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As filed with the Securities and Exchange Commission on July 1, 2014

Registration No. 333-            

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

FOUNDATION HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Oklahoma		8093		20-0180812
(State or other jurisdiction of incorporation or organization)		(Primary Standard Industrial Classification Code Number)		(I.R.S. Employer Identification Number)

14000 N. Portland Avenue, Ste. 200

Oklahoma City, Oklahoma 73134

(405) 608-1700

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 

 

Stanton Nelson

Chief Executive Officer

Foundation Healthcare, Inc.

14000 N. Portland Avenue, Ste. 200

Oklahoma City, Oklahoma 73134

(405) 608-1700

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

With copy to:

Robert E. Puopolo, Esq.

Goodwin Procter LLP

53 State Street

Boston, MA 02109

(617) 570-1000

Fax: (617) 523-1231

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this registration statement.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933 check the following box:  ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

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		¨		Accelerated filer		¨
Non-accelerated filer		¨  (Do not check if a smaller reporting company)		Smaller reporting company		x

 

 

CALCULATION OF REGISTRATION FEE

 

Title of Each Class of Securities to be Registered		Proposed Maximum Aggregate Offering Price(1)(2)		Amount of Registration Fee
Common Stock, $0.0001 par value		$23,000,000		$2,962.40
Total Registration Fee		$23,000,000		$2,962.40

(1)	Estimated solely for the purpose of calculating the amount of the registration fee pursuant to Rule 457(o) of the Securities Act of 1933, as amended (the “Securities Act”).

(2)	Pursuant to Rule 416(a) of the Securities Act of 1933, as amended, this registration statement shall be deemed to cover additional securities that may be offered or issued to prevent dilution resulting from stock splits, stock dividends or similar transactions.

 

 

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, or until the registration statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine.

 

 

 

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The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

 

SUBJECT TO COMPLETION, DATED JULY 1, 2014

Preliminary Prospectus

 

Foundation Healthcare, Inc.

[*] Shares of Common Stock

 

 

We are offering [*] shares of our common stock.

Our common stock is quoted on the OTCQB under the symbol “FDNH.” The last reported sale price of our common stock on the OTCQB on June 30, 2014 was $0.51 per share. There is no established public trading market for the warrants, and we do not expect a market to develop. In addition, we do not intend to apply for listing of the warrant on any national securities exchange or other nationally recognized trading system.

 

 

Investing in our common stock involves a high degree of risk.

 

 

See “Risk Factors” beginning on page 12.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

		Per Share				Total
Public offering price		$				$
Underwriting discounts and commissions(1)		$				$
Offering proceeds to us, before expenses		$				$

 

(1)	The underwriters will receive compensation in addition to the underwriting discount. See “Underwriting” beginning on page [*] of this prospectus for a description of compensation payable to the underwriters.

Delivery of the shares of common stock will be made on or about             . We expect to grant the underwriters an option for a period of [*] days to purchase, on the same terms and conditions set forth above, up to an additional [*] shares of our common stock to cover over-allotments, if any.

The date of this prospectus is                     , 2014.

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TABLE OF CONTENTS

 

		Page
Presentation of Certain Financial Measures			i
Prospectus Summary			1
Risk Factors			12
Cautionary Statement Concerning Forward-Looking Statements			30
Use of Proceeds			31
Dividend Policy			32
Dilution			33
Market Price of and Dividends on Common Equity and Related Stockholder Matters			34
Capitalization			36
Management’s Discussion and Analysis of Financial Condition and Results of Operations			37
Critical Accounting Policies			49
Our Business			52
Description of Property			70
Legal Proceedings			71
Management			72
Executive Compensation			77
Securities Authorized for Issuance Under Equity Compensation Plans			82
Certain Relationships and Related Party Transactions			83
Principal Stockholders			85
Description of Capital Stock			86
Underwriting			88
Legal Matters			91
Experts			91
Where You Can Find More Information			91
Documents Incorporated by Reference			92
Disclosure of Commission Position on Indemnification for Securities Act Liabilities			93
Financial Statements			F-1

You should rely only on the information contained in this prospectus, any amendment or supplement hereto, any free writing prospectus prepared by us or on our behalf, or any document incorporated herein by reference. We have not authorized anyone to provide you with information that is different. We are offering to sell, and seeking offers to buy, shares of common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus, any free writing prospectus, or document incorporated herein by reference is accurate only as of its date, regardless of the time of delivery of this prospectus or any free writing prospectus or of any sale of the common stock.

This prospectus contains estimates and other statistical data made by independent parties relating to market size, expenditures, growth and other data about our industry. We have not independently verified the statistical and other industry data generated by independent parties and contained in this prospectus and, accordingly, we cannot guarantee their accuracy or completeness.

This prospectus includes registered and unregistered trademarks of Foundation Healthcare, Inc. and its subsidiaries as well as the registered and unregistered trademarks of others. All other trademarks, tradenames and servicemarks appearing in this prospectus are the property of their respective owners.

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PRESENTATION OF CERTAIN FINANCIAL MEASURES

Certain financial measures presented in this prospectus, such as Adjusted EBITDA, are not recognized under accounting principles generally accepted in the United States, which we refer to as “GAAP.” Adjusted EBITDA has been presented in this prospectus as a supplemental measure of financial performance that is not required by, or presented in accordance with, GAAP. We define Adjusted EBITDA as net income before interest, taxes, depreciation, and amortization, further adjusted to eliminate the impact of certain additional items, including certain non-cash and other items that we do not consider in our evaluation of ongoing operating performance from period to period as discussed further below. Adjusted EBITDA is included in this prospectus because it is a key metric used by management to assess our financial performance. We use Adjusted EBITDA to supplement GAAP measures of performance in order to evaluate the effectiveness of our business strategies, to make budgeting decisions and to compare our performance against that of other peer companies using similar measures. Adjusted EBITDA is also frequently used by analysts, investors and other interested parties to evaluate companies in our industry.

Adjusted EBITDA is a non-GAAP measure of our financial performance and should not be considered as an alternative to net income (loss) as a measure of financial performance, or any other performance measure derived in accordance with GAAP, nor should it be construed as an inference that our future results will be unaffected by unusual or other items. In evaluating Adjusted EBITDA, you should be aware that in the future we will incur expenses that are the same as or similar to some of the adjustments in this presentation, such as preopening expenses, stock compensation expense, and other adjustments. Additionally, Adjusted EBITDA is not intended to be a measure of free cash flow for management’s discretionary use, as it does not reflect certain cash requirements such as tax payments, debt service requirements, capital expenditures, facility openings and certain other cash costs that may recur in the future. Adjusted EBITDA contains certain other limitations, including the failure to reflect our cash expenditures, cash requirements for working capital needs and cash costs to replace assets being depreciated and amortized. Management compensates for these limitations by supplementally relying on our GAAP results in addition to using Adjusted EBITDA. Our presentation of Adjusted EBITDA is not necessarily comparable to other similarly titled captions of other companies due to different methods of calculation.

 

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RISK FACTORS

An investment in our common stock involves a high degree of risk. You should carefully consider the risks described below before deciding to invest in shares of our common stock. Our business, prospects, financial condition or operating results could be materially adversely affected by any of these risks. The trading price of our common stock could decline due to any of these risks, and you may lose all or part of your investment. In assessing the risks described below, you should also refer to the other information contained in or incorporated by reference into this prospectus, including our consolidated financial statements and the related notes, before deciding to purchase any shares of our common stock.

We require a significant amount of cash flow from operations and third-party financing to pay our indebtedness, to execute our business plan and to fund our other liquidity needs.

We may not be able to generate sufficient cash flow from operations, and future borrowings may not be available to us under existing loan facilities or otherwise in an amount sufficient to pay our indebtedness, to execute our business plan or to fund our other liquidity needs. We anticipate the need for substantial cash flow to fund future acquisitions, which is our primary growth strategy.

At March 31, 2014, we have a short-term debt obligation with Arvest Bank of $3.9 million that matures on June 30, 2014 which is included in current liabilities from discontinued operations in our consolidated financial statements. At March 31, 2014, we have short-term debt and current portion of long-term debt payable to Legacy Bank of $2.8 million and $7.9 million, respectively. In addition, at March 31, 2014, we have additional short-term debt and current portion of long-term debt owed to other financial institutions totaling $3.4 million and $2.7 million, respectively. On June 30, 2014, we refinanced substantially all of our existing indebtedness, including the debt to Legacy Bank and Arvest Bank, under a new credit facility with Bank SNB. Further details about this indebtedness can be found in the footnotes to our consolidated financial statements included elsewhere in this prospectus and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

At March 31, 2014, we had total liabilities of approximately $62.3 million. There is no assurance that our operating results will provide sufficient funding to pay our liabilities on a timely basis. There is no assurance that we will be able to refinance any of our current indebtedness on commercially reasonable terms or at all. Failure to generate or raise sufficient funds may require us to modify, delay or abandon some of our future business growth strategies or expenditure plans.

We have incurred significant operating losses since the Foundation Acquisition and although we anticipate generating operating income in the near future, our operating losses could continue.

We have financed our operations through revenues from operations, as well as the issuance of debt and equity securities and have incurred significant losses since the Foundation Acquisition. Net loss attributable to Foundation Healthcare common stock was $20.4 million for the year ended December 31, 2014 and $1.9 million for the quarter ended March 31, 2014. While we anticipate generating operating income by the end of 2014, we are unable to predict the extent of any future losses or when we will become profitable at all. If we continue to incur losses, we may be unable to continue to operate our business and may need to cease operations entirely.

Our acquisition of FSA and FSHA may increase our risk of additional significant deficiencies or material weaknesses in our internal controls over financial reporting.

We have not performed an assessment of the effectiveness of the design and operation of the internal controls over financial reporting at FSA and FSHA; however, we have identified certain material weaknesses at FSA and FSHA related to the lack of sufficient internal review and approval of critical accounting schedules used in the preparation of financial statements and the lack of sufficient review and approval of the accounting impact and treatment of material contracts and agreements. FSA and FSHA were not required to be included in our assessment of internal controls for 2013 but will be included in our assessment for 2014, which may increase our risk for additional material weaknesses in our internal control over financial reporting.

 

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We may continue to see the growth of uninsured and “patient due” accounts, and deterioration in the collectability of these accounts could adversely affect our collections of accounts receivable, revenues, results of operations and cash flows.

The primary collection risks associated with our accounts receivable relate to the uninsured patient accounts and patient accounts for which the primary insurance carrier has paid the amounts covered by the applicable agreement, but patient responsibility amounts (deductibles and co-payments) remain outstanding. The provision for doubtful accounts relates primarily to amounts due directly from patients. This risk has increased, and will likely continue to increase, as more individuals enroll in high deductible insurance plans or those with high co-payments or who have no insurance coverage. These trends will likely be exacerbated if general economic conditions remain challenging or if unemployment levels in the communities in which we operate rise. As unemployment rates increase, our business strategies to generate organic growth and to improve admissions and adjusted admissions at our hospitals could become more difficult to accomplish.

The amount of our provision for doubtful accounts is based on our assessments of historical collection trends, business and economic conditions, trends in federal and state governmental and private employer health coverage and other collection indicators. A continuation in trends that results in increasing the proportion of accounts receivable being comprised of uninsured accounts and deterioration in the collectability of these accounts could adversely affect our collections of accounts receivable, results of operations and cash flows. As enacted, the ACA seeks to decrease, over time, the number of uninsured individuals. Among other things, the ACA will, beginning in 2014, incentivize states to expand their Medicaid eligibility requirements and incentivize employers to offer, and require individuals to carry, health insurance or be subject to penalties. However, it is difficult to predict the full impact of the ACA due to its complexity, lack of implementing regulations and interpretive guidance, gradual and potentially delayed implementation, and possible amendment, as well as our inability to foresee how individuals, businesses and states will respond to the choices afforded them by the ACA. In addition, even after implementation of the ACA, we may continue to experience bad debts and be required to provide uninsured discounts and charity care for undocumented aliens who are not permitted to enroll in a health insurance exchange or government healthcare programs.

Controls designed to reduce inpatient services may reduce our revenues.

Controls imposed by Medicare, Medicaid, and commercial third-party payors designed to reduce admissions and lengths of stay, commonly referred to as “utilization review,” have affected and are expected to continue to affect our facilities. Federal law contains numerous provisions designed to ensure that services rendered by hospitals to Medicare and Medicaid patients meet professionally recognized standards and are medically necessary and that claims for reimbursement are properly filed. These provisions include a requirement that a sampling of admissions of Medicare and Medicaid patients must be reviewed by quality improvement organizations, which review the appropriateness of Medicare and Medicaid patient admissions and discharges, the quality of care provided, the validity of MS-DRG classifications and the appropriateness of cases of extraordinary length of stay or cost on a post-discharge basis. Quality improvement organizations may deny payment for services or assess fines and also have the authority to recommend to HHS that a provider which is in substantial noncompliance with the standards of the quality improvement organization be excluded from participation in the Medicare program. The ACA potentially expands the use of prepayment review by Medicare contractors by eliminating statutory restrictions on their use, and, as a result, efforts to impose more stringent cost controls are expected to continue. Utilization review is also a requirement of most non-governmental managed care organizations and other third-party payors. Inpatient utilization, average lengths of stay and occupancy rates continue to be negatively affected by payor-required preadmission authorization and utilization review and by third party payor pressure to maximize outpatient and alternative healthcare delivery services for less acutely ill patients. Although we are unable to predict the effect these controls and changes will have on our operations, significant limits on the scope of services reimbursed and on reimbursement rates and fees could have a material, adverse effect on our business, financial position and results of operations.

 

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The industry trend towards value-based purchasing may negatively impact our revenues.

There is a trend in the healthcare industry toward value-based purchasing of healthcare services. These value-based purchasing programs include both public reporting of quality data and preventable adverse events tied to the quality and efficiency of care provided by facilities. Governmental programs including Medicare and Medicaid currently require hospitals to report certain quality data to receive full reimbursement updates. In addition, Medicare does not reimburse for care related to certain preventable adverse events. Many large commercial payors currently require hospitals to report quality data, and several commercial payors do not reimburse hospitals for certain preventable adverse events.

The ACA contains a number of provisions intended to promote value-based purchasing. Effective July 1, 2011, the ACA prohibits the use of federal funds under the Medicaid program to reimburse providers for medical assistance provided to treat hospital acquired conditions (“HAC”s). Beginning in federal fiscal year (“FFY”) 2015, hospitals that fall into the top 25% of national risk-adjusted HAC rates for all hospitals in the previous year will receive a 1% reduction in their total Medicare payments. Another provision reduces payments for all inpatient discharges for hospitals that experience excessive readmissions for certain conditions designated by the U.S. Department of Health & Human Services (“HHS”).

The ACA also requires HHS to implement a value-based purchasing program for inpatient hospital services. The ACA requires HHS to reduce inpatient hospital payments for all discharges by a percentage beginning at 1% in FFY 2013 and increasing by 0.25% each fiscal year up to 2% in FFY 2017 and subsequent years. HHS will pool the amount collected from these reductions to fund payments to reward hospitals that meet or exceed certain quality performance standards established by HHS. HHS will determine the amount each hospital that meets or exceeds the quality performance standards will receive from the pool of dollars created by these payment reductions.

We expect value-based purchasing programs, including programs that condition reimbursement on patient outcome measures, to become more common and to involve a higher percentage of reimbursement amounts. We are unable at this time to predict how this trend will affect our results of operations, but it could negatively impact our revenues.

The lingering effects of the economic recession could materially adversely affect our financial position, results of operations or cash flows.

The U.S. economy continues to experience the negative effects from an economic recession, and unemployment levels remain high. While certain healthcare spending is considered non-discretionary and may not be significantly impacted by economic downturns, other types of healthcare spending may be adversely impacted by such conditions. When patients are experiencing personal financial difficulties or have concerns about general economic conditions, they may choose:

 

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to defer or forego elective surgeries and other non-emergent procedures, which are generally more profitable lines of business for hospitals; or

 

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a high-deductible insurance plan or no insurance at all, which increases a hospitals dependence on self-pay revenue. Moreover, a greater number of uninsured patients may seek care in our emergency rooms.

We are unable to determine the specific impact of these economic conditions on our business at this time, but we believe that the lingering effects of the economic recession could have an adverse impact on our operations and could impact not only the healthcare decisions of our patients, but also the solvency of managed care providers and other counterparties to transactions with us.

The failure of certain employers, or the closure of certain manufacturing and other facilities in our markets, can have a disproportionate impact on our hospitals.

The economies in the non-urban communities in which our hospitals primarily operate are often dependent on a small number of large employers, especially manufacturing or other facilities. These employers often provide

 

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income and health insurance for a disproportionately large number of community residents who may depend on our hospitals for care. The failure of one or more large employers, or the closure or substantial reduction in the number of individuals employed at manufacturing or other facilities located in or near many of the non-urban communities in which our hospitals primarily operate, could cause affected employees to move elsewhere for employment or lose insurance coverage that was otherwise available to them. The occurrence of these events may cause a material reduction in our revenues and results of operations or impede our business strategies intended to generate organic growth and improve operating results at our hospitals.

We may have difficulty acquiring hospitals on favorable terms.

One element of our business strategy is expansion through the acquisition of surgical hospitals primarily in urban markets. We face significant competition to acquire attractive hospitals, and we may not find suitable acquisitions on favorable terms. Our primary competitors for acquisitions have included for-profit and tax-exempt hospitals and hospital systems and privately capitalized start-up companies. Buyers with a strategic desire for any particular hospital, for example, a hospital located near existing hospitals or those who will realize economic synergies, have demonstrated an ability and willingness to pay premium prices for hospitals. Strategic buyers, as a result, can present a competitive barrier to our acquisition efforts.

Given the increasingly challenging regulatory and enforcement environment, our ability to acquire hospitals could be negatively impacted if targets are found to have material unresolved compliance issues. We may condition our purchase on the resolution of such issues by reporting or refunding amounts under the voluntary self-disclosure protocols. We could experience delays in closing or fail to close transactions with targets that initially were attractive but became unattractive as a result of a poor compliance program, material non-compliance with laws or failure to timely address compliance risks.

The cost of an acquisition could result in a dilutive effect on our results of operations, depending on various factors, including the amount paid for the acquisition, the acquired hospital’s results of operations, allocation of purchase price, effects of subsequent legislation and limitations on rate increases. In the past, we have occasionally experienced temporary delays in improving the operating margins or effectively integrating the operations of our acquired hospitals. In the future, if we are unable to improve the operating margins of acquired hospitals, operate them profitably or effectively integrate their operations, we may be unable to achieve our growth strategy.

Even if we are able to identify an attractive target, we may not be able to obtain financing, if necessary, for any acquisitions or joint ventures that we might make or may be required to borrow at higher rates and on less favorable terms. We may incur or assume additional indebtedness as a result of acquisitions. Our failure to acquire non-urban hospitals consistent with our growth plans could prevent us from increasing our revenues.

In recent years, the legislatures and attorneys general of several states have become more interested in sales of hospitals by tax-exempt entities. This heightened scrutiny may increase the cost and difficulty, or prevent the completion, of transactions with tax-exempt organizations in the future.

We may encounter difficulty operating, integrating and improving financial performance at acquired hospitals.

We may be unable to timely and effectively integrate any hospitals that we acquire with our ongoing operations. We may experience delays in implementing operating procedures and systems in newly acquired hospitals. Integrating an acquired hospital could be expensive and time consuming and could disrupt our ongoing business, negatively affect cash flow and distract management and other key personnel. In addition, acquisition activity requires transitions from, and the integration of, operations and, usually, information systems that are used by acquired hospitals. In addition, we may not be able to achieve improved financial performance at acquired hospitals within our targeted time frames, or continue to improve financial performance for sustained periods following the acquisition.

 

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If we do not effectively attract, recruit and retain qualified physicians, our ability to deliver healthcare services efficiently will be adversely affected.

As a general matter, only physicians on our medical staffs may direct hospital admissions and the services ordered once a patient is admitted to a hospital. As a result, the success of our hospitals depends in part on the number and quality of the physicians on the medical staffs of our hospitals, the admitting practices of those physicians and maintaining good relations with those physicians.

The success of our efforts to recruit and retain quality physicians depends on several factors, including the actual and perceived quality of services provided by our hospitals, our ability to meet demands for new technology and our ability to identify and communicate with physicians who want to practice in non-urban communities. In particular, we face intense competition in the recruitment and retention of specialists because of the difficulty in convincing these individuals of the benefits of practicing or remaining in practice in non-urban communities. If the non-urban communities in which our hospitals primarily operate are not seen as attractive, then we could experience difficulty attracting and retaining physicians to practice in our communities. We may not be able to recruit all of the physicians we target. In addition, we may incur increased malpractice expense if the quality of physicians we recruit does not meet our expectations.

Additionally, our ability to recruit physicians is closely regulated. For example, the types, amount and duration of assistance we can provide to recruited physicians are limited by the Stark law, the Anti-kickback Statute, state anti-kickback statutes, and related regulations. For example, the Stark law requires, among other things, that recruitment assistance can only be provided to physicians who meet certain geographic and practice requirements, that the amount of assistance cannot be changed during the term of the recruitment agreement, and that the recruitment payments cannot generally benefit physicians currently in practice in the community beyond recruitment costs actually incurred by them. In addition to these legal requirements, there is competition from other communities and facilities for these physicians, and this competition continues after the physician is practicing in one of our communities.

Our hospitals face competition for staffing, which may increase labor costs and reduce profitability.

In addition to our physicians, the operations of our hospitals are dependent on the efforts, abilities and experience of our management and medical support personnel, such as nurses, pharmacists and lab technicians. We compete with other healthcare providers in recruiting and retaining qualified management and staff personnel responsible for the day-to-day operations of each of our hospitals, including nurses and other non-physician healthcare professionals. In some markets, the scarce availability of nurses and other medical support personnel presents a significant operating issue. This shortage may require us to enhance wages and benefits to recruit and retain nurses and other medical support personnel, recruit personnel from foreign countries, and hire more expensive temporary or contract personnel. In addition, the states in which we operate could adopt mandatory nurse-staffing ratios or could reduce mandatory nurse staffing ratios already in place. State-mandated nurse-staffing ratios could significantly affect labor costs and have an adverse impact on revenues if we are required to limit admissions in order to meet the required ratios. If our labor costs increase, we may not be able to raise rates to offset these increased costs. We also depend on the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate. Because a significant percentage of our revenue consists of fixed, prospective payments, our ability to pass along increased labor costs is constrained. Our failure to recruit and retain qualified management, nurses and other medical support personnel or to control our labor costs could have a material adverse effect on our financial condition or results of operations.

The loss of certain physicians can have a disproportionate impact on certain of our hospitals.

Generally, the top ten attending physicians within each of our facilities represent a large share of our inpatient revenues and admissions. The loss of one or more of these physicians, even if temporary, could cause a material reduction in our revenues and operating profits at such facility, which could take significant time to replace given the difficulty and cost associated with recruiting and retaining physicians.

 

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We are subject to risks associated with outsourcing functions to third parties.

To improve operating margins, productivity and efficiency, we outsource selected nonclinical business functions to third parties. We take steps to monitor and regulate the performance of independent third parties to whom the Company delegates selected functions, including revenue cycle management, patient access, billing, cash collections, payment compliance and support services, project implementation, supply chain management and payroll services.

Arrangements with third party service providers may make our operations vulnerable if vendors fail to satisfy their obligations to us as a result of their performance, changes in their own operations, financial condition, or other matters outside of our control. The expanding role of third party providers may also require changes to our existing operations and the adoption of new procedures and processes for retaining and managing these providers, as well as redistributing responsibilities as needed, in order to realize the potential productivity and operational efficiencies. Effective management, development and implementation of our outsourcing strategies are important to our business and strategy. If there are delays or difficulties in enhancing business processes or our third party providers do not perform as anticipated, we may not fully realize on a timely basis the anticipated economic and other benefits of the outsourcing projects or other relationships we enter into with key vendors, which could result in substantial costs, divert management’s attention from other strategic activities, negatively affect employee morale or create other operational or financial problems for us.

Terminating or transitioning arrangements with key vendors could result in additional costs and a risk of operational delays, potential errors and possible control issues as a result of the termination or during the transition phase.

If we acquire hospitals with unknown or contingent liabilities, we could become liable for material obligations.

Businesses we have acquired, or businesses we may acquire may have unknown or contingent liabilities for past activities of acquired businesses, including liabilities for failure to comply with healthcare laws and regulations, medical and general professional liabilities, worker’s compensation liabilities, previous tax liabilities and unacceptable business practices. Although we endeavor to continue to obtain contractual indemnification from sellers covering these matters, any indemnification obtained from sellers may be insufficient to cover material claims or liabilities for past activities of acquired businesses.

Other hospitals and outpatient facilities provide services similar to those which we offer. In addition, physicians provide services in their offices that could be provided in our hospitals. These factors increase the level of competition we face and may therefore adversely affect our revenues, profitability and market share

Competition among hospitals and other healthcare service providers, including outpatient facilities, has intensified in recent years. We compete with other hospitals, including larger tertiary care centers located in larger metropolitan areas, and with physicians who provide services in their offices which could otherwise be provided in our hospitals. Although the hospitals with which we compete may be a significant distance away from our facilities, patients in our markets may migrate on their own to, may be referred by local physicians to, or may be encouraged by their health plan to travel to these hospitals. Furthermore, some of the hospitals with which we compete may offer more or different services than those available at our hospitals, may have more advanced equipment or may have a medical staff that is thought to be better qualified. Also, some of the hospitals that compete with our facilities are owned by tax-supported governmental agencies or not-for-profit entities supported by endowments and charitable contributions. These hospitals, in most instances, are also exempt from paying sales, property and income taxes.

Quality of care and value-based purchasing have also become significant trends and competitive factors in the healthcare industry. In 2005, CMS began making public performance data relating to ten quality measures that hospitals submit in connection with their Medicare reimbursement. Since that time, CMS has on several occasions

 

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increased the number of quality measures hospitals are required to report in order to receive the full IPPS and OPPS market basket updates. In addition, the Medicare program no longer reimburses hospitals for care relating to certain preventable adverse events, and many private healthcare payors have adopted similar policies. If the public performance data become a primary factor in where patients choose to receive care, and if competing hospitals have better results than our hospitals on those measures, we would expect that our patient volumes could decline.

We also face very significant and increasing competition from services offered by physicians (including physicians on our medical staffs) in their offices and from other specialized care providers, including outpatient surgery, oncology, physical therapy and diagnostic centers (including many in which physicians may have an ownership interest). Some of our hospitals have and will seek to develop outpatient facilities where necessary to compete effectively. However, to the extent that other providers are successful in developing outpatient facilities or physicians are able to offer additional, advanced services in their offices, our market share for these services will likely decrease in the future.

If we do not continually enhance our hospitals with the most recent technological advances in diagnostic and surgical equipment, our ability to maintain and expand our markets may be adversely affected.

Technological advances, including with respect to computer-assisted tomography scanner (CTs), magnetic resonance imaging (MRIs) and robotic surgery devices, continue to evolve. In addition, the manufacturers of such equipment often provide incentives to try to increase their sales, including providing favorable financing to higher credit risk organizations. In an effort to compete, we must continually assess our equipment needs and upgrade our equipment as a result of technological improvements. We believe that the direction of the patient flow correlates directly to the level and intensity of such diagnostic equipment. If we don’t maintain our hospitals with diagnostic and surgical equipment that is in-line with current technological advances, we may lose patient traffic and our revenues may be materially reduced.

We may be subject to liabilities because of malpractice and related legal claims brought against our hospitals. If we become subject to these claims, we could be required to pay significant damages, which may not be covered by insurance.

We may be subject to medical malpractice lawsuits and other legal actions arising out of the operations of our owned and leased hospitals and the activities of our employed physicians. These actions may involve large claims and significant defense costs. In an effort to resolve one or more of these matters, we may choose to negotiate a settlement. Amounts we pay to settle any of these matters may be material. We maintain professional and general liability insurance with unrelated commercial insurance carriers to provide for losses in excess of our deductible amount. Also, some of these claims could exceed the scope of the coverage in effect, or coverage of particular claims could be denied. If we are required to pay material amounts which are not covered by insurance, it could have a material adverse effect on our cash position, cash flows from operations and net income.

Our failure to successfully implement our growth plan may adversely affect our financial performance.

We intend to grow incrementally through acquisitions of surgical hospitals. As this growth plan is pursued, we may encounter difficulties expanding and improving our operating and financial systems to maintain pace with the increased complexity of the expanded operations and management responsibilities.

The success of our growth strategy will also depend on a number of other factors, including:

 

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economic conditions;

 

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competition;

 

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the ability to attract and retain physician partners;

 

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financing and working capital requirements;

 

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the availability of new hospital acquisitions at a reasonable cost; and

 

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the ability to negotiate purchase agreements on favorable terms.

 

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The failure of our growth strategy may have a material adverse effect on our operating results and financial condition.

Material weaknesses in the design and operation of the internal controls over financial reporting of companies that we acquire could have a material adverse effect on our financial statements.

We intend to continue to grow our business through the acquisition of existing surgical hospitals. When we acquire such existing facilities our due diligence may fail to discover defects or deficiencies in the design and operations of the internal controls over financial reporting of such companies, or defects or deficiencies in the internal controls over financial reporting may arise when we try to integrate the operations of these newly acquired businesses with our own. We can provide no assurances that we will not experience such issues in future acquisitions, the result of which could have a material adverse effect on our financial statements. For example, we have identified certain material weaknesses at FSA and FSHA related to the lack of sufficient internal review and approval of critical accounting schedules used in the preparation of financial statements and the lack of sufficient review and approval of the accounting impact and treatment of material contracts and agreements.

The goodwill and other intangible assets acquired pursuant to our acquisitions of hospitals and ASCs may become impaired and require write-downs and the recognition of substantial impairment expense. Goodwill and other intangible assets related to future acquisitions may require additional write-downs and the recognition of additional substantial impairment expense.

At March 31, 2014, we had $1.0 million and $10.6 million in goodwill and other intangible assets, respectively, that were recorded in connection with the acquisitions of our hospitals and ASCs. We periodically evaluate whether or not to take an impairment charge on our goodwill, as required by the applicable accounting literature. Our evaluation is based on our (i) assessment of current and expected future economic conditions, (ii) trends, strategies and forecasted cash flows at each business unit and (iii) assumptions similar to those that market participants would make in valuing our business units. Our evaluation of goodwill and intangible assets completed during 2013 identified an impairment in goodwill of $21.9 million related to the goodwill attributable to the reverse acquisition treatment of the Foundation Acquisition.

In the event that this goodwill or other intangible assets are determined to be further impaired for any reason, we will be required to write-down or reduce the value of the goodwill and recognize an impairment expense. The impairment expense may be substantial in amount and adversely affect the results of our operations for the applicable period and may negatively affect the market value of our common stock.

Also, in the event that we record additional goodwill or other intangibles on future acquisitions and we subsequently determine the goodwill or other intangibles to be impaired for any reason, we will be required to write-down or reduce the value of the goodwill and recognize an impairment expense. The impairment expense may be substantial in amount and adversely affect the results of our operations for the applicable period and may negatively affect the market value of our common stock.

Risks Related to Healthcare Regulation

We cannot predict the effect that the ACA and its implementation may have on our business, financial condition or results of operations.

The ACA was signed into law, in two parts, on March 23, 2010 and March 30, 2010. The ACA dramatically alters the U.S. healthcare system and is intended to decrease the number of uninsured Americans and reduce the overall cost of healthcare. The ACA attempts to achieve these goals by, among other things, requiring most Americans to obtain health insurance, expanding Medicare and Medicaid eligibility, reducing Medicare and Medicaid disproportionate share hospital (“DSH”) payments to providers, expanding the Medicare program’s use of value-based purchasing programs, tying hospital payments to the satisfaction of certain quality criteria,

 

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bundling payments to hospitals and other providers, and instituting certain private health insurance reforms. Although a majority of the measures contained in the ACA just recently became effective, certain of the reductions in Medicare spending, such as negative adjustments to the Medicare hospital inpatient and outpatient prospective payment system market basket updates and the incorporation of productivity adjustments to the Medicare program’s annual inflation updates, became effective in 2010, 2011 and 2012. Although the expansion of health insurance coverage should increase revenues from providing care to certain previously uninsured individuals, many of these provisions of the ACA will continue to become effective beyond 2014, and the impact of such expansion may be gradual and may not offset scheduled decreases in reimbursement.

On June 28, 2012, the U.S. Supreme Court upheld the constitutionality of the ACA, including the “individual mandate” provisions of the ACA that generally require all individuals to obtain healthcare insurance or pay a penalty. However, the U.S. Supreme Court also held that the provision of the ACA that authorized the Secretary of HHS to penalize states that choose not to participate in the expansion of the Medicaid program by removing all of their existing Medicaid funding was unconstitutional. In response to the ruling, a number of U.S. governors, including those of some states in which we operate, have stated that they oppose their state’s participation in the expanded Medicaid program, which could result in the ACA not providing coverage to some low-income persons in those states. In addition, several bills have been and may continue to be introduced in Congress to repeal or amend all or significant provisions of the ACA.

The ACA changes how healthcare services are covered, delivered, and reimbursed. The net effect of the ACA on our business is subject to numerous variables, including the law’s complexity, lack of complete implementing regulations and interpretive guidance, gradual and potentially delayed implementation or possible amendment, as well as the uncertainty as to the extent to which states will choose to participate in the expanded Medicaid program. As a result, we are unable to predict the net effect on our business, financial condition or results of operations of the expected increases in insured individuals using our facilities, the reductions in government healthcare reimbursement spending, and numerous other provisions of the ACA that may affect us. We are also unable to predict how providers, payors, employers and other market participants will respond to the various reform provisions because many provisions will not be implemented for several years under the ACA’s implementation schedule. Further, we are unable to predict the outcome of new or remaining court challenges and the impact of continued legislative efforts to delay implementation of or amend the ACA.

Our revenues will decline if federal or state programs reduce our Medicare or Medicaid payments or if managed care companies reduce reimbursement amounts. In addition, the financial condition of payors and healthcare cost containment initiatives may limit our revenues and profitability.

In 2013, we derived 27% of our revenues from the Medicare and Medicaid programs, collectively. The Medicare and Medicaid programs are subject to statutory and regulatory changes, administrative rulings, interpretations and determinations concerning patient eligibility requirements, funding levels and the method of calculating payments or reimbursements and requirements for utilization review, among other things, and federal and state funding restrictions, all of which could materially increase or decrease payments from these government programs in the future, as well as affect the timing of payments to our facilities.

We are unable to predict the effect of future government healthcare funding policy changes on our operations. If the rates paid by governmental payors are reduced, if the scope of services covered by governmental payors is limited or if we or one or more of our hospitals are excluded from participation in the Medicare or Medicaid program or any other government healthcare program, there could be a material adverse effect on our business, financial condition, results of operations or cash flows. In addition, revenues from HMOs, PPOs and other private payors are subject to contracts and other arrangements that require us to discount the amounts we customarily charge for healthcare services.

During the past several years, healthcare payors, such as federal and state governments, insurance companies and employers, have undertaken initiatives to revise payment methodologies and monitor healthcare costs. As part of their efforts to contain healthcare costs, payors increasingly are demanding discounted fee structures or the

 

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assumption by healthcare providers of all or a portion of the financial risk related to paying for care provided, often in exchange for exclusive or preferred participation in their benefit plans. Similarly, many individuals and employers have attempted to reduce their healthcare costs by moving to private payor plans that reimburse our facilities at significantly lower rate than other competing private payors. We expect efforts to impose greater discounts and more stringent cost controls by government and private payors to continue, thereby reducing the payments we receive for our services. In addition, payors have instituted policies and procedures to substantially reduce or limit the use of inpatient services. For example, CMS has transitioned to full implementation of the MS- DRG system, which represents a refinement to the existing diagnosis-related group system. Future realignments in the MS-DRG system could impact the margins we receive for certain services. Furthermore, the ACA, the Tax Relief Act and the ATRA provide for material reductions in the growth of Medicare program spending, including reductions in Medicare market basket updates, and Medicare DSH funding.

All, but one, of our hospitals are certified as providers of Medicaid services. Medicaid programs are jointly funded by federal and state governments and are administered by states under an approved plan that provides hospital and other healthcare benefits to qualifying individuals who are unable to afford care. A number of states, however, are experiencing budget problems and have adopted or are considering legislation designed to reduce their Medicaid expenditures, including enrolling Medicaid recipients in managed care programs and imposing additional taxes on hospitals to help finance or expand such states’ Medicaid systems. It is possible that budgetary pressures will force states to resort to some of the cost saving measures mentioned above. These efforts could have a material adverse effect on our business, financial condition, results of operations or cash flows.

We are subject to increasingly stringent governmental regulation, and may be subjected to allegations that we have failed to comply with governmental regulations which could result in sanctions and even greater scrutiny that reduce our revenues and profitability.

All participants in the healthcare industry are required to comply with many laws and regulations at the federal, state and local government levels. These laws and regulations require that hospitals meet various requirements, including those relating to hospitals’ relationships with physicians and other referral sources, the adequacy and quality of medical care, inpatient admission criteria, privacy and security of health information, standards for equipment, personnel, operating policies and procedures, billing and cost reports, payment for services and supplies, maintenance of adequate records, compliance with building codes and environmental protection, among other matters. Many of the laws and regulations applicable to the healthcare industry are complex, and there are numerous enforcement authorities, including CMS, OIG, State Attorneys General, and contracted auditors, as well as whistleblowers. Some positions taken in connection with enforcement appear to be inconsistent with historical common practices within the industry but have not previously been challenged. Moreover, as a result of the provisions of the ACA that created potential False Claims Act liabilities for failing to report and repay known overpayments and return an overpayment within sixty (60) days of the identification of the overpayment or the date by which a corresponding cost report is due, whichever is later, hospitals and other healthcare providers are encouraged to disclose potential violations of law.

Hospitals continue to be one of the primary focal areas of the OIG and other governmental fraud and abuse programs. In January 2005, the OIG issued Supplemental Compliance Program Guidance for Hospitals that focuses on hospital compliance risk areas. Some of the risk areas highlighted by the OIG include correct outpatient procedure coding, revising admission and discharge policies to reflect current CMS rules, submitting appropriate claims for supplemental payments such as pass-through costs and outlier payments and a general discussion of the fraud and abuse risks related to financial relationships with referral sources. Each FFY, the OIG also publishes a General Work Plan that provides a brief description of the activities that the OIG plans to initiate or continue with respect to the programs and operations of HHS and details the areas that the OIG believes are prone to fraud and abuse.

The laws and regulations with which we must comply are complex and subject to change. In the future, different interpretations or enforcement of these laws and regulations could subject our practices to allegations of

 

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impropriety or illegality or could require us to make changes in our facilities, equipment, personnel, services, capital expenditure programs and operating expenses. If we fail to comply with applicable laws and regulations, we could suffer civil or criminal penalties, including the loss of our licenses to operate our hospitals and our ability to participate in the Medicare, Medicaid and other federal and state healthcare programs.

Finally, we are subject to various federal, state and local statutes and ordinances regulating the discharge of materials into the environment. Our healthcare operations generate medical waste, such as pharmaceuticals, biological materials and disposable medical instruments that must be disposed of in compliance with federal, state and local environmental laws, rules and regulations. Our operations are also subject to various other environmental laws, rules and regulations. Environmental regulations also may apply when we renovate or refurbish hospitals, particularly older facilities.

As a result of increased reviews of claims to Medicare and Medicaid for our services, we may incur additional costs and may be required to repay amounts already paid to us.

We are subject to regular post-payment inquiries, investigations and audits of the claims we submit to Medicare for payment for our services. These post-payment reviews are increasing as a result of government cost-containment initiatives, including enhanced medical necessity reviews for Medicare patients admitted as inpatients to general acute care hospitals for certain procedures (e.g., cardiovascular procedures) and audits of Medicare claims under the RAC programs. RACs utilize a post-payment targeted review process employing data analysis techniques in order to identify those Medicare claims most likely to contain overpayments, such as incorrectly coded services, short stays, incorrect payment amounts, non-covered services and duplicate payments. The claims review strategies used by the RACs generally include a review of high dollar claims, including inpatient hospital claims. As a result, a large majority of the total amounts recovered by RACs has come from hospitals. In addition, CMS has announced a pre-payment demonstration project that will allow RACs to review claims before they are paid to ensure that the provider complied with all Medicare payment rules. Under the demonstration project, RACs conduct prepayment reviews on certain types of claims that historically result in high rates of improper payments, beginning with those involving short stay inpatient hospital services. These reviews will focus on certain states with high populations of fraud and error-prone providers (including the state of Texas in which we operate) and other states high claims volumes of short inpatient hospital stays. The demonstration project began on August 27, 2012 and will run for a three year period.

The ACA expanded the RAC program’s scope to include managed Medicare and to include Medicaid claims, and all states are now required to establish programs to contract with RACs. In addition, CMS employs Medicaid Integrity Contractors (“MICs”) to perform post-payment audits of Medicaid claims and identify overpayments. The ACA increases federal funding for the MIC program for FFY 2011 and later years. In addition to RACs and MICs, the state Medicaid agencies and other contractors have also increased their review activities. Any such audit or investigation could have a material adverse effect on the results of our operations.

If we fail to comply with the Anti-Kickback Statute, we could be subject to criminal and civil penalties, loss of licenses and exclusion from governmental programs, which may result in a substantial loss of revenues.

The Anti-Kickback Statute prohibits the offer, payment, solicitation or receipt of any form of remuneration in return for referring, ordering, leasing, purchasing or arranging for or recommending the ordering, purchasing or leasing of items or services payable by Medicare, Medicaid or any other federally funded healthcare program. The Anti-Kickback Statute is broad in scope, and many of its provisions have not been uniformly or definitively interpreted by existing case law or regulations. Courts have found a violation of the Anti-Kickback Statute if just one purpose of the remuneration is to generate referrals, even if there are other lawful purposes. Violations of the Anti-Kickback Statute may result in substantial civil or criminal penalties, plus three times the remuneration involved or the amount claimed and exclusion from participation in the Medicare and Medicaid programs. Our exclusion from participation in such programs would have a material adverse effect on our business, prospects, results of operations and financial condition. In addition, many of the states in which we operate have also

 

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adopted laws, similar to the Anti-Kickback Statute, that prohibit payments to physicians in exchange for referrals, some of which apply regardless of the source of payment for care. These statutes typically impose criminal and civil penalties, including the loss of a license to do business in the state.

In July 1991, HHS issued final regulations defining various “safe harbors” under the Anti-Kickback Statute. Business arrangements that meet the requirements of the safe harbors are deemed to be in compliance with the Anti-Kickback Statute. Business arrangements that do not meet the safe harbor requirements do not necessarily violate the Anti-Kickback Statute, but may be subject to scrutiny by the Federal government to determine compliance.

Although we believe that our business arrangements do not violate the Anti-Kickback Statute or similar state laws, a government agency or a private party may assert a contrary position. Additionally, new federal or state laws may be enacted that would cause our relationships with our physician partners to become illegal or result in the imposition of penalties against us or our facilities. If any of our business arrangements with physician partners were alleged or deemed to violate the Anti-Kickback Statute or similar laws, or if new federal or state laws were enacted rendering these arrangements illegal, it could have a material adverse effect on our business, prospects, results of operations and financial condition.

We may be subjected to actions brought by the government under anti-fraud and abuse provisions or by individuals on the government’s behalf under the False Claims Act’s “qui tam” or “whistleblower” provisions.

The federal False Claims Act prohibits providers from, among other things, knowingly submitting false claims for payment to the federal government. The “qui tam” or “whistleblower” provisions of the False Claims Act allow private individuals to bring actions under the False Claims Act on behalf of the government. These private parties are entitled to share in any amounts recovered by the government, and, as a result, the number of “whistleblower” lawsuits that have been filed against providers has increased significantly in recent years. Defendants found to be liable under the federal False Claims Act may be required to pay three times the actual damages sustained by the government, plus mandatory civil penalties ranging between $5,500 and $11,000 for each separate false claim.

There are many potential bases for liability under the False Claims Act. The government has used the False Claims Act to prosecute Medicare and other government healthcare program fraud such as coding errors, billing for services not provided, submitting false cost reports, and providing care that is not medically necessary or that is substandard in quality. The ACA also provides that claims submitted in connection with patient referrals that result from violations of the Anti-kickback Statute constitute false claims for the purposes of the federal False Claims Act, and some courts have held that a violation of the Stark law can result in False Claims Act liability, as well. In addition, a number of states have adopted their own false claims and whistleblower provisions whereby a private party may file a civil lawsuit in state court. We are required to provide information to our employees and certain contractors about state and federal false claims laws and whistleblower provisions and protections.

Although we intend and will endeavor to conduct our business in compliance with all applicable federal and state fraud and abuse laws, many of these laws are broadly worded and may be interpreted or applied in ways that cannot be predicted. Therefore, we cannot assure you that our arrangements or business practices will not be subject to government scrutiny or be found to be in compliance with applicable fraud and abuse laws.

If we fail to effectively and timely implement electronic health record systems, our operations could be adversely affected.

As required by ARRA, the Secretary of HHS has developed and implemented an incentive payment program for eligible hospitals and healthcare professionals that adopt and meaningfully use electronic health record (“EHR”) technology. HHS uses the Provider Enrollment, Chain and Ownership System (“PECOS”) to verify Medicare enrollment prior to making EHR incentive program payments. If our hospitals and employed professionals are

 

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unable to meet the requirements for participation in the incentive payment program, including having an enrollment record in PECOS, we will not be eligible to receive incentive payments that could offset some of the costs of implementing EHR systems. Further, beginning in FFY 2015, eligible hospitals and professionals that fail to demonstrate meaningful use of certified EHR technology will be subject to reduced payments from Medicare. System conversions to comply with EHR could be time consuming and disruptive for physicians and employees. Failure to implement EHR systems effectively and in a timely manner could have a material adverse effect on our financial position and results of operations.

We are in process of converting certain of our clinical and patient accounting information system applications to newer versions of existing applications or all together new applications at several of our facilities. In connection with our implementations and conversions, we have incurred significant capitalized costs and additional training and implementation expenses. In addition, EHR incentive payments previously recognized are subject to audit and potential recoupment if it is determined that we did not meet the applicable meaningful use standards required in connection with such incentive payments.

If we fail to comply with physician self-referral laws as they are currently interpreted or may be interpreted in the future, or if other legislative restrictions are issued, we could incur substantial monetary penalties and a significant loss of revenues.

The federal physician self-referral law, commonly referred to as the Stark Law, prohibits a physician from making a referral to an entity for the furnishing of certain “designated health services” otherwise payable under Medicare or Medicaid if the physician or a member of the physician’s immediate family has a financial relationship with the entity, such as an ownership interest or compensation arrangement, unless an exception applies. The Stark Law also prohibits entities that provide designated health services otherwise payable by Medicare or Medicaid from billing the Medicare and Medicaid programs for any items or services that result from a prohibited referral and requires the entities to refund amounts received for items or services provided pursuant to the prohibited referral. HHS, acting through CMS, has promulgated regulations implementing the Stark Law. These regulations exclude health services provided by an ASC from the definition of “designated health services” if the services are included in the facility’s composite Medicare payment rate. Therefore, the Stark Law’s self-referral prohibition generally does not apply to health services provided by an ASC. However, if the ASC is separately billing Medicare for designated health services that are not covered under the ASC’s composite Medicare payment rate, or if either the ASC or an affiliated physician is performing (and billing Medicare) for procedures that involve designated health services that Medicare has not designated as an ASC service, the Stark Law’s self-referral prohibition would apply and such services could implicate the Stark Law. We believe that our operations do not violate the Stark Law, as currently interpreted. All services provided by our ASCs that would otherwise constitute designated health services are reimbursed by Medicare as part of the composite payment rate and are thus subject to an exception from the Stark Law, with the exception of implants. The Stark Law provides for a special exception for implants, such as intraocular lenses and artificial joints, furnished in ASCs as long as certain regulatory requirements are met. These requirements provide that the implant must be implanted by the referring physician or a member of his or her group practice, that the implant be implanted during a surgical procedure reimbursed as an ASC procedure by Medicare, that the arrangement for the furnishing of the implant not violate the Anti-Kickback Statute and that the billing for the implant be conducted legally. In addition, we believe that physician ownership of ASCs is not prohibited by similar self-referral statutes enacted at the state level. However, the Stark Law and similar state statutes are subject to different interpretations with respect to many important provisions. Moreover, the Stark Law applies to our surgical hospitals. Violations of these self-referral laws may result in substantial civil or criminal penalties, including large civil monetary penalties and exclusion from participation in the Medicare and Medicaid programs. If physician self-referral laws are interpreted differently or if other legislative restrictions are issued, we could incur significant sanctions and loss of revenues, or we could have to change our arrangements and operations in a way that could have a material adverse effect on our business, prospects, results of operations and financial condition.

 

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Companies within the healthcare industry continue to be the subject of federal and state audits and investigations, and we may be subject to such audits and investigations, including actions for false and other improper claims.

Federal and state government agencies, as well as commercial payors, have increased their auditing and administrative, civil and criminal enforcement efforts as part of numerous ongoing investigations of healthcare organizations. These audits and investigations relate to a wide variety of topics, including the following: cost reporting and billing practices; quality of care; financial reporting; financial relationships with referral sources; and medical necessity of services provided. In addition, the OIG and the U.S. Department of Justice (“DOJ”) have, from time to time, undertaken national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse.

The Federal government is authorized to impose criminal, civil and administrative penalties on any person or entity that files a false claim for payment from the Medicare or Medicaid programs. Claims filed with private insurers can also lead to criminal and civil penalties. While the criminal statutes are generally reserved for instances of fraudulent intent, the Federal government is applying its criminal, civil and administrative penalty statutes in an ever-expanding range of circumstances, including claiming payment for unnecessary services if the claimant merely should have known the services were unnecessary and claiming payment for low-quality services if the claimant should have known that the care was substandard. In addition, a violation of the Stark Law or the Anti-Kickback Statute can result in liability under the FCA.

Over the past several years, the Federal government has accused an increasing number of healthcare providers of violating the FCA, which prohibits a person from knowingly presenting, or causing to be presented, a false or fraudulent claim to the Federal government. The statute defines “knowingly” to include not only actual knowledge of a claim’s falsity, but also reckless disregard for or intentional ignorance of the truth or falsity of a claim. Violators of the FCA are subject to severe financial penalties, including treble damages and per claim penalties in excess of $10,000. Because our facilities perform hundreds or thousands of similar procedures each year for which they are paid by Medicare, and since the statute of limitations for such claims extends for six years under normal circumstances (and possibly as long as ten years in the event of failure to discover material facts), a repetitive billing error or cost reporting error could result in significant, material repayments and civil or criminal penalties.

We are also subject to various state laws and regulations, as well as contractual provisions with commercial payors that prohibit us from submitting inaccurate, incorrect or misleading claims. We believe that our surgical facilities are in material compliance with all such laws, regulations and contractual provisions regarding the submission of claims. We cannot be sure, however, that none of our surgical facilities’ claims will ever be challenged. If we were found to be in violation of a state’s laws or regulations, or of a commercial payor contract, we could be forced to discontinue the violative practice and be subject to recoupment actions, fines and criminal penalties, which could have a material adverse effect on our business, prospects, results of operations and financial condition.

All payors are increasingly conducting post-payment audits. For example, CMS has implemented the RAC program, involving Medicare claims audits nationwide. Under the program, CMS contracts with RACs on a contingency fee basis to conduct post-payment reviews to detect and correct improper payments in the fee-for-service Medicare program. The ACA expanded the RAC program’s scope to include managed Medicare plans and to include Medicaid claims. In addition, CMS employs Medicaid Integrity Contractors (“MICs”) to perform post-payment audits of Medicaid claims and identify overpayments. The ACA increases federal funding for the MIC program. In addition to RACs and MICs, the state Medicaid agencies and other contractors have increased their review activities. We are regularly subject to these external audits and we also perform internal audits and monitoring. Depending on the nature of the conduct found in such audits and whether the underlying conduct could be considered systemic, the resolution of these audits could have a material adverse effect on our business, prospects, results of operations and financial condition.

 

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Federal law restricts the ability of our surgical hospitals to expand surgical capacity.

The Stark Law includes an exception that permits physicians to refer Medicare and Medicaid patients to hospitals in which they have an ownership interest if certain requirements are met. However, the ACA dramatically curtailed this exception and prohibits physician ownership in hospitals that did not have a Medicare provider agreement by December 31, 2010. This prohibition does not apply to our surgical hospitals, each of which had a Medicare provider agreement in place prior to December 31, 2010 and are therefore able to continue operating with their existing ownership structure. However, the ACA prohibits “grandfathered” hospitals from increasing their percentage of physician ownership, and it limits to a certain extent their ability to grow, because it prohibits such hospitals from increasing the aggregate number of inpatient beds, operating rooms and procedure rooms.

We are subject to potential legal and reputational risk as a result of our access to personal information of our patients.

There are numerous federal and state laws and regulations addressing patient and consumer privacy concerns, including unauthorized access to or theft of personal information. In the ordinary course of our business, we, and vendors on our behalf, collect and store sensitive data, including personal health data and other personally identifiable information of our patients. The secure processing, maintenance and transmission of this information are critical to our operations and business strategy. We have developed a comprehensive set of policies and procedures in our efforts to comply with HIPAA and other privacy laws. The HHS Office for Civil Rights has imposed civil monetary penalties and corrective action plans on covered entities for violating HIPAA’s privacy rule. If, in spite of our compliance efforts we were to experience a breach, loss, or other compromise of such personal health information, such event could disrupt our operations, damage our reputation, result in regulatory penalties, legal claims and liability under HIPAA and other state and federal laws, which could have a material adverse effect on our business, financial condition and results of operations.

If we fail to comply with laws and regulations related to the protection of the environment and human health and safety, we could incur substantial penalties and fines.

We are subject to various federal, state and local laws and regulations relating to the protection of the environment and human health and safety, including those governing the management and disposal of hazardous substances and wastes, the cleanup of contaminated sites and the maintenance of a safe workplace. Our operations include the use, generation and disposal of hazardous materials. We also plan to acquire ownership or operational interests in new facilities and properties, some of which may have had a history of commercial or other operations. We may, in the future, incur liability under environmental statutes and regulations with respect to contamination of sites we own or operate (including contamination caused by prior owners or operators of such sites, abutters or other persons) and the off-site disposal of hazardous substances. Violations of these laws and regulations may result in substantial civil penalties or fines.

Risks Related to Ownership of Our Common Stock

Our common stock is quoted on the OTCQB, which may limit the liquidity and price of our common stock more than if our common stock quoted or listed on or a national securities exchange.

Our common stock is currently quoted on the OTCQB, an inter-dealer automated quotation system for equity securities not listed on a national securities exchange. Quotation of our common stock on the OTCQB may limit the liquidity and price of our common stock more than if our common stock was quoted or listed on a national securities exchange. Some investors may perceive our common stock to be less attractive because they are traded in the over-the-counter market. In addition, as an OTCQB company, we do not attract the extensive analyst coverage that accompanies companies listed on a national securities exchange. Further, institutional and other investors may have investment guidelines that restrict or prohibit investing in securities traded in the over-the-counter market. In addition, holders of our common stock may face restrictions on the resale of our common stock due to state “blue sky” laws. These factors may have an adverse impact on the trading and price of our common stock.

 

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Our securities are “Penny Stock” and subject to specific rules governing their sale to investors.

The SEC has adopted Rule 15g-9 which establishes the definition of a “penny stock,” for the purposes relevant to us, as any equity security that has a market price of less than $5.00 per share or with an exercise price of less than $5.00 per share, subject to certain exceptions. For any transaction involving a penny stock, unless exempt, the rules require that a broker or dealer approve a person’s account for transactions in penny stocks; and the broker or dealer receive from the investor a written agreement to the transaction, setting forth the identity and quantity of the penny stock to be purchased.

In order to approve a person’s account for transactions in penny stocks, the broker or dealer must obtain financial information and investment experience objectives of the person; and make a reasonable determination that the transactions in penny stocks are suitable for that person and the person has sufficient knowledge and experience in financial matters to be capable of evaluating the risks of transactions in penny stocks.

The broker or dealer must also deliver, prior to any transaction in a penny stock, a disclosure schedule prescribed by the SEC relating to the penny stock market, which, in highlight form sets forth the basis on which the broker or dealer made the suitability determination; and that the broker or dealer received a signed, written agreement from the investor prior to the transaction.

Generally, brokers may be less willing to execute transactions in securities subject to the “penny stock” rules. This may make it more difficult for our shareholders to sell shares of our common stock.

Disclosure also has to be made about the risks of investing in penny stocks in both public offerings and in secondary trading and about the commissions payable to both the broker-dealer and the registered representative, current quotations for the securities and the rights and remedies available to an investor in cases of fraud in penny stock transactions. Finally, monthly statements have to be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stocks.

Investors may experience dilution of their ownership interests because of the future issuance of additional shares of our common stock.

In the future, we may issue additional authorized but previously unissued equity securities, resulting in the dilution of the ownership interests of our present stockholders. We may also issue additional shares of our common stock or other securities that are convertible into or exercisable for common stock in connection with hiring or retaining employees, future acquisitions, future sales of our securities for capital raising purposes, or for other business purposes. The future issuance of any such additional shares of common stock may create downward pressure on the trading price of the common stock. There can be no assurance that we will not be required to issue additional shares, warrants or other convertible securities in the future in conjunction with any capital raising efforts, including at a price (or exercise prices) below the price at which shares of our common stock are currently traded on the OTCQB.

Our current principal stockholders have significant influence over us and they could delay, deter or prevent a change of control or other business combination or otherwise cause us to take action with which you might not agree.

Our executive officers, directors and holders of greater than 5% of our outstanding common stock together beneficially own approximately 89% of our outstanding common stock. As a result, our executive officers, directors and holders of greater than 5% of our outstanding common stock will have the ability to significantly influence all matters submitted to our stockholders for approval, including:

 

•

changes to the composition of our Board of Directors, which has the authority to direct our business and appoint and remove our officers;

 

•

proposed mergers, consolidations or other business combinations; and

 

•

amendments to our certificate of incorporation and bylaws which govern the rights attached to our shares of common stock.

 

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This concentration of ownership of shares of our common stock could delay or prevent proxy contests, mergers, tender offers, open market purchase programs or other purchases of shares of our common stock that might otherwise give you the opportunity to realize a premium over the then prevailing market price of our common stock. The interests of our executive officers, directors and holders of greater than 5% of our outstanding common stock may not always coincide with the interests of the other holders of our common stock. This concentration of ownership may also adversely affect our stock price.

The market price of our common stock may be volatile and this may adversely affect our stockholders.

The price at which our common stock trades may be volatile. The stock market has recently experienced significant price and volume fluctuations that have affected the market prices of securities, including securities of healthcare companies. The market price of our common stock may be influenced by many factors, including:

 

•

our operating and financial performance;

 

•

variances in our quarterly financial results compared to expectations;

 

•

the depth and liquidity of the market for our common stock;

 

•

future sales of common stock or the perception that sales could occur;

 

•

investor perception of our business and our prospects;

 

•

developments relating to litigation or governmental investigations;

 

•

changes or proposed changes in healthcare laws or regulations or enforcement of these laws and regulations, or announcements relating to these matters; or

 

•

general economic and stock market conditions.

In addition, the stock market in general has experienced price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of healthcare companies. These broad market and industry factors may materially reduce the market price of our common stock, regardless of our operating performance. In the past, securities class-action litigation has often been brought against companies following periods of volatility in the market price of their respective securities. We may become involved in this type of litigation in the future. Litigation of this type is often expensive to defend and may divert our management team’s attention as well as resources from the operation of our business.

We do not anticipate paying dividends on our common stock in the foreseeable future and, consequently, your ability to achieve a return on your investment will depend solely on appreciation in the price of our common stock.

We do not pay dividends on our shares of common stock and intend to retain all future earnings to finance the continued growth and development of our business and for general corporate purposes. In addition, we do not anticipate paying cash dividends on our common stock in the foreseeable future. Any future payment of cash dividends will depend upon our financial condition, capital requirements, earnings and other factors deemed relevant by our Board of Directors.

Risks Related to the Offering

We have broad discretion in how we use the net proceeds of this offering, and we may not use these proceeds effectively or in ways with which you agree.

Our management will have broad discretion as to the application of the net proceeds of this offering and could use them for purposes other than those contemplated at the time of this offering. Our stockholders may not agree

 

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with the manner in which our management chooses to allocate and spend the net proceeds. Moreover, our management may use the net proceeds for corporate purposes that may not yield profitable results or increase the market price of our common stock.

You will experience immediate and substantial dilution in the net tangible book value per share of the common stock you purchase.

Since the price per share of our common stock being offered is higher than the net tangible book value per share of our common stock, you will suffer substantial dilution in the net tangible book value of the common stock you purchase in this offering. Based on the public offering price of $[*] per share, and after deducting the underwriting discount and estimated offering expenses payable by us, if you purchase shares of common stock in this offering, you will suffer immediate and substantial dilution of $[*] per share in the net tangible book value of the common stock. If the underwriters exercise their over-allotment option, or if outstanding options and warrants to purchase our common stock are exercised, you will experience additional dilution. See the section entitled “Dilution” in this prospectus for a more detailed discussion of the dilution you will incur if you purchase common stock in this offering.

The market price of our common stock may be volatile, and the value of your investment could decline significantly.

The trading price for our common stock has been, and we expect it to continue to be, volatile. The price at which our common stock trades depends upon a number of factors, including our historical and anticipated operating results, our financial situation, our ability or inability to raise the additional capital we may need and the terms on which we raise it, and general market and economic conditions. Some of these factors are beyond our control. Broad market fluctuations may lower the market price of our common stock and affect the volume of trading in our stock, regardless of our financial condition, results of operations, business or prospects. There is no assurance that the market price of our shares of common stock will not fall in the future.

You may experience future dilution as a result of future equity offerings.

In order to raise additional capital, we may in the future offer additional shares of our common stock or other securities convertible into or exchangeable for our common stock at prices that may not be the same as the price per share in this offering. We may sell shares or other securities in any other offering at a price per share that is less than the price per share paid by investors in this offering, and investors purchasing shares or other securities in the future could have rights superior to existing stockholders. The price per share at which we sell additional shares of our common stock, or securities convertible or exchangeable into common stock, in future transactions may be higher or lower than the price per share paid by investors in this offering.

 

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CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS

Certain statements in this prospectus and the documents incorporated by reference may constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are based upon our current assumptions, expectations and beliefs concerning future developments and their potential effect on our business. In some cases, you can identify forward-looking statements by the following words: “may,” “will,” “could,” “would,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “approximately,” “estimate,” “predict,” “project,” “potential,” “continue,” “ongoing,” or the negative of these terms or other comparable terminology, although the absence of these words does not necessarily mean that a statement is not forward-looking. These forward-looking statements include, but are not limited to, statements about:

 

•

our ability to be a low cost provider;

 

•

our ability to retain or attract new physicians in the increasingly competitive surgical healthcare solutions business;

 

•

our expectations regarding growth strategies in our surgical healthcare solutions business;

 

•

our predictions of opportunities in our surgical healthcare solutions business;

 

•

our ability to generate sufficient cash flow to service our debt and lease obligations;

 

•

our ability to realize our future growth plans, attract qualified physicians and medical personnel, and engage in additional surgical hospital and related ancillary services acquisitions;

 

•

reimbursement rates from federal and third-party payors for our surgical services;

 

•

our competitors, market pressures, and our assessment of our ability to compete favorably;

 

•

plans to increase labor efficiency;

 

•

costs associated with remaining in compliance with government regulations and laws;

 

•

our ability to remain in compliance with government regulations and laws and the consequences if we are found in violation of any of these regulations or laws;

 

•

Medicaid, Medicare and other third-party payor reimbursement policies;

 

•

the effect of current and anticipated domestic legislation on our business;

 

•

the assumptions used in the preparation of our financial statements;

 

•

financial projections;

 

•

net proceeds and expenses of this offering.

The preceding list is not intended to be an exhaustive list of all of our forward-looking statements. You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including the reasons described in our “Risk Factors” section. Although the forward-looking statements in this prospectus reflect our good faith judgment, based on currently available information, they involve known and unknown risks, uncertainties and other factors that may cause our actual results or our industries’ actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance, or achievements expressed or implied by these forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in “Risk Factors” contained in this prospectus or the documents incorporated by reference. As a result of these factors, we cannot assure you that the forward-looking statements in this prospectus will prove to be accurate. Except as required by law, we undertake no obligation to update publicly any forward-looking statements for any reason after the date of this prospectus, to conform these statements to actual results, or to changes in our expectations. You should, however, review the factors and risks we describe in the reports we will file from time to time with the SEC after the date of this prospectus.

 

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USE OF PROCEEDS

We estimate that the net proceeds to us from the sale of the securities offered by this prospectus will be approximately $[*], or approximately $[*] if the underwriters exercise their over-allotment option in full, assuming the sale by us of [*] securities at an assumed public offering price of $[*] and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us.

A $1.00 increase (decrease) in the assumed public offering price of $[*] per share would increase (decrease) the expected net cash proceeds to us from this offering by approximately $[*], assuming that the number of securities offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the underwriting discounts and commissions and estimated offering expenses payable by us. Similarly, each 20% increase (decrease) in the assumed number of securities offered by us, as set forth on the cover page of this prospectus, would increase (decrease) the expected net proceeds to us from this offering by approximately $[*], assuming an public offering price of $[*] per share remains the same, and after deducting underwriting discounts and commissions and estimated offering expenses payable by us. See the sections entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

We intend to use approximately $[*] of the net proceeds of this offering for acquisitions of surgical hospitals, additional interests in our Equity Owned Hospitals, or acquisition and development of additional ancillary service lines, though no such acquisitions have been identified, and for working capital and general corporate purposes. As of the date of this prospectus, we cannot specify with certainty all of the particular uses for the net proceeds to us from this offering. Accordingly, our management will have broad discretion in the application of these proceeds.

This expected use of net proceeds from this offering represents our intentions based upon our current plans and business conditions. The amounts and timing of our actual expenditures may vary significantly depending on numerous factors, including the progress of our acquisition efforts, and any unforeseen cash needs. As a result, our management will retain broad discretion over the allocation of the net proceeds from this offering. In addition, our planned use of proceeds does not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments that we may make. We have no current understandings, agreements or commitments for any material acquisitions. We may find it necessary or advisable to use the net proceeds from this offering for other purposes, and we will have broad discretion in the application of net proceeds from this offering.

 

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DIVIDEND POLICY

Historically, we have not paid dividends on our common stock, and we currently do not intend to pay any dividends on our common stock after the completion of this offering. We currently plan to retain any earnings to support the operation, and to finance the growth, of our business rather than to pay cash dividends. Payments of any cash dividends in the future will depend on our financial condition, results of operations and capital requirements as well as other factors deemed relevant by our Board of Directors. Our existing credit facility restricts our ability to pay dividends without the approval of our lenders. See “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Liquidity and Capital Resources.”

 

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DILUTION

Our pro forma net tangible book value as of March 31, 2014 was $(28,779,533), or $(0.17) per share of common stock. Pro forma net tangible book value per share represents the amount of our total tangible assets less our total liabilities adjusted by the assumed proceeds of this offering, divided by the sum of the total number of shares of common stock outstanding, as of March 31, 2014 and the assumed shares from this offering.

After giving effect to this offering and the receipt of $[*] of estimated net proceeds from this offering, the pro forma net tangible book value of our common stock as of December 31, 2013 would have been $[*], or $[*] per share. This amount represents an immediate increase in net tangible book value of $[*] per share to the existing stockholders and an immediate dilution in net tangible book value of $[*] per share to purchasers of our common stock in this offering. Dilution is determined by subtracting pro forma net tangible book value per share after this offering from the amount of cash paid by a new investor for a share of common stock. The new investors will have paid $[*] per share even though the per share value of our assets after subtracting our liabilities is only $[*]. The following table illustrates such dilution on a per share basis:

 

Assumed public offering price per share						$	[*]
Historical net tangible book value per share as of March 31, 2014		$	(0.17	)
Increase per share attributable to this offering			[*]
Pro forma net tangible book value per share after this offering							[*]
Dilution per share to new investors						$	[*]

If the underwriter exercise its overallotment option in full, the pro forma net tangible book value per share after the offering would be $[*], or $[*] per share. This amount represents an immediate increase in net tangible book value of $[*] per share to the existing stockholders and an immediate dilution in net tangible book value of $[*] per share to purchasers of our common stock in this offering.

 

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MARKET PRICE OF AND DIVIDENDS ON COMMON EQUITY AND RELATED STOCKHOLDER

MATTERS

Market Information

Our common stock is quoted on the OTCQB under the symbol, “FDNH.” On December 12, 2013 and in conjunction with our name change, we changed our symbol from “GRMH” to “FDNH.” Prior to November 2, 2012, our common stock was listed on The Nasdaq Capital Market (“Nasdaq”) under the symbol, “GRMH.”

The following table sets forth, during the calendar quarters presented, the high and low sale prices of our common stock as reported by the OTCQB and Nasdaq, respectively. Such OTC market quotations reflect inter-dealer prices, without retail markup, markdown or commissions and may not necessarily represent actual transactions.

 

		High				Low
Year Ended December 31, 2014
June 30, 2014		$	0.67			$	0.31
March 31, 2014		$	0.70			$	0.30
Year Ended December 31, 2013
December 31, 2013		$	0.60			$	0.20
September 30, 2013		$	0.63			$	0.20
June 30, 2013		$	0.39			$	0.21
March 31, 2013		$	0.48			$	0.20
Year Ended December 31, 2012
December 31, 2012		$	0.52			$	0.17
September 30, 2012		$	0.50			$	0.30
June 30, 2012		$	0.50			$	0.30
March 31, 2012		$	0.80			$	0.41

On June 30, 2014, the closing price of our common stock as quoted on OTCQB was $0.51.

The market price of our common stock is subject to significant fluctuations in response to, and may be adversely affected by:

 

•

variations in quarterly operating results;

 

•

changes in earnings estimates by analysts;

 

•

developments in the surgical hospital and ASC markets;

 

•

announcements of acquisitions dispositions and other corporate level transactions;

 

•

announcements of financings and other capital raising transactions;

 

•

sales of stock by our larger shareholders,

 

•

announcements and introductions of product or service innovations, and

 

•

general stock market conditions.

Proposed Reverse Stock Split

On February 17, 2014, our Board of Directors approved a reverse stock split in one of eight ratios, namely 1-for-3, 1-for-4, 1-for-5, 1-for-6, 1-for-7, 1-for-8, 1-for-9, or 1-for-10 shares, with the final ratio to be determined by the Board following shareholder approval. We received shareholder approval at our 2014 Annual Meeting of Shareholders held on May 12, 2014. We intend to effect a 1-for-[            ] reverse stock split of our common stock after the close of business on [            ]. In determining a reverse stock split ratio of 1-for-[            ], the

 

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Board of Directors considered a ratio that would allow us to have a number of outstanding shares to have a sufficient trading volume while considering a stock price that would be consistent with an uplist of our common stock from OTC Markets QB Tier to a listing on the [            ] exchange. Our Board of Directors determined that a ratio of 1-for-[            ] was the best balance of these various factors.

Holders

As of June 25, 2014, we have 116 owners of record of our common stock.

 

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CAPITALIZATION

The following table sets forth, as of March 31, 2014, our cash and cash equivalents, long-term debt and our unaudited capitalization on an actual basis and on an as adjusted basis to give effect to this offering and the application of the net proceeds of this offering, as described under “Use of Proceeds.”

You should read this table in conjunction with our March 31, 2014 unaudited financial statements, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial information included elsewhere in this prospectus.

 

		As of March 31,
		Actual				As Adjusted
		(Audited)				(Unaudited)
Cash and cash equivalents		$	3,958,742			$
Short-term debt		$	6,183,610			$
Long-term debt, including current portion		$	16,581,182			$
Preferred noncontrolling interests		$	8,700,000			$
Shareholders’ equity:
Preferred stock $0.0001 par value, 10,000,000 shares authorized; no shares issued and outstanding		$	—			$	—
Common stock $0.0001 par value, 500,000,000 shares authorized; 171,323,381 and                 shares issued and outstanding, respectively			17,132
Paid-in capital			18,759,152
Accumulated deficit			(37,066,821	)
Total Foundation Healthcare stockholders’ equity (deficit)			(18,290,537	)
Noncontrolling interests			1,109,685
Total equity (deficit)		$	(17,180,852	)		$
Total capitalization		$	18,242,682			$

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

You should read the following discussion together with our consolidated financial statements and the related notes which have been included in or incorporated by reference into this prospectus. This discussion contains forward-looking statements about our business and operations. Our actual results may differ materially from those we currently anticipate as a result of the factors we describe under “Risk Factors” and elsewhere in this prospectus.

Overview

Our primary focus is owning controlling interests in surgical hospitals. We currently have two Consolidated Hospitals and two Equity Owned Hospitals in Texas. We also have ten ASCs located in Texas, Oklahoma, Pennsylvania, New Jersey, Maryland and Ohio. Additionally, we provide sleep testing management services to various rural hospitals in Iowa, Minnesota, Missouri, Nebraska and South Dakota under management contracts with the hospitals. We provide management services to a majority of our Affiliates under the terms of various management agreements.

We focus primarily on investing in and managing high quality cost effective surgical hospitals that meet the needs of patients, physicians and payors. We believe the facilities we invest in and manage provide an enhanced quality of care to our patients while providing administrative, clinical and economic benefits to physicians. Since physicians are critical to the direction of healthcare, we have developed our operating model to encourage physicians to affiliate with us and to use our facilities as an extension of their practices. We operate our facilities, structure our strategic relationships and adopt staffing, scheduling and clinical systems and protocols with the goal of increasing physician productivity. We believe that our focus on physician satisfaction, combined with providing high quality healthcare in a friendly and convenient environment for patients, will continue to increase the number of procedures performed at our facilities each year.

Reverse Acquisition

On July 22, 2013, we acquired 100% of the interests in Foundation Surgery Affiliates, LLC, or FSA, and FSA’s consolidated variable interest entity, Foundation Surgical Hospital Affiliates, LLC, or FSHA, and together with FSA, Foundation, from Foundation Healthcare Affiliates, LLC, or FHA, in exchange for 114,500,000 shares of our common stock and a promissory note in the amount of $2,000,000 which we refer to as the Foundation Acquisition. We also assumed certain debt and other obligations of FHA in the amount of $1,991,733. The promissory note bore interest at a fixed rate of 7% and was paid in full on October 14, 2013.

For accounting purposes, the acquisition of FSA was accounted for as a reverse acquisition and as a result, the historical operating results included in our consolidated financial statements for the periods prior to July 22, 2013 represent those of FSA. The historical financial statements of FSA have been adjusted for the effect of the recapitalization that occurred as a result of the reverse acquisition. Prior to July 22, 2013, FSA’s member had elected to have FSA’s income taxed as an S Corporation under provisions of the Internal Revenue Code and a similar section of the state income tax law. Therefore, taxable income or loss is reported to the individual member for inclusion in its respective tax returns and no provision for federal and state income taxes is included in these consolidated financial statements for periods prior to July 22, 2013. We have included pro forma income information in our consolidated statements of operations that provides an adjustment for income tax expense as if FSA and FSHA had been a C Corporation prior to July 22, 2013 at an assumed combined federal and state effective tax rate of 40%, which approximates the calculated statutory tax rates for the periods.

Going Concern and Management’s Plan

As of March 31, 2014, we had an accumulated deficit of $37.1 million and a working capital deficiency of $16.8 million. During the quarter ended March 31, 2014, we generated a net loss attributable to Foundation Healthcare

 

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of $1.7 million and generated cash flow from operating activities from continuing operations of $1.6 million. As of March 31, 2014, we had cash and cash equivalents of $4.0 million. On June 30, 2014, we completed a refinancing of substantially all of our outstanding indebtedness through the execution of the SNB Credit Facility. The SNB Credit Facility includes a Term Loan in the amount of $27.5 million and a Revolving Loan in the amount of $2.5 million. See “Management’s Discussion and Analysis of Financial Condition and Results of Operation – Liquidity and Capital Resources.”

We believe our cash on hand, the $2.5 million Revolving Loan and projected cash flow from operations will provide us enough liquidity to meet our cash requirements over the next 12 months. However, if our cash flows from operations do not meet or exceed our projections, we may need to raise additional funds through debt or equity financings. These uncertainties raise substantial doubt about our ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.

Hospital and ASC Business

At our Consolidated Hospitals, we serve as a majority owner, day-to-day manager, and we have significant influence over the operations of such facilities. When we have control of the facility, we account for our investment in the facility as a consolidated subsidiary. For our Equity Owned facilities, our influence does not represent control of the facility, but we do have the ability to exercise significant influence over operating and financial policies, we account for our investment in the facility under the equity method, and treat the facility as a nonconsolidated affiliate.

For our Consolidated Hospitals, our financial statements reflect 100% of the revenues and expenses for these subsidiaries, after elimination of intercompany transactions and accounts. The net income attributable to our physician partners who have ownership in our Consolidated Hospitals is included in net income attributable to noncontrolling interests in our consolidated statements of operations.

For our Equity Owned facilities, our share of the net income of each Equity Owned facility is based on the facility’s net income and our percentage of ownership in the facility and is included in our consolidated statements as equity in earnings of affiliates. We earn management fees from most of our Equity Owned facilities for our management of the day-to-day operations. We also provide management services to one ASC that we don’t own any equity interest.

 

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The following summarizes certain key metrics for our surgical hospital and ASC business:

 

Location		Specialty		Number of Physician Partners		Number of Operating Rooms		Percentage Owned by Company				Managed by Company?		Mgmt. Agreement Exp. Date
Consolidated Hospitals:
San Antonio, Texas		Multi-specialty		19		4			51.0	%		Yes		n/a
El Paso, Texas		Multi-specialty		68		6			53.97	%		Yes		n/a
Equity Owned Hospitals:
Sherman, Texas		Multi-specialty		43		10			20.0	%		Yes		6/1/2016
Houston, Texas		Multi-specialty		19		10			20.0	%		No		n/a
Equity Owned ASCs:
Chevy Chase, Maryland		Multi-specialty		22		4			18.0	%		Yes		10/1/2014
Cumberland Valley, Maryland		Multi-specialty		14		1			31.9	%		Yes		9/30/2017
Frederick, Maryland		Multi-specialty		20		4			19.6	%		Yes		3/31/2017
Mercerville, New Jersey		Multi-specialty		23		3			10.0	%		Yes		4/30/2020
Middleburg Heights, Ohio		Multi-specialty		12		4			10.0	%		Yes		3/5/2016
Oklahoma City, Oklahoma		Multi-specialty		33		6			20.0	%		Yes		1/19/2018
Huntingdon Valley, Pennsylvania		Multi-specialty		21		4			20.0	%		Yes		5/5/2014
Houston, Texas		Multi-specialty		13		4			10.0	%		Yes		2/28/2016
Houston, Texas		Multi-specialty		22		4			10.0	%		Yes		12/31/2018
Nacogdoches, Texas		Multi-specialty		9		3			12.5	%		Yes		7/28/2014
Managed Only ASCs:
Baton Rouge, Louisiana		Multi-specialty		21		6			—			Yes		Month to month

We seek to maintain diversity of case mix at our facilities to insulate us from potential negative effects that could stem from emphasizing one particular case type. The following is our case mix by specialty for the years ended December 31, 2013 and 2012:

 

		Hospitals								ASC
		2013				2012				2013				2012
Orthopedic			25	%			25	%			23	%			23	%
General surgery			18	%			6	%			5	%			5	%
Neurology			12	%			4	%			—	%			—	%
Gastroenterology			10	%			9	%			18	%			19	%
Otolaryngology (ENT)			7	%			9	%			13	%			13	%
Ophthalmology			5	%			9	%			17	%			18	%
Podiatry			5	%			4	%			5	%			4	%
Obstetrics and gynecology			4	%			3	%			2	%			2	%
Pain management			3	%			6	%			6	%			6	%
Other			11	%			25	%			11	%			10	%
Total			100	%			100	%			100	%			100	%

Discontinued Operations

In conjunction with establishing our focus on surgical hospitals resulting from the Foundation Acquisition, we have sold or closed all of our freestanding sleep diagnostic and therapy facilities. The facilities sold or closed were selected because the revenue from these facilities had not met expectations and were not adequate to offset fixed operating costs. The facilities sold or closed were located in Oklahoma, Texas, Nevada, Kansas, Missouri and Iowa.

As a result of identifying these sites as held for sale, the related assets, liabilities, results of operations and cash flows of the identified sites are classified as discontinued operations in our consolidated financial statements.

 

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The following table sets forth selected results of our operations for the three months ended March 31, 2014 and 2013. The following information was derived and taken from our unaudited financial statements appearing elsewhere in this report.

Comparison of the Three Month Periods Ended March 31, 2014 and 2013

 

		For the Three Months Ended March 31,
		2014				2013
Net Revenues:
Patient services		$	19,513,483			$	15,860,660
Management fee from affiliates			1,269,306				1,738,228
Equity in earnings from affiliates			527,083				1,216,715
Other revenue			1,118,326				474,889
Provision for doubtful accounts			(361,517	)			(636,851	)
Revenue			22,066,681				18,653,641
Salaries and benefits			7,977,419				6,338,097
Supplies			4,941,370				4,500,940
Other operating expenses			9,042,701				7,756,021
Depreciation and amortization			1,466,268				1,116,687
Net other expense			496,121				373,662
Income (loss) from continuing operations, before taxes			(1,857,198	)			(1,431,766	)
Provision for income taxes			852,005				—
Income (loss) from continuing operations, net of taxes			(1,005,193	)			(1,431,766	)
Discontinued operations, net of tax			(312,323	)			—
Net income (loss)			(1,317,516	)			(1,431,766	)
Less: Noncontrolling interests			384,921				(1,092,031	)
Net income (loss) attributable to Foundation Healthcare		$	(1,702,437	)		$	(339,735	)

Discussion of Three Month Periods Ended March 31, 2014 and 2013

Overall comments – as a result of the Foundation transaction on July 22, 2013 being recorded as a reverse acquisition, the operating results of the Company’s legacy business (referred to as “legacy Graymark”) is not included in the operating results of the three months ended March 31, 2014.

Patient services revenue increased $3.6 million or 23% during the three months ended March 31, 2014 compared with the first quarter of 2013. The increase was primarily due to:

 

•

An increase in both outpatient surgical cases and inpatient spine cases resulted in an increase in patient service revenue of $1.5 million at EEPMC and;

 

•

An increase in surgical case volume and the average reimbursement per surgical case at Foundation Bariatric Hospital of San Antonio (“FBH SA”) which was driven by an increase in spine and orthopedic cases resulted in an increase in patient services revenue of $2.1 million.

Management fees from affiliates decreased $0.5 million or 27% during the three months ended March 31, 2014 compared with the first quarter of 2013. Our management fees at both our ASCs and surgical hospitals are based on a percentage of collections. Lower collections at our ASCs due to reduced volumes and unplanned closures due to inclement weather resulted in a decrease of $0.3 million. An agreement to lower our management fees at one of our managed hospitals resulted in a decrease of $0.2 million.

Income from equity investments in affiliates decreased $0.7 million or 57% during the three months ended March 31, 2014 compared with the first quarter of 2013. A change in accounting method for one of our ASC’s

 

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from the equity method to the cost method resulted in the revenue from that location being booked as Other revenue in 2014 resulting in a decrease of $0.5 million. Additionally, lower volumes and average reimbursement levels at one of our ASC’s in Pennsylvania resulted in a decrease of $0.2 million.

Other revenue increased $0.7 million or 136% during the three months ended March 31, 2014 compared with the first quarter of 2013. The increase was due to $0.5 million in revenue earned during the first quarter of 2014 from the sleep center management fees earned at our legacy Graymark hospital outreach locations, there is no revenue included from the hospital outreach locations during the first quarter of 2013 as a result of the reverse acquisition recorded on July 22, 2013, and $0.5 million related to the change in accounting for one of our ASC locations from the equity method to the cost method in the first quarter of 2014 compared to the first quarter of 2013. The offsetting decrease in other revenue of $0.3 million during the first quarter of 2014 compared to the first quarter of 2013 is primarily due to a $0.3 million distribution from our minority owned hospital in Houston, Texas received in the first quarter of 2013. We did not receive a distribution from that facility in the first quarter of 2014.

Provision for doubtful accounts decreased $0.3 million or 43% during the three months ended March 31, 2014 compared with the first quarter of 2013. Provision for doubtful accounts as a percent of patient services revenue was 1.9% and 4.0% for the first quarter of 2014 and 2013, respectively. Based on our quarterly analysis of historic bad debt trends, we reduced our allowance rates in several aging categories, in line with the historical trends, at both our EPPMC and FBH SA facilities which resulted in the $0.3 million decrease compared to the first quarter of 2013.

Salaries and benefits increased $1.7 million or 26% to $8.0 million from $6.3 million during the three months ended March 31, 2014, compared with the first quarter of 2013. The increase in salaries and benefits was primarily due to:

 

•

$0.8 million of stock compensation expense;

 

•

$0.6 million of salaries and benefits at legacy Graymark; and

 

•

$0.3 million due to increased salaries and benefits resulting from a combination of normal annual salary increases and increased personnel required to manage our expanding hospital operations.

Supplies expense increased $0.4 million or 10% to $4.9 million from $4.5 million during the three months ended March 31, 2014, compared with the first quarter of 2013. The increase is due to a combination of higher surgical volume at both our EEPMC and FBH SA hospital locations, including an increase in spine and orthopedic cases which have a high implant cost per case.

Other operating expenses increased $1.2 million or 17% to $9.0 million from $7.8 million during the three months ended March 31, 2014, compared with the first quarter of 2013. The increase in other operating expenses was primarily due to:

 

•

$0.4 million in increased professional fees related to increased audit and legal fees;

 

•

$0.6 million of other operating expenses at legacy Graymark;

 

•

$0.1 million increase in corporate office operating expenses related to increased corporate infrastructure;

 

•

$0.2 million increase in operating expense at our EEPMC and FBH SA facilities related to supporting the increased volumes;

 

•

$0.1 million decrease in out of state franchise taxes primarily related to our Maryland locations.

Depreciation and amortization represents the depreciation expense associated with our fixed assets and the amortization attributable to our intangible assets. Depreciation and amortization increased $0.3 million in the

 

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first quarter of 2014 compared to the first quarter of 2013. The increase was primarily due to $0.1 million related to additional information technology assets at our corporate offices and medical equipment assets at our EEPMC and FBH SA facilities and $0.2 million of depreciation and amortization at legacy Graymark.

Net other expense represents primarily interest expense on borrowings reduced by interest income earned on cash and cash equivalents and the gain or loss on the sale of equity investments in affiliates. Net other expense decreased $0.1 million in the first quarter of 2014 compared to the first quarter of 2013. The decrease is related to a $0.1 million gain on the sale of investments in affiliates in the first quarter of 2013. We did not sell any of our investments in affiliates in the first quarter of 2014.

Provision for income taxes was a benefit $0.9 million for the first quarter of 2014. Prior to July 22, 2013, FSA’s member had elected to have FSA’s income taxed as an S Corporation under provisions of the Internal Revenue Code and a similar section of the state income tax law. Therefore, taxable income or loss is reported to the individual member for inclusion in its respective tax returns and no provision for federal and state income taxes is included in our consolidated financial statements for periods prior to July 22, 2013. We have included pro forma income information in our consolidated statements of operations that provides an adjustment for income tax expense as if FSA and FSHA had been a C Corporation prior to July 22, 2013 at an assumed combined federal and state effective tax rate of 38%, which approximates the calculated statutory tax rates for the periods.

Discontinued operations represent the net loss from the operations of our independent diagnostic testing facilities (“IDTF”) which were classified as held for sale prior the Graymark reverse acquisition. The results from our discontinued operations for the three months ended March 31, 2014 are summarized below:

 

Revenues		$	123,729
Net loss before taxes		$	(503,747	)
Income tax benefit			191,424
Net loss from discontinued operations, net of tax		$	(312,323	)

Noncontrolling interests were allocated $0.4 million of net income and $1.1 million of net loss during the three months ended March 31, 2014 and 2013, respectively. Noncontrolling interests are the equity ownership interests in our majority owned hospital subsidiaries, EEPMC and FBH SA.

Net income (loss) attributable to Foundation Healthcare. Our operations resulted in a net loss of $1.7 million during the first quarter of 2014, compared to net loss of $0.3 million during the first quarter of 2013.

Key Performance Measure

Adjusted EBITDA

We define Adjusted EBITDA as net income before interest, taxes, depreciation, and amortization, further adjusted to eliminate the impact of certain additional items, including certain non-cash and other items that we do not consider in our evaluation of ongoing operating performance from period to period as discussed further below. Adjusted EBITDA is included in this prospectus because it is a key metric used by management to assess our financial performance. We use Adjusted EBITDA to supplement GAAP measures of performance in order to evaluate the effectiveness of our business strategies, to make budgeting decisions and to compare our performance against that of other peer companies using similar measures. Adjusted EBITDA is also frequently used by analysts, investors and other interested parties to evaluate companies in our industry.

Adjusted EBITDA is a non-GAAP measure of our financial performance and should not be considered as an alternative to net income (loss) as a measure of financial performance, or any other performance measure derived in accordance with GAAP, nor should it be construed as an inference that our future results will be unaffected by unusual or other items. In evaluating Adjusted EBITDA, you should be aware that in the future we will incur

 

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expenses that are the same as or similar to some of the adjustments in this presentation, such as preopening expenses, stock compensation expense, and other adjustments. Additionally, Adjusted EBITDA is not intended to be a measure of free cash flow for management’s discretionary use, as it does not reflect certain cash requirements such as tax payments, debt service requirements, capital expenditures, facility openings and certain other cash costs that may recur in the future. Adjusted EBITDA contains certain other limitations, including the failure to reflect our cash expenditures, cash requirements for working capital needs and cash costs to replace assets being depreciated and amortized. Management compensates for these limitations by supplementally relying on our GAAP results in addition to using Adjusted EBITDA. Our presentation of Adjusted EBITDA is not necessarily comparable to other similarly titled captions of other companies due to different methods of calculation.

The following table sets forth a reconciliation of our Adjusted EBITDA to net income (loss) using data derived from our consolidated financial statements for the periods indicated:

 

		Unaudited												Unaudited
		Actual for Years Ended December 31,												Actual for Three Months Ended March 31,
		2013				2012				2011				2014				2013
Net income (loss)		$	(15,059,107	)		$	3,775,760			$	3,908,851			$	(1,317,516	)		$	(1,431,766	)
Less: Extraordinary gain, net of tax			8,107,239				—				—				—				—
Less: Loss from discontinued operations, net of tax			(839,238	)			—				—				(312,323	)			—
Income (loss) from continuing operations, net of taxes			(22,327,108	)			3,775,760				3,908,851				(1,005,193	)			(1,431,766	)
EBITDA adjustments:
Plus: Interest expense, net			2,171,327				1,263,797				1,314,613				496,121				466,669
Plus: Provision (benefit) for income taxes			814,513				—				—				(852,005	)			—
Plus: Depreciation and amortization			5,093,246				2,593,969				2,191,473				1,466,268				1,116,687
Total EBITDA adjustments			8,079,086				3,857,766				3,506,086				1,110,384				1,583,356
EBITDA from continuing operations		$	(14,248,022	)		$	7,633,526			$	7,414,937			$	105,191			$	151,590
EBITDA from continuing operations		$	(14,248,022	)		$	7,633,526			$	7,414,937			$	105,191			$	151,590
Adjusted EBITDA adjustments:
Plus: Impairment of goodwill			21,864,781				—				—				—				—
Plus: Impairment of equity investment in affiliates			1,640,389				200,000				—				—				—
Plus: Stock compensation expense			129,721				—				—				788,782				—
Total Adjusted EBITDA adjustments			23,634,891				200,000				—				788,782				—
Adjusted EBITDA		$	9,386,869			$	7,833,526			$	7,414,937			$	893,973			$	151,590

Liquidity and Capital Resources

Generally our liquidity and capital resource needs are funded from operations, loan proceeds and equity offerings. As of March 31, 2014, our liquidity and capital resources included cash and cash equivalents of $4.0 million and a working capital deficit of $16.8 million. As of December 31, 2013, our liquidity and capital resources included cash and cash equivalents of $4.2 million and working capital deficit of $15.0 million.

 

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Cash provided by operating activities from continuing operations was $1.6 million during the three months ended March 31, 2014 compared to the first three months of 2013 when operating activities from continuing operations used $1.4 million. During the three months ended March 31, 2014, the primary sources of cash from operating activities from continuing operations were cash generated by income from continuing operations (net loss increased by non-cash items) of $0.3 million and increases in accrued liabilities and other liabilities totaling $3.9 million. During the three months ended March 31, 2014, the primary uses of cash from continuing operations, were an increase in accounts receivables totaling $0.3 million and decreases in accounts payable and other current liabilities of $2.3 million. During the three months ended March 31, 2013, the primary uses of cash from operating activities from continuing operations were cash required to fund losses from continuing operations (net loss reduced by non-cash items) of $0.9 million and increase in accounts receivable and prepaid and other current assets totaling $2.4 million and a decrease in accounts payable of $1.4 million. The primary source of cash from operating activities from continuing operations in the first three months of 2013 was an increase in accrued liabilities of $3.3 million.

Cash used by discontinued operations for the three months ended March 31, 2014 was $0.1 million. There were no discontinued operations during the three months ended March 31, 2013.

Net cash provided by investing activities from continuing operations during the three months ended March 31, 2014 was $0.2 million compared to the first three months of 2013 when investing activities from continuing operations used $1.3 million. Investing activities during the first three months of 2014 were primarily related to distributions received from equity investments of $0.6 million which were offset by purchases of property and equipment of $0.4 million. Investing activities during the first three months of 2013 were primarily related to distributions received from equity investments of $1.3 million which were offset by purchases of property and equipment of $2.6 million.

Net cash used by financing activities from continuing operations during the three months ended March 31, 2014 was $2.0 million compared to the first three months of 2013 when financing activities from continuing operations provided $1.2 million. During the three months ended March 31, 2014 and 2013, we received debt proceeds of $0.8 million and $3.4 million, respectively, and we made debt payments of $1.6 million and $1.4 million, respectively. During the three months ended March 31, 2014 and 2013, we made distributions to noncontrolling interests of $0.9 million and $37 thousand, respectively. During the three months ended March 31, 2014 and 2013, we paid preferred noncontrolling dividends of $0.3 million and $0.4 million, respectively. During the three months ended March 31, 2013, we made distributions to FHA (prior to the reverse acquisition on July 22, 2013) of $0.4 million.

As of March 31, 2014, we had an accumulated deficit of $37.1 million and a working capital deficiency of $16.8 million. During the three months ended March 31, 2014, we generated a net loss attributable to Foundation Healthcare of $1.7 million and generated cash flow from operating activities from continuing operations of $1.6 million. On June 30, 2014, we refinanced substantially all of our outstanding indebtedness through the execution of the SNB Credit Facility. Our annual debt service payments as part of the refinancing have been significantly reduced; however, there is no assurance that we will produce adequate cash flow to fund our operations. We may seek to raise additional funds through the sale of equity securities, but there is no guarantee that we will do so or that we will be successful if we seek such financing.

SNB Credit Facility

Effective June 30, 2014, we entered into a Loan Agreement with Bank SNB, National Association, and Texas Capital Bank, together referred to as Lenders and collectively the agreement is referred to as the SNB Credit Facility. The SNB Credit Facility was used to consolidate all of our and our subsidiaries’ debt in the principal amount of $27.5 million, which we refer to as the Term Loan, and provides for an additional revolving loan in the amount of $2.5 million, which we refer to as the Revolving Loan. We have also entered into a number of ancillary agreements in connection with the SNB Credit Facility, including deposit account control agreements, subsidiary guarantees, security agreements and promissory notes.

 

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Maturity Dates. The Term Loan matures on June 30, 2021 and the Revolving Loan matures on June 30, 2016.

Interest Rates. The interest rate for the Term Loan and Revolving Loan is 30-day LIBOR plus the Applicable Margins based on our Senior Debt Ratio, as defined. The Applicable Margins are as follows:

 

		Applicable Margin
Senior Debt Ratio		Revolving Loan		Term Loan
³ 2.5x		3.75%		4.25%
< 2.5x, but ³ 2.0x		3.25%		3.75%
< 2.0 x		2.75%		3.25%

The Applicable Margins are established at 3.75% for the Revolving Loan and 4.25% for the Term Loan through December 31, 2014. Subsequent to December 31, 2014, the Applicable Margins will be adjusted on a quarterly basis based on our senior debt ratio.

The Senior Debt Ratio is calculated by dividing all of our indebtedness, including capital leases, that is secured by a lien or security interest in any of our assets by our EBITDA for the preceding four fiscal quarters. EBITDA is defined in the SNB Credit Facility as our net income calculated before interest expense, provision for income taxes, depreciation and amortization expenses, stock compensation, gains arising from the write-up of assets, extraordinary gains and any one-time expenses approved by Bank SNB.

Interest and Principal Payments. We are required to make quarterly payments of principal and interest on the Term Loan. The first four quarterly payments on the Term Loan will be $875,000 plus all accrued and unpaid interest. Each subsequent quarterly payment will be $1,000,000 plus all accrued and unpaid interest. We are required to make quarterly payments on the Revolving Loan equal to the accrued and unpaid interest. All unpaid principal and interest on the Term Loan and Revolving Loan must be paid on the respective maturity dates of June 30, 2021 and June 30, 2016.

Mandatory Prepayments. If we sell any assets in excess of $100,000 or collectively sell any assets in a 12 month period in excess of $100,000, we must make a prepayment equal to the net proceeds of the asset sale(s). If we receive proceeds from a debt or equity offering that is not used for a permitted acquisition over a 12 month period following the offering or for repayment of our preferred noncontrolling interests, we must make a prepayment equal to the net proceeds of the debt or equity offering. Subsequent to the completion of our annual audited financial statements, we must make a prepayment equal to 30% of our Excess Cash Flow which is defined as the amount of EBITDA (as defined in the SNB Credit Facility) for the fiscal year that exceeds the sum of debt service payments plus capital expenditures plus cash payments for federal, state and local income taxes, plus distributions made by our Equity Owned Hospitals to persons other than us.

Voluntary Prepayments. We may prepay amounts under the Term Loan at any time provided that we are required to pay a prepayment penalty of 2% of the amount prepaid if payment is made prior to the first anniversary, 1.5% if the prepayment is made after the first anniversary but prior to the second anniversary and 1% if the prepayment is made after the second anniversary but prior to the maturity date. We may prepay amounts under the Revolving Loan at any time without penalty.

Guaranties. Each of our direct or indirect wholly-owned subsidiaries jointly and severally and unconditionally guaranty payment of our obligations owed to Lenders.

Financial Covenants:

Senior Debt Ratio. We must maintain a Senior Debt Ratio not in excess of 3.00 to 1.00 as of the end of each fiscal quarter beginning with the quarter ending September 30, 2014.

Senior Debt Service Coverage Ratio. We must maintain a Senior Debt Service Coverage Ratio of not less than 1.30 to 1.00 as of the end of each fiscal quarter beginning with the quarter ending September 30, 2014.

 

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The Senior Debt Service Coverage ratio is the ratio of EBITDA (as defined in the SNB Credit Facility) for the preceding four fiscal quarters minus cash payments for federal, state and local taxes, minus capital expenditures to our debt service payments for the same period.

Adjusted Senior Debt Service Coverage Ratio. We must maintain an Adjusted Senior Debt Service Coverage Ratio of not less than 1.05 to 1.00 as of the end of each fiscal quarter beginning with the quarter ending September 30, 2014.

The Adjusted Senior Debt Service Coverage Ratio is the ratio of EBITDA (as defined in the SNB Credit Facility) for the preceding four fiscal quarters minus cash payments for federal, state and local taxes, minus capital expenditures, plus distributions made to our preferred noncontrolling interest holders, plus distributions made by our Equity Owned Hospitals to persons other than us to our debt service payments for the same period.

Minimum EBITDA. We must have EBITDA of not less than $2 million for the fiscal quarter ended on June 30, 2014.

Annualized EBITDA. Until June 30, 2015 and for purposes of calculating compliance with the financial covenants in SNB Credit Facility, EBITDA shall be determined by annualizing EBITDA for the fiscal quarter ending on September 30, 2014 and each quarter that has elapsed thereafter.

Restrictions on Indebtedness. We and our Equity Owned Hospitals are not allowed to create any indebtedness other than indebtedness for the purchase of fixed assets not exceeding $500,000 in any fiscal year, trade payables incurred in the ordinary course of business and not past due, contingent obligations and unsecured indebtedness not exceeding $100,000 in the aggregate at any time outstanding.

Use of Proceeds. All proceeds of the Term Loan were used solely for the refinancing of existing indebtedness. The proceeds of the Revolving Loan will be used for working capital.

Collateral. Payment and performance of our obligations under the SNB Credit Facility are secured in general by all of our assets.

Defaults and Remedies. In addition to the general defaults of failure to perform our obligations under the Loan Agreement, events of default also include the occurrence of a change in control, as defined, and the loss of our Medicare or Medicaid certification, collateral casualties, entry of a judgment of $150,000 or more, failure of first liens on collateral and the termination of any of our management agreements that represent more than 10% of our management fees for the preceding 18 month period. In the event of a monetary default, all of our obligations due under the SNB Credit Facility shall become immediately due and payable. In the event of a non-monetary default, we have 10 days or in some cases three days to cure before Bank SNB has the right to declare our obligations due under the SNB Credit Facility immediately due and payable.

Legacy Bank Credit Facility

We previously entered into various short-term and long-term notes payable with our senior lender, Legacy Bank (referred to as “Legacy Debt”). As of March 31, 2014, the balance of the Legacy Debt was $10.7 million. The Legacy Debt was collateralized by substantially all of the assets of our subsidiaries, FSA and FSHA, and a portion is personally guaranteed by certain of our officers. On June 30, 2014, the Legacy Debt was paid in full from the proceeds of the SNB Credit Facility.

Arvest Bank Credit Facility

On July 22, 2013, our subsidiaries, SDC Holdings, LLC and ApothecaryRx, LLC (collectively the “Borrowers”), we and Mr. Stanton Nelson (the “Guarantor” and the Company’s chief executive officer) entered into a Second Amended and Restated Loan Agreement (the “New Loan Agreement”) and an Amended and Restated Promissory Note (the “New Note”) with Arvest Bank. We, Borrowers, Guarantor and other guarantors previously

 

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entered into the Amended and Restated Loan Agreement dated effective December 17, 2010, as amended by the First Amendment to Loan Agreement dated January 1, 2012, the Second Amendment to Loan Agreement dated effective June 30, 2012, and the Third Amendment to Loan Agreement dated effective October 12, 2012 (the “Prior Agreement”). Under the Prior Agreement, we and Borrowers were indebted to Arvest Bank under the Amended and Restated Promissory Note, in the original principal amount of $15,000,000 dated June 30, 2010 and the Second Amended and Restated Promissory Note, in the original principal amount of $30,000,000, dated June 30, 2010 (the “Prior Notes”). We, Arvest Bank, the Borrowers and the Guarantor have agreed to restructure the loan evidenced by the Prior Notes and the Prior Agreement. As of March 31, 2014, the outstanding principal amount of the New Note was $9.9 million.

On July 22, 2013, in conjunction with the New Loan Agreement with Arvest Bank, we entered into a Participation Agreement with Arvest Bank in which we purchased a $6,000,000 participation in the New Note from Arvest Bank in exchange for 13,333,333 shares of the Company’s common stock. The Company purchased the participation in the last $6,000,000 of the principal amount due under the Arvest credit facility. The Company’s participation in the note is eliminated against the New Note. Since the operations of the Borrowers has been discontinued, the New Note, net of the participation, is included in current liabilities from discontinued operations in our consolidated balance sheet.

The New Note is collateralized by substantially all of the assets of the Borrowers and the personal guaranty of the Guarantor which is limited to $2,919,000. In June 2014, with an effective date of April 30, 2014, we, the Borrowers, the Guarantor and Arvest Bank entered into agreements to amend and restate the New Loan Agreement and New Note to extend the maturity date of the New Note to June 30, 2014. In conjunction with the extension of the New Note, we paid Arvest Bank $210,162 in consideration of the following: (a) $49,062 in interest on the Note, (b) $150,000 to be applied to the principal balance of the Note, and (c) fees and expense reimbursements payable to Arvest Bank of $11,100. On June 30, 2014, the Arvest Credit Facility was paid in full from the proceeds of the SNB Credit Facility.

Financial Commitments

We do not have any material capital commitments during the next 12 months; however, we have contractual commitments of $35.3 million for payments on our indebtedness, operating lease payments and preferred noncontrolling interests. Although we have not entered into any definitive arrangements for obtaining additional capital resources, either through long-term lending arrangements or equity offering, we continue to explore various capital resource alternatives to replace our long-term bank indebtedness.

Our future commitments under contractual obligations by expected maturity date at March 31, 2014 are as follows:

 

		< 1 year				1-3 years				3-5 years				> 5 years				Total
Short-term debt(1)		$	6,409,647			$	—			$	—			$	—			$	6,409,647
Long-term debt(1)			11,303,859				5,972,981				78,181				—				17,355,021
Operating leases			11,967,4409				24,433,748				24,361,943				92,790,617				153,553,748
Other long-term liabilities			30,000				32,500				—				—				62,500
Liabilities and commitments of discontinued operations(2)			3,983,946				—				—				—				3,983,946
Preferred noncontrolling interests(3)			1,591,074				3,017,052				6,509,914				—				11,118,040
		$	35,285,966			$	33,456,281			$	30,950,038			$	92,790,617			$	192,482,902

 

(1)	Includes principal and interest obligations.

(2)	Represents the debt principal and interest obligations and future minimum lease payments included in our discontinued operations.

 

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(3)	Represents the redemption obligation, including interest, of our preferred noncontrolling interests.

Off-Balance Sheet Arrangements

We had no material off-balance sheet arrangements (as defined in Item 303(a) (4) of Regulation S-K) as of December 31, 2013 and 2012.

 

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CRITICAL ACCOUNTING POLICIES

The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and include amounts based on management’s prudent judgments and estimates. Actual results may differ from these estimates. Management believes that any reasonable deviation from those judgments and estimates would not have a material impact on our consolidated financial position or results of operations. To the extent that the estimates used differ from actual results, however, adjustments to the statement of earnings and corresponding balance sheet accounts would be necessary. These adjustments would be made in future statements. Some of the more significant estimates include revenue recognition, allowance for contractual adjustments and doubtful accounts, and goodwill and intangible asset impairment. We use the following methods to determine our estimates:

Revenue recognition and accounts receivable – We recognize revenues in the period in which services are performed. Accounts receivable primarily consist of amounts due from third-party payors and patients. Our ability to collect outstanding receivables is critical to its results of operations and cash flows. Amounts we receives for treatment of patients covered by governmental programs such as Medicare and Medicaid and other third-party payors such as health maintenance organizations, preferred provider organizations and other private insurers are generally less than our established billing rates. Additionally, to provide for accounts receivable that could become uncollectible in the future, we establish an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. Accordingly, the revenues and accounts receivable reported in our consolidated financial statements are recorded at the net amount expected to be received.

Contractual Discounts and Cost Report Settlements – We derive a significant portion of our revenues from Medicare, Medicaid and other payors that receive discounts from its established billing rates. We must estimate the total amount of these discounts to prepare its consolidated financial statements. The Medicare and Medicaid regulations and various managed care contracts under which these discounts must be calculated are complex and are subject to interpretation and adjustment. We estimate the allowance for contractual discounts on a payor-specific basis given its interpretation of the applicable regulations or contract terms. These interpretations sometimes result in payments that differ from our estimates. Additionally, updated regulations and contract renegotiations occur frequently, necessitating regular review and assessment of the estimation process by management. Changes in estimates related to the allowance for contractual discounts affect revenues reported in our consolidated statements of operations.

Cost report settlements under reimbursement agreements with Medicare and Medicaid are estimated and recorded in the period the related services are rendered and are adjusted in future periods as final settlements are determined. There is a reasonable possibility that recorded estimates will change by a material amount in the near term.

Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation. We believe that we are in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing that would have a material effect on our financial statements. Compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties and exclusion from the Medicare and Medicaid programs.

Provision and Allowance for Doubtful Accounts – To provide for accounts receivable that could become uncollectible in the future; we establish an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. The primary uncertainty lies with uninsured patient receivables and deductibles, co-payments or other amounts due from individual patients.

We have an established process to determine the adequacy of the allowance for doubtful accounts that relies on a number of analytical tools and benchmarks to arrive at a reasonable allowance. No single statistic or measurement determines the adequacy of the allowance for doubtful accounts. Some of the analytical tools that

 

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we utilizes include, but are not limited to, the aging of accounts receivable, historical cash collection experience, revenue trends by payor classification, revenue days in accounts receivable, the status of claims submitted to third party payors, reason codes for declined claims and an assessment of our ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan. Accounts receivable are written off after collection efforts have been followed in accordance with our policies.

Due to the nature of the healthcare industry and the reimbursement environment in which we operate, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time services are provided. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on our operating results and cash flows in subsequent periods. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded.

The patient and their third party insurance provider typically share in the payment for our services. The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network. Due to uncertainties surrounding deductible levels and the number of out-of-network patients, we are not certain of the full amount of patient responsibility at the time of service. We estimate amounts due from patients prior to service and generally collects those amounts prior to service. Remaining amounts due from patients are then billed following completion of service.

Long-lived assets – We evaluate our long-lived assets for possible impairment whenever circumstances indicate that the carrying amount of the asset, or related group of assets, may not be recoverable from estimated future cash flows. Fair value estimates are derived from established market values of comparable assets or internal calculations of estimated future net cash flows. Our estimates of future cash flows are based on assumptions and projections it believes to be reasonable and supportable. Our assumptions take into account revenue and expense growth rates, patient volumes, changes in payor mix and changes in legislation and other payor payment patterns.

Goodwill and Intangible Assets – We evaluate goodwill for impairment at least on an annual basis and more frequently if certain indicators are encountered. Goodwill is to be tested at the reporting unit level, defined as an ASC or hospital (referred to as a component), with the fair value of the reporting unit being compared to its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered to be impaired.

Intangible assets other than goodwill which include physician membership interests, service contracts and covenants not to compete are amortized over their estimated useful lives using the straight line method. The remaining lives range from five to seven years. We evaluate the recoverability of identifiable intangible asset whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.

Income Taxes – We recognize deferred tax assets and liabilities for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. In the event we determine that the deferred tax assets will not be realized in the future, the valuation adjustment to the deferred tax assets is charged to earnings in the period in which we makes such a determination.

We use a two-step process to evaluate a tax position. The first step is to determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including the resolution of any related appeals or litigation based on the technical merits of that position. The second step is to measure a tax position that meets the more-likely-than-not threshold to determine the amount of benefit to be recognized in the financial statements. A tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.

 

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Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent period in which the threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not criteria should be de-recognized in the first subsequent financial reporting period in which the threshold is no longer met. We report tax-related interest and penalties as a component of income tax expense.

Recently Adopted and Recently Issued Accounting Guidance

Adopted Guidance

In February 2013, the FASB issued changes to the accounting for obligations resulting from joint and several liability arrangements. These changes require an entity to measure such obligations for which the total amount of the obligation is fixed at the reporting date as the sum of (i) the amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors, and (ii) any additional amount the reporting entity expects to pay on behalf of its co-obligors. An entity will also be required to disclose the nature and amount of the obligation as well as other information about those obligations. Examples of obligations subject to these requirements are debt arrangements and settled litigation and judicial rulings. These changes become effective for us on January 1, 2014. We have determined that the adoption of these changes did not have an impact on our consolidated financial statements, as we do not currently have any such arrangements.

In July 2013, the FASB issued changes to the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. These changes require an entity to present an unrecognized tax benefit as a liability in the financial statements if (i) a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position, or (ii) the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset to settle any additional income taxes that would result from the disallowance of a tax position. Otherwise, an unrecognized tax benefit is required to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. Previously, there was diversity in practice as no explicit guidance existed. These changes become effective us on January 1, 2014. We have determined that the adoption of these changes did not have a significant impact on our consolidated financial statements

Issued Guidance

In April 2014, the FASB issued changes to the reporting of discontinued operations and disclosures of disposals of components of an entity. The amendments change the criteria for reporting discontinued operations while enhancing disclosures in this area. Under the new guidance, only disposals representing a strategic shift in operations should be presented as discontinued operations. Additionally, the new guidance requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income and expenses of discontinued operations. The amendments are effective prospectively for all disposals (or classifications as held for sale) of components of an entity, and for all businesses that, on acquisition, are classified as held for sale that occur within annual periods beginning on or after December 15, 2014, and interim periods within those years. We are currently evaluating the new guidance to determine the impact it may have to our consolidated financial statements.

 

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OUR BUSINESS

Overview

We are a healthcare services company primarily focused on owning controlling interests in surgical hospitals and the inclusion of ancillary service lines. We currently own controlling and noncontrolling interests in surgical hospitals located in Texas. We also own noncontrolling interests in ambulatory surgery centers (“ASCs”) located in Texas, Oklahoma, Pennsylvania, New Jersey, Maryland and Ohio. Additionally, we provide sleep testing management services to various rural hospitals in Iowa, Minnesota, Missouri, Nebraska and South Dakota under management contracts with the hospitals. We provide management services to a majority of our Affiliates under the terms of various management agreements. Prior to December 2, 2013, our name was Graymark Healthcare, Inc.

We focus primarily on investing in and managing high quality cost effective surgical hospitals that meet the needs of patients, physicians and payors. We also focus on the inclusion of ancillary service lines to our surgical hospitals including hyperbarics, sleep labs, intraoperative monitoring, imaging and robotic surgery. We believe the facilities we invest in and manage provide an enhanced quality of care to our patients while providing administrative, clinical and economic benefits to physicians. Since physicians are critical to the direction of healthcare, we have developed our operating model to encourage physicians to affiliate with us and to use our facilities as an extension of their practices. We operate our facilities, structure our strategic relationships and adopt staffing, scheduling and clinical systems and protocols with the goal of increasing physician productivity. We believe that our focus on physician satisfaction, combined with providing high quality healthcare in a friendly and convenient environment for patients, will continue to increase the number of procedures performed at our facilities each year.

Reverse Acquisition

On July 22, 2013, we acquired 100% of the interests in Foundation Surgery Affiliates, LLC (“FSA”) and FSA’s consolidated variable interest entity, Foundation Surgical Hospital Affiliates, LLC (“FSHA”) (collectively “Foundation”) from Foundation Healthcare Affiliates, LLC (“FHA”) in exchange for 114,500,000 shares of our common stock and a promissory note in the amount of $2,000,000 (the “Foundation Acquisition”). We also assumed certain debt and other obligations of FHA in the amount of $1,991,733. The promissory note bore interest at a fixed rate of 7% and was paid in full on October 14, 2013.

For accounting purposes, the acquisition of FSA was accounted for as a reverse acquisition and as a result, the historical operating results included in our consolidated financial statements for the periods prior to July 22, 2013 represent those of FSA. The historical financial statements of FSA have been adjusted for the effect of the recapitalization that occurred as a result of the reverse acquisition. Prior to July 22, 2013, FSA’s member had elected to have FSA’s income taxed as an S Corporation under provisions of the Internal Revenue Code and a similar section of the state income tax law. Therefore, taxable income or loss is reported to the individual member for inclusion in its respective tax returns and no provision for federal and state income taxes is included in these consolidated financial statements for periods prior to July 22, 2013. We have included pro forma income information in our consolidated statements of operations that provides an adjustment for income tax expense as if FSA and FSHA had been a C Corporation prior to July 22, 2013 at an assumed combined federal and state effective tax rate of 40%, which approximates the calculated statutory tax rates for the periods.

Hospital and ASC Business Overview

We are a nationally prominent owner and manager of surgical hospitals and ASCs with facilities located in Louisiana, Maryland, New Jersey, Ohio, Oklahoma, Pennsylvania and Texas. As of December 31, 2013, we owned interests four surgical hospitals and ten ASCs in partnership with over 400 local physicians. We own equity interests in all of our ASC and surgical hospital facilities except for one ASC that we only manage.

 

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Through our facilities, we are a major provider of surgical services; we performed approximately 72,500 outpatient and 2,200 inpatient surgical cases during 2013. We believe that our acquisition and development strategy and operating model will enable us to continue to grow by taking advantage of highly-fragmented markets, an increasing demand for short stay surgery and a need by physicians to forge strategic alliances to meet the needs of the evolving healthcare landscape while also shaping the clinical environments in which they practice.

We own over 51% in two of our larger hospitals located in San Antonio and El Paso, Texas (referred to as “Consolidated Hospitals”). Historically, our focus was to own a minority ownership in facilities and we currently have ownership, ranging from 10% to 32%, in two hospitals and ten ASCs (referred to as “Equity Owned Hospitals,” “Equity Owned ASCs,” or “Equity Owned Facilities”; also referred to as “Affiliates”). Our facilities collectively offer a “portfolio” of specialties ranging from relatively intensive specialties such as orthopedics and neurosurgery to low-surgery-intensive specialties such as pediatric ENT (tubes / adenoids), pain management and gastroenterology. Each of our facilities is located in freestanding buildings or medical office buildings. Our surgical hospitals have from 10 to 40 beds and average seven operating rooms, ranging in size from 40,000 to 126,000 square feet and are open 24 hours a day, 365 days a year. Our average ASC has approximately 16,000 square feet of space with four operating rooms, as well as ancillary areas for preparation, recovery, reception and administration. Our ASCs are normally open weekdays from 7:00 a.m. to approximately 5:00 p.m. or until the last patient is discharged.

Our facilities are licensed at the state level, participate within the Medicare program and are accredited by the Accreditation Association for Ambulatory Healthcare (AAAHC) or the Det Norske Veritas (DNV) with the exception of our ASC in Nacogdoches, Texas. The Nacogdoches facility meets the accreditation standards, but the governing board of the ASC has elected to not be accredited. We recognize that accreditation is a crucial quality benchmark for payors since many managed care organizations will not contract with a facility until it is accredited. We believe that our historical success in obtaining and retaining accreditation for our facilities reflects our commitment to providing high quality care in its facilities.

Generally, our facilities are owned and operated by limited partnerships or limited liability companies in which ownership interests are also held by local physicians who are on the medical staffs of the facilities. The facilities’ partnership and limited liability company agreements typically provide for the monthly or quarterly pro rata distribution of cash equal to net profits from operations, less amounts held in reserve for expenses and working capital. Even where we own a minority of the interests in a facility, the partnership or limited liability company agreements generally grant us representation on the facility’s governing board and ensure our participation in fundamental decisions. Our influence over the businesses of our facilities is enhanced by the management agreements which we possess with such facilities.

Our surgical hospital and ASC facilities depend upon third-party reimbursement programs, including governmental and private insurance programs, to pay for the preponderance of the services rendered to patients. Our surgical hospital and ASC facilities derive a portion of their revenues from governmental healthcare programs, primarily Medicare and managed Medicare programs, and the remainder from a wide mix of commercial payors and patient co-pays and deductibles. Private payors typically follow the method in which the government reimburses healthcare providers. Under the government’s methodology our surgical hospital and ASC facilities are reimbursed for the performance of services through the payment of facility fees which vary according to whether the facility is a hospital or an ASC and the type of procedure that is performed. Hospitals are reimbursed for outpatient procedures in a manner similar to ASCs except that the methodologies employed to calculate reimbursement generally result in hospitals being reimbursed in this setting at a higher rate than free-standing ASCs. ASCs are reimbursed through the payment of a composite “ASC rate” which includes payment for most of the expenses associated with the performance of a procedure such as nursing services, supplies, and staffing costs. The reimbursement rates for inpatient hospital services are determined using Medicare severity diagnosis related groups which are intended to compensate hospitals according to the estimated intensity of hospital resources necessary to furnish care for a particular diagnosed illness.

 

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Discontinued Operations

In conjunction with establishing our focus on surgical hospitals resulting from the Foundation Acquisition, we have sold or closed all of our freestanding sleep diagnostic and therapy facilities. The facilities sold or closed were selected because the revenue from these facilities had not met expectations and were not adequate to offset fixed operating costs. The facilities sold or closed were located in Oklahoma, Texas, Nevada, Kansas, Missouri and Iowa.

As a result of identifying these sites as held for sale, the related assets, liabilities, results of operations and cash flows of the identified sites are classified as discontinued operations in our consolidated financial statements.

Company History

Our existing focus on surgical hospitals was formulated in conjunction with the Foundation Acquisition on July 22, 2013. Prior to July 22, 2013, our primary focus was providing care management solutions to the sleep disorder market which began on January 2, 2008 when our predecessor company, Graymark Productions Inc., acquired ApothecaryRx, LLC, and SDC Holdings, LLC, collectively referred to as the “Graymark Acquisition.” For financial reporting purposes, Graymark was deemed acquired by ApothecaryRx, LLC and SDC Holdings, LLC. In conjunction with the Graymark Acquisition, all former operations of Graymark Productions were discontinued. On December 6, 2010, we completed the sale of substantially all of the assets of ApothecaryRx.

On March 13, 2008, our Board of Directors approved a reverse split of our common stock at a ratio of one-for-five shares. The effective date of the reverse split was April 11, 2008. On January 26, 2011, our Board of Directors approved a reverse stock split in one of five ratios, namely 1 for 2, 3, 4, 5 or 6. On February 1, 2011, we received the consent of a majority of our shareholders for this reverse stock split. On May 18, 2011, our Board of Directors resolved to effect the reverse stock split of our common stock in a ratio of 1-for-4 effective after the close of business on June 3, 2011. We executed the reverse stock split to regain compliance with the continued listing standards of the Nasdaq Capital Market (we were ultimately delisted from the Nasdaq Capital Market on November 2, 2012).

Surgical Healthcare Market Overview

We believe many physicians and patients prefer surgical hospitals and ASCs over general acute care hospitals. We believe that this is due to the non-emergency nature of the procedures performed at our facilities, which allows physicians to schedule their time more efficiently and therefore increase the number of surgeries they can perform in a given amount of time. In addition, outpatient facilities usually provide physicians with greater scheduling flexibility, more consistent nurse staffing and faster turnaround time between cases. While surgical hospitals and ASCs generally perform scheduled surgeries, large acute care hospitals generally provide a broad range of services, including high priority and emergency procedures. Medical emergencies often demand the unplanned use of operating rooms and result in the postponement or delay of scheduled surgeries, disrupting physicians’ practices and inconveniencing patients. Surgical hospitals and ASCs are designed to improve physician work environments and improve physician efficiency. In addition, many physicians choose to perform surgery in facilities like ours because their patients prefer the comfort of a less institutional atmosphere and the convenience of simplified admissions and discharge procedures.

New surgical techniques and technology, as well as advances in anesthesia, have significantly expanded the types of surgical procedures that are being performed in surgical hospitals and ASCs and have helped drive the growth in outpatient surgery. Lasers, arthroscopy, enhanced endoscopic techniques and fiber optics have reduced the trauma and recovery time associated with many surgical procedures. Improved anesthesia has shortened recovery time by minimizing post-operative side effects such as nausea and drowsiness, thereby avoiding the need for overnight hospitalization in many cases. In addition, some states in the United States permit ASCs to keep a patient for up to 23 hours. This allows more complex surgeries, previously only performed in an inpatient setting, to be performed in an ASC.

 

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In addition to these technological and other clinical advancements, a changing payor environment has contributed to the growth of outpatient surgery relative to all surgery performed. Government programs, private insurance companies, managed care organizations and self-insured employers have implemented cost containment measures to limit increases in healthcare expenditures, including procedure reimbursement. In addition, as self-funded employers are looking to curb annual increases in premiums, they continue to shift additional financial responsibility to patients through higher co-payments, higher deductibles and higher premium contributions. These cost containment measures have contributed to the significant shift in the delivery of healthcare services away from traditional acute care inpatient hospitals to more cost-effective alternate sites, including ASCs or surgical hospitals. We believe that surgery performed at a surgical hospital or an ASC is generally less expensive than hospital-based outpatient surgery because of lower facility development costs, more efficient staffing and space utilization and a specialized operating environment focused on quality of care and cost containment.

According to the American Hospital Association, from 1989 to 2009, outpatient surgeries increased from 48.5% of total surgery volumes to 63.2%. In addition, a significant share of outpatient surgeries shifted from hospitals to free-standing facilities over a similar period. The primary factors driving this dramatic growth are the cost advantages that surgical hospitals and ASCs have over the traditional general acute care hospital setting, physician and patient preferences, and improved and specialized medical technology, most notably minimally invasive surgical techniques. New technology and advances in anesthesia, which have been increasingly accepted by physicians and payors, have significantly expanded the types of surgical procedures that can be performed in surgical hospitals and ASCs. Lasers, enhanced endoscopic techniques and fiber optics have reduced the trauma and recovery time associated with surgical procedures. Improved anesthesia has also shortened recovery time by minimizing postoperative side effects thereby avoiding overnight hospitalization. Today, large healthcare systems generally offer both inpatient and outpatient surgery on site.

Our Surgical Healthcare Solution

While we cannot predict how changes in reimbursement trends will impact our business, we believe we are well positioned by the following competitive strengths with respect to possible changes in healthcare reimbursement for several reasons:

Low Cost Provider: The delivery of healthcare will continue to be directed to low cost venues. Typically, our contracts with third-party payors are negotiated at rates that are lower than those demanded by larger hospitals and healthcare systems. Those larger hospitals and healthcare systems have significantly higher overhead costs compared to our focused facilities. As a result, we believe that our willingness to contract at more competitive rates, and our ability to provide high quality services with less overhead, will continue to play in our favor as the healthcare industry continues to evolve.

Experienced management team. Our senior management has, on average, over 25 years of experience in the healthcare industry and has extensive knowledge of our industry and the regulatory environment in which we operate. These seasoned executives bring expertise in financial, operational, legal and strategic development areas, to name a few. Additionally, many of our senior management team has extensive experience working for our Company.

Infrastructure. Our current infrastructure (e.g., sophisticated information systems and analytical tools, business office support, reporting, and purchasing power) provide an excellent platform for continued growth without significant additional infrastructure investment. We believe there to be a significant opportunity to acquire additional facilities in our existing markets and merge or consolidate those into our existing facilities, thereby combining revenue into a relatively fixed cost base with only incremental increase in expenses.

Ability to identify and integrate acquisitions. We use experienced teams of operations and financial personnel to conduct a review of all aspects of a target facility’s operations, including (1) the quality and reputation of the physicians affiliated with the center, (2) the market position of the facility and the physicians affiliated with the

 

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facility, (3) the facility’s payor contracts and case mix, (4) competition and growth opportunities in the market, (5) the facility’s staffing and supply policies, (6) an assessment of the facility’s equipment, and (7) opportunities for operational efficiencies. We also have a dedicated team responsible for the integration of acquired facilities. This team is responsible for converting acquired facilities to our reporting, staffing, and performance measurement systems and other operating systems. Once an acquisition is consummated, it is generally fully integrated within 60 days.

Our Surgical Business Strategy

We believe we are a leader in the acquisition, development and operation of surgical facilities and related ancillary services. The key components of our strategy are:

Attract and retain physicians that are leaders in their specialty and market. Physicians are critical to the delivery of healthcare and are a valuable component of our operating model. We currently operate two Consolidated Hospitals, two Equity Owned Hospital and ten Equity Owned ASCs with over 400 physician partners. Under our partnership structure, physicians gain a partner in Foundation who provides management services, including clinical and regulatory support, financial reporting, performance measurement, group purchasing, contracting, and marketing services. We believe our focus on physician satisfaction, combined with providing safe, high quality healthcare in a patient friendly and convenient environment helps us attract and retain physician partners.

Increase same-center revenue growth. Recruit New Casual Users: On an ongoing basis, we identify and recruit new casual users, which are defined as physicians who perform cases at the facility that are not partners at the facility. Some physicians, for a variety of reasons (age, risk adversity, financial means, hospital politics and/or payor issues) may not wish to become a partner but may still relish the opportunity to perform cases outside a hospital setting. We work with our physician partners to identify qualified casual users that perform quality and profitable cases which are portable to the facility. We illustrate the efficiency, ease, and convenience to both the physician and their patients of having cases performed in the surgical hospital and ASC setting versus the general acute care hospital setting.

Add Cases from Existing Partners: Our sales and marketing efforts are directed primarily at physicians, who are principally responsible for referring patients to our facilities. We market our facilities to physicians by emphasizing (1) the high level of patient and physician satisfaction with our facilities, which is based on surveys we take concerning our facilities, (2) the quality and responsiveness of our services, and (3) the practice efficiencies provided by our facilities.

We will employ a number of options to increase utilization of existing partners. We believe that the physicians need to be engaged to “police themselves” by forming physician growth committees to assist with recruitment of new partners, casual users and employ peer pressure to stop leakage and maximize center utilization by existing partners.

We also employ a strategy of operating out-of-network with certain commercial health insurance payors when such payors are unwilling to either contract with our facility or unwilling to pay rates that are commensurate with our established contracts with other payors.

Marketing our facilities to referring physicians, payors and patients. We market to referring physicians and payors by emphasizing the quality, high patient satisfaction and lower cost at our facilities. We have a dedicated team that is responsible for negotiating contracts with third party payors. They are responsible for obtaining new contracts with payors that do not currently contract with us and negotiating increases to reimbursement rates pursuant to existing contracts.

Increase operating efficiencies of our facilities. We have dedicated professionals with business and clinical expertise that are responsible for implementing best practices within our facilities. The following are other areas where we implement best practices to improve operating efficiencies:

 

•

physician scheduling enhancements;

 

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•

improved patient flow; and

 

•

improved operating room turnover.

We also enhance the profitability of our facilities through benefits we receive through economies of scale such as group purchasing, staffing and clinical efficiencies, and cost containment initiatives. We also track facility performance relative to certain benchmarks in order to maximize center-level revenue and profitability. The information we gather and collect from our facilities and operations team members allows us to develop best practices and identify those facilities that could benefit from improved operating efficiency techniques and cost containment measures.

Expand our presence in existing markets. One of the elements of our business strategy is to grow selectively in markets in which we already operate facilities. For our surgical hospital facilities we believe that selective acquisition and development of ancillary services, such as ASCs or imaging facilities, in existing markets allow us to leverage our existing knowledge of these markets, grow our revenues, and improve operating efficiency. In particular, our experience has been acquisition of such ancillary service facilities in markets where we already have a presence is one of the best uses of our capital.

Expand our national network of facilities. The surgical hospital and ASC market is highly fragmented, and as such we believe that there exists a large base of premier physician practices as well as surgical facility owners that are seeking to affiliate with experienced operators with access to capital, management expertise, scale in payor contracting and other resources which will provide an excellent opportunity for consolidation and acquisitions.

Our development team identifies existing facilities that are potential acquisition candidates and physicians who are potential partners for new facility development. We begin our acquisition process with a due diligence review of the target facility and its market. We use experienced teams of operations and financial personnel to conduct a review of all aspects of the facility’s operations, including the following:

 

•

quality and reputation of the physicians affiliated with the facility;

 

•

market position of the facility and the physicians affiliated with the facility,

 

•

payor and case mix;

 

•

competition and growth opportunities in the market;

 

•

staffing and supply review;

 

•

equipment assessment, and

 

•

opportunities for operational efficiencies.

We believe our current infrastructure (e.g., sophisticated information systems, support capacity at its corporate headquarters, development capabilities, managed care expertise and analytics) provides a strong platform to be an industry consolidator and is capable of supporting more than its current number of surgical facilities without significant additional investment.

We manage each facility overseeing the business office, contracting, marketing, financial reporting, accreditation, clinical, regulatory and administrative operations of the facilities. Certain significant aspects of the limited partnership’s or limited liability company’s governance are overseen by a governing board, which is comprised of representation by Foundation and our physician partners. We work closely with our physician partners to increase the likelihood of a successful partnership.

 

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Sources of Revenue

Our patient services revenues are derived from the fees charged for surgical and other ancillary procedures performed in our Consolidated Hospitals. These fees vary depending on the procedure, but usually include all charges for operating room usage, special equipment usage, supplies, recovery room usage, nursing staff and medications. Facility fees do not include professional fees charged by the physician that performs the surgical procedure. Revenue is recorded at the time of the patient encounter and billings for such procedures are made on or about that same date. It is our policy to collect patient co-payments and deductibles at the time the surgery is performed. Our revenues are recorded net of estimated contractual adjustments from third-party medical service payors. Our billing and accounting systems provide us historical trends of the surgical facilities’ cash collections and contractual write-offs, accounts receivable aging and established fee adjustments from third-party payors. These estimates are recorded and monitored monthly for each of our facilities as revenue is recognized. Our ability to accurately estimate contractual adjustments is dependent upon and supported by the fact that our facilities perform and bill for limited types of procedures, the range of reimbursement for those procedures within each facility specialty is very narrow and payments are typically received within 15 to 45 days of billing.

Our facilities depend upon third-party reimbursement programs, including governmental and private insurance programs, to pay for substantially all of the services rendered to patients.

Our revenues from Equity Owned Facilities are derived from (i) the pro rata distributions we receive on our ownership in the facilities, and (ii) management fees that we receive from these facilities. Such management fees are generally calculated as a percentage of the monthly collected net revenues. We own equity interests in all of surgical hospital and ASC facilities except one that we only manage.

Our revenues by type and payor and the respective percentages of revenues during 2013 and 2012 were as follows:

 

		2013								2012
		Amount				Ratio				Amount				Ratio
Patient services:
Medicare		$	22,338,570				24	%		$	8,583,647				16	%
Medicaid			2,549,171				3				2,937,182				6
Commercial health insurance payors			50,861,687				54				24,376,965				46
Patient self-pay			4,205,165				5				2,343,131				4
Management fees from affiliates			6,514,089				7				7,945,061				15
Equity in earnings of affiliates			5,885,188				6				6,927,466				13
Other			4,545,608				5				828,471				2
Revenues before provision for doubtful accounts			96,899,478								53,941,923
Provision for doubtful accounts			(3,755,035	)			(4	)			(966,420	)			(2	)
Revenues		$	93,144,443				100	%		$	52,975,503				100	%

Patients generally are not responsible for any difference between customary hospital charges and amounts reimbursed for the services under Medicare, Medicaid, private insurance plans, HMOs or PPOs, but patients are responsible for services not covered by these plans, exclusions, deductibles or co-payment features of their coverage. The amount of exclusions, deductibles and co-payments generally has been increasing each year as employers have been shifting a higher percentage of healthcare costs to employees.

Medicare

Our revenues from Medicare were $22.3 million, or 24% of total revenues for the year ended December 31, 2013. Medicare provides hospital and medical insurance benefits, regardless of income, to persons age 65 and over, some disabled persons and persons with end-stage renal disease. Our hospitals are currently certified as

 

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providers of Medicare services. Amounts received under the Medicare program are often significantly less than the hospital’s customary charges for the services provided. Since 2003, Congress and the Centers for Medicare and Medicaid Services (“CMS”) have made several sweeping changes to the Medicare program and its reimbursement methodologies, such as the implementation of the prescription drug benefit that was created by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “MMA”) and as the provisions of the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 (collectively, the “ACA”) continue to be implemented.

As of March 31, 2014, both of our Consolidated Hospitals are licensed as hospitals and receive reimbursement from Medicare for inpatient services under Medicare’s Inpatient Prospective Payment System, under which a hospital receives a fixed amount as reimbursement for inpatient hospital services based on each patient’s final assigned Medicare severity diagnosis-related group (“MS-DRG”). Our surgical hospitals generally focus on performing outpatient procedures and perform a relatively low number of Medicare inpatient cases.

Each federal fiscal year (which begins October 1), MS-DRG rates are updated and their weights are recalibrated. The index to update the MS-DRGs known as the “market basket” gives consideration to the inflation experienced by hospitals as well as entities outside the healthcare industry in purchasing goods and services. For several years, however, the percentage increases to the prospective payment rates have been generally lower than the percentage increases in the costs of goods and services for hospitals. Further, the ACA introduced new limitations on the increase in the market basket.

Our surgical hospitals are subject to a separate Medicare payment system for outpatient services. Most outpatient services provided by surgical hospitals are classified into groups called Ambulatory Payment Classifications (“APCs”) that are reimbursed by Medicare under the Outpatient Prospective Payment System (“OPPS”). A Medicare payment rate has been established for each APC. Depending on the services provided, a hospital may be paid for more than one APC for a patient visit. CMS establishes a payment rate for each APC by multiplying the scaled relative weight for the APC by a conversion factor. The payment rate is further adjusted to reflect geographic wage differences. The APC conversion factors for calendar years (“CYs”) 2014, 2013, and 2012 are $72.672, $71.313, and $70.016, respectively, after the inclusion of the 0.8% reduction for CY 2014, the 0.8% reduction for CY 2013, and the 1.1% reduction for CY 2012 that were required by the ACA.

CMS has implemented a quality data reporting program for hospital outpatient care, known as the Hospital Outpatient Quality Data Reporting Program. CMS has adopted a similar quality data reporting program for hospital inpatient services, known as the Hospital Inpatient Quality Reporting Program. Hospitals that fail to report inpatient or outpatient data required for the quality measures selected by CMS in the form and manner required by CMS may incur a 2% reduction in the annual payment update factor. Therefore, if we fail to provide quality data in the manner and form required by CMS, our surgical hospitals could be subject to a reduction of the Medicare payment update by 2%. Any reduction would apply only to the payment year involved and would not be taken into account in computing the applicable payment update factor for a subsequent payment year.

Effective October 1, 2012, Medicare began offering incentive payments to hospitals for delivering high-quality care through a value-based purchasing program. The incentives will be funded through a 1% deduction in the base MS-DRG payments for hospitals’ discharges. The reductions will increase over subsequent years. Hospitals must meet or exceed a baseline score on a set of predetermined clinical and patient experience measures.

The following summarizes the Medicare inpatient MS-DRG and outpatient OPPS payments we received for the years ended December 31, 2013 and 2012:

 

		Medicare
		MS-DRG Payments				OPPS Payments
2013		$	8,871,758			$	4,663,380
2012		$	4,385,150			$	4,077,782

 

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Medicaid

Our revenues under the various state Medicaid programs, including state-funded managed care programs, were $2.5 million, or 3% of total revenues for the year ended December 31, 2013. Medicaid programs are jointly funded by federal and state governments. As the Medicaid program is administered by the individual states under the oversight of CMS in accordance with certain regulatory and statutory guidelines, there are substantial differences in reimbursement methodologies and coverage policies from state to state. Many states have experienced shortfalls in their Medicaid budgets and are implementing significant cuts in Medicaid reimbursement rates. Additionally, certain states control Medicaid expenditures through restricting or eliminating coverage of certain services.

Cost Reports

Because of our participation in the Medicare and Medicaid programs, we are required to meet certain financial reporting requirements. Federal and some state regulations require the submission by us and our surgical hospitals of annual cost reports stating the revenues, costs and expenses associated with the services provided to Medicare beneficiaries and Medicaid recipients at those hospitals.

These annual cost reports are subject to routine audits, which may result in adjustments to the amounts ultimately determined to be due to us under these reimbursement programs. It generally takes years to settle audits of these cost reports. These audits are used for determining if any under- or over-payments were made by payors under these programs, setting payment levels for future years and detecting fraud. Providers are required to make certain certifications with these cost report submissions, including that they are in compliance with law. Such certifications, if incorrect and submitted knowingly or recklessly, may result in a False Claims Act (“FCA”) liability.

Commercial Health Insurance Payors

In addition to government programs, our hospitals are reimbursed by differing types of private payors including HMOs, PPOs, other private insurance companies and employers. Our revenues from commercial health insurance payors were approximately $50.9 million, or 54% of total revenues for the year ended December 31, 2013. To attract additional volume, most of our hospitals offer discounts from established charges to certain large group purchasers of healthcare services. These discount programs often limit our ability to increase charges in response to increasing costs. Generally, patients covered by HMOs, PPOs and other private insurers will be responsible for certain co-payments and deductibles.

In some cases, our hospitals do not have written contracts prior to providing services, commonly known as “out-of-network” services. Our out-of-network third-party payors have traditionally paid for our services at a percentage of their allowed charges. There has been a growing trend in recent years, however, for third-party payors to implement out-of-network fee schedules, which are more comparable to our contracted rates.

Patient Self-Pay

Patient self-pay revenues are derived from patients who do not have any form of healthcare coverage. Our revenues from self-pay patients were approximately $4.2 million, or 5% of total revenues for the year ended December 31, 2013. The revenues associated with self-pay patients are generally reported at our gross charges. We evaluate these patients, after the patient’s medical condition is determined to be stable, for qualifications of Medicaid or other governmental assistance programs.

Management Fees from Affiliates

Our management fees from affiliates were $6.5 million, or 7% of total revenues for the year ended December 31, 2013. We have entered into agreements with certain of our Equity Owned facilities to provide management

 

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services. In addition, we have a management agreement with an ASC that we don’t own any equity interest. As compensation for these services, the hospitals and ASCs are charged management fees which are either fixed or are based on a percentage of the Affiliate’s cash collected or the Affiliate’s net revenue. The percentages range from 2.25% to 6.0%.

Equity in Earnings of Affiliates

Our equity in earnings of affiliates for which we own non-controlling interests were 5.9 million, or 6% of total revenues for the year ended December 31, 2013. We account for our investments in Equity Owned Facilities that we exhibit significant influence, but not control, in accordance with the equity method of accounting. We do not consolidate our equity method investments, but rather we measure them at their initial costs and then subsequently adjust their carrying values through income for our respective shares of the earnings or losses during the period.

Provision for Doubtful Accounts

To provide for accounts receivable that could become uncollectible in the future, we establish an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. The primary uncertainty lies with uninsured patient receivables and deductibles, co-payments or other amounts due from individual patients. Our provision for doubtful accounts had the effect of reducing total revenues by $3.8 million, or 4% of total revenues for the year ended December 31, 2013.

We have an established process to determine the adequacy of the allowance for doubtful accounts that relies on a number of analytical tools and benchmarks to arrive at a reasonable allowance. No single statistic or measurement determines the adequacy of the allowance for doubtful accounts. Some of the analytical tools that we utilize include, but are not limited to, the aging of accounts receivable, historical cash collection experience, revenue trends by payor classification, revenue days in accounts receivable, the status of claims submitted to third party payors, reason codes for declined claims and an assessment of our ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan. Accounts receivable are written off after collection efforts have been followed in accordance with our policies.

Competition for Patients and Partners

In all of our markets, our facilities compete with other providers, including major acute care hospitals, other surgical hospitals and other ASCs. General acute care hospitals have various competitive advantages over us, including their established managed care contracts, community position, physician loyalty and geographical convenience for physicians’ inpatient and outpatient practices. However, we believe that, in comparison to hospitals with which we compete, our surgical hospitals and ASCs compete favorably on the basis of cost, quality, efficiency and responsiveness to physician needs in a more comfortable environment for the patient.

We compete with other providers in each of our markets for patients, physicians and for contracts with insurers or managed care payors. Competition for managed care contracts with other providers is focused on the pricing, number of facilities in the market and affiliation with key physician groups in a particular market. We believe that our relationships with our hospital partners enhance our ability to compete for managed care contracts. We also encounter competition with other companies for acquisition and development of facilities and for strategic relationships with physicians.

There are several companies, both public and private, that acquire and develop freestanding multi-specialty surgical hospitals and ASCs. Some of these competitors have greater resources than we do. The principal competitive factors that affect our ability and the ability of our competitors to acquire surgical hospitals and ASCs are price, experience, reputation and access to capital. Further, many physician groups develop ASCs without a corporate partner and this presents a competitive threat to our company.

 

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Government Regulation

The healthcare industry is subject to extensive regulation by federal, state and local governments. Government regulation affects our business by controlling growth, requiring licensing or certification of facilities, regulating how facilities are used and controlling payment for services provided. Our ability to conduct our business and to operate profitably will depend in part upon obtaining and maintaining all necessary licenses, certificates of need and other approvals, and complying with applicable healthcare laws and regulations. See “Risk Factors – Risks Related To Healthcare Regulation.”

Licensure, Certificate of Need and Change of Ownership Regulations

Capital expenditures for the construction of new facilities, the addition of capacity or the acquisition, relocation, change of ownership or change of control of existing facilities may be reviewable by state regulators under certificate of need (“CON”) laws. A certificate of need is a permit issued by a state health planning authority evidencing the authority’s opinion that a proposed facility or expansion is consistent with the need for the services to be offered by the facility. States with CON laws often place limits on the number of facilities or operating rooms in a region, or restrict providers’ ability to build, relocate, expand or change the ownership control of healthcare facilities and services. In some states, approvals are required for capital expenditures exceeding certain specified amounts or involving certain facilities or services, including surgical hospitals and ASCs. As of December 31, 2013, Maryland is the only state we operate in with CON laws.

Our facilities are also subject to state and local licensing requirements ranging from the quality of care to compliance with building codes and environmental protection laws. Governmental and other authorities periodically inspect our facilities to assure continued compliance with these regulations. Failure to comply with these regulations could result in the suspension or revocation of a facility’s license or other penalties.

In addition, as of December 31, 2013, all of our surgical hospitals and nine of our ten ASCs were accredited by either the AAAHC or DNV, two of the major national organizations that establish standards relating to the physical plant, administration, quality of patient care and operation of medical staffs of various types of healthcare facilities. We have one ASC whose governing board has elected to not be accredited; however, we believe that it meets the requirements for accreditation. Many commercial payors require our facilities to be accredited in order to be a participating provider under their health plans.

Medicare and Medicaid Programs

Medicare is a federally funded and administered health insurance program, primarily for individuals entitled to social security benefits who are age sixty-five years or older or who are disabled. Medicare prospectively determines fixed payment amounts for procedures performed at ASCs. These amounts are adjusted for regional wage variations.

To participate in the Medicare program and receive Medicare payments, our facilities must comply with regulations promulgated by CMS. Among other things, these regulations, known as “conditions for coverage” for ASCs and “conditions of participation” for hospitals, set forth requirements relating to the facility’s equipment, personnel, policies, standards of medical care and compliance with state and local laws and regulations. All of our surgical hospitals and ASCs are certified in the Medicare program and are subject to on-site, unannounced surveys by state survey agencies working on behalf of CMS. The frequency of on-site ASC surveys by state survey agencies has increased in recent years. Failure to comply with Medicare’s conditions for coverage and conditions of participation may result in loss of payment or other governmental sanctions, including termination of participation in the Medicare program. We have established ongoing quality assurance activities to monitor our facilities’ compliance with these conditions.

Medicaid is a health insurance program jointly funded by state and federal governments that provides medical assistance to qualifying low-income persons. Each state Medicaid program has the option to provide payment for ASC services. All of the states in which we currently operate provide Medicaid coverage for some ASC services;

 

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however, these states may elect to discontinue covering services, and states into which we expand our operations may not cover or continue to cover surgery center services. Medicaid programs pay us a fixed payment for our services, and the amounts paid vary state to state.

Health Reform Initiatives

There have been numerous legislative and regulatory initiatives on the federal and state levels for comprehensive reforms affecting the payment for and availability of healthcare services. On March 23, 2010, the ACA was signed into law. The ACA included a number of provisions specific to our facilities as described below.

The ACA represents significant change to the healthcare industry. The ACA includes provisions designed to change how healthcare services are covered, delivered and reimbursed through, among other things, expanded coverage of uninsured individuals, reduced growth in Medicare program spending and the establishment of programs where reimbursement is tied to quality. The ACA also reforms certain aspects of health insurance, expands existing efforts to tie Medicare and Medicaid payments to performance and quality, and contains provisions intended to strengthen fraud and abuse enforcement. On June 28, 2012, the United States Supreme Court upheld the constitutionality of key provisions of the ACA but struck down provisions that would have allowed HHS to penalize states that do not implement the Medicaid expansion provisions of the law with the loss of existing federal Medicaid funding. As a result, some states may choose not to implement the Medicaid expansion, and fewer individuals will be covered by a state Medicaid program than would have been covered had the Supreme Court upheld the ACA in its entirety.

The ACA includes a number of reforms that will directly affect our facilities, including without limitation the reforms summarized below.

The ACA includes a provision requiring CMS to apply a negative productivity adjustment to the indexes used to update Medicare payment rates on an annual basis. The productivity adjustment is to equal the 10-year moving average of changes in the annual economy-wide private non-farm business multi-factor productivity measure, as reported by the Bureau of Labor Statistics and updated in the spring of each year. Hospital and ASC services were subject to this productivity adjustment starting in calendar year 2011. As a result, the rate of increase in reimbursement was less in calendar year 2011 than it would have been in the absence of the productivity adjustment. For example, ASCs would have seen an increase of 1.5%, but as a result of the -1.3% productivity adjustment mandated by the ACA, the increase was only 0.2%. Thus, the practical impact of the productivity adjustment for ASCs and hospitals is to reduce the amount of annual rate increases from Medicare, potentially to an amount below zero (that is, the index-based increase may be outweighed by the productivity adjustment and as a result reimbursement rates would decline). For our surgical hospitals, there is an additional downward adjustment for each of the following federal fiscal years as follows: 0.1% in 2013; 0.3% in 2014; 0.2% in 2015 and 2016 and 0.75% in 2017, 2018 and 2019.

Additionally, pursuant to the ACA, HHS submitted a report to Congress in 2011 outlining HHS’s plan to implement a value-based purchasing program for ASCs. While the report describes efforts to improve quality and payment efficiency in ASCs and examines the steps required to design and implement an ASC value-based purchasing program, Congress has not yet authorized CMS to implement such a program.

The ACA established a new Independent Payment Advisory Board, which, if a Medicare per capita target growth rate is exceeded, will develop and submit proposals for a Medicare spending reduction to the President and Congress beginning in 2014 for implementation in 2015. This Board would have the authority to reduce Medicare payments to certain providers, including ASCs. In addition, the Board is precluded from submitting proposals that reduce Medicare payments prior to December 31, 2019 for providers scheduled to receive a reduction in their payment updates as a result of the Medicare productivity adjustment, which currently includes our facilities.

Based on the Congressional Budget Office’s February 2013 projection, the ACA will expand insurance coverage to approximately 27 million individuals currently lacking health insurance by 2022.

 

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However, on July 2, 2013, the U.S. Department of Treasury announced that it will delay for one year the mandatory employer and insurer reporting requirements under the ACA currently scheduled to be effective January 1, 2014. Further, the U.S. Department of Treasury announced on that date that it will delay the implementation of “shared responsibility payments” under the ACA, which are sometimes referred to as the “play-or-pay penalties.” In addition, a number of other delays to, waivers of and exemptions from other provisions of the ACA have been granted by the current Administration. These delays, waivers and exemptions may reduce the number of individuals to whom coverage will be expanded by 2022 to a number below the projected number.

The extent to which this expanded coverage and associated reimbursement may or may not offset other impacts of the ACA on our results is not clear at this time. We believe healthcare reform initiatives will continue to develop during the foreseeable future. If adopted, some aspects of previously proposed reforms, such as further reductions in Medicare or Medicaid payments, or additional prohibitions on physicians’ financial relationships with facilities to which they refer patients, could adversely affect us in a material way.

Federal Anti-Kickback Statute

State and federal laws regulate relationships among providers of healthcare services, including employment or service contracts and investment relationships. These restrictions include a federal criminal law, referred to as the Anti-Kickback Statute, which prohibits knowingly and willfully offering, paying, soliciting or receiving any form of remuneration in return for:

 

•

referring patients for services or items payable under a federal healthcare program, including Medicare or Medicaid, or

 

•

purchasing, leasing, ordering, or arranging for or recommending purchasing, leasing or ordering, any good, facility, service or item for which payment may be made in whole or in part by a federal healthcare program.

Violations of the Anti-Kickback Statute may be punished by a criminal fine of up to $25,000 for each violation or imprisonment, civil money penalties of up to $50,000 per violation and damages of up to three times the total amount of the remuneration and/or exclusion from participation in federal healthcare programs, including Medicare and Medicaid. The ACA provides that submission of a claim for services or items generated in violation of the Anti-Kickback Statute constitutes a false or fraudulent claim and may be subject to additional penalties under the FCA.

The Anti-Kickback Statute is broad in scope and the applicability of its provisions to many business transactions in the healthcare industry has not yet been subject to judicial or regulatory interpretation. The method by which investors are selected and bought out, the pricing of the issuance and redemption of partnership or LLC units to or from referring physicians and all of our other financial dealings with physicians are subject to regulation by the Anti-Kickback Statute. Courts have found a violation of the Anti-Kickback Statute if just one purpose of the remuneration is to generate referrals, even if there are other lawful purposes. Furthermore, the ACA provides that knowledge of the law or intent to violate the law is not required to establish a violation of the Anti-Kickback Statute.

The Federal government pays particular attention to joint ventures and other transactions among healthcare providers, particularly joint ventures involving physicians and other referral sources. In 1989, OIG published a fraud alert that outlined questionable features of “suspect” joint ventures, and the OIG has continued to refer to those fraud alerts in later pronouncements. The OIG has also published regulations containing numerous “safe harbors” that exempt some practices from enforcement under the Anti-Kickback Statute. These safe harbor regulations, if fully complied with, assure participants in particular types of arrangements that the OIG will not treat their participation as a violation of the Anti-Kickback Statute. The safe harbor regulations do not expand the scope of activities that the Anti-Kickback Statute prohibits, nor do they provide that failure to satisfy the terms of a safe harbor constitutes a violation of the Anti-Kickback Statute. The OIG has, however, indicated that failure to satisfy the terms of a safe harbor may subject an arrangement to increased scrutiny.

 

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On November 19, 1999, the OIG promulgated a safe harbor applicable to ASCs. The ASC safe harbor generally protects ownership or investment interests in a center by physicians who are in a position to refer patients directly to the center and perform procedures at the center on referred patients, if certain conditions are met. More specifically, the ASC safe harbor protects any payment that is a return on an ownership or investment interest to an investor if certain standards are met in one of four categories of ASCs: (1) physician-owned surgery centers, (2) single-specialty surgery centers, (3) multi-specialty surgery centers and (4) hospital/physician surgery centers.

For “multi-specialty” surgery centers, the following standards, among others, apply:

 

(1)

all of the investors must either be physicians who are in a position to refer patients directly to the center and perform procedures on the referred patients, group practices composed exclusively of those physicians or investors who are not employed by the entity or by any of its investors are not in a position to provide items or services to the entity or any of its investors, and are not in a position to make or influence referrals directly or indirectly to the entity or any of its investors;

 

(2)

at least one-third of each physician investor’s medical practice income from all sources for the previous fiscal year or twelve-month period must be derived from performing outpatient procedures that require a surgery center or private specialty hospital setting in accordance with Medicare reimbursement rules;

 

(3)

at least one-third of the Medicare-eligible outpatient surgery procedures performed by each physician investor for the previous fiscal year or previous twelve-month period must be performed at the surgery center in which the investment is made; and

 

(4)

no ownership interests may be held by a non-physician or non-hospital investor if that investor is (a) employed by the center or another investor, (b) in a position to provide items or services to the center or any of its other investors or (c) in a position to make or influence referrals directly or indirectly to the center or any of its investors.

For our ASCs that are considered “physician-owned surgery centers” and “single-specialty surgery centers,” the third standard listed above is not applicable. For our facilities that are considered “hospital/physician surgery centers,” the safe harbor includes standards prohibiting the hospital investor and the center from sharing space and equipment except in certain instances, prohibiting the hospital investor from including costs associated with the center on the hospital’s cost report and prohibiting the hospital from being in a position to make or influence referral to the center or to any other investor in the center.

Entities that own facilities which provide services under the Medicare and Medicaid programs, and their respective physician partners and members, are subject to the Anti-Kickback Statute. In cases where one of our subsidiaries is an investor in the partnership or limited liability company that owns the facility, and we or our subsidiary provides management and other services to the facility, our arrangements with physician investors do not meet all of the specific terms of the ASC safe harbor or any other safe harbor. See “Risk Factors – Risks Related to Healthcare Regulation.”

However, we believe that our operations do not violate the Anti-Kickback Statute. Moreover, we strive to ensure that our management services and lease agreements with facilities are consistent with our standards for documented fair market value for services and space provided to or received from the facilities or the physician partners at the facilities.

Federal Physician Self-Referral Law

The Stark Law prohibits any physician from referring patients to any entity for the furnishing of certain “designated health services” otherwise payable by Medicare or Medicaid, if the physician or an immediate family member has a financial relationship with the entity, unless an exception applies. The Stark Law also prohibits entities that provide designated health services otherwise payable by Medicare or Medicaid from billing the Medicare and Medicaid programs for any items or services that result from a prohibited referral and requires the entities to refund amounts received for items or services provided pursuant to the prohibited referral. As defined

 

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by the Stark Law, the term “financial relationship” includes both ownership (or investment) interests and compensation arrangements. Unlike safe harbors under the Anti-Kickback Statute with which compliance is voluntary, a financial relationship must comply with every requirement of a Stark Law exception in order to not violate the Stark Law. Persons who violate the Stark Law are subject to potential civil money penalties of up to $15,000 for each bill or claim submitted in violation of the Stark Law and up to $100,000 for each “circumvention scheme” they are found to have entered into, and potential exclusion from the Medicare and Medicaid programs. In addition, the Stark Law requires the denial (or refund, as the case may be) of any Medicare and Medicaid payments received for designated health services that result from a prohibited referral.

CMS has promulgated regulations to implement the Stark Law. Under these regulations, services provided by an ASC that would otherwise constitute “designated health services” are excluded from the definition of that term if the services are reimbursed by Medicare as part of the ASC’s composite payment rate. All services provided by our ASCs that would otherwise constitute designated health services are reimbursed by Medicare as part of the composite payment rate and are thus exempted from the Stark Law, with the exception of implants. The Stark Law provides for a special exception for implants, such as intraocular lenses and artificial joints, furnished in ASCs as long as certain regulatory requirements are met. These requirements provide that the implant must be implanted by the referring physician or a member of his or her group practice, that the implant be implanted during a surgical procedure reimbursed as an ASC procedure by Medicare, that the arrangement for the furnishing of the implant not violate the Anti-Kickback Statute and that the billing for the implant be conducted legally. We believe the operations of our ASCs comply with these requirements and, consequently, that the Stark Law generally does not apply to services provided by our ASCs. See “Risk Factors – Risks Related to Healthcare Regulation.”

As of December 31, 2013, four of our facilities are surgical hospitals. The Stark Law includes an exception that permits physicians to refer Medicare and Medicaid patients to hospitals in which they have an ownership interest if certain requirements are met. Federal legislation enacted in 2010 dramatically curtailed this exception and prohibits physician ownership in hospitals that did not have a Medicare provider agreement by December 31, 2010. This prohibition does not apply to our surgical hospitals, each of which had a Medicare provider agreement prior to December 31, 2010 and are therefore able to continue operating with their existing ownership structure in compliance with the applicable exception. However, the law prohibits “grandfathered” hospitals from increasing the percentage of physician ownership, and the law limits to a certain extent their ability to grow because it prohibits such hospitals from increasing the aggregate number of inpatient beds, operating rooms and procedure rooms. In addition, the new law required all our surgical hospitals with physician owners to adopt certain measures addressing potential conflicts of interest, ensuring that physician investments are bona fide and relating to patient safety. We believe our facilities are in compliance with such requirements, but even the assertion of a violation of the Stark Law could have a material adverse effect upon us.

False and Other Improper Claims

The Federal government is authorized to impose criminal, civil and administrative penalties on any person or entity that files a false claim for payment from the Medicare or Medicaid programs. False claims filed with private insurers can also lead to criminal and civil penalties. While the criminal statutes are generally reserved for instances of fraudulent intent, the government applies criminal, civil and administrative penalty statutes to a range of circumstances, including coding errors, billing for services not provided, submitting false cost reports and submitting claims resulting from arrangements prohibited by the Stark Law or the Anti-Kickback Statute.

Over the past decade or more, the government has accused an increasing number of healthcare providers of violating the FCA, which prohibits a person from knowingly presenting, or causing to be presented, a false or fraudulent claim to the United States. The statute defines “knowingly” to include not only actual knowledge of a claim’s falsity, but also reckless disregard for or intentional ignorance of the truth or falsity of a claim. Violations of the FCA can result in awards of treble damages and significant per claim penalties.

Also, under the “qui tam” provisions of the FCA, private parties (“relators” or “whistleblowers”) may bring actions against providers on behalf of the Federal government. Such private parties are entitled to share in any

 

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amounts recovered by the government through trial or settlement. Qui tam cases are sealed by the court at the time of filing. The only parties privy to the information contained in the complaint are the relator, the Federal government and the presiding court.

Both direct enforcement activity by the government and whistleblower lawsuits under the FCA have increased significantly in recent years and have increased the risk of healthcare companies like us having to defend a false claims action, repay claims paid by the government, pay fines or be excluded from the Medicare and Medicaid programs. In addition, under the ACA, if we receive an overpayment, we must report and refund the overpayments before the later of 60 days after the overpayment was identified or the date any corresponding cost report is due, if applicable. Any overpayment that is retained after this deadline is considered an obligation subject to an action under the FCA.

Although we believe that our operations materially comply with both federal and state laws, they may nevertheless be the subject of a whistleblower lawsuit, or may otherwise be challenged or scrutinized by governmental authorities. See “Risk Factors – Risks Related to Healthcare Regulation.”

State Anti-Kickback, Physician Self-Referral and False Claims Laws

Many states, including those in which we do business, have laws that prohibit payment of kickbacks or other remuneration in return for the referral of patients. Some of these laws apply only to services reimbursable under state Medicaid programs. In most states, these laws have not been subjected to significant judicial and regulatory interpretation. Noncompliance with these laws could subject us to penalties and sanctions and have a material adverse effect on us. We believe that our operations are in material compliance with the physician self-referral laws of the states in which our facilities are located.

A number of states, including some of those in which we do business, have their own laws prohibiting the submission of false claims. These laws may be modeled on the FCA and contain qui tam provisions. Some state false claims acts can involve broader liability in terms of the costs that losing defendants must pay or the types of claims that are subject to the act.

Healthcare Industry Investigations and Audits

Both federal and state government agencies have increased their civil and criminal enforcement efforts in the healthcare industry and the ACA includes additional federal funding of $350 million to fight healthcare fraud, waste and abuse. Investigations by government agencies have addressed a wide variety of issues, including billing practices and financial arrangements with referral sources. In addition, the OIG and the DOJ have, from time to time, established national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. An investigation of our facilities could result in significant liabilities and penalties, as well as adverse publicity.

In addition, government agencies and their agents may conduct audits of the operations of our facilities. Under the Recovery Audit Contractor (“RAC”) program, CMS contracts with RACs on a contingency basis to conduct post-payment reviews to detect and correct improper Medicare payments. The ACA expanded the scope of the RAC program to include Medicaid claims by requiring all states to enter into contracts with RACs to audit payments to Medicaid providers. In addition to RACs, other contractors, such as Medicare Administrative Contractors and Medicaid Integrity Contractors, perform payment audits to identify and correct improper payments.

Health Information Privacy and Security Practices

The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) contains provisions that require covered entities, including most healthcare providers, to employ systems and procedures designed to protect individually identifiable health information, known as “protected health information.” Pursuant to HIPAA, HHS has promulgated privacy and security regulations that extensively regulate the use and disclosure of protected

 

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health information and require covered entities to implement administrative, physical and technical safeguards to protect the security of such information. The American Recovery and Reinvestment Act of 2009 (“ARRA”) contains provisions that broaden the scope of the HIPAA privacy and security regulations and strengthen HIPAA’s enforcement provisions. As covered entities under HIPAA, both we and our facilities are required to comply with rules governing the use and disclosure of protected health information and to impose those rules, by contract, on any business associate to which such information is disclosed. In other relationships, such as when we provide management or consulting services to another covered entity, we are subject to the rules applicable under HIPAA and ARRA to business associates. Pursuant to a rule issued to implement ARRA, business associates and their subcontractors are subject to direct liability under the HIPAA privacy and security regulations. In addition, a covered entity may be subject to penalties as a result of its business associate violating the HIPAA privacy and regulations if the business associate is found to be an agent of the covered entity.

As required by ARRA, covered entities must report breaches of unsecured protected health information to affected individuals without unreasonable delay and in no case later than 60 days after the discovery of the breach by the covered entity or its agents. Notification must also be made to HHS and, in certain situations involving large breaches, to the media. HHS is required to publish on its website a list of all covered entities that report a breach involving more than 500 individuals. Pursuant to a rule issued to implement ARRA, HHS has created a presumption that all non-permitted uses or disclosures of unsecured protected health information are breaches unless the covered entity or business associate establishes that there is a low probability the information has been compromised. Various state laws and regulations may also require us to notify affected individuals in the event of a data breach involving individually identifiable information.

Violations of the HIPAA privacy and security regulations may result in civil and criminal penalties. ARRA increased the amount of civil penalties for HIPAA violations, with penalties now ranging up to $50,000 per violation and a maximum civil penalty of $1.5 million in a calendar year for violations of the same requirement. In addition, ARRA authorizes state attorneys general to bring civil actions seeking either injunction or damages in response to violations of HIPAA privacy and security regulations that threaten the privacy of state residents.

States may impose more protective privacy and security laws, and both state and federal laws are subject to modification or enhancement of privacy and security protection at any time. Our facilities will continue to remain subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA. These statutes vary and could impose additional requirements on us and more severe penalties for breaches of privacy.

HIPAA Transactions and Code Sets Standards

HIPAA and its implementing regulations establish electronic data transmission standards that all healthcare providers must use for certain electronic healthcare transactions, such as submitting claims for payment for medical services. The ACA requires the adoption of standards for additional electronic transactions and provides for the creation of operating rules to promote uniformity in the implementation of each standardized electronic transaction.

Under HIPAA, HHS has also published a final rule requiring the use or updated standard code sets for certain diagnoses and procedures known as ICD-10 code sets. Use of the ICD-10 code sets is required beginning October 1, 2014. It is possible that our facilities could experience disruptions or delays in payment due to the implementation of new electronic data transmission standards and the transition to ICD-10 code sets.

Federal Emergency Medical Treatment and Active Labor Act

The federal Emergency Medical Treatment and Active Labor Act (“EMTALA”) applies to our four surgical hospitals. EMTALA requires hospitals participating in the Medicare program, including those without emergency rooms, to evaluate individuals who present with emergencies, provide initial stabilizing treatment and refer or transfer patients where appropriate. Possible liability for a violation of EMTALA includes a civil action by the patient as well as civil monetary penalties and exclusion from participation in the Medicare program.

 

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Antitrust Laws

The federal government and most states have enacted antitrust laws that prohibit certain types of conduct deemed to be anti-competitive. These laws prohibit price fixing, concerted refusal to deal, market monopolization, price discrimination, tying arrangements, acquisitions of competitors and other practices that have, or may have, an adverse effect on competition. Violations of federal or state antitrust laws can result in various sanctions, including criminal and civil penalties. Antitrust enforcement in the healthcare industry is currently a priority of the FTC.

Some of our operating activities are subject to regulation by the antitrust laws. For example, the exchange of pricing information in connection with the creation of a joint venture or an acquisition, the formation of joint ventures with large health systems and the negotiation of our commercial payor contracts by our health system partners are all regulated by the antitrust laws. We undertake to conduct all of our business operations in compliance with these laws. The DOJ and the FTC, the two agencies charged with enforcing the federal antitrust laws, have promulgated a series of “Statements Antitrust Enforcement Policy in Health Care.” These statements provide a series of “safety zones.” A “safety zone” describes conduct that the FTC and the DOJ will not challenge under the antitrust laws, absent extraordinary circumstances. Our activities do not necessarily fall within any of these safety zones. Nevertheless, we believe that our operations are in compliance with the antitrust laws, but courts or regulatory authorities may reach a contrary conclusion, and such a conclusion could adversely affect our operations.

Utilization Review

Federal law contains numerous provisions designed to ensure that services rendered by hospitals to Medicare and Medicaid patients meet professionally recognized standards and are medically necessary and that claims for reimbursement are properly filed. These provisions include a requirement that a sampling of admission of Medicare and Medicaid patients must be reviewed by quality improvement organizations, which review the appropriateness of Medicare and Medicaid patient admissions and discharges, the quality of care provided, the validity of diagnosis related group classifications and the appropriateness of cases of extraordinary length of stay or cost. Quality improvement organizations may deny payment for services provided or assess fines and also have the authority to recommend to HHS that a provider which is in substantial noncompliance with the standards of the quality improvement organization be excluded from participation in the Medicare program.

Employees

As of December 31, 2013, we and our Equity Owned Facilities that we manage employed 1,012 people, 733 of whom were full-time employees and 279 of whom were part-time employees. Of our employees, 145 are corporate employees, primarily based at our headquarters in Oklahoma City, Oklahoma. None of these employees are represented by a union. We believe our relationship with our employees to be good.

A detail of our employees as of December 31, 2013 follows:

 

		Full-Time				Part-Time				Total
Corporate			142				3				145
Consolidated Hospitals			224				74				298
Equity Owned Hospitals			136				42				178
Equity Owned ASCs			231				160				391
Total			733				279				1,012

 

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DESCRIPTION OF PROPERTY

Our corporate headquarters and offices are located in Oklahoma City, Oklahoma. The office facilities consist of an approximately 52,000 square feet medical office building (“OKC MOB”) and are occupied under a master lease agreement, requiring monthly rental payments of $104,000, with annual rate escalations of 2% plus additional payments for our allocable share of the basic expenses. The master lease agreement expires on September 30, 2023. Currently, we occupy 20,800 square feet and sublease the remaining 31,200 square feet under sublease agreements that expire from December 2014 to December 2020. The master lease agreement was executed as part of a transaction in which we simultaneously bought and sold the OKC MOB for $10.6 million and $15.6 million, respectively. Given the disparity between the annual rent expense under the master lease and the rental income of the underlying sub-leases, the gain on the sale of the OKC MOB was deferred and is being recorded on a straight-line basis as a reduction in the rent expense under the master lease. We believe that suitable additional or substitute space will be available as needed on reasonable terms.

As of December 31, 2013, we operated two hospitals in Texas and our Affiliates operated two hospitals in Texas and ten ASCs in six states. Most of the locations are occupied under multiple-year (or long-term) lease arrangements requiring monthly rental payments. The following table presents, as of December 31, 2013, the locations and lease expiration dates of occupancy leases, if applicable, of each facility:

 

Type and Location		Lease Expiration Date
Consolidated Hospitals:
San Antonio, Texas		December 2022
El Paso, Texas		August 2028
Equity Owned Hospitals:
Sherman, Texas		Owned
Houston, Texas		December 2023
Equity Owned ASCs:
Chevy Chase, Maryland		November 2021
Cumberland Valley, Maryland		June 2018
Frederick, Maryland		December 2019
Mercerville, New Jersey		December 2018
Oklahoma City, Oklahoma (located in OKC MOB)		December 2020
Middleburg Heights, Ohio		March 2016
Huntingdon Valley, Pennsylvania		June 2019
Nacogdoches, Texas		Owned
Houston, Texas		July 2015
Houston, Texas		April 2017

 

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LEGAL PROCEEDINGS

From time to time, we are subject to claims and suits arising in the ordinary course of our business, including claims for damages for personal injuries. In our management’s opinion, the ultimate resolution of any of these pending claims and legal proceedings will not have a material adverse effect on our financial position or results of operations.

 

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MANAGEMENT

Directors and Executive Officers

The following table sets forth information regarding our directors and executive officers as of the date of this prospectus:

 

Name		Age		Position with the Company
Thomas Michaud		67		Chairman of the Board
Stanton Nelson		43		Chief Executive Officer and Director
Hubert King		66		Chief Financial Officer
Grant A. Christianson		45		Chief Accounting Officer and Treasurer
Joseph Harroz, Jr.		47		Director
Robert A. Moreno, M.D.(1)(2)(3)		59		Director
Steven L. List(1)(2)(3)		46		Director
Scott R. Mueller(1)(2)(3)		43		Director
Robert M. Byers		67		Advisor to Chairman of the Board

 

(1)	Serves on our Compensation Committee.

(2)	Serves on our Audit Committee.

(3)	Serves on our Nominating and Governance Committee.

Biographical Information

The following is a brief description of the business experience of our executive officers and directors:

Thomas Michaud was appointed as Chairman of the Board, effective July 2013. Mr. Michaud’s responsibilities include marketing the Foundation program to potential surgeon partners, developing new geographic and product markets for the Company, along with medium and long term corporate planning and strategy. Mr. Michaud founded Foundation Surgery Affiliates (“FSA”) in January 1996 and serves as Chief Executive Officer of FSA and Foundation Surgical Hospital Affiliates, LLC, which are wholly-owned subsidiaries of the Company. Prior to founding FSA, Mr. Michaud held the positions of Chief Operating Officer and Chief Financial Officer of a regional surgery center management company. After graduating from Boston College with a Bachelor of Science degree in Accounting, Mr. Michaud earned his CPA certificate while serving as a staff accountant with the international accounting firm, Ernst & Young. Mr. Michaud’s experience also includes a position as a partner in a local CPA firm, acting as Chief Operating Officer of a regional wholesale company, along with holding the upper management positions of Manager of Management Information Systems and Manager of Materials at an aerospace company. Mr. Michaud’s qualifications to serve on our Board of Directors include his service as Foundation’s Chief Executive Officer, his experience in commercial enterprises in diverse industries and his background in public accounting.

Stanton Nelson was named as our Chief Executive Officer in January 2008 and has served as one of our directors since August 2003 and our Chairman of the Board from July 2008 until June 2011. From September 2001 to December 2013, Mr. Nelson served as Executive Vice President of R.T. Oliver Investment Company, a privately-held company engaged in oil and gas exploration, retail and commercial real estate and banking. R.T. Oliver Investments is controlled by Roy T. Oliver, one of our greater than 5% shareholders. Mr. Nelson also serves on the board of directors of Valliance Bank as its Vice Chairman. Previously, from July 1996 to January 2000, Mr. Nelson was the Chief Executive Officer of Monroe-Stephens Broadcasting, a privately-held company that owned and operated radio stations in Southwest Oklahoma and North Texas. Mr. Nelson began his career as a staff member for United States Senator David Boren. Mr. Nelson has a B.B.A. in business management from the University of Oklahoma. Mr. Nelson’s qualifications to serve on our Board of Directors include his service as our Chief Executive Officer, his prior experience as a chief executive officer and his experience in commercial enterprises in diverse industries.

 

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Hubert King was named our Chief Financial Officer on July 1. 2014. From April 2010 to April 2014, Mr. King served as Vice President and Chief Financial Officer of SoutheastHEALTH which is a four hospital system consisting of a tertiary care hospital with three satellite hospital facilities and multiple outpatient facilities. From 2006 to January 2010, Mr. King held various positions with Quorum Health Resources including roles as Chief Executive Officer and Chief Financial Officer of a community hospital in Texas and Chief Operating Officer and Chief Financial Officer of a three hospital health system in California. Mr. King’s career includes other positions as Chief Financial Officer of hospitals and healthcare systems. From 1995 to 1998, Mr. King founded and owned a consulting services company in Florida that was focused on providing consulting services to hospitals. Mr. King began his career in public accounting. Mr. King is a Certified Public Accountant (inactive) and holds a M.B.A. from Southern Methodist University and a B.S.B.A. in accounting from the University of Central Florida.

Grant Christianson was named our Chief Accounting Officer in November 2010 and previously served as our Chief Financial Officer from April 2009 until November 2010. Mr. Christianson has served as Vice President for Finance and Accounting of ApothecaryRx, LLC since August 2006. Prior to becoming Vice President for Finance and Accounting of ApothecaryRx, Mr. Christianson was a principal in a financial operations consulting firm that he founded in 2005. Previously he held financial management positions within Novartis Medical Nutrition and McKesson Medication Management. Mr. Christianson is a member of the American Institute of Certified Public Accountants, and he received a Bachelor of Accountancy from the University of North Dakota.

Joseph Harroz, Jr. has served as one of our directors since December 2007. Mr. Harroz is currently the Dean of the University of Oklahoma, College of Law and Vice President of the University, positions he has held since July 2010. Previously, Mr. Harroz served as our President from July 2008 until June 2010 and our Chief Operating Officer from July 2008 until September 2009. Mr. Harroz served as Vice President and General Counsel of the Board of Regents, University of Oklahoma from 1996 to 2008. He has been the Managing Member of Harroz Investments, LLC (commercial enterprise) since 1998. He is also a member and Chair of the Board of Trustees of Waddell and Reed Ivy Funds (member from 2004 to present; Chair from 2008 to present) and a Trustee of Waddell and Reed Advisors, Ivy VIP and InvestEd Funds (member from 1998 to present; Vice Chair from 2014 to present), both open-ended mutual fund complexes managed by Waddell and Reed. Additionally, he serves as a Director of Valliance Bank (2004 to present), Mewbourne Family Support Organization (2000 to present), and Oklahoma Foundation for Excellence (2008 to present). Mr. Harroz’ qualifications to serve on our Board of Directors include his past experience as our President, as well as his knowledge and expertise as a general counsel and a director of various companies. He is able to provide a depth of knowledge as to best practices in corporate governance as well as provide advice on transactional matters.

Robert A. Moreno, M.D. was appointed one of our directors in July 2013. Dr. Moreno is a practicing physician with over 20 years’ experience in internal medicine and rehabilitative medicine. Dr. Moreno is the President of the El Paso Integrated Physicians Group, which he founded in 1990. Dr. Moreno has served as chief of staff and medical director of numerous hospitals including: Highlands Regional Rehabilitation Hospital, Rio Vista Rehabilitation Hospital and Southwestern General Hospital. Dr. Moreno graduated from University of Texas Medical Branch in 1980 and University of Ciudad Juarez in 1985 with a Doctorate of Medicine. Dr. Moreno’s qualifications to serve on our Board of Directors include his experience in health care as a practicing physician and on other boards of directors. His health care experience is relevant to us in gaining a better understanding of the relationships with our physician partners.

Steven L. List has served as one of our directors since December 2009. Mr. List is a Managing Director at Mount Kellett Asset Management, an investment firm, having joined in April 2012. Previously, Mr. List was a Managing Director at CRG Partners, a financial advisory firm, having joined in February 2011. Mr. List was an independent consultant who provided financial advisory and transaction services to companies from June 2008 to February 2011. Previously, Mr. List was Senior Vice President and Chief Financial Officer of Mattress Giant Corporation from February 2002 to June 2008 and served as a Managing Director of Crossroads, LLC from December 1998 to January 2002. From May 1995 to November 1998, he served as Senior Manager, Corporate Restructuring at KPMG, LLP. Mr. List earned his BBA in accounting from the University of Oklahoma and is a

 

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certified public accountant and certified insolvency and restructuring advisor. Mr. List’s qualifications to serve on our Board of Directors include his experience as a chief financial officer of numerous companies in different industries which is relevant to our business as well as to provide us advice in financial and transactional matters.

Scott R. Mueller has served as one of our directors since July 2008. Mr. Mueller is currently the Chief Financial Officer of American Energy Partners, having joined in March 2013. From October 2011 until March 2013, Mr. Mueller was the Chief Financial Officer for Arcadia Resources, an oil and gas business. Mr. Mueller was a partner at the private equity firm of Hall Capital Partners from July 2009 until October 2011, when he joined Arcadia Resources. Prior to joining Hall Capital Partners, he was a partner at TLW Investments from June 2008 to July 2009. He was employed at Goldman Sachs from 1999 through May 2008, most recently as a vice president in the Private Wealth Management group from 2002 through 2008. Mr. Mueller earned a Masters of Business Administration from the University of Texas in 1999 and graduated from the Honors College at Michigan State University in 1992 with a Bachelor of Arts in General Administration-Pre Law. Mr. Mueller also serves on the board of ProspX, Inc. Mr. Mueller’s qualifications to serve on our Board of Directors include his experience as a chief financial officer as well as his experience in private equity and financial matters which provide us advice in operational, financial and transactional matters.

Robert M. Byers joined us in July 2013 and currently serves as Advisor to the Chairman of the Board, a position he was appointed to in February 2014. Prior to that time, Mr. Byers served as President and Chief Operating Officer of Foundation Surgery Affiliates since February 2001. Prior to 2001, Mr. Byers served as president of an Oklahoma City CPA firm and as chief financial officer of a mortgage company. He has been a licensed Certified Public Accountant for over 40 years. Mr. Byers received a Bachelor of Business Administration degree in Accounting from the University of Oklahoma in Norman and earned his Certified Public Accountant certificate while serving with the international firm of Ernst & Ernst.

Other Involvement in Certain Legal Proceedings

None of our directors or executive officers has been involved in any bankruptcy or criminal proceedings, nor have there been any judgments or injunctions brought against any of our directors or executive officers during the last ten years that we consider material to the evaluation of the ability and integrity of any director or executive officer.

Information Concerning our Board of Directors

Director Independence

Our Board of Directors currently consists of six members, three of whom qualify as independent within the meaning of the listing standards of The NASDAQ Stock Market, Inc. The Board determined that Robert A. Moreno, M.D., Steven L. List and Scott R. Mueller, qualify as independent directors. Dr. Moreno and Messrs. List and Mueller comprise the membership of our Audit Committee, Compensation Committee, and Nominating and Corporate Governance Committee.

Board Committees

Our Board maintains three standing committees: Audit, Compensation, and Nominating and Corporate Governance. The Compensation Committee and Audit Committee were established in January 2008 and the Corporate Governance Committee was established in April 2008. There will, from time to time, be occasions on which the Board may form a new committee or disband a current committee depending upon the circumstances.

All committees report on their activities to our Board and serve at the pleasure of our Board. Each Committee has a written charter, approved by the Board, which describes the Committee’s general authority and responsibilities. Each Committee will undertake an annual review of its charter, and will work with the Board to make such revisions as are considered appropriate.

 

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Each Committee has the authority to engage outside experts, advisors and counsel to the extent it considers appropriate to assist the Committee in its work.

Audit Committee

The Audit Committee, is established in accordance with Section 3(a)(58)(A) of the Exchange Act, is responsible for the selection and retention of our independent auditors, reviews the scope of the audit function of the independent auditors, and reviews audit reports rendered by the independent auditors. All of the members of the Audit Committee are “independent directors” as defined in Rule 5605 of the NASDAQ Stock Market, Inc. marketplace rules (the “NASDAQ rules”), and one member, Scott R. Mueller, serves as the Audit Committee’s financial expert. The Audit Committee is comprised of Robert A. Moreno, M.D. (since August 2013), Steven L. List and Scott R. Mueller (Chair). S. Edward Dakil, M.D., served as a member of our Audit Committee until his resignation in August 2013. During 2013, the Audit Committee met 4 times.

The Audit Committee operates under a written charter adopted by the Board, which is available on the Company’s website at http://www.fdnh.com under “Investor Relations – Corporate Governance.”

Compensation Committee

The Compensation Committee reviews our compensation philosophy and programs, and exercises authority with respect to payment of direct salaries and incentive compensation to our officers. The Compensation Committee is comprised of Robert A. Moreno, M.D. (since August 2013), Steven L. List (Chair) and Scott R. Mueller. S. Edward Dakil, M.D., served as a member of our Compensation Committee until his resignation in August 2013. During 2013, the Compensation Committee met 2 times.

The Compensation Committee operates under a written charter adopted by the Board, which is available on the Company’s website at http://www.fdnh.com under “Investor Relations – Corporate Governance.”

The purpose of the committee shall be to carry out the Board’s overall responsibility relating to executive officer compensation. In furtherance of this purpose, the Compensation Committee shall have the following authority and responsibilities:

 

•

To evaluate candidates for executive positions, including the Chief Executive Officer, and to oversee the development of executive succession plans;

 

•

To review and approve the corporate goals and objectives with respect to compensation for the Chief Executive Officer. The Committee shall evaluate at least once a year, the Chief Executive Officer’s performance in light of these established goals and objectives and based upon these evaluations shall set the Chief Executive Officer’s annual compensation, including salary, bonus, incentive and equity compensation;

 

•

To review and approve on an annual basis the evaluation process and compensation structure for the Company’s executive officers. The committee shall approve the annual compensation, including salary, bonus, incentive and equity compensation, for the Company’s executive officers. The Committee shall also provide oversight of management’s decisions concerning the performance and compensation of other Company officers;

 

•

To review the Company’s incentive compensation plans (including equity and stock option plans) and recommend changes to such plans to the Board as needed. The Committee shall have and shall exercise all the authority of the Board with respect to the administration of such plans;

 

•

To maintain regular contact with the leadership of the Company in order to continually assess and assist with the making of progress towards the Company’s goals and objectives; and

 

•

To prepare and publish an annual executive compensation report in the Company’s proxy statement as required by federal securities laws.

 

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Nominating and Corporate Governance Committee

The Nominating and Corporate Governance Committee (a) monitors and oversees matters of corporate governance, including the evaluation of Board performance and processes and the “independence” of directors, and (b) selects, evaluates and recommends to the Board qualified candidates for election or appointment to the Board. The Nominating and Corporate Governance Committee is comprised of Robert A. Moreno, M.D. (since August 2013), Steven L. List and Scott R. Mueller (Chair). S. Edward Dakil, M.D., served as a member of our Nominating and Corporate Governance Committee until his resignation in August 2013. During 2013, the Nominating and Corporate Governance Committee met 1 time.

The Nominating and Corporate Governance Committee operates under a written charter adopted by the Board, which is available on the Company’s website at http://www.fdnh.com under “Investor Relations – Corporate Governance.”

The responsibilities of the Nominating and Corporate Governance Committee include:

 

•

Formulating, recommending to the Board and overseeing the implementation and administration of the Company’s corporate governance structure and framework;

 

•

Monitoring and reviewing any issues regarding the “independence” of the directors or involving potential conflicts of interest, and evaluating any change of status of directors and making recommendations regarding the propriety of continued service;

 

•

Reviewing the Company’s Code of Conduct at least annually and recommending changes, as necessary, to the Board;

 

•

Reviewing and reporting additional corporate governance matters as necessary or appropriate or as directed by the Chairman of the Board;

 

•

Leading the search for, screening, evaluating and recommending to the Board qualified candidates or nominees for election or appointment as directors;

 

•

Recommending Board committee assignments and committee chairs for consideration by the Board;

 

•

Recommending the number of members that shall serve on the Board; and

 

•

Periodically administering and reviewing with the Board an evaluation of the processes and performance of the Board in order to identify areas of concern or potential issues relating to Board and committee processes, performance and effectiveness and to assess and evaluate the overall effectiveness of individual directors.

 

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EXECUTIVE COMPENSATION

The following Summary Compensation Table sets forth the total compensation paid or accrued of our Chief Executive Officer, our Chief Financial Officer and certain other executive officers for our fiscal years ended December 31, 2013 and 2012 (the “named executive officers”).

 

Name and Principal Position		Year				Salary				Bonus				Stock Awards(1)				Option Awards(2)				All Other Compensation				Total
Stanton Nelson(3)			2013			$	199,000			$	—			$	—			$	—			$	—			$	199,000
Chief Executive Officer			2012				199,000				100,000				—				62,400				—				361,400
Thomas Michaud(6)(7)			2013				263,000				17,000				—				—				51,000				331,000
Chairman, CEO of FSA and FSHA			2012				263,000				15,000				—				—				55,000				333,000
Hubert King(4)			2013				—				—				—				—				—				—
Chief Financial Officer			2012				—				—				—				—				—				—
Mark R. Kidd(5)			2013				120,000				50,000				—				—				—				170,000
Former Chief Financial Officer			2012				96,600				—				7,200				—				—				103,800
Grant A. Christianson			2013				130,900				—				—				—				—				130,900
Chief Accounting Officer			2012				162,000				—				—				—				—				162,000
Robert M. Byers(6)(7)			2013				248,000				17,000				—				—				55,000				320,000
Advisor to Chairman of the Board			2012				248,000				15,000				—				—				29,000				292,000

 

(1)

The value of Stock Awards is the grant date fair value multiplied by the number of shares awarded computed in accordance with FASB ASC Topic 718. For financial reporting purposes, the fair value of the Stock Awards is expensed over the requisite vesting period for the award. The assumptions the Company used for calculating the grant date fair values are set forth in Note 15 to the Company’s consolidated financial statements for the year ended December 31, 2013, which are included herein.

(2)

The value of Option Awards is the aggregate grant date fair value computed in accordance with FASB ASC Topic 718. For financial reporting purposes, the fair value of the Option Awards is expensed over the requisite vesting period for the award. The assumptions the Company used for calculating the grant date fair values are set forth in Note 15 to the Company’s consolidated financial statements for the year ended December 31, 2013, which are included herein.

(3)	Mr. Nelson’s salary and bonus for 2012 includes $165,800 and $100,000, respectively, in compensation that was earned in 2012 but not paid by the Company until 2013.

(4)	Mr. King was appointed as our Chief Financial Officer on July 1, 2014.

(5)	Mr. Kidd served as our Chief Financial Officer from May 14, 2012 to June 30, 2014. Mr. Kidd will remain as and has previously served as our SEC Reporting Manager from July 2008 to May 2012 and our Chief Financial Officer from August 2003 to July 2008.

(6)

The compensation information reported for Messrs. Michaud and Byers includes compensation received by the individuals from the Foundation Entities prior to our July 2013 acquisition and as such, was not considered compensation awarded by us. The compensation information reported for Messrs. Michaud and Byers subsequent to July 22, 2013, the acquisition date, and awarded by us to the individuals is approximately $156,000 and $151,000, respectively.

(7)

While employed by the Foundation Entities, prior to September 2012, Messrs. Michaud and Byers were under a vacation policy that provided for unlimited accrual of paid-time off. In September 2012, the Foundation Entities transitioned to a vacation policy that limited the amount that could be carried forward. The amount of accrued paid-time off that was owed to Messrs. Michaud and Byers at that time is being paid out over a three-year period and is reported under “All Other Compensation” in this table.

 

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Outstanding Equity Awards at Fiscal Year-End

The following table sets forth information related to equity awards held by our named executive officers as of December 31, 2013. During 2013, no options to purchase our common stock were exercised by the named executive officers.

 

		Outstanding Equity Awards at December 31, 2013
		Option Awards																Stock Awards
		Number of Common Stock Underlying Options								Option Exercise Price				Option Expiration Date				Number of Shares of Stock That Have Not Vested				Market Value of Shares of Stock That Have Note Vested
Name		Exercisable				Unexercisable
Stanton Nelson(1)			330,000				—			$	0.50				3/30/2022				—			$	—
Thomas Michaud			—				—			$	—				—				—			$	—
Hubert King(2)			—				—			$	—				—				—			$	—
Mark R. Kidd			—				—			$	—				—				—			$	—
Grant A. Christianson			—				—			$	—				—				—			$	—
Robert M. Byers			—				—			$	—				—				—			$	—

 

(1)

On March 30, 2012, Mr. Nelson was granted options to purchase 330,000 shares of the Company’s common stock at $0.50 per share. The option grant had six tranches of 55,000 shares each that vested based on the passage of time and/or the achievement of certain performance targets by the Company. On July 22, 2013, a change of control provision within Mr. Nelson’s option award was triggered as a result of the acquisition of the Foundation Entities and all of his options became vested.

(2)	Mr. King was appointed as our Chief Financial Officer on July 1, 2014 and was awarded, subject to the approval of the Company’s Board of Directors, a stock grant of 1,000,000 shares of the Company’s common stock. The stock award vests over a five year period beginning on January 1, 2015.

Employment Arrangements with Named Executive Officers

We have entered into an employment agreement with Stanton Nelson, our Chief Executive Officer. We originally entered into such agreement effective October 1, 2009, and the agreement was subsequently amended and restated on April 6, 2012. The material terms of this employment agreement, as amended to such date, are summarized below.

Initial Employment Agreement with Stanton Nelson

Effective October 1, 2009, we entered into an employment agreement with Mr. Nelson to serve as either or both the Chief Executive Officer and Chairman of the Board of Directors of the Company. Mr. Nelson’s agreement is for an initial three-year term, and automatically extends for additional three year periods, unless earlier terminated in accordance with its terms or we notify him within 120 days of termination date that the term will not be extended. The employment of Mr. Nelson is full time and may be terminated by him or the Company with or without cause. Except to a limited extent and as expressly permitted by our Board of Directors, Mr. Nelson is prohibited from serving as an officer or director of a publicly-held company or owning an interest in a company that interferes with his full-time employment or that is engaged in a business activity similar to our business. Mr. Nelson is to receive a base salary of $1.00, and is eligible to be paid bonus compensation, if any, as determined in the absolute discretion of the Company. In addition, upon execution of the employment agreement, and on October 1 of each year during the term of his employment agreement, Mr. Nelson shall be granted a fully vested stock award of 100,000 shares of the Company’s common stock pursuant to the Company’s Amended 2008 Plan. Mr. Nelson is eligible for participation in any and all benefit programs that the Company makes available to its employees, including health, dental and life insurance to the extent that he meets applicable eligibility requirements. Mr. Nelson is entitled to four weeks paid vacation yearly. We have the right to terminate Mr. Nelson’s agreement without cause for any reason, and Mr. Nelson may terminate his employment for cause, in either case on at least 30-day advance notice. In the event of termination without cause by us or termination by

 

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Mr. Nelson for cause, Mr. Nelson is entitled to a grant of 300,000 shares of fully vested common stock under our Amended 2008 Plan, reduced by any amounts of common stock already granted to him pursuant to his employment agreement, issued in 24 equal installments, plus eligibility in health and certain other benefit plans for 12 months from termination.

Amended and Restated Employment Agreement with Stanton Nelson

The amended employment agreement with Mr. Nelson replaces his prior employment agreement that became effective on October 1, 2009. Under the terms of the amended agreement, Mr. Nelson will continue to serve as Chief Executive Officer of the Company. Mr. Nelson’s employment is “at will” and may be terminated at any time by Mr. Nelson or the Company, subject to the terms of the amended agreement. Except to a limited extent and as expressly permitted by our Board of Directors, Mr. Nelson is prohibited from serving as an officer or director of a publicly-held company or owning an interest in a company that interferes with his full-time employment or that is engaged in a business activity similar to our business. Mr. Nelson will receive a base salary of $199,000, which may be increased in the discretion of the Compensation Committee of the Board of Directors of the Company. Mr. Nelson is eligible for participation in any and all benefit programs that the Company makes available to its employees, including health, dental and life insurance to the extent that he meets applicable eligibility requirements. Mr. Nelson is entitled to four weeks paid vacation yearly. We have the right to terminate Mr. Nelson’s agreement without cause for any reason, and Mr. Nelson may terminate his employment for cause, in either case on at least 30-days advance notice. In the event of termination without cause by us or termination by Mr. Nelson for cause, Mr. Nelson shall be entitled to a payment equal to 18-months of his most recent base salary plus eligibility in health and certain other benefit plans for 18 months from termination.

In addition, Mr. Nelson agreed that, during the 24 months following termination of his employment, he will:

 

•

Not acquire, attempt to acquire, solicit, perform services (directly or indirectly) in any capacity for, or aid another in the acquisition or attempted acquisition of an interest in any business involved in providing sleep disorder diagnostic services, sleep therapy or re-supply services in any city in the United States where the Company or any of its affiliates owns a sleep center, or that is within 40 miles of a sleep center location owned by the Company or any of its affiliates;

 

•

Not solicit, induce, entice or attempt to entice (directly or indirectly) any employee, officer or director (except the executive officer’s personal secretary, if any), contractor, customer, vendor or subcontractor of the Company or any of its affiliates, or breach any relationship with the Company or any of its affiliates; and

 

•

Not solicit, induce, entice or attempt to entice any customer, vendor or subcontractor of the Company or any of its affiliates to cease doing business with the Company or any of its affiliates.

The foregoing summary of the Amended and Restated Employment Agreement is qualified in its entirety by reference to the exhibit incorporated by reference hereto.

Compensation of Directors

During 2013, we did not compensate our directors for service on our Board of Directors or for attending meetings of our Board of Directors or any of its committees, other than Ms. Jamie Hopping. Pursuant to an agreed-upon arrangement, we compensated our former Chairman of the Board, Ms. Jamie Hopping, $10,000 per month for services provided in her capacity as Chairman but do not have such an arrangement in place with our current Chairman. From January 2013 until her resignation in July 2013, Ms. Hopping earned $70,000 for her services as Chairman. We reimburse our independent directors for travel and out-of-pocket expenses in connection with their attendance at meetings of our Board of Directors.

 

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Director Compensation Table

 

		Fees Earned or Paid in Cash				Stock Awards				Option Awards				All Other Compensation				Total
Thomas Michaud(1)		$	—			$	—			$	—			$	—			$	—
Jamie Hopping (former Chairman of the Board)(2)		$	70,000			$	—			$	—			$	—			$	70,000	(3)
Scott R. Mueller		$	—			$	—			$	—			$	—			$	—
Steven L. List		$	—			$	—			$	—			$	—			$	—
Joseph Harroz, Jr.		$	—			$	—			$	—			$	—			$	—
Robert A. Moreno, M.D.(1)		$	—			$	—			$	—			$	—			$	—
S. Edward Dakil, M.D. (former Director)(2)		$	—			$	—			$	—			$	—			$	—

 

(1)	Mr. Michaud and Dr. Moreno were elected to the Board on July 22, 2013.

(2)	Ms. Hopping and Dr. Dakil each respectively resigned from the Board on July 22, 2013.

(3)

Ms. Hopping earned $70,000 for her services as Chairman during the period of January – July 2013. At the time of Ms. Hopping’s resignation in July 2013, the Company owed her $130,000 for fees earned but not paid. This information is not included in the total compensation above as it was compensation earned prior to 2013. In October 2013, we issued Ms. Hopping 100,000 shares of common stock and agreed to pay her $90,000 in settlement of the amount owed to her. We no longer have any outstanding obligations owed to Ms. Hopping.

Agreement with Jamie Hopping

We entered into a Chairman of the Board Agreement with our former Chairman, Ms. Jamie Hopping, pursuant to which she was paid a fee of $10,000 per month for serving as Chairman of the Board and attending meetings of our Board. We also reimbursed Ms. Hopping, along with our other independent directors, for travel and out-of-pocket expenses in connection with their attendance at meetings of our Board. When Ms. Hopping resigned in July 2013, we owed her $130,000 for fees that had been earned under the agreement but not been paid by us. In October 2013, we issued Ms. Hopping 100,000 shares of common stock and agreed to pay her $90,000 in settlement of the amount owed to her. We no longer have any outstanding obligations owed to Ms. Hopping.

Equity Compensation Plans

For the benefit of our employees, directors and consultants, we have adopted the Amended and Restated 2008 Long-Term Incentive Plan, or Amended 2008 Plan. The following is a summary of the existing terms of the Amended 2008 Plan.

We have submitted a proposal to amend and restate certain terms of the Amended 2008 Plan for shareholder approval at our 2014 Annual Meeting of Shareholders to be held on May 12, 2014. Approval of the proposed amendment and restatement of our Amended 2008 Plan is intended to (i) increase the number of shares of common stock authorized for issuance under the plan by 17,250,000 to 20,000,000 (there are currently 2,750,000 shares of common stock reserved and only 696,208 shares remain available), (ii) to amend the maximum award of stock options, stock awards, stock appreciation rights or performance units under the Amended 2008 Plan so that no individual can receive awards covering more than 10,000,000 shares of common stock in any year and amend the maximum award of a performance bonus so that no individual may receive a performance bonus valued at more than $2,500,000 for any calendar year period; and (iii) to correct minor administrative and typographical errors.

The Amended and Restated 2008 Long-Term Incentive Plan. The Amended 2008 Plan was established to create equity compensation incentives designed to motivate our directors and employees to put forth maximum effort toward our success and growth and enable our ability to attract and retain experienced individuals who by their position, ability and diligence are able to make important contributions to our success. The Amended 2008 Plan provides for the grant of stock options, including incentive stock options (within the meaning of Section 422 of

 

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the Internal Revenue Code of 1986, as amended (the “Code”)), restricted stock awards, performance units, performance bonuses and stock appreciation rights to our employees and the grant of nonqualified stock options, stock appreciation rights and restricted stock awards to non-employee directors, subject to the conditions of the Amended 2008 Plan (“Incentive Awards”). The number of shares of common stock currently authorized and reserved for issuance under the Amended 2008 Plan is 2,750,000, notwithstanding the proposed amended terms of the Plan.

For purposes of administration of the Amended 2008 Plan, it is deemed to consist of three separate incentive plans, a Non-Executive Officer Participant Plan, an Executive Officer Participant Plan and a Non-Employee Director Participant Plan. Except for administration and the category of employees eligible to receive incentive awards, the terms of the Non-Executive Officer Participant Plan and the Executive Officer Participant Plan are identical. The Non-Employee Director Plan has other variations in terms and only permits the grant of nonqualified stock options and restricted stock awards. The Amended 2008 Plan is designed to provide flexibility to meet our needs in a changing and competitive environment while minimizing dilution to our shareholders. We do not intend to use all incentive elements of the Amended 2008 Plan at all times for each participant but will selectively grant the incentive awards and rights to achieve long-term goals.

The Amended 2008 Plan became effective on October 29, 2008 and was approved and adopted by our Board of Directors, as amended, on March 30, 2012 and by our shareholders on May 14, 2012. The Amended 2008 Plan has a 10-year term, ending October 29, 2018, during which time incentive awards may be granted. The Amended 2008 Plan will continue in effect until all matters relating to the payment of incentive awards and administration are settled.

 

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SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS

The following table sets forth as of December 31, 2013, information related to each category of equity compensation plan approved or not approved by our shareholders, including individual compensation arrangements with our non-employee directors. The equity compensation plan approved by our shareholders is our Amended & Restated 2008 Long-Term Incentive Plan (“2008 Incentive Plan”). All stock options and rights to acquire our equity securities are exercisable for or represent the right to purchase our common stock.

 

Plan category		Number of securities to be issued upon exercise of outstanding options, warrants and rights				Weighted- average exercise price of outstanding options, warrants and rights				Number of securities remaining available for future issuance under equity compensation plans
Equity compensation plans approved by security holders:
2008 Incentive Plan			1,125,000			$	0.76				796,208
Equity compensation plans not approved by security holders:
Warrants issued to investor relation firm			75,000			$	0.50				—
Options issued to directors			25,000			$	3.65				—
Total			1,225,000			$	0.80				796,208

 

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CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

Our policies with respect to related party transaction are included in more general conflict of interest policies and practices set forth in our Code of Conduct.

Our Code of Conduct prohibits conflicts involving family members, ownership in outside businesses, and outside employment. Our directors, officers and employees and their family members are not permitted to own, directly or indirectly, a significant financial interest in any business enterprise that does or seeks to do business with, or is in competition with, us unless prior specific written approval has been granted by our Board of Directors. As a guide, “a significant financial interest” refers to an ownership interest of more than 1% of the outstanding securities or capital value of the business enterprise or that represents more than 5% of the total assets of the director, officer, employee or family member.

Our Nominating and Corporate Governance Committee is charged with reviewing conflicts of interests. If the matter cannot be resolved by the committee, our Board of Directors may take action, or in the case of a conflict among all or nearly all of the members of our Board of Directors, the matter may be brought to our shareholders.

Contained below is a description of transactions and proposed transactions we entered into with our officers, directors and shareholders that beneficially own more than 5% of our common stock during 2013 and 2012. These transactions will continue in effect and may result in conflicts of interest between us and these individuals. Although our officers and directors have fiduciary duties to us and our shareholders, there can be no assurance that conflicts of interest will always be resolved in favor of us and our shareholders.

Effective June 1, 2014, our Equity Owned Hospital in El Paso, Texas entered into a sublease agreement with The New Sleep Lab International, Ltd., referred to as New Sleep. New Sleep is controlled by Dr. Robert Moreno, one of our Directors. The sublease with New Sleep calls for monthly rent payments of $8,767 and the sublease expires on November 30, 2018. The space subleased from New Sleep will be sublet to physician partners and casual uses of our hospital and is located in a building that also houses one of our imaging facilities.

On August 31, 2012, December 31, 2012, March 1, 2013, April 2, 2013 and July 22, 2013, we executed promissory notes with Mr. Roy T. Oliver in the amount of $1,184,808, $351,710, $485,082, $351,710 and $5,648,290, respectively, for a total of $8,021,600 (the “Oliver Notes”). The interest rate on the notes was 8% and the maturity dates of the notes were July 31, 2013. All principal and interest outstanding were due on the maturity date. Mr. Oliver is one of our greater than 5% shareholders and affiliates and also held such status at the time of each transaction. The promissory notes were subordinate to our credit facility with Arvest Bank. We used the proceeds from the notes to fund our payment obligations to Arvest Bank. On July 22, 2013, we issued Mr. Oliver 17,970,295 shares of common stock for full satisfaction of the Oliver Notes including principal and accrued interest owed thereon of $114,263. No underwriters were involved.

In October 2013, we and our wholly-owned subsidiary, Foundation Health Enterprises, LLC (“FHE”) completed a private placement offering $9,135,000. The offering was comprised of 87 units (“FHE Unit” or “preferred noncontrolling interest”). Each FHE Unit was offered at $105,000 and entitled the purchaser to one (1) Class B membership interest in FHE, valued at $100,000, and 10,000 shares of the Company’s common stock, valued at $5,000. Mr. Stanton Nelson, our chief executive officer, purchased 5 FHE units for $525,000.

As of December 31, 2013 and 2012, we had approximately $2.2 million and $33,000 on deposit at Valliance Bank. Valliance Bank is controlled by Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates. In addition, we are obligated to Valliance Bank under certain notes payable totaling approximately $5.9 million and $0.8 million at December 31, 2013 and 2012, respectively. The interest rates on the notes range from 5% to 10%. Non-controlling interests in Valliance Bank are held by Mr. Stanton Nelson, our Chief Executive Officer and Mr. Joseph Harroz, Jr., one of our directors. Mr. Nelson and Mr. Harroz also serve as directors of Valliance Bank.

 

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In March 2012, we executed a lease agreement with City Place, LLC (“City Place”) for our new corporate headquarters and offices. Under the lease agreement, we pay monthly rent of $17,970 through June 30, 2014; $0.00 from July 1, 2014 to January 31, 2015 and $17,970 from February 1, 2015 to March 31, 2017 plus additional payments for allocable basic expenses of City Place. The lease expires on March 31, 2017. As part of the lease agreement, City Place paid $450,000 to offset a portion of the costs we incurred to build-out the office space. Non-controlling interests in City Place are held by Roy T. Oliver, one of our greater than 5% shareholders and affiliates, and Mr. Stanton Nelson, our Chief Executive Officer. During 2013 and 2012, we incurred approximately $70,000 in lease expense under the terms of the lease.

Our previous corporate headquarters and offices were occupied under a month to month lease with Oklahoma Tower Realty Investors, LLC, requiring monthly rental payments of approximately $7,000. Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates, controls Oklahoma Tower Realty Investors, LLC (“Oklahoma Tower”). During 2012, we incurred approximately $21,000 in lease expense under the terms of the lease. In addition, during 2012, we paid Oklahoma Tower approximately $42,000 for employee parking under a month to month agreement.

We have received cash advances from FHA and certain real estate subsidiaries and affiliates of FHA (“FHA Real Estate”). As of December 31, 2013, we owed FHA Real Estate approximately $1.0 million.

On October 1, 2012, we entered into a purchase agreement to acquire 100% of the membership interests of Midwest Sleep Specialists (“MSS”) located in Kansas City, Missouri, for a purchase price of $720,000. The membership interests of MSS are currently held by Dr. Steven Hull, our Chief Medical Officer. Under the agreement, the purchase price was to be paid in semi-monthly installments of $15,000 commencing on October 18, 2012 and ending on September 30, 2014 (the “Transfer Date”). Under the agreement, the membership interests will not be transferred to us until the final payment is made on the Transfer Date. Prior to the Transfer Date, we do not have any control over the operation of MSS. In addition, we are not obligated to continue to make the semi-monthly payments and may rescind the agreement at any time. As a result, we would not record the MSS purchase until the Transfer Date. As of June 30, 2013, we had incurred cumulative semi-monthly payments of $300,000. In July 2013, we exercised our right to rescind the agreement. As a result, the installment payments made to date were written-off.

On October 1, 2012, we entered into a management services agreement with MSS to provide certain administrative staffing and other support to the back office operations of MSS. MSS is owned by Dr. Steven Hull, our Chief Medical Officer. The term of the management services agreement is five years and renews automatically for successive five year periods unless either party provides 90 day written notice of termination. Additionally, the management services agreement will automatically terminate upon the Transfer Date. We have received approximately $64,000 in management fees since October 1, 2012 under this agreement. Prior to the current agreement, we provided similar services to MSS under other arrangements. Under the previous arrangements, the total management fees received from MSS during 2012 were approximately $298,000.

 

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PRINCIPAL STOCKHOLDERS

The following table presents certain information regarding the beneficial ownership of our common stock as of June 30, 2014, of (i) the only persons known by us to own beneficially more than 5% of our common stock; (ii) each of our current directors and executive officers; and (iii) all of our executive officers and directors as a group, together with their percentage holdings of the beneficially owned outstanding shares. All persons listed have sole voting and investment power with respect to their shares unless otherwise indicated in the applicable footnotes, subject to community property laws, where applicable. For purposes of the table, the number of shares and percent of ownership of outstanding common stock that the named person beneficially owns includes common stock shares that the named person has the right to acquire within 60 days following June 30, 2014 (pursuant to exercise of stock options, warrants or conversion rights) and are deemed to be outstanding, but are not deemed to be outstanding for the purposes of computing the number of shares beneficially owned and percent of outstanding common stock of any other named person.

 

Name and Address of Beneficial Owner		Shares Owned of Record				Rights to Acquire				Total Shares				Ownership Percentage (1)
Foundation Healthcare Affiliates, LLC(5)			114,500,000				—				114,500,000				66.8	%
Oliver Company Holdings, LLC(2)			17,926,957				431,035				18,357,992				10.7	%
Arvest Bank(6)			13,333,333				—				13,333,333				7.8	%
Thomas Michaud(3)(4)			—				—				—				—	%
Stanton Nelson(3)(4)			8,247,547				330,000				8,577,547				5.0	%
Joseph Harroz, Jr.(3)(4)			110,350				—				110,350				*	%
Scott R. Mueller(3)(4)			103,546				—				103,546				*	%
Steven L. List(3)(4)			80,000				—				80,000				*	%
Robert A. Moreno, M.D.(3)(4)			261,000				—				261,000				*	%
Hubert King(3)(4)(7)			—				—				—				*	%
Mark R.Kidd(3)(4)(8)			20,000				—				20,000				*	%
Grant A. Christianson(3)(4)			24,540				—				24,540				*	%
Robert M. Byers(3)(4)			—				—				—				—	%
Executive Officers and Directors as a group (9 individuals)			8,846,983				330,000				9,176,983				5.2	%

 

*	Represents less than one percent (1.0%) of the outstanding shares of common stock.

(1)	Percentages are rounded to the nearest one percent, based upon 171,899,181 shares of common stock outstanding.

(2)

Includes (i) 50,000 shares held by Mr. Roy T. Oliver and (ii) 17,455,322 shares held by Oliver Company Holdings, LLC and 431,035 shares held by Valiant Investments, LLC. Valiant Investments, LLC hold warrants exercisable for 431,035 shares. Mr. Oliver has voting and investment power over the shares held by Oliver Company Holdings, LLC and Valiant Investments, LLC, and therefore may be deemed to beneficially own such shares. The business address of each of Oliver Company Holdings, LLC and Roy T. Oliver is 101 North Robinson, Ste. 900, Oklahoma City, Oklahoma 73102.

(3)	The named person is an executive officer or a director or both.

(4)	The business address of such person is 14000 N. Portland Ave., Ste. 200, Oklahoma City, Oklahoma 73134.

(5)

The business address of Foundation Healthcare Affiliates, LLC (FHA) is 14000 N. Portland Ave., Ste. 204, Oklahoma City, Oklahoma 73134. FHA is governed by a board of directors that includes five members. Messrs. Michaud and Byers are both on the board of FHA and own 36% and 11%, respectively, of FHA.

(6)	The business address of Arvest Bank is 5621 N. Classen Blvd., Oklahoma City, Oklahoma 73118.

(7)	Mr. King was appointed as our Chief Financial Officer on July 1, 2014 and was awarded a stock grant, subject to approval by the Company’s board of directors, of 1,000,000 shares of the Company’s common stock. The stock award vests over a five year period beginning on January 1, 2015.

(8)	Mr. KIDD Resigned his position as our Chief Financial Officer on July 1, 2014.

 

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DESCRIPTION OF CAPITAL STOCK

The following is a summary of the material terms of our capital stock and provisions of our amended and restated certificate of incorporation and amended and restated bylaws. This summary does not purport to be complete and is qualified in its entirety by the provisions of our amended and restated certificate of incorporation and amended and restated bylaws, copies of which will be filed as exhibits to the registration statement of which this prospectus is a part. Our authorized capital stock consists of 500,000,000 shares of common stock, par value $0.0001 per share, [*] shares of which were outstanding as of [*], and 10,000,000 shares of preferred stock, par value $0.0001 per share, none of which are outstanding.

Proposed Reverse Stock Split

On February 17, 2014, our Board of Directors approved a reverse stock split in one of eight ratios, namely 1-for-3, 1-for-4, 1-for-5, 1-for-6, 1-for-7, 1-for-8, 1-for-9, or 1-for-10 shares, with the final ratio to be determined by the Board following shareholder approval. We received shareholder approval at our 2014 Annual Meeting of Shareholders held on May 12, 2014. We intend to effect a 1-for-[    ] reverse stock split of our common stock after the close of business on [        ]. In determining a reverse stock split ratio of 1-for-[    ], the Board of Directors considered a ratio that would allow us to have a number of outstanding shares to have a sufficient trading volume while considering a stock price that would be consistent with an uplist of our common stock from OTC Markets QB Tier to a listing on the [        ] exchange. Our Board of Directors determined that a ratio of 1-for-[    ] was the best balance of these various factors.

Common Stock

The rights, privileges, disabilities and restrictions in general of the holders of our outstanding shares of the common stock are as follows:

 

•

the right to receive ratably dividends, if any, as may be declared from time to time by the Board of Directors out of assets legally available therefor, subject to the payment of preferential dividends with respect to our then outstanding preferred stock;

 

•

the right to share ratably in all assets available for distribution to the common stock shareholders after payment of our liabilities in the event of our liquidation, dissolution and winding-up, subject to the prior distribution rights of the holders of our then outstanding preferred stock;

 

•

the right to one vote per share on matters submitted to a vote by our common stock shareholders;

 

•

no preferential or preemptive right and no subscription, redemption or conversion privilege with respect to the issuance of additional shares of our common stock; and

 

•

no cumulative voting rights, which means that the holders of a majority of shares voting for the election of directors can elect all members of our Board of Directors then subject to election.

In general, a majority vote of shares represented at a meeting of common stock shareholders at which a quorum (a majority of the outstanding shares of common stock) is present, is sufficient for all actions that require the vote or concurrence of shareholders, subject to and possibly in connection with the voting rights of the holders of our then outstanding preferred stock and entitled to vote with the holders of our common stock. Upon issuance of the common stock offered under the offering, all of the outstanding shares of our common stock will be fully paid and non-assessable.

Preferred Stock

Our authorized preferred stock may be issued from time to time in one or more series. Our Board of Directors, without further approval of the common stock shareholders, is authorized to fix the relative rights, preferences, privileges and restrictions applicable to each series of our preferred stock. We believe that having this class of

 

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preferred stock provides greater flexibility in financing, acquisitions and other corporate activities. While there are no current plans, commitments or understandings, written or oral, to issue any of our preferred stock, in the event of any issuance, our common stock shareholders will not have any preemptive or similar rights to acquire any of the preferred stock. Issuance of preferred stock could adversely affect the voting power of the holders of our then outstanding common stock, the likelihood that the holders will receive dividend payments and payments upon liquidation and could have the effect of delaying or preventing a change in shareholder and management control.

Transfer Agent and Registrar

Computershare is the registrar and transfer agent of our common stock. The mailing address for Computershare is P.O. Box 43078, Providence, RI 02940.

Shareholder Action

Under our bylaws, the affirmative vote of the holders of a majority of the shares of the common stock voted at a meeting of shareholders is sufficient to authorize, affirm, ratify or consent to any act or action required of or by the holders of the common stock, except as otherwise provided by the Oklahoma General Corporation Act.

Under the Oklahoma General Corporation Act, our shareholders may take actions by written consent without holding a meeting. The written consent must be signed by the holders of a sufficient number of shares to approve the act or action had all of our outstanding shares of capital stock entitled to vote thereon been present at a meeting. In this event, we are required to provide prompt notice of any corporate action taken without a meeting to our shareholders who did not consent in writing to the act or action. However, any time that we have 1,000 or more shareholders of record, any act or action required of or by the holders of our capital stock entitled to vote thereon may only be taken by unanimous affirmative written consent of the shareholders or a shareholder meeting.

Anti-Takeover Provisions

Our certificate of incorporation and the Oklahoma General Corporation Act include a number of provisions that may have the effect of encouraging persons considering unsolicited tender offers or other unilateral takeover proposals to negotiate with our Board of Directors rather than pursue non-negotiated takeover attempts. We believe that the benefits of these provisions outweigh the potential disadvantages of discouraging the proposals because, among other things, negotiation of the proposals might result in an improvement of the takeover terms. The description below related to provisions of our certificate of incorporation is intended as a summary only and is qualified in its entirety by reference to our certificate of incorporation. Our certificate of incorporation authorizes the issuance of the preferred stock in classes. Our Board of Directors is authorized to set and determine the voting rights, redemption rights, conversion rights and other rights relating to the class of preferred stock. In some circumstances, the preferred stock could be issued and have the effect of preventing a merger, tender offer or other takeover attempt which our Board of Directors opposes.

 

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UNDERWRITING

We intend to enter into an underwriting agreement with [*] in connection with this offering. Subject to certain conditions, we have agreed to sell to the underwriter, and the underwriter has agreed to purchase from us, at the public offering price less the underwriting discounts and commissions set forth on the cover page of this prospectus and [*] shares of our common stock.

The underwriting agreement provides that the obligation of the underwriter to purchase the shares offered hereby is subject to certain conditions and that the underwriter is obligated to purchase all of the shares of common stock offered hereby if any of the shares are purchased.

The underwriter proposes to offer to the public the shares of common stock purchased pursuant to the underwriting agreement at the public offering price on the cover page of this prospectus. After the shares are released for sale to the public, the underwriter may change the offering price and other selling terms at various times.

Over-Allotment Option

If the underwriter sells more than [*] in offering, the underwriter has an option for [*] days to buy up to an additional [*] shares from us at the public offering price, less the underwriting commissions and discounts, to cover these sales.

Discounts, Commissions and Expenses

In connection with the sale of the shares of common stock to be purchased by the underwriter, the underwriter will be deemed to have received compensation in the form of underwriting commissions and discounts.

The following table summarizes the compensation and estimated expenses we will pay in connection with this offering:

 

Per Share Common Stock

Total

Without over- allotment

With over- allotment

Underwriting discounts and commissions, paid by us

$

[

*]

$

[

*]

$

[

*]

We estimate that total expenses payable by us in connection with this offering, excluding underwriting discounts and excluding a corporate financing fee payable to [*] will be approximately $[*].

Lock-Up Agreements

We have agreed, subject to certain exceptions, not to offer, sell, contract to sell or otherwise issue any shares of common stock or securities exchangeable or convertible into common stock, without the prior written consent of [*], for a period of [*] days, subject extension under certain circumstances, following the date of this prospectus. In addition, all of our executive officers and directors and certain of our greater than 5% shareholders have entered into a lock-up agreement with the underwriter. Under the lock-up agreement, subject to certain exceptions, we may not, directly or indirectly, offer, sell, contract to sell, pledge (other than in connection with Company financings) or otherwise dispose of or hedge any common stock or securities convertible into or exchangeable for shares of common stock, or publicly announce to do any of the foregoing, without the prior written consent of [*], for a period of [*] days from the date of this prospectus, subject to extension under certain circumstances.

 

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Indemnification

Pursuant to the underwriting agreement, we have agreed to indemnify the underwriter against certain liabilities, including liabilities under the Securities Act, or to contribute to payments which the underwriter or such other indemnified parties may be required to make in respect of any such liabilities.

Other Relationships

The underwriter and its affiliates have provided, and may in the future provide, various investment banking, commercial banking and other financial services for us for which services they have received, and may receive in the future, customary fees.

Price Stabilization, Short Positions and Penalty Bids

In connection with the offering the underwriters may engage in stabilizing transactions, over-allotment transactions, syndicate covering transactions and penalty bids in accordance with Regulation M under the Exchange Act.

Stabilizing transactions permit bids to purchase the underlying security so long as the stabilizing bids do not exceed a specified maximum.

 

•

Over-allotment involves sales by the underwriters of shares in excess of the number of shares the underwriters are obligated to purchase, which creates a syndicate short position. The short position may be either a covered short position or a naked short position. In a covered short position, the number of shares over-allotted by the underwriters is not greater than the number of shares that they may purchase in the over-allotment option. In a naked short position, the number of shares involved is greater than the number of shares in the over-allotment option. The underwriters may close out any covered short position by either exercising their over-allotment option and/or purchasing shares in the open market.

 

•

Syndicate covering transactions involve purchases of the common stock in the open market after the distribution has been completed in order to cover syndicate short positions. In determining the source of shares to close out the short position, the underwriters will consider, among other things, the price of shares available for purchase in the open market as compared to the price at which they may purchase shares through the over-allotment option. A naked short position occurs if the underwriters sell more shares than could be covered by the over-allotment option. This position can only be closed out by buying shares in the open market. A naked short position is more likely to be created if the underwriters are concerned that there could be downward pressure on the price of the shares in the open market after pricing that could adversely affect investors who purchase in the offering.

 

•

Penalty bids permit the representative to reclaim a selling concession from a syndicate member when the common stock originally sold by the syndicate member is purchased in a stabilizing or syndicate covering transaction to cover syndicate short positions.

These stabilizing transactions, syndicate covering transactions and penalty bids may have the effect of raising or maintaining the market price of our common stock or preventing or retarding a decline in the market price of the common stock. As a result, the price of our common stock may be higher than the price that might otherwise exist in the open market. These transactions may be discontinued at any time.

Electronic Distribution

This prospectus may be made available in electronic format on the Internet sites or through other online services maintained by the underwriter participating in the offering or by its affiliates. In those cases, prospective

 

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investors may view offering terms online and prospective investors may be allowed to place orders online. Other than the prospectus in electronic format, the information on the underwriter’s or our website and any information contained in any other website maintained by the underwriter or by us is not part of the prospectus or the registration statement of which this prospectus form a part, has not been approved and/or endorsed by us or the underwriter in its capacity as underwriter and should not be relied upon by investors.

Listing

Our common stock is quoted on the OTCQB, the OTC market tier for companies that report to the SEC, under the symbol, “FDNH.”

Selling Restrictions

No action has been taken in any jurisdiction (except in the United States) that would permit a public offering of our common stock, or the possession, circulation or distribution of this prospectus or any other material relating to us or our common stock in any jurisdiction where action for that purpose is required. Accordingly, shares of our common stock may not be offered or sold, directly or indirectly, and neither this prospectus nor any other offering material or advertisements in connection with our common stock may be distributed or published, in or from any country or jurisdiction except in compliance with any applicable rules and regulations of any such country or jurisdiction.

 

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LEGAL MATTERS

Goodwin Procter LLP, Boston, Massachusetts is acting as securities counsel for us in connection with this offering. The validity of the issuance of the shares of common stock offered by this prospectus will be passed upon for us by our counsel,                     , Oklahoma City, Oklahoma.                     is acting as counsel for the underwriter in connection with this offering.

EXPERTS

The consolidated financial statements of Foundation Healthcare, Inc. and its subsidiaries as of December 31, 2013 and 2012, and for each of the years in the periods ended December 31, 2013 and 2012, included in this prospectus and registration statement have been audited by Hein & Associates LLP, independent registered public accounting firm, as set forth in their report thereon included herein, and are included in reliance upon such report given on the authority of such firm as experts in accounting and auditing.

WHERE YOU CAN FIND MORE INFORMATION

We have filed with the SEC a registration statement on Form S-1 under the Securities Act that registers the securities to be sold in this offering. The registration statement, including the attached exhibits and schedules, contains additional relevant information about us and our capital stock. The rules and regulations of the SEC allow us to omit from this prospectus certain information included in the registration statement. For further information about us and our common stock, you should refer to the registration statement and the exhibits and schedules filed with the registration statement. With respect to the statements contained in this prospectus regarding the contents of any agreement or any other document, in each instance, the statement is qualified in all respects by the complete text of the agreement or document, a copy of which has been filed as an exhibit to the registration statement. In addition, we file annual, quarterly, and current reports, proxy statements and other information with the SEC under the Exchange Act. You may obtain copies of this information by mail from the Public Reference Room of the SEC at 100 F Street, N.E., Washington, D.C. 20549, at prescribed rates and you may read the information in person free of charge. You may obtain information on the operation of the public reference rooms by calling the SEC at 1–800–SEC–0330. The SEC also maintains an internet website that contains reports, proxy statements and other information about issuers that file electronically with the SEC. The address of that website is www.sec.gov.

 

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DOCUMENTS INCORPORATED BY REFERENCE

The SEC allows us to “incorporate by reference” information we file with it, which means that we can disclose important information to you by referring you to other documents. The information incorporated by reference is considered to be a part of this prospectus. We incorporate by reference into this prospectus the documents listed below:

 

•

our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on March 31, 2014;

 

•

our Quarterly Report on Form 10-Q for the three months ended March 31, 2014, filed with the SEC on May 15, 2014;

 

•

all other reports filed pursuant to Section 13(a) or 15(d) of the Exchange Act or proxy or information statements filed pursuant to Section 14 of the Exchange Act since the end of the fiscal year covered by the annual report referred to in above.

Pursuant to Rule 412 under the Securities Act, any statement contained in a document incorporated or deemed to be incorporated by reference into this prospectus will be deemed to be modified or superseded for purposes of this prospectus to the extent that a statement contained in this prospectus or any other subsequently filed document that is deemed to be incorporated by reference into this prospectus modifies or supersedes the statement. Any statement so modified or superseded will not be deemed, except as so modified or superseded, to constitute a part of this prospectus.

Our filings with the SEC, including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports, are available free of charge on our website (www.fdhc.com) as soon as reasonably practicable after they are filed with, or furnished to, the SEC. Our website and the information contained on that site, or connected to that site, are not incorporated into and are not a part of this prospectus. You may also obtain a copy of these filings at no cost by writing or telephoning us at: Foundation Healthcare, Inc. at 14000 N. Portland Ave., Suite 200, Oklahoma City, Oklahoma 73134, telephone: (405) 608-1700.

Except for the documents incorporated by reference as noted above, we do not intend to incorporate into this prospectus any of the information included on our website.

 

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DISCLOSURE OF COMMISSION POSITION ON INDEMNIFICATION FOR SECURITIES ACT LIABILITIES

We have been advised that, in the opinion of the Securities and Exchange Commission, indemnification for liabilities arising under the Securities Act is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities is asserted by one of our directors, officers, or controlling persons in connection with the securities being registered, we will, unless in the opinion of our legal counsel the matter has been settled by controlling precedent, submit the question of whether such indemnification is against public policy to a court of appropriate jurisdiction. We will then be governed by the court’s decision.

Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers or persons controlling the registrant pursuant to the foregoing provisions, the registrant has been informed that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is therefore unenforceable.

 

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FOUNDATION HEALTHCARE, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

I.		Consolidated Financial Statements (Unaudited) for the quarters ended March 31, 2014 and 2013
		a.		Condensed Consolidated Balance Sheets (Unaudited)			F-2
		b.		Condensed Consolidated Statements of Operations (Unaudited)			F-3
		c.		Condensed Consolidated Statements of Cash Flows (Unaudited)			F-4
		d.		Notes to Condensed Consolidated Financial Statements (Unaudited)			F-5
II.		Consolidated Financial Statements for the years ended December 31, 2013 and 2012
		a.		Report of Independent Registered Public Accounting Firm			F-19
		b.		Consolidated Balance Sheets as of December 31, 2013 and 2012			F-20
		c.		Consolidated Statements of Operations for the Years Ended December 31, 2013 and 2012			F-21
		d.		Consolidated Statements of Shareholders’ Deficit for the Years Ended December 31, 2013 and 2012			F-22
		e.		Consolidated Statements of Cash Flows for the Years Ended December 31, 2013 and 2012			F-23
		f.		Notes to Consolidated Financial Statements			F-25

 

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FOUNDATION HEALTHCARE, INC.

Condensed Consolidated Balance Sheets

(Unaudited)

 

		March 31, 2014				December 31, 2013
ASSETS
Cash and cash equivalents		$	3,958,742			$	4,212,076
Accounts receivable, net of allowances for doubtful accounts of $2,536,980 and $4,778,915, respectively			12,655,299				12,755,642
Receivables from affiliates			854,987				848,002
Supplies inventories			1,940,870				1,931,142
Prepaid and other current assets			4,805,921				4,302,885
Current assets from discontinued operations			199,032				518,629
Total current assets			24,414,851				24,568,376
Property and equipment, net			11,479,697				12,073,986
Equity method investments in affiliates			5,600,880				5,699,093
Intangible assets, net			10,624,754				11,138,621
Goodwill			973,927				973,927
Other assets			226,784				244,598
Other assets from discontinued operations			513,379				576,228
Total assets		$	53,834,272			$	55,274,829
LIABILITIES, PREFERRED NONCONTROLLING INTEREST AND SHAREHOLDERS’ DEFICIT
Liabilities:
Accounts payable		$	10,627,288			$	11,648,987
Accrued liabilities			5,148,921				4,114,915
Preferred noncontrolling interests dividends payable			121,878				195,411
Short term debt			6,183,610				5,664,827
Current portion of long-term debt			10,592,445				7,919,179
Other current liabilities			3,031,628				4,391,587
Current liabilities from discontinued operations			5,507,982				5,620,697
Total current liabilities			41,213,752				39,555,603
Long-term debt, net of current portion			5,988,737				10,031,732
Other liabilities			15,112,635				12,255,809
Other liabilities from discontinued operations			—				9,969
Total liabilities			62,315,124				61,853,113
Preferred noncontrolling interest			8,700,000				8,700,000
Commitments and contingencies (Note 9)
Foundation Healthcare shareholders’ deficit:
Preferred stock $0.0001 par value, 10,000,000 authorized; no shares issued and outstanding			—				—
Common stock $0.0001 par value, 500,000,000 shares authorized; 171,323,381 and 163,834,886 issued and outstanding, respectively			17,132				16,383
Paid-in capital			18,759,152				18,241,756
Accumulated deficit			(37,066,821	)			(35,171,315	)
Total Foundation Healthcare shareholders’ deficit			(18,290,537	)			(16,913,176	)
Noncontrolling interests			1,109,685				1,634,892
Total deficit			(17,180,852	)			(15,278,284	)
Total liabilities, preferred noncontrolling interest and shareholders’ deficit		$	53,834,272			$	55,274,829

See Accompanying Notes to Condensed Consolidated Financial Statements

 

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FOUNDATION HEALTHCARE, INC.

Condensed Consolidated Statements of Operations

For the Three Months Ended March 31, 2014 and 2013

(Unaudited)

 

		2014				2013
Net Revenues:
Patient services		$	19,513,483			$	15,860,660
Management fees from affiliates			1,269,306				1,738,228
Equity in earnings of affiliates			527,083				1,216,715
Other revenue			1,118,326				474,889
Provision for doubtful accounts			(361,517	)			(636,851	)
Revenues			22,066,681				18,653,641
Operating Expenses:
Salaries and benefits			7,977,419				6,338,097
Supplies			4,941,370				4,500,940
Other operating expenses			9,042,701				7,756,021
Depreciation and amortization			1,466,268				1,116,687
Total operating expenses			23,427,758				19,711,745
Other Income (Expense):
Interest expense, net			(496,121	)			(466,669	)
Other income			—				93,007
Net other (expense)			(496,121	)			(373,662	)
Income (loss) from continuing operations, before taxes			(1,857,198	)			(1,431,766	)
Benefit for income taxes			852,005				—
Income (loss) from continuing operations, net of taxes			(1,005,193	)			(1,431,766	)
Loss from discontinued operations, net of tax			(312,323	)			—
Net income (loss)			(1,317,516	)			(1,431,766	)
Less: Net income attributable to noncontrolling interests			384,921				(1,092,031	)
Net income (loss) attributable to Foundation Healthcare			(1,702,437	)			(339,735	)
Preferred noncontrolling interests dividends			(193,069	)			—
Net income (loss) attributable to Foundation Healthcare common stock		$	(1,895,506	)		$	(339,735	)
Earnings per common share (basic and diluted):
Net income (loss) attributable to continuing operations attributable to Foundation Healthcare common stock		$	(0.01	)		$	(0.00	)
Loss from discontinued operations, net of tax			(0.00	)			—
Net income (loss) per share, attributable to Foundation Healthcare common stock		$	(0.01	)		$	(0.00	)
Weighted average number of common and diluted shares outstanding			167,329,517				162,523,276
Pro forma income information (Note 3):
Pro forma benefit for income taxes						$	129,099
Pro forma net loss attributable to Foundation Healthcare common stock						$	(210,636	)
Pro forma basic and diluted net income (loss) per share						$	(0.00	)

See Accompanying Notes to Condensed Consolidated Financial Statements

 

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FOUNDATION HEALTHCARE, INC.

Condensed Consolidated Statements of Cash Flows

For the Three Months Ended March 31, 2014 and 2013

(Unaudited)

 

		2014				2013
Operating activities:
Net income (loss)		$	(1,317,516	)		$	(1,431,766	)
Less: Loss from discontinued operations, net of tax			(312,323	)			—
Income (loss) from continuing operations			(1,005,193	)			(1,431,766	)
Adjustments to reconcile loss from continuing operations to net cash provided by (used in) operating activities:
Depreciation and amortization			1,466,268				1,116,687
Stock-based compensation, net of cashless vesting			518,145				—
Provision for doubtful accounts			361,517				636,851
Equity in earnings of affiliates			(527,083	)			(1,216,715	)
Changes in assets and liabilities –
Accounts receivable, net of provision for doubtful accounts			(261,174	)			(2,111,768	)
Receivables from affiliates			(6,985	)			(35,691	)
Supplies Inventories			(9,728	)			38,020
Prepaid and other current assets			(503,036	)			(246,902	)
Other assets			17,814				—
Accounts payable			(1,021,699	)			(1,437,536	)
Accrued liabilities			1,034,006				3,286,995
Other current liabilities			(1,359,959	)			30,000
Other liabilities			2,856,826				(3,905	)
Net cash provided by (used in) operating activities from continuing operations			1,559,719				(1,375,730	)
Net cash provided by operating activities from discontinued operations			76,726				—
Net cash provided by (used in) operating activities			1,636,445				(1,375,730	)
Investing activities:
Purchase of property and equipment			(358,112	)			(2,612,598	)
Distributions from affiliates			625,296				1,266,100
Net cash provided by (used in) investing activities from continuing operations			267,184				(1,346,498	)
Net cash provided by investing activities from discontinued operations			—				—
Net cash provided by (used in) investing activities			267,184				(1,346,498	)
Financing activities:
Debt proceeds		$	767,923			$	3,431,211
Debt payments			(1,618,869	)			(1,383,326	)
Preferred noncontrolling interests dividends			(266,602	)			(424,594	)
Distributions to noncontrolling interests			(910,128	)			(37,444	)
Distributions to member			—				(377,930	)
Net cash provided by (used in) financing activities from continuing operations			(2,027,676	)			1,207,917
Net cash (used in) financing activities from discontinued operations			(129,287	)			—
Net cash provided by (used in) financing activities			(2,156,963	)			1,207,917
Net change in cash and cash equivalents			(253,334	)			(1,514,311	)
Cash and cash equivalents at beginning of period			4,212,076				3,037,067
Cash and cash equivalents at end of period		$	3,958,742			$	1,522,756
Cash Paid for Interest and Income Taxes:
Interest expense		$	504,509			$	443,709
Interest expense, discontinued operations		$	62,234			$	—
Income taxes, continuing operations		$	1,950,000			$	—

See Accompanying Notes to Condensed Consolidated Financial Statements

 

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FOUNDATION HEALTHCARE, INC.

Notes to Condensed Consolidated Financial Statements

For the Periods Ended March 31, 2014 and 2013

(Unaudited)

Note 1 – Nature of Business

Foundation Healthcare, Inc. (the “Company”) is organized under the laws of the state of Oklahoma and owns controlling and noncontrolling interests in surgical hospitals located in Texas. The Company also owns noncontrolling interests in ambulatory surgery centers (“ASCs”) located in Texas, Oklahoma, Pennsylvania, New Jersey, Maryland and Ohio. Additionally, the Company provides sleep testing management services to various rural hospitals in Iowa, Minnesota, Missouri, Nebraska and South Dakota under management contracts with the hospitals. The Company provides management services to a majority of the facilities that it has noncontrolling interests (referred to as “Affiliates”) under the terms of various management agreements.

Note 2 – Basis of Presentation

Reverse Acquisition – On July 22, 2013, the Company acquired Foundation Surgery Affiliates, LLC (“FSA”) and FSA’s consolidated variable interest entity, Foundation Surgical Hospital Affiliates, LLC (“FSHA”) (collectively referred to as “Foundation”). For accounting purposes, the acquisition of FSA was accounted for as a reverse acquisition and as a result, the Company’s historical operating results included in the accompanying consolidated financial statements for the periods prior to July 22, 2013 represent those of FSA. The historical financial statements of FSA have been adjusted for the effect of the recapitalization that occurred as a result of the reverse acquisition.

Going Concern and Management’s Plan – As of March 31, 2014, the Company had an accumulated deficit of $37.1 million and a working capital deficiency of $16.8 million. During the three months ended March 31, 2014, the Company generated a net loss attributable to Foundation Healthcare of $1.7 million and generated cash flow from operating activities from continuing operations of $1.6 million. As of March 31, 2014, the Company had cash and cash equivalents of $4.0 million. Management expects to refinance, by the end of the second quarter of 2014, a significant portion of the Company’s long-term debt obligations. Management expects that the Company will be able to significantly reduce its annual debt service payments as part of the refinancing; however, there is no assurance that management will be successful in completing the debt refinancing.

If management is unable to refinance a significant portion of its existing debt as noted above, the Company may be forced to obtain extensions on existing debt obligations as they become due in 2014. Although management has historically been successful in obtaining extensions, there is no assurance that the Company’s lenders will continue to grant them in the future. In addition, management may choose to raise additional funds through the sale of equity or assets, but there is no assurance that the Company will be successful in completing such actions.

If management does not complete the debt refinancing or alternatively obtain extensions on some of its debt obligations during 2014, the Company may not have sufficient cash on hand or generate sufficient cash flow from operations to meet its cash requirements over the next 12 months. These uncertainties raise substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.

Note 3 – Summary of Significant Accounting Policies

For a complete list of the Company’s significant accounting policies, please see the Company’s Annual Report on Form 10-K for the year ending December 31, 2013.

 

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Interim Financial Information – The condensed consolidated financial statements included herein are unaudited and have been prepared in accordance with generally accepted accounting principles for interim financial statements and in accordance with Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2014 are not necessarily indicative of results that may be expected for the year ended December 31, 2014. The consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K for the year ended December 31, 2013. The December 31, 2013 consolidated balance sheet was derived from audited financial statements.

Pro forma income information – Prior to July 22, 2013, FSA’s and FSHA’s member had elected to have FSA’s and FSHA’s income taxed as an S Corporation under provisions of the Internal Revenue Code and a similar section of the state income tax law. Therefore, taxable income or loss is reported to the individual member for inclusion in its tax returns and no provision for income taxes is included in the Company’s consolidated financial statements for periods prior to July 22, 2013. The pro forma income information provides an adjustment for income tax expense as if FSA and FSHA had been a C Corporation prior to July 22, 2013 at an assumed combined federal and state effective tax rate of 38%, which approximates the calculated statutory tax rates for the periods.

Consolidation – The accompanying consolidated financial statements include the accounts of the Company and its wholly owned, majority owned and controlled subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation.

The Company accounts for its investments in Affiliates in which the Company exhibits significant influence, but not control, in accordance with the equity method of accounting. The Company does not consolidate its equity method investments, but rather measures them at their initial costs and then subsequently adjusts their carrying values through income for their respective shares of the earnings or losses during the period. The Company monitors its investments for other-than-temporary impairment by considering factors such as current economic and market conditions and the operating performance of the companies and records reductions in carrying values when necessary.

Use of estimates – The preparation of financial statements in conformity with generally accepted accounting principles requires management of the Company to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Revenue recognition and accounts receivable – The Company recognizes revenues in the period in which services are performed. Accounts receivable primarily consist of amounts due from third-party payors and patients. The Company’s ability to collect outstanding receivables is critical to its results of operations and cash flows. Amounts the Company receives for treatment of patients covered by governmental programs such as Medicare and Medicaid and other third-party payors such as health maintenance organizations, preferred provider organizations and other private insurers are generally less than the Company’s established billing rates. Additionally, to provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. Accordingly, the revenues and accounts receivable reported in the Company’s consolidated financial statements are recorded at the net amount expected to be received.

Contractual Discounts and Cost Report Settlements – The Company derives a significant portion of its revenues from Medicare, Medicaid and other payors that receive discounts from its established billing rates. The Company must estimate the total amount of these discounts to prepare its consolidated financial statements. The Medicare and Medicaid regulations and various managed care contracts under which these discounts must be

 

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calculated are complex and are subject to interpretation and adjustment. The Company estimates the allowance for contractual discounts on a payor-specific basis given its interpretation of the applicable regulations or contract terms. These interpretations sometimes result in payments that differ from the Company’s estimates. Additionally, updated regulations and contract renegotiations occur frequently, necessitating regular review and assessment of the estimation process by management. Changes in estimates related to the allowance for contractual discounts affect revenues reported in the Company’s accompanying consolidated statements of operations.

Cost report settlements under reimbursement agreements with Medicare and Medicaid are estimated and recorded in the period the related services are rendered and are adjusted in future periods as final settlements are determined. There is a reasonable possibility that recorded estimates will change by a material amount in the near term. There was no adjustment for estimated cost report settlements in the three month periods ended March 31, 2014 or 2013. The net cost report settlements due to the Company was approximately $235,000 and $235,000 at March 31, 2014 and December 31, 2013, respectively, and in included in prepaid and other current assets in the accompanying consolidated balance sheets. The Company’s management believes that adequate provisions have been made for adjustments that may result from final determination of amounts earned under these programs.

Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation. The Company believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing that would have a material effect on the Company’s financial statements. Compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties and exclusion from the Medicare and Medicaid programs.

Provision and Allowance for Doubtful Accounts – To provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. The primary uncertainty lies with uninsured patient receivables and deductibles, co-payments or other amounts due from individual patients.

The Company has an established process to determine the adequacy of the allowance for doubtful accounts that relies on a number of analytical tools and benchmarks to arrive at a reasonable allowance. No single statistic or measurement determines the adequacy of the allowance for doubtful accounts. Some of the analytical tools that the Company utilizes include, but are not limited to, the aging of accounts receivable, historical cash collection experience, revenue trends by payor classification, revenue days in accounts receivable, the status of claims submitted to third party payors, reason codes for declined claims and an assessment of the Company’s ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan. Accounts receivable are written off after collection efforts have been followed in accordance with the Company’s policies. During the Company’s normal quarterly review process at March 31, 2014, management determined that a portion of the accounts receivable related to personal injury cases at our FSH SA location had grown to a level requiring it to be analyzed as a distinct payor category. Based on the historical cash collection experience and other analytical measures as noted above, the allowance for doubtful accounts related to the personal injury cases was lowered by $1.0 million.

Due to the nature of the healthcare industry and the reimbursement environment in which the Company operates, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time products or services are provided. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on the Company’s operating results and cash flows in subsequent periods. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded.

The patient and their third party insurance provider typically share in the payment for the Company’s products and services. The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network. Due to uncertainties surrounding deductible levels and the

 

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number of out-of-network patients, the Company is not certain of the full amount of patient responsibility at the time of service. The Company estimates amounts due from patients prior to service and generally collects those amounts prior to service. Remaining amounts due from patients are then billed following completion of service.

The activity in the allowance for doubtful accounts for the three months ending March 31, 2014 follows:

 

		2014
Balance at beginning of period		$	4,778,915
Provisions recognized as reduction in revenues			361,517
Write-offs, net of recoveries			(2,603,452	)
Balance at end of period		$	2,536,980

Cash and cash equivalents – The Company considers all highly liquid temporary cash investments with an original maturity of three months or less to be cash equivalents. Certificates of deposit with original maturities of more than three months are also considered cash equivalents if there are no restrictions on withdrawing funds from the account.

Goodwill and Intangible Assets – The Company evaluates goodwill for impairment at least on an annual basis and more frequently if certain indicators are encountered. Goodwill is to be tested at the reporting unit level, defined as an ASC or hospital (referred to as a component), with the fair value of the reporting unit being compared to its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered to be impaired. The Company will complete its annual impairment test in December 2014.

Intangible assets other than goodwill which include physician membership interests, service contracts and covenants not to compete are amortized over their estimated useful lives using the straight line method. The remaining lives range from five to ten years. The Company evaluates the recoverability of identifiable intangible asset whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.

Net income (loss) per share – Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted loss per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted during the period. Dilutive securities having an anti-dilutive effect on diluted loss per share are excluded from the calculation.

Recently Adopted and Recently Issued Accounting Guidance

Adopted Guidance

In February 2013, the FASB issued changes to the accounting for obligations resulting from joint and several liability arrangements. These changes require an entity to measure such obligations for which the total amount of the obligation is fixed at the reporting date as the sum of (i) the amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors, and (ii) any additional amount the reporting entity expects to pay on behalf of its co-obligors. An entity will also be required to disclose the nature and amount of the obligation as well as other information about those obligations. Examples of obligations subject to these requirements are debt arrangements and settled litigation and judicial rulings. These changes become effective for the Company on January 1, 2014. Management has determined that the adoption of these changes did not have an impact on the Company’s consolidated financial statements, as the Company does not currently have any such arrangements.

 

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In July 2013, the FASB issued changes to the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. These changes require an entity to present an unrecognized tax benefit as a liability in the financial statements if (i) a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position, or (ii) the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset to settle any additional income taxes that would result from the disallowance of a tax position. Otherwise, an unrecognized tax benefit is required to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. Previously, there was diversity in practice as no explicit guidance existed. These changes become effective for the Company on January 1, 2014. Management has determined that the adoption of these changes did not have a significant impact on the Company’s consolidated financial statements.

Issued Guidance

In April 2014, the FASB issued changes to the reporting of discontinued operations and disclosures of disposals of components of an entity. The amendments change the criteria for reporting discontinued operations while enhancing disclosures in this area. Under the new guidance, only disposals representing a strategic shift in operations should be presented as discontinued operations. Additionally, the new guidance requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income and expenses of discontinued operations. The amendments are effective prospectively for all disposals (or classifications as held for sale) of components of an entity, and for all businesses that, on acquisition, are classified as held for sale that occur within annual periods beginning on or after December 15, 2014, and interim periods within those years. The Company is currently evaluating the new guidance to determine the impact it may have to its consolidated financial statements.

Note 4 – Reverse Acquisition

On July 22, 2013, the Company acquired FSA and FSA’s consolidated variable interest entity, FSHA, from Foundation Healthcare Affiliates, LLC (“FHA”) pursuant to an Amended and Restated Membership Purchase Agreement (the “Purchase Agreement”). Pursuant to the Purchase Agreement, the Company (i) issued to FHA 114,500,000 shares of its common stock, (ii) issued to FHA a demand promissory note in the principal amount of $2.0 million, and (iii) assumed certain liabilities and obligations of FHA totaling approximately $2.0 million.

For accounting purposes, the acquisition of FSA was accounted for as a reverse acquisition and as a result, the Company’s historical operating results included in the accompanying condensed consolidated financial statements for the periods prior to July 22, 2013 represent those of FSA. The historical financial statements of FSA have been adjusted for the effect of the recapitalization that occurred as a result of the reverse acquisition.

The acquisition of Foundation was based on management’s belief that Foundation’s acquisition and development strategy and operating model will enable the Company to grow by taking advantage of highly-fragmented markets, an increasing demand for short stay surgery and a need by physicians to forge strategic alliances to meet the needs of the evolving healthcare landscape while also shaping the clinical environments in which they practice.

Simultaneous with and subject to the reverse acquisition, the Company issued 13,333,333 shares of common stock to purchase a $6.0 million participation in the credit facility owed by the Company to Arvest Bank (see Note 5 – Discontinued Operations for more information) and 17,970,295 shares of common stock to Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates, for full satisfaction of debt owed to Mr. Oliver totaling $8,136,390. Since the completion of the reverse acquisition was subject to these transactions, they have been recorded as part of the reverse acquisition.

 

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Since FSA is deemed to be the accounting acquirer, the reverse acquisition was recorded by allocating the purchase price of the acquisition to the assets acquired, including intangible assets and liabilities assumed, from the legacy business of Graymark Healthcare, Inc. (“Graymark”), based on their estimated fair values at the acquisition date. The excess of the cost of the acquisitions over the net amounts assigned to the estimated fair value of the assets acquired, net of liabilities assumed, was recorded as goodwill, none of which is anticipated to be tax deductible.

The fair value of the total consideration issued in the reverse acquisition amounted to $17.4 million and included $13.4 million for the issuance of the Company’s common stock to FHA, Arvest Bank and Mr. Oliver, $2.0 million for the promissory note issued to FHA and $2.0 million for the debt obligations and liabilities assumed from FHA.

The final purchase allocation for the reverse acquisition is presented in the table below:

 

		Graymark
Cash and cash equivalents		$	68,170
Accounts receivable			249,333
Current assets from discontinued operations			1,360,143
Other current assets			198,976
Total current assets			1,876,622
Property and equipment			1,389,169
Intangible assets			2,733,000
Goodwill			21,864,781
Other assets from discontinued operations			1,224,140
Other assets			252,528
Total assets acquired			29,340,240
Liabilities assumed:
Accounts payable and accrued liabilities			2,899,823
Short term debt			2,000,000
Current portion of long-term debt			714,711
Current liabilities from discontinued operations			7,375,521
Total current liabilities			12,990,055
Long-term debt, net of current portion			742,385
Other liabilities from discontinued operations			305,969
Other liabilities			1,362,957
Total liabilities assumed			15,401,366
Net assets acquired		$	13,938,874

During the three months ended March 31, 2013, the Company incurred $93,197 in expenses related to the reverse acquisition. The expenses incurred related primarily to legal fees related to the Purchase Agreement and structure of the transaction and professional fees related to the audits of the 2012 and 2011 consolidated financial statements of FSA.

 

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The amounts of acquisition revenues and earnings included in the Company’s consolidated statements of operations for the three months ended March 31, 2014, and the revenue and earnings of the combined entity had the reverse acquisition date for Graymark been January 1, 2013 are as follows:

 

						Loss from Continuing Operations								Attributable to Foundation
		Revenue								Net Loss				Net Loss				Net Loss Per Share
Actual:
From 1/1/2014 to 3/31/2014		$	504,943			$	(1,955,672	)		$	(2,459,419	)		$	(2,459,419	)		$	(0.01	)
Supplemental Pro Forma:
Three months ending 3/31/2013		$	21,561,851			$	(4,194,248	)		$	(4,139,689	)		$	(3,000,129	)		$	(0.02	)

The pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that actually would have been achieved had the acquisition been consummated as of that time, nor is it intended to be a projection of future results.

Note 5 – Discontinued Operations

Prior to the reverse acquisition, Graymark committed to a plan to divest of or close certain sleep diagnostic and sleep therapy locations. The decision was based on a combination of the financial performance of the facilities and the shift in focus to the business model of Foundation. As a result of the pending closure or sale of these locations, the related assets, liabilities, results of operations and cash flows were classified as discontinued operations which were acquired by the Company in the reverse acquisition.

Under the plan, from July 2013 to October 2013, the Company closed or sold 24 sleep diagnostic locations including both IDTF and contracted locations in Georgia, Iowa, Kansas, Missouri, Nevada, Oklahoma and Texas and 5 sleep therapy locations in Iowa, Kansas, Nevada, Oklahoma and Texas.

As part of the reverse acquisition, the Company acquired the special charge liability of $475,570 related to the estimated closing costs resulting from the plan to sell or close the sleep diagnostic and therapy locations. For the three month period ended March 31, 2014, the activity in the acquired accruals for restructuring charges established for lease termination costs were as follows:

 

		Lease Termination Costs
Balance at December 31, 2013		$	78,235
Adjustments			151,531
Cash payments			(32,121	)
Balance at March 31, 2014		$	197,645

Adjustments to the special charge liability include changes to estimated settlements or other changes to the liabilities. Additional charges or adjustments may be recorded in future periods dependent upon the Company’s ability to sub-lease or otherwise mitigate future lease costs at closed facilities.

The operating results of the discontinued sleep diagnostic and therapy locations and the Company’s other discontinued operations for the three month period ended March 31, 2014 are summarized below:

 

		2014
Revenues		$	123,729
Net loss before taxes		$	(503,747	)
Income tax benefit			191,424
Net loss from discontinued operations, net of tax		$	(312,323	)

 

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The balance sheet items for discontinued operations are summarized below:

 

		March 31, 2014				December 31, 2013
Cash and cash equivalents		$	19,108			$	49,252
Accounts receivable, net of allowances			39,284				222,943
Inventories			—				1,893
Other current assets			140,640				244,541
Total current assets			199,032				518,629
Fixed assets, net			363,379				426,228
Other assets			150,000				150,000
Total noncurrent assets			513,379				576,228
Total assets		$	712,411			$	1,094,857
Payables and accrued liabilities		$	1,564,374			$	1,557,771
Short term debt			3,882,932				3,994,932
Current portion of long-term debt			60,676				67,994
Total current liabilities			5,507,982				5,620,697
Long-term debt			—				9,969
Total liabilities		$	5,507,982			$	5,630,666

The Company’s borrowings and capital lease obligations included in discontinued operations are as follows:

 

		Rate(1)				Maturity Date				March 31, 2014				December 31, 2013
Short-term Debt:
Senior bank debt			6	%			Apr. 2014			$	3,882,932			$	3,994,932
Long-term Debt:
Sleep center notes payable			6	%			Jan. 2015			$	21,000			$	28,723
Equipment capital leases			8	%			Nov. 2014				39,676				49,389
Total											60,676				78,112
Less: Current portion of long-term debt											(60,676	)			(68,143	)
Long-term debt										$	—			$	9,969

 

(1)	Effective rate as of March 31, 2014

At March 31, 2014, future maturities of long-term debt included in discontinued operations were as follows:

 

Twelve months ended March 31, 2015		$	60,676

On July 22, 2013, the Company’s subsidiaries, SDC Holdings, LLC and ApothecaryRx, LLC (collectively the “Borrowers”), the Company and Mr. Stanton Nelson (the “Guarantor” and the Company’s chief executive officer) entered into a Second Amended and Restated Loan Agreement (the “New Loan Agreement”) and an Amended and Restated Promissory Note (the “New Note”) with Arvest Bank. The Company, Borrowers, Guarantor and other guarantors previously entered into the Amended and Restated Loan Agreement dated effective December 17, 2010, as amended by the First Amendment to Loan Agreement dated January 1, 2012, the Second Amendment to Loan Agreement dated effective June 30, 2012, and the Third Amendment to Loan Agreement dated effective October 12, 2012 (the “Prior Agreement”). Under the Prior Agreement, the Company and Borrowers were indebted to Arvest Bank under the Amended and Restated Promissory Note, in the original

 

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principal amount of $15,000,000 dated June 30, 2010 and the Second Amended and Restated Promissory Note, in the original principal amount of $30,000,000, dated June 30, 2010 (the “Prior Notes”). Arvest Bank, the Company, the Borrowers and the Guarantor have agreed to restructure the loan evidenced by the Prior Notes and the Prior Agreement. As of March 31, 2014 and December 31, 2013, the outstanding principal amount of the New Note was $9,882,932 and $9,994,932, respectively.

On July 22, 2013, in conjunction with the New Loan Agreement with Arvest Bank, the Company entered into a Participation Agreement with Arvest Bank in which we purchased a $6,000,000 participation in the New Note from Arvest Bank in exchange for 13,333,333 shares of the Company’s common stock. The Company purchased the participation in the last $6,000,000 of the principal amount due under the Arvest credit facility. The Company’s participation in the note is eliminated against the New Note in the long-term debt table shown above.

The New Loan Agreement and New Note were entered into on the same date as and in conjunction with the reverse acquisition. As such, the New Note is included in the opening balance sheet in the reverse acquisition accounting (see Note 4 – Reverse Acquisition).

The New Note is collateralized by substantially all of the assets of the Borrowers and the personal guaranty of the Guarantor which is limited to $2,919,000. The note bears interest at the greater of the prime rate or 6.0% and provided the Borrowers are not in default, the Borrowers are required to make monthly payments of interest only. The entire unpaid principal balance and all accrued and unpaid interest thereon was due and payable on April 30, 2014. Additionally, the New Note is subject to certain financial covenants including a debt service coverage ratio (“DSR”) covenant of not less than 1.25 to 1. Arvest Bank has waived the DSR and other financial covenant requirements through April 30, 2014, which was the maturity date of the New Note. The Company is in the process of extending the maturity date of the New Note and the waiver of financial covenants. Historically, management has been successful in obtaining extensions and waivers of covenant violations, however there is no assurance that Arvest Bank will continue to extend the note or waive the covenant violations. See Note 2 – Basis of Presentation for additional information on management’s plan to refinance its existing debt obligations.

Note 6 – Goodwill and Other Intangibles

Changes in the carrying amount of goodwill are as follows:

 

		Gross Amount				Accumulated Impairment Losses				Net Carrying Value
December 31, 2013		$	23,019,309			$	(22,045,382	)		$	973,927
March 31, 2014		$	23,019,309			$	(22,045,382	)		$	973,927

Goodwill and intangible assets with indefinite lives must be tested for impairment at least once a year. Carrying values are compared with fair values, and when the carrying value exceeds the fair value, the carrying value of the impaired asset is reduced to its fair value. The Company tests goodwill for impairment on an annual basis in the fourth quarter or more frequently if management believes indicators of impairment exist. The performance of the test involves a two-step process. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. The Company generally determines the fair value of its reporting units using the income approach methodology of valuation that includes the discounted cash flow method as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the Company performs the second step of the goodwill impairment test to determine the amount of impairment loss. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill.

 

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The Company has estimated the goodwill associated with the reverse acquisition to be $21.9 million. The Company then determined the projected cash flows from the continuing operations of the legacy Graymark business were not sufficient to support the recorded goodwill. The Company evaluated the fair value of the goodwill subsequent to the reverse acquisition and determined the acquired goodwill was fully-impaired.

Changes in the carrying amount of intangible assets during the three months ended March 31, 2014 were as follows:

 

		Carrying Amount				Accumulated Amortization				Net
December 31, 2013		$	14,524,500			$	(3,385,879	)		$	11,138,621
Amortization			—				(513,867	)			(513,867	)
March 31, 2014		$	14,524,500			$	(3,899,746	)		$	10,624,754

Intangible assets as of March 31, 2014 and December 31, 2013 include the following:

 

		Useful Life (Years)		March 31, 2014												December 31, 2013 Net
				Carrying Value				Accumulated Amortization				Net
ASC management contracts		6 – 8		$	3,498,500			$	(1,843,754	)		$	1,654,746			$	1,763,463
Covenants not to compete		5			2,027,000				(545,094	)			1,481,906				1,583,256
Physician memberships		7			6,468,000				(1,309,000	)			5,159,000				5,390,000
Trade name		5			381,000				(52,832	)			328,168				347,218
Service contracts		10			2,150,000				(149,066	)			2,000,934				2,054,684
Total				$	14,524,500			$	(3,899,746	)		$	10,624,754			$	11,138,621

Amortization expense for the three months ended March 31, 2014 and 2013 was $513,867 and $113,242 respectively. Amortization expense for the next five years related to these intangible assets is expected to be as follows:

 

Twelve months ended March 31,
2015		$	2,055,474
2016			2,055,474
2017			2,055,474
2018			1,818,641
2019			1,174,757

Note 7 – Borrowings and Capital Lease Obligations

The Company’s short-term debt obligations are as follows:

 

		Rate(1)		March 31, 2014				December 31, 2013
Senior Lender:
Notes payable – working capital		6.5 –7.0%		$	2,803,270			$	2,814,027
Other Lenders:
Note payable – S&H Leasing		11.5%			1,865,600				1,865,600
Note payable – working capital		5.0%			800,000				800,000
Insurance premium financings		3.0 – 4.8%			652,837				101,135
Note payable – Medicare cost report		10.1%			61,903				84,065
Short-term debt				$	6,183,610			$	5,664,827

 

(1)	Effective rate as of March 31, 2014

 

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In April 2014, the Company extended the maturity date of two short-term working capital loans from its senior lender. The notes are collateralized by the inventory, accounts receivable, equipment and other assets of one of the Company’s hospital subsidiaries. The notes bear interest at variable rates of prime plus 1.5% and 3.75% with floors of 6.5% and 7%. The Company is required to make monthly payments totaling $15,679 with the balances due at maturity in January 2015 and February 2016. The note that matures in February 2016 is classified as short-term debt because it is due on demand.

The Company’s long-term debt and capital lease obligations are as follows:

 

		Rate(1)		Maturity Date		March 31, 2014				December 31, 2013
Senior Lender:
Line of credit		7.0%		Jun. 2014		$	896,000			$	896,000
Notes payable – working capital		5.5 – 7.0%		Sep. 2015 – Mar. 2016			3,322,646				3,715,088
Note payable – equity investments		6.25%		Sept. 2016			2,999,360				3,270,427
Note payable – management agreements		6.0%		Dec. 2016			591,922				640,466
Note payable – assumption		6.75%		Jan. 2015			114,270				146,857
Other Lenders:
Note payable – preferred interest redemption		10.0%		Jul. 2015			5,100,000				5,100,000
Notes payable – settlements		5.25 – 8.0%		Dec. 2014 – Jan. 2018			1,020,056				1,189,725
Note payable – THE		4.6 – 8.0%		Jan. 2015 – Feb. 2016			272,811				311,149
Notes payable – physician partners		5.25 – 6.5%		May 2014 – Dec. 2014			55,161				103,604
Notes payable – acquisition		6.0%		Dec. 2014 – Oct. 2015			79,346				99,610
Capital lease obligations		4.8 – 13.7%		Sep. 2014 – Jul. 2017			2,129,610				2,477,985
Total							16,581,182				17,950,911
Less: Current portion of long-term debt							(10,592,445	)			(7,919,179	)
Long-term debt						$	5,988,737			$	10,031,732

 

(1)	Effective rate as of March 31, 2014

In April 2014, the Company extended the maturity date of two working capital loans from its senior lender to March 2016. The notes bear interest at variable rates of prime plus 1.5% with floors of 6.5% and require monthly payments of principal and interest totaling $47,510. The notes are collateralized by the inventory, accounts receivable, equipment and other assets of one of the Company’s hospital subsidiaries. The total principal owed on the notes at March 31, 2014 is $1,389,582.

The Company has entered into various short-term and long-term notes payable with its senior lender, Legacy Bank (referred to as “Legacy Debt”). As of March 31, 2014 and December 31, 2013, the balance of the Legacy Debt was $10.7 million and $11.5 million, respectively. The Legacy Debt is collateralized by substantially all of the assets of the Company’s subsidiaries, FSA and FSHA, and a portion is personally guaranteed by certain officers of the Company. In conjunction with the Legacy Debt, the Company has agreed to comply with certain financial covenants (as defined and calculated at the FSA and FSHA level) including:

 

•

Debt Service Coverage Ratio of 1.05 to 1 and increasing to 1.1 to 1 by December 31, 2013; 1.15 to 1 by March 31, 2014; and 1.2 to 1 by June 30, 2014; and

 

•

Minimum Tangible Net Worth (as defined for FSA and FSHA) of $11.1 million increased each quarter (beginning in September 30, 2013 by 50% of FSA’s and FSHA’s net income for the quarter).

 

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As of March 31, 2014, FSA and FSHA are not in compliance with the Legacy Debt Minimum Tangible Net Worth financial covenant. Management has requested a waiver from Legacy Bank for the covenant violation. Historically, management has been successful in obtaining waivers from the bank for any covenant non-compliance; however there is no assurance that the Company will be able to obtain waivers in the future. Management does not anticipate obtaining a waiver for a period greater than 12 months and it is unlikely that the Company will regain compliance with the Minimum Tangible Net Worth covenant within the next 12 months. As a result, the Legacy Debt has been classified as current in the accompanying consolidated balance sheets as of March 31, 2014. See Note 2 – Basis of Presentation for additional information on management’s plan to refinance its existing debt obligations.

At March 31, 2014, future maturities of long-term debt were as follows:

 

2015		$	10,592,445
2016			5,587,036
2017			326,688
2018			52,562
2019			22,451
Thereafter			—

Note 8 – Preferred Noncontrolling Interests

During 2013, the Company’s wholly-owned subsidiary, Foundation Health Enterprises, LLC (“FHE”) completed a private placement offering of $9,135,000. The offering was comprised of 87 units (“FHE Unit” or “preferred noncontrolling interest”). Each FHE Unit was offered at $105,000 and entitled the purchaser to one (1) Class B membership interest in FHE, valued at $100,000, and 10,000 shares of the Company’s common stock, valued at $5,000. The total consideration of $9,135,000 was comprised of $8,700,000 attributable to the preferred noncontrolling interest and $435,000 attributable to the 870,000 shares of the Company’s common stock.

The FHE Units provide for a cumulative preferred annual return of 9% on the amount allocated to the Class B membership interests. The FHE Units will be redeemed by FHE in four annual installments beginning in July 2014. The first three installments shall be in the amount of $10,000 per FHE Unit and the fourth installment will be in the amount of the unreturned capital contribution and any undistributed preferred distributions. The FHE Units are convertible at the election of the holder at any time prior to the complete redemption into restricted common shares of the Company at a conversion price of $2.00 per share. Since the FHE Units have a redemption feature and a conversion feature which the Company determined to be substantive, the preferred noncontrolling interests has been recorded at the mezzanine level in the accompanying consolidated balance sheets and the corresponding dividends are recorded as a reduction of accumulated deficit.

Note 9 – Commitments and Contingencies

Legal claims – The Company is exposed to asserted and unasserted legal claims encountered in the normal course of business, including claims for damages for personal injuries, medical malpractice, breach of contracts, wrongful restriction of or interference with physicians’ staff privileges and employment related claims. In certain of these actions, plaintiffs request payment for damages, including punitive damages that may not be covered by insurance. Management believes that the ultimate resolution of these matters will not have a material adverse effect on the operating results or the financial position of the Company. There were no settlement expenses during the three months ended March 31, 2014 and 2013 related to the Company’s ongoing unasserted legal claims.

Self-insurance – Effective January 1, 2014, the Company began using a combination of insurance and self-insurance for employee-related healthcare benefits. The self-insurance liability is determined actuarially, based on the actual claims filed and an estimate of incurred but not reported claims. Self-insurance reserves as of March 31, 2014 were $418,246 and are included in accrued liabilities in the accompanying consolidated balance sheets.

 

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Note 10 – Fair Value Measurements

Fair value is the price that would be received from the sale of an asset or paid to transfer a liability (i.e., an exit price) in the principal or most advantageous market in an orderly transaction between market participants. In determining fair value, the accounting standards established a three-level hierarchy that distinguishes between (i) market data obtained or developed from independent sources (i.e., observable data inputs) and (ii) a reporting entity’s own data and assumptions that market participants would use in pricing an asset or liability (i.e., unobservable data inputs). Financial assets and financial liabilities measured and reported at fair value are classified in one of the following categories, in order of priority of observability and objectivity of pricing inputs:

 

•

Level 1 – Fair value based on quoted prices in active markets for identical assets or liabilities.

 

•

Level 2 – Fair value based on significant directly observable data (other than Level 1 quoted prices) or significant indirectly observable data through corroboration with observable market data. Inputs would normally be (i) quoted prices in active markets for similar assets or liabilities, (ii) quoted prices in inactive markets for identical or similar assets or liabilities or (iii) information derived from or corroborated by observable market data.

 

•

Level 3 – Fair value based on prices or valuation techniques that require significant unobservable data inputs. Inputs would normally be a reporting entity’s own data and judgments about assumptions that market participants would use in pricing the asset or liability.

The fair value measurement level for an asset or liability is based on the lowest level of any input that is significant to the fair value measurement. Valuation techniques should maximize the use of observable inputs and minimize the use of unobservable inputs.

Recurring Fair Value Measurements: The carrying value of the Company’s financial assets and financial liabilities is their cost, which may differ from fair value. The carrying value of cash held as demand deposits, money market and certificates of deposit, accounts receivable, short-term borrowings, accounts payable and accrued liabilities approximated their fair value. At March 31, 2014, the fair value of the Company’s long-term debt, including the current portion was determined to be approximately equal to its carrying value.

Nonrecurring Fair Value Measurements: During the three months ended March 31, 2014, the Company did have any assets or liabilities recorded using nonrecurring fair value measurements.

Note 11 – Real Estate Transaction

On March 1, 2014, the Company executed a 15 year master lease on the building occupied by the Company’s hospital subsidiary in San Antonio, Texas for an annual rent of $2.3 million with annual escalations of 3%. The current lease income on the underlying sub-lease is approximately $2.1 million per year which includes the rent paid by FBH SA. The master lease is an operating lease. In conjunction with the master lease and certain other agreements with the landlord, the Company received $4.1 million at the time of the lease. Given the disparity between the annual rent expense under the master lease and the rental income of the underlying sub-lease, the cash received at the execution of the lease was deferred and will be recorded on a straight-line basis as a reduction in the rent expense under the master lease.

Note 12 – Related Party Transactions

As of March 31, 2014, the Company had $2.3 million on deposit at Valliance Bank. Valliance Bank is controlled by Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates. In addition, the Company is obligated to Valliance Bank under certain notes payable totaling approximately $5.9 million at March 31, 2014 and December 31, 2013. The interest rates on the notes range from 5% to 10%. Non-controlling interests in Valliance Bank are held by Mr. Stanton Nelson, the Company’s chief executive officer and Mr. Joseph Harroz, Jr., a director of the Company. Mr. Nelson and Mr. Harroz also serve as directors of Valliance Bank.

 

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In October 2013, the Company completed a private placement offering $9,135,000 (see Note 8 – Preferred Noncontrolling Interests for additional information). The offering was comprised of 87 FHE Units. Each FHE Unit was offered at $105,000 and entitled the purchaser to one (1) Class B membership interest in FHE, valued at $100,000, and 10,000 shares of the Company’s common stock, valued at $5,000. Mr. Stanton Nelson, the Company’s chief executive officer, purchased 5 FHE units for $525,000.

The Company occupies office space subject to a lease agreement with City Place, LLC (“City Place”). Under the lease agreement, the Company pays monthly rent of $17,970 until June 30, 2014; $0.00 from July 1, 2014 to January 31, 2015 and $17,970 from February 1, 2015 to March 31, 2017 plus additional payments for allocable basic expenses of City Place; the lease expires on March 31, 2017. Non-controlling interests in City Place are held by Roy T. Oliver, one of the Company’s greater than 5% shareholders and affiliates. During the three months ended March 31, 2014, the Company incurred approximately $22,000 in lease expense under the terms of the lease.

As of March 31, 2014 and December 31, 2013, the Company has obligations of $1.4 million that are owed to FHA and certain real estate subsidiaries and affiliates of FHA related to transactions that occurred prior to the Foundation acquisition in July 2013. The amounts owed to FHA and FHA affiliates are included in other liabilities on the accompanying consolidated balance sheets.

The Company has entered into agreements with certain of its Affiliate ASCs and hospitals to provide management services. As compensation for these services, the surgery centers and hospitals are charged management fees which are either fixed or are based on a percentage of the Affiliates cash collected or the Affiliates net revenue. The percentages range from 2.25% to 6.0%.

Note 13 – Subsequent Events

Management evaluated all activity of the Company and concluded that no material subsequent events have occurred, other than those disclosed in the notes to the consolidated financial statements, that would require recognition in the consolidated financial statements or disclosure in the notes to the consolidated financial statements.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Audit Committee, Board of Directors,

    and Shareholders of Foundation Healthcare, Inc.

We have audited the accompanying consolidated balance sheets of Foundation Healthcare, Inc. and subsidiaries (the “Company”) as of December 31, 2013 and 2012, and the related consolidated statements of operations, shareholders’ deficit and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits 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 financial statement presentation. 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 Foundation Healthcare, Inc. and subsidiaries as of December 31, 2013 and 2012, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company had insufficient working capital as of December 31, 2013 to fund anticipated working capital needs over the next twelve months. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ Hein & Associates LLP

Denver, Colorado

March 31, 2014

 

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FOUNDATION HEALTHCARE, INC.

Consolidated Balance Sheets

As of December 31, 2013 and 2012

 

		2013				2012
ASSETS
Cash and cash equivalents		$	4,212,076			$	3,037,067
Accounts receivable, net of allowance for doubtful accounts of $4,778,915 and $1,659,337, respectively			12,755,642				6,849,055
Receivables from affiliates			848,002				1,045,485
Supplies inventories			1,931,142				1,943,284
Deferred tax assets			2,118,637				—
Prepaid and other current assets			2,184,248				1,903,486
Current assets from discontinued operations			518,629				—
Total current assets			24,568,376				14,778,377
Property and equipment, net			12,073,986				9,403,853
Equity method investments in affiliates			5,699,093				7,013,611
Intangible assets, net			11,138,621				10,270,858
Goodwill			973,927				1,154,528
Other assets			244,598				126,559
Other assets from discontinued operations			576,228				—
Total assets		$	55,274,829			$	42,747,786
LIABILITIES AND SHAREHOLDERS’ DEFICIT
Liabilities:
Accounts payable		$	11,648,987			$	10,596,333
Accrued liabilities			4,114,915				5,585,180
Income taxes payable			3,564,455				—
Preferred noncontrolling interests dividends payable			195,411				3,549,670
Short-term debt			5,664,827				2,007,597
Current portion of long-term debt			7,919,179				5,971,339
Other current liabilities			827,132				—
Current liabilities from discontinued operations			5,620,697				—
Total current liabilities			39,555,603				27,710,119
Long-term debt, net of current portion			10,031,732				11,532,751
Deferred tax liabilities			2,604,879				—
Other liabilities			9,650,930				5,773,638
Other liabilities from discontinued operations			9,969				—
Total liabilities			61,853,113				45,016,508
Preferred noncontrolling interests			8,700,000				11,072,465
Commitments and contingencies (Note 12)
Foundation Healthcare shareholder’s deficit:
Preferred stock $0.0001 par value, 10,000,000 shares authorized; no shares issued and outstanding			—				—
Common stock $0.0001 par value, 500,000,000 shares authorized; 163,834,886 and 162,523,276 shares issued and outstanding, respectively			16,383				16,252
Paid-in capital			18,241,756				3,437,219
Accumulated deficit			(35,171,315	)			(14,744,688	)
Total Foundation Healthcare shareholders’ deficit			(16,913,176	)			(11,291,217	)
Noncontrolling interests			1,634,892				(2,049,970	)
Total deficit			(15,278,284	)			(13,341,187	)
Total liabilities, preferred noncontrolling interests and shareholders’ deficit		$	55,274,829			$	42,747,786

See Accompanying Notes to Consolidated Financial Statements

 

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FOUNDATION HEALTHCARE, INC.

Consolidated Statements of Operations

For the Years Ended December 31, 2013 and 2012

 

		2013				2012
Revenues:
Patient services		$	79,954,593			$	38,240,925
Management fees from affiliates			6,514,089				7,945,061
Equity in earnings of affiliates			5,885,188				6,927,466
Other revenue			4,545,608				828,471
Provision for doubtful accounts			(3,755,035	)			(966,420	)
Revenues			93,144,443				52,975,503
Operating Expenses:
Salaries and benefits			28,244,950				15,659,561
Supplies			22,871,118				11,114,752
Other operating expenses			32,916,003				18,467,864
Impairment of goodwill			21,864,781				—
Impairment of equity investment in affiliate			1,640,389				200,000
Depreciation and amortization			5,093,246				2,593,969
Total operating expenses			112,630,487				48,036,146
Other Income (Expense):
Interest expense, net			(2,171,327	)			(1,263,797	)
Loss on sale of equity investments in affiliates			—				(173,499	)
Other income (expense)			144,776				273,699
Net other (expense)			(2,026,551	)			(1,163,597	)
Income (loss) from continuing operations, before taxes			(21,512,595	)			3,775,760
Provision for income taxes			(814,513	)			—
Income (loss) from continuing operations, net of taxes			(22,327,108	)			3,775,760
Loss from discontinued operations, net of tax			(839,238	)			—
Extraordinary gain attributable to Foundation Healthcare, net of tax			4,833,715				—
Extraordinary gain attributable to noncontrolling interests			3,273,524				—
Net income (loss)			(15,059,107	)			3,775,760
Less: Net income attributable to noncontrolling interests			4,345,417				46,867
Net income (loss) attributable to Foundation Healthcare			(19,404,524	)			3,728,893
Preferred noncontrolling interests dividends			(1,022,103	)			(1,274,985	)
Net income (loss) attributable to Foundation Healthcare common stock		$	(20,426,627	)		$	2,453,908
Earnings per common share (basic and diluted):
Net income (loss) from continuing operations attributable to Foundation Healthcare common stock		$	(0.15	)		$	0.02
Loss from discontinued operations, net of tax			(0.01	)			—
Extraordinary gain, attributable to Foundation Healthcare, net of tax			0.03				—
Net income (loss) per share, attributable to Foundation Healthcare common stock		$	(0.13	)		$	0.02
Weighted average number of common and diluted shares outstanding			162,930,125				162,523,276
Pro forma income information (Note 3):
Pro forma provision for income taxes		$	(914,350	)		$	(1,434,789	)
Pro forma net income (loss) attributable to Foundation Healthcare common stock		$	(20,526,464	)			1,019,119
Pro forma basic and diluted net income (loss) per share		$	(0.13	)		$	0.01

See Accompanying Notes to Consolidated Financial Statements

 

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FOUNDATION HEALTHCARE, INC.

Consolidated Statements of Shareholders’ Deficit

For the Years Ended December 31, 2013 and 2012

 

		Common Stock								Paid-in Capital				Accumulated Deficit				Noncontrolling Interests				Total
		Shares				Amount
Balances, January 1, 2012			162,523,276			$	16,252			$	5,284,661			$	(17,198,596	)		$	(1,983,328	)		$	(13,881,011	)
Net income			—				—				—				3,728,893				—				3,728,893
Net income attributable to noncontrolling interests			—				—				—				—				46,867				46,867
Preferred noncontrolling interests dividends			—				—				—				(1,274,985	)			—				(1,274,985	)
Distributions to noncontrolling interests			—				—				—				—				(126,009	)			(126,009	)
Contributions from noncontrolling interests			—				—				—				—				12,500				12,500
Distributions to member			—				—				(1,847,442	)			—				—				(1,847,442	)
Balances, December 31, 2012			162,523,276				16,252				3,437,219				(14,744,688	)			(2,049,970	)			(13,341,187	)
Net loss			—				—				—				(19,404,524	)			—				(19,404,524	)
Net income attributable to noncontrolling interests			—				—				—				—				4,345,417				4,345,417
Reverse acquisition			—				—				13,938,874				—				—				13,938,874
Issuance of common stock and warrants			870,000				87				1,370,913				—				—				1,371,000
Stock-based compensation			225,938				23				129,698				—				—				129,721
Issuance of stock for payment of liabilities			247,000				24				108,513				—				—				108,537
Cancellation of outstanding shares			(31,328	)			(3	)			3				—				—				—
Preferred noncontrolling interests dividends			—				—				—				(1,022,103	)			—				(1,022,103	)
Distributions to noncontrolling interests			—				—				—				—				(660,555	)			(660,555	)
Distributions to member			—				—				(743,464	)			—				—				(743,464	)
Balances, December 31, 2013			163,834,886			$	16,383			$	18,241,756			$	(35,171,315	)		$	1,634,892			$	(15,278,284	)

See Accompanying Notes to Consolidated Financial Statements

 

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FOUNDATION HEALTHCARE, INC.

Consolidated Statements of Cash Flows

For the Years Ended December 31, 2013 and 2012

 

		2013				2012
Operating activities:
Net income (loss)		$	(15,059,107	)		$	3,775,760
Less: Net loss from discontinued operations, net of tax			(839,238	)			—
Less: Extraordinary gain, net of tax			8,107,239				—
Income (loss) from continuing operations			(22,327,108	)			3,775,760
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization			5,093,246				2,593,969
Impairment of goodwill			21,864,781				—
Impairment of equity investment in affiliate			1,640,389				200,000
Deferred tax benefit			(301,713	)			—
Stock-based compensation, net of cashless vesting			129,721				—
Loss on sale of equity investment in affiliates			—				173,499
Gain on redemption of noncontrolling interests			(66,915	)			—
Provision for doubtful accounts			3,755,035				966,420
Equity in earnings of affiliates			(5,885,188	)			(6,927,466	)
Changes in assets and liabilities, net of acquisitions –
Accounts receivable, net of provision for doubtful accounts			(9,412,289	)			(1,574,044	)
Receivables from affiliates			197,483				962,236
Supplies inventories			12,142				(195,639	)
Prepaid and other current assets			(81,786	)			(175,129	)
Other assets			534,489				10,373
Accounts payable			(170,691	)			1,028,196
Accrued liabilities			365,981				983,638
Income taxes payable			3,564,455				—
Other current liabilities			827,132				—
Other liabilities			3,302,290				(699,938	)
Net cash provided by operating activities from continuing operations			3,041,454				1,121,875
Net cash (used in) operating activities from discontinued operations			(992,512	)			—
Net cash provided by operating activities from continuing operations			2,048,942				1,121,875
Investing activities:
Cash received in business acquisition			68,170				193,314
Purchase of businesses			—				(309,048	)
Purchase of property and equipment			(3,794,643	)			(1,290,651	)
Disposal of property and equipment			90,762				—
Distributions from affiliates			5,559,317				6,889,405
Cash received in extraordinary gain transaction			463,678				—
Sale of equity investments in affiliates			—				1,665,266
Purchase of equity investments in affiliates			—				(200,000	)
Net cash provided by investing activities from continuing operations			2,387,284				6,948,286
Net cash provided by investing activities from discontinued operations			395,000				—
Net cash provided by investing activities			2,782,284				6,948,286

 

 

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FOUNDATION HEALTHCARE, INC.

Consolidated Statements of Cash Flows (continued)

For the Years Ended December 31, 2013 and 2012

 

		2013				2012
Financing activities:
Debt proceeds			10,035,860				1,243,596
Debt payments			(8,513,927	)			(4,713,016	)
Common stock proceeds			435,000				—
Preferred noncontrolling interests proceeds			8,700,000
Redemption of preferred noncontrolling interests			(11,102,372	)
Preferred noncontrolling interests dividends			(1,003,635	)			(583,828	)
Distributions to noncontrolling interests			(660,555	)			(126,009	)
Contributions from noncontrolling interests			—				12,500
Distributions to member			(743,464	)			(1,847,442	)
Net cash used in financing activities from continuing operations			(2,853,093	)			(6,014,199	)
Net cash used in financing activities from discontinued operations			(803,124	)			—
Net cash used in financing activities			(3,656,217	)			(6,014,199	)
Net change in cash and cash equivalents			1,175,009				2,055,962
Cash and cash equivalents at beginning of year			3,037,067				981,105
Cash and cash equivalents at end of year		$	4,212,076			$	3,037,067
Cash paid for interest and income taxes:
Interest expense		$	2,366,345			$	1,574,050
Interest expense, discontinued operations		$	124,821			$	—
Income taxes		$	—			$	—
Income taxes, discontinued operations		$	—			$	—
Noncash investing and financing activities:
Debt converted to common stock		$	(14,138,187	)		$	—
Common stock warrants issued		$	(936,000	)		$	—
Common stock issued as payment for liabilities		$	(108,537	)		$	—
Seller financing – reverse acquisition		$	2,000,000			$	—
Debt and liabilities assumed – reverse acquisition		$	2,032,098			$	—
Debt issued in purchase of noncontrolling preferred interest		$	(2,339,905	)		$	—

See Accompanying Notes to Consolidated Financial Statements

 

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FOUNDATION HEALTHCARE, INC.

Notes to Consolidated Financial Statements

For the Years Ended December 31, 2013 and 2012

Note 1 – Nature of Business

Foundation Healthcare, Inc. (the “Company”) is organized under the laws of the state of Oklahoma and owns controlling and noncontrolling interests in surgical hospitals located in Texas. The Company also owns noncontrolling interests in ambulatory surgery centers (“ASCs”) located in Texas, Oklahoma, Pennsylvania, New Jersey, Maryland and Ohio. Additionally, the Company provides sleep testing management services to various rural hospitals in Iowa, Minnesota, Missouri, Nebraska and South Dakota under management contracts with the hospitals. The Company provides management services to a majority of the facilities that it has noncontrolling interests (referred to as “Affiliates”) under the terms of various management agreements.

Note 2 – Basis of Presentation

Reverse Acquisition – On July 22, 2013, the Company acquired Foundation Surgery Affiliates, LLC (“FSA”) and FSA’s consolidated variable interest entity, Foundation Surgical Hospital Affiliates, LLC (“FSHA”) (collectively referred to as “Foundation”). For accounting purposes, the acquisition of FSA was accounted for as a reverse acquisition and as a result, the Company’s historical operating results included in the accompanying consolidated financial statements for the periods prior to July 22, 2013 represent those of FSA. The historical financial statements of FSA have been adjusted for the effect of the recapitalization that occurred as a result of the reverse acquisition.

Going Concern and Management’s Plan – As of December 31, 2013, the Company had an accumulated deficit of $35.2 million and a working capital deficiency of $15.0 million. During the year ended December 31, 2013, the Company generated a net loss attributable to Foundation Healthcare of $19.4 million, including a goodwill impairment charge of $21.9 million, and generated cash flow from operating activities from continuing operations of $3.0 million. As of December 31, 2013, the Company had cash and cash equivalents of $4.2 million and in March 2014, the Company received $4.1 million as part of a lease transaction (see Note 19 – Subsequent Events). Management expects to refinance, by the end of the second quarter of 2014, a significant portion of the Company’s long-term debt obligations. Management expects that the Company will be able to significantly reduce its annual debt service payments as part of the refinancing; however, there is no assurance that management will be successful in completing the debt refinancing.

If management is unable to refinance a significant portion of its existing debt as noted above, the Company may be forced to obtain extensions on existing debt obligations as they become due in 2014. Although management has historically been successful in obtaining extensions, there is no assurance that the Company’s banks will continue to grant them in the future. In addition, management may choose to raise additional funds through the sale of equity or assets, but there is no assurance that the Company will be successful in completing such actions.

If management does not complete the debt refinancing or alternatively obtain extensions on some of its debt obligations during 2014, the Company may not have sufficient cash on hand or generate sufficient cash flow from operations to meet its cash requirements over the next 12 months. These uncertainties raise substantial doubt about the Company’s ability to continue as a going concern. The consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.

Note 3 – Summary of Significant Accounting Policies

Consolidation – The accompanying consolidated financial statements include the accounts of Foundation Healthcare, Inc. and its wholly owned, majority owned and controlled subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

 

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The Company accounts for its investments in Affiliates in which the Company exhibits significant influence, but not control, in accordance with the equity method of accounting. The Company does not consolidate its equity method investments, but rather measures them at their initial costs and then subsequently adjusts their carrying values through income for their respective shares of the earnings or losses during the period. The Company monitors its investments for other-than-temporary impairment by considering factors such as current economic and market conditions and the operating performance of the companies and records reductions in carrying values when necessary.

Use of estimates – The preparation of financial statements in conformity with generally accepted accounting principles requires management of the Company to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Reclassifications – Certain amounts presented in prior years have been reclassified to conform to the current year’s presentation. Such reclassifications had no effect on net loss.

Pro forma income information – Prior to July 22, 2013, FSA’s and FSHA’s member had elected to have FSA’s and FSHA’s income taxed as an S Corporation under provisions of the Internal Revenue Code and a similar section of the state income tax law. Therefore, taxable income or loss is reported to the individual member for inclusion in its tax returns and no provision for income taxes is included in the Company’s consolidated financial statements for periods prior to July 22, 2013. The pro forma income information provides an adjustment for income tax expense as if FSA and FSHA had been a C Corporation prior to July 22, 2013 at an assumed combined federal and state effective tax rate of 38%, which approximates the calculated statutory tax rates for the periods.

Revenue recognition and accounts receivable – The Company recognizes revenues in the period in which services are performed. Accounts receivable primarily consist of amounts due from third-party payors and patients. The Company’s ability to collect outstanding receivables is critical to its results of operations and cash flows. Amounts the Company receives for treatment of patients covered by governmental programs such as Medicare and Medicaid and other third-party payors such as health maintenance organizations, preferred provider organizations and other private insurers are generally less than the Company’s established billing rates. Additionally, to provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. Accordingly, the revenues and accounts receivable reported in the Company’s consolidated financial statements are recorded at the net amount expected to be received.

During the years ended December 31, 2013 and 2012, the Company’s revenue payor mix was as follows:

 

		2013				2012
Medicare and Medicaid			27	%			16	%
Commercial health insurance payors			54	%			46	%
Patient self-pay			5	%			4	%
Management fees from affiliates			7	%			15	%
Equity in earnings of investments in affiliates			6	%			13	%
Other			5	%			2	%
Provision for doubtful accounts			(4	%)			(2	%)

Contractual Discounts and Cost Report Settlements – The Company derives a significant portion of its revenues from Medicare, Medicaid and other payors that receive discounts from its established billing rates. The Company must estimate the total amount of these discounts to prepare its consolidated financial statements. The Medicare and Medicaid regulations and various managed care contracts under which these discounts must be calculated are complex and are subject to interpretation and adjustment. The Company estimates the allowance

 

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for contractual discounts on a payor-specific basis given its interpretation of the applicable regulations or contract terms. These interpretations sometimes result in payments that differ from the Company’s estimates. Additionally, updated regulations and contract renegotiations occur frequently, necessitating regular review and assessment of the estimation process by management. Changes in estimates related to the allowance for contractual discounts affect revenues reported in the Company’s accompanying consolidated statements of operations.

Cost report settlements under reimbursement agreements with Medicare and Medicaid are estimated and recorded in the period the related services are rendered and are adjusted in future periods as final settlements are determined. There is a reasonable possibility that recorded estimates will change by a material amount in the near term. There was no adjustment for estimated cost report settlements in 2013 or 2012. The net cost report settlements due to the Company was approximately $235,000 and $3,500 at December 31, 2013 and 2012, respectively, and in included in prepaid and other current assets in the accompanying consolidated balance sheets. The Company’s management believes that adequate provisions have been made for adjustments that may result from final determination of amounts earned under these programs.

Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation. The Company believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing that would have a material effect on the Company’s financial statements. Compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties and exclusion from the Medicare and Medicaid programs.

Provision and Allowance for Doubtful Accounts – To provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. The primary uncertainty lies with uninsured patient receivables and deductibles, co-payments or other amounts due from individual patients.

The Company has an established process to determine the adequacy of the allowance for doubtful accounts that relies on a number of analytical tools and benchmarks to arrive at a reasonable allowance. No single statistic or measurement determines the adequacy of the allowance for doubtful accounts. Some of the analytical tools that the Company utilizes include, but are not limited to, the aging of accounts receivable, historical cash collection experience, revenue trends by payor classification, revenue days in accounts receivable, the status of claims submitted to third party payors, reason codes for declined claims and an assessment of the Company’s ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan. Accounts receivable are written off after collection efforts have been followed in accordance with the Company’s policies.

Due to the nature of the healthcare industry and the reimbursement environment in which the Company operates, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time products or services are provided. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on the Company’s operating results and cash flows in subsequent periods. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded.

The patient and their third party insurance provider typically share in the payment for the Company’s products and services. The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network. Due to uncertainties surrounding deductible levels and the number of out-of-network patients, the Company is not certain of the full amount of patient responsibility at the time of service. The Company estimates amounts due from patients prior to service and generally collects those amounts prior to service. Remaining amounts due from patients are then billed following completion of service.

 

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The activity in the allowances for doubtful accounts for the years ending December 31, 2013 and 2012 follows:

 

		2013				2012
Balances at beginning of year		$	1,659,337			$	1,353,710
Reclassification from contractual allowances			1,458,737				—
Provisions recognized as reduction in revenues			3,755,035				966,420
Write-offs, net of recoveries			(2,094,194	)			(660,793	)
Balances at end of year		$	4,778,915			$	1,659,337

Cash and cash equivalents – The Company considers all highly liquid temporary cash investments with an original maturity of three months or less to be cash equivalents. Certificates of deposit with original maturities of more than three months are also considered cash equivalents if there are no restrictions on withdrawing funds from the account.

Restricted cash – As of December 31, 2013 and 2012, the Company had restricted cash of approximately $701,000 and $400,000, respectively, included in prepaid and other current assets in the accompanying consolidated balance sheets. The restricted cash is pledged as collateral against certain debt of the Company.

Receivables from Affiliates – Receivables from Affiliates are stated at the amount billed to the Affiliates plus any accrued and unpaid interest.

Supplies inventories – Supplies inventories are stated at the lower of cost or market and primarily include operating supplies used in the direct or indirect treatment of patients. The Company accounts for inventories using the first in–first out method of accounting for substantially all of its inventories.

Property and equipment – Property and equipment is stated at cost and depreciated using the straight line method to depreciate the cost of various classes of assets over their estimated useful lives. At the time assets are sold or otherwise disposed of, the cost and accumulated depreciation are eliminated from the asset and depreciation accounts; profits and losses on such dispositions are reflected in current operations. Fully depreciated assets are written off against accumulated depreciation. Assets under capital leases are amortized using the straight-line method over the shorter of the estimated useful life of the assets or life of the lease term, excluding any lease renewals, unless the lease renewals are reasonably assured. Expenditures for major renewals and betterments that extend the useful lives of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred.

The estimated useful lives of the Company’s property and equipment are as follows:

 

Asset Class		Useful Life
Furniture and equipment			3 to 7 years
Equipment under capital leases			3 to 7 years
Leasehold improvements			5 to 10 years or remaining lease period, whichever is shorter

Long-lived assets – The Company evaluates its long-lived assets for possible impairment whenever circumstances indicate that the carrying amount of the asset, or related group of assets, may not be recoverable from estimated future cash flows. Fair value estimates are derived from established market values of comparable assets or internal calculations of estimated future net cash flows. The Company’s estimates of future cash flows are based on assumptions and projections it believes to be reasonable and supportable. The Company’s assumptions take into account revenue and expense growth rates, patient volumes, changes in payor mix and changes in legislation and other payor payment patterns.

 

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Goodwill and Intangible Assets – Goodwill is not amortized; instead, it is reviewed for impairment annually (in the fourth quarter) or more frequently if indicators of impairment exist or if a decision is made to sell a business. A significant amount of judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include deterioration in general economic conditions, negative developments in equity and credit markets, adverse changes in the markets in which an entity operates, increases in input costs that have a negative effect on earnings and cash flows, or a trend of negative or declining cash flows over multiple periods, among others. The fair value that could be realized in an actual transaction may differ from that used to evaluate the impairment of goodwill. Goodwill is allocated among and evaluated for impairment at the reporting unit level.

The Financial Accounting Standards Board (“FASB”) guidance on testing goodwill for impairment provides an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the estimated fair value of a reporting unit is less than its carrying amount. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the existing two-step quantitative impairment test (described below), otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the two-step quantitative impairment test. The ultimate outcome of the goodwill impairment review for a reporting unit should be the same whether an entity chooses to perform the qualitative assessment or proceeds directly to the two-step quantitative impairment test.

The Company evaluates goodwill for impairment at least on an annual basis and more frequently if certain indicators are encountered. Goodwill is to be tested at the reporting unit level, defined as an ASC or hospital (referred to as a component), with the fair value of the reporting unit being compared to its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered to be impaired. The Company completed its annual impairment test as of December 31, 2013, and determined that goodwill was not impaired.

Intangible assets other than goodwill which include customer relationships, customer files, covenants not to compete, trademarks and payor contracts are amortized over their estimated useful lives using the straight line method. The remaining lives range from three to five years. The Company evaluates the recoverability of identifiable intangible asset whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.

Noncontrolling Interests – Noncontrolling interests in the results of operations of consolidated subsidiaries represents the noncontrolling shareholders’ share of the income or loss of the various consolidated subsidiaries. The noncontrolling interests in the consolidated balance sheet reflect the original investment by these noncontrolling shareholders in these consolidated subsidiaries, along with their proportional share of the earnings or losses of these subsidiaries less distributions made to these noncontrolling interest holders.

Legal Issues – For asserted claims and assessments, liabilities are recorded when an unfavorable outcome of a matter is deemed to be probable and the loss is reasonably estimable. Management determines the likelihood of an unfavorable outcome based on many factors such as the nature of the matter, available defenses and case strategy, progress of the matter, views and opinions of legal counsel and other advisors, applicability and success of appeals processes, and the outcome of similar historical matters, among others. Once an unfavorable outcome is deemed probable, management weighs the probability of estimated losses, and the most reasonable loss estimate is recorded. If an unfavorable outcome of a matter is deemed to be reasonably possible, then the matter is disclosed and no liability is recorded. With respect to unasserted claims or assessments, management must first determine that the probability that an assertion will be made is likely, then, a determination as to the likelihood of an unfavorable outcome and the ability to reasonably estimate the potential loss is made. Legal matters are reviewed on a continuous basis or sooner if significant changes in matters have occurred to determine if a change in the likelihood of an unfavorable outcome or the estimate of a loss is necessary.

 

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Concentration of credit risk – The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risk. As of December 31, 2013 and 2012, the Company had cash deposits in excess of FDIC limits of $3.4 million and $2.9 million, respectively.

Advertising Costs – Advertising costs are expensed as incurred. Advertising expense for 2013 and 2012, included in continuing operations, was approximately $244,000 and $153,000, respectively.

Acquisition Costs – Acquisition costs are charged directly to expense when incurred.

Income Taxes – In 2012, the Company’s member elected to have the Company’s income taxed as an “S” Corporation under provisions of the Internal Revenue Code and a similar section of the state income tax law. Therefore, taxable income or loss is reported to the individual member for inclusion in its respective tax returns and no provision for federal and state income taxes is included in the 2012 consolidated financial statements.

For 2013, the Company recognizes deferred tax assets and liabilities for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. In the event the Company determines that the deferred tax assets will not be realized in the future, the valuation adjustment to the deferred tax assets is charged to earnings in the period in which the Company makes such a determination.

The Company uses a two-step process to evaluate a tax position. The first step is to determine whether it is more-likely-than-not that a tax position will be sustained upon examination, including the resolution of any related appeals or litigation based on the technical merits of that position. The second step is to measure a tax position that meets the more-likely-than-not threshold to determine the amount of benefit to be recognized in the financial statements. A tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.

Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent period in which the threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not criteria should be de-recognized in the first subsequent financial reporting period in which the threshold is no longer met. The Company reports tax-related interest and penalties as a component of income tax expense.

Based on all known facts and circumstances and current tax law, the Company believes that the total amount of unrecognized tax benefits as of December 31, 2013, is not material to its results of operations, financial condition or cash flows. The Company also believes that the total amount of unrecognized tax benefits as of December 31, 2013, if recognized, would not have a material effect on its effective tax rate. The Company further believes that there are no tax positions for which it is reasonably possible, based on current tax law and policy that the unrecognized tax benefits will significantly increase or decrease over the next 12 months producing, individually or in the aggregate, a material effect on the Company’s results of operations, financial condition or cash flows.

Loss per share – Basic loss per share is computed by dividing net loss by the weighted average number of common shares outstanding for the period. Diluted loss per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted during the period. Dilutive securities having an anti-dilutive effect on diluted earnings (loss) per share are excluded from the calculation.

The dilutive potential common shares on options and warrants are calculated in accordance with the treasury stock method, which assumes that proceeds from the exercise of all options and warrants are used to repurchase common stock at market value. The amount of shares remaining after the proceeds are exhausted represents the potential dilutive effect of the securities.

 

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The following securities were not included in the computation of diluted earnings (loss) per share from continuing operations or discontinued operations as their effect would be anti-dilutive:

 

		2013				2012
Stock options and warrants			18,361,064				—

Stock options – The Company accounts for its stock option grants using the modified prospective method. Under the modified prospective method, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period, which is the vesting period.

Recently Adopted and Recently Issued Accounting Guidance

Adopted Guidance

On January 1, 2013, the Company adopted changes issued by the FASB to the testing of indefinite-lived intangible assets for impairment, similar to the goodwill changes issued in September 2011. These changes provide an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not (more than 50%) that the fair value of an indefinite-lived intangible asset is less than its carrying amount. Such qualitative factors may include the following: macroeconomic conditions; industry and market considerations; cost factors; overall financial performance; and other relevant entity-specific events. If an entity elects to perform a qualitative assessment and determines that an impairment is more likely than not, the entity is then required to perform the existing two-step quantitative impairment test, otherwise no further analysis is required. An entity also may elect not to perform the qualitative assessment and, instead, proceed directly to the two-step quantitative impairment test. Since management proceeds directly to the two-step quantitative test for the Company’s indefinite-lived intangible assets, these do not affect the outcome of the impairment analysis of an indefinite-lived intangible asset. As a result, management determined these changes did not have an impact on the Company’s consolidated financial statements.

On January 1, 2013, the Company adopted changes issued by FASB to the disclosure of offsetting assets and liabilities. These changes require an entity to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. The enhanced disclosures will enable users of an entity’s financial statements to understand and evaluate the effect or potential effect of master netting arrangements on an entity’s financial position, including the effect or potential effect of rights of setoff associated with certain financial instruments and derivative instruments. Other than the additional disclosure requirements, management determined that the adoption of these changes did not have an impact on the Company’s consolidated financial statements.

On January 1, 2012, the Company adopted changes issued by the FASB to conform existing guidance regarding fair value measurement and disclosure between GAAP and International Financial Reporting Standards. These changes both clarify the FASB’s intent about the application of existing fair value measurement and disclosure requirements and amend certain principles or requirements for measuring fair value or for disclosing information about fair value measurements. The clarifying changes relate to the application of the highest and best use and valuation premise concepts, measuring the fair value of an instrument classified in a reporting entity’s shareholders’ equity, and disclosure of quantitative information about unobservable inputs used for Level 3 fair value measurements. The amendments relate to measuring the fair value of financial instruments that are managed within a portfolio; application of premiums and discounts in a fair value measurement; and additional disclosures concerning the valuation processes used and sensitivity of the fair value measurement to changes in unobservable inputs for those items categorized as Level 3, a reporting entity’s use of a nonfinancial asset in a way that differs from the asset’s highest and best use, and the categorization by level in the fair value hierarchy for items required to be measured at fair value for disclosure purposes only. Other than the additional disclosure requirements, the adoption of these changes had no impact on the Company’s consolidated financial statements.

 

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Issued Guidance

In February 2013, the FASB issued changes to the accounting for obligations resulting from joint and several liability arrangements. These changes require an entity to measure such obligations for which the total amount of the obligation is fixed at the reporting date as the sum of (i) the amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors, and (ii) any additional amount the reporting entity expects to pay on behalf of its co-obligors. An entity will also be required to disclose the nature and amount of the obligation as well as other information about those obligations. Examples of obligations subject to these requirements are debt arrangements and settled litigation and judicial rulings. These changes become effective for the Company on January 1, 2014. Management has determined that the adoption of these changes will not have an impact on the Company’s consolidated financial statements, as the Company does not currently have any such arrangements.

In July 2013, the FASB issued changes to the presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. These changes require an entity to present an unrecognized tax benefit as a liability in the financial statements if (i) a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position, or (ii) the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset to settle any additional income taxes that would result from the disallowance of a tax position. Otherwise, an unrecognized tax benefit is required to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. Previously, there was diversity in practice as no explicit guidance existed. These changes become effective for the Company on January 1, 2014. Management has determined that the adoption of these changes will not have a significant impact on the Company’s consolidated financial statements.

Note 4 – Reverse Acquisition

On July 22, 2013, the Company acquired FSA and FSA’s consolidated variable interest entity, FSHA, from Foundation Healthcare Affiliates, LLC (“FHA”) pursuant to an Amended and Restated Membership Purchase Agreement (the “Purchase Agreement”). Pursuant to the Purchase Agreement, the Company (i) issued to FHA 114,500,000 shares of its common stock, (ii) issued to FHA a demand promissory note in the principal amount of $2.0 million, and (iii) assumed certain liabilities and obligations of FHA totaling approximately $2.0 million.

For accounting purposes, the acquisition of FSA was accounted for as a reverse acquisition and as a result, the Company’s historical operating results included in the accompanying consolidated financial statements for the periods prior to July 22, 2013 represent those of FSA. The historical financial statements of FSA have been adjusted for the effect of the recapitalization that occurred as a result of the reverse acquisition.

The acquisition of Foundation was based on management’s belief that Foundation’s acquisition and development strategy and operating model will enable the Company to grow by taking advantage of highly-fragmented markets, an increasing demand for short stay surgery and a need by physicians to forge strategic alliances to meet the needs of the evolving healthcare landscape while also shaping the clinical environments in which they practice. The Company expects the acquisition of Foundation will generate positive earnings and cash flow that will be accretive to the earnings and cash flow of the Company.

Simultaneous with and subject to the reverse acquisition, the Company issued 13,333,333 shares of common stock to purchase a $6.0 million participation in the credit facility owed by the Company to Arvest Bank (see Note 6 – Discontinued Operations for more information) and 17,970,295 shares of common stock to Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates, for full satisfaction of debt owed to Mr. Oliver totaling $8,136,390. Since the completion of the reverse acquisition was subject to these transactions, they have been recorded as part of the reverse acquisition.

 

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Since FSA is deemed to be the accounting acquirer, the reverse acquisition was recorded by allocating the purchase price of the acquisition to the assets acquired, including intangible assets and liabilities assumed, from the legacy business of Graymark Healthcare, Inc. (“Graymark”), based on their estimated fair values at the acquisition date. The excess of the cost of the acquisitions over the net amounts assigned to the estimated fair value of the assets acquired, net of liabilities assumed, was recorded as goodwill, none of which is anticipated to be tax deductible.

The fair value of the total consideration issued in the reverse acquisition amounted to $27.3 million and included $13.9 million for the issuance of the Company’s common stock to FHA, Arvest Bank and Mr. Oliver, $2.0 million for the promissory note issued to FHA, $2.0 million for the debt obligations and liabilities assumed from FHA and $9.3 million in debt and working capital deficit assumed by the Company.

The fair value amounts were initially recorded using preliminary estimates. Subsequently, management engaged a third-party valuation company to complete a valuation of the fair value of the assets acquired and liabilities assumed in the reverse acquisition. The preliminary and final purchase allocations for the reverse acquisition are as follows:

 

		Preliminary				Final
Cash and cash equivalents		$	68,170			$	68,170
Accounts receivable			249,333				249,333
Current assets from discontinued operations			1,773,471				1,360,143
Other current assets			198,977				198,976
Total current assets			2,289,951				1,876,622
Property and equipment			647,862				1,389,169
Intangible assets			3,800,000				2,733,000
Goodwill			20,847,608				21,864,781
Other assets from discontinued operations			295,542				1,224,140
Other assets			12,753				252,528
Total assets acquired			27,893,716				29,340,240
Liabilities assumed:
Accounts payable and accrued liabilities			2,501,877				2,899,823
Short term debt			2,000,000				2,000,000
Current portion of long-term debt			714,711				714,711
Current liabilities from discontinued operations			7,812,192				7,375,521
Total current liabilities			13,028,780				12,990,055
Long-term debt, net of current portion			742,385				742,385
Other liabilities from discontinued operations			174,509				305,969
Other liabilities			575,000				1,362,957
Total liabilities assumed			14,520,674				15,401,366
Net assets acquired		$	13,373,042			$	13,938,874

During the year ended December 31, 2013 and 2012, the Company incurred approximately $506,000 and $446,000 in expenses related to the reverse acquisition. The expenses incurred related primarily to legal fees related to the Purchase Agreement and structure of the transaction and professional fees related to the audits of the 2012 and 2011 consolidated financial statements of FSA.

 

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The amounts of acquisition revenues and earnings included in the Company’s consolidated statements of operations for the year ended December 31, 2013, and the revenue and earnings of the combined entity had the reverse acquisition date for Graymark been January 1, 2012 are as follows:

 

														Attributable to Foundation
		Revenue				Loss from Continuing Operations				Net Income (Loss)				Net Income (Loss)				Net Income (Loss) per Share
Actual:
From 7/22/2013 to 12/31/2013		$	968,729			$	(23,413,107	)		$	(24,995,058	)		$	(24,995,058	)
Supplemental Pro Forma:
Year ending 12/31/2013		$	94,514,058			$	(24,733,907	)		$	(19,402,769	)		$	(23,616,628	)		$	(0.14	)
Year ending 12/31/2012		$	70,178,706			$	(18,792,393	)		$	(19,016,863	)		$	(18,720,810	)		$	(0.12	)

The pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that actually would have been achieved had the acquisition been consummated as of that time, nor is it intended to be a projection of future results.

Note 5 – Acquisitions

On October 26, 2012, the Company acquired a controlling interest in East El Paso Physicians’ Medical Center, LLC (“El Paso”), located in El Paso, Texas. The Company obtained its controlling interest through the acquisition of 108.41 Class A ownership units and 37.00 non-dilutable Class C ownership units of the total 223.41 ownership units of El Paso, or 66.39%. The Company obtained the Class A units by guaranteeing debt in the amount of $50,000 per unit. Additional Class A units may be sold to other investors which may dilute the Company’s overall ownership percentage in El Paso. The Company obtained the Class C units by guaranteeing debt in the amount of $50,000 per unit. The Class C units may only be held by the Company and represent a 19.68% ownership in El Paso. This ownership percentage may not be diluted by the future sale of any other class of ownership unit. In the fourth quarter of 2012, the Company also completed the acquisition of two imaging centers located in El Paso, Texas (“Imaging Centers”). The Imaging Centers were acquired through a combination of cash payments and the assumption of certain debt and other obligations of the sellers.

The acquisition of El Paso was based on management’s belief that through the application of the Company’s management and operating model the hospital could be turned around to generate positive earnings and cash flow that will be accretive to the earnings and cash flow of the Company. The acquisition of the Imaging Centers is consistent with the Company’s strategy of growing revenue and earnings through acquiring ancillary service providers in close proximity to a managed or owned hospital.

 

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The acquisitions were recorded by allocating the cost of the acquisition to the assets acquired, including intangible assets and liabilities assumed based on their estimated fair values at the acquisition date. The excess of the cost of the acquisitions over the net amounts assigned to the fair value of the assets acquired, net of liabilities assumed, was recorded as goodwill, none of which is tax deductible. As of December 31, 2012, management completed a valuation of the fair value of the assets acquired and liabilities assumed in the El Paso acquisition. The fair value amounts for the Imaging Centers were initially recorded using preliminary estimates. During the fourth quarter of 2013, management engaged a third-party valuation company to complete a valuation of the fair value of the assets acquired and liabilities assumed in the Imaging Center acquisitions. The purchase allocations for the acquisitions were as follows:

 

						Imaging Centers
		El Paso				Preliminary				Final
Cash and cash equivalents		$	193,314			$	—			$	—
Accounts receivable			1,814,324				—				—
Inventories			932,184				7,500				7,500
Other current assets			613,860				—				—
Total current assets			3,553,682				7,500				7,500
Property and equipment			5,319,000				358,709				539,309
Intangible assets			8,293,000				—				—
Goodwill			603,250				551,278				370,678
Total assets acquired			17,768,932				917,487				917,487
Liabilities assumed:
Accounts payable and accrued liabilities			7,621,930				85,330				85,330
Other current liabilities			110,000				—				—
Short term debt			1,413,278				156,242				156,242
Current portion of long-term debt			1,982,848				78,423				78,423
Total current liabilities			11,128,056				319,995				319,995
Long-term debt, net of current portion			3,842,341				288,444				288,444
Other liabilities			2,798,535				—				—
Total liabilities assumed			17,768,932				608,439				608,439
Net assets acquired		$	—			$	309,048			$	309,048

El Paso agreed to pay the legal, due diligence and other expenses associated with the acquisition. As a result, during 2012, the Company did not record any material expenses related to the acquisition of El Paso. The company also did not incur any material expenses in the acquisition of the imaging centers.

The amounts of acquisitions revenues and earnings included in the Company’s consolidated statements of operations for the year ended December 31, 2012, and the revenue and earnings of the combined entity had the acquisition dates for El Paso and the Imaging Centers been January 1, 2012 are as follows:

 

		Revenues				Earnings
Actual:
From 10/26/2012 to 12/31/2012		$	5,151,604			$	(1,252,763	)
Supplemental Pro Forma:
2012		$	69,442,123			$	(7,388,605	)

The pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that actually would have been achieved had the acquisition been consummated as of that time, nor is it intended to be a projection of future results.

 

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Note 6 – Discontinued Operations

Prior to the reverse acquisition, Graymark committed to a plan to divest of or close certain sleep diagnostic and sleep therapy locations. The decision was based on a combination of the financial performance of the facilities and the shift in focus to the business model of Foundation. As a result of the pending closure or sale of these locations, the related assets, liabilities, results of operations and cash flows were classified as discontinued operations which were acquired by the Company in the reverse acquisition.

Under the plan, from July 2013 to October 2013, Graymark closed or sold 24 sleep diagnostic locations including both IDTF and contracted locations in Georgia, Iowa, Kansas, Missouri, Nevada, Oklahoma and Texas and 5 sleep therapy locations in Iowa, Kansas, Nevada, Oklahoma and Texas.

As part of the reverse acquisition, the Company acquired the special charge liability of $475,570 related to the estimated closing costs resulting from the plan to sell or close the sleep diagnostic and therapy locations. From July 22, 2013 to December 31, 2013, the activity in the acquired accruals for restructuring charges established for lease termination and other exit costs were as follows:

 

		Lease Termination Costs				Other Exit Costs				Total
Acquired balance at July 22, 2013		$	355,028			$	140,542			$	495,570
Adjustments			(192,685	)			—				(192,685	)
Cash payments			(84,108	)			(140,542	)			(224,650	)
Balance at December 31, 2013		$	78,235			$	—			$	78,235

Additional charges may be recorded in future periods dependent upon the Company’s ability to sub-lease or otherwise mitigate future lease costs at closed facilities.

The operating results of the discontinued sleep diagnostic and therapy locations and the Company’s other discontinued operations from July 22, 2013 to December 31, 2013 are summarized below:

 

		July 22 to December 31, 2013
Revenues		$	877,362
Net loss before taxes		$	(1,353,609	)
Income tax benefit			514,371
Net loss from discontinued operations, net of tax		$	(839,238	)

 

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The balance sheet items for discontinued operations are summarized below:

 

		December 31, 2013
Cash and cash equivalents		$	49,252
Accounts receivable, net of allowances			222,943
Inventories			1,893
Other current assets			244,541
Total current assets			518,629
Fixed assets, net			426,228
Other assets			150,000
Total noncurrent assets			576,228
Total assets		$	1,094,857
Payables and accrued liabilities		$	1,557,771
Short term debt			3,994,932
Current portion of long-term debt			67,994
Total current liabilities			5,620,697
Long-term debt			9,969
Total liabilities		$	5,630,666

The Company’s borrowings and capital lease obligations included in discontinued operations as of December 31, 2013 is as follows:

 

		Rate(1)				Maturity Date				December 31, 2013
Short-term Debt
Senior bank debt			6	%			Apr. 2014			$	3,994,932
Long-term Debt
Sleep center notes payable			6	%			Nov. 2014			$	28,723
Equipment capital leases			8	%			Jan. 2015				49,389
Total											78,112
Less: Current portion of long-term debt											(68,143	)
Long-term debt										$	9,969

 

(1)	Effective rate as of December 31, 2013

At December 31, 2013, future maturities of long-term debt included in discontinued operations were as follows:

 

Twelve months ended December 31,
2014		$	68,143
2015			9,969
2016			—
2017			—
2018			—
Thereafter			—

On July 22, 2013, the Company’s subsidiaries, SDC Holdings, LLC and ApothecaryRx, LLC (collectively the “Borrowers”), the Company and Mr. Stanton Nelson (the “Guarantor” and the Company’s chief executive

 

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officer) entered into a Second Amended and Restated Loan Agreement (the “New Loan Agreement”) and an Amended and Restated Promissory Note (the “New Note”) with Arvest Bank. The Company, Borrowers, Guarantor and other guarantors previously entered into the Amended and Restated Loan Agreement dated effective December 17, 2010, as amended by the First Amendment to Loan Agreement dated January 1, 2012, the Second Amendment to Loan Agreement dated effective June 30, 2012, and the Third Amendment to Loan Agreement dated effective October 12, 2012 (the “Prior Agreement”). Under the Prior Agreement, the Company and Borrowers were indebted to Arvest Bank under the Amended and Restated Promissory Note, in the original principal amount of $15,000,000 dated June 30, 2010 and the Second Amended and Restated Promissory Note, in the original principal amount of $30,000,000, dated June 30, 2010 (the “Prior Notes”). Arvest Bank, the Company, the Borrowers and the Guarantor have agreed to restructure the loan evidenced by the Prior Notes and the Prior Agreement. As of December 31, 2013, the outstanding principal amount of the New Note was $9,994,932.

On July 22, 2013, in conjunction with the New Loan Agreement with Arvest Bank, the Company entered into a Participation Agreement with Arvest Bank in which we purchased a $6,000,000 participation in the New Note from Arvest Bank in exchange for 13,333,333 shares of the Company’s common stock. The Company purchased the participation in the last $6,000,000 of the principal amount due under the Arvest credit facility. The Company’s participation in the note is eliminated against the New Note in the long-term debt table shown above.

The New Loan Agreement and New Note were entered into on the same date as and in conjunction with the reverse acquisition. As such, the New Note is included in the opening balance sheet in the reverse acquisition accounting (see Note 4 – Reverse Acquisition).

The New Note is collateralized by substantially all of the assets of the Borrowers and the personal guaranty of the Guarantor which is limited to $2,919,000. The note bears interest at the greater of the prime rate or 6.0% and provided the Borrowers are not in default, the Borrowers are required to make monthly payments of interest only. The entire unpaid principal balance and all accrued and unpaid interest thereon will be due and payable on December 31, 2013. Additionally, the New Note is subject to certain financial covenants including a debt service coverage ratio (“DSR”) covenant of not less than 1.25 to 1. Arvest Bank has waived the DSR and other financial covenant requirements through April 30, 2014, which is the maturity date of the New Note.

Note 7 – Equity Investments in Affiliates

The Company invests in non-majority interests in its Affiliates. The Company’s equity investments and respective ownership interest as of December 31, 2013 and 2012 are as follows:

 

				Ownership %
Affiliate		Location		2013				2012
Surgical Hospitals:
Grayson County Physicians Property, LLC		Sherman, TX			20	%			20	%
Houston Orthopedic Hospital, LLC		Houston, TX			20	%			20	%
ASCs
Foundation Surgery Affiliate of Nacogdoches, LLP		Nacogdoches, TX			13	%			13	%
Kirby Glen Surgery Center		Houston, TX			10	%			10	%
Park Ten Surgery Center		Houston, TX			10	%			10	%
Foundation Surgery Affiliate of Middleburg Heights, LLC		Middleburg Heights, OH			10	%			10	%
Foundation Surgery Affiliate of Huntingdon Valley, LP		Huntingdon Valley, PA			20	%			20	%
Foundation Surgery Affiliate of Seguin, LLP		Seguin, TX			20	%			20	%
New Jersey Surgery Center, LLC		Mercerville, NJ			10	%			10	%
Foundation Surgery Affiliate of Northwest Oklahoma City, LLC		Oklahoma City, OK			20	%			20	%
Foundation Surgery Affiliate of Grayson County, LLP		Sherman, TX			20	%			20	%
Metropolitan Medical Partners, LLC (“Chevy Chase”)		Chevy Chase, MD			18	%			18	%
Cumberland Valley Surgery Center, LLC		Hagerstown, MD			32	%			32	%
Frederick Surgical Center, LLC		Frederick, MD			20	%			19	%

 

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The unaudited results of operations and financial position for the years ended and as of December 31, 2013 and 2012, respectively, of the Company’s equity investments in Affiliates are as follows:

 

(Unaudited)		2013				2012
Net operating revenues		$	186,777,871			$	203,083,755
Net income		$	40,559,684			$	43,345,570
Current assets		$	44,091,846			$	48,755,477
Noncurrent assets			44,668,968				48,369,312
Total assets		$	88,760,814			$	97,124,789
Current liabilities		$	31,891,679			$	29,161,233
Noncurrent liabilities			29,015,316				36,047,919
Total liabilities		$	60,906,995			$	65,209,152
Members’ equity		$	27,853,819			$	31,915,637

During 2012, the Company sold certain equity investments in Affiliates. The Company did not sell any equity investments in Affiliates in 2013. The gain or loss recorded on those transactions follows:

 

		Ownership % Sold				2013				2012
FSA of Middleburg Heights, LLC			10	%		$	—			$	342,055
Park Ten Surgery Center			10	%			—				35,299
Kirby Glen Surgery Center			10	%			—				16,537
Perkins Plaza ASC, LLC			24	%			—				(524,590	)
River Oaks Surgical Center, LLP			10	%			—				(42,800	)
Gain (loss) on sale of equity investments in Affiliates						$	—			$	(173,499	)

The Master Agreement covering the Company’s ownership in Chevy Chase includes a redemption feature that allows the majority owner of Chevy Chase to purchase the Company’s 18% interest in Chevy Chase for $178,000. In January 2014, the Company received notice from the majority owner that they intend to exercise their right to purchase the Company’s interest in October 2014 which is the term date of the Company’s management agreement. Based on these facts, management concluded that the Company no longer has significant influence over Chevy Chase and, effective December 31, 2013, began accounting for Chevy Chase using the cost method of accounting versus the equity method previously used. In addition, the Company performed an impairment analysis of the investment in Chevy Chase and determined that the projected cash distributions in 2014 from Chevy Chase would approximate the Company’s share in the earnings of Chevy Chase. As a result, the Company recorded an impairment charge of $1.6 million to write-down the recorded investment down to $178,000. The distributions that the Company receives in 2014 will be recorded as other revenue.

In May 2012, the Company invested $200,000 for a 20% interest in River City Surgical Institute, LLC (“River City ASC”). This venture was a start-up ASC in Jacksonville, Florida along with one surgeon partner who owned the remaining 80% interest. The physician partner did not fulfill his obligations and as a result the River City ASC has not opened and management does not anticipate it opening. As a result, management determined that the Company’s investment in the River City ASC was impaired and recorded an impairment charge of $200,000 during the year ended December 31, 2012.

 

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Note 8 – Property and Equipment

Following are the components of property and equipment included in the accompanying consolidated balance sheets as of December 31, 2013 and 2012:

 

		2013				2012
Equipment		$	22,820,537			$	11,755,055
Equipment under capital leases			4,477,231				12,186,938
Leasehold improvements			2,240,442				914,592
Land			2,065,000				—
			31,603,210				24,856,585
Accumulated depreciation			(19,529,224	)			(15,452,732	)
		$	12,073,986			$	9,403,853

Depreciation expense for the years ended December 31, 2013 and 2012 was $3,228,009 and $1,812,399 respectively.

Note 9 – Goodwill and Other Intangibles

Changes in the carrying amount of goodwill during the years ended December 31, 2013 and 2012 were as follows:

 

		2013				2012
December 31, 2012		$	1,154,528			$	—
Reverse acquisition			21,864,781				—
Impairment charge			(21,864,781	)			—
Finalization valuation – Imaging Centers			(180,601	)
Business acquisitions			—				1,154,528
Balance, end of year		$	973,927			$	1,154,528

Goodwill and intangible assets with indefinite lives must be tested for impairment at least once a year. Carrying values are compared with fair values, and when the carrying value exceeds the fair value, the carrying value of the impaired asset is reduced to its fair value. The Company tests goodwill for impairment on an annual basis in the fourth quarter or more frequently if management believes indicators of impairment exist. The performance of the test involves a two-step process. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. The Company generally determines the fair value of its reporting units using the income approach methodology of valuation that includes the discounted cash flow method as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the Company performs the second step of the goodwill impairment test to determine the amount of impairment loss. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill.

The goodwill associated with the reverse acquisition was $21,864,781. The Company then determined the projected cash flows from the continuing operations of the legacy Graymark business were not sufficient to support the recorded goodwill. The Company evaluated the fair value of the goodwill subsequent to the reverse acquisition and determined the acquired goodwill was fully-impaired.

 

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Changes in the carrying amount of intangible assets during the years ended December 31, 2013 and 2012 were as follows:

 

		Carrying Amount				Accumulated Amortization				Net
January 1, 2012		$	3,498,500			$	(739,072	)		$	2,759,428
Business Acquisition			8,293,000				—				8,293,000
Amortization			—				(781,570	)			(781,570	)
December 31, 2012			11,791,500				(1,520,642	)			10,270,858
Business acquisition			2,733,000				—				2,733,000
Amortization			—				(1,865,237	)			(1,865,237	)
December 31, 2013		$	14,524,500			$	(3,385,879	)		$	11,138,621

Intangible assets as of December 31, 2013 and 2012 include the following:

 

						2013												2012
		Useful Life (Years)				Carrying Amount				Accumulated Amortization				Net				Net
ASC management contracts			6 – 8			$	3,498,500			$	(1,735,037	)		$	1,763,463			$	2,202,858
Covenants not to compete			5				2,027,000				(443,744	)			1,583,256				1,764,167
Physician memberships			7				6,468,000				(1,078,000	)			5,390,000				6,303,833
Trade name			5				381,000				(33,782	)			347,218				—
Service contracts			10				2,150,000				(95,316	)			2,054,684				—
Total						$	14,524,500			$	(3,385,879	)		$	11,138,621			$	10,270,858

Amortization expense for the next five years related to these intangible assets is expected to be as follows:

 

2014		$	2,055,470
2015			2,055,470
2016			2,055,470
2017			1,994,637
2018			1,227,890

Note 10 – Borrowings and Capital Lease Obligations

The Company’s short-term debt obligations as of December 31, 2013 and 2012 are as follows:

 

		Rate(1)		2013				2012
Senior Lender:
Notes payable – working capital		6.5 – 7.0%		$	2,814,027			$	778,287
Other Lenders:
Note payable – S&H Leasing		11.5%			1,865,600				—
Note payable – working capital		5.0%			800,000				796,231
Insurance premium financings		3.0 – 3.9%			101,135				176,837
Note payable – Medicare cost report		10.1%			84,065				—
Note payable – HC REIT					—				100,000
Notes payable – acquisition					—				156,242
Short-term debt				$	5,664,827			$	2,007,597

 

(1)	Effective rate as of December 31, 2013

 

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The Company has two short-term working capital loans from its senior lender that are collateralized by the inventory, accounts receivable, equipment and other assets of one of the Company’s hospital subsidiaries. The notes bear interest at variable rates of prime plus 1.5% and 3.75% with floors of 6.5% and 7%. The Company is required to make monthly payments totaling $15,608 with the balances due at maturity in March 2014 and July 2014. The Company is in process of extending the maturity date on both notes to January 2015.

On July 22, 2013, in conjunction with the Tyche Transaction (see Note 11 – Preferred Noncontrolling Interests), the Company issued a note payable to S&H Leasing, LLC (“S&H Leasing”), a member of Tyche. The note is unsecured and bears interest at a fixed rate of 11.5%. All principal and interest on the note is due at maturity on August 1, 2014.

The Company has a short-term working capital loan with a bank that is collateralized by the accounts receivable of one of the Company’s hospital subsidiaries. The note bears interest at a variable rate of prime plus 1% with a floor of 5% and the Company is required to make monthly interest payments of $3,333 with the balance due at maturity in October 2014.

The Company has various insurance premium financing notes payable that bear interest rates ranging from 3.0% to 3.9%. The insurance notes mature from February 2014 to September 2014 and the Company is required to make monthly principal and interest payments totaling $26,118.

In November 2013, the Company entered into an unsecured note payable with a finance company for $91,329. The note bears interest at 10.13% and requires monthly payments of principal and interest totaling $8,035. The note matures in November 2014. The proceeds from the note were used to pay amounts due under a Medicare cost report at one of the Company’s hospital subsidiaries.

In August 2013, the HC REIT short-term note payable (“HC REIT Note 1”) was forgiven by HC REIT in conjunction with the El Paso Real Estate Transaction described in Note 16 – Extraordinary Gain and Other Item.

On July 22, 2013, in conjunction with the Foundation acquisition, the Company issued a promissory note for $2,000,000 to FHA. The note was unsecured, bore interest at a fixed rate of 7% and was due on demand. The balance on the note was paid in full in October 2013.

 

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The Company’s long-term debt and capital lease obligations as of December 31, 2013 and 2012 are as follows:

 

		Rate(1)		Maturity Date		2013				2012
Senior Lender:
Line of credit		7.0%		Jun. 2014		$	896,000			$	431,000
Notes payable – working capital		5.5 – 7.0%		Mar. 2014 – Feb. 2016			3,715,088				5,216,251
Note payable – equity investments		6.25%		Sept. 2016			3,270,427				4,289,057
Note payable – management agreements		6.0%		Dec. 2016			640,466				826,617
Note payable – assumption		6.75%		Jan. 2015			146,857				—
Other Lenders:
Note payable – preferred interest redemption		10.0%		Jul. 2015			5,100,000				—
Notes payable – settlements		5.25 – 8.0%		Dec. 2014 – Jan. 2018			1,189,725				—
Notes payable – THE		4.6 – 8%		Dec. 2014 – Feb. 2016			311,149				453,034
Notes payable – physician partners		5.25 – 6.75%		Jun. 2013 – Nov. 2014			103,604				617,198
Notes payable – acquisition		6.0%		Dec. 2014 – Oct. 2015			99,610				172,289
Note payable – HC REIT							—				450,917
Note payable – equity investments							—				167,841
Capital lease obligations		0.2 – 11.0%		Oct. 2013 – Jul. 2017			2,477,985				4,879,886
Total							17,950,911				17,504,090
Less: Current portion of long-term debt							(7,919,179	)			(5,971,339	)
Long-term debt						$	10,031,732			$	11,532,751

 

(1)	Effective rate as of December 31, 2013

The Company has a $1 million line of credit with its senior lender that is collateralized by the accounts receivable of one of the Company’s hospital subsidiaries. The line bears interest at a variable interest rate of prime plus 1% with a floor of 7% and the Company is required to make monthly payments of interest. As of December 31, 2013 and 2013, the Company had $104,000 and $569,000, respectively, available to borrow under the line.

The Company has various working capital notes payable with its senior lender that are collateralized by the Company’s accounts receivable, inventory, equipment and other assets. The notes bear interest at variable rates ranging from prime plus 1% to prime plus 1.5% with floor rates ranging from 5.5% to 7%. The Company is required to make monthly principal and interest payments under the notes payable totaling $156,912. Two of the working capital notes matured in March 2014. The Company is in process of extending the maturity of these notes to January 2015.

The Company has a note payable with its senior lender that is collateralized by the Company’s equity investment in one of its Affiliates. The note bears interest at a variable rate of prime plus 1.5% with a floor of 6.25% and the Company is required to make monthly principal and interest payments of $107,821.

The Company has a note payable with its senior lender that is collateralized by the Company’s management agreement with one of its ASC Affiliates. The note bears interest at a variable rate of prime plus 2.75% and the Company is required to make monthly principal and interest payments under the note of $19,683.

On July 22, 2013, as part of the acquisition of Foundation, the Company assumed a note payable with its senior lender from FHA. The note is unsecured and bears interest at a fixed rate of 6.75%. The Company is required to make monthly principal and interest payments under the note of $11,628.

 

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On July 22, 2013, in conjunction with the Tyche Transaction (see Note 11 – Preferred Noncontrolling Interests), the Company issued a note payable a bank for $5.1 million. The note is secured by the preferred noncontrolling interests purchased from Tyche and bears interest at a fixed rate of 10%. The Company is required to make one payment of $728,571 in August 2014 with the remaining balance plus accrued interest due at maturity.

On July 22, 2013, as part of the acquisition of Foundation, the Company assumed various notes payable from FHA, totaling $1.2 million that are owed to various third parties and a bank. The notes payable were related to past legal settlements of the Company that were funded by FHA through the notes payable. The assumed settlement notes bear interest at fixed rates ranging from 5.25% to 8%. On September 3, 2013, the Company entered into a note payable with a noncontrolling interest holder in one of the Company’s hospital subsidiaries. The note bears interest at prime plus 2% and was entered into as a settlement of a dispute and for the purpose of purchasing the noncontrolling interest from the holder. All of the settlements notes payable are unsecured and the Company is required to make monthly principal and interest payments totaling $48,029.

The Company has two notes payable with THE Investments, LLC (“THE”). The notes are unsecured and bear interest at a fixed rates ranging from 4.6% to 8%. The Company is required to make monthly principal and interest payments totaling $15,913. The managing member of THE is also the managing member of Tyche.

The Company has various working capital notes payable with banks that are collateralized by the personal guarantees of Company’s physician partners that own noncontrolling interests in one of the Company’s hospital subsidiaries. The notes bear interest at fixed rates ranging from 5.25% to 6.5%. The Company is required to make monthly principal and interest payments totaling $17,609.

The Company has two unsecured notes payable related to the purchase of an imaging center in 2012. One of the notes, with a balance of $76,957 at December 31, 2013, is owed to the seller of the imaging center; the other note payable, with a balance of $22,653 at December 31, 2013, is related to the payment of rent that was owed on the imaging center at the time it was purchased. The notes bear interest at a fixed rate of 6% and the Company is required to make monthly principal and interest payments totaling $7,219.

In August 2013, the HC REIT note payable (“HC REIT Note 2”) was assigned to FSHA as part of the El Paso Real Estate Transaction described in Note 16 – Extraordinary Gain and Other Item.

The Company has entered into various capital leases that are collateralized by certain computer and medical equipment used by the Company. The capital leases bear interest at fixed rates ranging from 4.8% to 13.7%. The Company is required to make monthly principal and interest payments under the capital leases totaling $129,989.

The Company has entered into various short-term and long-term notes payable with its senior lender, Legacy Bank (referred to as “Legacy Debt”). As of December 31, 2013 and 2012, the balance of the Legacy Debt was $11.48 million and $11.54 million, respectively. The Legacy Debt is collateralized by substantially all of the assets of the Company’s subsidiaries, FSA and FSHA, and a portion is personally guaranteed by certain officers of the Company. In conjunction with the Legacy Debt, the Company has agreed to comply with certain financial covenants (as defined and calculated at the FSA and FSHA level) including:

 

•

Debt Service Coverage Ratio of 1.05 to 1 and increasing to 1.1 to 1 by December 31, 2013; 1.15 to 1 by March 31, 2014; and 1.2 to 1 by June 30, 2014; and

 

•

Minimum Tangible Net Worth (as defined for FSA and FSHA) of $11.1 million increased each quarter (beginning in September 30, 2013 by 50% of FSA’s and FSHA’s net income for the quarter).

As of December 31, 2013, FSA and FSHA are in compliance with the Legacy Debt financial covenants. There is no assurance that Legacy Bank will waive any future violations of the financial covenants. Historically, management has been successful in obtaining waivers from the bank for any covenant non-compliance; however there is no assurance that the Company will be able to obtain waivers in the future.

 

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At December 31, 2013, future maturities of long-term debt were as follows:

 

2014		$	7,919,179
2015			8,235,461
2016			1,641,600
2017			73,100
2018			52,349
Thereafter			29,222

Note 11 – Preferred Noncontrolling Interests

On March 13, 2013, the Company’s wholly-owned subsidiary, Foundation Health Enterprises, LLC (“FHE”) initiated a private placement offering for up to $15,960,000. The offering was comprised of 152 units (“FHE Unit” or “preferred noncontrolling interest”). Each FHE Unit was offered at $105,000 and entitled the purchaser to one (1) Class B membership interest in FHE, valued at $100,000, and 10,000 shares of the Company’s common stock, valued at $5,000. During July 2013 to October 2013, FHE and the Company completed the sale of 87 FHE Units for total consideration of $9,135,000 which was comprised of $8,700,000 attributable to the preferred noncontrolling interest and $435,000 attributable to the 870,000 shares of the Company’s common stock.

The FHE Units provide for a cumulative preferred annual return of 9% on the amount allocated to the Class B membership interests. The FHE Units will be redeemed by FHE in four annual installments beginning in July 2014. The first three installments shall be in the amount of $10,000 per FHE Unit and the fourth installment will be in the amount of the unreturned capital contribution and any undistributed preferred distributions. The FHE Units are convertible at the election of the holder at any time prior to the complete redemption into restricted common shares of the Company at a conversion price of $2.00 per share. Since the FHE Units have a redemption feature and a conversion feature which the Company determined to be substantive, the preferred noncontrolling interests has been recorded at the mezzanine level in the accompanying consolidated balance sheets and the corresponding dividends are recorded as a reduction of accumulated deficit.

As of December 31, 2012, the Company had an outstanding preferred membership interest of $11,072,465. The preferred member interest was owned by Tyche Health Enterprises, LLC (“Tyche”) and provided for annual cash dividends at a rate of 11.5%. On March 31, 2013, the Company entered into an Asset Purchase Agreement (the “Tyche Agreement”) with Tyche which was subsequently amended on March 31, 2013 and amended and closed on July 22, 2013. Under the Tyche Agreement, the Company purchased from Tyche (i) all of Tyche’s right, title and interest in the Membership Interest Purchase Agreement; (ii) all of Tyche’s right, title and interest in the preferred and common membership interest in FSH and the right to various equity interests in the affiliates of FSH; (iii) all of Tyche’s right, title and interest in the preferred and common membership interest in FSHA and the right to various equity interest in the affiliates of FSHA; and (iv) all of Tyche’s right, title and interest in any preferred or non-preferred ownership interest in any Foundation entities that have been acquired as a result of the Membership Interest Purchase Agreement.

Under the Tyche Agreement, the Company paid $11,102,372 to Tyche and Tyche related entities and TSH issued promissory notes totaling $2,339,905 to Tyche and Tyche related entities for total consideration of $13,442,277. As further consideration for the Tyche Agreement, the Company issued Tyche and certain Tyche related entities warrants for the purchase of Company’s common stock. The warrants issued included:

 

1.

Five year warrants for the purchase of a total of 1,937,500 shares of the Company’s common stock at a strike price of $1.00 per share;

 

2.

Seven and one-half year warrants for the purchase of a total of 3,516,204 shares of the Company’s common stock at a strike price of $1.35 per share; and

 

3.

Ten year warrants for the purchase of a total of 2,296,296 shares of the Company’s common stock at a strike price of $1.60 per share.

 

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Note 12 – Commitments and Contingencies

Legal Issues

The Company is exposed to asserted and unasserted legal claims encountered in the normal course of business, including claims for damages for personal injuries, medical malpractice, breach of contracts, wrongful restriction of or interference with physicians’ staff privileges and employment related claims. In certain of these actions, plaintiffs request payment for damages, including punitive damages that may not be covered by insurance. Management believes that the ultimate resolution of these matters will not have a material adverse effect on the operating results or the financial position of the Company. During the year ended December 31, 2013, the Company did not incur any settlement expenses related to its ongoing asserted and unasserted legal claims. During the year ended December 31, 2012, the Company incurred $71,000 in settlement expenses related to its ongoing asserted and unasserted legal claims.

Operating Leases

The Company leases all of the real property used in its business for office space, surgical hospital facilities and certain medical equipment under operating lease agreements. Rent expense for leases that contain scheduled rent increases is recognized on a straight-line basis over the lease term (“Deferred Rent”). As of December 31, 2013 and 2012, the Company had Deferred Rent of $6,648,369 and $4,307,500, respectively, which is included in other liabilities in the accompanying consolidated balance sheets. In addition to minimum lease payments, certain leases require reimbursement for common area maintenance and insurance, which are expensed when incurred.

The Company’s rental expense, net of sublease income, for operating leases in 2013 and 2012 was $7,112,362 and $4,314,690, respectively.

Following is a summary of the future minimum lease payments under operating leases as of December 31, 2013:

 

2014		$	9,611,819
2015			9,584,196
2016			9,791,970
2017			9,798,571
2018			9,554,184
Thereafter			64,449,264
Less: Sublease income			(3,938,036	)
Total		$	108,851,968

At December 31, 2013, the Company had current and long-term deferred lease incentives of $614,987 and $5,563,984, respectively. The lease incentives are included in current other liabilities and other liabilities the accompanying consolidated balance sheets and are amortized on a straight line basis over the life of the lease as a reduction in rent expense. There were no deferred lease incentives at December 31, 2012.

Note 13 – Income Taxes

Prior to July 22, 2013, FSA’s and FSHA’s member had elected to have FSA’s and FSHA’s income taxed as an S Corporation under provisions of the Internal Revenue Code and a similar section of the state income tax law. Therefore, taxable income or loss is reported to the individual member for inclusion in its tax returns and no provision for income taxes is included in the Company’s consolidated financial statements for periods prior to July 22, 2013. The pro forma income information provides an adjustment for income tax expense as if FSA and FSHA had been a C Corporation prior to July 22, 2013 at an assumed combined federal and state effective tax rate of 38%, which approximates the calculated statutory tax rates for the periods.

 

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The income tax provision for the year ended December 31, 2013 consists of:

 

		2013
Current provision		$	1,116,226
Deferred benefit			(378,781	)
Increase in valuation allowance			77,068
Total		$	814,513
Tax benefit, discontinued operations		$	(514,371	)
Tax provision, extraordinary item		$	2,962,600

The Company has accrued interest and penalties of approximately $200,000 at December 31, 2013 related to the late filing of certain tax returns related to Graymark. The accrued interest and penalties are included in accrued liabilities in the accompanying consolidated balance sheets.

Deferred income tax assets and liabilities as of December 31, 2013 are comprised of:

 

		2013
Deferred income tax assets:
Accounts receivable		$	135,983
Accounts payable			1,131,070
Accrued liabilities			338,901
Deferred rent and lease incentives			2,353,514
Stock compensation			202,453
Other assets			54,836
Total deferred tax assets			4,216,757
Valuation allowance			(314,289	)
Net deferred tax assets			3,902,468
Deferred income tax liabilities:
Fixed assets			(1,158,897	)
Intangible assets			(1,725,099	)
Equity investments in affiliates			(1,330,295	)
Prepaid and other current assets			(174,419	)
Total deferred tax liabilities			(4,388,710	)
Net deferred tax liabilities		$	(486,242	)

The balance sheet classification of deferred income tax assets (liabilities) at December 31, 2013 follows:

 

		2013
Current		$	2,118,637
Long-term			(2,604,879	)
Total		$	(486,242	)

 

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The change in the Company’s valuation allowance on deferred tax assets during the year ended December 31, 2013 follows:

 

		2013
Beginning valuation allowance		$	—
Reverse acquisition			237,221
Change in valuation allowance			77,068
Ending valuation allowance		$	314,289

The Company’s effective income tax rate for continuing operations differs from the U.S. Federal statutory rate as follows:

 

		2013
Federal statutory rate			34	%
State			4
Impairment of goodwill			-43	%
Tax provision, extraordinary item			15	%
Tax benefit, discontinued operations			-3	%
Deferred taxes, reverse acquisition			-4	%
Other			-7	%
Effective income tax rate			-4	%

The amount of income taxes the Company pays is subject to ongoing examinations by federal and state tax authorities. To date, there have been no reviews performed by federal or state tax authorities on any of the Company’s previously filed returns. The Company’s 2007 and later tax returns are still subject to examination.

At the time of the Foundation reverse acquisition, Graymark had federal and state net operating loss carryforwards in excess of $30 million. Due to the change of control resulting from the Foundation reverse acquisition, the Company will not be able to utilize the loss carryforwards.

Note 14 – Capital Structure

During 2013 in conjunction with the FHE private placement offering, the Company issued 870,000 shares of common stock valued at $435,000 ($0.50 per share). See Note 11 – Preferred Noncontrolling Interests for additional information.

During 2013, the Company issued 247,000 shares of common stock as payments for liabilities owed to certain professional service providers. The shares were valued at $108,537 which represented the fair value of the services provided.

Note 15 – Stock Options, Grants and Warrants

As part of the Foundation Acquisition, the Company has adopted the 2008 Long-Term Incentive Plan (the “Incentive Plan”). The Incentive Plan consists of three separate stock incentive plans, a Non-Executive Officer Participant Plan, an Executive Officer Participant Plan and a Non-Employee Director Participant Plan. Except for administration and the category of employees eligible to receive incentive awards, the terms of the Non-Executive Officer Participant Plan and the Executive Officer Participant Plan are identical. The Non-Employee Director Plan has other variations in terms and only permits the grant of nonqualified stock options and restricted stock awards. Each incentive award will be pursuant to a written award agreement. The number of shares of common stock authorized and reserved under the Incentive Plan is 2,750,000.

 

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The fair value of each option and warrant grant is estimated on the date of grant using the Black-Scholes option pricing model. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables. These variables include the expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends. Given the Company’s limited trading history and lack of employee option exercise history, the Company has included the assumptions and variables of similar companies in the determination of the actual variables used in the option pricing model. The Company bases the risk-free interest rate used in the option pricing model on U.S. Treasury zero-coupon issues. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore an expected dividend yield of zero is used in the option pricing model.

The assumptions used to value the option and warrant grants are as follows:

 

		2013
Expected life (in years)			2.5 – 5.0
Volatility			73 – 76	%
Risk free interest rate			0.46 – 1.32	%
Dividend yield			0	%

Information with respect to stock options and warrants outstanding follows:

 

		Shares				Average Exercise Price
Outstanding at December 31, 2012			—			$	—
Reverse acquisition – warrants			8,572,418				1.54
Reverse acquisition – options			562,500				1.33
Granted – warrants			8,663,646				1.33
Granted – options			600,000				0.43
Forfeited – options			(37,500	)			4.00
Outstanding at December 31, 2013			18,361,064			$	1.29

 

		Options and Warrants Outstanding												Options and Warrants Exercisable
		Shares Outstanding at 12/31/13				Average Remaining Life (Years)				Average Exercise Price				Shares Outstanding at 12/31/13				Average Exercise Price
$0.50 to $1.00			2,942,500				4.9			$	0.81				2,542,500			$	0.88
$1.01 to $2.00			15,218,564				4.4				1.37				15,208,564				1.37
$2.01 to $4.00			200,000				2.3				2.49				200,000				2.49
Total			18,361,064												17,951,064

The fair value of the 600,000 options issued in 2013 was estimated to be $120,000. The value of the options is recorded as compensation expense over the requisite service period which equals the vesting period of the options. Compensation expense related to stock options was approximately $145,000 during 2013. There was no compensation expense related to stock options during 2012.

Included in the warrants obtained as part of the reverse acquisition were warrants that were issued under a warrant agreement that contains an anti-dilution provision that requires the exercise price and number of shares exercisable under the warrants to be adjusted in certain instances including when the Company issues an equity security at a price less than $1.50. During 2013, the Company granted 913,646 additional warrants under this provision and adjusted the exercise price from $1.40 to $1.24. The total amount of money the Company would receive under the exercise of the warrants did not change.

 

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In conjunction with the Tyche Agreement, the Company issued Tyche and certain Tyche related entities warrants for the purchase of Company’s common stock (the “Tyche Warrants”). The Tyche Warrants included:

 

1.

Five year warrants for the purchase of a total of 1,937,500 shares of the Company’s common stock at a strike price of $1.00 per share;

 

2.

Seven and one-half year warrants for the purchase of a total of 3,516,204 shares of the Company’s common stock at a strike price of $1.35 per share; and

 

3.

Ten year warrants for the purchase of a total of 2,296,296 shares of the Company’s common stock at a strike price of $1.60 per share.

The fair value of the Tyche Warrants was estimated to be $936,000. See Note 11 – Preferred Noncontrolling Interests for additional information on the Tyche Agreement.

The options and warrants outstanding and options and warrants exercisable as of December 31, 2013 had no intrinsic value. The intrinsic value is calculated as the difference between the market value and exercise price of the shares.

Information with respect to the Company’s restricted stock awards follows:

 

Unvested Restricted Stock Awards		Shares				Weighted Average Grant Date Fair Value
Unvested at December 31, 2012			—			$	—
Reverse acquisition			43,750				1.11
Granted			230,000				0.49
Vested			(13,750	)			2.88
Forfeited			—				—
Unvested at December 31, 2013			260,000			$	0.47

During 2013, the Company issued 230,000 restricted stock grant awards to certain key employees. The fair value of the restricted stock grant awards was approximately $113,000 and was calculated by multiplying the number of restricted shares issued times the closing share price on the date of issuance. The value of the stock grants is recorded as compensation over the requisite service period which equals vesting period of the stock award. During 2013, the Company recorded compensation expense related to stock grant awards of approximately $130,000. As of December 31, 2013, the Company has unrecognized compensation expense associated with the stock grants, options and warrants of approximately $165,000.

Note 16 – Extraordinary Gain and Other Item

Extraordinary Gain – On August 30, 2013, the Company, entered into an Agreement of Sale and Purchase (“Purchase Sale Agreement” or “PSA”) with HCRI Texas Properties, Ltd. (“Seller”) and HC REIT and an Agreement in Connection with Assignment and Assumption of PSA (“Assignment Agreement”) with DOC-FSH El Paso Medical Center, LLC (“DOC”) resulting in an extraordinary gain of $11.1 million (collectively referred to as the “El Paso Real Estate Transaction”). The income taxes related to the extraordinary gain and the amount of the extraordinary gain attributable to noncontrolling interests are summarized below:

 

		Gross				Tax				Net
Attributable to Foundation Healthcare		$	7,796,315			$	(2,962,600	)		$	4,833,715
Attributable to noncontrolling interests			3,273,524				—				3,273,524
Total extraordinary gain		$	11,069,839			$	(2,962,600	)		$	8,107,239

 

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Pursuant to the PSA, the Company agreed to acquire from Seller the real property occupied and certain personal property used by the Company’s subsidiary East El Paso Physicians’ Medical Center, LLC (“EEPPMC”) under a master lease agreement (“Master Lease”) between EEPPMC, Seller and HCN.

The real property and other consideration covered by the Purchase Sale Agreement includes the hospital (“Hospital”) and medical office building (“MOB”) occupied by EEPPMC, an adjoining parcel of vacant land (“Excess Land”), the HC REIT Note 2, and certain personal property, including medical equipment, owned by Seller and attached to or located in and used in the operation of the Hospital and MOB (“Personal Property. The purchase price under the Purchase Agreement was $39,066,428.

Simultaneous with the execution of the Purchase Sale Agreement, the Company executed the Assignment Agreement with DOC whereby FSHA assigned and DOC assumed all of FSHA’s right, title, interest and obligations in, to and under the Purchase Sale Agreement, except for the Excess Land, HC REIT Note 2 and Personal Property. The consideration under the Assignment Agreement with DOC was $40,000,000 and was composed of the following:

 

1.

$39,066,428 which was paid directly to Seller;

 

2.

$400,000 which was retained by DOC as a security deposit for the performance of EEPPMC’s payment obligations under the Master Lease;

 

3.

$463,678 which was paid to the Company; and

 

4.

$69,894 which was paid on behalf of the Company to cover certain legal and closing expenses.

The estimated excess value of the assets obtained compared to the consideration paid as a result of the PSA and Assignment agreement was $4,027,562. The Company is in the process of conducting formal valuations of the Excess Land and Personal Property acquired in the transaction and will adjust the extraordinary gain accordingly based on the results of those evaluations.

In conjunction with the execution of the PSA and Assignment Agreement, HC REIT agreed to forgive certain liabilities totaling $7,108,562 due to HC REIT from EEPPMC composed of the following:

 

1.

$714,824 in capital equipment leases net of the write off of the related capital lease assets;

 

2.

$467,132 in a note (HC REIT Note 1) and related accrued and unpaid interest (HC REIT Note 1 and HC REIT Note 2);

 

3.

$2,767,905 in unpaid, past due rent on the hospital and MOB;

 

4.

$3,158,701 in other accrued liabilities related to the hospital and MOB facilities.

The Company determined that the nature of the El Paso Real Estate Transaction was both unusual in nature and infrequent in occurrence given the nature of our business and current operating environment. The event is unusual given we are a health care organization that invests in and manages existing healthcare facilities, not a real estate company. This event is also unique given the complex nature of both the transaction and the unusual level of debt and liabilities forgiven as part of the transaction and as such would not be reasonably expected to reoccur in the foreseeable future.

Other Item – On September 30, 2013, the Company entered into an Agreement of Sale and Purchase (“OKC MOB Agreement”) with Foundation Medical Center of Oklahoma City, LLC (“FMC”) pursuant to which the Company agreed to acquire from Seller the real property occupied as the corporate headquarters of FSA and FSHA.

The real property covered by the OKC MOB Agreement includes an ambulatory surgery center facility owned and operated by a Foundation affiliate called Foundation Surgery Affiliate of Northwest Oklahoma City,

 

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LLC. The remainder of the building is medical office space occupied by a physician group, a sleep lab, a medical infusion company, and the Foundation corporate office. The building consists of approximately 52,000 square feet. The purchase price under the Purchase Agreement was $10,588,235.

Simultaneous with the execution of the OKC MOB Agreement, the Company entered into an Agreement in Connection with Assignment and Assumption of PSA (“OKC MOB Assignment Agreement”) with DOC-GREYMARK HQ OKC MOB, LLC (“OKC DOC”) whereby the Company assigned and OKC DOC assumed, all of the Company’s right, title, interest and obligations in, to and under the OKC MOB Agreement. The consideration under the OKC MOB Assignment Agreement with OKC DOC was $15,600,000 and was composed of the following:

 

1.

$10,588,235 which was paid directly to FMC;

 

2.

$4,885,328 which was paid to the Company; and

 

3.

$35,937 which was paid on behalf of the Company to cover certain legal and closing expenses.

Simultaneous with the sale to OKC DOC, the Company executed a 10 year master lease on the building for an annual rent of $1,248,000 with annual escalations of 2%. The current lease income on the underlying sub-leases is approximately $900,000 per year. The master lease is an operating lease. Given the disparity between the annual rent expense under the master lease and the rental income of the underlying sub-leases, the gain on the sale to OKC DOC was treated as a lease incentive and is being recorded on a straight-line basis as a reduction in the rent expense under the master lease.

Note 17 – Fair Value Measurements

Fair value is the price that would be received from the sale of an asset or paid to transfer a liability (i.e., an exit price) in the principal or most advantageous market in an orderly transaction between market participants. In determining fair value, the accounting standards established a three-level hierarchy that distinguishes between (i) market data obtained or developed from independent sources (i.e., observable data inputs) and (ii) a reporting entity’s own data and assumptions that market participants would use in pricing an asset or liability (i.e., unobservable data inputs). Financial assets and financial liabilities measured and reported at fair value are classified in one of the following categories, in order of priority of observability and objectivity of pricing inputs:

 

•

Level 1 – Fair value based on quoted prices in active markets for identical assets or liabilities.

 

•

Level 2 – Fair value based on significant directly observable data (other than Level 1 quoted prices) or significant indirectly observable data through corroboration with observable market data. Inputs would normally be (i) quoted prices in active markets for similar assets or liabilities, (ii) quoted prices in inactive markets for identical or similar assets or liabilities or (iii) information derived from or corroborated by observable market data.

 

•

Level 3 – Fair value based on prices or valuation techniques that require significant unobservable data inputs. Inputs would normally be a reporting entity’s own data and judgments about assumptions that market participants would use in pricing the asset or liability.

The fair value measurement level for an asset or liability is based on the lowest level of any input that is significant to the fair value measurement. Valuation techniques should maximize the use of observable inputs and minimize the use of unobservable inputs.

Recurring Fair Value Measurements: The carrying value of the Company’s financial assets and financial liabilities is their cost, which may differ from fair value. The carrying value of cash held as demand deposits, money market and certificates of deposit, accounts receivable, short-term borrowings, accounts payable and accrued liabilities approximated their fair value. At December 31, 2013 and 2012, the fair value of the Company’s long-term debt approximated its fair value. The fair value of the Company’s debt was valued using Level 3 inputs.

 

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Nonrecurring Fair Value Measurements:

Reverse Acquisition – During 2013, the Company completed the Foundation reverse acquisition; see Note 4 – Reverse Acquisition for additional information. The assets acquired and liabilities assumed in the reverse acquisition were recorded at their fair values on the date of acquisition.

El Paso Real Estate Transaction – On August 30, 2013, the Company, entered into an Agreement of Sale and Purchase (“Purchase Sale Agreement” or “PSA”) with HCRI Texas Properties, Ltd. (“Seller”) and HC REIT and an Agreement in Connection with Assignment and Assumption of PSA (“Assignment Agreement”) with DOC-FSH El Paso Medical Center, LLC (“DOC”) to acquire from Seller the real property occupied and certain personal property used by the Company’s subsidiary East El Paso Physicians’ Medical Center, LLC (“EEPPMC”); see Note 16 – Extraordinary Gain for additional information. The assets acquired as a result of the El Paso Real Estate Transaction were recorded at their fair market value on the date of the transaction.

Business Acquisitions – During 2012, the Company acquired El Paso and the Imaging Centers; see Note 5 – Acquisitions for additional information. The assets acquired and liabilities assumed in the El Paso and Imaging Centers transactions were recorded at their respective fair values on the date of the acquisition.

For the reverse acquisition and the business acquisitions, the nonrecurring fair value measurements were developed using significant unobservable inputs (Level 3). For the El Paso Real Estate Transaction, a portion of the fair value measurements were developed using significant other observable inputs (Level 2). The primary valuation technique used was an income methodology based on estimates of forecasted cash flows for each business unit, with those cash flows discounted to present value using rates commensurate with the risks of those cash flows. Assumptions used were similar to those that would be used by market participants performing valuations of these business units and were based on analysis of current and expected future economic conditions and the updated strategic plan for each business unit.

The fair value measurements for the Company’s assets measured at fair value on a nonrecurring basis as of December 31, 2013 and 2012 follows:

 

		Total				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)				Total Gains (Losses)
December 31, 2013:
Foundation reverse acquisition:
Assets		$	7,475,459			$	—			$	—			$	7,475,459			$	(21,864,781	)
Liabilities			(15,401,366	)			—				—				(15,401,366	)			—
El Paso Real Estate Transaction			3,024,550				—				2,573,633				450,917				3,958,122
																		$	(17,906,659	)
December 31, 2012:
El Paso acquisition:
Assets		$	17,768,932			$	—			$	—			$	17,768,932			$	—
Liabilities			(17,768,932	)			—				—				(17,768,932	)			—
Imaging Centers acquisition:
Assets			917,487				—				—				917,487				—
Liabilities			(608,439	)			—				—				(608,439	)			—

Note 18 – Related Party Transactions

On July 22, 2013, the Company issued Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates, 17,970,295 shares of common stock for full satisfaction of debt owed to Mr. Oliver totaling $8,136,390. The Company previously used the proceeds from the debt to fund its payment obligations to Arvest Bank.

 

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As of December 31, 2013, the Company had $2.2 million on deposit at Valliance Bank. Valliance Bank is controlled by Mr. Roy T. Oliver, one of our greater than 5% shareholders and affiliates. In addition, the Company is obligated to Valliance Bank under certain notes payable totaling approximately $5.9 million and $0.8 million at December 31, 2013 and December 31, 2012, respectively. The interest rates on the notes range from 5% to 10%. Non-controlling interests in Valliance Bank are held by Mr. Stanton Nelson, the Company’s chief executive officer and Mr. Joseph Harroz, Jr., a director of the Company. Mr. Nelson and Mr. Harroz also serve as directors of Valliance Bank.

The Company occupies office space subject to a lease agreement with City Place, LLC (“City Place”). Under the lease agreement, the Company pays monthly rent of $17,970 until June 30, 2014; $0.00 from July 1, 2014 to January 31, 2015 and $17,970 from February 1, 2015 to March 31, 2017 plus additional payments for allocable basic expenses of City Place; the lease expires on March 31, 2017. Non-controlling interests in City Place are held by Roy T. Oliver, one of the Company’s greater than 5% shareholders and affiliates, and Mr. Stanton Nelson, the Company’s Chief Executive Officer. During the period from July 22, 2013 to December 31, 2013, the Company incurred approximately $57,000 in lease expense under the terms of the lease.

Until September 30, 2013, FHA charged the Company rent for office space and an allocation for shared services, including payroll, legal and support services. The total rental expense allocation charged to the Company was $211,787 and $310,810 during 2013 and 2012, respectively.

The Company has entered into agreements with certain of its Affiliate ASCs and hospitals to provide management services. As compensation for these services, the surgery centers and hospitals are charged management fees which are either fixed or are based on a percentage of the Affiliates cash collected or the Affiliates net revenue. The percentages range from 2.25% to 6.0%.

The Company has received cash advances from FHA and certain real estate subsidiaries and affiliates of FHA (“FHA Real Estate”) and New Age Fuel, Inc. (“New Age”). New Age has an ownership interest in Tyche. As of December 31, 2013 and 2012, the Company owes FHA Real Estate a total of $1,049,303 and New Age $316,833. The amounts owed to FHA Real Estate and New Age are included in “Other liabilities” on the accompanying consolidated balance sheets.

Note 19 – Subsequent Events

Management evaluated all activity of the Company and concluded that no material subsequent events have occurred that would require recognition in the consolidated financial statements or disclosure in the notes to the consolidated financial statements, except as noted below:

On March 1, 2014, the Company executed a 15 year master lease on the building occupied by the Company’s hospital subsidiary in San Antonio, Texas for an annual rent of $2.3 million with annual escalations of 3%. The current lease income on the underlying sub-lease is approximately $2.1 million per year which includes the rent paid by FBH SA. The master lease is an operating lease. In conjunction with the master lease and certain other agreements with the landlord, the Company received $4.1 million at the time of the lease. Given the disparity between the annual rent expense under the master lease and the rental income of the underlying sub-lease, the cash received at the execution of the lease will be deferred and recorded on a straight-line basis as a reduction in the rent expense under the master lease.

On February 17, 2014, the Company’s board of directors granted Mr. Stanton Nelson, the Company’s chief executive officer, a restricted stock award for 8,191,745 shares of the Company’s common stock. The award vests over a five-year period with 20% of the award vesting at the beginning of each year. For the shares that vested at the time award grant (1,638,349 shares), Mr. Nelson elected to exercise his right to cashless vest in the shares and have the Company pay the withholding taxes on the award. As a result of the cashless vesting, Mr. Nelson received 865,099 shares.

 

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Foundation Healthcare Inc.

 

[*] Shares of Common Stock

 

 

PROSPECTUS

 

 

[*]

 

 

July [*], 2014

 

 

 

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PART II

INFORMATION NOT REQUIRED IN PROSPECTUS

Item 13. Other Expenses of Issuance and Distribution

The following table sets forth the various expenses, all of which will be borne by the registrant, in connection with the sale and distribution of the securities being registered, other than the underwriting discounts and commissions. All amounts shown are estimates except for the SEC registration fee, and the FINRA filing fee.

 

		Amount to be paid
Approximate SEC registration fee		$	[*]
FINRA filing fee		$	[*]
Transfer agent fees		$	2,500.00
Accounting fees and expenses		$	50,000.00
Legal fees and expenses		$	150,000.00
Miscellaneous (including EDGAR filing fees)		$	[*]
Total		$	[*]

Item 14. Indemnification of Officers and Directors

Section 1031 of the Oklahoma General Corporation Act permits (and our Certificate of Incorporation and Bylaws, which are incorporated by reference herein, authorize) indemnification of directors and officers of our Company and officers and directors of another corporation, partnership, joint venture, trust or other enterprise who serve at our request of, against expenses, including attorney’s fees, judgments, fines and amount paid in settlement actually and reasonably incurred by such person in connection with any action, suit or proceeding in which such person is a party by reason of such person being or having been a director or officer of our Company or at our request, if he conducted himself in good faith and in a manner he reasonably believed to be in or not opposed to our best interests, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his conduct was unlawful. We may not indemnify an officer or a director with respect to any claim, issue or matter as to which such officer or director shall have been adjudged to be liable to us, unless and only to the extent that the court in which such action or suit was brought shall determine upon application that, despite the adjudication of liability but in view of all the circumstances of the case, such person is fairly and reasonably entitled to indemnity for such expenses which the court shall deem proper. To the extent that an officer or director is successful on the merits or otherwise in defense on the merits or otherwise in defense of any action, suit or proceeding with respect to which such person is entitled to indemnification, or in defense of any claim, issue or matter therein, such person is entitled to be indemnified against expenses, including attorney’s fees, actually and reasonably incurred by him in connection therewith.

The circumstances under which indemnification is granted with an action brought on behalf of our Company are generally the same as those set forth above; however, expenses incurred by an officer or a director in defending a civil or criminal action, suit or proceeding may be paid by us in advance of final disposition upon receipt of an undertaking by or on behalf of such officer or director to repay such amount if it is ultimately determined that such officer or director is not entitled to indemnification by us.

These provisions may be sufficiently broad to indemnify such persons for liabilities arising under the Securities Act, in which case such provision is against public policy as expressed in the Securities Act and is therefore unenforceable.

Item 15. Recent Sales of Unregistered Securities

During the three years preceding the filing of this registration statement, we sold the following securities, which were not registered under the Securities Act. The securities were issued in reliance upon Section 4(a)(2) of the

 

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Securities Act of 1933, as amended, as a transaction by an issuer not involving a public offering. Each holder had adequate access to information about us through his or her relationship with us or through information provided to him or her. We did not, nor do we plan to, pay or give, directly or indirectly, any commission or other remuneration, including underwriting discounts or commissions, in connection with any of the issuances of securities listed below. In addition, each of the certificates issued representing the securities in the transactions listed above bears a restrictive legend permitting the transfer thereof only in compliance with applicable securities laws. The recipients of securities in each of the transactions listed above represented to us their intention to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof. All recipients had or have adequate access, through their employment or other relationship with us or through other access to information provided by our Company, to information about our Company.

On February 17, 2014, the Compensation Committee of the Board of Directors granted Mr. Nelson, our Chief Executive Officer, a restricted stock award for 8,191,745 shares of common stock pursuant to the Amended 2008 Plan. The award is subject to vesting as follows: 20% vesting as of the date of grant and 20% vesting on each anniversary of the date of grant; however, such grant is subject to forfeiture in the event that our shareholders fail to approve the proposal to increase the number of shares of common stock authorized for issuance under the Amended 2008 Plan at our 2014 Annual Meeting of Shareholders to be held on May 12, 2014.

During the three months ended December 31, 2013, we issued 147,000 shares of our common stock to three professional services companies as payment for services valued at $68,537. No underwriters were involved.

In October 2013, we issued 100,000 shares of our common stock as payment for professional services rendered by our former Chairman of the Board of Directors, Ms. Jamie Hopping. The professional services performed by Ms. Hopping were covered by her Chairman Agreement with us and were valued at $40,000.

During August 2013, we acquired, by means of net share settlements, 4,062 shares of common stock, at a price of $0.36 per share, related to the vesting of an employee restricted stock award to satisfy withholding tax obligations. We do not have any on-going stock repurchase programs.

On July 22, 2013, in connection with the Foundation Acquisition aforementioned in this registration statement, we issued 114,500,000 shares of common stock to Foundation Healthcare Affiliates, LLC, which represents on a post-transaction basis, approximately 70% of our outstanding common stock. We issued these shares in consideration of the acquisition of the membership interests of Foundation Surgery Affiliates, LLC and Foundation Surgical Hospital Affiliates, LLC. No underwriters were involved.

Arvest Bank Credit Facility

On July 22, 2013, our subsidiaries, SDC Holdings, LLC and ApothecaryRx, LLC (collectively the “Borrowers”), we and Mr. Stanton Nelson (the “Guarantor” and our Chief Executive Officer) entered into a Second Amended and Restated Loan Agreement (the “New Loan Agreement”) and an Amended and Restated Promissory Note (the “New Note”) with Arvest Bank. On July 22, 2013, in conjunction with the New Loan Agreement with Arvest Bank, we entered into a Participation Agreement with Arvest Bank in which we purchased a $6,000,000 participation in the New Note from Arvest Bank in exchange for 13,333,333 shares of the our common stock. No underwriters were involved.

Oliver Debt Transaction

On August 31, 2012, December 31, 2012, March 1, 2013, April 1, 2013 and July 22, 2013, we executed promissory notes with Roy T. Oliver in the amount of $1,184,808, $351,710, $485,082, $351,470 and $5,648,290, respectively, for a total of $8,021,360 (collectively referred to as the “Oliver Notes”). We used the proceeds from the notes to fund our payment obligations to Arvest Bank. On July 22, 2013, we issued Mr. Oliver 17,970,295 shares of common stock for full satisfaction of the Oliver Notes including principal and accrued interest owed thereon of $114,263. No underwriters were involved.

 

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Preferred Interest Financing Transaction

From July 22, 2013 to October 2, 2013, we and our wholly-owned subsidiary, Foundation Health Enterprises, LLC (“FHE”) sold 87 units of FHE (“FHE Unit”) for total proceeds of $9,135,000. Each FHE Unit was offered at $105,000 and entitled the purchaser to one (1) Class B membership interest in FHE, valued at $100,000 and 10,000 shares of our common stock, valued at $5,000. We issued 870,000 shares of common stock to the purchasers of the FHE Units. The FHE Units provide for a cumulative preferred annual return of 9% on the amount allocated to the Class B membership interests. The FHE Units will be redeemed by FHE in four annual installments beginning in July 2014. The first three installments shall be in the amount of $10,000 per FHE Unit and the fourth installment will be in the amount of the unreturned capital contribution and any undistributed preferred distributions. In addition, the FHE Units are convertible into shares of our common stock at the option of the holder at a conversion price of $2.00 per share. No underwriters were involved.

Tyche Transaction

On March 31, 2013, we and our wholly-owned subsidiary, TSH Acquisition, LLC (“TSH”) entered into an Asset Purchase Agreement (the “Tyche Agreement”) with Tyche Health Enterprises, LLC (“Tyche”) which was subsequently amended on March 31, 2013 and July 22, 2013. The Tyche Agreement provided for the purchase of the preferred membership interests that Tyche owns in certain subsidiaries of Foundation under a Membership Interest Purchase Agreement, dated July 17, 2007, between Tyche and Foundation Surgery Holdings, LLC, Foundation Weightwise Holdings, LLC, Foundation Healthcare Affiliates, LLC as well as the right to various equity interest in the affiliates of Foundation.

On July 22, 2013, in connection with the purchase of preferred noncontrolling interests from Tyche, we issued to Tyche and related entities the following warrants exercisable for our common stock: (i) five year warrants for the purchase of a total of 1,937,500 shares of our common stock at a strike price of $1.00 per share; (ii) seven and one-half year warrants for the purchase of a total of 3,516,204 shares of our common stock at a strike price of $1.35 per share; and (iii) ten year warrants for the purchase of a total of 2,296,296 shares of our common stock at a strike price of $1.60 per share. No underwriters were involved.

On November 12, 2012, we executed a subscription agreement with Graymark Investments, LLC (doing business as Oklahoma Health Partners (“OHP”)) in which OHP agreed to purchase 1,444,445 shares of our common stock for $650,000 ($0.45 per share). The proceeds from OHP were received on November 13, 2012 and will be used to fund our operations. No underwriters were utilized in this transaction.

On May 14, 2012, we issued to Genesis Select Corporation, for the purchase price of $150, a warrant for the purchase of up to 150,000 shares of our common stock exercisable at $0.50 per share and subject to vesting. Such warrant expires five years from the issuance date. The warrant was issued in connection with and as partial consideration for services to be rendered by Genesis Select under a consulting agreement with us. No underwriters or placement agents were used in connection with this transaction.

 

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Item 16. Exhibits and Financial Statement Schedules

(a) Exhibits.

See the Index of Exhibits on the page immediately preceding the exhibits for a list of exhibits filed as part of this registration statement on Form S-1, which is hereby incorporated by reference.

(b) Financial Statement Schedules.

All other schedules have been omitted because they are either inapplicable or the required information has been given in the consolidated financial statements or the notes thereto.

Item 17. Undertakings

(a) The undersigned registrant hereby undertakes:

(1) To file, during any period in which offers or sales are being made, a post-effective amendment to this registration statement:

(i) To include any prospectus required by Section 10(a)(3) of the Securities Act of 1933;

(ii) To reflect in the prospectus any facts or events arising after the effective date of the registration statement (or the most recent post-effective amendment thereof) which, individually or in the aggregate, represent a fundamental change in the information set forth in the registration statement. Notwithstanding the foregoing, any increase or decrease in volume of securities offered (if the total dollar value of securities offered would not exceed that which was registered) and any deviation from the low or high end of the estimated maximum offering range may be reflected in the form of prospectus filed with the Commission pursuant to Rule 424(b) if, in the aggregate, the changes in volume and price represent no more than a 20 percent change in the maximum aggregate offering price set forth in the “Calculation of Registration Fee” table in the effective registration statement;

(iii) To include any material information with respect to the plan of distribution not previously disclosed in the registration statement or any material change to such information in the registration statement.

(2) That, for the purpose of determining any liability under the Securities Act of 1933, each such post-effective amendment shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof.

(3) To remove from registration by means of a post-effective amendment any of the securities being registered which remain unsold at the termination of the offering.

(5) That, for purposes of determining liability under the Securities Act of 1933 to any purchaser:

(i)(B)(ii) If the registrant is subject to Rule 430C, each prospectus filed pursuant to Rule 424(b) as part of a registration statement relating to an offering, other than registration statements relying on Rule 430B or other than prospectuses filed in reliance on Rule 430A, shall be deemed to be part of and included in the registration statement as of the date it is first used after effectiveness. Provided, however, that no statement made in a registration statement or prospectus that is part of the registration statement or made in a document incorporated or deemed incorporated by reference into the registration statement or prospectus that is part of the registration statement will, as to a purchaser with a time of contract of sale prior to such first use, supersede or modify any statement that was made in the registration statement or prospectus that was part of the registration statement or made in any such document immediately prior to such date of first use.

 

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(b) The undersigned registrant hereby undertakes that, for purposes of determining any liability under the Securities Act of 1933, each filing of the registrant’s annual report pursuant to section 13(a) or section 15(d) of the Securities Exchange Act of 1934 (and, where applicable, each filing of an employee benefit plan’s annual report pursuant to section 15(d) of the Securities Exchange Act of 1934) that is incorporated by reference in the registration statement shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof.

(h)(3) Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue.

(i) The undersigned registrant hereby undertakes that:

(1) for purposes of determining any liability under the Securities Act, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by the registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this registration statement as of the time it was declared effective.

(2) for the purpose of determining any liability under the Securities Act, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof.

 

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SIGNATURES

Pursuant to the requirements of the Securities Act of 1933, as amended, the registrant has duly caused this Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in Oklahoma City, State of Oklahoma, on the 1st day of July, 2014.

 

Pursuant to the requirements of the Securities Act of 1933, as amended, this Registration Statement has been signed below by the following persons in the capacities indicated on July 1, 2014.

Each person whose signature appears below in so signing also makes, constitutes and appoints Stanton Nelson and Hubert King, and each of them, his true and lawful attorney-in-fact, with full power of substitution, for him in any and all capacities, to execute and cause to be filed with the Securities and Exchange Commission any and all amendments to this Registration Statement, with exhibits thereto and other documents in connection therewith, and hereby ratifies and confirms all that said attorney-in-fact or his substitute or substitutes may do or cause to be done by virtue hereof.

 

Signature		Title		Date
/s/ STANTON NELSON Stanton Nelson		Chief Executive Officer (Principal Executive Officer)		July 1, 2014
/s/ HUBERT KING Hubert King		Chief Financial Officer (Principal Financial Officer)		July 1, 2014
/s/ GRANT A. CHRISTIANSON Grant A. Christianson		Chief Accounting Officer (Principal Accounting Officer)		July 1, 2014
/s/ THOMAS MICHAUD Thomas Michaud		Chairman of the Board		July 1, 2014
/s/ JOSEPH HARROZ, JR. Joseph Harroz, Jr.		Director		July 1, 2014
/s/ SCOTT MUELLER Scott Mueller		Director		July 1, 2014
/s/ STEVEN L. LIST Steven L. List		Director		July 1, 2014
/s/ ROBERT A. MORENO, M.D. Robert A. Moreno, M.D.		Director		July 1, 2014

 

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EXHIBIT INDEX

 

Exhibit No.		Description
1.1@		Form of Underwriting Agreement.
3.1		Certificate of Amendment to the Registrant’s Restated Certificate of Incorporation is incorporated by reference to Exhibit 3.1.1 to the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2008.
3.1.1		Certificate of Amendment to the Registrant’s Restated Certificate of Incorporation, is incorporated by reference to Exhibit 3.1.1 of Registrant’s Registration Statement on Form S-1 as filed with the U.S. Securities and Exchange Commission on June 7, 2011.
3.1.2		Certificate of Amendment to the Registrant’s Restated Certificate of Incorporation, is incorporated by reference to Exhibit 3.1 of Registrant’s Current Report on Form 8-K as filed with the U.S. Securities and Exchange Commission on December 4, 2014.
3.2		Registrant’s Amended and Restated Bylaws, incorporated by reference to Exhibit 3.2 of Registrant’s Quarterly Report on Form 10-Q as filed with the U.S. Securities and Exchange Commission on August 14, 2008.
4.1		Form of Certificate of Common Stock of Registrant, incorporated by reference to Exhibit 4.1 of Registrant’s Registration Statement on Form SB-2 (No. 333-111819) as filed with the U.S. Securities and Exchange Commission on January 9, 2004.
4.2		Financial Advisor Warrant Agreement issued to ViewTrade Securities, Inc. and dated June 11, 2009 (expires July 15, 2014), is incorporated by reference to Exhibit 4.7 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
4.3		Form of Warrant to Purchase Common Stock issued pursuant to the Underwriting Agreement dated June 14, 2011, is incorporated by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on June 15, 2011.
4.4		Warrant to Purchase Common Stock issued to Genesis Select Corporation dated May 14, 2012, is incorporated by reference to Exhibit 4.1 to the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2012.
4.5		Form of Five Year Common Stock Purchase Warrant (1,937,500 shares of common stock at $1.00 exercise price), dated July 22, 2013, issued to Tyche Health Enterprises, LLC and THE Managers, LLC, is incorporated by reference to Exhibit 10.15 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
4.6		Form of Seven Year Common Stock Purchase Warrant (2,296,296 shares of common stock at $1.35 exercise price), dated July 22, 2013, issued to Tyche Health Enterprises, LLC and THE Managers, LLC, is incorporated by reference to Exhibit 10.16 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
4.7		Form of Ten Year Common Stock Purchase Warrant (1,937,500 shares of common stock at $1.60 exercise price), dated July 22, 2013, issued to Tyche Health Enterprises, LLC and THE Managers, LLC, is incorporated by reference to Exhibit 10.17 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
4.8		Registration Rights Agreement, dated July 22, 2013, among Graymark Healthcare, Inc., Tyche Health Enterprises, LLC and THE Managers, LLC, is incorporated by reference to Exhibit 10.18 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.

 

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Exhibit No.		Description
5.1@		Opinion of [Counsel]
10.1		Amended and Restated Foundation Healthcare, Inc. 2008 Long-Term Incentive Plan, is incorporated by reference to Annex B of the Company’s Schedule 14A Proxy Statement filed with the U.S. Securities and Exchange Commission on April 18, 2014.
10.1.1		Graymark Healthcare, Inc. 2008 Long-term Incentive Plan, Form of Restricted Stock Award Agreement, is incorporated by reference to Exhibit 10.3.1 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
10.1.2		Graymark Healthcare, Inc. 2008 Long-term Incentive Plan, Form of Stock Option Agreement, is incorporated by reference to Exhibit 10.3.2 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2010.
10.2		Amended and Restated Employment Agreement between Registrant and Stanton Nelson, dated April 6, 2012, is incorporated by reference to Exhibit 10.12.1 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on April 9, 2012.
10.3		Form of Indemnification Agreement between the Company and each of its directors and executive officers, is incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on August 24, 2010.
10.4		Office Lease Agreement between the Registrant and City Place, L.L.C., dated as of February 15, 2012, is incorporated by reference to Exhibit 10.21 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on April 9, 2012.
10.5		Membership Interest Purchase Agreement, dated August 13, 2012, among Graymark Healthcare, Inc., TSH Acquisition, LLC and Foundation Healthcare Affiliates, LLC, is incorporated by reference to Exhibit 2.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on August 17, 2012.
10.5.1		Amendment to Membership Interest Purchase Agreement, dated as of September 28, 2012, among Graymark Healthcare, Inc., TSH Acquisition, LLC and Foundation Healthcare Affiliates, LLC, is incorporated by reference to Exhibit 2.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on October 4, 2012.
10.5.2		Amended and Restated Membership Interest Purchase Agreement, dated as of March 29, 2013, among Graymark Healthcare, Inc., TSH Acquisition, LLC and Foundation Healthcare Affiliates, LLC, is incorporated by reference to Exhibit 2.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on April 2, 2013.
10.5.3		First Amendment to Amended and Restated Membership Interest Purchase Agreement, dated as of July 22, 2013 among Graymark Healthcare, Inc., TSH Acquisition, LLC and Foundation Healthcare Affiliates, LLC, is incorporated by reference to Exhibit 10.2 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
10.6		Promissory Note, dated August 31, 2012, in favor of Roy T. Oliver, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on September 7, 2012.
10.6.1		Promissory Note, dated December 31, 2012, in favor of Roy T. Oliver, is incorporated by reference to Exhibit 10.24.1 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on April 1, 2013.

 

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Exhibit No.		Description
10.6.2		Promissory Note, dated March 31, 2013, in favor of Roy T. Oliver, is incorporated by reference to Exhibit 10.24.2 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on April 1, 2013.
10.6.3		Renewal Promissory Note, dated March 31, 2013 (renewal of August 31, 2012 Promissory Note), in favor of Roy T. Oliver, is incorporated by reference to Exhibit 10.24.3 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on April 1, 2013.
10.6.4		Renewal Promissory Note, dated March 31, 2013 (renewal of December 31, 2012 Promissory Note), in favor of Roy T. Oliver, is incorporated by reference to Exhibit 10.24.4 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on April 1, 2013.
10.6.5		Promissory Note, dated July 22, 2013, in favor of Roy T. Oliver, is incorporated by reference to Exhibit 10.5 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
10.6.6		Promissory Note, dated April 2, 2013, in favor of Roy T. Oliver, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on April 5, 2013.
10.6.7		Promissory Note (Demand), dated July 22, 2013, in favor of Foundation Healthcare Affiliates, LLC, is incorporated by reference to Exhibit 10.3 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
10.7		Closing Agreement 2, dated May 21, 2013, among Roy T. Oliver, Graymark Healthcare, Inc., TSH Acquisition, LLC, Foundation Healthcare Affiliates, LLC, Foundation Surgical Hospital Affiliates, LLC, and Foundation Surgery Affiliates, LLC, is incorporated by reference to Exhibit 10.6 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
10.8		Second Amended And Restated Loan Agreement, dated July 22, 2013, among SDC Holdings, LLC, ApothecaryRx, LLC, Graymark Healthcare, Inc., Stanton M. Nelson, and Arvest Bank, is incorporated by reference to Exhibit 10.7 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
10.8.1		Amended and Restated Promissory Note, dated July 22, 2013, made by SDC Holding, LLC and ApothecaryRx, LLC in favor of Arvest Bank, is incorporated by reference to Exhibit 10.8 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
10.8.2		Participation Agreement, dated July 22, 2013, between Graymark Healthcare, Inc. and Arvest Bank, is incorporated by reference to Exhibit 10.9 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
10.8.3		Subscription Agreement, dated July 22, 2013, between Graymark Healthcare, Inc. and Arvest Bank, is incorporated by reference to Exhibit 10.10 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
10.9		Loan Agreement, dated July 22, 2013, between Foundation Health Enterprises, LLC and Valliance Bank, is incorporated by reference to Exhibit 10.11 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
10.9.1		Promissory Note, dated July 22, 2013, made by Foundation Health Enterprises, LLC in favor of Valliance Bank, is incorporated by reference to Exhibit 10.12 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.

 

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Exhibit No.		Description
10.10		Consent, Ratification, Acknowledgement and Amendment to Loan Documents Agreement, dated July 22, 2013, among Legacy Bank, Foundation Healthcare Affiliates, LLC, Graymark Healthcare, Inc., TSH Acquisition LLC, Foundation Surgery Affiliates, LLC, Foundation Surgical Hospital Affiliates, LLC and other indirect subsidiaries of the registrant, is incorporated by reference to Exhibit 10.13 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
10.11		Asset Purchase Agreement, dated March 31, 2013, between Tyche Health Enterprises, LLC and TSH Acquisition, LLC, is incorporated by reference to Exhibit 10.14 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
10.12		Letter Agreement, dated June 22, 2013, between Tyche Health Enterprises, LLC, TSH Acquisition, LLC and Graymark Healthcare, Inc, is incorporated by reference to Exhibit 10.14.1 of the Registrant’s Current Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on August 14, 2013.
10.13		Agreement of Sale and Purchase, dated August 30, 2013, among Foundation Surgical Hospital Affiliates, LLC, HCRI Texas Properties, Ltd. and Health Care REIT, Inc., is incorporated by reference to Exhibit 2.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on September 6, 2013.
10.14		Agreement in Connection with Assignment and Assumption Agreement, dated August 30, 2013, among Foundation Surgical Hospital Affiliates, LLC and DOC-FSH El Paso Medical Center, LLC, is incorporated by reference to Exhibit 2.2 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on September 6, 2013.
10.15		Amended and Restated Master Lease by and between DOC-FSH El Paso Medical Center, LLC and East El Paso Physicians’ Medical Center, LLC, dated August 31, 2013, is incorporated by reference to Exhibit 10.20 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.15.1		First Amendment to Amended and Restated Master Lease by and between DOC-FSH El Paso Medical Center, LLC and East El Paso Physicians’ Medical Center, LLC, dated September 25, 2013, is incorporated by reference to Exhibit 10.20.1 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.15.2		Assignment and Assumption of Lease Agreement among El Paso Physicians’ Medical Center, LLC, EEPPMC Partners, LLC and DOC-FSH El Paso Medical Center, LLC, dated September 27, 2013, is incorporated by reference to Exhibit 10.20.2 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.16		Agreement of Sale and Purchase, dated September 30, 2013, among Graymark Healthcare, Inc., and Foundation Medical Center of Oklahoma City, LLC, is incorporated by reference to Exhibit 2.1 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on October 4, 2013.
10.17		Agreement in Connection with Assignment and Assumption Agreement, dated September 30, 2013, among Graymark Healthcare, Inc., and DOC-Greymark HQ OKC MOB, LLC, is incorporated by reference to Exhibit 2.2 of the Registrant’s Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on October 4, 2013.
10.18		Master Lease by and between DOC-Greymark HQ OKC MOB, LLC and Foundation Surgery Affiliates, LLC, dated September 30, 2013, is incorporated by reference to Exhibit 10.23 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.

 

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Exhibit No.		Description
10.19		Lease Agreement by and between Foundation Bariatric Real Estate of San Antonio, L.P. and Foundation Bariatric Hospital of San Antonio, L.L.C. dated December 1, 2005, is incorporated by reference to Exhibit 10.24 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.19.1		Addendum to the Lease Agreement by and between Foundation Bariatric Real Estate of San Antonio, L.P. and Foundation Bariatric Hospital of San Antonio, L.P. dated February 19, 2007, is incorporated by reference to Exhibit 10.24.1 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.19.2		Second Addendum to the Lease Agreement by and between Foundation Bariatric Real Estate of San Antonio, L.L.L.P. and Foundation Bariatric Hospital of San Antonio, L.L.C. dated June 1, 2007, is incorporated by reference to Exhibit 10.24.2 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.19.3		Third Amendment to the Lease Agreement by and between Foundation Bariatric Real Estate of San Antonio, L.L.L.P. and Foundation Bariatric Hospital of San Antonio, L.L.C. dated July 15, 2010, is incorporated by reference to Exhibit 10.24.3 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.20		Lease Agreement by and between Foundation Bariatric Real Estate of Huebner, L.P. and Foundation Bariatric Hospital of San Antonio, L.P. dated October 11, 2006, is incorporated by reference to Exhibit 10.25 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.21		Private Placement Memorandum of Foundation Health Enterprises LLC dated March 18, 2013, is incorporated by reference to Exhibit 10.26 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.22		Promissory note, dated March 19, 2013, by Foundation Surgery Affiliates, LLC and East El Paso Physicians’ Medical Center LLC in favor of Legacy Bank, is incorporated by reference to Exhibit 10.27 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.22.1		Promissory note (1 of 2), dated March 21, 2012, by East El Paso Physicians’ Medical Center LLC in favor of Legacy Bank, is incorporated by reference to Exhibit 10.28 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.22.2		Promissory note (2 of 2), dated March 21, 2012, by East El Paso Physicians’ Medical Center LLC in favor of Legacy Bank, is incorporated by reference to Exhibit 10.29 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.23		First Modification to Promissory Notes and to First Amended and Restated Loan and Security Agreement, dated June 28, 2013, between Foundation Bariatric Hospital of San Antonio, L.L.C. and Legacy Bank, is incorporated by reference to Exhibit 10.30 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.24		Promissory Note (Note No. 2), dated September 7, 2010, by Foundation Bariatric Hospital of San Antonio, L.L.C. in favor of Legacy Bank, is incorporated by reference to Exhibit 10.31 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.

 

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Exhibit No.		Description
10.25		Second Amended and Restated Promissory Note (Note No. 1), dated July 5, 2013, by Foundation Surgery Affiliates, LLC, Foundation Surgery Holdings, LLC and Foundation Surgery Management, LLC in favor of Legacy Bank, is incorporated by reference to Exhibit 10.32 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.26		Promissory Note (Note No. 3), dated December 30, 2011, by Foundation Surgery Affiliates, LLC, Foundation Surgery Holdings, LLC and Foundation Surgery Management, LLC in favor of Legacy Bank, is incorporated by reference to Exhibit 10.33 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.27		Promissory Note, Change in Terms Agreement, dated September 6, 2006, by Foundation Surgical Hospital Affiliates, LLC in favor of Legacy Bank, is incorporated by reference to Exhibit 10.34 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.28		Promissory Note, Deferral/Extension Agreement, dated October 25, 2013 by East El Paso Physicians’ Medical Center, LLC in favor of Legacy Bank, is incorporated by reference to Exhibit 10.35 of the Registrant’s Quarterly Report on Form 10-Q filed with the U.S. Securities and Exchange Commission on November 20, 2013.
10.29		Agreement in Connection with Assignment and Assumption of Membership Interest Purchase Agreement, dated February 28, 2014, by and between Foundation Surgical Hospital Affiliates, LLC and Physicians Realty L.P, is incorporated by reference to Exhibit 10.30 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2014.
10.30		Master Lease, dated March 1, 2014, by and between DOC-FSH San Antonio, LLC and Foundation Surgical Hospital Affiliates, LLC, is incorporated by reference to Exhibit 10.31 of the Registrant’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission on March 31, 2014.
10.31		Loan, Security and Guaranty Agreement, dated June 30, 2014, by and between Foundation Healthcare, Inc. and Bank SNB, National Association and Texas Capital Bank, is incorporated by reference to Exhibit 10.1 of the Registrant’s Current Report on Form 8-K filed with U.S. Securities and Exchange Commission on July 1, 2014.
23.1+		Consent of Hein & Associates LLP
23.2@		Consent of [Counsel] (included in Exhibit 5.1)
24.1		Power of Attorney (see page II-6).

 

+	Filed herewith.

@	To be filed by amendment.

 

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