior secured notes, plus accrued and unpaid interest to the date of purchase. Senior secured notes with an aggregate principal amount of $8,200,000 were tendered, and Prospect repurchased such notes effective January 19, 2011. The $8,200,000 of senior secured notes repaid in January 2011 have been classified as a current liability in the accompanying December 31, 2010 balance sheet, while the remaining $151,800,000 not tendered has been classified as a non-current liability.

On December 15, 2010, the effective time of the merger, the Company and U.S. Bank National Association, a national banking association (the “Trustee”), entered into a First Supplemental Indenture (the “First Supplemental Indenture”) in connection with the merger, pursuant to which the Company is permitted under Section 3.3 of the Indenture to make certain “Restricted Payments” immediately following consummation of the merger. Also on December 15, 2010, the Company and Royal Bank of Canada entered into a Consent and Agreement that provided for certain consents in connection with the Ivy Merger and certain amendments of covenants and conditions contained in the Credit Agreement.

Brotman’s Debt:

Brotman has debt under a Senior Secured Revolving Credit Facility, Secured Term Loans and an Unsecured Subordinated Promissory Note entered into in conjunction with affecting its Plan of Reorganization. The Company has not guaranteed any portion of Brotman’s debt or other obligations. Given the Company’s majority ownership in Brotman, effective April 14, 2009, all Brotman debt is included in the Company’s consolidated financial statements. The Company has no obligation to fund Brotman’s operations. Under the Company’s senior secured revolving credit agreement, as amended on December 15, 2010, the Company is permitted to make additional investments in Brotman in an aggregate amount not to exceed $15,000,000, provided that such investments can exceed $15,000,000 if the amounts are funded solely with the proceeds of Equity Interests of the Company (as defined).

Senior Secured Revolving Credit Facility

On April 14, 2009, the Effective Date of the Plan of Reorganization, Brotman obtained a commitment from Gemino Healthcare Finance, LLC (“Gemino”) for a three year, $6.0 million (subsequently increased to $7.0 million pursuant to an amendment described below), senior credit facility secured by Brotman’s accounts receivable. The facility expires on the earlier of April 14, 2012 and the Los Angeles Jewish Home for Aging (“JHA”) loan (see below) maturity date and bears interest at LIBOR plus 7% per annum (11.0% as of December 31, 2010, given a LIBOR floor of 4%). Interest is incurred based on the greater of $2 million or the actual outstanding principal balance. The agreement also includes an unused line fee of 0.5% per annum and a collateral line fee, based on the average outstanding principal balance, of 0.5% per annum. Loan fees associated with the Gemino loan totaling approximately $120,000, were capitalized and have been included as deferred financing costs in the accompanying unaudited condensed consolidated balance sheet as of December 31, 2010, with the amount being amortized over the term of the related debt using the effective interest method. The senior credit facility agreement contains customary covenants for facilities of this type, including restrictions on the payment of dividends, change in ownership and management, asset sales, incurrence of additional indebtedness, sale-leaseback transactions, and related party transactions. Brotman must also comply with certain financial covenants. Prior to the February 17, 2010 amendment discussed below, Brotman was required to comply with a fixed charge coverage ratio of not less than (i) 1.10:1.00 for the fiscal quarter ended December 31, 2009, (ii) 1.15:1.00 originally for the fiscal quarter ended September 30, 2009; and (iii) 1.20:1.00 for each fiscal quarter ending thereafter.

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Pursuant to an amendment entered into effective December 11, 2009, the Gemino credit agreement was amended to provide, among other things, a waiver of the specified events of default and the amendment to the definition of fixed charge coverage ratio. Under the amended credit agreement, the fixed charge coverage ratio was amended to require not less than (i) 1.00:1.00 for the fiscal quarters ended December 31, 2009 and March 31, 2010; (ii) 1.05:1.00 for the fiscal quarters ended December 31, 2010 and ending September 30, 2010, (iii) 1.10:1.00 for the fiscal quarters ending December 31, 2010 and March 31, 2011, and (iv) 1.20:1.00 for the fiscal quarter ending June 30, 2011 and each fiscal quarter ending thereafter. Pursuant to an amendment entered into effective February 17, 2010, the Gemino credit agreement and promissory note were amended to increase the loan commitment by $1.0 million, to a total commitment of $7.0 million. As of December 31, 2010, Brotman was not in compliance with the required financial covenants under the amended credit agreement. Brotman’s management is currently negotiating with the lender to obtain a waiver of the covenant violations. The lender may not grant such waiver and could require full and immediate repayment of the loan, which would negatively impact Brotman’s liquidity, ability to operate and ability to continue as a going concern.

The average outstanding balance and average interest rate on the senior secured revolving credit facility for the three-month period ended December 31, 2010 approximated $5,898,000 and 11%, respectively.

Secured Credit Facilities Term Loans: A and B

On April 14, 2009, the effective date of the Plan of Reorganization, JHA agreed to provide Brotman with up to $22.25 million in financing, consisting of two term loans: (i) a Term A Loan of $16 million (the “Term A Loan”) with a 24-month term and (ii) a Term B Loan of up to $6.25 million, with a term of 36 months (the “Term B Loan”). Subject to the notification requirements set forth in the loan agreements, the term of the Term A Loan can be extended up to 36 months. Interest on the Term A Loan is payable at 10% per annum for the first year of the loan, and 7.5% thereafter. Interest on the Term B Loan is payable at 10% per annum for the term of the loan. The Term A Loan and Term B Loan are secured by certain of Brotman’s personal property, and a mortgage on certain of Brotman’s real property. The proceeds of the JHA loans were used to repay all existing senior secured loans at Brotman as of April 14, 2009. Loan fees associated with the JHA loans totaling approximately $1,549,000, were capitalized and have been included as deferred financing costs in the accompanying unaudited condensed consolidated balance sheet as of December 31, 2010, with that amount being amortized over the term of the related debt using the effective interest method.

With respect to the Term A Loan, JHA was granted the right (“Put Right”) to declare the unpaid loan amount, including remaining interest and any other amounts due and payable under the loan agreements, immediately due and payable at any time after April 14, 2010 and prior to the date which is twenty-four months after the Closing Date, subject to JHA providing written notification to Brotman of its exercise of the Put Right at least 180 days in advance.  Effective February 10, 2010, JHA and Brotman entered into an amendment to the Term A Loan, whereby the earliest date on which JHA could provide notice of its exercise of the Put Right was extended from April 14, 2010 to October 14, 2010, effectively extending the earliest maturity date for the Term A Loan to April 14, 2011. Brotman and JHA are currently negotiating a comprehensive amendment to and extension of the Term A Loan, pending completion of which, amounts owing under this loan have been reflected as current in the accompanying December 31, 2010 unaudited condensed consolidated balance sheet.

As part of the JHA financing, Brotman granted JHA an option to purchase certain Brotman-owned property, where JHA plans to construct a senior living facility, for a purchase price equal to the outstanding principal balance of the Term A Loan plus any prepaid amounts. In connection with JHA’s option right, Brotman is required to deposit $130,000 monthly into a reserve account (up to a maximum of $3,120,000), with such funds specifically earmarked for the construction of a new Brotman emergency room. Additionally, Brotman is required to deposit $10,000 monthly into a reserve account for capital improvements and a Tax and Insurance Deposit Account. As of December 31, 2010, Brotman is delinquent on these required deposits in the amount of approximately $310,000. Accordingly, the Term B Loan has been reclassified as current in the accompanying unaudited condensed consolidated balance sheet as of December 31, 2010.

In accordance with relevant accounting pronouncements, the Term A Loan, which contains a real estate purchase option, is recorded at its present value, with any excess of the proceeds over that amount recorded as an option deposit liability account. The present value of the loan was estimated using discounted cash flow analyses based on market rates obtained from independent third parties for similar type debt. Based on an estimated market interest rate of 10.0%, the present value of the loan was estimated to be approximately $15,655,000 at inception. The difference of $345,000 between the recorded present value and the face value of the loan has been recorded as a discount against the loan and is being amortized to interest expense, using the effective interest rate method, over the term of the loan. The Company began amortizing the discount during the quarter ending June 30, 2010. For the three months ended December 31, 2010 and 2009, amortization expense in the amount of $85,000 and $75,000, respectively was recorded in the accompanying unaudited condensed consolidated financial statements.

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Subordinated Promissory Note

On April 14, 2009, the Effective Date of the Plan of Reorganization, Brotman executed a $4,000,000 unsecured Class 4 Note, to be held by the Creditor Trust for the benefit of holders of allowed Class 4 claims (as defined in the Plan of Reorganization) and paid pro rata to holders of allowed Class 4 claims. The Note bears interest at 7.50% per annum and is payable in sixteen equal quarterly installments of principal and accrued interest through February 15, 2013. The Note contains a covenant which, so long as amounts remain outstanding under the Note, restricts Brotman from paying Prospect Hospital Advisory Services, Inc. a consulting fee of more than $100,000 per month, as specified in the Amended and Restated Consulting Services Agreement (see Note 7).  As such, although the amount of the consulting fee was increased to 4.5% of Brotman’s net operating revenue effective April 14, 2009, the amount of such consulting fee actually paid in cash will not exceed $100,000 per month until such time as permitted by applicable agreement, or the Creditor Trust Note has been amended or repaid. Brotman has not made any payments under the consulting services agreement since September 2009.

9. Acquisitions

Brotman Medical Center, Inc.

On August 31, 2005, the Company invested $1,000,000 for an approximately 33.1% stake in Brotman, a 420-bed licensed and accredited acute care hospital, located in Culver City, California. The Company made the investment with the intention that it, with Brotman, would be able to offer joint contracting to HMOs operating in Brotman’s service area. Brotman incurred significant losses before and after the Company’s initial investment and, on October 25, 2007 (the “Petition Date”), Brotman filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code. On the Petition Date, the Company entered into an amendment to its existing consulting services agreement with Brotman, providing for an increased level of service (see Note 7). Additionally, effective April 22, 2008, Samuel S. Lee (Prospect’s CEO and Chairman of the Board) was appointed as the Chairman of the Board of Directors of Brotman. On August 31, 2010, Mr. Lee resigned from his position as Chairman of the Brotman Board, and Mr. Heather was appointed to replace Mr. Lee.

On April 14, 2009 (The “Effective Date”), the U.S. Bankruptcy Court confirmed and declared effective the final Chapter 11 Plan of Reorganization (the “Plan”) of Brotman whereby, among other things, all of Brotman’s outstanding securities were canceled and, in exchange for their pro rata share of the New Value Contribution (as defined in the Plan) totaling $3,500,000, holders of Brotman’s securities would receive New Common Stock in Brotman in the same percentage as their pro rata share of the New Value Contribution. Pursuant to the terms of the Plan, the Company made a $1,814,000 investment in Brotman on January 13, 2009 and $705,000 on December 31, 2009, totaling $2,519,000 (net of $37,000 of acquisition costs) while the minority shareholders made a total cash investment of $981,000. Based on such contributions, Prospect acquired an additional 38.86% ownership interest in Brotman, effective April 14, 2009, which brought its total ownership interest to approximately 72%. Effective November 15, 2010, Brotman completed a $3,750,000 rights offering, wherein the Company participated in the amount of approximately $3,065,000, increasing its ownership to approximately 78%. Additionally, see Note 15 for discussion of Brotman’s February 2011 rights offering.

For financial accounting purposes, the additional investment in Brotman was referred to as the “Brotman Acquisition.” As required by U.S. GAAP, the business combination, which was achieved in stages, provides for recognition of assets at current fair value with respect to the proportion of the Company’s incremental ownership interest in Brotman. The aggregate cost of the acquired assets, which includes cash paid of $2.5 million and expenses incurred in connection with the acquisition totaling $37,000, were allocated to the assets acquired and liabilities assumed. The excess of the consideration over the estimated fair value of the assets and liabilities assumed has been allocated to goodwill and an identifiable intangible asset. Due to negative net book value of assets acquired, goodwill attributable to the non-controlling (formerly minority) interest was not recognized. As the non-controlling interest in Brotman exceeds 20%, the accounting basis in the acquired ownership in Brotman have not been pushed-down to the financial statements of Brotman and have been reflected in the Parent Company financial statements. The results of operations of Brotman have been included in the consolidated financial statements since the April 14, 2009 acquisition date. Brotman’s operations for the three months ended December 31, 2010 reflected a net loss. The Company does not have the intent or ability, including under the terms of its debt agreements, to provide significant financial support to Brotman. Prior to October 1, 2009, a pro rata share of net income attributable to minority interest was not included under minority interest in the Company’s consolidated statement of operations, as the cumulative minority share of such income did not exceed their cumulative share of prior losses absorbed by the Company. Effective October 1, 2009, with the adoption date of new accounting literature, a pro rata share of net loss attributable to non-controlling interest was reported as a component of equity separate from the Company’s equity in the unaudited condensed consolidated balance sheet and as net loss attributable to non-controlling interest in the unaudited condensed consolidated statement of operations.

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As discussed at Note 7, on December 15, 2009, Brotman initiated a rights offering, whereby existing shareholders of Brotman could subscribe to purchase up to $5,500,000 of Brotman convertible subordinated promissory notes (the “Brotman Notes”). The terms of the Brotman Notes provide that they are due three years from the date of issuance, bear interest at 15% per annum and are convertible at the option of the holder into shares of Brotman, at $3.34 per share. PHAS exercised its right to purchase a portion of its pro rata (then approximately 72%) share of the Brotman Notes and, effective January 7, 2010, purchased $3,500,000 of such Brotman Notes. As a result of the Rights Offering, Culver Hospital Holdings, L.P. (“Culver”), a minority shareholder of Brotman, filed a shareholder complaint against Prospect, PHAS, Brotman, and each member of the Brotman Board of Directors.  The court granted a preliminary injunction that enjoins Prospect from taking the following actions:  (1) acquiring Culver’s share of convertible promissory notes, (2) converting the Brotman Notes into shares of Brotman common stock, (3) converting Brotman’s debt owed to Prospect into shares of Brotman common stock, and (4) using the proceeds of the Rights Offering to repay debt Brotman owes to Prospect.  Prospect has filed a notice of appeal.

The following is an analysis of the final allocation of assets acquired and liabilities assumed and the goodwill and identifiable intangible asset amount recognized in connection with the Brotman Acquisition, as of April 14, 2009 (in thousands):

The assets acquired include the relative percentage (38.83%) of the step-up in basis of the assets acquired to estimated fair value, amounting to $10,518,000.

Goodwill from the Brotman Acquisition is primarily related to new capacity for future growth, new geographic coverage, additional types of hospital services and in-place workforce. As a stock purchase, the goodwill acquired in the Brotman Acquisition is not deductible for income tax purposes. Brotman recorded income related to discharge of debt upon emergence from the Chapter 11 Bankruptcy reorganization.

Since emergence from bankruptcy, Brotman has continued to incur losses and experience liquidity issues. Additionally, pursuant to an amendment entered into effective February 10, 2010, $16,000,000 of the indebtedness due to the Los Angeles Jewish Home for Aging may have to be repaid as early as April 2011 (Note 8). Management is currently attempting to implement operational improvements aimed at returning Brotman to profitability and is evaluating the refinancing or renegotiation and extension of this debt. Prospect has limited ability to fund Brotman’s post acquisition operations.

As discussed in Note 13, Brotman could potentially be a net payer under the AB 1653 program by in excess of $4,000,000 through December 31, 2010. Brotman has been informed that, beginning February 14, 2011 withholds of its expected Medi-Cal payments in the amount of $65,000 per week are scheduled to start. Brotman management is contesting these withholds. Failure by management to successfully contest such withholds however could potentially be a triggering event that would require a specific impairment evaluation of Brotman’s intangibles. Such impairment evaluation would likely result in an impairment charge as early as the second quarter of fiscal 2011.

10. Segment Information

The Company’s operations are organized into three reporting segments: (i) Hospital Services—which is comprised of the Alta and Brotman reporting units, owns and operates five hospitals—Los Angeles Community Hospital, Hollywood Community Hospital, Norwalk Community Hospital, Van Nuys Community Hospital and Brotman Medical Center; (ii) Medical Group—which is comprised of the Prospect and ProMed reporting units, provides management services to affiliated physician organizations that operate as independent physician associations; and (iii) Corporate, which represents expenses incurred by Prospect Medical Holdings, Inc. (the “Parent Entity”), that were not allocated to the other reporting segments.

The accounting policies of the reporting segments are the same as those described in the summary of significant accounting policies (see Note 2). The Company evaluates financial performance and allocates resources primarily based on earnings from continuing operations before interest expense, interest income, income taxes, depreciation and amortization, as well as income or loss from operations before income taxes, excluding infrequent or unusual items.

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The reporting segments are strategic business units that offer different services within the healthcare industry. Business in each reporting segment is conducted by one or more direct or indirect wholly-owned subsidiaries of the Company and certain affiliated physician organizations controlled through assignable option agreements and management services agreements.

The following table summarizes certain information for each of the reporting segments regularly provided to and reviewed by the chief operating decision maker (in thousands, unaudited):

(1)                                  Prospect files consolidated tax returns and allocates costs for shared services and corporate overhead to each of the reporting segments. With the exception of the Brotman Acquisition, all acquisition-related debt, including those related to the Medical Group and Hospital Services segment, is recorded at the Parent entity level. As such, the Company does not allocate interest expense, and gain or loss on interest rate swaps to the operating segments.

(2)                               Prospect Medical Group, Inc. (which serves as a holding company for the other affiliated physician organizations) files consolidated tax returns.

11. Income Taxes

The Company recorded a tax (benefit) provision of approximately $(3,375,000) and $2,503,000 for the three months ended December 31, 2010 and December 31, 2009, at effective tax rates of 21.3% and 50.4%, respectively. The lower effective tax rates in the fiscal 2011 period were primarily due to non-deductible transaction costs relating to the Ivy Merger.

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As of December 31, 2010, management has determined that there is no material unrecognized tax benefits and expects no material change within the next twelve months.

The Company incurred approximately $13,300,000 in transaction related costs related to the Ivy Merger, primarily during the three months ended December 31, 2010. The Company is currently performing a detailed analysis regarding the tax treatment of such costs in accordance with Treasury Reg. Section 1.263(a)-5. Pending the completion of such analysis, for fiscal 2011 first quarter financial reporting purposes, management has determined, based on estimate, that approximately $6,500,000 (tax effected approximately $1,380,000 of benefit) of such costs is deductible for tax purposes as the more-likely-than-not condition has been  met in the period for which a tax position is taken. On final completion of the analysis however, the Company’s deductible costs relating to the merger could increase or decrease materially; however it is not possible to estimate the potential change at this time.

In connection with the December 15, 2010 Ivy Merger, the Company cashed out substantially all employee stock options, which generated a substantial tax deduction. An estimate of this deduction has been recognized in the accompanying December 31, 2010 unaudited condensed consolidated financial statements. The Company engaged an outside accounting firm to assist with a detailed analysis of this matter, including consideration of Treasury Reg. Sections 280G. This analysis is substantially complete, and management has determined that the estimated deduction recognized in the unaudited consolidated financial statements meets the more-likely-than-not criteria for recognition. It is reasonably possible that the Company’s estimated deduction, once all analysis has been finalized, could change, and the amount of such change could be material; however it is not possible to estimate the potential change at this time.

12. Fair Value of Financial Investments

The Company adopted the revised accounting guidance for fair value measurements and disclosure of its financial assets and liabilities and its non-financial assets and liabilities on October 1, 2008 and October 1, 2009, respectively. The guidance defines fair value, establishes guidelines for measuring fair value and expands disclosure regarding fair value measurements.  It does not create or modify any current GAAP requirements to apply fair value accounting.  However, it provides a single definition for fair value that is to be applied consistently for all prior accounting pronouncements.  The adoption of this guidance did not have a material impact on the Company’s financial position or results of operations.  The guidance establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The three levels of the fair value hierarchy are described below:

·                  Level 1—Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;

·                  Level 2—Quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability; and

·                  Level 3—Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (supported by little or no market activity).

Financial Items Measured at Fair Value on a Recurring Basis