UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934

Commission file number 1-12996

ADVOCAT INC.

Delaware		62-1559667
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
1621 Galleria Boulevard, Brentwood, TN		37027
(Address of principal executive offices)		(Zip Code)

Title of each class		Name of each Exchange on which registered
Common Stock, $0.01 par value per share		The NASDAQ Capital Market

Yes o No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes o No þ

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 þ 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 (§232.405 of this chapter) 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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.

Large accelerated filer o		Accelerated filer o		Non-accelerated filer o		o Smaller reporting company þ
				(Do not check if a smaller reporting company)

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

The aggregate market value of Common Stock held by non-affiliates on June 30, 2010 (based on the closing price of such shares on the NASDAQ Capital Market) was approximately $14,460,000. For purposes of the foregoing calculation only, all directors, named executive officers and persons known to the registrant to be holders of 5% or more of the registrant’s Common Stock have been deemed affiliates of the registrant.

On February 17, 2011, 5,743,756 shares of the registrant’s $0.01 par value Common Stock were outstanding.

Registrant’s definitive proxy materials for its 2011 annual meeting of shareholders are incorporated by reference into Part III, Items 10, 11, 12, 13 and 14 of this Form 10-K.

 

 

PART I

ITEM 1.		BUSINESS

Introductory Summary.

Advocat Inc. provides long-term care services to nursing center patients in eight states, primarily in the Southeast and Southwest United States. Unless the context indicates otherwise, references herein to “Advocat,” “the Company,” “we,” “us” and “our” include Advocat Inc. and all of our subsidiaries.

The long-term care profession encompasses a broad range of non-institutional and institutional services. For those among the elderly requiring temporary or limited special services, a variety of home care options exist. As needs for assistance in activities of daily living develop, assisted living facilities become the most viable and cost effective option. For those among the elderly requiring much more intensive care, skilled nursing center care may become the only viable option. We have chosen to focus our business on the skilled nursing centers sector and to specialize in this aspect of the long-term care continuum.

Principal Address and Website.

Our principal executive offices are located at 1621 Galleria Boulevard, Brentwood, TN 37027. Our telephone number at that address is 615.771.7575, and our facsimile number is 615.771.7409. Our website is located at www.advocatinc.com. The information on our website does not constitute part of this Annual Report on Form 10-K.

Operating and Growth Strategy.

Our operating objective is to be the provider of choice of health care and related services to the elderly in the communities in which we operate. Our strategic operations development plan focuses on (i) providing a broad range of cost-effective elder care services; (ii) improving occupancy and skilled mix in our nursing centers; (iii) implementing Electronic Medical Records (“EMR”) in our nursing centers; and (iv) clustering our operations on a regional basis. Interwoven into our objectives and operating strategy is our mission:

	•		Committed to Compassion
	•		Striving for Excellence
	•		Serving Responsibly

To achieve our objective we:

Provide a broad range of cost-effective services. Our objective is to provide a variety of services in a broad continuum of care which meet the needs of the elderly requiring skilled nursing care. Our service offerings currently include skilled nursing, comprehensive rehabilitation services, programming for Life Steps and Lighthouse units (described below) and other specialty programming. By addressing varying levels of acuity, we work to meet the needs of the elderly population we serve. We seek to establish a reputation as the provider of choice in a particular market. Furthermore, we believe we are able to deliver quality services cost-effectively, compared to other healthcare providers along the spectrum of care, thereby expanding the elderly population base that can benefit from our services.

Improve occupancy and skilled mix in our nursing centers. By enhancing our registered nurse coverage and adding specialized clinical care, we believe we can improve occupancy and reimbursement. The investments in nursing and clinical care are being conducted in concert with additional investments in facility based marketing representatives to develop referral and managed care relationships. These investments will better attract quality payor sources for patients covered by Medicare, Managed Care (including Health Maintenance Organizations (“HMO’s”) and Medicare replacement payors) as well as certain private pay individuals. We will also continue our program for the renovation and improvement of our nursing centers to attract and retain patients.

Implement Electronic Medical Records. We believe we can improve operations, profitability and our Continuous Quality Improvement program in our nursing centers by implementing EMR. EMR provides the ability to electronically record the care provided to our patients and improves customer and employee satisfaction, improves facility regulatory compliance and provides real-time monitoring and scheduling of care delivery. It is anticipated that the improved documentation of care will also provide greater tracking and capture of services we provide to patients.

Cluster operations on a regional basis. We have developed regional concentrations of operations in order to achieve operating efficiencies, generate economies of scale and capitalize on marketing opportunities created by having multiple operations in a regional market area.

Key elements of our growth strategy are to:

Increase revenues and profitability at existing facilities. Our strategy includes increasing center revenues and profitability through increasing occupancy levels, improving quality payor mix, obtaining appropriate reimbursement for the care we provide, containing costs and providing high quality patient care. In addition to our facility renovation program, ongoing investments are being made in expanded nursing and clinical care. We continue to enhance facility based marketing initiatives to promote higher occupancy levels and improved skilled mix at our nursing centers.

Improve physical plants. Our nursing centers have an average age of approximately 32 years as of December 31, 2010. During 2005 we began an initiative to complete strategic renovations of certain facilities to improve occupancy, quality of care and profitability. We developed a plan to identify those facilities with the greatest potential for benefit and began the renovation program during the third quarter of 2005. As of December 31, 2010, we have completed renovations at fifteen facilities and we are developing plans for additional renovation projects. Major renovations result in significant cosmetic upgrades, including new flooring, wall coverings, lighting, ceilings and furniture throughout the facility. Renovations also usually include certain external work to improve curb appeal, such as concrete work, landscaping, roof and signage enhancements. Many of our renovation projects will include adding functionality and space for our rehabilitation therapy offerings.

Development of additional specialty services. Our strategy includes the development of additional specialty units and programming in facilities that could benefit from these services. The specialty programming will vary depending on the needs of the specific marketplace, and may include Life Steps and Lighthouse units and other specialty programming. These services allow our facilities to improve census and payor mix. A center specific assessment of the market and the current programming being offered is conducted related to specialty programming to determine if unmet needs exist as a predictor of the success of particular niche offerings and services.

Acquisition, leasing and development of new centers. We continue to pursue and investigate opportunities to acquire, lease or develop new facilities, focusing primarily on opportunities within our existing areas of operation. Two of our most recent development projects are discussed below:

	•		West Virginia Facility. We entered into an agreement with a real estate developer that will construct, furnish, and equip a 90 bed skilled nursing center near Milton, West Virginia, which we will lease upon completion. The center will utilize a Certificate of Need we initially obtained in the June 2009 acquisition of certain assets of a skilled nursing center in Milton, West Virginia. The initial lease term is 20 years from the date the center is completed and fit for occupancy as a skilled nursing center. We have the option to renew the lease for two additional five-year periods. Construction on the nursing center began in November 2010 and it is estimated the center will be completed in late 2011. The lease agreement grants us the right to purchase the center beginning at the end of the first year of the initial term of the lease and continuing through the fifth year for a purchase price ranging from 110% to 120% of the total project cost.
	•		Texas Facility. In August 2009, we completed the construction of a 119 bed leased skilled nursing center, Brentwood Terrace, located in Paris, Texas, replacing an existing 102 bed leased facility. The new facility was financed with funding from our lessor, and is leased under a long term operating lease with renewal options through 2035.

Nursing Centers and Services.

Advocat provides a broad range of long-term care services to the elderly including skilled nursing, ancillary health care services and assisted living. In addition to the nursing and social services usually provided in long-term care centers, we offer a variety of rehabilitative, nutritional, respiratory, and other specialized ancillary services. As of December 31, 2010, we operate 46 nursing centers containing 5,364 licensed nursing beds.

Our nursing centers range in size from 48 to 320 licensed nursing beds. The following table summarizes certain information with respect to the nursing centers we own or lease as of December 31, 2010:

		Number of				Licensed Nursing				Available Nursing
		Centers				Beds(1)				Beds(1)
Operating Locations:
Alabama			6				711				704
Arkansas			12				1,311				1,160
Florida			1				79				79
Kentucky			6				489				485
Ohio			1				139				110
Tennessee			5				617				576
Texas			13				1,868				1,675
West Virginia			2				150				150
			46				5,364				4,939
Classification:
Owned			9				936				848
Leased			37				4,428				4,091
Total			46				5,364				4,939

Our nursing centers provide skilled nursing health care services, including room and board, nutrition services, recreational therapy, social services, housekeeping and laundry services. Our nursing centers dispense medications prescribed by the patients’ physicians, and a plan of care is developed by professional nursing staff for each resident. We also provide for the delivery of ancillary medical services at the nursing centers we operate. These specialty services include rehabilitation therapy services, such as audiology, speech, occupational and physical therapies, which are provided through licensed therapists and registered nurses, and the provision of medical supplies, nutritional support, infusion therapies and related clinical services. The majority of these services are provided using our internal resources and clinicians.

Within the framework of a nursing center, we may provide other specialty care, including:

Life Steps Unit. Nineteen of our nursing centers have units designated as Life Steps Units, our designation for patients requiring short-term rehabilitation following an incident such as a stroke, joint replacement or bone fracture. These units specialize in short-term rehabilitation with the goal of returning the patient to their previous level of functionality. These units provide enhanced services with emphasis on upgraded amenities including electric beds, televisions, telephones at bedside and feature a separate entrance for guests and visitors. The design and programming of the units generally appeal to the clinical and hospitality needs of individuals as they progress to the next appropriate level of care. Specialized therapeutic treatment regimens include orthopedic rehabilitation, neurological rehabilitation and complex medical rehabilitation. While these patients generally have a shorter length of stay, the intensive level of rehabilitation typically results in higher levels of reimbursement.

Lighthouse Unit. Twenty-two of our nursing centers have Lighthouse Units, our designation for advanced care for dementia related disorders including Alzheimer’s disease. The goal of the units is to provide a safe, homelike and supportive environment for cognitively impaired patients, utilizing an interdisciplinary team approach. Family and community involvement compliment structured programming in the secure environment instrumental in fostering as much resident independence as possible despite diminished capacity.

Enhanced Therapy Services. We have complimented our traditional therapy services with programs that provide electrotherapy, ultrasound and shortwave diathermy therapy treatments that promote pain management, wound healing, continence improvement and contractures management, improving the results of therapy treatments for our patients. We currently offer these treatment programs in 40 of our facilities.

Other Specialty Programming. We implement other specialty programming based on a center’s specific needs. We have developed one adult day care center on the campus of a nursing center. We have developed specialty programming for bariatric patients (generally, patients weighing more than 350 pounds). These individuals have unique psychosocial and equipment needs.

Continuous Quality Improvement. We have in place a Continuous Quality Improvement (“CQI”) program, which is focused on identifying opportunities for improvement of all aspects of the care provided in a center, as well as overseeing the initiation and effectiveness of interventions. The CQI program was designed to support and drive facility efforts to meet accreditation standards and to exceed state and federal government regulations. We conduct monthly audits to monitor adherence to the standards of care established by the CQI program at each center which we operate. The facility administrator, with assistance from regional nursing personnel, is primarily responsible for adherence to our quality improvement standards. In that regard, the annual operational objectives established by each facility administrator include specific objectives with respect to quality of care. Performance of these objectives is evaluated quarterly by the regional vice president or manager and each facility administrator’s incentive compensation is based, in part, on the achievement of the specified quality objectives. A major component of our CQI program is employee empowerment initiatives, with particular emphasis placed on selection, recruitment, retention and recognition programs. Our administrators and managers include employee retention and turnover goals in the annual facility, regional and personal objectives. We also have established a quality improvement committee consisting of nursing representatives from each region and our corporate quality personnel. This committee periodically reviews our quality improvement programs and conducts facility audits.

Implement Electronic Medical Records. We are currently implementing EMR in our nursing centers, with the expectation of having at least one module in all of our facilities by the end of 2011. EMR improves our ability to accurately record the care provided to our patients and quickly respond to areas of need. EMR improves customer and employee satisfaction, facility regulatory compliance and provides real-time monitoring and scheduling of care delivery. We believe our EMR system will support our quality initiatives and position us for higher acuity service offerings. Our EMR System includes three primary components:

	•		Tracking Activities of Daily Living (“ADLs”). ADLs are the routine functions that each person must perform on a daily basis, including but not limited to: getting dressed, bathing, and eating, The ADL tracking will allow us to improve the documentation of the activities of our nursing, dietary and housekeeping staff in assisting with ADLs quickly, efficiently and electronically.
	•		Nursing Notes. Nursing notes are an important component of our medical records. Licensed nursing professionals make notes on the care and condition of each resident. The EMR system has a module for nursing notes and allows for improved capture, monitoring and review of resident records.
	•		Medications. Our residents often receive a number of daily medications. This module assists with tracking the required medications and documenting the administration of those medications.

For all three modules, the EMR system provides a dashboard that can be reviewed at a number of kiosks throughout the nursing center, allowing our staff to securely access a list of upcoming resident care tasks and providing our supervisors a tool to help manage and monitor staff performance to better support the quality of care for our residents. Through December 31, 2010, we have deployed full EMR in 8 centers and ADL tracking in 13 others. During 2011, we will deploy full EMR in all nursing centers, at a rate of approximately five to six centers every two months. We expect to invest approximately $130,000 per facility to deploy EMR in all buildings.

Organization. Our long-term care facilities are currently organized into four regions, each of which is supervised by a regional vice president. The regional vice president is generally supported by specialists in several functions, including nursing, human resources, marketing, accounts receivable management and administration, all of whom are employed by us. The day-to-day operations of each of our nursing centers are led by an on-site, licensed administrator. The administrator of each nursing center is supported by other professional personnel, including a medical director, who assists in the medical management of the facility, and a director of nursing, who supervises a staff of registered nurses, licensed practical nurses and nurse aides. Other personnel include those providing therapy, dietary, activities and social service, housekeeping, laundry and maintenance and office services. The majority of personnel at our facilities, including the administrators, are our employees. We employ contract therapy labor at certain facilities depending on market availability of therapy labor.

Marketing.

At a local level, our sales and marketing efforts are designed to promote higher occupancy levels and optimal payor mix. We believe that the long-term care profession is fundamentally a local business in which both patients and residents and the referral sources for them are based in the immediate geographic area in which the facility is located. Our marketing plan and related support activities emphasize the role and performance of administrators, admissions coordinators and social services directors of each nursing center, all of whom are responsible for contacting various referral sources such as doctors, hospitals, hospital discharge planners, churches and various community organizations. As part of our operating strategy we are increasing the number of facility based marketing personnel to further develop relationships with physicians as well as managed care organizations.

Our administrators are evaluated based on their ability to meet specific goals and performance standards that are tied to compensation incentives. Our regional managers and marketing coordinators assist local marketing personnel and administrators in establishing relationships and follow-up procedures with such referral sources.

In addition to soliciting admissions from these sources, we emphasize involvement in community affairs in order to promote a public awareness of our nursing centers and services. We have ongoing family councils and community based “family night” functions where organizations come to the center to educate the public on various topics such as Medicare benefits, powers of attorney, and other matters of interest. We also promote effective customer relations and seek feedback through family surveys. We typically host “open house” events once we complete a renovation of a center where members of the local community are invited to visit and see the improvements. In addition, we have regional marketing coordinators to support the overall marketing program in each local center, in order to promote higher occupancy levels and improved payor and case mixes at our nursing centers. Regional and local marketing personnel and efforts are supported by our corporate marketing personnel.

We have an internally-developed marketing program that focuses on the identification and provision of services needed by the community. The program assists each facility administrator in analysis of local demographics and competition with a view toward complementary service development. We believe that the primary referral area in the long-term care industry generally lies within a five-to-fifteen-mile radius of each facility depending on population density; consequently, local marketing efforts are more beneficial than broad-based advertising techniques.

Acquisitions, Development Projects and Divestitures.

On July 14, 2010 we entered into an agreement with a real estate developer that will construct, furnish, and equip a 90 bed skilled nursing center near Milton, West Virginia which we will lease upon completion. The center will utilize a Certificate of Need we initially obtained in the June 2009 acquisition of certain assets of a skilled nursing center in Milton, West Virginia. The initial lease term is 20 years from the date the center is completed and fit for occupancy as a skilled nursing center. We have the option to renew the lease for two additional five-year periods. Construction on the nursing center began in November 2010 and it is estimated the center will be completed in late 2011. The lease agreement grants us the right to purchase the center beginning at the end of the first year of the initial term of the lease and continuing through the fifth year for a purchase price ranging from 110% to 120% of the total project cost.

In August 2009, we completed the construction of a 119 bed leased skilled nursing center, Brentwood Terrace, located in Paris, Texas, replacing an existing 102 bed leased facility. The new facility was financed with funding from our lessor, and is leased under a long term operating lease with renewal options through 2035.

The Centers for Medicare and Medicaid Services (“CMS”) issued regulations that became effective October 1, 2009 that prohibit us from billing Medicare Part B for certain enteral nutrition, urological, ostomy and tracheostomy supplies, and these services are now provided by third parties. We are still required to provide the labor for the delivery of services but are no longer a supplier and will not be entitled to any compensation. The revenue and cost of goods sold for providing these services prior to October 2009 have been reclassified as discontinued operations.

The net assets of discontinued operations presented in property and equipment on our balance sheet represent real estate related to an assisted living facility in North Carolina closed in April 2006. During the fourth quarter of 2010 we recorded an impairment charge of $0.4 million to reduce the carrying value of this asset. We are continuing our efforts to sell this land.

Effective March 31, 2010, we terminated operations of four nursing centers in Florida under a lease that, as amended, would have expired in August 2010. The operating margins of the four facilities subject to this lease did not meet our goals. The facilities were, on average, 50 years old (including three of our ten oldest facilities), with several structural limitations that significantly impaired marketing ability in the very competitive marketplace in Florida. We transitioned operations at these leased facilities on March 31, 2010, and we have reclassified the operations and the current assets of these facilities as discontinued operations in the accompanying consolidated financial statements.

Nursing Center Profession.

We believe there are a number of significant trends within the long-term care industry that will support the continued growth of the nursing home profession. These trends are also likely to impact our business. These factors include:

     Demographic trends. The primary market for our long-term health care services is comprised of persons aged 75 and older. This age group is one of the fastest growing segments of the United States population. As the number of persons aged 75 and over continues to grow, we believe that there will be corresponding increases in the number of persons who need skilled nursing care.

     Cost containment pressures. In response to rapidly rising health care costs, governmental and other third-party payors have adopted cost-containment measures to reduce admissions and encourage reduced lengths of stays in hospitals and other acute care settings. The federal government had previously acted to curtail increases in health care costs under Medicare by limiting acute care hospital reimbursement for specific services to pre-established fixed amounts. Other third-party payors have begun to limit reimbursement for medical services in general to predetermined reasonable charges, and managed care organizations (such as health maintenance organizations) are attempting to limit hospitalization costs by negotiating for discounted rates for hospital and acute care services and by monitoring and reducing hospital use. In response, hospitals are discharging patients earlier and referring elderly patients, who may be too sick or frail to manage their lives without assistance, to nursing centers where the cost of providing care is typically lower than hospital care. In addition, third-party payors are increasingly becoming involved in determining the appropriate health care settings for their insureds or clients based primarily on cost and quality of care.

     Limited supply of centers. As the nation’s elderly population continues to grow, life expectancy continues to expand, and there continue to be limitations on granting Certificates of Need (“CON’s”) for new skilled nursing centers, so we believe that there will be continued demand for skilled nursing beds in the markets in which we operate. The majority of states have adopted CON or similar statutes requiring that prior to adding new skilled beds or any new services, or making certain capital expenditures, a state agency must determine that a need exists for the new beds or proposed activities. We believe that this CON process tends to restrict the supply and availability of licensed skilled nursing center beds. High construction costs, limitations on state and federal government reimbursement for the full costs of construction, and start-up expenses also act to restrict growth in the supply for such centers. At the same time, skilled nursing center operators are continuing to focus on improving occupancy and expanding services to include high acuity subacute patients, who require significantly higher levels of skilled nursing personnel and care.

     Reduced reliance on family care. Historically, the family has been the primary provider of care for seniors. We believe that the increase in the percentage of dual income families, the reduction of average family size and the increased mobility in society will reduce the role of the family as the traditional care-giver for aging parents. We believe that this trend will make it necessary for many seniors to look outside the family for assistance as they age.

Competition.

The long-term care business is highly competitive. We face direct competition for additional centers, and our centers face competition for employees and patients. Some of our present and potential competitors for acquisitions are significantly larger and have or may obtain greater financial and marketing resources. Competing companies may offer new or more modern centers or new or different services that may be more attractive to patients or residents than some of the services we offer.

The nursing centers operated by us compete with other facilities in their respective markets, including rehabilitation hospitals and other “skilled” and personal care residential facilities. In the few urban markets in which we operate, some of the long-term care providers with which our facilities compete are significantly larger and have or may obtain greater financial and marketing resources than our facilities. Some of these providers are not-for-profit organizations with access to sources of funds not available to our centers. Construction of new long-term care facilities near our existing centers could adversely affect our business. We believe that the most important competitive factors in the long-term care business are: a facility’s local reputation with referral sources, such as acute care hospitals, physicians, religious groups, other community organizations, managed care organizations, and a patient’s family and friends; physical plant condition; the ability to identify and meet particular care needs in the community; the availability of qualified personnel to provide the requisite care; and the rates charged for services. There is limited, if any, price competition with respect to Medicaid and Medicare patients, since revenues for services to such patients are strictly controlled and are based on fixed rates and cost reimbursement principles. Although the degree of success with which our centers compete varies from location to location, we believe that our centers generally compete effectively with respect to these factors.

Revenue Sources

We classify our revenues from patients and residents into four major categories: Medicaid, Medicare, managed care, and private pay and other. Medicaid revenues are composed of the traditional Medicaid program established to provide benefits to those in need of financial assistance in the securing of medical services. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. Managed care revenues include payments for patients who are insured by a third-party entity, typically called a Health Maintenance Organization, often referred to as an HMO plan, or are Medicare beneficiaries who assign their Medicare benefits to a managed care replacement plan often referred to as Medicare replacement products. The private pay and other revenues are composed primarily of individuals or parties who directly pay for their services. Included in the private pay and other are patients who are hospice beneficiaries as well as the recipients of Veterans Administration benefits. Veterans Administration payments are made pursuant to renewable contracts negotiated with these payors.

The following table sets forth net patient and resident revenues related to our continuing operations by payor source for the periods presented (dollar amounts in thousands):

										Year Ended December 31,
		2010								2009								2008
Medicaid		$	155,035				53.4	%		$	149,987				54.2	%		$	140,524				53.3	%
Medicare			88,920				30.7				85,433				30.8				84,647				32.1
Managed care			8,619				3.0				7,412				2.7				5,993				2.3
Private Pay and other			37,556				12.9				34,147				12.3				32,673				12.3
Total		$	290,130				100.0	%		$	276,979				100.0	%		$	263,837				100.0	%

The following table sets forth average daily skilled nursing census by payor source for our continuing operations for the periods presented:

										Year Ended December 31,
		2010								2009								2008
Medicaid			2,886				68.8	%			2,854				69.6	%			2,773				69.2	%
Medicare			544				13.0				534				13.0				548				13.7
Managed care			59				1.4				51				1.2				45				1.1
Private Pay and other			704				16.8				661				16.2				641				16.0
Total			4,193				100.0	%			4,100				100.0	%			4,007				100.0	%

Consistent with the nursing center industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare, managed care, and private pay and other can significantly affect the profitability of the facility’s operations.

Medicare and Medicaid Reimbursement

A significant portion of our revenues are derived from government-sponsored health insurance programs. Our nursing centers derive revenues under Medicaid, Medicare, managed care, private pay and other third party sources. We employ specialists in reimbursement at the corporate level to monitor regulatory developments, to comply with reporting requirements, and to ensure that proper payments are made to our operated nursing centers. It is generally recognized that all government-funded programs have been and will continue to be under cost containment pressures, but the extent to which these pressures will affect our future reimbursement is unknown.

Medicare

For the year ending December 31, 2010, our Medicare rates were significantly impacted by changes for the Medicare fiscal years ending September 30, 2010 and 2011, respectively. Effective October 1, 2009, the Centers for Medicare and Medicaid Services (“CMS”) reduced Medicare payments to skilled nursing centers by approximately 1.1% compared to the fiscal year ending September 30, 2009. The decrease was determined as the net effect of a 3.3% decrease intended to correct CMS forecasting errors that resulted when the Resource Utilization Group III (“RUG III”) system went into effect in 2006, partially offset by a 2.2% inflation increase as measured by the SNF “market basket.” As discussed in our results of operations, this Medicare rate reduction decreased our Medicare revenue and our Medicare rate per patient day through September 30, 2010.

Effective October 1, 2010, Medicare rates were increased by CMS implementation of a market basket adjustment and the implementation of MDS 3.0 and Resource Utilization Group IV (“RUG IV”). The net impact of the market basket adjustment increased Medicare reimbursement to skilled nursing centers by approximately 1.7% compared to the fiscal year ending September 30, 2010. The rate increase was determined as the net effect of a 2.3% inflation increase as measured by the SNF “market basket,” offset by a 0.6% decrease intended to correct a CMS forecasting error that was made in an inflation increase for the Medicare fiscal year ending September 30, 2009. CMS also implemented MDS 3.0, a new patient assessment tool for the collection of clinical data to be used for classification into the RUG categories for all Medicare patients and those Medicaid patients in RUG-based reimbursement states. In addition to the patient assessment tool, CMS expanded RUG categories to 66 under RUG IV up from 53 under RUG III. As a result, our Medicare rates increased in the fourth quarter of 2010. The new regulations have also resulted in an increase in costs to complete the patient assessments required by these new rules.

Therapy Services. There are annual Medicare Part B reimbursement limits on therapy services that can be provided to an individual. The limits effective January 1, 2011 impose a $1,870 per patient annual ceiling on physical and speech therapy services, and a separate $1,870 per patient annual ceiling on occupational therapy services. CMS established an exception process to permit therapy services in certain situations and as is standard within our industry, we provide services that are reimbursed under the exceptions process. The exceptions process has been extended several times, most recently by the Medicare and Medicaid Extenders Act of 2010

which extended this exception process through December 31, 2011. It is unknown if any further extension of the therapy cap exceptions will be included in future legislation. If the exception process is discontinued, it is expected that the reimbursement limitations will reduce therapy revenues and negatively impact our operating results and cash flows.

On November 2, 2010, CMS released a final proposed rule as part of the Medicare Physician Fee Schedule that was effective January 1, 2011. The policy impacts the reimbursement we receive for Medicare Part B therapy services in our facilities. The policy provides that Medicare Part B pay the full rate for the therapy unit of service that has the highest Practice Expense (PE) component for each patient on each day they receive multiple therapy treatments. Reimbursement for the second and subsequent therapy units for each patient each day they receive multiple therapy treatments would be reimbursed at a rate equal to 75% of the applicable PE component. This rule would have resulted in a decrease in our revenue of $0.5 million absent other changes to the Medicare Fee Schedule, but based on certain other increases the net impact to our revenue is only expected to be a decrease of $0.3 million in 2011.

Supply Services. CMS issued regulations that became effective October 1, 2009 that prohibit us from billing Medicare Part B for certain enteral nutrition, urological, ostomy and tracheostomy supplies. Beginning October 1, 2009, these services are now provided by third parties. We are still required to provide the labor for the delivery of service but are no longer a supplier and are not entitled to any compensation for providing such labor.

Medicaid

Several states in which we operate face budget shortfalls, which could result in reductions in Medicaid funding for nursing centers. The federal government made an effort to address the financial challenges state Medicaid programs are facing by increasing the amount of Medicaid funding available to states. On February 17, 2009, the American Recovery and Reinvestment Act of 2009, (“ARRA”) was enacted. Among other provisions, ARRA provided $87 billion for a temporary period to assist states in maintaining and expanding Medicaid enrollment. Pressures on state budgets are expected to continue in the future and are expected to result in Medicaid rate reductions once the ARRA provisions that assist states in maintaining and expanding Medicaid end on December 31, 2010. In August 2010, the federal government passed legislation that will provide limited additional funding to assist states in matching Medicaid, similar to some of the ARRA provisions. The additional matching funds will continue through June 2011 and will be less in the second quarter of 2011 than the first quarter of 2011. It is unclear what additional matching fund enhancements, if any, will continue past June 30, 2011.

We receive the majority of our annual Medicaid rate increases during the third quarter of each year. The rate changes received in the third quarter of 2009 were the primary contributor to our 2.2% increase in average rate per day for Medicaid patients in 2010 but were accompanied by provider tax increases in certain states, which reduced the net effective Medicaid rate increase to approximately 1.8%. We received annual Medicaid rate increases during the third quarter of 2010 of approximately 1.6%.

We are unable to predict what, if any, reform proposals or reimbursement limitations will be implemented in the future, or the effect such changes would have on our operations. For the year ended December 31, 2010, we derived 30.7% and 53.4% of our total patient and resident revenues related to continuing operations from the Medicare and Medicaid programs, respectively. Any health care reforms that significantly limit rates of reimbursement under these programs could, therefore, have a material adverse effect on our profitability.

We will attempt to increase revenues from non-governmental sources to the extent capital is available to do so, if at all. However, private payors, including managed care payors, are increasingly demanding that providers accept discounted fees or assume all or a portion of the financial risk for the delivery of health care services. Such measures may include capitated payments, which can result in significant losses to health care providers if patients require expensive treatment not adequately covered by the capitated rate.

Employees.

As of February 1, 2011, we employed a total of approximately 5,600 individuals in connection with our continuing operations, approximately 4,400 of which are considered full time employees. We believe that our employee relations are good. Approximately 160 of our employees are represented by a labor union.

Although we believe we are able to employ sufficient nurses and therapists to provide our services, a shortage of health care professional personnel in any of the geographic areas in which we operate could affect our ability to recruit and retain qualified employees and could increase our operating costs. We compete with other health care providers for both professional and non-professional employees and with non-health care providers for non-professional employees. This competition contributed to a significant increase in the salaries that we had to pay to hire and retain these employees. As is common in the health care industry, we expect the salary and wage increases for our skilled healthcare providers will continue to be higher than average salary and wage increases nationally.

Supplies and Equipment.

We purchase drugs, solutions and other materials and lease certain equipment required in connection with our business from many suppliers. We have not experienced, and do not anticipate that we will experience, any significant difficulty in purchasing supplies or leasing equipment from current suppliers. In the event that such suppliers are unable or fail to sell us supplies or lease equipment, we believe that other suppliers are available to adequately meet our needs at comparable prices. National purchasing contracts are in place for all major supplies, such as food, linens and medical supplies. These contracts assist in maintaining quality, consistency and efficient pricing. Based on contract pricing for food and other supplies, we expect cost increases in 2011 to be higher than the increases we experienced in 2010.

Government Regulation.

The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Over the last several years, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse statutes and regulations as well as laws and regulations governing quality of care issues in the skilled nursing profession in general. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations is subject to ongoing government review and interpretation, as well as regulatory actions in which government agencies seek to impose fines and penalties. The Company is involved in regulatory actions of this type from time to time.

Licensure and Certification. All our nursing centers must be licensed by the state in which they are located in order to accept patients, regardless of payor source. In most states, nursing centers are subject to CON laws, which require us to obtain government approval for the construction of new nursing centers or the addition of new licensed beds to existing centers. Our nursing centers must comply with detailed statutory and regulatory requirements on an ongoing basis in order to qualify for licensure, as well as for certification as a provider eligible to receive payments from the Medicare and Medicaid programs. Generally, the requirements for licensure and Medicare/Medicaid certification are similar and relate to quality and adequacy of personnel, quality of medical care, record keeping, dietary services, resident rights, and the physical condition of the facility and the adequacy of the equipment used therein. Each facility is subject to periodic inspections, known as “surveys” by health care regulators, to determine compliance with all applicable licensure and certification standards. Such requirements are both subjective and subject to change. If the survey concludes that there are deficiencies in compliance, the facility is subject to various sanctions, including but not limited to monetary fines and penalties, suspension of new admissions, non-payment for new admissions and loss of licensure or certification. Generally, however, once a facility receives written notice of any compliance deficiencies, it may submit a written plan of correction and is given a reasonable opportunity to correct the deficiencies. There can be no assurance that, in the future, we will be able to maintain such licenses and certifications for our facilities or that we will not be required to expend significant sums in order to comply with regulatory requirements. Recently, we have experienced an increase in the severity of survey citations and the size of monetary penalties, consistent with industry trends.

Health care and health insurance reform. In March 2010, significant legislation concerning health care and health insurance was passed, including the “Patient Protection and Affordable Care Act”, (“Patient Protection Act”) along with the “Health Care and Education Reconciliation Act of 2010” (“Reconciliation Act”) collectively defined as the “Legislation.” We expect this Legislation to impact our Company, our employees and our patients and residents in a variety of ways. Some aspects of these new laws are immediate while others will be phased in over the next ten years when all mandates become effective. This Legislation significantly changes the future responsibility of employers with respect to providing health care coverage to employees in the United States. Two of the main provisions of the Legislation become effective in 2014 whereby most individuals will be required to either have health insurance or pay a fine and employers with 50 or more employees will either have to provide minimum essential coverage or will be subject to additional taxes. We have not estimated the financial impact of the Legislation and the costs associated with complying with the increased levels of health insurance we will be required to provide our employees and their dependents in future years. We expect the Legislation will result in increased operating expenses.

We also anticipate this Legislation will continue to impact our Medicaid and Medicare reimbursement as well, though the timing and ultimate level of that impact is currently unknown as we anticipate that many of the provisions of the Legislation may be subject to further clarification and modification through the rule making process. The Legislation expands the role of home based and community services, which may place downward pressure on our sustaining population of Medicaid residents. The provisions of the legislation discussed above are examples of recently-enacted federal health reform provisions that we believe may have a material

impact on the long-term care industry and on our business. However, the foregoing discussion is not intended to constitute, nor does it constitute, an exhaustive review and discussion of the legislation.

Medicare and Medicaid. Medicare is a federally-funded and administered health insurance program for the aged and for certain chronically disabled individuals. Part A of the Medicare program covers inpatient hospital services and certain services furnished by other institutional providers such as skilled nursing facilities. Part B covers the services of doctors, suppliers of medical items, various types of outpatient services and certain ancillary services of the type provided by long-term and acute care facilities. Medicare payments under Part A and Part B are subject to certain caps and limitations, as provided in Medicare regulations. Medicare benefits are not available for intermediate and custodial levels of nursing center care or for assisted living facility arrangements.

Medicaid is a medical assistance program for the indigent, operated by individual states with financial participation by the federal government. Criteria for medical indigence and available Medicaid benefits and rates of payment vary somewhat from state to state, subject to certain federal requirements. Basic long-term care services are provided to Medicaid beneficiaries, including nursing, dietary, housekeeping and laundry, restorative health care services, room and board and medications. Federal law requires that a state Medicaid program must provide for a public process for determination of Medicaid rates of payment for nursing center services. Under this process, proposed rates, the methodologies underlying the establishment of such rates and the justification for the proposed rates are published. This public process gives providers, beneficiaries and concerned state residents a reasonable opportunity for review and comment. Certain of the states in which we now operate are actively seeking ways to reduce Medicaid spending for nursing center care by such methods as capitated payments and substantial reductions in reimbursement rates.

As a component of CMS administration of the government’s reimbursement programs, a new ratings system was implemented in December 2008 to assist the public in choosing a skilled care provider. While data for the consumer has been available for several years, the display of quality with a “Star” ranking with a “5 Star” ranking being the highest and a “1 Star” ranking being the lowest was new in 2008. The “5 Star” system is an attempt to simplify all the data for each facility to a “Star” ranking. The overall Star rating is determined by three components (three years survey results, quality measure calculations, and staffing data), with each of the components receiving star rankings as well. As this initiative becomes a bigger part of our business environment we remain diligent in continuing to provide outstanding patient care to achieve high rankings for our facilities, as well as assuring that our rankings are correct and appropriately reflect our quality results.

Health Insurance Portability and Accountability Act of 1996 Compliance. The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) has mandated an extensive set of regulations to standardize electronic patient health, administrative and financial data transactions, and to protect the privacy of individually identifiable health information. We have a HIPAA compliance committee and designated privacy and security officers.

The HIPAA transaction standards are intended to simplify the electronic claims process and other healthcare transactions by encouraging electronic transmission rather than paper submission. These regulations provide for uniform standards for data reporting, formatting and coding that we must use in certain transactions with health plans. The HIPAA security regulations establish detailed requirements for safeguarding protected health information that is electronically transmitted or electronically stored. Some of the security regulations are technical in nature, while others are addressed through policies and procedures. We implemented or upgraded computer and information systems as we believe necessary to comply with the new regulations.

The HIPAA regulations related to privacy establish comprehensive federal standards relating to the use and disclosure of individually identifiable health information (“protected health information”). The privacy regulations establish limits on the use and disclosure of protected health information, provide for patients’ rights, including rights to access, to request amendment of, and to receive an accounting of certain disclosures of protected health information, and require certain safeguards for protected health information. In addition, each covered entity must contractually bind individuals and entities that furnish services to the covered entity or perform a function on its behalf, and to which the covered entity discloses protected health information, to restrictions on the use and disclosure of that protected health information. In general, the HIPAA regulations do not supersede state laws that are more stringent or grant greater privacy rights to individuals. Thus, we must reconcile the HIPAA regulations and other state privacy laws.

Although we believe that we are in material compliance with these HIPAA regulations, the HIPAA regulations are expected to continue to impact us operationally and financially and may pose increased regulatory risk.

Self-Referral and Anti-Kickback Legislation. The health care industry is subject to state and federal laws which regulate the relationships of providers of health care services, physicians and other clinicians. These self-referral laws impose restrictions on physician referrals to any entity with which they have a financial relationship, which is a broadly defined term. We believe our relationships with physicians are in compliance with the self-referral laws. Failure to comply with self-referral laws could subject us to a range of sanctions, including civil monetary penalties and possible exclusion from government reimbursement programs. There are also federal and state laws making it illegal to offer anyone anything of value in return for referral of patients. These laws, generally

known as “anti-kickback” laws, are broad and subject to interpretations that are highly fact dependent. Given the lack of clarity of these laws, there can be no absolute assurance that any health care provider, including us, will not be found in violation of the anti-kickback laws in any given factual situation. Strict sanctions, including fines and penalties, exclusion from the Medicare and Medicaid programs and criminal penalties, may be imposed for violation of the anti-kickback laws.

Reporting Obligations under Section 111 of the Medicare, Medicaid and SCHIP Extension Act of 2007 (“MMSEA”). Since January 1, 2010, we have reported specific information regarding all claimants and claim settlements involving Medicare participants so CMS can recover Medicare funds expended to provide healthcare treatment to the claimant. The requirements are to ensure that CMS is notified so that it may recoup the amounts paid for services from the settlement proceeds. This does not result in us making additional payments to CMS for these services provided and does not result in an incremental cost to us. Strict sanctions, including fines and penalties, exclusion from the Medicare and Medicaid programs and criminal penalties, may be imposed for non-compliance with these reporting obligations.

Available Information.

We file reports with the Securities and Exchange Commission (“SEC”), including annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K. Copies of our reports filed with the SEC may be obtained by the public at the SEC’s Public Reference Room by calling the SEC at 1-800-SEC-0330. We file such reports with the SEC electronically, and the SEC maintains an Internet site at www.sec.gov that contains our reports, proxy and information statements, and other information filed electronically. We also make available, free of charge through our website, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and other materials filed with the SEC as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC via a link to the SEC’s EDGAR system. Our website address is www.advocatinc.com. The information provided on our website is not part of this report, and is therefore not incorporated by reference unless such information is otherwise specifically referenced elsewhere in this report.

In addition, copies of the Company’s annual report will be made available, free of charge, upon written request.

ITEM 1A. RISK FACTORS

There have been a number of material developments both within the Company and the long-term care industry. These developments have had and are likely to continue to have a material impact on us. This section summarizes these developments, as well as other risks that should be considered by our shareholders and prospective investors.

We are substantially self-insured and have significant potential professional liability exposure.

The provision of health care services entails an inherent risk of liability. Participants in the health care industry are subject to an increasing number of lawsuits alleging malpractice, negligence, product liability or related legal theories, many of which involve large claims and significant defense costs. Like many other companies engaged in the long-term care profession in the United States, we have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. We expect to continue to be subject to such suits as a result of the nature of our business. See “Item 3. Legal Proceedings” for further descriptions of pending claims and see “Item 7. Management’s Discussion and Analysis of Financial Condition — Accounting Policies and Judgments — Professional Liability and Other Self-Insurance Reserves” for discussion of our reserve for self-insured claims and of our ability to meet our anticipated cash needs.

For claims made after March 9, 2001, we have purchased professional liability insurance coverage for our nursing centers that, based on historical claims experience, is likely to be substantially less than the amount required to satisfy claims that are expected to be incurred. We have essentially exhausted all of our insurance coverage for claims first asserted prior to May 31, 2010.

We have had substantial adjustments to our accrual for professional liability claims which has caused significant changes in our net earnings.

Each year, we record adjustments to our accrual for self-insured risks associated with professional liability claims. While these adjustments to the accrual result in changes to reported expenses and income, they are not directly related to changes in cash because the accrual is not funded. These self-insurance reserves are assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period. Our actual professional liabilities may vary significantly from the accrual, and the amount of the accrual has and may continue to fluctuate by a material amount in any given quarter. For the years ended December 31, 2010, 2009 and 2008, we recorded professional liability expense of $5.4 million, $8.2 million and $1.5 million, respectively.

Our outstanding indebtedness is subject to various financial covenants and floating rates of interest which could be subject to fluctuations based on changing interest rates.

We have $24.4 million of indebtedness at December 31, 2010. Certain of our debt agreements contain various financial covenants, the most restrictive of which relate to cash flow, census and debt service coverage ratios. As of December 31, 2010, we were in compliance with these financial covenants. Our failure to comply with those covenants could result in an event of default, which, if not cured or waived, could result in the acceleration of some or all of our debts. Such non-compliance could result in a material adverse impact to our financial position, results of operations and cash flows. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” for additional discussion of our covenants.

At December 31, 2010, all of our $24.4 million of indebtedness was subject to variable interest rates. In connection with the refinancing transaction discussed in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources”, we entered into an interest rate swap agreement in order to mitigate the floating interest rate risk with respect to our mortgage loan. The interest rate swap converted the variable rate on approximately $23 million of our indebtedness to a synthetically fixed interest rate, which decreases our exposure to risks of variable rates of interest. While limiting our risk to increases in interest rates by utilizing the interest rate swap, we forgo benefits that might result from downward fluctuations in interest rates. We also are exposed to the risk that our counterpart to the swap agreement will default on its obligations.

We are highly dependent on reimbursement by third-party payors.

Substantially all of our nursing center revenues are directly or indirectly dependent upon reimbursement from third-party payors, including the Medicare and Medicaid programs, and private insurers. For the year ended December 31, 2010, our patient revenues from continuing operations derived from Medicaid, Medicare, managed care and private pay (including private insurers) sources were approximately 53.4%, 30.7%, 3.0%, and 12.9%, respectively. Changes in the mix of our patients among Medicare, Medicaid, managed care and private pay categories and among different types of private pay sources may affect our net revenues and profitability. Our net revenues and profitability are also affected by the continuing efforts of all payors to contain or reduce the costs of health care. Efforts to impose reduced payments, greater discounts and more stringent cost controls by government and other payors are expected to continue.

The Federal Government makes frequent changes to the reimbursement provided under the Medicare program and future changes could significantly reduce the reimbursement we receive. Also, a number of state governments, including several of the states in which we operate, have announced projected budget shortfalls and/or deficit spending situations. Possible actions by these states include reductions of Medicaid reimbursement to providers such as us or the failure to increase Medicaid reimbursements to cover increased operating costs, or implementation of alternatives to long-term care, such as community and home-based services.

Any changes in reimbursement levels or in the timing of payments under Medicare, Medicaid or private pay programs and any changes in applicable government regulations could have a material adverse effect on our net revenues, net income and cash flows. We are unable to predict what reform proposals or reimbursement limitations will be adopted in the future or the effect such changes will have on our operations. We are limited in our ability to reduce the direct costs of providing care when decreases in reimbursement rates are imposed. No assurance can be given that such reforms will not have a material adverse effect on us. See “Item 1. Business — Government Regulation and Reimbursement.”

We are subject to significant government regulation.

The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Various federal and state laws regulate relationships among providers of services, including employment or service contracts and investment relationships. The operation of long-term care centers and the provision of services are also subject to extensive federal, state, and local laws relating to, among other things, the adequacy of medical care, distribution of pharmaceuticals, equipment, personnel, operating policies, environmental compliance, compliance with the Americans with Disabilities Act, fire prevention and compliance with building codes.

Long-term care facilities are subject to periodic inspection to assure continued compliance with various standards and licensing requirements under state law, as well as with Medicare and Medicaid conditions of participation. The failure to obtain or renew any required regulatory approvals or licenses could adversely affect our growth and could prevent us from offering our existing or additional services. In addition, health care is an area of extensive and frequent regulatory change. Changes in the laws or new interpretations of existing laws can have a significant effect on methods and costs of doing business and amounts of payments

received from governmental and other payors. Our operations could be adversely affected by, among other things, regulatory developments such as mandatory increases in the scope and quality of care to be afforded patients and revisions in licensing and certification standards. We attempt at all times to comply with all applicable laws; however, there can be no assurance that we will remain in compliance at all times with all applicable laws and regulations or that new legislation or administrative or judicial interpretation of existing laws or regulations will not have a material adverse effect on our operations or financial condition. Federal or state proceedings seeking to impose fines and penalties for violations of applicable laws and regulations, as well as federal and state changes in these laws and regulations may negatively impact us. See “Item 1. Business — Government Regulation.” See also “Item 3. Legal Proceedings.”

The health care industry has been the subject of increased regulatory scrutiny recently.

The Office of Inspector General (“OIG”), the enforcement arm of the Medicare and Medicaid programs, formulates a formal work plan each year for nursing centers. The OIG’s most recent work plan indicates that quality of care, assessment and monitoring, poorly performing nursing facilities, hospitalizations, criminal background checks, Medicare part B services, accuracy of nursing facilities Minimum Data, transparency of ownership, and civil monetary penalty funds will be an investigative focus in 2011. We cannot predict the likelihood, scope or outcome of any such investigations on our facilities.

We are subject to claims under the self-referral and anti-kickback legislation.

In the United States, various state and federal laws regulate the relationships between providers of health care services, physicians, and other clinicians. These self-referral laws impose restrictions on physician referrals for designated health services to entities with which they have financial relationships. These laws also prohibit the offering, payment, solicitation or receipt of any form of remuneration in return for the referral of Medicare or state health care program patients or patient care opportunities for the purchase, lease or order of any item or service that is covered by the Medicare and Medicaid programs. To the extent that we, any of our facilities with which we do business, or any of the owners or directors have a financial relationship with each other or with other health care entities providing services to long-term care patients, such relationships could be subject to increased scrutiny. There can be no assurance that our operations will not be subject to review, scrutiny, penalties or enforcement actions under these laws, or that these laws will not change in the future. Violations of these laws may result in substantial civil or criminal penalties for individuals or entities, including large civil monetary penalties and exclusion from participation in the Medicare or Medicaid programs. Such exclusion or penalties, if applied to us, could have a material adverse effect on our profitability.

We operate in an industry that is highly competitive.

The long-term care industry generally, and the nursing home business particularly, is highly competitive. We face direct competition for the acquisition of facilities. In turn, our facilities face competition for employees and patients. Our ability to compete is based on several factors and include, but are not limited to building age, appearance, reputation, relationships with referral sources, availability of patients, survey history and CMS rankings. Some of our present and potential competitors are significantly larger and have or may obtain greater financial and marketing resources than we can. Some hospitals that provide long-term care services are also a potential source of competition. In addition, we may encounter substantial competition from new market entrants. Consequently, there can be no assurance that we will not encounter increased competition in the future, which could limit our ability to attract patients or expand our business, and could materially and adversely affect our business or decrease our market share.

Healthcare reform legislation could adversely affect our revenue and financial condition.

In recent years, there have been initiatives on the federal and state levels for comprehensive reforms affecting the availability, payment and reimbursement of healthcare services in the United States. In March 2010, significant legislation concerning health care and health insurance was passed which will significantly change the future of health care in the United States. If the reforms are phased in over the next ten years as currently enacted, they may significantly increase our costs to provide employee health insurance and have an adverse effect on our financial condition and results of operations. It is also expected that this new legislation will impact our operations and reimbursement from Federal programs such as Medicare and Medicaid as well as private insurance. The timing and ultimate level of that impact is currently unknown as we anticipate that many of the provisions of the Legislation may be subject to further clarification and modification through the rule making process.

Investing in our business initiatives and development could adversely impact our results of operations and financial condition.

We plan to invest in business initiatives and development that will increase our operating expenses for the next one or two years. These initiatives may or may not be successful in growing our census or revenues. There is typically a time delay between incurring such expenses and the attaining of revenues and cash flows expected from these initiatives and development. As a result, our revenue

and operating cash flow may not increase enough during a reporting period to cover these increased expenses. Such additional revenues may not materialize at the level we anticipate, if at all.

Our ability and intent to pay cash dividends in the future may be limited.

We currently pay a $0.055 quarterly dividend on our common shares and while the Board of Directors intends to pay quarterly dividends, the Board will make the determination of the amount of future cash dividends, if any, to be declared and paid based on, among other things, our financial condition, funds from operations, the level of our capital expenditures and future business prospects.

We have a number of policies in place that could be considered anti-takeover protections.

We have adopted a shareholder rights plan (the “Plan”). On August 14, 2009, our board of directors (“Board”) amended the Plan to change the definition of “Acquiring Person” to be such person that acquires 20% or more of the shares of Common Stock of the Company, up from the 15% that previously defined an acquiring person. The Plan is intended to encourage potential acquirers to negotiate with our Board and to discourage coercive, discriminatory and unfair proposals. Our Certificate of Incorporation (the “Certificate”) provides for the classification of our Board into three classes, with each class of directors serving staggered terms of three years. Our Certificate requires the approval of the holders of two-thirds of the outstanding shares to amend certain provisions of the Certificate. Section 203 of the Delaware General Corporate Law restricts the ability of a Delaware corporation to engage in any business combination with an interested shareholder. We are also authorized to issue up to 795,000 shares of preferred stock, the rights of which may be fixed by our Board without shareholder approval. Provisions in certain of our executive officers’ employment agreements provide for post-termination compensation, including payment of amounts up to 2.5 times their annual salary, following certain changes in control (as defined in such agreements). Our stock incentive plans provide for the acceleration of the vesting of options in the event of certain changes in control (as defined in such plans). Certain changes in control also constitute an event of default under our bank credit facility. The foregoing matters may, together or separately, have the effect of discouraging or making more difficult an acquisition or change of control of the company.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

We own 9 and lease 37 long-term care facilities as discussed in “Item 1 Business — Nursing Centers and Services.” A description of our lease agreements follows.

Description of Lease Agreements.

Our current operations include 37 nursing centers subject to operating leases, including 36 owned by Omega and one owned by another party. In our role as lessee, we are responsible for the day-to-day operations of all operated centers. These responsibilities include recruiting, hiring and training all nursing and other personnel, and providing resident care, nutrition services, marketing, quality improvement, accounting, and data processing services for each facility. The lease agreements pertaining to our 37 leased facilities are “triple net” leases, requiring us to maintain the premises, pay taxes and pay for all utilities. The average remaining term of our lease agreements, including renewal options, is approximately 20 years.

Omega Master Lease. We lease 28 nursing centers from Omega pursuant to one lease agreement dated October 1, 2000 (the “Omega Master Lease”). The Omega Master Lease has an initial term, as amended, that expires September 30, 2018, provides for a renewal option of an additional twelve years, assuming no defaults, and provides for annual increases in lease payments equal to the lesser of two times the increase in the Consumer Price Index or 3.0%.

Effective August 11, 2007, we completed the acquisition of the leases and leasehold interests in seven facilities from Senior Management Services of America North Texas (“SMSA”) which are leased from a subsidiary of Omega. In connection with this acquisition, we amended the Omega Master Lease to include the seven SMSA facilities (“SMSA Amendment”), increasing the number of facilities under the Omega Master Lease to 35. The substantive terms of the previous SMSA lease, including payment provisions and lease period including renewal options, were not changed by the SMSA Amendment. The SMSA Amendment provides for an initial term and renewal periods at our option through May 31, 2035 for the seven SMSA facilities. The SMSA Amendment provides for annual increases in lease payments equal to the increase in the Consumer Price Index, not to exceed 2.5%.

The Omega Master Lease requires us to fund annual capital expenditures currently equal to $398 per licensed bed, subject to adjustment for increases in the Consumer Price Index. Upon expiration of, or in the event of a default under the Omega Master Lease, we are required to transfer all of the leasehold improvements, equipment, furniture and fixtures of the leased facilities to Omega.

In May 2009, we entered into an amendment to the Master lease under which Omega agreed to provide $5,000,000 to fund renovations to several nursing centers leased from Omega. This arrangement is similar to amendments entered into in 2006 and 2005 that provided financing totaling $10,000,000 which was used to fund renovations to several nursing centers leased from Omega. The annual base rent related to these facilities was increased to reflect the amount of capital improvements to the respective facilities as the related expenditures were made. The increase is based on a rate of 10.25% per year of the amount financed under this amendment. As of December 31, 2010, renovation projects have been completed at twelve leased facilities with these funds, and substantially all $15 million allotted by Omega to fund renovations has been used. Plans are being developed for additional renovation projects including those that would potentially be funded through Omega.

The Omega Master Lease prohibits us from operating any additional facilities within a certain radius of each leased facility. We are generally required to maintain comprehensive insurance covering the facilities we lease as well as personal and real property damage insurance and professional liability insurance. The failure to pay rentals within a specified period or to comply with the required operating and financial covenants generally constitutes a default, if uncured, this default permits Omega to terminate the lease and assume the property and the contents within the facilities.

In August 2009, we completed the construction of a 119 bed skilled nursing center, Brentwood Terrace, located in Paris, Texas, replacing an existing 102 bed facility leased from Omega. The new facility was financed with funding from Omega and is leased from Omega under a long term operating lease with renewal options through 2035. Annual rent was approximately $0.8 million for the year ending December 31, 2010 and is based on a calculation of 10.25% of $7.7 million, the total cost of the replacement facility. The Brentwood Terrace facility lease provides for annual increases in lease payments equal to the increase in the Consumer Price Index, not to exceed 2.5%.

Other Leases. We operate a 150 bed facility located in Tennessee subject to a lease with an initial term that expires March 2012 and renewal options through March 2019. Rent for this facility is approximately $0.8 million and provides for annual increases in lease payments equal to 3.0%.

We lease approximately 27,000 square feet of office space in Brentwood, Tennessee that houses our executive offices, and centralized management support functions. In addition, we lease our regional office with approximately 4,000 square feet of office space in Ashland, Kentucky. Lease periods on these facilities range up to seven years. Regional executives for Alabama, Arkansas, Florida and Tennessee work from offices of up to 1,500 square feet each. We believe that our leased properties are adequate for our present needs and that suitable additional or replacement space will be available as required.

ITEM 3. LEGAL PROCEEDINGS

The provision of health care services entails an inherent risk of liability. Participants in the health care industry are subject to lawsuits alleging malpractice, product liability, or related legal theories, many of which involve large claims and significant defense costs. Like many other companies engaged in the long-term care profession in the United States, we have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. It is expected that we will continue to be subject to such suits as a result of the nature of our business. Further, as with all health care providers, we are periodically subject to regulatory actions seeking fines and penalties for alleged violations of health care laws and are potentially subject to the increased scrutiny of regulators for issues related to compliance with health care fraud and abuse laws and with respect to the quality of care provided to residents of our facility. Like other health care providers, in the ordinary course of our business, we are also subject to claims made by employees and other disputes and litigation arising from the conduct of our business.

As of December 31, 2010, we are engaged in 32 professional liability lawsuits. Seven lawsuits are currently scheduled for trial through March 2012, and it is expected that additional cases will be set for trial. The ultimate results of any of our professional liability claims and disputes cannot be predicted. We have limited, and sometimes no, professional liability insurance with regard to most of these claims. A significant judgment entered against us in one or more of these legal actions could have a material adverse impact on our financial position and cash flows.

In January 2009, a purported class action complaint was filed in the Circuit Court of Garland County, Arkansas against us and certain of our subsidiaries and Garland Nursing & Rehabilitation Center (the “Facility”). The complaint alleges that the defendants breached their statutory and contractual obligations to the residents of the Facility over the past five years. The lawsuit remains in its early stages and has not yet been certified by the court as a class action. We intend to defend the lawsuit vigorously.

We cannot currently predict with certainty the ultimate impact of any of the above cases on our financial condition, cash flows or results of operations. An unfavorable outcome in any of the lawsuits, any regulatory action, any investigation or lawsuit alleging violations of fraud and abuse laws or of elderly abuse laws or any state or Federal False Claims Act case could subject us to fines, criminal sanctions, penalties and damages, including exclusion from the Medicare or Medicaid programs, and could have a material adverse impact on our financial condition, cash flows or results of operations.

ITEM 4. RESERVED

PART II

ITEM 5.		MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information. Our common stock was traded on NASD’s OTC Bulletin Board under the symbol “AVCA” through September 11, 2006. During the third quarter of 2006, our common stock was approved for listing on the NASDAQ Capital Market and began trading there on September 12, 2006 under the symbol “AVCA.” The following table sets forth the high and low bid prices of our common stock, as reported by NASDAQ.com, for each quarter in 2009 and 2010:

Period				High				Low
2009 — 1st		Quarter		$	3.78			$	1.96
2009 — 2nd		Quarter			3.90				2.21
2009 — 3rd		Quarter			7.27				2.67
2009 — 4th		Quarter			8.94				5.33
2010 — 1st		Quarter			8.44				5.40
2010 — 2nd		Quarter			6.98				4.65
2010 — 3rd		Quarter			5.95				4.00
2010 — 4th		Quarter			5.95				4.49

Our common stock has been traded since May 10, 1994. On February 17, 2011, the closing price for our common stock was $5.25, as reported by NASDAQ.com.

Holders. On February 17, 2011, there were approximately 246 holders of record. Most of our shareholders have their holdings in the street name of their broker/dealer.

Dividends. We did not pay cash dividends on our common stock until the second quarter of 2009. We currently pay a quarterly dividend of $0.055 per common share. While the Board of Directors intends to pay quarterly dividends, the Board will make the determination of the amount of future cash dividends, if any, to be declared and paid based on, among other things, the Company’s financial condition, funds from operations, the level of its capital expenditures and its future business prospects. We are required to pay an annual dividend at a rate of 7% of the stated value on our outstanding Series C Redeemable Preferred Stock, payable quarterly. As a result, we have paid a quarterly dividend on the outstanding Series C Redeemable Preferred Stock of $86,000.

Equity Compensation Plan Information

The following table provides aggregate information as of December 31, 2010, with respect to shares of our common stock that may be issued under our existing equity compensation plans:

Number of Securities

Number of Securities

Available for Future

to be Issued Upon

Weighted-Average

Issuance Under Equity

Exercise of

Exercise Price of

Compensation Plans

Outstanding Options,

Outstanding Options,

(excluding Securities

Warrants and Rights

Warrants and Rights

Reflected in Column (a))

Plan Category

(a)

(b)

(c)(1)

Equity Compensation Plans Approved by Security Holders

610,000

$

6.59

441,000

Equity Compensation Plans Not Approved by Security Holders

None

None

None

Total

610,000

$

6.59

441,000

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

The selected financial data of Advocat presented in the following table have been derived from our consolidated financial statements, and should be read in conjunction with the annual financial statements and related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations. The SMSA facilities are included in selected financial data effective August 11, 2007 and the single facility lease in Texas is included effective November 1, 2007. This selected financial data for all periods shown have been reclassified to present the effects of certain divestitures as discontinued operations.

		Year Ended December 31,
		2010				2009				2008				2007				2006
		(in thousands, except per share amounts)
Statement of Operations Data
REVENUES:
Patient revenues, net		$	290,130			$	276,979			$	263,837			$	219,911			$	190,077
EXPENSES:
Operating			229,081				219,567				207,998				167,852				144,804
Lease			22,600				21,791				21,331				18,388				14,431
Professional liability			5,364				8,228				1,532				(1,559	)			(6,918	)
General and administrative			19,680				17,926				17,973				17,062				20,551
Depreciation and amortization			5,825				5,446				5,065				3,884				3,312
			282,550				272,958				253,899				205,627				176,180
OPERATING INCOME			7,580				4,021				9,938				14,284				13,897
OTHER INCOME (EXPENSE):
Foreign currency transaction gain (loss)			—				191				(1,005	)			808				21
Other income			—				549				—				—				207
Interest income			2				161				453				1,016				679
Interest expense			(1,634	)			(1,877	)			(2,870	)			(3,545	)			(3,707	)
Debt retirement costs			(127	)			—				—				(116	)			(194	)
			(1,759	)			(976	)			(3,422	)			(1,837	)			(2,994	)
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES			5,821				3,045				6,516				12,447				10,903
(PROVISION) BENEFIT FOR INCOME TAXES			(1,858	)			(1,165	)			(2,208	)			(4,953	)			10,347
NET INCOME FROM CONTINUING OPERATIONS			3,963				1,880				4,308				7,494				21,250
DISCONTINUED OPERATIONS, net of taxes			(114	)			721				1,427				1,893				694
NET INCOME		$	3,849			$	2,601			$	5,735			$	9,387			$	21,944
INCOME (LOSS) PER COMMON SHARE:
Basic-
Continuing operations		$	0.63			$	0.27			$	0.70			$	1.22			$	3.62
Discontinued operations			(0.02	)			0.13				0.25				0.32				0.12
Net per common share		$	0.61			$	0.40			$	0.95			$	1.54			$	3.74
Diluted-
Continuing operations		$	0.62			$	0.26			$	0.67			$	1.17			$	3.24
Discontinued operations			(0.02	)			0.13				0.25				0.31				0.11
Net per common share		$	0.60			$	0.39			$	0.92			$	1.48			$	3.35
CASH DIVIDENDS DECLARED PER COMMON SHARE		$	0.215			$	0.15				—				—				—
WEIGHTED AVERAGE COMMON SHARES:
Basic			5,732				5,678				5,693				5,870				5,784
Diluted			5,854				5,797				5,887				6,127				6,507

		December 31,
		2010				2009				2008				2007				2006
		(in thousands)
Balance Sheet Data
Working capital		$	16,416			$	12,334			$	10,885			$	15,677			$	8,174
Total assets		$	105,518			$	105,451			$	107,339			$	110,090			$	96,901
Short-term borrowings and long-term debt including current portion		$	24,014			$	24,829			$	32,410			$	34,455			$	31,516
Preferred Stock — Series C (including unamortized premium)		$	4,918			$	6,192			$	7,891			$	9,590			$	11,289
Shareholders’ Equity		$	22,205			$	19,693			$	17,551			$	12,744			$	3,837

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Advocat Inc. provides long-term care services to nursing center patients in eight states, primarily in the Southeast and Southwest United States. Our centers provide a range of health care services to their patients. In addition to the nursing, personal care and social services usually provided in long-term care centers, we offer a variety of comprehensive rehabilitation services as well as nutritional support services.

As of December 31, 2010, our continuing operations consist of 46 nursing centers with 5,364 licensed nursing beds. As of December 31, 2010, our continuing operations included nine owned nursing centers and 37 leased nursing centers.

Divestitures.

The Centers for Medicare and Medicaid Services (“CMS”) issued regulations that became effective October 1, 2009 that prohibit us from billing Medicare Part B for certain enteral nutrition, urological, ostomy and tracheostomy supplies, and these services are now provided by third parties. We are still required to provide the labor for the delivery of services but are no longer a supplier and will not be entitled to any compensation. The revenue and cost of goods sold for providing these services prior to October 2009 have been reclassified as discontinued operations.

The net assets of discontinued operations presented in property and equipment on our balance sheet represent real estate related to an assisted living facility in North Carolina closed in April 2006. Based on an evaluation of the estimated realizable value of the land, we recorded an impairment charge of $0.4 million to reduce the carrying value of the land. We are continuing our efforts to sell this land.

Effective March 31, 2010, we terminated operations of four nursing centers in Florida under a lease that, as amended, would have expired in August 2010. The operating margins of the four facilities subject to this lease did not meet our goals. Effective March 31, 2010, we transitioned operations at these leased facilities, and we have reclassified the operations of these facilities as discontinued operations and current assets in the accompanying consolidated financial statements.

Basis of Financial Statements. Our patient revenues consist of the fees charged for the care of patients in the nursing centers we own and lease. Our operating expenses include the costs, other than lease, depreciation and amortization expenses, incurred in the operation of the nursing centers we own and lease. Our general and administrative expenses consist of the costs of the corporate office and regional support functions. Our interest, depreciation and amortization expenses include all such expenses across the range of our operations.

Selected Financial and Operating Data

The following table summarizes the Advocat statements of continuing operations for the years ended December 31, 2010, 2009 and 2008, and sets forth this data as a percentage of revenues for the same years.

		Year Ended December 31,
		(Dollars in thousands)
		2010								2009								2008
Revenues:
Patient revenues, net		$	290,130				100.0	%		$	276,979				100.0	%			263,837				100.0	%
Expenses:
Operating			229,081				79.0				219,567				79.3				207,998				78.8
Lease			22,600				7.8				21,791				7.8				21,331				8.1
Professional liability			5,364				1.8				8,228				3.0				1,532				0.6
General & administrative			19,680				6.8				17,926				6.5				17,973				6.8
Depreciation and amortization			5,825				2.0				5,446				1.9				5,065				1.9
			282,550				97.4				272,958				98.5				253,899				96.2
Operating income			7,580				2.6				4,021				1.5				9,938				3.8
Other income (expense):
Foreign currency transaction gain (loss)			—				—				191				0.1				(1,005	)			(0.4	)
Other income			—				—				549				0.2				—				—
Interest income			2				—				161				—				453				0.2
Interest expense			(1,634	)			(0.6	)			(1,877	)			(0.7	)			(2,870	)			(1.1	)
Debt retirement costs			(127	)			—				—				—				—				—
			(1,759	)			(0.6	)			(976	)			(0.4	)			(3,422	)			(1.3	)
Income from continuing operations before income taxes			5,821				2.0				3,045				1.1				6,516				2.5
Provision for income taxes			(1,858	)			(0.6	)			(1,165	)			(0.4	)			(2,208	)			(0.9	)
Net income from continuing operations		$	3,963				1.4	%		$	1,880				0.7	%			4,308				1.6	%

The following table presents data about the facilities we operated as part of our continuing operations as of the dates or for the years indicated:

		December 31,
		2010				2009				2008
Licensed Nursing Center Beds:
Owned			936				936				942
Leased			4,428				4,848				4,831
Total			5,364				5,784				5,773
Facilities:
Owned			9				9				9
Leased			37				41				41
Total			46				50				50

Critical Accounting Policies and Judgments

A “critical accounting policy” is one which is both important to the understanding of our financial condition and results of operations and requires management’s most difficult, subjective or complex judgments often of the need to make estimates about the effect of matters that are inherently uncertain. Actual results could differ from those estimates and cause our reported net income to vary significantly from period to period. Our accounting policies that fit this definition include the following:

Revenues

Patient Revenues

The fees we charge patients in our nursing centers are recorded on an accrual basis. These rates are contractually adjusted with respect to individuals receiving benefits under federal and state-funded programs and other third-party payors. Our net revenues are derived substantially from Medicare, Medicaid and other government programs (approximately 84.1%, 85.0% and 85.4% for 2010, 2009, and 2008, respectively). Medicare intermediaries make retroactive adjustments based on changes in allowed claims. In addition, certain of the states in which we operate require complicated detailed cost reports which are subject to review and adjustments. In the opinion of management, adequate provision has been made for adjustments that may result from such reviews. Retroactive adjustments, if any, are recorded when objectively determinable, generally within

three years of the close of a reimbursement year depending upon the timing of appeals and third-party settlement reviews or audits.

Allowance for Doubtful Accounts

We evaluate the collectability of our accounts receivable by reviewing current aging summaries of accounts receivable, historical collections data and other factors. As a percentage of revenue, our provision for doubtful accounts was approximately 0.7% for both 2010 and 2009 and 0.8% for 2008. Historical bad debts have generally resulted from uncollectible private pay balances, some uncollectible coinsurance and deductibles and other factors. Receivables that are deemed to be uncollectible are written off.

Professional Liability and Other Self-Insurance Reserves

Accrual for Professional and General Liability Claims-

Effective June 1, 2010, our nursing centers are covered by one of two professional liability insurance policies. Our 25 nursing centers in Arkansas, Kentucky, Tennessee, and West Virginia are currently covered by an insurance policy with coverage limits of $250,000 per medical incident and total annual aggregate policy limits of $750,000. This policy provides the only commercially affordable insurance coverage available for claims made during this period against these nursing centers. Our 21 nursing centers in Alabama, Florida, Ohio and Texas are currently covered by an insurance policy with coverage limits of $1,000,000 per medical incident, subject to a deductible of $495,000 per claim, with a total annual aggregate policy limit of $15,000,000 and a sublimit per center of $3,000,000.

Because our actual liability for existing and anticipated professional liability and general liability claims will exceed our limited insurance coverage, we have recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $17.3 million as of December 31, 2010. This accrual includes estimates of liability for incurred but not reported claims, estimates of liability for reported but unresolved claims, actual liabilities related to settlements, including settlements to be paid over time, and estimates of related legal costs incurred and expected to be incurred. All losses are projected on an undiscounted basis.

Semi-annually we retain the Actuarial Division of Willis of Tennessee, Inc. (“Willis”), a third-party actuarial firm, to estimate the appropriate accrual for incurred general and professional liability claims. The actuary, Willis, primarily uses historical data regarding the frequency and cost of our past claims over a multi-year period and information regarding our number of occupied beds to develop its estimates of our ultimate professional liability cost for current periods. The actuary estimates our professional liability accrual for past periods by using currently-known information to adjust the initial reserve that was created for that period.

On a quarterly basis, we obtain reports of claims and lawsuits that we have incurred from insurers and a third party claims administrator. These reports contain information relevant to the liability actually incurred to date with that claim as well as the third-party administrator’s estimate of the anticipated total cost of the claim. This information is reviewed by us quarterly and provided to the actuary semi-annually. The actuary uses this information to determine the timing of claims reporting and the development of reserves, and compares the information obtained to its original estimates of liability. Based on the actual claim information obtained and on estimates regarding the number and cost of additional claims anticipated in the future, the reserve estimate for a particular period may be revised upward or downward on a quarterly basis. Final determination of our actual liability for claims incurred in any given period is a process that takes years.

The Company’s cash expenditures for self-insured professional liability costs were $5.1 million, $4.8 million and $6.6 million for the years ended December 31, 2010, 2009 and 2008, respectively.

Although we retain a third-party actuarial firm to assist us, professional and general liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. Professional liability cases have a long cycle from the date of an incident to the date a case is resolved, and final determination of our actual liability for claims incurred in any given period is a process that takes years. As a result, our actual liabilities may vary significantly from the accrual, and the amount of the accrual has and may continue to fluctuate by a material amount in any given quarter.

Professional liability costs are material to our financial position, and changes in estimates, as well as differences between estimates and the ultimate amount of loss, may cause a material fluctuation in our reported results of operations. Our professional liability expense was $5.4 million, $8.2 million and $1.5 million for the years ended December 31, 2010, 2009 and 2008, respectively. These amounts are material in relation to our reported net income from continuing operations for the

related periods of $4.0 million, $1.9 million and $4.3 million, respectively. The total liability recorded at December 31, 2010, was $17.3 million, compared to current assets of $42.4 million and total assets of $105.5 million.

Accrual for Other Self-Insured Claims-

With respect to workers’ compensation insurance, substantially all of our employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. We are completely self-insured for workers’ compensation exposures prior to May 1997. We have been and remain a non-subscriber to the Texas workers’ compensation system and are, therefore, completely self-insured for employee injuries with respect to its Texas operations. From June 30, 2003 until June 30, 2007, our workers’ compensation insurance programs provided coverage for claims incurred with premium adjustments depending on incurred losses. For the period from July 1, 2008 through June 30, 2011, we are covered by a prefunded deductible policy. Under this policy, we are self insured for the first $500,000 per claim, subject to an aggregate maximum of $3,000,000. We fund a loss fund account with the insurer to pay for claims below the deductible. We account for premium expense under this policy based on its estimate of the level of claims subject to the policy deductibles expected to be incurred.

We are self-insured for health insurance benefits for certain employees and dependents for amounts up to $175,000 per individual annually. We provide reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate, based on known claims and estimates of unknown claims based on historical information. The differences between actual settlements and reserves are included in expense in the period finalized. Our reserves for health insurance benefits can fluctuate materially from one year to the next depending on the number of significant health issues of our covered employees and their dependants.

Asset Impairment

We evaluate our property, equipment and other long-lived assets on a quarterly basis to determine if facts and circumstances suggest that the assets may be impaired or that the estimated depreciable life of the asset may need to be changed such as significant physical changes in the property, significant adverse changes in general economic conditions, and significant deteriorations of the underlying cash flows or fair values of the property. The need to recognize an impairment is based on estimated future cash flows from a property compared to the carrying value of that property. If recognition of impairment is necessary, it is measured as the amount by which the carrying amount of the property exceeds the fair value of the property. We have no assets recorded at fair value; however, our asset impairment analysis is consistent with the fair value measurements described in the accounting guidance for “Fair Value Measurements and Disclosures.” We recorded an impairment of $0.4 million in 2010 for land held for sale based on the expected realizable value of the land. We did not record any asset impairments in 2009 or 2008. If our estimates or assumptions with respect to a property change in the future, we may be required to record additional impairment charges for our assets.

Business Combinations

Effective January 1, 2009, we adopted the new accounting guidance on “Business Combinations” which established principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree as well as the goodwill acquired or gain recognized in a bargain purchase. The new guidance also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. During the fourth quarter of 2008, we expensed $202,000 in acquisition costs related to the transaction discussed in Note 3 of the Consolidated Financial Statements. Under the business combination accounting guidance in effect prior to January 1, 2009, these costs were considered part of the purchase price and as such were capitalized, but effective January 1, 2009 the accounting guidance required these costs be expensed as incurred. Both the current and previous guidance require that we make certain valuations to determine the fair value of assets acquired and the liabilities assumed. These valuations are subject to retroactive adjustment during the twelve month period subsequent to the acquisition date. Such valuations require us to make significant estimates, judgments and assumptions, including projections of future events and operating performance.

Stock-Based Compensation

We recognize compensation cost for all share-based payments granted after January 1, 2006 on a straight-line basis over the vesting period. We calculated the recognized and unrecognized stock-based compensation using the Black-Scholes-Merton option valuation method, which requires us to use certain key assumptions to develop the fair value estimates. These key assumptions include expected volatility, risk-free interest rate, expected dividends and expected term. During the years ended December 31, 2010, 2009 and 2008, we recorded charges of approximately $0.6 million, $0.7 million and $0.9 million in stock-based compensation, respectively. Stock-

based compensation expense is a non-cash expense and such amounts are included as a component of general and administrative expense or operating expense based upon the classification of cash compensation paid to the related employees.

Income Taxes

We determine deferred tax assets and liabilities based upon differences between financial reporting and tax bases of assets and liabilities and measure them using the enacted tax laws that will be in effect when the differences are expected to reverse. We maintain a valuation allowance of approximately $0.9 million to reduce the deferred tax assets by the amount we believe is more likely than not to not be utilized through the turnaround of existing temporary differences, future earnings, or a combination thereof. In future periods, we will continue to assess the need for and adequacy of the remaining valuation allowance. We follow the relevant guidance found in the FASB codification, accounting for uncertainty in income taxes. The guidance provides information and procedures for financial statement recognition and measurement of tax positions taken, or expected to be taken, in tax returns.

Contractual Obligations and Commercial Commitments

We have certain contractual obligations of continuing operations as of December 31, 2010, summarized by the period in which payment is due, as follows (dollar amounts in thousands):

						Less than				1 to 3				3 to 5				After
Contractual Obligations		Total				1 year				Years				Years				5 Years
Long-term debt obligations (1)		$	32,742			$	2,133			$	4,377			$	4,126			$	22,106
Settlement Obligations (2)			940				940				—				—				—
Series C Preferred Stock (3)			4,918				4,918				—				—				—
Elimination of Preferred Stock Conversion feature (4)			5,323				687				1,374				1,374				1,888
Operating leases			577,888				22,560				46,751				49,009				459,568
Required capital expenditures under mortgage loans and operating leases (5)			20,965				448				611				611				19,295
Total		$	642,776			$	31,686			$	53,113			$	55,120			$	502,857

We have employment agreements with certain members of management that provide for the payment to these members of amounts up to 2.5 times their annual salary in the event of a termination without cause, a constructive discharge (as defined), or upon a change of control of the Company (as defined). The maximum contingent liability under these agreements is approximately $1.9 million as of December 31, 2010. The terms of such agreements are from one to three years and automatically renew for one year if not terminated by us or the employee. In addition, upon the occurrence of any triggering event, those certain members of management may elect to require that we purchase equity awards granted to them for a purchase price equal to the difference in the fair market value of our common stock at the date of termination versus the stated equity award exercise price. Based on the closing price of our stock on December 31, 2010, the maximum contingent liability for the repurchase of the equity grants is approximately $0.1 million. No amounts have been accrued for these contingent liabilities.

Payor Sources

We classify our revenues from patients and residents into four major categories: Medicaid, Medicare, Managed care, and private pay and other. Medicaid revenues are composed of the traditional Medicaid program established to provide benefits to those in need of financial assistance in the securing of medical services. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. Managed care revenues include payments for patients who are insured by a third-party entity, typically called a Health Maintenance Organization, often referred to as an HMO plan, or are Medicare beneficiaries who assign their Medicare benefits to a Managed Care replacement plan often referred to as Medicare replacement products. The private pay and other revenues are composed primarily of individuals or parties who directly pay for their services. Included in the private pay and other are patients

who are hospice beneficiaries as well as the recipients of Veterans Administration benefits. Veterans Administration payments are made pursuant to renewable contracts negotiated with these payors.

The following table sets forth net patient and resident revenues related to our continuing operations by payor source for the periods presented (dollar amounts in thousands):

		Year Ended December 31,
		2010								2009								2008
Medicaid		$	155,035				53.4	%		$	149,987				54.2	%		$	140,524				53.3	%
Medicare			88,920				30.7				85,433				30.8				84,647				32.1
Managed care			8,619				3.0				7,412				2.7				5,993				2.3
Private Pay and other			37,556				12.9				34,147				12.3				32,673				12.3
Total		$	290,130				100.0	%		$	276,979				100.0	%		$	263,837				100.0	%

The following table sets forth average daily skilled nursing census by payor source for our continuing operations for the periods presented:

		Year Ended December 31,
		2010								2009								2008
Medicaid			2,886				68.8	%			2,854				69.6	%			2,773				69.2	%
Medicare			544				13.0				534				13.0				548				13.7
Managed care			59				1.4				51				1.2				45				1.1
Private Pay and other			704				16.8				661				16.2				641				16.0
Total			4,193				100.0	%			4,100				100.0	%			4,007				100.0	%

Consistent with the nursing center industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare, Managed care and private pay can significantly affect the profitability of the facility’s operations.

Results of Operations

As discussed in the overview at the beginning of Management’s Discussion and Analysis of Financial Condition and Results of Operations, we have completed certain divestitures, acquisitions and entered a new lease agreement. We have reclassified our Consolidated Financial Statements to present certain divestitures as discontinued operations for all periods presented.

		Year Ended December 31,
(in thousands)		2010				2009				Change				%
PATIENT REVENUES, net		$	290,130			$	276,979			$	13,151				4.7	%
EXPENSES:
Operating			229,081				219,567				9,514				4.3
Lease			22,600				21,791				809				3.7
Professional liability			5,364				8,228				(2,864	)			(34.8	)
General and administrative			19,680				17,926				1,754				9.8
Depreciation and amortization			5,825				5,446				379				7.0
Total expenses			282,550				272,958				9,592				3.5
OPERATING INCOME			7,580				4,021				3,559				88.5
OTHER INCOME (EXPENSE):
Foreign currency transaction gain			—				191				(191	)			(100.0	)
Other income			—				549				(549	)			(100.0	)
Interest income			2				161				(159	)			(98.8	)
Interest expense			(1,634	)			(1,877	)			243				12.9
Debt retirement costs			(127	)			—				(127	)			(100.0	)
			(1,759	)			(976	)			(783	)			(80.2	)
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES			5,821				3,045				2,776				91.2
PROVISION FOR INCOME TAXES			(1,858	)			(1,165	)			(693	)			(59.5	)
NET INCOME FROM CONTINUING OPERATIONS		$	3,963			$	1,880			$	2,083				110.8	%

		Year Ended December 31,
(in thousands)		2009				2008				Change				%
PATIENT REVENUES, net		$	276,979			$	263,837			$	13,142				5.0	%
EXPENSES:
Operating			219,567				207,998				11,569				5.6
Lease			21,791				21,331				460				2.2
Professional liability			8,228				1,532				6,696				437.1
General and administrative			17,926				17,973				(47	)			(0.3	)
Depreciation and amortization			5,446				5,065				381				7.5
Total expenses			272,958				253,899				19,059				7.5
OPERATING INCOME			4,021				9,938				(5,917	)			(59.5	)
OTHER INCOME (EXPENSE):
Foreign currency transaction gain (loss)			191				(1,005	)			1,196				(119.0	)
Other income			549				—				549				—
Interest income			161				453				(292	)			(64.5	)
Interest expense			(1,877	)			(2,870	)			993				34.6
			(976	)			(3,422	)			2,446				71.5
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES			3,045				6,516				(3,471	)			(53.3	)
PROVISION FOR INCOME TAXES			(1,165	)			(2,208	)			(1,043	)			(47.2	)
NET INCOME FROM CONTINUING OPERATIONS		$	1,880			$	4,308			$	(2,428	)			(56.4	)%

Year Ended December 31, 2010 Compared with Year Ended December 31, 2009

Patient Revenues

Patient revenues increased to $290.1 million in 2010 from $277.0 million in 2009, an increase of $13.1 million, or 4.7%.

The following table summarizes key revenue and census statistics for continuing operations for each period:

		Year Ended
		December 31
		2010				2009
Skilled nursing occupancy			78.1	%			76.6	%
As a percent of total census:
Medicare census			13.0	%			13.0	%
Managed care census			1.4	%			1.2	%
As a percent of total revenues:
Medicare revenues			30.7	%			30.8	%
Medicaid revenues			53.4	%			54.2	%
Managed care revenues			3.0	%			2.7	%
Average rate per day:
Medicare		$	403.67			$	397.74
Medicaid		$	146.84			$	143.65
Managed care		$	386.08			$	378.85

The average Medicare rate per patient day for 2010 increased 1.5% compared to 2009, resulting in a net increase in revenue of $1.2 million. On October 1, 2010, CMS implemented RUG IV in connection with the MDS 3.0 patient assessment tool, RUG IV expanded RUG categories to 66 from 53 under RUG III. Also on October 1, 2010, CMS implemented a Medicare rate increase of 1.7% for the annual SNF market basket adjustment. The combined effect of these rate changes, together with changes in patient acuity levels, increased revenue by $2.7 million in the fourth quarter of 2010. Partially offsetting these increases was a 1.1% rate decrease implemented by CMS on October 1, 2009. That decrease was the net effect of a 3.3% forecast error correction related to the implementation of RUG III in 2006, partially offset by a 2.2% market basket adjustment. The effect of this 1.1% rate decrease and changes in patient acuity levels was to reduce revenue in the first nine months of 2010 by $1.5 million.

An increase in Medicare census contributed approximately $1.4 million to the total revenue increase. Medicare average daily census increased 1.9% to 544 in 2010 from 534 in 2009. We experienced an increase of $1.2 million in revenue delivery to our Medicare B patients in 2010 compared to 2009.

Medicaid rates and census contributed approximately $4.9 million of the total revenue increase. The average Medicaid rate per patient day for 2010 increased 2.2% compared to 2009, resulting in a net increase in revenue of $3.4 million. This average rate per day for Medicaid patients is the result of rate increases in certain states, partially funded by increased provider taxes, and increasing patient acuity levels. Taking higher provider taxes into consideration, the net increase in average rate per day for Medicaid patients was 1.8%.

Managed care rates and census contributed approximately $1.2 million of the total revenue increase. The average managed care rate per patient day for 2010 increased 1.9% compared to 2009 and managed care average daily census increased 15.7%. Private and hospice payors contributed a combined $3.5 million to the increase as a result of higher rates and average daily census among those payor types.

Operating expense

Operating expense increased to $229.1 million in 2010 from $219.6 million in 2009, an increase of $9.5 million, or 4.3%. This increase is primarily attributable to cost increases related to wages and other costs discussed below. Operating expense decreased to 79.0% of revenue in 2010, compared to 79.3% of revenue in 2009.

The largest component of operating expenses is wages, which increased to $142.0 million in 2010 from $134.2 million in 2009, an increase of $7.8 million, or 5.8%. The increase in wages was primarily due to labor costs associated with the 2.3% increase in average daily census levels, the 3.1% increase in Medicare and managed care patients, competitive labor markets in most of the areas in which we operate and regular merit and inflationary raises for personnel (increase of approximately 2.0% for the year). We made several additions to staffing as part of our plan to increase occupancy and skilled mix, which included approximately $1.7 million in therapy staffing cost to support the needs of our higher skilled census, $0.3 million in nursing center staffing costs to improve our ability to market to and care for high acuity patients and $0.6 million for increased wages that resulted from the transition to the new MDS 3.0 patient assessment tool in all our facilities.

Provider taxes increased approximately $0.6 million in 2010, primarily due to increases in tax rates and higher census in certain states in which we operate.

Payroll taxes were reduced during 2010 by approximately $0.4 million as a result of payroll tax credits we received under the Hiring Incentives to Restore Employment (HIRE) Act, enacted in March 2010. These credits eliminated a portion of payroll taxes on wages of employees hired during 2010 who met certain requirements. The credits ended effective December 31, 2010, but we may be eligible to receive additional income tax credits in 2011 if these employees remain in our service for one year.

Employee health insurance costs were approximately $0.6 million lower in 2010 compared to 2009, a decrease of 7.6%. The Company is self insured for the first $175,000 in claims per employee each year, and we experienced a lower level of claims costs during 2010. Employee health insurance costs can vary significantly from year to year, and we evaluate the provisions of these plans annually.

Workers compensation insurance expense decreased approximately $0.5 million in 2010 compared to 2009. The decrease is the result of better claims experience in 2010 compared to 2009.

The remaining increases in operating expense are primarily due to the effects of the increase in patient census.

Lease expense

Lease expense increased to $22.6 million in 2010 from $21.8 million in 2009. The primary reason for the increase in lease expense was rent for the Brentwood Terrace replacement center completed in August 2009 as well as rent increases for lessor funded property renovations.

Professional liability

Professional liability expense was $5.4 million in 2010 compared to $8.2 million in 2009, a decrease of $2.8 million. We were engaged in 32 professional liability lawsuits as of December 31, 2010, compared to 33 as of December 31, 2009. Our cash expenditures for professional liability costs of continuing operations were $5.1 million and $4.8 million for 2010 and 2009, respectively. Professional liability expense and cash expenditures fluctuate from year to year based respectively on the results of our third-party professional liability actuarial studies and on the costs incurred in defending and settling existing claims.

General and administrative expense

General and administrative expenses were approximately $19.7 million in 2010 compared to $17.9 million in 2009, an increase of $1.8 million, or 9.8%. As a percentage of revenue, general and administrative expense increased to 6.8% in 2010 from 6.5% in 2009. We experienced higher compensation costs of $0.3 million as a result of new staff positions and average wage increases of 1.6%. Performance-based incentive expense was $0.8 million higher in 2010. We experienced increased general and administrative costs of $0.4 million related to the implementation of electronic medical records systems in 20 facilities during the last half of 2010. In 2010, we incurred $0.4 million in non-recurring general and administrative expense comprised of charges for severance and hiring costs related to new positions.

Depreciation and amortization

Depreciation and amortization expense was approximately $5.8 million in 2010 and $5.4 million in 2009. The increase in 2010 is primarily due to depreciation and amortization expenses related to capital expenditures for additions to property and equipment.

Foreign currency transaction gain

A foreign currency transaction gain of $0.2 million was recorded in 2009. This gain resulted from foreign currency translation of a note receivable from the sale of our Canadian operations in 2004. The balance due on this note was collected in June 2009. There was no foreign currency gain or loss in 2010.

Other income

Other income in 2009 of $549,000 is a non-cash gain that resulted from the settlement of pre-acquisition cost report obligations related to one of the centers we acquired in Texas in 2007. We had previously recorded a contingent liability related to cost report assessments and the other income results from the settlement of this liability with CMS for less than the amount accrued.

Interest expense

Interest expense decreased to $1.6 million in 2010 compared to $1.9 million in 2009. The reduction in expense is primarily due to principal payments made on our debt.

Income from continuing operations before income taxes; income from continuing operations per common share

As a result of the above, continuing operations reported income before income taxes of $5.8 million and $3.0 million in 2010 and 2009, respectively. The provision for income taxes was $1.9 million in 2010, an effective rate of 31.9% and $1.2 million in 2009, an effective rate of 38.3%. The basic and diluted income per common share from continuing operations were $0.63 and $0.62, respectively, in 2010 compared to $0.27 and $0.26, respectively, in 2009.

Year Ended December 31, 2009 Compared With Year Ended December 31, 2008

Patient Revenues

Patient revenues increased to $277.0 million in 2009 from $263.8 million in 2008, an increase of $13.2 million, or 5.0%. This increase is primarily due to increased Medicaid rates in certain states, increased Medicaid, private and Managed Care census, and Medicare rate increases in the first nine months of 2009 compared to 2008, partially offset by the effects of lower Medicare census and a Medicare rate reduction effective October 1, 2009.

The following table summarizes key revenue and census statistics for continuing operations for each period:

		Year Ended
		December 31,
		2009				2008
Skilled nursing occupancy			76.6	%			74.9	%
As a percent of total census:
Medicare census			13.0	%			13.7	%
Managed care census			1.2	%			1.1	%
As a percent of total revenues
Medicare revenues			30.8	%			32.1	%
Medicaid revenues			54.2	%			53.3	%
Managed care revenues			2.7	%			2.3	%
Average rate per day:
Medicare		$	397.74			$	384.71
Medicaid		$	143.65			$	138.20
Managed care		$	378.85			$	346.52

The Company’s average rate per day for Medicare Part A patients increased 3.4% in 2009 compared to 2008 as a result of the annual inflation adjustment that was effective October 1, 2008 and the acuity levels of Medicare patients in our nursing centers, as indicated by RUG level scores, which were higher in 2009 than in 2008. However, effective October 1, 2009, CMS reduced Medicare rates approximately 1.1%. Our average rate per day for Medicaid patients increased 4.0% in 2009 compared to 2008 as a result of rate increases in certain states, partially funded by increased provider taxes, and increasing patient acuity levels. Taking higher provider taxes into consideration, the net increases in Medicaid rates were 3.5%.

Operating expense

Operating expense increased to $219.6 million in 2009 from $208.0 million in 2008, an increase of $11.6 million, or 5.6%. This increase is primarily attributable to cost increases related to wages and benefits and other costs discussed below. Operating expense increased to 79.3% of revenue in 2009, compared to 78.8% of revenue in 2008.

The largest component of operating expenses is wages, which increased to $134.2 million in 2009 from $126.0 million in 2008, an increase of $8.2 million, or 6.5%. Wages increased primarily as a result of labor costs associated with increases in census and patient acuity levels, competitive labor markets in most of the areas in which we operate and regular merit and inflationary raises for personnel (increase of approximately 2.4% for the period). Wages also increased $0.4 million in 2009 as a result of increased dietary, laundry and housekeeping employees hired in 2008 following the termination of an outsourcing contract for these services at eight facilities.

Employee health insurance costs were approximately $1.5 million higher in 2009 compared to 2008, an increase of 24.6%. The Company was self insured for the first $160,000 in claims per employee each year, and we experienced a higher level of costs during the 2009 period. Employee health insurance costs can vary significantly from year to year, and we evaluate the provisions of these plans annually. Effective January 1, 2010, we implemented changes to our health insurance plans to increase employee-paid premiums and deductibles, which is expected to reduce the level of future cost increases borne by the Company.

Provider taxes increased approximately $0.7 million in 2009, primarily due to new rate legislation in Florida. Effective April 1, 2009, Florida enacted a provider tax that resulted in increases in the Medicaid rate for facilities in that state.

As part of the transition to the newly constructed Brentwood Terrace replacement facility, we incurred approximately $0.2 million in increased operating costs. The increased operating costs were a result of additional wages, maintenance, advertising and travel related to the transition of residents and operations to the new building and the increase in census at this new building.

The above increases were offset by a reduction in workers’ compensation insurance expense of approximately $0.6 million in 2009. We had better claims experience in 2009, resulting in lower expense.

The remaining increases in operating expense are primarily due to the effects of increases in patient acuity levels as indicated by RUG level scores, which were higher in 2009, resulting in greater costs to care for these patients.

Lease expense

Lease expense increased to $21.8 million in 2009 from $21.3 million in 2008. The primary reason for the increase in lease expense was rent increases for lessor funded property renovations and the Brentwood Terrace replacement facility. Initial quarterly rent expense for Brentwood Terrace is approximately $0.2 million per quarter and accounted for $0.3 million of the increase in 2009 for the three and a half months the new facility was open.

Professional liability

Professional liability expense increased to $8.2 million in 2009 from $1.5 million in 2008, an increase of $6.7 million. We were engaged in 33 professional liability lawsuits as of December 31, 2009, compared to 28 as of December 31, 2008. Our cash expenditures for professional liability costs were $4.8 million and $6.6 million for 2009 and 2008, respectively. Professional liability cash expenditures can fluctuate from year to year.

General and administrative expense

General and administrative expense was approximately $17.9 million in 2009 compared to $18.0 million in 2008. As a percentage of revenue, general and administrative expense decreased to 6.5% in 2009 from 6.8% in 2008. There was an increase of approximately $0.3 million increase in wages, as well as higher costs of approximately $0.2 million incurred in connection with the solicitation of proxies for our annual shareholders’ meeting. These increases were offset by decreases in travel costs and stock-based compensation costs. Effective January 1, 2009, we instituted a wage freeze for our corporate and regional management teams, with reduced wage increases for the balance of our employees. These policies have been extended in 2010 and will be reevaluated as business and economic conditions merit.

Depreciation and amortization

Depreciation and amortization expense was approximately $5.4 million in 2009 and $5.1 million in 2008. The increase in 2009 is primarily due to depreciation and amortization expenses related to capital expenditures for additions to property and equipment.

Foreign currency transaction gain (loss).

A foreign currency transaction gain of $191,000 was recorded in 2009 compared to a loss of $1.0 million in 2008. Such losses result primarily from foreign currency translation of a note receivable from the sale of our Canadian operations in 2004. The balance due on this note was collected in June 2009.

Other income

Other income of $549,000 is a non-cash gain that is the result of the settlement of pre-acquisition cost report obligations related to one of the centers we acquired in Texas in 2007. We had previously recorded a contingent liability related to cost report assessments and the other income results from the settlement of this liability with CMS for less than the amount accrued.

Interest expense

Interest expense decreased to $1.9 million in 2009 compared to $2.9 million in 2008. The reduction in expense is due to principal payments made during 2009 and 2008 and reductions in variable interest rates.

Income from continuing operations before income taxes; income from continuing operations per common share

As a result of the above, continuing operations reported income before income taxes of $3.0 million in 2009 compared to income of $6.5 million in 2008. The provision for income taxes was $1.2 million in 2009, an effective rate of 38.3%, compared to $2.2 million in 2008, an effective rate of 33.9%. During 2008, our income taxes were reduced by carryforward credits we generated under the Work Opportunity Tax Credit program in years prior to 2001. The basic and diluted income per common share from continuing operations were $0.27 and $0.26, respectively, in 2009, as compared to a basic and diluted income per common share from continuing operations of $0.70 and $0.67, respectively, in 2008.

Liquidity and Capital Resources

Liquidity

Our primary source of liquidity is the net cash flow provided by the operating activities of our facilities. We believe that these internally generated cash flows will be adequate to service existing debt obligations, the costs of professional liability claims, fund required capital expenditures as well as provide cash flows for investing opportunities. In determining priorities for our cash flow, we evaluate alternatives available to us and select the ones that we believe will most benefit the Company over the long term. Options for our cash include, but are not limited to, capital improvements, dividends, purchase of additional shares of our common stock, acquisitions, payment of existing debt obligations, preferred stock redemptions as well as initiatives to improve facility performance. We review these potential uses and align them to our cash flows with a goal of achieving long term success. We plan to invest in business initiatives and development that will increase our operating expenses for the next one to two years as part of our plan to improve our high acuity offerings.

Net cash provided by operating activities of continuing operations totaled $9.3 million, $10.3 million and $7.6 million in 2010, 2009 and 2008, respectively. Operating activities of discontinued operations provided cash of $0.7 million, $2.1 million and $1.9 million in 2010, 2009 and 2008, respectively.

Investing activities of continuing operations used cash of $6.4 million, $9.0 million and $9.6 million in 2010, 2009 and 2008, respectively. These amounts primarily represent cash used for purchases of property, plant and equipment. We have used between $6.4 million and $9.4 million for capital expenditures of continuing operations in each of the three calendar years ended December 31, 2010. These uses of cash were partially offset by collections on a note receivable of $4.2 million and $0.8 in 2009 and 2008, respectively. The $6.9 million and $0.8 million in “payment for construction in progress — leased facility” in 2009 and 2008, respectively, relate to the replacement facility that was constructed in Texas with lease financing. During the third quarter 2009, the facility was completed and the sale and leaseback of the Brentwood Terrace facility was deemed to have occurred.

Financing activities of continuing operations used cash of $3.4 million, $2.2 million and $3.6 million in 2010, 2009 and 2008 respectively. Cash used in 2010, 2009 and 2008 primarily resulted from payment of existing debt obligations of $4.3 million, $7.6 million and $2.0 million, respectively, and the repurchase of $1.7 million of our common stock in 2008. Net cash used in 2010 was impacted by the payment of $0.5 million in financing costs in connection with the new revolving credit facility under which we borrowed $3.5 million. Financing activities reflect $1.2 million and $0.6 million in common stock dividends in 2010 and 2009, respectively. The $6.9 million and $0.8 million in “construction allowance receipts — leased facility” in 2009 and 2008, respectively, relate to the replacement facility that was constructed in Texas with lease financing. During the third quarter 2009, the facility was completed and the sale and leaseback of the Brentwood Terrace facility was deemed to have occurred.

Our cash expenditures related to professional liability claims were $5.1 million, $4.8 million and $6.6 million in 2010, 2009 and 2008, respectively. Although we work diligently to limit the cash required to settle and defend professional liability claims, a significant judgment entered against us in one or more legal actions could have a material adverse impact on our cash flows and could result in our being unable to meet all of our cash needs as they become due.

Electronic Medical Records

During 2010, we developed a plan to introduce EMR to all our facilities. We expect to complete our EMR implementation plan during the remainder of 2011. It is anticipated that our investment in EMR will provide operational improvements through automation of record keeping and improvement in clinical records quality. Through December 31, 2010 we have capitalized $1.8 million related to our EMR initiative and expensed $0.5 million for training costs. We expect to have total training expenses during 2010 and 2011 related to implementing our electronic medical record system of between $1.8 million and $2.0 million and total capital expenditures during this period of approximately $3.6 million.

Dividends

On February 25, 2011, the Board of Directors declared a quarterly dividend on common shares of $0.055 per share. While the Board of Directors intends to pay quarterly dividends, the Board will make the determination of the amount of future cash dividends, if any, to be declared and paid based on, among other things, the Company’s financial condition, funds from operations, the level of its capital expenditures and its future business prospects and opportunities.

Redeemable Preferred Stock

At December 31, 2010, we have outstanding 5,000 shares of Series C Redeemable Preferred Stock (“Preferred Stock”) that has a stated value of approximately $4.9 million which pays an annual dividend rate of 7% of its stated value. Dividends on the Preferred Stock are paid quarterly in cash. The Preferred Stock was issued to Omega in 2006 and is not convertible, but is redeemable at its stated value at Omega’s option since September 30, 2010, and since September 30, 2007, is redeemable at its stated value at our option. Redemption under our option or Omega’s is subject to certain limitations. We believe we have adequate resources to redeem the Preferred Stock if Omega were to elect to redeem it.

Note Receivable

On June 30, 2009, we collected the balance due on a note receivable denominated in Canadian dollars issued in the sale of our Canadian subsidiary in 2004. We received installments totaling approximately $4.9 million Canadian ($4.2 million US) during May and June 2009. In accordance with our bank term loan agreement, $1.8 million of the proceeds we received in collection of this note receivable were paid on the principal balance of our long term debt obligations.

Professional Liability

For the last several years, due to our past claims experience and increasing cost of claims throughout the long-term care industry, the premiums we paid for professional liability and other liability insurance exceeded the coverage purchased so that it cost more than $1 to purchase $1 of insurance coverage. Since March 9, 2001, we purchased professional liability insurance coverage for our facilities that, based on historical claims experience, was substantially less than the amount required to satisfy claims that were incurred. We have essentially exhausted all of our insurance coverage for claims first asserted prior to May 31, 2010.

Effective June 1, 2010, our nursing centers are covered by one of two professional liability insurance policies. Our 25 nursing centers in Arkansas, Kentucky, Tennessee, and West Virginia are currently covered by an insurance policy with coverage limits of $250,000 per medical incident and total annual aggregate policy limits of $750,000. This policy provides the only commercially affordable insurance coverage available for claims made during this period against these nursing centers. Our 21 nursing centers in Alabama, Florida, Ohio and Texas are currently covered by an insurance policy with coverage limits of $1,000,000 per medical incident, subject to a deductible of $495,000 per claim, with a total annual aggregate policy limit of $15,000,000 and a sublimit per center of $3,000,000.

As of December 31, 2010, we have recorded total liabilities for reported and settled professional liability claims and estimates for incurred but unreported claims of $17.3 million. A significant judgment entered against us in one or more of these legal actions could have a material adverse impact on our financial position and cash flows.

Capital Resources

As of December 31, 2010, we had $24.0 million of outstanding borrowings. The $24.0 million is comprised primarily of $20.5 million owed on our mortgage loan and $3.5 million owed on our revolving line of credit.

The $20.5 million mortgage loan was scheduled to mature in August 2011. On March 1, 2011, we entered into an agreement with a syndicate of banks that provides a credit facility to refinance our mortgage loan and extend the maturity of our existing revolving credit facility. This refinancing has allowed us to classify $20.1 million in debt that was refinanced in the transaction as long-term at December 31, 2010.

Under the terms of the new agreement, the syndicate of banks provided mortgage debt (“Mortgage Loan”) of $23 million with a five year maturity and extended the maturity of our $15 million revolving credit facility (“revolver”) from March 2013 to March 2016. The proceeds of the new mortgage loan were used to retire our existing mortgage loan, pay transaction costs and will fund approximately $2.4 million in capital improvements at our owned homes. The Mortgage Loan has a term of five years, with principal and interest payable monthly based on a 25 year amortization. Interest is based on LIBOR plus 4.5% but is fixed at 7.07% based on the interest rate swap described below. The new mortgage loan is secured by four owned nursing centers, related equipment and a lien on the accounts receivable of these facilities. The Mortgage Loan and the revolver are cross-collateralized.

The March 1, 2011 refinancing transaction extended the maturity of our existing $15 million revolving credit facility and amended the interest rate terms. We originally entered into this revolver in March 2010, replacing an existing revolving credit facility. As part of the March 2010 agreement, we used $3.5 million in proceeds from the facility to retire an existing bank term loan and pay certain transaction costs. The March 2010 revolver originally had an interest rate of LIBOR (with a floor of 3.0%) plus 3.5% and was to

expire in March 2013. The March 1, 2011 refinancing extended the maturity of the revolver to March 2016, removed the 3.0% floor on LIBOR and changed the LIBOR margin on loans from 3.5% to 4.5%.

In connection with the March 2010 transaction, we recorded debt retirement costs of $0.1 million which were recorded in earnings during 2010. These costs relate to the write off of deferred financing costs of the term loan that was retired with proceeds of the March 2010 revolver. In connection with the March 2010 revolving credit facility financing, we recorded total deferred loan costs of $0.4 million of which $0.2 million were paid at closing with proceeds from the new facility.

The revolver is secured by accounts receivable and is subject to limits on the maximum amount of loans that can be outstanding under the revolver based on borrowing base restrictions. As of December 31, 2010, we have $3.5 million in borrowings outstanding under the revolving credit facility. Annual fees for letters of credit issued under this revolver are 3.00% of the amount outstanding. We have a letter of credit of $4.6 million to serve as a security deposit for our leases. Considering the balance of eligible accounts receivable at December 31, 2010, the letter of credit, the amounts outstanding under the revolving credit facility and the maximum loan amount of $15 million, the balance available for borrowing under the revolving credit facility is $7.0 million. Eligible accounts receivable are calculated as defined and consider 80% of certain net receivables while excluding receivables from private pay patients, those pending approval by Medicaid and receivables greater than 90 days.

Our debt agreements contain various financial covenants, the most restrictive of which relate to cash flow, census and debt service coverage ratios. We are in compliance with all such covenants at December 31, 2010. Our calculated compliance with financial covenants is presented below:

						Level at
		Requirement				December 31, 2010
Minimum fixed charge coverage ratio			≥1.05:1.00				1.16
Debt service coverage ratio (mortgaged facilities)			≥1.30:1.00				3.89

As part of the mortgage refinancing in March 2011, we entered into an interest rate swap agreement with a member of the bank syndicate as the counterparty. The interest rate swap agreement has the same effective date, maturity date and notional amount as the Mortgage Loan. The interest rate swap agreement requires us to make fixed rate payments to the bank calculated on a notional amount, an annual fixed rate of 7.07% while the bank is obligated to make payments to us based on LIBOR on the same notional amount. We entered into the interest rate swap agreement to mitigate the variable interest rate risk on our outstanding mortgage borrowings.

Lease Agreement — West Virginia Nursing Center

On July 14, 2010 we entered into an agreement with a real estate developer that will construct, furnish, and equip a 90 bed skilled nursing center near Milton, West Virginia which we will lease upon completion. The center will utilize a Certificate of Need we initially obtained in the June 2009 acquisition of certain assets of a skilled nursing center in Milton, West Virginia. The initial lease term is 20 years from the date the center is completed and fit for occupancy as a skilled nursing center. We have the option to renew the lease for two additional five-year periods. Construction on the nursing center began in November 2010 and it is estimated the center will be completed in late 2011. Annual lease costs will be based initially on 10.25% of the total project costs and provides for annual increases in lease payments equal to the increase in the Consumer Price Index, not to exceed 2.5%. The lease agreement grants us the right to purchase the center beginning at the end of the first year of the initial term of the lease and continuing through the fifth year for a purchase price ranging from 110% to 120% of the total project cost.

Texas Facility

In August 2009, we completed the construction of a 119 bed skilled nursing center, Brentwood Terrace, located in Paris, Texas, replacing an existing 102 bed facility leased from Omega. The new facility was financed with funding from Omega, and is leased from Omega under a long term operating lease with renewal options through 2035. Annual rent is $789,000 initially, equal to 10.25% of $7.7 million, the total cost of the replacement facility.

Facility Renovations

During 2005, we began an initiative to complete strategic renovations of certain facilities to improve occupancy, quality of care and profitability. We developed a plan to begin with those facilities with the greatest potential for benefit, and began the renovation program during the third quarter of 2005. As of December 31, 2010, we have completed renovations at fifteen facilities and we are developing plans for additional renovation projects.

A total of $22.1 million has been spent on these renovation programs to date, with $15.0 million financed through Omega, $6.0 million financed with internally generated cash, and $1.1 million financed with long-term debt.

For the fifteen facilities with renovations completed as of the beginning of the fourth quarter 2010 compared to the last twelve months prior to the commencement of renovation, average occupancy increased from 69.8% to 77.3% and Medicare average daily census increased from a total of 177 to 190 in the fourth quarter of 2010.

Receivables

Our operations could be adversely affected if we experience significant delays in reimbursement from Medicare, Medicaid and other third-party revenue sources. Our future liquidity will continue to be dependent upon the relative amounts of current assets (principally cash, accounts receivable and inventories) and current liabilities (principally accounts payable and accrued expenses). In that regard, accounts receivable can have a significant impact on our liquidity. Continued efforts by governmental and third-party payors to contain or reduce the acceleration of costs by monitoring reimbursement rates, by increasing medical review of bills for services, or by negotiating reduced contract rates, as well as any delay by us in the processing of our invoices, could adversely affect our liquidity and results of operations.

Accounts receivable attributable to patient services of continuing operations totaled $26.7 million at December 31, 2010, compared to $23.9 million at December 31, 2009, representing approximately 34 and 32 days revenue in accounts receivable, respectively. The increase in days revenue in accounts receivable is the result of increased managed care revenue which typically has a longer collection period.

The allowance for bad debt was $2.8 million and $2.6 million at December 31, 2010 and 2009, respectively. We continually evaluate the adequacy of our bad debt reserves based on patient mix trends, aging of older balances, payment terms and delays with regard to third-party payors, collateral and deposit resources, as well as other factors. We continue to evaluate and implement additional procedures to strengthen our collection efforts and reduce the incidence of uncollectible accounts.

Inflation

Based on contract pricing for food and other supplies and recent market conditions, we expect cost increases in 2011 to be higher than the increases in 2010. We expect salary and wage increases for our skilled health care providers to continue to be higher than average salary and wage increases, as is common in the health care industry.

Off-Balance Sheet Arrangements

We have a letter of credit outstanding of approximately $4.6 million as of December 31, 2010, which serves as a security deposit for our facility lease with Omega. The letter of credit was issued under our revolving credit facility. Our accounts receivable serve as the collateral for this revolving credit facility. During the years ended December 31, 2010 and 2009, we incurred approximately $0.2 million in fees each year related to the outstanding letter of credit.

Recent Accounting Guidance

In August 2010, the FASB issued updated guidance in the form of a FASB Accounting Standards Update on “Presentation of Insurance Claims and Related Insurance Recoveries” to clarify that a health care entity should not net insurance recoveries against a related claim liability and that the amount of the claim liability should be determined without consideration of insurance recoveries. The update is intended to improve accounting guidance by eliminating an existing industry exception and reduce diversity in practice by removing the ability to offset insurance recoveries against liabilities. We will adopt this guidance effective January 1, 2011. We are currently assessing the impact of the new guidance though it is not expected to change our operating results or cash flows.

Forward-Looking Statements

The foregoing discussion and analysis provides information deemed by management to be relevant to an assessment and understanding of our consolidated results of operations and financial condition. This discussion and analysis should be read in conjunction with our consolidated financial statements included herein. Certain statements made by or on behalf of us, including those contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere, are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those contemplated by the forward-looking statements made herein. In addition to any assumptions and other factors referred to specifically in connection with such statements, other factors, many of which are beyond our ability to control or predict, could cause our actual results to differ materially from the results expressed or implied in any forward-looking statements including, but not

limited to, our ability to successfully construct and operate the new nursing center in West Virginia, our ability to increase census at our renovated facilities, changes in governmental reimbursement, government regulation, the impact of the recently adopted federal health care reform or any future health care reform, any increases in the cost of borrowing under our credit agreements, our ability to comply with covenants contained in those credit agreements, the outcome of professional liability lawsuits and claims, our ability to control ultimate professional liability costs, the accuracy of our estimate of our anticipated professional liability expense, the impact of future licensing surveys, the outcome of proceedings alleging violations of laws and regulations governing quality of care or violations of other laws and regulations applicable to our business, costs and impacts associated with the implementation of our electronic medical records plan, the costs of investing in our business initiatives and development, our ability to control costs, changes to our valuation of deferred tax assets, changes in occupancy rates in our facilities, changing economic and competitive conditions, changes in anticipated revenue and cost growth, changes in the anticipated results of operations, the effect of changes in accounting policies as well as others. Investors also should refer to the risks identified in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as risks identified in “Part I. Item 1A. Risk Factors” for a discussion of various risk factors of the Company and that are inherent in the health care industry. Given these risks and uncertainties, we can give no assurances that these forward-looking statements will, in fact, transpire and, therefore, caution investors not to place undue reliance on them. These assumptions may not materialize to the extent assumed, and risks and uncertainties may cause actual results to be different from anticipated results. These risks and uncertainties also may result in changes to the Company’s business plans and prospects. Such cautionary statements identify important factors that could cause our actual results to materially differ from those projected in forward-looking statements. In addition, we disclaim any intent or obligation to update these forward-looking statements.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The chief market risk factor affecting our financial condition and operating results is interest rate risk. As of December 31, 2010, we had outstanding borrowings of approximately $24.0 million all of which was subject to variable interest rates. In connection with our refinancing, we entered into an interest rate swap with respect to the mortgage loan to mitigate the floating interest rate risk of such borrowing. Therefore, only approximately $3.5 million of our borrowings remains subject to variable interest rates after the March 1, 2011 refinancing transaction. In the event that interest rates were to change 1%, the impact on future pre-tax cash flows would be approximately $35,000 annually, representing the impact of increased or decreased interest expense on variable rate debt.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Audited financial statements are contained on pages F-1 through F-30 of this Annual Report on Form 10-K and are incorporated herein by reference. Audited supplemental schedule data is contained on pages S-1 through S-2 of this Annual Report on Form 10-K and is incorporated herein by reference.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures

Advocat, with the participation of our principal executive and financial officers, has evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of December 31, 2010. Based on this evaluation, the principal executive and financial officers have determined that such disclosure controls and procedures are effective to ensure that information required to be disclosed in our filings under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities Exchange Commission’s rules and forms.

Management’s Report on Internal Control over Financial Reporting

We are responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). We assessed the effectiveness of our internal control over financial reporting as of December 31, 2010. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. We have concluded that, as of December 31, 2010, our internal control over financial reporting is effective based on these criteria.

Changes in Internal Control over Financial Reporting

There has been no change (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal control over financial reporting that has occurred during our fiscal quarter ended December 31, 2010 that has materially affected, or is reasonably likely to materially affect our internal control over financial reporting.

Our management does not expect that our disclosure controls and procedures or our internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefit of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

ITEM 9B. OTHER INFORMATION

None.

PART III

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

Information concerning our Directors, Executive Officers and Corporate Governance is incorporated herein by reference to our definitive proxy statement for our 2011 Annual Meeting of Shareholders, which we will file within 120 days of the end of the fiscal year to which this Report relates.

ITEM 11. EXECUTIVE COMPENSATION

Information concerning Executive Compensation is incorporated herein by reference to our definitive proxy statement for our 2011 Annual Meeting of Shareholders, which we will file within 120 days of the end of the fiscal year to which this Report relates.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS

Information concerning Security Ownership of Certain Beneficial Owners and Management is incorporated herein by reference to our definitive proxy statement for our 2011 Annual Meeting of Shareholders, which we will file within 120 days of the end of the fiscal year to which this Report relates.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information concerning Certain Relationships and Related Transactions is incorporated herein by reference to our definitive proxy statement for our 2011 Annual Meeting of Shareholders, which we will file within 120 days of the end of the fiscal year to which this Report relates.

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

Information concerning the fees and services provided by our principal accountant is incorporated herein by reference to our definitive proxy statement for our 2011 Annual Meeting of Shareholders, which we will file within 120 days of the end of the fiscal year to which this Report relates.

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

The Financial statements and schedule for us and our subsidiaries required to be included in Part II, Item 8 are listed below.

		Form 10-K
		Pages
Financial Statements
Report of Independent Registered Public Accounting Firm		F-1
Consolidated Balance Sheets as of December 31, 2010 and 2009		F-2
Consolidated Statements of Income for the Years Ended December 31, 2010, 2009 and 2008		F-3
Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2010, 2009 and 2008		F-4
Consolidated Statements of Cash Flows for the Years Ended December 31, 2010, 2009 and 2008		F-5
Notes to Consolidated Financial Statements as of December 31, 2010, 2009 and 2008		F-7 to F-30
Financial Statement Schedule
Schedule II — Valuation and Qualifying Accounts		S-1 to S-2

Exhibits

The exhibits filed as part of this Report on Form 10-K are listed in the Exhibit Index immediately following the financial statement pages.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

/s/ Wallace E. Olson   Wallace E. Olson				/s/ William C. O’Neil. Jr.   William C. O’Neil, Jr.
Chairman of the Board				Director
March 7, 2011				March 7, 2011
/s/ William R. Council, III   William R. Council, III				/s/ Richard M. Brame   Richard M. Brame
President and Chief Executive Officer				Director
Director				March 7, 2011
March 7, 2011
/s/ Robert Z. Hensley   Robert Z. Hensley				/s/ Chad A. McCurdy   Chad A. McCurdy
Director				Director
March 7, 2011				March 7, 2011

ADVOCAT INC. AND SUBSIDIARIES

Consolidated Financial Statements
For the Years Ended December 31, 2010, 2009 and 2008
Together with Report of Independent Registered Public Accounting Firm

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Report of Independent Registered Public Accounting Firm			F-1
Consolidated Balance Sheets			F-2
Consolidated Statements of Income			F-3
Consolidated Statements of Shareholders’ Equity			F-4
Consolidated Statements of Cash Flows			F-5
Notes to Consolidated Financial Statements			F-7
Schedule II — Valuation and Qualifying Accounts			S-1

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Shareholders
Advocat Inc.
Brentwood, Tennessee

We have audited the accompanying consolidated balance sheets of Advocat Inc. as of December 31, 2010 and 2009 and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. In connection with our audits of the financial statements, we have also audited the financial statement schedule listed in the accompanying index. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedule. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Advocat Inc. at December 31, 2010 and 2009, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States of America.

Also, in our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

/s/ BDO USA, LLP

Nashville, Tennessee
March 7, 2011

ADVOCAT INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2010 AND 2009

		2010				2009
ASSETS
CURRENT ASSETS:
Cash and cash equivalents		$	8,862,000			$	8,609,000
Receivables, less allowance for doubtful accounts of $2,822,000 and $2,566,000, respectively			23,916,000				21,711,000
Other receivables			352,000				1,406,000
Prepaid expenses and other current assets			2,935,000				2,043,000
Income tax refundable			1,439,000				455,000
Deferred income taxes			4,207,000				4,792,000
Current assets of discontinued operations			686,000				2,903,000
Total current assets			42,397,000				41,919,000
PROPERTY AND EQUIPMENT, at cost			78,690,000				76,270,000
Less accumulated depreciation			(41,563,000	)			(40,461,000	)
Discontinued operations, net			1,053,000				1,553,000
Property and equipment, net			38,180,000				37,362,000
OTHER ASSETS:
Deferred income taxes			12,408,000				13,804,000
Deferred financing and other costs, net			834,000				639,000
Other assets			2,319,000				1,963,000
Acquired leasehold interest, net			9,380,000				9,764,000
Total other assets			24,941,000				26,170,000
		$	105,518,000			$	105,451,000
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Current portion of long-term debt and capitalized lease obligations		$	582,000			$	2,278,000
Trade accounts payable			3,120,000				4,537,000
Accrued expenses:
Payroll and employee benefits			11,047,000				9,314,000
Current portion of self-insurance reserves			6,753,000				7,860,000
Other current liabilities			4,479,000				4,323,000
Current liabilities of discontinued operations			—				1,273,000
Total current liabilities			25,981,000				29,585,000
NONCURRENT LIABILITIES:
Long-term debt and capitalized lease obligations, less current portion			23,819,000				22,551,000
Self-insurance reserves, less current portion			11,847,000				12,235,000
Other noncurrent liabilities			16,748,000				15,195,000
Total noncurrent liabilities			52,414,000				49,981,000
COMMITMENTS AND CONTINGENCIES
SERIES C REDEEMABLE PREFERRED STOCK,
$.10 par value, 5,000 shares authorized, issued and outstanding, stated value of $4,918,000 including premium of $0 and $1,274,000, respectively			4,918,000				6,192,000
SHAREHOLDERS’ EQUITY:
Series A preferred stock, authorized 200,000 shares, $.10 par value, none issued and outstanding			—				—
Common stock, authorized 20,000,000 shares, $.01 par value, 5,976,000 and 5,949,000 shares issued, 5,744,000 and 5,717,000 shares outstanding, respectively			60,000				59,000
Treasury stock at cost, 232,000 shares of common stock			(2,500,000	)			(2,500,000	)
Paid-in capital			17,896,000				17,647,000
Retained earnings			6,749,000				4,487,000
Total shareholders’ equity			22,205,000				19,693,000
		$	105,518,000			$	105,451,000