HealthSouth 10-K 2005
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
Commission File Number 000-14940
(Exact Name of Registrant as Specified in its Charter)
Registrants Telephone Number, Including Area Code: (205) 967-7116
Securities Registered Pursuant to Section 12(b) of the Act:
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, $0.01 Par Value
Indicate by check mark whether the registrant (1) has filed all Reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such Reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ¨ No x
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of September 30, 2005, there were outstanding 397,224,001 shares of common stock of the registrant, net of treasury shares. As of June 30, 2005, the aggregate market value of common stock held by non-affiliates was approximately $2.2 billion. For purposes of the foregoing calculation only, executive officers and directors of the registrant have been deemed to be affiliates.
Documents Incorporated by Reference: None
TABLE OF CONTENTS
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This annual report contains historical information, as well as forward-looking statements that involve known and unknown risks and relate to future events, our future financial performance, or our projected business results. In some cases, you can identify forward-looking statements by terminology such as may, will, should, expects, plans, anticipates, believes, estimates, predicts, targets, potential, or continue or the negative of these terms or other comparable terminology. Such forward-looking statements are necessarily estimates based upon current information and involve a number of risks and uncertainties. Actual events or results may differ materially from the results anticipated in these forward-looking statements as a result of a variety of factors. While it is impossible to identify all such factors, factors that could cause actual results to differ materially from those estimated by us include:
The cautionary statements referred to in this section also should be considered in connection with any subsequent written or oral forward-looking statements that may be issued by us or persons acting on our behalf. We undertake no duty to update these forward-looking statements, even though our situation may change in the future. Furthermore, we cannot guarantee future results, events, levels of activity, performance, or achievements.
HealthSouth is the largest provider of ambulatory surgery and rehabilitative health care services in the United States, with approximately 1,300 facilities and 40,000 full- and part-time employees as of December 31, 2004. As used in this report, the terms HealthSouth, we, us, our, and the company refer to HealthSouth Corporation and its subsidiaries, unless otherwise stated or indicated by context. In addition, we use the term HealthSouth Corporation to refer to HealthSouth Corporation alone wherever a distinction between HealthSouth Corporation and its subsidiaries is required or aids in the understanding of this filing.
HealthSouth Corporation was organized as a Delaware corporation in February 1984. Our principal executive offices are located at One HealthSouth Parkway, Birmingham, Alabama 35243, and the telephone number of our principal executive offices is (205) 967-7116.
Recent Significant Events
Below is a summary of significant events that have occurred since March 2003, when we first learned of the broad governmental investigation into our public reporting and related matters. We encourage you to read this summary together with the discussions contained in this Item, Risk Factors, and in Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, which highlight additional considerations about HealthSouth.
As described more fully below, we recently settled a lawsuit brought by the United States Securities and Exchange Commission (the SEC) relating to our financial reporting practices prior to March 2003. Investigations by the criminal division of the United States Department of Justice (the DOJ) and the United States Attorneys Office for the Northern District of Alabama are ongoing. We also were the subject of an investigation by the DOJs civil division regarding our participation in federal health care programs that was recently concluded, although the DOJs civil division continues to review certain other matters, including self-disclosures made by us to the Office of Inspector General (the OIG) of the United States Department of Health and Human Services (HHS). As reflected in the following timeline, we became aware of these investigations beginning in late 2002 and early 2003.
Public disclosure of these investigations and the SECs lawsuit precipitated a number of events that had an immediate and substantial negative impact on our business, financial condition, results of operations, and cash flows. These events, which began within weeks of the SECs lawsuit, are summarized below:
As described more fully below, as of the filing date of this annual report:
Still, developments relating to governmental investigations and responses to those investigations by us and by others will continue to create various risks and uncertainties that could materially and adversely affect our business, financial condition, results of operations, and cash flows.
Our Response to the Crisis
On March 19, 2003, the date the SEC announced its lawsuit against us, our board of directors placed our then-Chairman and Chief Executive Officer, Richard M. Scrushy, and our then-Chief Financial Officer, William T. Owens, on administrative leave. Their employment was subsequently terminated. Also on March 19, 2003, the board of directors elected Joel C. Gordon, a HealthSouth director since 1996, as interim Chairman of the Board, and Robert P. May, a HealthSouth director since 2002, as interim Chief Executive Officer.
On March 22, 2003, our board directed a special committee of the board of directors (the Special Audit Review Committee) to conduct an independent forensic investigation of accounting irregularities at HealthSouth and to consider any related matters that it concluded deserved review or comment. Our board of directors selected Jon F. Hanson, then one of only two board members who had not served as a director when the principal events under investigation occurred, to conduct the committees inquiry. Neither Mr. Hanson nor the committees legal counsel or accounting advisors had any relationships with HealthSouth, our board of directors, our employees, or others with whom we conducted business that would limit an objective inquiry regarding our financial reporting irregularities.
By early April 2003, we had taken several important steps to stabilize our business and operations, obtain vital management assistance and coordinate our legal strategy, including the following:
We subsequently engaged:
Board, Management, and Internal Controls and Reporting Improvements
With our crisis response team in place, we immediately began the difficult tasks of identifying weaknesses in our governance, accounting, reporting, compliance, and management functions, and developing a plan for restructuring HealthSouth to remedy those weaknesses for the long term. Some of these efforts are summarized below.
Our New Board of Directors
On April 4, 2003, we created a special committee of our board of directors (the Special Committee). Our board of directors delegated to the Special Committee, to the fullest extent permitted by Delaware law, all authority that may be delegated to the Special Committee, and authorized the Special Committee, to the fullest extent permitted by Delaware law, to exercise all of the powers and authority of the board of directors in the management of the business and affairs of HealthSouth when the board of directors is not in session. The Special Committee currently consists of all members of the board of directors except Mr. Scrushy, who has refused our requests to resign as a director. Mr. Owens resigned from our board of directors on October 19, 2003 and was never a member of the Special Committee.
The transition of our board of directors continued with our announcement on December 2, 2003 that we had adopted a transition plan pursuant to which five long-standing members of our board of directors would voluntarily leave the board. In accordance with this plan, the following directors voluntarily resigned from the board: George H. Strong (effective December 15, 2003), Charles W. Newhall III (effective December 15, 2003), Larry D. Striplin, Jr. (effective April 2, 2004), C. Sage Givens (effective April 15, 2004), and John S. Chamberlin (effective August 19, 2004).
Of our current eleven-person board of directors, nine members were added since March 2003: Steven R. Berrard (effective January 31, 2004), Edward A. Blechschmidt (effective January 31, 2004), Jay Grinney (effective May 10, 2004), Leo I. Higdon, Jr. (effective August 17, 2004), John E. Maupin, Jr. (effective August 17, 2004), Charles M. Elson (effective September 9, 2004), Yvonne Curl (effective November 18, 2004), L. Edward Shaw Jr. (effective June 29, 2005), and Donald L. Correll (effective June 29, 2005). Jon F. Hanson joined the board of directors on September 17, 2002, after the principal events under investigation by the SEC occurred. Nine members of our current board of directors qualify as independent directors under our Corporate Governance Guidelines. Lee S. Hillman and Robert P. May voluntarily resigned from our board of directors effective February 18, 2005 and October 1, 2005, respectively. In addition, Joel C. Gordon retired from the board effective May 10, 2005 pursuant to our mandatory director retirement policy. See Item 10, Directors and Executive Officers of the Registrant, for more information about our directors, including the name of each independent director.
The Special Committee has overseen the formulation and implementation of our turnaround strategy. Following the events of March 2003, the Special Committee installed a crisis response and interim management team and worked closely with that team to reduce costs, stabilize operations, and negotiate with our bondholders and other creditors. The Special Committee was also instrumental in identifying and hiring key executives, including our chief executive officer, and directing our negotiations with the various parties with which we have reached settlement, including the DOJ and the SEC, which settlements are described later in this Item. The Special Committee, whose membership has changed over time along with changes to our board of directors, continues to oversee our management team and we anticipate that the business and affairs of the company will continue to be managed under the direction of the Special Committee until we are able to hold an annual meeting of our stockholders, at which point we anticipate the Special Committee will be disbanded.
Our New Management Team
Since March 2003, we have recruited a new management team of experienced professionals, including the following new members of our executive management team:
Except for Ms. Davis and Mr. Tarr, none of the members of our executive management team has been employed by HealthSouth in the past. In addition to our executive management team, we have substantially replaced and expanded the management of our accounting and finance, internal audit, and compliance functions, and we have replaced or added key management personnel in each of our divisions.
Corporate Governance Improvements
Since March 2003, we have revised our Corporate Governance Guidelines and charters for all five of the standing committees of our board of directors (the Audit Committee, Compensation Committee, Corporate Compliance Committee, Finance Committee, and Nominating/Corporate Governance Committee). Our revised guidelines and charters meet or exceed the requirements of the Sarbanes-Oxley Act of 2002. Our revised guidelines and charters require three-quarters of the members of our board of directors to meet the criteria for independence set forth in our new Corporate Governance Guidelines. Our new Corporate Governance Guidelines also create a new position of non-executive chairman of the board, limit the number of terms any director may serve, and impose limitations on the number of outside directorships our directors may hold. Additionally, non-management directors meet regularly, with the non-executive chairman of the board presiding at those meetings, and all transactions with related parties must receive the prior approval of our board of directors. Our revised guidelines and charters are available at our website, www.healthsouth.com. We will provide to any person, without charge, upon request, a copy of our revised guidelines and charters. Requests for a copy may be made in writing to the following address: Secretary, HealthSouth Corporation, P.O. Box 380243, Birmingham, Alabama 35238.
As discussed later in this Item, SEC Settlement, we have been required to retain a qualified governance consultant to perform a review of the adequacy and effectiveness of our corporate governance systems, policies, plans, and practices. That review is now complete. The consultants report of that review concludes, among other things, that [t]he companys current practices, created by the new directors and executives, meet contemporary standards of corporate governance.
Internal Control Improvements
As discussed in Item 9A, Controls and Procedures, our new management team and advisors have determined that our financial systems and internal controls historically have been ineffective. Given the state of our internal controls, we hired a large group of accounting professionals and consultants to assist us with a substantive reconstruction of our historical accounting records so that we could prepare restated financial statements for 2001 and 2000 and initial financial statements for 2004, 2003, and 2002. In addition, we have engaged in, and are continuing to engage in, substantial efforts to improve our internal control over financial reporting and disclosure controls and procedures related to substantially all areas of our financial statements and disclosures. These efforts include the following:
We are also upgrading our information systems. For example, we plan to complete an upgrade of our inpatient divisions patient accounting system and computing infrastructure by October 2006. We have already completed the upgrade of our surgery centers divisions patient accounting system. We are nearing completion of the modernization of the clinical computing infrastructure in our outpatient division. We plan to use these new technologies to automate the interface of our patient accounting systems to our general ledger, to create tangible operating efficiencies, and to improve accounts receivable collection.
Corporate Compliance Improvements
Since March 2003, we have adopted a revised compliance program, including revised Standards of Business Conduct, to reinforce our dedication to compliance with all laws and regulations and good corporate governance. We have incorporated elements of the Standards of Business Conduct into a formal compliance training program which is required to be completed by all employees. We require each HealthSouth employee to sign a written acknowledgment that the employee has completed the program and agrees to be bound by the Standards of Business Conduct.
In addition to revising our compliance program, we have instituted several important compliance-related organizational changes. First, we engaged an independent third party to receive calls made to our compliance hotline. By outsourcing this function, the Corporate Compliance Committee seeks to create an environment that encourages the reporting of inappropriate or suspicious conduct without the fear of reprisal. Additionally, we hired John Markus as our Executive Vice President and Chief Compliance Officer. We are committing substantial financial resources to our corporate compliance department on a yearly basis, including the creation of a dedicated regulatory compliance audit staff. We have also established a compliance steering committee that includes all members of our executive management team and have appointed compliance officers for each of our operating divisions.
Results of Forensic Audit Review and Restatement and Reclassification of Previously Issued Consolidated Financial Statements
As mentioned above, the Special Audit Review Committees legal counsel retained PricewaterhouseCoopers LLP to assist in a forensic review of our historical accounting and financial reporting. Furthermore, we engaged Grant Thornton LLP, Callaway Partners, LLC, KPMG LLP, and American Appraisal Associates to assist in reconstructing our financial records.
In the course of reviewing our historical accounting and financial reporting and reconstructing our financial records:
The Special Audit Review Committee completed its review in May 2004 and provided a copy of the report of its findings to us on May 28, 2004. We furnished the report to the SEC in a Form 8-K on June 1, 2004. In June 2005, we completed the reconstruction of our accounting records for periods from January 1, 2000 to December 31, 2003. PricewaterhouseCoopers LLP completed its audits of our 2003 and 2002 consolidated financial statements, as well as the reaudits of our 2001 and 2000 consolidated financial statements, and its report accompanied our Form 10-K for the fiscal years ended December 31, 2003 and 2002, which we filed on June 27, 2005.
The response of our lenders and other creditors to the governmental investigations regarding our financial reporting and related activities forced us to take immediate steps to increase our liquidity, including implementing severe cost reductions and entering into protracted negotiations with our lenders and other creditors to expand our credit options.
During 2003 and 2004, we aggressively pursued cost reduction activities in non-patient care areas, including the elimination of non-clinical corporate positions, the completion of several non-core asset sales that resulted in total sale proceeds of $271 million, the completion of lease buyouts that resulted in annual savings in lease obligations, and the tightening of spending controls, including a reduction in non-critical capital expenditures. See this Item, Our BusinessOperational Agenda for a description of our continuing efforts to reduce overhead.
Consent Solicitations for Publicly Traded Debt
On March 16, 2004, we announced that we were soliciting consents seeking approval of proposed amendments to, and waivers under, the indentures governing all of our public debt. We solicited these consents to resolve issues relating to our inability to provide current financial statements, to increase our ability to incur indebtedness under certain circumstances, and to obtain waivers of all alleged and potential defaults under the respective indentures governing our public debt.
On June 24, 2004, we announced that we had closed our consent solicitations and executed seven supplemental indentures, bringing us into compliance on all of our $2.6 billion in public debt. We paid $80 million in consent fees for all of our debt issues covered by the consent solicitations.
The documents governing certain of our indebtedness contain covenants that require us to file, on a timely basis, all reports required to be filed for periods ending on or after December 31, 2005. If we are unable to file our periodic reports on a timely basis beginning in 2006 and are unable to file the required reports within the designated cure period, and if such a technical default is treated as an Event of Default under those governing documents, our business, results of operations, and cash flows could be materially adversely affected.
For more information regarding our consent solicitations, see Item 4, Submission of Matters to a Vote of Security Holders, and Note 9, Long-term Debt, to our accompanying consolidated financial statements.
Amended and Restated Credit Agreement
On March 23, 2003, our line of credit was frozen under the $1.25 billion credit agreement with JPMorgan Chase Bank, which serves as administrative agent, Wachovia Bank, N.A., UBS Warburg LLC, Deutsche Bank AG, and Bank of America, N.A. On March 27, 2003, we received notice that we were in default under this agreement. We commenced negotiations with our lenders to resolve the default. On March 21, 2005, we amended and restated our credit agreement, thereby curing any defaults of the credit agreement that existed prior to such amendment and restatement. Our amended and restated credit agreement consists of a $315 million term loan, a $250 million revolving line of credit, and $150 million in letter of credit facilities. It is secured by substantially all of HealthSouths assets. For additional information about our amended and restated credit agreement, see Note 9, Long-term Debt, to our accompanying consolidated financial statements.
Senior Subordinated Credit Agreement
As a result of the default under our $1.25 billion credit agreement, our lenders instituted a payment blockage that prohibited us from making an approximately $350 million payment of principal and interest due to holders of our 3.25% Convertible Subordinated Debentures due April 1, 2003. On January 16, 2004, we repaid these bonds ($344 million in the aggregate) from the net proceeds of a $355 million loan arranged by Credit Suisse First Boston. This loan has an interest rate of 10.375% per annum, payable quarterly, with a 7-year maturity, callable after the third year with a premium. We also issued a warrant to the lender to purchase 10 million shares of our common stock. The warrant has a term of 10 years from the date of issuance and an exercise price of $6.50 per share. For additional information about our senior subordinated credit agreement, see Note 9, Long-term Debt, to our accompanying consolidated financial statements.
Term Loan Agreement
On June 15, 2005, we entered into a $200 million term loan agreement with a consortium of financial institutions, JPMorgan Chase Bank, N.A., as Administrative Agent (JPMorgan), and Citicorp North America, Inc., as Syndication Agent. Pursuant to the term loan agreement, we obtained a new senior unsecured term facility consisting of term loans in an aggregate principal amount of $200 million. The term loans initially bear interest at a rate of LIBOR (adjusted for statutory reserve requirements) plus 5% per year (the Initial Rate). Thereafter, they will bear interest, at our option, at a rate of (1) the Initial Rate or (2) 4% per year plus the higher of (x) JPMorgans prime rate and (y) the Federal Funds Rate plus 0.5%. The term loans mature in full on June 15, 2010.
The proceeds of the term loans, together with cash on hand, were used to repay our $245 million 6.875% Senior Notes due June 15, 2005 and to pay fees and expenses related to the term loans. For additional information about our term loan agreement, see Note 9, Long-term Debt, to our accompanying consolidated financial statements.
Certain trends in our business, including declining revenues resulting from the 75% Rule, discussed later in this Item, acute care volume weakness, recent changes to the prospective payment system applicable to our inpatient rehabilitation facilities, and continued weakness in our surgery centers division, could make it difficult for us to meet certain financial covenantsparticularly relating to debt coverage ratioscontained in our
amended and restated credit agreement, senior subordinated credit agreement, and term loan agreement. Although we are in compliance with these covenants as of the filing of this annual report and believe we will be in compliance with these as of December 31, 2005, we believe that at some point in 2006, we may be in jeopardy of violating certain financial covenants. If we were to violate these covenants and were unable to obtain waivers of such violations or otherwise arrange financing with amended debt coverage ratios, our business and results of operations could be materially and adversely affected. We will, of course, continue to monitor our compliance with all of our debt covenants and, if we feel that we are likely to violate any covenant, we will seek to obtain the necessary relief.
Status of Long-Term Indebtedness and Liquidity
Our long-term debt as of December 31, 2004 is summarized in the following chart.
As of September 30, 2005, the maturity schedule for (1) the indebtedness set forth in the table above under the caption Bonds Payable and (2) the indebtedness related to our amended and restated credit agreement (assuming the maturity for the amended and restated credit agreement is extended to 2010), is as follows:
If all noteholders were to exercise their options to require us to repurchase their notes in 2007 and 2009, the maturity schedule would be as follows:
As of October 31, 2005, we had approximately $185 million in available cash. We also had approximately $239 million in restricted cash, which is cash we cannot use because of various obligations we have under lending agreements, partnership agreements, and other arrangements primarily related to our captive insurance company. For more information about our liquidity, please see Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, Liquidity and Capital Resources, Note 1, Summary of Significant Accounting Policies, Note 2, Liquidity, and Note 9, Long-term Debt, to our accompanying consolidated financial statements.
Medicare Program Settlement
The Civil DOJ Settlement
On January 23, 2002, the United States intervened in four lawsuits filed against us under the federal civil False Claims Act. These so-called qui tam (i.e., whistleblower) lawsuits were transferred to the Western District of Texas and were consolidated under the caption United States ex rel. Devage v. HealthSouth Corp., et al., No. 98-CA-0372 (DWS) (W.D. Tex. San Antonio).
On April 10, 2003, the United States informed us that it was expanding its investigation to review whether fraudulent accounting practices affected our previously submitted Medicare cost reports.
On December 30, 2004, we entered into a global settlement agreement (the Settlement Agreement) with the United States. This settlement was comprised of (1) the claims consolidated in the Devage case, which related to claims for reimbursement for outpatient physical therapy services rendered to Medicare, the TRICARE Management Activity (TRICARE), or United States Department of Labor (DOL) beneficiaries, (2) the
submission of claims to Medicare for costs relating to our allegedly improper accounting practices, (3) the submission of other unallowable costs included in our Medicare Home Office Cost Statements and in our individual provider cost reports, and (4) certain other conduct (collectively, the Covered Conduct). The parties to this global settlement include us and the United States acting through the DOJs civil division, the OIG, the DOL through the Employment Standards Administrations Office of Workers Compensation Programs, Division of Federal Employees Compensation (OWCP-DFEC), TRICARE, and certain other individuals and entities which had filed civil suits against us and/or our affiliates (those other individuals and entities, the Relators).
Pursuant to the Settlement Agreement, we agreed to make cash payments to the United States in the aggregate amount of $325 million, plus accrued interest from November 4, 2004 at an annual rate of 4.125%. The United States agreed, in turn, to pay the Relators the portion of the Settlement Amount due to the Relators pursuant to the terms of the Settlement Agreement. We made an initial payment of $75 million (plus interest) to the United States on January 3, 2005, with the remaining balance of $250 million (plus interest) to be paid in quarterly installments over three years. We made our first three quarterly payments of approximately $22.3 million (including interest) each on March 31, June 30, and September 30, 2005.
The Settlement Agreement provides for our release by the United States from any civil or administrative monetary claim the United States had or may have had relating to Covered Conduct that occurred on or before December 31, 2002 (with the exception of Covered Conduct for certain outlier payments, for which the release date is extended to September 30, 2003). The Settlement Agreement also provides for our release by the Relators from all claims based upon any transaction or incident occurring prior to December 30, 2004, including all claims that have been or could have been asserted in each Relators civil action, and from any civil monetary claim the United States had or may have had for the Covered Conduct that is pled in each Relators civil action.
The Settlement Agreement also provides for the release of HealthSouth by the OIG and OWCP-DFEC, and the agreement by the OIG and OWCP-DFEC to refrain from instituting, directing, or maintaining any administrative action seeking exclusion from Medicare, Medicaid, the FECA Program, the TRICARE Program and other federal health care programs, as applicable, for the Covered Conduct. The DOJs civil division continues to review certain other matters, including self-disclosures made by us to the OIG.
The Administrative Settlement Agreement
In connection with the Settlement Agreement, we entered into a separate settlement agreement (the Administrative Settlement Agreement) with the Centers for Medicare & Medicaid Services (CMS) acting on behalf of HHS, to resolve issues associated with various Medicare cost reporting practices.
Subject to certain exceptions and the terms and conditions of the Administrative Settlement Agreement, the Administrative Settlement Agreement provides for the release of HealthSouth by CMS from any obligations related to any cost statements or cost reports that had or could have been submitted to CMS or its fiscal intermediaries by HealthSouth for cost reporting periods ended on or before December 31, 2003. The Administrative Settlement Agreement provides that all covered cost reports be closed and considered final and settled.
Financial Consequences of the Civil DOJ Settlement and the Administrative Settlement Agreement
As described in Note 20, Medicare Program Settlement, to our accompanying consolidated financial statements, the total known cost of settlement is $347.7 million, which is comprised of the $325 million cash settlement to be paid to the United States, $19.7 million representing uncollectible amounts due arising from cost reports submitted for the fiscal years ended December 31, 2003 and prior, as well as unallowable costs in the covered cost reports, and $3 million in associated legal fees.
The December 2004 Corporate Integrity Agreement
On December 30, 2004, we entered into a new corporate integrity agreement (CIA) with the OIG. This new CIA has an effective date of January 1, 2005 and a term of five years from that effective date. It incorporates
a number of compliance program changes already implemented by us and requires, among other things, that not later than 90 days after the effective date we:
On April 28, 2005, we submitted an implementation report to the OIG stating that we had, within the 90-day time frame, materially complied with the initial requirements of this new CIA.
The CIA also requires that we engage an Independent Review Organization (IRO) to assist us in assessing and evaluating: (1) our billing, coding, and cost reporting practices with respect to our inpatient rehabilitation facilities (IRFs), (2) our billing and coding practices for outpatient items and services furnished by outpatient departments of our inpatient facilities and through other HealthSouth outpatient rehabilitation facilities; and (3) certain other obligations pursuant to the CIA and the Settlement Agreement. We have engaged PricewaterhouseCoopers LLP to serve as our IRO.
Failure to meet our obligations under our CIA could result in stipulated financial penalties. Failure to comply with material terms, however, could lead to exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues.
On June 6, 2005, the SEC approved a settlement (the SEC Settlement) with us relating to the action filed by the SEC on March 19, 2003 captioned SEC v. HealthSouth Corporation and Richard M. Scrushy, No. CV-03-J-0615-S (N.D. Ala.) (the SEC Litigation).
That lawsuit alleges that HealthSouth and our former Chairman and Chief Executive Officer, Richard M. Scrushy, violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal controls provisions of the federal securities laws. On April 3, 2003, the SEC filed an amended complaint adding additional charges against Mr. Scrushy. On May 7, 2003, the SEC Litigation was stayed pending the resolution of any criminal charges against Mr. Scrushy in connection with the alleged violations of federal securities laws. Mr. Scrushy was subsequently acquitted of the criminal charges brought in the Northern District of Alabama and, on September 7, 2005, the SEC filed a second amended complaint against Mr. Scrushy. That civil case is still pending.
Under the terms of the SEC Settlement, we have agreed, without admitting or denying the SECs allegations, to be enjoined from future violations of certain provisions of the securities laws. We have also agreed to:
We have retained a qualified governance consultant to perform a review of the adequacy and effectiveness of our corporate governance systems, policies, plans, and practices. That review is now complete. The consultants report of that review concludes, among other things, that [t]he companys current practices, created by the new directors and executives, meet contemporary standards of corporate governance. The company continues to comply with the other terms of the SEC Settlement.
The SEC Settlement also provides that we must treat the amounts ordered to be paid as civil penalties as penalties paid to the government for all purposes, including all tax purposes, and that we will not be able to be reimbursed or indemnified for such payments through insurance or any other source, or use such payments to set off or reduce any award of compensatory damages to plaintiffs in related securities litigation pending against us.
In connection with the SEC Settlement, we consented to the entry of a final judgment in the SEC Litigation (which judgment was entered by the United States District Court for the Northern District of Alabama, Southern Division) to implement the terms of the SEC Settlement. However, Mr. Scrushy remains a defendant in the SEC Litigation.
For additional information about the SEC Settlement, see Note 21, SEC Settlement, to our accompanying consolidated financial statements.
We have spent over two years responding to the various legal, financial, and operational challenges summarized above. We are now in the first year of a multi-year turnaround plan. We are primarily focused on continuing to evaluate our business, the broader health care market, and the specific geographic markets we serve, with the goal of repositioning HealthSouth as a leading provider of post-acute care and select ambulatory services. To this end, we are planning to expand the post-acute care services provided at or complementary to our inpatient facilities, such as long-term acute care, skilled nursing, and home health services. In addition, we plan to reposition the focus of our outpatient facilities (surgery, outpatient rehabilitation, and diagnostic) into key markets, and look for expansion and growth opportunities in those markets. We also have received inquiries from parties interested in acquiring our diagnostic division. As we continue to develop our strategic plan, we will evaluate the role of each division, including the diagnostic division, in that plan. Even if consistent with our strategic plan, an important consideration in our decision to divest any material asset from our portfolio would be whether the transaction would help to deleverage the company.
As a provider of rehabilitative health care, ambulatory surgery, and diagnostic services, our revenues and growth are affected by trends in health care spending. According to estimates published by CMSs Office of the Actuary, the health care sector is growing faster than the overall economy. In 2004, the total U.S. gross domestic product is estimated to be $11.7 trillion. Total national health care spending comprised $1.8 trillion, or 15.4% of
that figure. While the United States Department of Commerce reports that the overall economy is estimated to have grown at an average rate of 5.2% per year since 1990, health care spending has increased by an average of 7% per year over that same time period. CMS estimates that by 2014 total national health care expenditures will have increased to $3.6 trillion, which will represent 18.7% of the projected U.S. gross domestic product.
Demographic factors contribute to long-term growth projections in health care spending. According to the U.S. Census Bureaus 2004 interim projections, there were approximately 35 million Americans aged 65 or older. The number of Americans aged 65 or older is expected to increase to approximately 40 million by 2010 and approximately 54 million by 2020. By 2030, the number of Americans aged 65 or older is expected to reach approximately 70 million, or 20% of the U.S. population.
We believe that the aging of the U.S. population and the continuing growth in health care spending will increase demand for the types of services we provide. First, many of the health conditions associated with agingsuch as strokes and heart attacks, neurological disorders, and diseases and injuries to the muscles, bones, and jointswill increase the demand for ambulatory surgery and rehabilitative services. Second, pressure from payors to provide efficient, high-quality health care services is forcing many procedures traditionally performed in acute care facilities out of the acute care environment.
We believe that demographics, regulation, payor pressures to reduce cost, technological advancements, and increased quality requirements will continue to fuel demand for the services we provide. We believe we can take advantage of these health care trends in the markets we currently occupy as well as leverage our size and expertise to expand our services and increase our influence in key markets.
We currently provide various patient care services through four primary operating divisions and certain other services through a fifth operating division, which together correspond to our five reporting segments. Although we have no current plans to change our operating divisions, we are continually evaluating and looking to optimize our operational structure and the mix of services we provide, which may lead to future changes in our operating divisions. Our consolidated net operating revenues were $3.8 billion for the fiscal year ended December 31, 2004. We had a diversified payor mix across all our reporting segments, with Medicare representing the highest percentage of revenues.
For additional information regarding our business segments and related information, see Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, Segment Results of Operations, and Note 23, Segment Reporting, to our accompanying consolidated financial statements.
We are the nations largest provider of inpatient rehabilitation services. Our inpatient division operates IRFs and long-term acute care hospitals (LTCHs) and provides treatment on both an inpatient and outpatient basis. Our inpatient facilities are located in 28 states, with a concentration of facilities in Texas, Pennsylvania, Florida, Tennessee, and Alabama. We also have facilities in Puerto Rico and Australia.
As of December 31, 2004, our inpatient division operated 94 freestanding IRFs (65 of which are wholly owned and 29 of which are jointly owned), 1 wholly owned acute care hospital where we ceased providing acute care services in favor of inpatient rehabilitation services, and 3 satellite facilities with inpatient beds. As of December 31, 2004, we operated 9 LTCHs (8 of which are wholly owned and 1 of which is jointly owned), 7 of which are freestanding and 2 of which are hospital-within-hospital facilities. We also operated 2 satellite facilities with LTCH beds. One of our LTCHs was not certified as an LTCH by CMS until April 2005, although it received patients in 2004 and was reimbursed by Medicare as an acute care hospital. As of December 31, 2004, our inpatient division also provided outpatient services through 152 facilities (128 of which are wholly owned and 24 of which are jointly owned) located within our IRFs or in satellite facilities near our IRFs. In addition to facilities in which we have an ownership interest, our inpatient division operated 13 inpatient facilities, 11 outpatient facilities, and 2 gamma knives through management contracts as of December 31, 2004.
Our IRFs provide services to patients who require intensive inpatient rehabilitative care. Inpatient rehabilitation patients typically experience significant physical disabilities due to various conditions, such as head injury, spinal cord injury, stroke, certain orthopedic problems, and neuromuscular disease. Our IRFs provide the medical, nursing, therapy, and ancillary services required to comply with local, state, and federal regulations, as well as accreditation standards of the Joint Commission on Accreditation of Healthcare Organizations (the JCAHO) and, for some facilities, the Commission on Accreditation of Rehabilitation Facilities. The outpatient services offered by our inpatient division generally differ from those offered by our outpatient division (described below) based on patient diagnosis.
Although the market for inpatient rehabilitation services is highly competitive, it is also highly fragmented. This fragmentation creates potential consolidation opportunities for us. In addition, because of our size, we believe we differentiate ourselves from our competitors in the following ways:
Our inpatient divisions payor mix is weighted toward government-funded sources, including Medicare. For the years ended December 31, 2004, 2003, and 2002, Medicare represented 70.2%, 70.6%, and 64.0%, respectively, of the inpatient divisions net operating revenues, which totaled $2.0 billion, $2.0 billion, and $1.9 billion, respectively.
On May 7, 2004, CMS issued a final rule that stipulates revised Medicare classification criteria that a facility is required to meet to be considered an IRF by Medicare. This is known as the 75% Rule. The 75% Rule, as revised, generally provides that to be considered an IRF, and to receive reimbursement for services under the IRF-PPS methodology, 75% of a facilitys total patient population must require intensive rehabilitation services associated with treatment of at least one of 13 designated medical conditions. As a practical matter, this means that to maintain our current level of revenue from our IRFs we will need to reduce the number of non-qualifying patients treated at our IRFs and replace them with qualifying patients, establish other sources of revenues at our IRFs, or both. The 75% Rule is being phased in over a three-year period that began on July 1, 2004. Thus, full compliance will be required for cost reporting periods beginning on or after July 1, 2007.
Our inpatient division has begun to reduce or refocus admissions at most locations to ensure our continued compliance with the phase-in schedule for the 75% Rule. As discussed in greater detail in Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, we project this reduction in census, unless mitigated, will have a materially adverse impact on our inpatient divisions financial position, operating results, and cash flows. To reduce the negative impact on our inpatient divisions revenues, we are implementing the following mitigation strategies:
In addition to the specific mitigation strategies discussed above, we are participating with the rest of the industry to help educate various governmental agencies and policy makers about the efficacy of inpatient rehabilitative care in an attempt to modify the requirements of the 75% Rule. Because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve continued compliance with or mitigate the 75% Rule could have a material adverse effect on our business, financial condition, results of operations, and cash flows. In addition to the significant volume volatility created by the 75% Rule, our inpatient division is facing lower unit pricing as a result of recent IRF-PPS changes, which are discussed later in this Item, Sources of Revenues. These two factors have combined to create a very challenging operating environment for us.
We operate one of the largest networks of ambulatory surgery centers (ASCs) in the United States. As of December 31, 2004, our surgery centers division provided ambulatory surgery services through 177 freestanding ASCs and 3 surgical hospitals in 36 states, with a concentration of centers in California, Texas, Florida, North Carolina, and Pennsylvania.
Our ASCs provide the facilities and medical support staff necessary for physicians to perform non-emergency surgical procedures. Our typical ASC is a freestanding facility with two to six fully equipped operating and procedure rooms and ancillary areas for reception, preparation, recovery, and administration. Each of our ASCs is licensed by the state and certified as a provider under federal programs, including specifically Medicare and Medicaid. Our ASCs are available for use only by licensed physicians, oral surgeons, and podiatrists. To ensure consistent quality of care, each of our ASCs has a medical advisory committee of three to ten physicians that implements quality control procedures and reviews the professional credentials of physicians applying for medical staff privileges at the center. In addition, all but a few unique specialty centers are certified by the JCAHO.
Like most other ASCs, the majority of our centers are owned in partnership with surgeons and other physicians who perform procedures at the centers. As a result of increased competition in the ASC market and other factors, physicians are demanding increased equity participation in ASCs. Consequently, we expect an increasing level of physician equity participation in our ASCs, and thus our percentage ownership of centers within our ASC portfolio will decline over time. Currently, our ownership interest in centers within our ASC portfolio varies from 20% to 100%. Our average ownership is over 50%.
A critical component of this divisions performance depends upon our ability to periodically provide physicians who use our ASCs with the opportunity to purchase ownership interests in our ASCs. This so-called resyndication of ownership interests is important because it enables us to increase the ownership participation of physicians who use our ASCs as well as attract new physicians to our ASCs. Attracting new physician investors who intend to maintain an active practice promotes, we believe, partnership interest in and support for continuing investments in necessary facility improvements as well as a general focus on quality. Our ability to resyndicate ASC ownership interests has been limited to date because, until recently, we have not been able to produce reliable financial statements. Since July 2004, we have commenced resyndications of 35 ASCs and have restructured two other ASCs. We anticipate we will commence another 10 to 12 resyndications in the remaining month of 2005. We have assembled a dedicated team of accountants, attorneys, and other specialists to expedite this effort.
Our surgery centers division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the years ended December 31, 2004, 2003, and 2002, managed care and other discount plans represented 55.2%, 51.6%, and 52.7%, respectively, of the divisions net operating revenues, which totaled $852.8 million, $909.3 million, and $912.8 million respectively.
The ASC market continues to grow, due in part to improved anesthesia, new instrumentation, payor pressure to reduce costs, and other factors. Because the market is highly fragmented, however, it is highly competitive. We plan to combat this competition (1) by increasing our concentration in specific markets, (2) by leveraging the size of our network to realize improved operating efficiencies, increased marketing opportunities, and better payor contracting, and (3) by using technology such as standardized e-coding to improve division performance.
We are one of the largest operators of outpatient rehabilitation facilities in the United States. As of December 31, 2004, our outpatient division provided outpatient therapy through 765 HealthSouth facilities (706 of which are wholly owned and 59 of which are jointly owned) and 39 facilities managed under contract by us. These facilities are located in 44 states, with a concentration of centers in Florida, Texas, New Jersey, and Missouri.
Our outpatient rehabilitation facilities are staffed by physical therapists, occupational therapists, and other clinicians and support personnel, depending on the services provided at a particular location, and are open at hours designed to accommodate the needs of the patient population being served and the local demand for services. Our centers offer a range of rehabilitative health care services, including physical therapy and occupational therapy, with a particular focus on orthopedic, sports-related, work-related, hand and spine injuries, and various neurological/neuromuscular conditions.
Our outpatient division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the years ended December 31, 2004, 2003, and 2002, managed care and other discount plans represented 47.6%, 45.3%, and 43.5%, respectively, of the divisions net operating revenues, which totaled $487.2 million, $577.5 million, and $653.3 million, respectively.
We are one of the largest operators of freestanding diagnostic imaging centers in the United States. As of December 31, 2004, our diagnostic division operated 96 diagnostic centers (80 of which are wholly owned and 16 of which are jointly owned) in 26 states and the District of Columbia, with a concentration of centers in Texas, Washington, D.C., Alabama, Georgia, and Florida. Our diagnostic centers provide outpatient diagnostic imaging services, including MRI services, CT services, X-ray services, ultrasound services, mammography services, nuclear medicine services, and fluoroscopy. We do not provide all services at all sites, although approximately 75% of our diagnostic centers are multi-modality centers offering multiple types of service.
Our diagnostic centers provide outpatient diagnostic procedures performed by experienced radiological technologists. After the diagnostic procedure is completed, the images are reviewed by radiologists who have contracted with us. Those radiologists prepare an interpretation which is then delivered to the referring physician.
Our diagnostic division has a diversified payor mix with managed care and other discount plans representing the highest percentage. For the years ended December 31, 2004, 2003, and 2002, managed care and other discount plans represented 60.5%, 65.6%, and 59.2%, respectively, of the divisions net operating revenues, which totaled $242.6 million, $270.3 million, and $294.0 million, respectively.
Although the market for diagnostic services is highly competitive, we are expanding our focus on referring physicians outside of the orthopedic specialty to broaden our base of referrals. We also have received inquiries from parties interested in acquiring our diagnostic division. As we continue to develop our strategic plan, we will
evaluate the role of each division, including the diagnostic division, in that plan. Even if consistent with our strategic plan, an important consideration in our decision to divest any material asset from our portfolio would be whether the transaction would help to deleverage the company.
Corporate and Other
This division comprises all revenue producing activities that do not fall within one of the four operating divisions discussed above, including our medical centers, other patient care services, and certain non-patient care services.
For the years ended December 31, 2004, 2003, and 2002, respectively, the divisions net operating revenues totaled $238.0 million, $227.8 million, and $215.4 million, respectively.
We have established a multi-year operational agenda that is divided into the following focus areas:
Revenue. Our current strategy is to grow our revenues by expanding the post-acute care services provided at or complementary to our inpatient facilities, such as long-term acute care, skilled nursing, and home health services. We also plan to reposition the focus of our outpatient facilities (surgery, outpatient rehabilitation, and diagnostic) into key markets, and look for expansion and growth opportunities in those markets. In addition, we hope to mitigate the impact of the 75% Rule using a combination of the four mitigation strategies discussed in this Item, Our BusinessInpatient. We are also considering ways to increase revenues through improved managed care contract modeling and consolidated sales and marketing efforts.
Cost. We have substantially reduced unnecessary overhead expense and closed or sold under-performing facilities. We will continue to work to reduce costs by reorganizing and flattening each operating division, implementing standardized labor management metrics and performance expectations, and streamlining our supply chain. In addition, we are closely monitoring our business and will, when necessary, close or sell additional under-performing facilities.
Infrastructure. We have invested significant resources to evaluate and improve our financial, reporting, and compliance infrastructure, and will continue to invest heavily in our infrastructure throughout this turnaround period. Although our infrastructure needs improvement in many areas, we are specifically focused on implementing required internal controls (e.g., compliance with Section 404 of the Sarbanes-Oxley Act of 2002), enhancing our financial infrastructure (e.g., improving financial and operational reporting and establishing a formal capital expenditure process and formal budget process), enhancing our management reporting capabilities (e.g., standardizing our monthly reporting and analysis, standardizing our financial projections, and implementing a faster month-end close), developing regulatory compliance programs, enhancing our information systems (e.g. upgrading our patient accounting systems), and implementing an information technology strategic plan.
Quality. We are working to enhance strong quality assurance programs within our facilities and divisions. We plan to supplement these programs by improving a robust company-wide quality agenda that will include standardized division-specific quality metrics and improved clinical information through the use of technology.
People. We have replaced our executive management team and a number of other management personnel, and we plan to continue investing in recruiting new employees. We are also looking at ways to increase retention and employee development, as well as overall employee relations, and we have developed a human resources strategic plan. Our goal is to build a culture of integrity, transparency, diversity, and excellence, while simplifying and flattening our organizational structure.
Our IRFs and LTCHs compete primarily with rehabilitation units and skilled nursing units within acute care hospitals in the markets we serve. In addition, we face competition from large privately and publicly held companies such as Rehabcare Group, Inc., Select Medical Corporation, and Kindred Healthcare, Inc.
Some of these competitors may have greater patient referral support and financial and personnel resources in particular markets than we do. We believe we compete successfully within the marketplace based upon our size, reputation for quality, competitive prices, and positive rehabilitation outcomes.
We face competition from other providers of ambulatory surgical care in developing ASC joint ventures, acquiring existing centers, attracting patients, and negotiating managed care contracts in each of our markets.
There are several publicly held companies, divisions or subsidiaries of publicly held companies, and several private companies that operate ASCs. Further, many physician groups develop ASCs without a corporate partner, utilizing consultants who typically perform these services for a fee and who may not require an equity interest in the ongoing operations of the center.
We believe that we compete effectively in this market because of our size, experience, and reputation for providing quality care. Our limited access to capital makes it more difficult for us to develop or acquire new ASCs, however, which puts us at a competitive disadvantage in certain markets.
Our outpatient rehabilitation facilities compete directly or indirectly with the physical and occupational therapy departments of hospitals, physician-owned therapy clinics, other private therapy clinics, and chiropractors. We also face competition from large privately held and publicly held physical therapy companies such as U.S. Physical Therapy, Inc. and Benchmark Medical, Inc., as well as mid-sized regional companies. It is particularly difficult to compete with physician-owned therapy clinics because physicians have traditionally been our customers, rather than our competitors. Consequently, in addition to competing with those physicians who offer physical therapy services as in-office ancillary services, we lose them as a referral source.
Some of these competitors may have greater patient referral support and financial and personnel resources in particular markets than we do. We believe we compete successfully within the marketplace based upon our reputation for quality, competitive prices, positive rehabilitation outcomes, and innovative programs.
The market for diagnostic services is highly fragmented and highly competitive. Many physicians and physician groups have opened diagnostic facilities as an in-office ancillary service. Our diagnostic centers also compete with local hospitals, other multi-center imaging companies, and local independent diagnostic centers.
In some states where we operate, the construction or expansion of facilities, the acquisition of existing facilities, or the introduction of new beds or services may be subject to review by and prior approval of state regulatory agencies under a Certificate of Need program. Certificate of Need laws often require the reviewing agency to determine the public need for additional or expanded health care facilities and services. Certificate of Need programs generally require approvals for capital expenditures involving IRFs, LTCHs, acute care hospitals, and ASCs if such capital expenditures exceed certain thresholds. We potentially face competition any time we initiate a Certificate of Need project or seek to acquire an existing facility or Certificate of Need. This competition may arise either from competing national or regional companies or from local hospitals or other providers which file competing applications or oppose the proposed Certificate of Need project. The necessity for these approvals serves as a barrier to entry and has the potential to limit competition. We have generally been successful in obtaining Certificates of Need or similar approvals when required, although there can be no assurance that we will achieve similar success in the future.
We rely significantly on our ability to attract, develop, and retain physicians, therapists, and other clinical personnel for our facilities. We compete for these professionals with other health care companies, hospitals, and potential clients and partners. In addition, changes in health care regulations have enabled physicians to open facilities in direct competition with us, which has increased the choices for such professionals and therefore made it more difficult and/or expensive for us to hire the necessary personnel for our facilities.
Sources of Revenues
We receive payment for patient care services from the federal government (primarily under the Medicare program), state governments (under their respective Medicaid or similar programs), managed care plans, private insurers, and directly from patients. In addition, we receive payment for non-patient care activities from various sources. The following table identifies the sources and relative mix of our revenues for the periods stated:
Medicare is a federal program that provides certain hospital and medical insurance benefits to persons aged 65 and over, some disabled persons, and persons with end-stage renal disease. Medicaid is a jointly administered federal and state program that provides hospital and medical benefits to qualifying individuals who are unable to afford health care.
Our facilities generally offer discounts from established charges to certain group purchasers of health care services, including Blue Cross and Blue Shield (BCBS), other private insurance companies, employers, HMOs, PPOs, and other managed care plans. These discount programs, which are often negotiated for multi-year terms, limit our ability to increase revenues in response to increasing costs.
Patients are generally not responsible for the difference between established gross charges and amounts reimbursed for such services under Medicare, Medicaid, BCBS plans, HMOs, or PPOs, but are responsible to the extent of any exclusions, deductibles, copayments, or coinsurance features of their coverage. The amount of such exclusions, deductibles, copayments, and coinsurance has been increasing each year. Collection of amounts due from individuals is typically more difficult than from governmental or third-party payors.
Medicare, through statutes and regulations, establishes reimbursement methodologies for various types of health care facilities and services. These methodologies have historically been subject to periodic revisions that can have a substantial impact on existing health care providers. In accordance with authorization from Congress, CMS makes annual upward or downward adjustments to Medicare payment rates in most areas. Frequently, these adjustments can result in decreases in actual dollars per procedure or a freeze on reimbursement despite increases in costs.
We expect that Congress and CMS will address reimbursement rates for a variety of care settings over the next several years. Any downward adjustment to rates for the types of facilities that we operate could have a material adverse effect on our business, financial condition, results of operations, and cash flows.
A basic summary of current Medicare reimbursement in our service areas follows:
Acute Care. As a result of the Social Security Act Amendments of 1983, Congress adopted a prospective payment system (PPS) to cover the routine and ancillary operating and capital costs of most Medicare inpatient acute care hospital services. Under this system, the Secretary of HHS has established fixed payment amounts per discharge based on diagnosis-related groups (DRGs). With limited exceptions, reimbursement received for inpatient acute care hospital services is limited to the DRG payment rate, regardless of the number of services
provided to the patient or the length of the patients hospital stay. Under Medicares acute care PPS, a hospital may retain the difference, if any, between its DRG payment rate and its operating costs incurred in furnishing inpatient services, and is at risk for any operating costs that exceed its DRG payment rate. We currently operate several hospitals that are reimbursed under Medicares acute care PPS. Only one of these hospitals receives significant acute care PPS payments relating to Medicare inpatient services, however. These hospitals can qualify for additional payments available for outlier cases that incorporate certain higher cost factors. CMS instituted a change to the cost outlier threshold and reimbursement methodology for acute care facilities effective October 1, 2003. Generally, this change has resulted in lower overall reimbursement to acute care facilities.
On August 12, 2005, CMS published its final rule for fiscal year 2006 PPS payments. Acute care hospitals that report selected quality data will receive a 3.7% increase in payment rates under the inpatient PPS. Acute care hospitals that do not participate in the quality reporting initiative will receive only a 3.3% increase in payments. The rule also reduces the outlier threshold used to pay high cost cases. Additionally, the final rule revised certain cardiovascular surgery DRGs to differentiate cardiac surgery patients based on whether they have a major cardiovascular condition. The final rule expands the number of DRGs that are subject to the post-acute transfer policy in order to reduce payment to acute care hospitals when the patient is transferred to a post-acute care setting prior to a predetermined length of stay. This transfer policy will apply to 182 DRGs. This transfer policy will have a direct impact on acute care hospital payments. In addition, the transfer policy may indirectly affect our IRFs by changing the timing of when patients are referred to our IRFs. At this time, we have not determined whether the transfer policy will have a material adverse effect on Medicare reimbursement in our hospitals.
Inpatient Rehabilitation and the 75% Rule. Historically, freestanding and hospital-based IRF units received cost-based reimbursement from Medicare under an exemption from the acute care PPS. The Balanced Budget Act of 1997 and its implementing regulations replaced the traditional IRF cost-based methodology, however, with a PPS system that recognizes 21 Rehabilitation Impairment Categories. This IRF-PPS became effective on January 1, 2002.
To qualify as an IRF under Medicare, a facility must show that 75% of the facilitys patient population requires intensive rehabilitation services that fall into a specified list of conditions. Currently, the 75% Rule lists 13 conditions:
CMS established a phase-in period for compliance with the 75% Rule, as follows:
Any IRF that fails to meet the requirements of the 75% Rule is subject to reclassification as an acute care hospital. The effect of such reclassification would be to revert Medicare IRF-PPS payment rates to lower acute care payment rates (assuming that state certificate of need and licensing rules permit the use of the beds for acute care services). Our inpatient division has begun to reduce or refocus admissions at most locations to ensure continued compliance with the phase-in schedule for the 75% Rule. We estimate that the 75% Rule will have a material adverse impact on our inpatient divisions revenues. For additional information about the estimated impact of the 75% Rule, see Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations. As discussed in this Item, Our BusinessInpatient, we have begun to implement a strategy to mitigate the impact of the 75% Rule on our revenues.
Because we receive a significant percentage of our revenues from our inpatient division, and because our inpatient division receives a significant percentage of its revenues from Medicare, our inability to achieve continued compliance with or mitigate the 75% Rule could have a material adverse effect on our business, financial condition, results of operations, and cash flows.
In November 2005, the United States Senate approved budget reconciliation legislation that included a provision that would maintain the minimum threshold for compliance with the 75% Rule at 50% for two additional years. Also in November 2005, the United States House of Representatives approved its own budget reconciliation legislation that did not address the 75% Rule. A conference committee is expected to be appointed to address differences between the House and Senate versions. If the Senate version is enacted by Congress and signed by the President, this legislation would mitigate the impact of the 75% Rule over this period.
Effective October 1, 2005, CMS made changes to DRGs for hospital payments. Of greatest potential significance to us is the changed status of 182 DRGs so they cover post-acute-care transfers. As a result of the change, the discharge of a patient being treated under one of these DRGs to a post acute facility may be treated as a transfer. Such transfer results in the acute care facility and the post acute facility sharing a single payment. At this time we have not determined if this change will have a material adverse effect on Medicare reimbursements in our rehabilitation facilities.
We continue our efforts to temper the negative effects of the 75% Rule, including our support of Congressional proposals to delay scheduled increases in minimum compliance thresholds. Although the 75% Rule presents one of our primary operating risks, other coverage policies can affect our operations. For example, Medicare providers like us can be negatively affected by the adoption of coverage policies, either at the national or local level, that determine whether an item or service is covered and under what clinical circumstances it is considered to be reasonable, necessary, and appropriate. In the absence of a national coverage determination, local Medicare fiscal intermediaries may specify more restrictive criteria than otherwise would apply nationally. For instance, Cahaba Government Benefit Administrators, the fiscal intermediary for many of our inpatient division facilities, has issued a local coverage determination setting forth very detailed criteria it proposes to use in determining the medical appropriateness of services provided by IRFs. Other Medicare fiscal intermediaries have implemented similar local coverage rules. We cannot predict how these local coverage rules will affect us.
On August 15, 2005, CMS published a final rule, as amended by the subsequent correction notice published on September 30, 2005, that updates the IRF-PPS for the federal fiscal year 2006 (which covers discharges occurring on or after October 1, 2005 and on or before September 30, 2006). Although the final rule increases market basket payments by 3.6%, it makes several other adjustments that we estimate will result in a net reduction in reimbursement to us. For example, the final rule (1) reduces the standard payment rates by 1.9%, (2) implements changes to Case-Mix Groups, comorbidity tiers, and relative weights, (3) updates the formula for the low income patient payment adjustment, (4) adopts the new geographic labor market area definitions based on the definitions created by the Office of Management and Budget known as Core-Based Statistical Areas, (5) implements new and revised payment adjustments on a budget-neutral basis, (6) implements a new indirect medical education teaching adjustment, and (7) incorporates several other modifications to Medicare reimbursement for IRFs. Although CMS predicted that overall payments to IRFs nationwide would increase by 3.4%, we estimate that the revised IRF-PPS will reduce Medicare reimbursement to our IRFs by 3.5% to 4%, primarily owing to the changes to Case-Mix Groups, comorbidity tiers, and relative weights. We estimate this net impact on reimbursement will reduce our inpatient divisions net revenues by approximately $10 million during the fourth quarter of 2005 and approximately $40 million on an annualized basis. These estimates do not take into account potential changes in our case-mix resulting from our compliance with the 75% Rule, which could have the effect of increasing the acuity of our case-mix and therefore reducing the overall net impact of the IRF-PPS changes.
Long Term Acute Care Hospitals. Long Term Acute Care Hospitals (LTCHs) provide diagnostic and medical treatment to patients with chronic diseases or complex medical conditions. In order for a facility to qualify as an LTCH, patients discharged from the facility in any given cost reporting year must have an average length-of-stay in excess of 25 days. Currently LTCHs are exempt from acute care PPS and receive Medicare reimbursement on the basis of reasonable costs subject to certain limits. However, this cost-based reimbursement is transitioning to a PPS system over a 5-year period which began for twelve-month periods beginning on or after October 1, 2002. Providers were given the option to transition into the full LTCH-PPS by receiving 100% of the federal payment rate at any time through the transition period. We have elected to receive the full federal payment rate for all of our LTCHs. Under the new LTCH-PPS system, Medicare will classify patients into distinct diagnostic groups (LTC-DRGs) based upon specific clinical characteristics and expected resource needs. The LTCH-PPS also provides for an adjustment for differences in area wages as well as a cost of living adjustment for LTCHs located in Alaska or Hawaii.
On May 6, 2005, CMS published a final rule regarding LTCH-PPS rate updates and policy changes effective for discharges on or after July 1, 2005. The final rule increases LTCH-PPS standard payment rates by 3.4% and adopts revised labor market area definitions based on the Core-Based Statistical Areas designated by the Office of Management and Budget using 2000 census data. The final rule also lowers the eligibility threshold for hospitals to qualify for outlier payments. On August 12, 2005, CMS published its final rule establishing the fiscal year 2006 acute care PPS that will impact LTCH relative weights and LTC-DRG assignments for the period October 1, 2005 through September 30, 2006. This final rule will reduce total Medicare payments to us as a result of the impact of the relative weight calculations on our LTCH reimbursement. We estimate that both final rule revisions will cause a reduction in inpatient division revenues of approximately $2.5 million for the period affected.
Effective July 1, 2004, CMS expanded its interrupted stay policy to include a discharge and readmission to the LTCH within three days, regardless of where the patient is transferred upon discharge. Accordingly, if a patient is readmitted to an LTCH within three days of discharge, Medicare will pay only one LTC-DRG. This expanded, but did not replace, the prior interrupted stay policy which provides that if an LTCH patient is discharged to an acute care hospital, an IRF, or a skilled nursing facility and then is readmitted to the LTCH within a fixed period of time, the entire hospitalization, both before and after the interruption, will be considered one episode of care and thus generate one LTC-DRG payment.
Effective October 1, 2004, CMS promulgated regulations altering the separateness and control requirements pertaining to LTCHs which are located within a hospital. Such hospitals within hospitals (HIHs) must meet more stringent requirements as to their independence from the host hospital and further must follow additional
HIH requirements based upon the percentage of admittances from the host hospital. These HIH policies are to be phased in over a four-year period which began on October 1, 2004. See this Item, RegulationHospital Within Hospital Rules. We expect Congress and CMS to conduct a further review of LTCH payment policy. Any changes in program rules or reimbursement levels could adversely affect our LTCH operations.
Ambulatory Surgery Centers. ASC services are reimbursed by Medicare based on prospectively determined rates. These rates are not based on DRGs like acute care hospital services. Rather, they are based upon the classifications of procedures into different payment groups which are based on surgical procedure complexity. Surgical procedures approved by CMS for ASC reimbursement are classified into nine payment groups for facility reimbursement purposes. All approved surgical procedures within the same payment group are reimbursed at a single rate, adjusted by the location of the facility and applicable wage index.
On May 4, 2005, CMS published an interim final rule updating the list of approved surgical procedures. The interim final rule, which became effective on July 1, 2005, deletes five approved procedures and adds 65 new procedures to the list of approved surgical procedures. Other significant changes in ASC reimbursement are presently being contemplated.
The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) froze Medicare payment rates for ASCs beginning in April 2004 through 2009 and directed HHS to implement a new payment system by 2008. For 2004, ASCs were subject to a 1% Medicare rate reduction, which dropped payment levels to roughly the 2002 rates. The MMA also required HHS to take into account a GAO study of ASCs to be completed by December 31, 2004. That study, which has not yet been completed, will examine the costs of providing the same service in the centers versus hospital outpatient departments, the accuracy of ASC payment levels and whether the outpatient prospective payment system would be a good basis for a new ASC payment system. Both the Medicare Payment Advisory Commission (Med PAC) and the OIG are recommending greater parity of payments for services performed in hospital outpatient departments (HOPDs) and those performed in ASCs. Such parity would likely result in lower payments for certain procedures that receive higher reimbursement in ASCs than in a HOPD, but could result in higher reimbursement for those services currently priced lower in ASCs than in HOPDs. Although Congressional action is required before ASC payment levels could actually be adjusted, further reductions in ASC Medicare reimbursement are possible. Any significant reductions in Medicare reimbursement could have a material adverse effect on our business, financial condition, results of operations, and cash flows.
Outpatient Rehabilitation. Our outpatient rehabilitation facilities are certified by Medicare and reimbursed by Medicare on an adjusted fee schedule basis. Under this basis, facilities receive a fixed fee per reimbursable procedure performed. This fee is adjusted by the geographical area in which the facility is located. The Balanced Budget Act of 1997 changed the reimbursement methodology for Medicare Part B therapy services from cost based to fee screen payments. It also established two types of annual per-beneficiary limitations on outpatient therapy services: (1) a $1,500 cap for all outpatient therapy services and speech language pathology services; and (2) a $1,500 cap for all outpatient occupational therapy services. Both of these amounts were indexed for inflation. Subsequent legislation suspended implementation of these caps through 2002. CMS began enforcing the therapy caps on September 1, 2003 (the inflation-adjusted amounts for 2003 were $1,590). The MMA suspended application of the therapy cap from the date of enactment (December 8, 2003) through calendar year 2005. Unless Congress extends this moratorium, the limits will apply in 2006. The dollar amount caps for 2006 will depend on the Medicare Economic Index. The Senate approved legislation in November 2005 that, if passed, will extend the moratorium on therapy caps until January 1, 2007. The therapy caps do not apply to therapy services provided in acute care hospital outpatient departments or outpatient departments of IRFs. At this time, we are currently working to quantify the impact of this legislation on our business, financial condition, results of operations, and cash flows.
Diagnostic Facilities. Medicare allows diagnostic facilities that are independent of physician practices or hospitals to bill for approved diagnostic procedures as Independent Diagnostic Testing Facilities (IDTFs). Such procedures must be performed by licensed or certified nonphysician personnel under appropriate physician
supervision or by physicians in accordance with detailed guidelines. IDTFs are reimbursed for approved tests with required physician orders on the basis of appropriate Current Procedural Terminology (CPT) codes under Medicare Part B. CPT reimbursement is geographically adjusted by CMS. Medicare uses the Resource-Based Relative Value Scale (RBRVS) fee schedule to pay for services provided in freestanding imaging centers. Each CPT code is assigned a set of relative value units (RVUs) that reflects the average time, effort, and practice costs (including a geographic adjustment) involved in performing a given procedure. Medicare payment amounts are based on a procedures total RVUs multiplied by a dollar conversion factor. Medicare makes payment determinations for diagnostic radiology procedures and imaging agents based on where the procedure is performed. More specifically, Medicare uses different payment methodologies for procedures performed in a hospital outpatient department versus an IDTF.
On November 21, 2005, CMS issued a final Physician Fee Schedule rule that reduces payment for the technical component of subsequent diagnostic imaging procedures performed in the same session on contiguous body areas. This reduction will be phased in over two years with a 25% reduction for the 2006 calendar year and a 50% reduction for the 2007 calendar year. Certain diagnostic tests conducted in IDTFs require multiple imaging procedures. Accordingly, this reduction could result in a significant reduction in IDTF Medicare reimbursement and may negatively affect our diagnostic division.
Hospital Outpatient Surgical Services. The Balanced Budget Act of 1997 authorized CMS to implement the Hospital Outpatient Prospective Payment System (OPPS) on July 1, 2000, for certain hospital outpatient services, which excludes diagnostic laboratory services, ambulance services, orthotics, prosthetics, chronic dialysis, screening mammographies, and outpatient rehabilitation services. OPPS payments are based on procedures and common procedure codes grouped by Ambulatory Payment Classifications (APCs). Our three surgical hospitals, which provide mostly outpatient surgical services, as well as our acute care hospital located in Birmingham, Alabama, are paid under the OPPS for outpatient surgical services.
On November 15, 2004, CMS published the 2005 OPPS final rule. The rule affects Medicare outpatient services furnished on or after January 1, 2005. The rate adjustments to the OPPS will mainly affect the Birmingham Medical Center, and our three surgical hospitals. The changes are expected to increase Medicare outpatient net revenues for these facilities.
On November 10, 2005, CMS published a final rule to update OPPS payment rates for calendar year 2006. CMS projects that the update will increase OPPS payments by 2.2% after taking into account changes in drug reimbursement. At this time, we are unable to quantify the impact this legislation will have on our business.
Medicaid programs are jointly funded by the 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 methodology and coverage from state to state. Many states have experienced shortfalls in their Medicaid budget and are implementing significant cuts in both reimbursement rates and service coverage. Additionally, certain states control Medicaid expenditures through rationing or restricting certain services. Downward pressure on Medicaid payment rates could cause a decline in revenues.
Because of our participation in the Medicare, Medicaid and TRICARE programs, we are required to meet certain financial reporting requirements. Federal and, where applicable, state regulations require the submission of annual cost reports covering the revenue, costs, and expenses associated with the services provided by our inpatient and certain surgery center hospitals to Medicare beneficiaries and Medicaid recipients.
Annual cost reports required under the Medicare and Medicaid programs are subject to routine audits, which may result in adjustments to the amounts determined to be ultimately due HealthSouth under these reimbursement programs. These audits are used for determining if any under- or over-payments were made to these programs and to set payment levels for future years.
On December 30, 2004, we announced that HealthSouth had signed an agreement with CMS to resolve issues associated with various Medicare cost reporting practices. Subject to certain exceptions, the settlement provides for the release of HealthSouth by CMS from any obligations related to any cost statements or cost reports which had, or could have been submitted to CMS or its fiscal intermediaries by HealthSouth for cost reporting periods ended on or before December 31, 2003. The settlement provides that all covered federal cost reports be closed and considered final and settled. Open state Medicaid cost reports are still subject to potential audits as described above. See this Item, Medicare Program Settlement.
Charge Structure for Uninsured Patients
During 2003 and 2004, a great deal of attention was focused on the charge structure and lack of available discounts extended to uninsured patients by health care facilities. Many health care providers have historically been reluctant to grant discounts that would produce charges to uninsured patients below the level of reimbursement provided by Medicare and Medicaid because of regulatory prohibitions on billing Medicare or Medicaid programs more than a providers usual and customary charges. Recent regulatory guidance has indicated, however, that health care providers may offer free or substantially discounted services to uninsured patients in many circumstances.
We cannot predict whether other regulatory or statutory provisions will be enacted by federal or state authorities that would prohibit or otherwise regulate relationships which we have established or may establish with other health care providers or the possibility of materially adverse effects on our business or revenues arising from such future actions. We believe, however, that we will be able to adjust our operations so as to be in compliance with any regulatory or statutory provision that may be applicable.
Managed Care and Other Discounted Plans
Most of our facilities offer discounts from established charges to certain large group purchasers of health care services, including managed care plans, BCBS, other private insurance companies, and employers. Managed care contracts typically have terms of between one and three years, although we have a number of managed care contracts that automatically renew each year unless a party elects to terminate the contract. While some of our contracts provide for annual rate increases of three to five percent, we cannot provide any assurance that we will continue to receive increases.
The health care industry is subject to significant federal, state, and local regulation that affects our business activities by controlling the reimbursement we receive for services provided, requiring licensure or certification of our facilities, regulating the use of our properties, and controlling our growth.
Licensure and Certification
Health care facility construction and operation are subject to numerous federal, state, and local regulations relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, maintenance of adequate records, fire prevention, and compliance with building codes and environmental protection laws. Our facilities are subject to periodic inspection by governmental and non-governmental certification authorities to ensure continued compliance with the various standards necessary for facility licensure. All of our inpatient facilities and substantially all of our ASCs are currently required to be licensed. Only a relatively small number of states require licensure for outpatient rehabilitation facilities. Many states do not require diagnostic facilities to be licensed.
In addition, facilities must be certified by CMS to participate in the Medicare program and generally must be certified by Medicaid state agencies to participate in Medicaid programs. All of our inpatient facilities participate in (or are awaiting the assignment of a provider number to participate in) the Medicare program. As of December 31, 2004, approximately 88% of our outpatient therapy facilities (including outpatient rehabilitation facilities and other outpatient facilities) currently participate in, or are awaiting the assignment of a provider number to participate in, Medicare programs. Substantially all of our ASCs and diagnostic centers are certified (or are awaiting certification) under the Medicare program. Our Medicare-certified facilities undergo periodic on-site surveys in order to maintain their certification.
Failure to comply with applicable certification requirements may make our facilities ineligible for Medicare or Medicaid reimbursement. In addition, Medicare or Medicaid may seek retroactive reimbursement from noncompliant facilities or otherwise impose sanctions on noncompliant facilities. Non-governmental payors often have the right to terminate provider contracts if a facility loses its Medicare or Medicaid certification. We have developed operational systems to oversee compliance with the various standards and requirements of the Medicare program and have established ongoing quality assurance activities; however, given the complex nature of governmental health care regulations, there can be no assurance that Medicare, Medicaid, or other regulatory authorities will not allege instances of noncompliance.
Certificates of Need
In some states where we operate, the construction or expansion of facilities, the acquisition of existing facilities, or the introduction of new beds or services may be subject to review by and prior approval of state regulatory agencies under a Certificate of Need program. Certificate of Need laws often require the reviewing agency to determine the public need for additional or expanded health care facilities and services. Certificate of Need programs generally require approvals for capital expenditures involving IRFs, LTCHs, acute care hospitals, and ASCs if such capital expenditures exceed certain thresholds. Most states do not require such approvals for outpatient rehabilitation, occupational health, or diagnostic facilities and services. However, any time a Certificate of Need is required, we must obtain it before acquiring, opening, or expanding a health care facility or starting a new health care program.
False Claims Act
Over the past several years, an increasing number of health care providers have been accused of violating the federal False Claims Act. That act prohibits the knowing presentation of a false claim to the United States government, and provides for penalties equal to three times the actual amount of any overpayments plus up to $11,000 per claim. In addition, the False Claims Act allows private persons, known as relators, to file complaints under seal and provides a period of time for the government to investigate such complaints and determine whether to intervene in them and take over the handling of all or part of such complaints. Because of the sealing provisions of the False Claims Act, it is possible for health care providers to be subject to False Claims Act suits for extended periods of time without notice of such suits or an opportunity to respond to them. Because we perform thousands of similar procedures a year for which we are reimbursed by Medicare and other federal payors and there is a relatively long statute of limitations, a billing error or cost reporting error could result in significant civil or criminal penalties under the False Claims Act or other laws. We have recently entered into a substantial settlement of claims under the False Claims Act. See this Item, Medicare Program Settlement. We remain a named defendant in certain unsealed suits under the False Claims Act where the United States did not intervene. See Item 3, Legal Proceedings, Certain Regulatory Actions.
Corporate Integrity Agreement
As described in this Item, Medicare Program Settlement, we entered into a new corporate integrity agreement (CIA) in December 2004, which is effective for five years beginning January 1, 2005. Failure to meet our obligations under our CIA could result in stipulated financial penalties. Failure to comply with material
terms, however, could lead to exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues. See Note 20, Medicare Program Settlement, in the accompanying consolidated financial statements for a description of the accounting treatment of the settlement relating to this CIA. On April 28, 2005, we submitted an implementation report to the OIG stating that we had, within the 90-day time frame, materially complied with the initial requirements of this new CIA.
Relationships with Physicians and Other Providers
The Anti-Kickback Law. Various state and federal laws regulate relationships between providers of health care services, including employment or service contracts and investment relationships. Among the most important of these restrictions is a federal criminal law prohibiting (a) the offer, payment, solicitation, or receipt of remuneration by individuals or entities to induce referrals of patients for services reimbursed under the Medicare or Medicaid programs or (b) the leasing, purchasing, ordering, arranging for, or recommending the lease, purchase, or order of any item, good, facility, or service covered by such programs (the Anti-Kickback Law). In addition to federal criminal sanctions, including penalties of up to $50,000 for each violation plus tripled damages for improper claims, violators of the Anti-Kickback Law may be subject to exclusion from the Medicare and/or Medicaid programs. In 1991, the OIG issued regulations describing compensation arrangements that are not viewed as illegal remuneration under the Anti-Kickback Law (the 1991 Safe Harbor Rules). The 1991 Safe Harbor Rules create certain standards (Safe Harbors) for identified types of compensation arrangements that, if fully complied with, assure participants in the particular arrangement that the OIG will not treat that participation as a criminal offense under the Anti-Kickback Law or as the basis for an exclusion from the Medicare and Medicaid programs or the imposition of civil sanctions.
The OIG closely scrutinizes health care joint ventures involving physicians and other referral sources for compliance with the Anti-Kickback Law. In 1989, the OIG published a Fraud Alert that outlined questionable features of suspect joint ventures, and has continued to rely on such Fraud Alert in later pronouncements. We currently operate some of our rehabilitation hospitals and outpatient rehabilitation facilities as general partnerships, limited partnerships, or limited liability companies (collectively, partnerships) with third-party investors, including other institutional health care providers but also including, in a number of cases, physician investors. Some of these partners may be deemed to be in a position to make or influence referrals to our facilities. Those partnerships that are providers of services under the Medicare program, and their owners, are subject to the Anti-Kickback Law. A number of the relationships we have established with physicians and other health care providers do not fit within any of the Safe Harbors. The 1991 Safe Harbor Rules do not expand the scope of activities that the Anti-Kickback Law prohibits, nor do they provide that failure to fall within a Safe Harbor constitutes a violation of the Anti-Kickback Law; however, the OIG has indicated that failure to fall within a Safe Harbor may subject an arrangement to increased scrutiny. While we do not believe that our rehabilitation facility partnerships engage in activities that violate the Anti-Kickback Law, there can be no assurance that such violations may not be asserted in the future, nor can there be any assurance that our defense against any such assertion would be successful.
Most of our ASCs are owned by partnerships, which include as partners physicians who perform surgical or other procedures at such centers. HHS has promulgated four categories of safe harbors under the Anti-Kickback Law for ASCs (the ASC Safe Harbors). Under the ASC Safe Harbors, ownership by a referring physician in a freestanding ASC will be protected if a number of conditions are satisfied. The conditions include the following:
Because we invest in each partnership that owns an ASC and often provide management and other services to the ASC, our arrangements with physician investors do not fit within the terms of the ASC Safe Harbors. In addition, because we do not control the medical practices of our physician investors or control where they perform surgical procedures, in some of our ASCs, the quantitative tests described above have not been met and/or will not be met in the future, and that certain other conditions of the ASC Safe Harbors have not been or will not be satisfied. We cannot ensure that all physician-investors will perform, or have performed, one-third of their procedures at the ASC or have informed or will inform their referred patients of their investment interests. Accordingly, there can be no assurance that the ownership interests in some of our ASCs will not be challenged under the Anti-Kickback Law.
Some of our diagnostic centers are also owned or operated by partnerships that include radiologists as partners. While those ownership interests are not directly covered by the Safe Harbor Rules, we do not believe that the structure of such arrangements violate the Anti-Kickback Law because radiologists are typically not in a position to make referrals to diagnostic centers. In addition, our mobile lithotripsy operations are conducted by partnerships in which urologists are limited partners. Because such urologists are in a position to, and do, perform lithotripsy procedures utilizing our lithotripsy equipment, we believe that the same analysis underlying the ASC Safe Harbor should apply to ownership interests in lithotripsy equipment held by urologists. There can be no assurance, however, that the Anti-Kickback Law will not be interpreted in a manner contrary to our beliefs with respect to diagnostic and lithotripsy services.
We have entered into agreements to manage many of our facilities that are owned by partnerships in which physicians have invested. A number of these agreements incorporate a percentage-based management fee. Although there is a safe harbor for personal services and management contracts, this safe harbor requires, among other things, that the aggregate compensation paid to the manager over the term of the agreement be set in advance. Because our management fee may be based on a percentage of revenues, the fee arrangement may not meet this requirement. However, we believe that our management arrangements satisfy the other requirements of the safe harbor for personal services and management contracts and that they comply with the Anti-Kickback Law. The OIG has taken the position that percentage-based management agreements are not protected by a safe harbor, and consequently, may violate the Anti-Kickback Law. On April 15, 1998, the OIG issued Advisory Opinion 98-4 which reiterates this proposition. This opinion focused on areas the OIG considers problematic in a physician practice management context, including financial incentives to increase patient referrals, no safeguards against overutilization and incentives to increase the risk of abusive billing. The opinion reiterated that proof of intent to violate the Anti-Kickback Law is the central focus of the OIG. We have implemented programs designed to safeguard against overbilling and otherwise achieve compliance with the Anti-Kickback Law and other laws, but we cannot assure you that the OIG would find our compliance programs to be adequate.
While several federal court decisions have aggressively applied the restrictions of the Anti-Kickback Law, they provide little guidance as to the application of the Anti-Kickback Law to our partnerships, and we cannot provide any assurances that a federal or state agency charged with enforcement of the Anti-Kickback Law and similar laws might not claim that some of our partnerships have violated or are violating the Anti-Kickback Law. Such a claim could adversely affect relationships we have established with physicians or other health care providers or result in the imposition of penalties on us or on particular HealthSouth facilities. Any conviction of a partnership for violations of the Anti-Kickback Law would have severe consequences on that partnerships ability to be a viable entity and our ability to attract physician investors to other partnerships and could result in substantial fines as well as our exclusion from Medicare and Medicaid. Moreover, even the assertion of a violation of the Anti-Kickback Law by one or more of our partnerships could have a material adverse effect upon our business, financial condition, results of operations, or cash flows.
Stark Prohibitions. The so-called Stark II provisions of the Omnibus Budget Reconciliation Act of 1993 amend the federal Medicare statute to prohibit the making by a physician of referrals for designated health services including physical therapy, occupational therapy, radiology services or radiation therapy, to an entity in which the physician has an investment interest or other financial relationship, subject to certain exceptions. Such prohibition took effect on January 1, 1995 and applies to all of our partnerships with physician partners and to our other financial relationships with physicians. Final Regulations for Phase II Stark Regulations were published in the Federal Register on March 26, 2004 and had an effective date of July 26, 2004. The final regulations substantially clarified recruitment arrangements among health care facilities, individual physicians and group practices and addressed compensation arrangements with physicians.
Ambulatory surgery is not identified as a designated health service under Stark II, and we do not believe the statute is intended to cover ambulatory surgery services. The Phase I Final Stark Regulations expressly clarify that the provision of designated health services in an ASC is excepted from the referral prohibition of Stark II if payment for such designated health services is included in the ambulatory surgery center payment rate. Likewise, the Stark regulations expressly provide that a referral for designated health services does not include a request by a radiologist for diagnostic radiology services if the request results from a consultation initiated by another physician and the tests or services are furnished by or under the supervision of a radiologist. As a result, we believe that radiologists may enter into joint ventures for diagnostic imaging centers without violating Stark II in most circumstances.
Our lithotripsy units frequently operate on hospital campuses, and it is possible to conclude that such services are inpatient and outpatient hospital servicesa category of designated health services under Stark II. CMS had indicated that lithotripsy services provided at a hospital would constitute inpatient and outpatient hospital services and thus would be subject to Stark II. However, a federal court decision does not support this
interpretation. On January 3, 2003, CMS withdrew its appeal of Judge Henry Kennedys decision in American Lithotripsy Society and Urology Society of America v. Thompson, made in the Federal District Court for the District of Columbia. The Court of Appeals accepted the withdrawal, and, accordingly, the District Court decision is final. This order permanently enjoined CMS from implementing and enforcing its Stark II regulation declaring lithotripsy a designated health service. However, according to CMS, even if lithotripsy provided under arrangement with a hospital is not a designated health service, this arrangement would result in an indirect compensation relationship between the urologist and the hospital with which the lithotripsy entity has an arrangement. Under that theory, referrals by the physician for designated health service other than lithotripsy (e.g. radiology, radiation oncology, etc.) are still prohibited unless the lithotripsy facility/hospital arrangement meets a Stark II exception. If Congress passes revised legislation on this topic, CMS adopts additional regulations or is otherwise successful in re-asserting its position on lithotripsy services and Stark, we would be forced to restructure many of our relationships for lithotripsy services at substantial cost.
While we do not believe that our financial relationships with physicians violate the Stark II statute or the associated regulations, no assurances can be given that a federal or state agency charged with enforcement of the Stark II statute and regulations or similar state laws might not assert a contrary position or that new federal or state laws governing physician relationships, or new interpretations of existing laws governing such relationships, might not adversely affect relationships we have established with physicians or result in the imposition of penalties on us or on particular HealthSouth facilities. Even the assertion of a violation could have a material adverse effect upon our business, financial condition, or results of operations. In addition, a number of states have passed or are considering statutes which prohibit or limit physician referrals of patients to facilities in which they have an investment interest. Any actual or perceived violation of these state statutes could have a material adverse effect on business, financial condition, results of operations, and cash flows.
The Health Insurance Portability and Accountability Act of 1996 (HIPAA) broadened the scope of certain fraud and abuse laws by adding several criminal provisions for health care fraud offenses that apply to all health benefit programs. HIPAA also added a prohibition against incentives intended to influence decisions by Medicare beneficiaries as to the provider from which they will receive services. In addition, HIPAA created new enforcement mechanisms to combat fraud and abuse, including the Medicare Integrity Program, and an incentive program under which individuals can receive up to $1,000 for providing information on Medicare fraud and abuse that leads to the recovery of at least $100 of Medicare funds. Federal enforcement officials now have the ability to exclude from Medicare and Medicaid any investors, officers, and managing employees associated with business entities that have committed health care fraud, even if the officer or managing employee had no knowledge of the fraud.
HIPAA also contains certain administrative simplification provisions that require the use of uniform electronic data transmission standards for certain health care claims and payment transactions submitted or received electronically. HHS has issued regulations implementing the HIPAA administrative simplification provisions and compliance with these regulations became mandatory for our facilities on October 16, 2003. HHS has agreed to accept noncompliant Medicare claims, for an unspecified time, to assist providers that are not yet able to process compliant transactions. However, this extension may be terminated by HHS and is not binding on private payors. We believe that the cost of compliance with these regulations has not had and is not expected to have a material adverse effect on our business, financial condition, results of operations, and cash flows.
HIPAA also requires HHS to adopt standards to protect the privacy and security of individually identifiable health-related information. HHS released regulations containing privacy standards in December 2000 and published revisions to the regulations in August 2002. Compliance with these regulations became mandatory on April 14, 2003. The privacy regulations regulate the use and disclosure of individually identifiable health-related information, whether communicated electronically, on paper, or orally. The regulations also provide patients with significant new rights related to understanding and controlling how their health information is used or disclosed.
HHS released security regulations on February 20, 2003. The security regulations became mandatory on April 20, 2005 and require health care providers to implement administrative, physical, and technical practices to protect the security of individually identifiable health information that is maintained or transmitted electronically. The privacy regulations and security regulations could impose significant costs on our facilities in order to comply with these standards.
Penalties for violations of HIPAA include civil and criminal monetary penalties. In addition, there are numerous legislative and regulatory initiatives at the federal and state levels addressing patient privacy concerns. 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 penalties.
CMS continued to accept electronic claims for payment even if such claims were not HIPAA compliant. However, on August 4, 2005, CMS announced that, effective October 1, 2005, it will no longer process non-HIPAA compliant electronic fee-for-service Medicare claims submitted for payment. CMS indicated that it will also end the contingency plan for other electronic healthcare transactions in the near future.
Our acute care hospital in Birmingham, Alabama and two of our surgical hospitals are subject to the Emergency Medical Treatment and Active Labor Act (EMTALA). This federal law requires any hospital that participates in the Medicare program to conduct an appropriate medical screening examination of every person who presents to the hospitals emergency room for treatment and, if the patient is suffering from an emergency medical condition, to either stabilize that condition or make an appropriate transfer of the patient to a facility that can handle the condition. The obligation to screen and stabilize emergency medical conditions exists regardless of a patients ability to pay for treatment. There are severe penalties under EMTALA if a hospital fails to screen or appropriately stabilize or transfer a patient or if the hospital delays appropriate treatment in order to first inquire about the patients ability to pay. Penalties for violations of EMTALA include civil monetary penalties and exclusion from participation in the Medicare program. In addition, an injured patient, the patients family, or a medical facility that suffers a financial loss as a direct result of another hospitals violation of the law can bring a civil suit against the hospital.
Hospital Within Hospital Rules
Effective October 1, 2004, CMS enacted final regulations that provide if a long term acute care hospital within hospital has Medicare admissions from its host hospital that exceed 25% (or an adjusted percentage for certain rural or Metropolitan Statistical Area dominant hospitals) of its Medicare discharges for its cost-reporting period, the LTCH will receive an adjusted payment for its Medicare patients of the lesser of (a) the otherwise full payment under the LTCH-PPS or (b) the full payment that Medicare would pay under the acute care PPS. In determining whether an LTCH meets the 25% criterion, patients transferred from the host hospital that have already qualified for outlier payments at the acute host facility would not count as part of the host hospitals allowable percentage. Cases admitted from the host hospital before the LTCH crosses the 25% threshold will be paid under the LTCH-PPS. Under the final regulation, this 25% Rule is set to phase in over a four year period which began on October 1, 2004.
Additionally, other excluded hospitals or units of a host hospital, such as inpatient rehabilitation facilities and/or units, must meet certain HIH requirements in order to maintain their excluded status and not be subject to Medicares acute care PPS.
The majority of our IRFs and LTCHs are freestanding facilities. As such, many of HealthSouths facilities are not subject to these rules. HealthSouths hospital within hospital LTCH or inpatient competitors or their referral sources could refer a certain number of patients to free-standing facilities for LTCH or inpatient rehabilitation services, and HealthSouth facilities may benefit from increased referrals.
Patient Safety and Quality Improvement Act of 2005
On July 29, 2005, the President signed the Patient Safety and Quality Improvement Act of 2005 which has the goal of reducing medical errors and increasing patient safety. This legislation establishes a confidential reporting structure in which providers can voluntarily report Patient Safety Work Product (PSWP) to Patient Safety Organizations. Under the system, PSWP is made privileged, confidential, and legally protected from disclosure. PSWP does not include medical, discharge, or billing records or any other original patient or provider records but does include information gathered specifically in connection with the reporting of medical errors and improving patient safety. This legislation does not preempt state or federal mandatory disclosure laws concerning information that does not constitute PSWP. Patient Safety Organizations will be certified by the Secretary of the Department of Health and Human Services for three year periods after the Secretary develops applicable certification criteria. Patient Safety Organizations will analyze PSWP, provide feedback to providers and may report non-identifiable PSWP to a database. In addition, these organizations are expected to generate patient safety improvement strategies. We are presently evaluating our participation in this voluntary reporting process.
Risk Management and Insurance
We insure a substantial portion of our professional, general liability, and workers compensation risks through a self-insured retention program implemented through HCS, Ltd., which is our wholly-owned offshore captive insurance subsidiary. HCS provides our first layer of insurance coverage for professional and general liability risks (up to $6 million per claim and $60 million in the aggregate per year) and workers compensation claims (between $250,000 and $1 million per claim, depending upon the state). We maintain professional and general liability insurance with unrelated commercial carriers for losses in excess of amounts insured by HCS. HealthSouth and HCS maintained reserves for professional, general liability, and workers compensation risks that totaled $187.1 million, net of insurance recoverables, at December 31, 2004. Management considers such reserves, which are based on actuarially determined estimates, to be adequate for those liability risks. However, there can be no assurance that the ultimate liability will not exceed managements estimates.
We also maintain directors and officers, property, and other typical insurance coverages with unrelated commercial carriers. Our director and officer liability insurance coverage for our current officers and directors is in the amount of $200 million, which includes $50 million in coverage for individual directors and officers in circumstances where we are legally or financially unable to indemnify these individuals. Examples of a companys inability to indemnify would include derivative suits, bankruptcy/financial restraints, and claims that are against public policy. Of the $200 million coverage, we have a self-insured retention of $10 million for claims against us.
In addition to the standard industry exclusions, our director and officer liability policy also includes exclusions of coverage for (1) our former Chairman and Chief Executive Officer, Richard M. Scrushy, and our former Chief Financial Officer, William T. Owens and (2) a prior acts exclusion and a pending and prior litigation exclusion as of July 31, 2003. See Item 3, Legal Proceedings, Insurance Coverage Litigation, for a description of various lawsuits that have been filed to contest coverage under certain directors and officers insurance policies.
While to date we have not had extraordinary difficulty in obtaining director and officer liability insurance coverage for our current directors and officers, the premium costs associated with this coverage have been dramatically higher than in the years prior to March 2003. We believe we will be able to continue to secure comparable coverage for the coming insurance year. We anticipate that, although the premium costs associated with our director and officer liability insurance coverage will be reduced during the coming insurance year, such premium costs will remain higher than in the years prior to March 2003. Despite these increased premium costs, we do not believe these costs are material to our results of operation or financial condition.
As of December 31, 2004, we employed approximately 40,000 individuals, of whom approximately 28,000 were full-time employees. We are subject to various state and federal laws that regulate wages, hours, benefits, and other terms and conditions relating to employment. Except for approximately 65 employees at one IRF (about 15% of that facilitys workforce), none of our employees are represented by a labor union. We are not aware of any current activities to organize our employees at other facilities. We believe our relationship with our employees is satisfactory. Like most health care providers, our labor costs are rising faster than the general inflation rate. In some markets, the availability of nurses and other medical support personnel has become a significant operating issue to health care providers. To address this challenge, we are implementing initiatives to improve retention, recruiting, compensation programs, and productivity. The shortage of nurses and other medical support personnel, including physical therapists, may require us to increase utilization of more expensive temporary personnel.
Our website address is www.healthsouth.com. We make available through our website the following documents, free of charge: our annual reports (Form 10-K), our quarterly reports (Form 10-Q), our current reports (Form 8-K), and any amendments we file with respect to any such reports promptly after we electronically file such material with, or furnish it to, the SEC. With the exception of current reports and this annual report, we have not filed periodic reports with the SEC for periods after December 31, 2003. In addition to the information that is available on our website, you may read and copy any materials we file with or furnish to the SEC at the SECs Public Reference Room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website, www.sec.gov, which includes reports, proxy, and information statements, and other information regarding us and other issuers that file electronically at the SEC.
Our business, operations, and financial condition are subject to various risks. Some of these risks are described below, and you should take such risks into account in evaluating HealthSouth or any investment decision involving HealthSouth. This section does not describe all risks that may be applicable to our company, our industry, or our business, and it is intended only as a summary of certain material risk factors. More detailed information concerning the risk factors described below is contained in other sections of this annual report.
Risks Related to Pending Governmental Investigations and Litigation
Any adverse outcome of continuing investigations being conducted by the DOJ and other governmental agencies could have a material adverse effect on us.
While we are fully cooperating with the DOJ and other governmental authorities in their investigations, we cannot predict the outcome of those investigations. Such investigations could have a material adverse effect on us, the trading prices of our securities, and our ability to raise additional capital. If we are convicted of a crime, certain contracts and licenses that are material to our operations could be revoked which would materially and adversely affect our business, financial condition, results of operations, and cash flows.
Several lawsuits have been filed against us involving our accounting practices and other related matters and the outcome of these lawsuits may have a material adverse effect on our business, financial condition, results of operations, and cash flows.
A number of class action, derivative, and individual lawsuits have been filed against us, as well as certain of our past and present officers and directors, relating to, among other things, allegations of numerous violations of securities laws. We cannot predict the outcome of these lawsuits. Substantial damages or other monetary remedies assessed against us could have a material adverse effect on our business, financial condition, results of operations, and cash flows. See Item 3, Legal Proceedings, for a discussion of these lawsuits.
Although we have entered into a recent settlement with various government agencies and other parties regarding our participation in federal health care programs, we remain a defendant in litigation relating to our participation in federal health care programs, and the outcome of these lawsuits may have a material adverse effect on our business, financial condition, results of operations, and cash flows.
Qui tam actions brought under the False Claims Act 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 court. Therefore, it is possible that additional qui tam actions have been filed against us that we are unaware of or which we have been ordered by the court not to discuss until the court lifts the seal from the case. Thus, it is possible that we are subject to liability exposure under the False Claims Act based on qui tam actions other than those discussed in this report.
CMS has been granted authority to suspend payments, in whole or in part, to Medicare providers if CMS possesses reliable information that an overpayment, fraud, or willful misrepresentation exists. If CMS suspects that payments are being or have been made as the result of fraud or misrepresentation, CMS may suspend payment at any time without providing us with prior notice. The initial suspension period is limited to 180 days. However, the payment suspension period can be extended almost indefinitely if the matter is under investigation by the OIG or the DOJ. Therefore, we are unable to predict if or when we may be subject to a suspension of payments by the Medicare and/or Medicaid programs, the possible length of the suspension period or the potential cash flow impact of a payment suspension. Any such suspension would adversely impact our business, financial condition, results of operations, and cash flows.
If the OIG determines we have violated federal laws governing kickbacks and self-referrals, it could impose substantial civil monetary penalties on us and could seek to exclude our provider entities from participation in the federal health care programs which would severely impact our financial condition and ability to continue operations.
If the OIG determines that we have violated the Anti-Kickback Law, the OIG may commence administrative proceedings to impose penalties under the Civil Monetary Penalties Law of up to three times the amount of damages and $11,000 per claim for each false or fraudulent claim allegedly submitted by us. If the OIG determines that we have violated the federal Stark statutes general prohibition on physician self-referrals (42 U.S.C. § 1395nn), it may impose a civil monetary penalty of up to $15,000 per service billed in violation of the statute.
The OIG has been granted the authority to exclude persons or entities from participation in the federal health care programs for a variety of reasons, including: (1) committing an act in violation of the Anti-Kickback Law, (2) submitting a false or fraudulent claim, (3) submitting a claim for services rendered in violation of the physician self-referral statute, or (4) violating any other provision of the Civil Monetary Penalties Law. Thus, if the OIG believes that we have submitted false or fraudulent claims, paid or received kickbacks, submitted claims in violation of the physician self-referral law, or committed any other act in violation of the Civil Monetary Penalties Law, the OIG could move to exclude our provider entities from participation in the federal health care programs.
Limitations of our director and officer liability insurance and potential indemnification obligations could have a material adverse effect on our business, financial condition, results of operations, and cash flows.
Our director and officer liability insurance coverage for our current officers and directors is in the amount of $200 million, which includes $50 million in coverage for individual directors and officers in circumstances where we are legally or financially unable to indemnify these individuals. Examples of a companys inability to indemnify would include derivative suits, bankruptcy/financial restraints, and claims that are against public policy. Of the $200 million coverage, we have a self-insured retention of $10 million for claims against us.
As discussed in Item 3, Legal Proceedings, several of our current and former directors and officers have been sued based on allegations that they participated in accounting fraud and other illegal activities. Several of our insurance carriers have filed lawsuits against us and are attempting to have our directors and officers liability policies that provide coverage for those claims voided or cancelled or have advised us that they do not intend to provide coverage with respect to those pending actions. If the insurance companies are successful in rescinding or denying coverage to us and/or some of our current and former directors and officers, our ability to reach a settlement with plaintiffs in the securities, derivative, and other litigation could be adversely affected. The failure to reach a settlement could have a material adverse effect on our business, financial condition, results of operations, and cash flows.
Under our bylaws and certain indemnification agreements, we may have an obligation to indemnify our current and former officers and directors. Although we contest the validity of his claim, Richard M. Scrushy recently requested that we reimburse him for costs relating to his criminal defense, which he estimates exceed $25 million. If the insurance companies are successful in rescinding or denying coverage of expenses incurred or liabilities imposed in connection with the pending actions against certain of our past and present directors and officers who we may be required to indemnify, that may have a material adverse effect on our business, financial condition, results of operations, and cash flows.
Risks Related to Our Financial Condition
Our substantial indebtedness may severely limit cash flow available for our operations and could impair our ability to service debt or obtain additional financing, if necessary.
We are highly leveraged. As of December 31, 2004, we had $3.5 billion of long-term debt outstanding, all of which we will need to repay or refinance by 2015, including $2.6 billion of which we will need to repay or refinance at various times through 2009 (assuming noteholders exercise their options to require us to repurchase
notes in 2007 and 2009). The substantial amount of payments due on our outstanding debt and other payment obligations could, among other things:
Our ability to satisfy interest payment obligations on our outstanding debt will depend largely on our future performance. Although we believe we have a solid core business and we have implemented a business plan to position HealthSouth for a successful restructuring, we are subject to numerous contingent liabilities and are subject to prevailing economic conditions and to financial, business, and other factors beyond our control. As a result, we cannot assure you that we will be able to generate sufficient cash flow to service our interest payment obligations under our outstanding debt, or that cash flows, future borrowings, or equity financing will be available for the payment or refinancing of our debt. To the extent we are not successful in repaying or negotiating renewals of our borrowings or in arranging new financing, our business and results of operations will be materially and adversely affected.
In addition, certain trends in our business, including declining revenues resulting from the 75% Rule, acute care volume weakness, recent IRF-PPS changes, and continued weakness in our surgery centers division, could make it difficult for us to meet certain financial covenantsparticularly relating to debt coverage ratioscontained in our amended and restated credit agreement, senior subordinated credit agreement, and term loan agreement. Although we are in compliance with these covenants as of the filing of this annual report and believe we will be in compliance with these as of December 31, 2005, we believe that at some point in 2006, we may be in jeopardy of violating certain financial covenants. If we were to violate these covenants and were unable to obtain waivers of such violations or otherwise arrange financing with amended debt coverage ratios, our business and results of operations could be materially and adversely affected. We will, of course, continue to monitor our compliance with all of our debt covenants and, if we feel that we are likely to violate any covenant, we will seek to obtain the necessary relief.
We have significant cash obligations relating to government settlements that, in addition to our indebtedness, may limit cash flow available for our operations and could impair our ability to service debt or obtain additional financing, if necessary.
In addition to being highly leveraged, we have significant cash obligations we must meet in the near future as a result of recent settlements with various federal agencies. Specifically, we are obligated to pay $325 million in quarterly installments over the next three years to satisfy our obligations under a settlement described in Item 1, Business, Medicare Program Settlement. Furthermore, we are obligated to pay $100 million to the SEC in five installments over a two year period beginning in the fourth quarter of 2005, as described in Item 1, Business, SEC Settlement.
We will not be able to apply to relist our common stock on a major securities exchange until the middle of 2006, and will not be able to meet the registration requirements of the Securities Act until the latter part of 2006, at the earliest. Until we are relisted on a major securities exchange, the prices at which our common stock trades in the over-the-counter market may be much more volatile than if it traded on a major securities exchange. Until we can meet the registration requirements of the Securities Act, our access to capital will be limited.
We do not expect to be able to meet the requirements for relisting on a major securities exchange until the middle of 2006. While our common stock is quoted on the OTC Bulletin Board and in the Pink Sheets, there is currently only a limited trading market for our shares and the market price of these shares may be volatile for the foreseeable future. The limited trading market for our common stock may cause fluctuations in the price and
volume of our shares to be more exaggerated than would occur on a major securities exchange. We cannot assure you that prior to relisting our shares on a major securities exchange, you will be able to sell shares of our common stock without a considerable delay or significant impact on the sale price.
In addition, it will likely be the latter part of 2006, at the earliest, before we can meet the registration requirements of the Securities Act and thereby have access to public capital markets. Because our internal controls are still ineffective, it may be difficult to file our 2005 Form 10-K on a timely basis, which could extend the time it will take for us to satisfy the registration requirements of the Securities Act. Consequently, we will not have access to public capital markets until the latter part of 2006, at the earliest, which will make it more difficult to grow our business.
We may not be able to file our periodic reports on a timely basis beginning in 2006, which could jeopardize certain covenants governing our indebtedness.
The indentures governing our public indebtedness contain covenants that require us to file, on a timely basis, all reports required to be filed for periods ending on or after December 31, 2005. Because our internal controls are still ineffective, it may be difficult for us to meet those requirements in 2006. If we are unable to file our periodic reports on a timely basis beginning in 2006 and are unable to file the required reports within the designated cure period, and if the requisite bondholders elect to treat such a technical default as an Event of Default under the indentures, our business, results of operations, and cash flows could be materially adversely affected. Our amended and restated credit agreement, senior subordinated credit agreement, and term loan agreement contain similar requirements.
We have determined that our internal controls are currently ineffective. The lack of internal controls could adversely affect our financial condition and ability to carry out our strategic business plan.
As discussed in Item 9A, Controls and Procedures, our new management team, under the supervision and with the participation of our chief executive officer and chief financial officer, conducted an evaluation of the effectiveness of the design and operation of HealthSouths internal controls. As of December 31, 2004, they concluded that HealthSouths disclosure controls and procedures, including HealthSouths internal control over financial reporting, were not effective. Although we have made improvements in our internal controls, if we are unsuccessful in our focused effort to permanently and effectively remedy the weaknesses in our internal control over financial reporting and to establish and maintain effective corporate governance practices, our financial condition and ability to carry out our strategic business plan, our ability to report our financial condition and results of operations accurately and in a timely manner, and our ability to earn and retain the trust of our patients, physician partners, employees, and security holders, could be adversely affected.
Risks Related to Our Business
The continuing time, effort, and expense relating to internal and external investigations, the restatement of historical financial statements, and the development and implementation of improved internal controls and procedures, may have an adverse effect on our business, results of operations, and cash flows.
In addition to the challenges of the various government investigations and extensive litigation we face, our new management team has spent considerable time and effort dealing with internal and external investigations involving our historical accounting and internal controls, and in developing and implementing accounting policies and procedures, disclosure controls and procedures, and corporate governance policies and procedures. The significant time and effort spent may have adversely affected our operations and may continue to do so in the future.
Current and prospective investors, patients, physician partners, and employees may react adversely to our inability to file all of our SEC filings in a timely manner.
Our future success depends in large part on the support of our current and future investors, patients, physician partners, and employees. The restatement of our historical financial statements and our inability to file on a timely basis all of our SEC filings has caused negative publicity, the delisting of our common stock from the NYSE, and has, and may continue to have, a negative impact on the market price of our securities. In addition, the restatement of our historical financial statements and our inability to file all of our SEC filings in a timely manner could cause current and future physician partners and patients to lose confidence in our company, which may affect their willingness to provide care for us or receive care from us. Further, the reconstruction of our historical financial records has caused us to restate not only our consolidated financial statements but also the financial statements of certain of our partnerships. While the process of communicating the effect of these restatement activities on our partners has begun, we anticipate the process of resolving with our partners issues arising from these restatements will continue beyond 2005, which may have a negative impact on our relationships with our partners. Finally, employees and prospective employees may factor in these considerations relating to our stability and the value of any equity incentives in their decision-making regarding employment opportunities.
If we fail to comply with the extensive laws and government regulations applicable to us, we could suffer penalties or be required to make significant changes to our operations.
We are required to comply with extensive and complex laws and regulations at the federal, state, and local government levels. These laws and regulations relate to, among other things:
In the future, changes in these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our investment structure, facilities, equipment, personnel, services, capital expenditure programs, operating procedures, and contractual arrangements.
If we fail to comply with applicable laws and regulations, we could be subjected to liabilities, including (1) criminal penalties, (2) civil penalties, including monetary penalties and the loss of our licenses to operate one or more of our facilities, and (3) exclusion or suspension of one or more of our facilities from participation in the Medicare, Medicaid, and other federal and state health care programs.
If we fail to comply with our new Corporate Integrity Agreement, we could be subject to severe sanctions.
In December 2004, we entered into a new corporate integrity agreement with the OIG to promote our compliance with the requirements of Medicare, Medicaid, and all other federal health care programs. Under that agreement, which is effective for five years from January 1, 2005, we are subject to certain administrative requirements and are subject to review of certain Medicare cost reports and reimbursement claims by an Independent Review Organization. Our failure to comply with the material terms of the corporate integrity agreement could lead to suspension or exclusion from further participation in federal health care programs, including Medicare and Medicaid, which currently account for a substantial portion of our revenues. Any of these sanctions would have a material adverse effect on our business, financial condition, results of operations, and cash flows.
Reductions or changes in reimbursement from government or third-party payors could adversely affect our operating results.
We derive a substantial portion of our net operating revenues from the Medicare and Medicaid programs. In 2004, 45.0% of our consolidated net operating revenues were derived from Medicare, 2.3% were derived from Medicaid, 8.1% were derived from workers compensation plans, 31.2% were derived from managed care and other discount plans, 2.8% were derived from patients, 5.4% were derived from other third-party payors, and 5.2% were derived from other income. There are increasing pressures from many payors to control health care costs and to reduce or limit increases in reimbursement rates for medical services. Our operating results could be adversely affected by changes in laws or regulations governing the Medicare and Medicaid programs. See this Item, Sources of Revenue.
Historically, Congress and some state legislatures have periodically proposed significant changes in the health care system. Many of these changes have resulted in limitations on and, in some cases, significant reductions in the levels of, payments to health care providers for services under many government reimbursement programs. See this Item, Regulation for a discussion of potential changes to the health care system that could materially and adversely affect our business, financial condition, results of operations, and cash flows.
In particular, the 75% Rule, which is discussed in this Item, Sources of Revenues, is one of the primary operating risks we face. Our inpatient division has begun to reduce or refocus admissions at most locations to ensure continued compliance with the phase-in schedule for the 75% Rule. We project this reduction in census, unless mitigated, will have a materially adverse impact on the inpatient segments net operating revenues. We previously estimated that the 75% Rule could negatively impact our net operating revenues by $95 million to $100 million in 2005. Our inpatient division is taking steps to mitigate the impact of the 75% Rule, and we previously estimated the impact to our net operating revenues to be approximately $50 million to $55 million when our mitigation strategies are taken into consideration. In our recently filed annual report on Form 10-K for the fiscal years ended December 31, 2003, and 2002, we noted that at the end of the second quarter of 2005, as many of our facilities approached the end of their cost reporting years, we saw a greater than anticipated decline in inpatient volumes, a significant portion of which we believed to be attributable to the 75% Rule. We continue to see a decline in inpatient volumes which we believe to be attributable to the 75% Rule as well as weakness in acute care volumes. Accordingly, the financial impact of the 75% Rule we previously estimated could be greater than previously disclosed.
In addition to volume volatility created by the 75% Rule, our inpatient division is facing lower unit pricing as a result of recent IRF-PPS changes. Although CMS predicted that overall payments to IRFs nationwide would increase by 3.4%, we estimate that the revised IRF-PPS will reduce Medicare reimbursement to our IRFs by between 3.5% and 4.0%, primarily owing to the changes to Case-Mix Groups, comorbidity tiers, and relative weights. We estimate this net impact on reimbursement will reduce our inpatient divisions net revenues by approximately $10 million during the fourth quarter of 2005 and approximately $40 million on an annualized basis. These estimates do not take into account potential changes in our case-mix resulting from our compliance with the 75% Rule, which could have the effect of increasing the acuity of our case-mix and therefore reducing the overall net impact of the IRF-PPS changes.
Our relationships with third-party payors, such as HMOs and PPOs, are generally governed by negotiated agreements. These agreements set forth the amounts we are entitled to receive for our services. We could be adversely affected in some of the markets where we operate if we are unable to negotiate and maintain favorable agreements with third-party payors. In addition, our third-party payors may, from time to time, request audits of the amounts paid to us under our agreements with them. We could be adversely affected in some of the markets where we operate and within certain of our operating divisions if the audits uncover substantial overpayments made to us. As part of the reconstruction of accounting records, we discovered the existence of substantial credit balances, which could represent posting errors, misapplied payments or overpayments due to patients and third-party payors, including the Medicare and Medicaid programs. We are currently in the process of reviewing these accounts to determine whether and to what extent we may be required to repay any of these credit balances to patients or third-party payors, including the Medicare and Medicaid programs. We could be adversely affected if we are required to repay all of these accounts.
The adoption of more restrictive Medicare coverage policies at the national and/or local levels could have an adverse impact on our ability to obtain Medicare reimbursement for inpatient rehabilitation services.
Medicare providers also can be negatively affected by the adoption of coverage policies, either at the national or local levels, describing whether an item or service is covered and under what clinical circumstances it is considered to be reasonable, necessary, and appropriate. In the absence of a national coverage determination, local Medicare fiscal intermediaries and carriers may specify more restrictive criteria than otherwise would apply nationally. For instance, Cahaba Government Benefit Administrators, the fiscal intermediary for many of our inpatient division facilities, has issued a local coverage determination setting forth very detailed criteria it proposes to use in determining the medical appropriateness of services provided by IRFs. We cannot predict whether other Medicare contractors will adopt additional local coverage determinations or other policies or how these will affect us.
Downward pressure on pricing from commercial and government payors may adversely affect the revenues and profitability of certain of our operations.
We have experienced downward pressure on prices in our markets, from both commercial and government payors, and we anticipate continuing price pressure in all our divisions. There can be no assurances that we will be able to maintain current prices in the face of continuing pricing pressures. We may be required to implement additional measures to mitigate these pressures and further enhance the efficiency of our operations or, in the alternative, dispose of inefficient operations. These pricing pressures have had, and if we are not successful in mitigating such pressures in the future, may continue to have, an adverse effect on the revenues and profitability of our surgery centers and our outpatient and diagnostic divisions, including certain operations which we are currently considering divesting. In the event that we decide to divest certain inefficient operations, we cannot assure you that we will be able to successfully do so at all, or on a timely basis or on terms acceptable to us. As discussed elsewhere in this report, we are seeking to divest our acute care facility located in Birmingham, Alabama. That operation represented approximately 2.4% of our consolidated net operating revenues and approximately 8.0% of our corporate and other segments operating loss (See Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations) for the year ended December 31, 2004. In addition, we have received inquiries from parties interested in acquiring our diagnostic division. That operation represented approximately 6.5% of our consolidated net operating revenues for the year ended December 31, 2004. During 2004, the diagnostic division experienced an operating loss of approximately $10.0 million (See Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations). No decision has been made with respect to the divestiture of our diagnostic division at this time.
Our facilities face national, regional, and local competition for patients from other health care providers.
We operate in a highly competitive industry. Although we are the largest provider of rehabilitative health care services, and one of the largest providers of ambulatory surgery and outpatient diagnostic services, in the United States, in any particular market we may encounter competition from local or national entities with longer operating histories or other competitive advantages. There can be no assurance that this competition, or other competition which we may encounter in the future, will not adversely affect our business, financial condition, results of operations, or cash flows.
Competition for staffing may increase our labor costs and reduce profitability.
Our operations are dependent on the efforts, abilities, and experience of our management and medical support personnel, such as physical therapists, nurses, and other health care professionals. We compete with other health care providers in recruiting and retaining qualified management and support personnel responsible for the daily operations of each of our facilities. In some markets, the availability of physical therapists, nurses, and other medical support personnel has become a significant operating issue to health care providers. This shortage may require us to continue to enhance wages and benefits to recruit and retain qualified personnel or to hire more expensive temporary personnel. We also depend on the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Because a significant percentage of our revenues consists of fixed,
prospective payments, our ability to pass along increased labor costs is limited. Our failure to recruit and retain qualified management, physical therapists, nurses, and other medical support personnel, or to control our labor costs, could have a material adverse effect on our business, financial condition, results of operations, and cash flows.
We depend on our relationships with the physicians who use our facilities.
Our business depends upon the efforts of the physicians who provide health care services at our facilities and/or refer their patients to our facilities and the strength of our relationships with these physicians. Each physician referring or treating patients at one of our facilities may also practice at other facilities not owned by us.
At each of our facilities, our business could be adversely affected if a significant number of key physicians or a group of physicians:
Our principal executive offices are located in Birmingham, Alabama, where we own and maintain a headquarters building of approximately 200,000 square feet located on an 85-acre corporate campus. In addition to our headquarters building, as of December 31, 2004 we leased or owned nearly 1,300 facilities through various consolidated entities to support our operations. Our leases generally have initial terms of 5 years, but range from 1 to 99 years. Most of our leases contain options to extend the lease period for up to 5 additional years. Our consolidated entities are sometimes responsible for property taxes, property and casualty insurance, and routine maintenance expenses. Other than our headquarters campus, our acute care hospital located in Birmingham, Alabama, and our Digital Hospital described below, none of our other properties is material to our business. Each of our material properties is used by our corporate and other segment, except our Digital Hospital, which is not in use but is held by our corporate and other segment. We have pledged all the property of HealthSouth Corporation as collateral to secure the performance of our obligations under our amended and restated credit agreement. For additional information about our amended and restated credit agreement, see Note 9, Long-term Debt, to our accompanying consolidated financial statements.
We also currently own, and from time to time may acquire, certain other improved and unimproved real properties in connection with our business. See Note 6, Property and Equipment, to our accompanying consolidated financial statements for more information about the properties we own and certain related indebtedness.
Since January 1, 2004, we have sold approximately $27 million in land and buildings, not including properties sold in connection with the sale of operating facilities. We sold one acute care hospital in June 2001 and another in October 2003. On July 20, 2005, we executed an asset purchase agreement with The Board of Trustees of the University of Alabama (the University of Alabama) for the sale of the real property, furniture, fixtures, equipment and certain related assets associated with our 219-licensed bed acute care hospital located in Birmingham, Alabama. This agreement provides that the sale of this hospital (as well as the subsequent sale of our interest in a joint venture with the University of Alabama for a Gamma Knife) will close after the satisfaction of certain conditions to closing, including, without limitation, specified regulatory approvals. The earliest time frame for the completion of these regulatory approvals is the first quarter of 2006, and there are no guarantees that such regulatory approvals will be obtained before the termination of the purchase agreement. In addition, we continue to seek a buyer for our Digital Hospital, which is currently under construction in Birmingham, Alabama. As of December 31, 2004, we had invested $190 million in the Digital Hospital project and estimate it will require an additional $200 million to complete. We have not signed a definitive agreement with respect to the
Digital Hospital, and there can be no assurance any sale will take place. See Note 6, Property and Equipment, to our accompanying consolidated financial statements, for a discussion of the impairment charge we recognized in 2004 relating to the Digital Hospital.
Our headquarters, facilities, and other properties are suitable for their respective uses and are, in general, adequate for our present needs. Our properties are subject to various federal, state, and local statutes and ordinances regulating their operation. Management does not believe that compliance with such statutes and ordinances will materially affect our business, financial condition, or results from operations.
Investigations and Proceedings Commenced by the SEC, the United States Department of Justice, and Other Governmental Authorities
In September 2002, the Securities and Exchange Commission (the SEC) notified us that it was conducting an investigation of trading in our securities that occurred prior to an August 27, 2002 press release concerning the impact of new Medicare billing guidance on our expected earnings. On February 5, 2003, the United States District Court for the Northern District of Alabama issued a subpoena requiring us to provide various documents in connection with a criminal investigation of us and certain of our directors, officers, and employees being conducted by the United States Attorney for the Northern District of Alabama. On March 18, 2003, agents from the Federal Bureau of Investigation (the FBI) executed a search warrant at our headquarters in connection with the United States Attorneys investigation and were provided access to a number of financial records and other materials. The agents simultaneously served a grand jury subpoena on us on behalf of the criminal division of the United States Department of Justice (the DOJ). Some of our employees also received subpoenas.
On March 19, 2003, the SEC filed a lawsuit captioned Securities and Exchange Commission v. HealthSouth Corp., et al., CV-03-J-0615-S, in the United States District Court for the Northern District of Alabama. The complaint alleges that we overstated earnings by at least $1.4 billion since 1999, and that this overstatement occurred because our then-Chairman and Chief Executive Officer, Richard M. Scrushy, insisted that we meet or exceed earnings expectations established by Wall Street analysts.
The SEC states in its complaint that our actions and those of Mr. Scrushy violated and/or aided and abetted violations of the antifraud, reporting, books-and-records, and internal controls provisions of the federal securities laws. Specifically, the SEC charged us with violations of Section 17(a) of the Securities Act of 1933 (the Securities Act) and Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 (the 1934 Act), and 1934 Act Rules 10b-5, 12b-20, 13a-1, and 13a-13. The SEC sought a permanent injunction against us, civil money penalties, disgorgement of ill-gotten gains and losses avoided, as well as prejudgment interest. On March 19, 2003, we consented to the entry of an order by the court that (1) required us to place in escrow all extraordinary payments (whether compensation or otherwise) to our directors, officers, partners, controlling persons, agents, and employees, (2) prohibited us and our employees from destroying documents relating to our financial activities and/or the allegations in the SECs lawsuit against us and Mr. Scrushy, and (3) provided for expedited discovery in the lawsuit brought by the SEC.
On June 6, 2005, the SEC approved a settlement (the SEC Settlement) with us relating to this lawsuit. Under the terms of the SEC Settlement, we have agreed, without admitting or denying the SECs allegations, to be enjoined from future violations of certain provisions of the securities laws. We have also agreed to pay a $100 million civil penalty and disgorgement of $100 to the SEC in installments over two years, beginning in the fourth quarter of 2005. We consented to the entry of a final judgment (which judgment was entered by the United States District Court for the Northern District of Alabama, Southern Division) to implement the terms of the SEC Settlement. See Item 1, Business, SEC Settlement, for additional information about the SEC Settlement. Mr. Scrushy remains a defendant in the lawsuit.
On November 4, 2003, Mr. Scrushy was charged in federal court on 85 counts of wrongdoing in connection with his actions while employed by us. A superseding indictment of 58 counts, released on September 29, 2004,
added charges of obstruction of justice and perjury while consolidating and eliminating some of the 85 counts of conspiracy, mail fraud, wire fraud, securities fraud, false statements, false certifications, and money laundering that were previously charged. The superseding indictment also sought the forfeiture of $278 million in property from Mr. Scrushy allegedly derived from his offenses. Some of the charges were dismissed by the court and Mr. Scrushy was acquitted of the remaining charges on June 28, 2005.
On April 10, 2003, the DOJs civil division notified us that it was expanding its investigation (which began with the lawsuit United States ex rel. Devage v. HealthSouth Corp., et al., C.A. No. SA-98-EA-0372-FV, filed in the United States District Court for the Western District of Texas, as discussed in Item 1, Business, Medicare Program Settlement) into allegations of fraud associated with Medicare cost reports submitted by us for fiscal years 1995 through 2002. We subsequently received subpoenas from the Office of Inspector General (the OIG) of the United States Department of Health and Human Services and requests from the DOJs civil division for documents and other information regarding this investigation. As described in Item 1, Business, Medicare Program Settlement, on December 30, 2004, we announced that we had entered into a global settlement agreement with the DOJs civil division and other parties to resolve the primary claims made in the Devage litigation, although the DOJs civil division continues to review certain other matters, including self-disclosures made by us to the OIG.
In the summer of 2003, we discovered certain irregular payments made to a foreign official under a consulting agreement entered into in connection with an October 2000 agreement between us and the Sultan Bin Abdul Aziz Foundation to manage an inpatient rehabilitation hospital in Riyadh, Saudi Arabia. We notified the DOJ immediately, and we cooperated fully with the investigation. One former executive pled guilty to charges of wire fraud in connection with the irregular payments, and another former executive pled guilty to charges of making a false statement to government investigators in connection with the investigation. Two additional former executives were acquitted by a jury of charges that they participated in the fraud. We terminated the October 2000 agreement and entered into a new agreement, effective January 1, 2004, to manage the Riyadh facility. Effective October 2004, we terminated our relationship with the Sultan Bin Abdul Aziz Foundation and the Riyadh facility entirely.
At least 17 of our former officers, including all five of our former chief financial officers, have pleaded guilty to federal criminal charges filed in connection with the investigations described above. These individuals pled guilty to a variety of charges, including securities fraud, accounting fraud, filing false tax returns, making a false statement to governmental authorities, falsifying books and accounts, wire fraud, conspiracy, and falsely certifying financial information with the SEC. One former executive was convicted on November 18, 2005 on criminal charges filed in connection with the accounting fraud investigation.
On June 24, 2003, the United States District Court for the Northern District of Alabama consolidated a number of separate securities lawsuits filed against us under the caption In re HealthSouth Corp. Securities Litigation, Master Consolidation File No. CV-03-BE-1500-S (the Consolidated Securities Action). The Consolidated Securities Action included two prior consolidated cases (In re HealthSouth Corp. Securities Litigation, CV-98-J-2634-S and In re HealthSouth Corp. 2002 Securities Litigation, Consolidated File No. CV-02-BE-2105-S) as well as six lawsuits filed in 2003. Including the cases previously consolidated, the Consolidated Securities Action comprised over 40 separate lawsuits. The court divided the Consolidated Securities Action into two subclasses:
On January 8, 2004, the plaintiffs in the Consolidated Securities Action filed a consolidated class action complaint. The complaint names us as a defendant, as well as more than 30 of our current and former employees, officers and directors, the underwriters of our debt securities, and our former auditor. The complaint alleges, among other things, (1) that we misrepresented or failed to disclose certain material facts concerning our business and financial condition and the impact of the Balanced Budget Act of 1997 on our operations in order to artificially inflate the price of our common stock, (2) that from January 14, 2002 through August 27, 2002, we misrepresented or failed to disclose certain material facts concerning our business and financial condition and the impact of the changes in Medicare reimbursement for outpatient therapy services on our operations in order to artificially inflate the price of our common stock, and that some of the individual defendants sold shares of such stock during the purported class period, and (3) that Richard M. Scrushy instructed certain former senior officers and accounting personnel to materially inflate our earnings to match Wall Street analysts expectations, and that senior officers of HealthSouth and other members of a self-described family held meetings to discuss the means by which our earnings could be inflated and that some of the individual defendants sold shares of our common stock during the purported class period. The consolidated class action complaint asserts claims under Sections 11, 12(a)(2) and 15 of the Securities Act, and claims under Sections 10(b), 14(a), 20(a) and 20A of the 1934 Act.
We have moved to dismiss in part the claims against us. We continue discussions with the parties to this litigation. On August 30, 2005, the court ordered the parties to resume mediation. Representatives of HealthSouth met with representatives of the plaintiffs in October 2005 to explore various issues relating to a potential settlement. The court-appointed mediators have also held a number of individual meetings with various parties. In addition, the mediators have scheduled a joint meeting with representatives of many of the parties to take place on December 2, 2005. The court has directed the parties to submit a joint status report on the progress of the mediation by December 15, 2005.
On March 17, 2004, an individual securities fraud action captioned Amalgamated Gadget, L.P. v. HealthSouth Corp., 4-04CV-198-A, was filed in the United States District Court for the Northern District of Texas. The complaint made allegations similar to those in the Consolidated Securities Action and asserted claims under the federal securities laws and Texas state law based on the plaintiffs purchase of $24 million in face amount of 3.25% convertible debentures. The court denied our motion to transfer the action to the United States District Court for the Northern District of Alabama, and also denied our motion to dismiss. This action has been settled by the agreement of the parties and dismissed with prejudice.
On November 24, 2004, an individual securities fraud action captioned Burke v. HealthSouth Corp., et al., 04-B-2451 (OES), was filed in the United States District Court of Colorado against us, some of our former directors and officers, and our former auditors. The complaint makes allegations similar to those in the Consolidated Securities Action and asserts claims under the federal securities laws and Colorado state law based on plaintiffs alleged receipt of unexercised options and his open-market purchases of our stock. By order dated May 3, 2005, the action was transferred to the United States District Court for the Northern District of Alabama, where it remains pending.
Between 1998 and 2004, a number of lawsuits purporting to be derivative actions (i.e., lawsuits filed by shareholder plaintiffs on our behalf) were filed in several jurisdictions, including the Circuit Court for Jefferson County, Alabama, the Delaware Court of Chancery, and the United States District Court for the Northern District of Alabama. Most of these lawsuits have been consolidated as described below:
When originally filed, the primary allegations in the Tucker case involved self-dealing by Richard M. Scrushy and other insiders through transactions with various entities allegedly controlled by Mr. Scrushy. The complaint was amended four times to add additional defendants and include claims of accounting fraud, improper Medicare billing practices, and additional self-dealing transactions. The Second Amended Complaint, filed on March 21, 2003, added Ernst & Young LLP as a defendant and alleged it was liable for negligently, wantonly, and/or recklessly failing to perform its professional obligations as an independent auditor. The Third Amended Complaint, filed on August 8, 2003, added UBS as a defendant and alleged that it was liable for breaching its fiduciary duties to us and for aiding and abetting the accounting fraud by falsely promoting our stock despite knowledge of inflated financial information. The other consolidated cases contain similar claims. On September 7, 2005, the Alabama Circuit Court ordered the parties to participate in mediation.
On September 8, 2003, a derivative lawsuit captioned Teachers Retirement Sys. of Louisiana v. Scrushy, C.A. No. 20529-NC, was filed in the Delaware Court of Chancery. The complaint contains allegations similar to those made in the Tucker case, class claims, as well as a request for relief seeking an order compelling us to hold an annual meeting of stockholders. On December 2, 2003, we announced a settlement of the plaintiffs claims seeking an annual meeting of stockholders. The Court of Chancery has stayed the remaining claims in favor of earlier-filed litigation in Alabama. This case was not consolidated with In re HealthSouth Corp. Shareholders Litigation.
On November 19, 2004, a derivative lawsuit captioned Campbell v. HealthSouth Corp., Scrushy, et al., CV-04-6985, was filed in Circuit Court of Jefferson County, Alabama, alleging that we wrongfully refused to file with the Internal Revenue Service refund requests for overpayment of taxes and seeking an order allowing the plaintiff to file claims for refund of excess tax paid by us. This suit was filed just prior to the voluntary dismissal of a similar suit brought by the same plaintiff in the United States District Court for the Northern District of Alabama. On August 23, 2005, the court granted our motion to dismiss without prejudice.
Litigation by and Against Former Independent Auditors
On March 18, 2005, Ernst & Young LLP filed a lawsuit captioned Ernst & Young LLP v. HealthSouth Corp., CV-05-1618, in the Circuit Court of Jefferson County, Alabama. The complaint asserts that the filing of the claims against us was for the purpose of suspending any statute of limitations applicable to those claims. The complaint alleges that we provided Ernst & Young LLP with fraudulent management representation letters, financial statements, invoices, bank reconciliations, and journal entries in an effort to conceal accounting fraud. Ernst & Young LLP claims that as a result of our actions, Ernst & Young LLPs reputation has been injured and
it has and will incur damages, expense, and legal fees. Ernst & Young LLP seeks recoupment and setoff of any recovery against Ernst & Young LLP in the Tucker case, as well as litigation fees and expenses, damages for loss of business and injury to reputation, and such other relief to which it may be entitled. On April 1, 2005, we answered Ernst & Young LLPs claims and asserted counterclaims alleging, among other things, that from 1996 through 2002, when Ernst & Young LLP served as our independent auditors, Ernst & Young LLP acted recklessly and with gross negligence in performing its duties, and specifically that Ernst & Young LLP failed to perform reviews and audits of our financial statements with due professional care as required by law and by its contractual agreements with us. Our counterclaims further allege that Ernst & Young LLP either knew of or, in the exercise of due care, should have discovered and investigated the fraudulent and improper accounting practices being directed by Richard M. Scrushy and certain other officers and employees, and should have reported them to our board of directors and the Audit Committee. The counterclaims seek compensatory and punitive damages, disgorgement of fees received from us by Ernst & Young LLP, and attorneys fees and costs.
In 2003, six lawsuits were filed in the United States District Court for the Northern District of Alabama against us and some of our current and former officers and directors alleging breaches of fiduciary duties in connection with the administration of our Employee Stock Benefit Plan (the ESOP). These lawsuits have been consolidated under the caption In re HealthSouth Corp. ERISA Litigation, Consolidated Case No. CV-03-BE-1700-S. The plaintiffs filed a consolidated complaint on December 19, 2003 that alleges, generally, that fiduciaries to the ESOP breached their duties to loyally and prudently manage and administer the ESOP and its assets in violation of sections 404 and 405 of the Employee Retirement Income Security Act of 1974, 29 U.S.C. § 1001 et seq. (ERISA), by failing to monitor the administration of the ESOP, failing to diversify the portfolio held by the ESOP, and failing to provide other fiduciaries with material information about the ESOP. The plaintiffs seek actual damages including losses suffered by the plan, imposition of a constructive trust, equitable and injunctive relief against further alleged violations of ERISA, costs pursuant to 29 U.S.C. § 1132(g), and attorneys fees. The plaintiffs also seek damages related to losses under the plan as a result of alleged imprudent investment of plan assets, restoration of any profits made by the defendants through use of plan assets, and restoration of profits that the plan would have made if the defendants had fulfilled their fiduciary obligations. We have agreed to a settlement of the plaintiffs claims against us. The terms of the partial settlement do not include a release of claims against Messrs. Scrushy, Beam, Martin, and Owens. On or about August 10, 2005, plaintiffs filed our settlement with the court, which must approve it before it becomes effective. The court has postponed considering our settlement, pending further negotiations involving the plaintiffs, these four individuals, and us.
Insurance Coverage Litigation
In 2003, approximately 14 insurance companies filed complaints in state and federal courts in Alabama, Delaware, and Georgia alleging that the insurance policies issued by those companies to us and/or some of our directors and officers should be rescinded on grounds of fraudulent inducement. The complaints also seek a declaration that we and/or some of our current and former directors and officers are not covered under various insurance policies. These lawsuits challenge the majority of our director and officer liability policies, including our primary director and officer liability policy in effect for the claims at issue. Actions filed by insurance companies in the United States District Court for the Northern District of Alabama were consolidated for pretrial and discovery purposes under the caption In re HealthSouth Corp. Insurance Litigation, Consolidated Case No. CV-03-BE-1139-S. Four lawsuits filed by insurance companies in the Circuit Court of Jefferson County, Alabama have been consolidated with the Tucker case for discovery and other pretrial purposes. Cases related to insurance coverage that were filed in Georgia and Delaware have been dismissed. We have filed counterclaims against a number of the plaintiffs in these cases alleging, among other things, bad faith for wrongful failure to provide coverage. On August 30, 2005, the U.S. District Court ordered the parties to resume mediation. On September 7, 2005, the Alabama Circuit Court ordered the parties to participate in mediation. Since September, 2005, the parties have commenced mediation efforts which are ongoing.
Litigation by Former Officers
Richard M. Scrushy filed two lawsuits against us in the Delaware Court of Chancery. One lawsuit, captioned Scrushy v. HealthSouth Corp., C.A. No. 20357-NC, filed on June 10, 2003, sought indemnification and advancement of Mr. Scrushys legal fees. The other lawsuit, captioned Scrushy v. Gordon, et al., C.A. No. 20375, filed June 16, 2003, named us and our then-current directors as defendants and petitioned the court to enjoin the defendants from excluding Mr. Scrushy from board meetings and from conducting the business of HealthSouth exclusively through the meetings of the Special Committee. The second lawsuit also sought access to certain information, including meetings of the Special Committee. Both lawsuits were voluntarily dismissed without prejudice.
On August 22, 2003, Anthony Tanner, our former Secretary and Executive Vice PresidentAdministration, filed a petition in the Circuit Court of Jefferson County, Alabama, captioned In re Tanner, CV-03-5378, seeking permission to obtain certain information through the discovery process prior to filing a lawsuit. That petition was voluntarily dismissed with prejudice on August 11, 2004. On December 29, 2004, Mr. Tanner filed a lawsuit in the Circuit Court of Jefferson County, Alabama, captioned Tanner v. HealthSouth Corp., CV-04-7715, alleging that we breached his employment contract by failing to pay certain retirement benefits. The complaint requests damages, a declaratory judgment, and a preliminary injunction to require payment of past due amounts under the contract and reinstatement of the claimed retirement benefits. This action is currently scheduled to go to trial in March 2006.
On December 23, 2003, Jason Hervey, one of our former officers, filed a lawsuit captioned Hervey v. HealthSouth Corp., et al., CV-03-8031, in the Circuit Court of Jefferson County, Alabama. The complaint sought compensatory and punitive damages in connection with our alleged breach of his employment contract. We settled this lawsuit in 2005.
Litigation Against Former Officers
On June 10, 2004, we filed a collection action in the Circuit Court of Jefferson County, Alabama, captioned HealthSouth Corp. v. James Goodreau, CV-04-3619, to collect unpaid loans in the original principal amount of $55,500 that we made to James A. Goodreau, our former Director of Corporate Security, while he was a HealthSouth employee. Mr. Goodreau has asserted counterclaims against us seeking monetary damages in an unspecified amount and equitable relief based upon his contention that he was promised lifetime employment with us by Mr. Scrushy. This case is still pending.
On August 30, 2004, we filed a collection action in the United States District Court for the Northern District of Alabama, captioned HealthSouth Corp. v. Daniel J. Riviere, CV-04-CO-2592-S, to collect unpaid loans in the original principal amount of $3,163,421 that we made to Daniel J. Riviere, our former PresidentAmbulatory Services Division, while he was a HealthSouth employee. Mr. Riviere filed a six-count counterclaim against us on April 5, 2005 seeking (1) severance benefits exceeding $2 million under a written employment agreement dated March 18, 2003, (2) a declaratory judgment that the non-compete clause in his employment agreement is void, (3) damages in an unspecified amount based on stock allegedly purchased and held by him in reliance on misrepresentations made by Richard M. Scrushy, (4) $500,000 in lost profits based allegedly on us forcing him to sell shares of our common stock after he was terminated, (5) damages in an unspecified amount based on our alleged conversion of the cash value of certain insurance policies after his termination, and (6) set-off of any award from his counterclaim against unpaid loans we made to him. On April 5, 2005, Mr. Riviere commenced a Chapter 7 bankruptcy case in the U.S. Bankruptcy Court for the Northern District of Florida, Case No. 05-30718-LMK, and this lawsuit is stayed pending resolution of the bankruptcy proceedings. We entered into a settlement agreement with Mr. Riviere and his bankruptcy trustee settling the disputes made the subject of the lawsuit. Pursuant to the settlement agreement, Mr. Riviere has agreed to pay us $1.5 million, plus accrued interest at 6% per annum, within three years. The settlement obligation will be secured by a mortgage on Mr. Rivieres residence in Destin, Florida. The settlement is contingent upon bankruptcy court approval, which has not yet been obtained.
On July 28, 2005, we filed a collection action in the Circuit Court of Jefferson County, Alabama captioned HealthSouth Corp. v. William T. Owens, CV-05-4420, to collect unpaid loans in the original principal amount of $1,028,514.25 that we made to William T. Owens, our former Chief Financial Officer, while he was a HealthSouth employee. The case is still pending.
Litigation by Former Medical Director
On April 5, 2001, Helen M. Schilling, one of our former medical directors, filed a lawsuit captioned Helen M. Schilling, M.D. v. North Houston Rehabilitation Associates d/b/a HealthSouth Houston Rehabilitation Institute, Romano Rehabilitation Hospital, Inc. and Anne Leon, Cause No. 01-04-02243-CV, in the 410th Judicial District Court of Montgomery County, Texas. The plaintiff claimed, among other things, that we wrongfully terminated her medical director agreement. On November 5, 2003, after a jury trial, the court entered a final judgment awarding the plaintiff $465,000 in compensatory damages and $865,000 in exemplary damages. We appealed the judgment and settled the case while on appeal in 2005.
Certain Regulatory Actions
The False Claims Act, 18 U.S.C. § 287, allows private citizens, called relators, to institute civil proceedings alleging violations of the False Claims Act. These so-called qui tam, or whistleblower, 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. We recently settled one qui tam lawsuit, Devage, which is discussed in Item 1. We are aware of two other qui tam lawsuits, Mathews and Colbert, which are discussed below. It is possible that additional qui tam lawsuits have been filed against us and that we are unaware of such filings or have been ordered by the presiding court not to discuss or disclose the filing of such lawsuits. Thus, we may be subject to liability exposure under one or more undisclosed qui tam cases brought pursuant to the False Claims Act.
On April 1, 1999, a plaintiff relator filed a lawsuit captioned United States ex rel. Mathews v. Alexandria Rehabilitation Hospital, CV-99-0604, in the United States District Court for the Western District of Louisiana. On February 29, 2000, the United States elected not to intervene in the lawsuit. The complaint alleged, among other things, that we filed fraudulent reimbursement claims under the Medicare program on a nationwide basis. The district court dismissed the False Claims Act allegations of two successive amended complaints. However, the district courts dismissal of the third amended complaint with prejudice was partially reversed by the United States Court of Appeals for the Fifth Circuit on October 22, 2002. The case was remanded to the district court, and our subsequent motion to dismiss was denied on February 21, 2004. The case is currently in the discovery stage on False Claims Act allegations concerning one HealthSouth facility during a specific timeframe.
On January 30, 2001, a plaintiff relator filed a lawsuit captioned United States ex rel. Colbert v. Blue Cross and Blue Shield of Alabama and HealthSouth Corp., CV-01-C-0292-S, in the United States District Court for the Northern District of Alabama. The lawsuit, in which the United States did not intervene, alleged, among other things, that we conspired with Blue Cross and Blue Shield of Alabama (Blue Cross) to hinder Blue Cross investigative functions in administering the Medicare program by having Blue Cross terminate, on a pretextual basis, the relators employment with Blue Cross. The complaint also claimed that we conspired with Blue Cross to (1) violate the whistleblower retaliation provision of the False Claims Act by having Blue Cross terminate the relators employment and (2) have certain unidentified false claims allowed or paid by Blue Cross under the Medicare program. The parties filed a joint stipulation of dismissal with prejudice and the case has been dismissed.
Americans with Disabilities Act Litigation
On April 19, 2001 a nationwide class action now captioned Michael Yelapi, et al. v. St. Petersburg Surgery Center, et al., Case No:8:01-CV-787-T-17EAJ, was filed in the United States District Court for the Middle District of Florida alleging violations of the Americans with Disabilities Act, 42 U.S.C. § 12181, et seq. (the
ADA) and the Rehabilitation Act of 1973, 92 U.S.C. § 792 et seq. (the Rehabilitation Act) at our facilities. The complaint alleges violations of the ADA and Rehabilitation Act for the purported failure to remove barriers and provide accessibility to our facilities, including reception and admitting areas, signage, restrooms, phones, paths of access, elevators, treatment and changing rooms, parking, and door hardware. As a result of these alleged violations, the plaintiffs are seeking an injunction ordering that we make necessary modifications to achieve compliance with the ADA and the Rehabilitation Act, as well as attorneys fees. We have entered into a settlement agreement with the plaintiffs that would require us to correct any deficiencies under the ADA and the Rehabilitation Act at all of our facilities. We are awaiting an order approving the settlement agreement from the court.
General Medicine, P.C. and Meadowbrook Actions
Pursuant to a Plan and Agreement of Merger dated February 18, 1997, Horizon/CMS Healthcare Corporation (Horizon/CMS) became a wholly-owned subsidiary of HealthSouth Corporation. At the time of the merger, there was pending against Horizon/CMS in the United States District Court for the Eastern District of Michigan a lawsuit captioned General Medicine, P.C. v. Horizon/CMS Healthcare Corporation, CV-96-72624 (the Michigan Action). The complaint in the Michigan Action alleged that Horizon/CMS wrongfully terminated a contract with General Medicine, P.C. (General Medicine) for the provision of medical directorship services to long-term care facilities owned and/or operated by Horizon/CMS. Effective December 31, 2001, while the Michigan Action was pending, we sold all of our stock in Horizon/CMS to Meadowbrook Healthcare Corporation (Meadowbrook) pursuant to a Stock Purchase Agreement dated November 2, 2001. Pursuant to the Stock Purchase Agreement, Meadowbrook indemnified us against losses arising out of the historic and ongoing operations of Horizon/CMS. The Michigan Action was disclosed to Meadowbrook in the Stock Purchase Agreement.
On April 21, 2004, Meadowbrook and Horizon/CMS entered into a settlement agreement with General Medicine in connection with the Michigan Action. Pursuant to the settlement agreement, Horizon/CMS consented to the entry of a final judgment in the amount of $376 million in favor of General Medicine in the Michigan Action on May 3, 2004 (the Consent Judgment). The settlement agreement between the parties provides that, with the exception of $300,000 paid by Meadowbrook, the Consent Judgment may only be collected from us. At the time of the Consent Judgment, we had no ownership or other interest in Horizon/CMS.
On August 16, 2004, General Medicine filed a lawsuit captioned General Medicine, P.C. v. HealthSouth Corp., CV-04-958, in the Circuit Court of Shelby County, Alabama, seeking to recover the unpaid amount of the Consent Judgment from us. The complaint alleges that while Horizon/CMS was a wholly-owned subsidiary of HealthSouth Corporation and General Medicine was an existing creditor of Horizon/CMS, we caused Horizon/CMS to transfer assets to us thereby rendering Horizon/CMS insolvent and unable to pay its creditors. The complaint asserts that these transfers were made for less than a reasonably equivalent value and/or with the actual intent to defraud creditors of Horizon/CMS, including General Medicine, in violation of the Alabama Uniform Fraudulent Transfer Act. General Medicines complaint requests relief including the avoidance of the subject transfers of assets, attachment of the assets transferred to us, appointment of a receiver over the transferred properties, and a monetary judgment for the value of properties transferred.
On February 28, 2005, the Circuit Court of Shelby County, Alabama entered an order transferring the General Medicine case to the Circuit Court of Jefferson County, Alabama, where it was assigned case number CV-05-1483. We have filed an answer denying that we have any liability to General Medicine.
On September 27, 2004, we sent a letter to Meadowbrook notifying it of our claim for indemnification against the claims asserted by General Medicine in its lawsuit pursuant to our Stock Purchase Agreement with Meadowbrook.
On October 6, 2004, Meadowbrook filed a declaratory judgment action against us in the Circuit Court of Shelby County, Alabama, captioned Meadowbrook Healthcare Corporation v. HealthSouth Corp., CV-04-1131, seeking a declaration that it is not contractually obligated to indemnify us against General Medicines complaint.
On May 9, 2005, the Circuit Court of Shelby County, Alabama entered an order transferring the Meadowbrook case to the Circuit Court of Jefferson County, Alabama, where it was assigned case number CV-05-3042.
On July 26, 2005, we filed an Answer and Verified Counterclaim for Injunctive and Other Relief in the Meadowbrook case seeking a judgment requiring Meadowbrook to indemnify us against the claims asserted by General Medicine in its complaint and other relief. In August of 2005, both sides filed motions for summary judgment in the Meadowbrook case. On September 15, 2005, the court entered a Final Order denying our motion for summary judgment and granting Meadowbrooks motion for summary judgment. In its Final Order, the court determined that Meadowbrook is not legally or equitably required to indemnify us against the claims asserted by General Medicine in its complaint. We filed a motion to vacate or amend the Final Order on October 17, 2005 requesting the court to reconsider its entry of the Final Order. On November 15, 2005, the court issued an order partially granting our motion to vacate or amend, and allowing our equitable claims against Meadowbrook to stand. These claims, if successful, would require Meadowbrook to pay our liability, if any, to General Medicine. The court did not overturn its prior ruling that Meadowbrook has no contractual obligation to indemnify us under the Stock Purchase Agreement; however, we intend to appeal this ruling.
For additional information about Meadowbrook, see Note 6, Property and Equipment, to the accompanying consolidated financial statements.
Massachusetts Real Estate Actions
On February 3, 2003, HRPT Properties Trust (HRPT) filed a lawsuit against Senior Residential Care/North Andover, Limited Partnership (SRC) in the Land Court for the Commonwealth of Massachusetts captioned HRPT Properties Trust v. Senior Residential Care/North Andover, Limited Partnership, Misc. Case No. 287313, in which it claimed an ownership interest in certain parcels of real estate in North Andover, Massachusetts and alleged that SRC unlawfully occupied and made use of those properties. On March 17, 2003, we (and our subsidiary, Greenery Securities Corp.) moved to intervene in this case claiming ownership of the disputed property pursuant to an agreement that involved the conveyance of five nursing homes. We seek to effect a transfer of title to the disputed property by HRPT to us or our nominee.
On April 16, 2003, Senior Housing Properties Trust (SNH) and its wholly owned subsidiary, HRES1 Properties Trust (HRES1), filed a lawsuit against us in Land Court for the Commonwealth of Massachusetts captioned Senior Housing Properties Trust and HRES1 Properties Trust v. HealthSouth Corporation, Misc. Case No. 289182, seeking reformation of a lease pursuant to which we, through subsidiaries, operate the Braintree Rehabilitation Hospital in Braintree, Massachusetts and the New England Rehabilitation Hospital in Woburn, Massachusetts. HRES1 and SNH allege that certain of our representatives made false statements regarding our financial condition, thereby inducing HRES1 to enter into lease terms and other arrangements to which it would not have otherwise agreed. HRES1 and SNH have since amended their complaint to add claims for rescission and damages for fraud. HRES1 and SNH seek to reform the lease to increase the annual rent from $8.7 million to $10.3 million, to increase the repurchase option price at the end of the lease term to $80.3 million from $40 million, and to change the lease term to expire on January 1, 2006 instead of December 31, 2011. We filed an answer to the complaint and amended complaint denying the allegations, and we asserted claims against HRPT and counterclaims against SNH and HRES1 for breach of contract, reformation, and fraud based on the failure to convey title to the property in North Andover. We also seek damages incurred as a result of that failure to convey. The two actions in the Land Court have been consolidated for all purposes.
On May 13, 2005, the Land Court ruled that we are entitled to a jury trial in the consolidated cases. SNH, HRES1, and HRPT have taken an interlocutory appeal from this order, and argument before the Massachusetts Supreme Judicial Court is scheduled for the first week of January, 2006. The consolidated Land Court cases have been stayed pending disposition of the appeal. The parties were still in the discovery phase of the proceedings at the time the stay came into effect.
In a related action, on November 2, 2004, we filed a lawsuit in the Commonwealth of Massachusetts, Middlesex County Superior Court, captioned HealthSouth Corporation v. HRES1 Properties Trust, Case No. 04-4345, in response to our receipt of a notice from HRES1 purporting to terminate our lease governing the Braintree Rehabilitation Hospital in Braintree, Massachusetts and the New England Rehabilitation Hospital in Woburn, Massachusetts due to our alleged failure to furnish quarterly and annual financial information pursuant to the terms of the lease. In the lawsuit, we seek a declaration that we are not in default of our obligations under the lease, as well as an injunction preventing HRES1 from terminating the lease, taking possession of the property on which the hospitals and facilities are located, and assuming or acquiring the hospital businesses and any licenses related thereto. We filed an amended complaint asserting violations of the Massachusetts unfair and deceptive business practices statute. On November 8, 2004, HRES1 and SNH, its parent, filed a counterclaim seeking a declaration that it lawfully terminated the lease and an order requiring us to use our best efforts to transfer the licenses for the hospitals and to continue to manage the hospitals during the time necessary to effect such transfer.
On September 25, 2005, the Superior Court granted HRES1s motion for partial summary judgment, ruling that HRES1s termination of the parties lease was valid. The Superior Court also appointed a receiver to hold the net cash proceeds of operations of the Braintree Rehabilitation Hospital and the New England Rehabilitation Hospital until the litigation is resolved. Because it did not dispose of the entire case, HealthSouth is not yet entitled to appeal this ruling. The case is currently being tried on the remaining issues, which involve our obligations upon termination. SNH and HRES1 have taken the position that no trial is necessary on these issues, and have filed a motion for judgment on the pleadings on the meaning of the yield-up provision.
In particular, SNH and HRES1 have argued that, during the time necessary to effect the transfer of the licenses for the hospitals, we are required to manage the facilities for their account and remit all of the net cash proceeds to SNH and HRES1. It is our position that the terms of the lease do not provide for these remedies.
On September 29, 2005, the Superior Court ordered that, while these issues are being litigated, we are required to submit monthly operating statements for the hospitals to an independent receiver within thirty days of the end of each calendar month. After the receiver determines the net cash proceeds of operations for the hospitals for such month, after deduction of a management fee equal to 5% of gross revenues, we are required to remit to the receiver an amount equal to those net cash proceeds. The net cash proceeds are then held in escrow by the receiver pending a final order of the court regarding the distribution of the funds. We are pursuing an interlocutory appeal of this order with a Single Justice of the Massachusetts Appeals Court.
On September 17, 1998, John Darling, who was one of the federal False Claims Act relators in the now-settled Devage case (see discussion in Item 1), filed a lawsuit captioned Darling v. HealthSouth Sports Medicine & Rehabilitation, et al., 98-6110-CI-20, in the Circuit Court for Pinellas County, Florida. The complaint alleges that Mr. Darling was injured while receiving physical therapy during a 1996 visit to a HealthSouth outpatient rehabilitation facility in Clearwater, Florida. The complaint was amended in December 2004 to add a punitive damage claim. This amended complaint alleges that fraudulent misrepresentations and omissions by us resulted in the injury to Mr. Darling. The court recently ordered the parties to participate in non-binding arbitration.
We have been named as a defendant in two lawsuits brought by individuals in the Circuit Court of Jefferson County, Alabama, Nichols v. HealthSouth Corp., CV-03-2023, filed March 28, 2003, and Hilsman v. Ernst & Young, HealthSouth Corp., et al., CV-03-7790, filed December 12, 2003. The plaintiffs allege that we, some of our former officers, and our former auditor engaged in a scheme to overstate and misrepresent our earnings and financial condition. The plaintiffs seek compensatory and punitive damages. On March 24, 2003, a lawsuit captioned Warren v. HealthSouth Corp., et al., CV-03-5967, was filed in the Circuit Court of Montgomery County,
Alabama. The lawsuit, which claims damages for the defendants alleged negligence, wantonness, fraud and breach of fiduciary duty, was transferred to the Circuit Court of Jefferson County, Alabama. Each of the lawsuits described in this paragraph has been consolidated with the Tucker case for discovery and other pretrial purposes.
On June 30, 2004, two physical therapy providers in New Jersey filed a class action lawsuit captioned William Weiss Physical Therapy, et al., v. HealthSouth Corporation, et al., Docket No. BER-L-10218-04 (N.J. Super.) in the Superior Court of New Jersey. The nine count complaint alleges certain unfair trade practices in offering physical therapy services in violation of the New Jersey Physical Therapy Licensing Act of 1983. This case has been dismissed with prejudice.
On May 13, 2003, Plano Hospital Investors, Inc. (Plano) filed a complaint captioned Plano Hospital Investors, Inc., et al., v. HealthSouth Corp., et al., Cause No. 219-1416-03, in the 219th Judicial District Court of Collin County, Texas. Plano was a limited partner in Collin County Rehab Associates Limited Partnership, a partnership in which we, through wholly owned subsidiaries, are the general partner and hold limited partner interests. Plano alleged that we conducted unauthorized and improper sweeps of partnership funds into a HealthSouth centralized cash management account instead of a partnership account, that we improperly received late partnership distributions, and that the predecessor general partner took a negative capital contribution improperly increasing its interest, and upon the sale of that interest to us, our interest, in the partnership. Effective on or about May 31, 2005, we settled this case and obtained a full and final release of all claims.
On December 28, 2004, we commenced a collection action in the Circuit Court of Jefferson County, Alabama, captioned HealthSouth Medical Center, Inc. v. Neurological Surgery Associates, P.C., CV-04-7700, to collect unpaid loans in the original principal amount of $275,000 made to Neurological Surgery Associates, P.C. (NSA), pursuant to a written Practice Guaranty Agreement. The purpose of the loans was to enable NSA to employ a physician who would bring necessary specialty skills to patients served by both NSA and our acute-care hospital in Birmingham, Alabama. NSA has asserted counterclaims that we breached verbal promises to lease space and employees from NSA, to pay NSA for billing and coding services performed by NSA on behalf of the subject physician-employee, and to pay NSA to manage the subject physician-employee. This case is currently in the discovery phase.
On April 15, 2004, Klemett L. Belt, Jr. filed a complaint captioned Belt v. HealthSouth Corp., CV-2004-02517, in the Second Judicial District Court of Bernalillo County, New Mexico. Mr. Belt, a former executive officer and director of Horizon/CMS Healthcare Corporation, entered into a Non-Competition and Retirement Agreement with Horizon/CMS that we subsequently assumed in our acquisition of Horizon/CMS pursuant. Mr. Belt alleged in his complaint that he was entitled to retirement benefits, life insurance and, in the event of certain events of default, liquidated damages pursuant to a contractual provision requiring that the life insurance policies be fully paid and permitting Mr. Belt to receive a lump sum cash payment in lieu of certain unpaid retirement benefits. Mr. Belt alleges that we defaulted under the terms of the agreement due to our nonpayment of insurance policy premium payments beginning on December 31, 2003. As a result of our alleged default under the agreement, Mr. Belt sought liquidated damages in lieu of retirement benefits, payment of insurance policy premiums, amounts sufficient to compensate Mr. Belt for excess income taxes, interest, expenses, attorneys fees, and such other relief as may be determined by the court. We entered into a settlement agreement with Mr. Belt pursuant to which we must pay certain damages and relinquish our right to receive returned insurance premiums, if any, under a split dollar arrangement.
On June 2, 2003, Vanderbilt Health Services, Inc. and Vanderbilt University filed a lawsuit captioned Vanderbilt Health Services, Inc. and Vanderbilt University v. HealthSouth Corporation, Case No. 03-1544-III, in the Chancery Court for Davidson County, Tennessee. We are partners with the plaintiffs in a partnership that operates a rehabilitation hospital in Nashville, Tennessee. In the complaint, the plaintiffs allege that we violated the terms of a non-competition provision in the partnership agreement in connection with our purchase of a number of rehabilitation clinics in the Nashville area. We are currently engaged in settlement negotiations with the plaintiffs.
On July 19, 2005, Gary Bellinger filed a pro se complaint captioned Gary Bellinger v. Eric Hanson, d/b/a U.S. Strategies, Inc., Medika Group, Ltd., Laserlife, Inc., & Relife, Inc.; and Richard Scrushy, d/b/a HealthSouth, Case No. 05-06898-B, In the District Court, Dallas County, Texas, 44th Judicial District. Mr. Bellinger claims
the defendants violated the terms of a distribution agreement with his company, Laser Bio Therapy, Inc., resulting in that companys bankruptcy. He has sued for breach of contract, breach of fiduciary duty, and fraud, and claims compensatory damages of $270 million and punitive damages of $10 million. We filed a Motion to Quash Service of Process because we were not properly named or served. That motion is currently pending before the court.
On March 16, 2004, we commenced a solicitation of consents seeking approval of proposed amendments to, and waivers under, the indentures governing our 6.875% Senior Notes due 2005, 7.375% Senior Notes due 2006, 7.000% Senior Notes due 2008, 8.500% Senior Notes due 2008, 8.375% Senior Notes due 2011, 7.625% Senior Notes due 2012, and 10.750% Senior Subordinated Notes due 2008 on issues relating to our inability to provide current financial statements and our ability to incur indebtedness under certain circumstances. On May 7, 2004, we announced that we were amending the solicitation of consents from holders of our 10.750% Senior Subordinated Notes due 2008 to further conform the definition of Refinancing Indebtedness in the indenture governing our 10.750% Senior Subordinated Notes to the definition in the indentures governing our senior notes. On June 24, 2004, we announced that we had closed all of our consent solicitations for our outstanding public debt. The vote totals for the consents are set forth on the following table:
In connection with the consummation of the consent solicitations, we executed the following supplemental indentures as of May 14, 2004:
We also executed the following supplemental indentures as of June 24, 2004:
On March 19, 2003, after the Securities and Exchange Commission issued an Order of Suspension of Trading, the New York Stock Exchange (NYSE) suspended trading in our common stock, which was then listed under the symbol HRC. That same day, Standard & Poors announced that it removed our common stock from the S&P 500 Index. The NYSE continued the trading halt and eventually delisted our common stock. On March 25, 2003, immediately following the delisting from the NYSE, our stock began trading in the over-the-counter Pink Sheets market under the symbol HLSH.
The following table sets forth the high and low bid quotations per share of HealthSouth common stock as reported on the over-the-counter market from March 25, 2003 through December 31, 2004 and the high and low reported sale prices for HealthSouth common stock as reported on the NYSE Composite Transactions Tape for prior periods. The stock price information is based on published financial sources. Over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commissions, and may not necessarily represent actual transactions.
As of September 30, 2005, there were 397,224,001 shares of HealthSouth common stock issued and outstanding, net of treasury shares, held by approximately 8,572 holders of record.
We have never paid cash dividends on our common stock, and we do not anticipate paying cash dividends in the foreseeable future. In addition, the terms of our principal bank credit agreement and the indentures covering some of our publicly traded debt securities restrict our ability to pay cash dividends on our common stock if we do not meet specified financial requirements. We currently anticipate that any future earnings will be retained to finance our operations and reduce debt.
Recent Sales of Unregistered Securities
Between December 2003 and August 2005 we sold an aggregate of 280,750 shares of common stock to various employees pursuant to the exercise of outstanding stock options in transactions that were not registered under the Securities Act of 1933. The aggregate consideration for these sales was $1,116,460. In 2004 we issued
468,057 shares of restricted stock to various directors and executive officers in reliance on Section 4(2) of the Securities Act of 1933, as amended. There was no monetary consideration for the issuances of restricted stock.
Securities Authorized for Issuance Under Equity Compensation Plans
The information required by Item 201(d) of Regulation S-K is provided under Item 12, Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters, Securities Authorized for Issuance Under Equity Compensation Plans, which is incorporated herein by reference.
Purchases of Equity Securities
We derived the selected historical consolidated financial data presented below for the years ended December 31, 2004, 2003, and 2002 from our audited consolidated financial statements and related notes included elsewhere in this filing. We derived the selected historical consolidated financial data presented below for the years ended December 31, 2001 and 2000 from our audited consolidated financial statements and related notes included in our Form 10-K for the fiscal years ended December 31, 2003 and 2002. You should refer to Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, and the notes to our accompanying consolidated financial statements for additional information regarding the financial data presented below, including matters that might cause this data not to be indicative of our future financial condition or results of operations. In addition, you should note the following information regarding the selected historical consolidated financial data presented below.
The following Managements Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. The discussion also provides information about the financial results of the various segments of our business to provide a better understanding of how those segments and their results affect the financial condition and results of operations of HealthSouth as a whole.
Forward Looking Information
This MD&A should be read in conjunction with our accompanying consolidated financial statements and related notes. See Cautionary Statement Regarding Forward-Looking Statements on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1, Business, Risk Factors.
As described in detail in Item 1, Business, the past several years have been marked by profound turmoil and change. During this period, a significant portion of our time and attention has been devoted to matters primarily outside the ordinary course of business such as replacing our executive management team, cooperating with federal investigators, restructuring our finances, and reconstructing our accounting records. We have also devoted substantial resources to improving fundamental business systems including our corporate governance functions, financial controls, and operational infrastructure. At the same time, our accounting staff and outside professionals have spent more than one million hours completing the reconstruction of our books and the restatement of our previously issued 2001 and 2000 consolidated financial statements.
While we have been primarily focused on responding to these pressing challenges, our business, and the health care market in general, have continued to evolve. On the positive side, health care sector growth continues to outpace the economy in response to an aging U.S. population and other factors. In addition, the delivery of health care services is migrating to outpatient and post-acute care environments, which suits our business model. On the other hand, we are experiencing pricing pressure in the markets we serve, as well as increased competition. For example, the 75% Rule, which is described in greater detail later in this Item, presents a very significant operating challenge as it limits our ability to treat Medicare patients in our largest division. In addition to the significant volume volatility created by the 75% Rule, our inpatient division is facing lower unit pricing as a result of recent changes to the prospective payment system applicable to our inpatient rehabilitation facilities (IRF-PPS). These two factors have combined to create a very challenging operating environment for us.
On the whole, our core business remains sound. We continue to be the largest provider of ambulatory surgery and rehabilitative health care services in the United States, with (as of December 31, 2004) approximately 1,300 facilities and 40,000 full- and part-time employees. We believe that we are responding to
challenges in the inpatient market as well as or better than our competitors, which may lead to potential consolidation opportunities in the future. In addition, despite the serious financial, operational, and legal difficulties we have faced and continue to face, our business is generating significant cash. Under ordinary circumstances, we think these factors could create important competitive advantages. Unfortunately, we have significant issues to overcome before we can capitalize on any of these potential advantages or other competencies.
Our business is currently divided into four primary operating divisionsinpatient, surgery centers, outpatient, and diagnosticand a fifth division that manages certain other revenue producing activities and corporate functions. These five divisions correspond to our five reporting segments discussed later in this Item and throughout this annual report.
Inpatient. Our inpatient division, which comprises the majority of our net operating revenues and is our most profitable division, provides treatment at (as of December 31, 2004) 94 inpatient rehabilitation facilities (IRFs), 9 long-term acute care hospitals (LTCHs), and 152 satellites of inpatient facilities providing primarily outpatient care. This division continues to be the market leader in inpatient rehabilitation services in terms of revenues, number of IRFs, and patients served. Between 2002 and 2003, our inpatient division performed well due primarily to Medicare reimbursement changes, discussed later in this Item, which rewarded efficient providers. In 2004, operating earnings of this division remained stable due largely to treating higher acuity patients and stricter expense controls. However, as discussed below, the 75% Rule and recent IRF-PPS changes are likely to have a materially negative impact on future results of operations for 2005 and beyond.
Surgery Centers. Our surgery centers division, which is our second largest division in terms of net operating revenues, operates (as of December 31, 2004) 177 freestanding ambulatory surgery centers (ASCs) and 3 surgical hospitals. Our surgery centers segments net operating revenues declined from 2002 to 2004. Since March 2003, the division has struggled due in large part to an inability to efficiently resyndicate (i.e., sell ownership interests in) its partnership portfolio and its inability to control supply costs. Since January 2005, resyndication activity has improved, and we are working on new processes to improve operating room efficiency, decrease supply costs, and optimize staffing. We expect this division to benefit as outpatient procedures continue to migrate to the more efficient ASC environment. However, potential benefits from industry growth may be offset by physician partners who are demanding a higher ownership interest in our partnerships, thereby lowering our share of partnership earnings.
Outpatient. Our outpatient division currently provides outpatient therapy services (as of December 31, 2004) at 765 HealthSouth facilities and 39 facilities managed under contract by us. This divisions performance was disappointing between 2002 and 2004, due primarily to poor operational systems and increased competition from physician-owned physical therapy sites. We continue to try to improve margins by closing underperforming facilities and by making operational improvements within the division, and we believe these initiatives will begin to produce positive results.
Diagnostic. Our diagnostic division operates (as of December 31, 2004) 96 diagnostic imaging centers. This divisions performance declined from 2002 to 2004 due to poor margins for the diagnostic market in general and strong competition from physician-owned diagnostic service centers. We are beginning to see stabilization of both net operating revenues and operating earnings, which we believe is due in part to payor pressures to decrease perceived over-utilization of diagnostic services by physician-owned diagnostic service centers. We are also beginning to see same-center growth. We continue to focus on operational improvements to increase our margins.
As shown by the following charts, our inpatient and surgery centers divisions made up approximately 80% of 2004 net operating revenues and almost 90% of 2004 Consolidated Adjusted EBITDA (as defined in this Item,
Consolidated Results of Operations,) from our four primary operating divisions. For a reconciliation of loss from continuing operations to Consolidated Adjusted EBITDA, see this Item, Consolidated Adjusted EBITDA.
We believe that the aging of the U.S. population, changes in technology, and the continuing growth in health care spending will increase demand for the types of services we provide. First, many of the health conditions associated with aginglike stroke and heart attacks, neurological disorders, and diseases and injuries to the muscles, bones, and jointswill increase the demand for ambulatory surgery and rehabilitative services. Second, pressure from payors to provide efficient, high-quality health care services is forcing many procedures traditionally performed in acute care hospitals out of the acute care environment. We believe these market factors align with our strengths. Given our limited resources, we plan to prioritize investment of time and capital based on where realistic growth prospects are strongest, which is currently our inpatient and surgery centers divisions.
Although our business is continuing to generate substantial revenues, and market factors appear to favor our outpatient and post-acute care business model, we still have several immediate internal and external challenges to overcome before we can realize significant improvements in our business, including:
Although managements attention recently has been focused on a range of tactical issues critical to HealthSouths survival, our new executive management team has spent considerable time developing a comprehensive strategic plan for the next three to five years that is focused on HealthSouths future, not its past. The plan, which has been approved by the Special Committee of our board of directors, is divided into the following three phases:
We are into the first phase of our strategic plan, and we are already making significant strides. For example, we have cured long-term debt defaults and increased our liquidity. We are continuing to cooperate with government investigations and have entered into key settlements with the government and various private parties. Operationally, we have replaced the presidents of each of our primary operating divisions, reorganized these divisions by eliminating unnecessary management layers, increased productivity, divested underperforming facilities, and worked to improve operational systems. We are also beginning to implement mitigation strategies for the 75% Rule in our inpatient facilities, enhance the resyndication process for our ASCs, and implement new information systems to improve cash collections in our diagnostic division.
We believe our strategic plan capitalizes on our strengths, market direction, and legitimate growth opportunities. We are implementing a realistic operational plan and creating the appropriate infrastructureorganization, policies, protocols, systems, and informationto support it. Finally, we are setting priorities based on resources and with our long-range goals of quality, profitability, and shareholder value at the forefront of our minds.
Consolidated Results of Operations
HealthSouth is the largest provider of ambulatory surgery and rehabilitative health care services in the United States, with approximately 1,300 facilities and 40,000 full- and part-time employees. We provide these services through a national network of inpatient and outpatient rehabilitation facilities, outpatient surgery centers, diagnostic centers, medical centers, and other health care facilities.
During 2004, 2003, and 2002, we derived consolidated net operating revenues from the following payor sources:
We provide our patient care services through four primary operating divisions and certain other services through a fifth operating division. These five divisions correspond to our five reporting segments discussed in this Item, Segment Results of Operations, and throughout this annual report.
When reading our consolidated statements of operations, it is important to recognize the following items included within our results of operations:
As a result of the Medicare Program Settlement, as discussed in more detail in Note 20, Medicare Program Settlement, to our accompanying consolidated financial statements, we recorded a total charge of $347.7 million during 2002 as Government and class action settlements expense. Of this charge, approximately $194.0 million, $96.5 million, and $57.2 million have been allocated to our inpatient, outpatient, and corporate and other segments, respectively. Although the Medicare Program Settlement was made on a global basis rather than a claim-by-claim basis, our allocation was based upon our evaluation of the damages asserted by the United States Department of Justice (the DOJ) civil division on a claim-by-claim basis and our analysis of the value of those claims.
This gain was offset by a $13.9 million loss from a real estate transaction with First Cambridge, as discussed in more detail in Note 19, Related Party Transactions, to our accompanying consolidated financial statements. The remaining $2.3 million of loss on early extinguishment of debt in 2002 is due to the refinancing of our 1998 Credit Agreement and the write-off of $2.3 million of unamortized loan costs in association with this transaction. For more information regarding these transactions, please see Note 9, Long-term Debt, to our accompanying consolidated financial statements.
From 2002 through 2004, our consolidated results of operations were as follows:
Operating Expenses as a % of Net Operating Revenues
Net Operating Revenues
Our consolidated net operating revenues primarily include revenues derived from patient care services provided by one of our four primary operating segments. It also includes other revenues generated from management and administrative fees, trainer income, operation of the conference center located on our corporate campus, and other non-patient care services.
The decrease in our consolidated net operating revenues from 2003 to 2004 was due primarily to volume decreases within our surgery centers, outpatient, and diagnostic segments. The volume decline within our surgery centers segment was due to the limited resyndication activity which occurred in 2004. Volume decreases within both our outpatient and diagnostic segments were due to competition from physician-owned similar sites.
In spite of the negative publicity and turmoil surrounding the company in 2003, consolidated net operating revenues remained relatively flat year over year. Although our segments experienced significant declines in volume related to the negative publicity and other competitive factors, our segments achieved improved payor mix and price increases to offset the decline in volume.
Salaries and Benefits
Salaries and benefits represents the most significant cost to us and includes all amounts paid to full- and part-time employees, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor.
Salaries and benefits grew as a percent of net operating revenues during 2004. This was due to rising costs associated with group medical and workers compensation across all of our segments, increased use of contract labor within our inpatient segment, and an inability to further adjust minimal staffing levels within our diagnostic segment. Due to staffing shortages for therapists and nurses, our inpatient segment was forced to increase its use of higher-priced contract labor to properly care for its patients during 2004. As discussed further in this Item, Segment Results of OperationsDiagnostic, our diagnostic segment reached minimal staffing levels and could not further adjust its staffing levels with the declining volumes experienced in 2004. All of the above contributed to the increase in salaries and benefits as a percent of net operating revenues during the year.
During 2003, our full time equivalents decreased by approximately 1,200 employees, as we adjusted our staffing levels for the volume declines experienced by our operating segments and reduced our workforce at our corporate headquarters. However, the average cost per full time equivalent increased due to the rising costs of
medical and other benefits and workers compensation expenses. These rising costs offset the cost savings anticipated from the reduction in full time equivalents and resulted in only a 1.6% decrease in salaries and benefits from 2002 to 2003.
Professional and Medical Director Fees
Professional and medical director fees include fees paid under contracts with radiologists, medical directors, and other clinical professionals at our centers for services provided.
The change in professional and medical director fees from 2003 to 2004 was not material. Professional and medical director fees decreased from 2002 to 2003 due primarily to the termination of contracts associated with Alabama Sports Medicine and Orthopedic Center due to relationships and conflicts of interests, as well as high costs associated with these contracts.
Supplies include costs associated with supplies used while providing patient care at our facilities. Examples include pharmaceuticals, implants, bandages, food, and other similar items. In each year, our inpatient and surgery centers segments comprise over 78% of our supplies expense.
The decrease in supplies expense from 2003 to 2004 was due to the closure of Metro West hospital in September 2004 offset slightly by an increase in supplies expense in our inpatient segment due to increasing costs associated with supplies and the higher acuity of our patients in 2004. Higher acuity results in increased costs associated with supplies, especially in drug costs.
Over 85% of the increase in supplies from 2002 to 2003 was due to the acquisition of Metro West hospital in November 2002. During 2003, we incurred a full year of Metro Wests operating expenses, including approximately $32.9 million related to supplies expense.
Other Operating Expenses
Other operating expenses include costs associated with managing and maintaining our operating facilities as well as the general and administrative costs related to the operation of our corporate office. These expenses include such items as repairs and maintenance, utilities, contract services, rent, and insurance.
Other operating expenses also include software development costs. During 2004, 2003, and 2002, we provided funding to Source Medical for the HCAP software development, as discussed in more detail in Note 8, Investment in and Advances to Nonconsolidated Affiliates, to our accompanying consolidated financial statements. During 2004, 2003, and 2002, $5.3 million, $11.8 million and $25.3 million, respectively, were provided to Source Medical.
The decrease in other operating expenses from 2003 to 2004 primarily related to decreased operating expenses within our inpatient segment. Continuing a trend seen in 2003, our inpatient segments operating expenses decreased in 2004 as the segment continued to digest the change to the Prospective Payment System (PPS) from 2002 and faced the challenge of mitigating the 75% Rule impact on its net operating revenues.
The decrease in other operating expenses from 2002 to 2003 was due to increased expenses at our inpatient segment offset by reduced expenses at our corporate and other segment. Operating expenses increased at our inpatient segment due to an increase in the acuity of patients serviced in 2003, as discussed in more detail within the Segment Results of Operations section below, and the net increase of two inpatient facilities during the year. These increased costs were offset by a reduction in discretionary spending as a result of the events of March 19, 2003. We decreased our discretionary spending on items such as office supplies, telephone, travel and
entertainment, meetings, contract services, media production, contributions, airplane and hangar rent, software development costs, and event sponsorships. However, we incurred $70.6 million in Professional feesreconstruction and restatement, during 2003, as discussed above.
Provision for Doubtful Accounts
Our provision for doubtful accounts remained consistent as a percent of net operating revenues from 2003 to 2004. Although we made progress collecting aged receivables and implementing improved cash collections procedures within our diagnostic and surgery centers segments, our inpatient segment experienced an increase in its provision for doubtful accounts. For more information, please see this Item, Segment Results of Operations.
From 2002 to 2003, the provision for doubtful accounts remained consistent as a percent of net operating revenues. During 2003, our inpatient segment was able to decrease its provision for doubtful accounts through continued significant improvements in collections precipitated by consistent application of policies around the identification, pursuit, and recording of bad debts which began in 2001. Our provision for doubtful accounts also decreased due to the increase in the percent of our net operating revenues from Medicare, as bad debts have not historically been associated with Medicare as a payor. However, these improvements in the provision for doubtful accounts were offset by cash collections difficulties within our diagnostic segment. See Segment Results of OperationsDiagnostic within this Item for more information regarding the provision for doubtful accounts in our diagnostic segment.
Depreciation and Amortization
From 2003 to 2004, our depreciation and amortization expense increased by less than 1%. Although depreciation and amortization expense decreased within our operating segments due to closure of facilities, impairment charges, and an increase in fully depreciated assets, depreciation and amortization expense within our corporate and other segment increased due to the reduction in useful lives made to the property and equipment of the Birmingham Medical Center in anticipation of the transfer of the Birmingham Medical Centers certificate of need for 219 licensed beds to the Digital Hospital.
The decrease in depreciation and amortization expense from 2002 to 2003 was primarily due to the sale of assets and closure of facilities during 2003, primarily in our outpatient and diagnostic segments.
Loss (Gain) on Disposal of Assets
The net loss on disposal of assets in 2004 primarily resulted from facility closures in our outpatient and diagnostic segments. Continuing volume declines and competition in these segments forced us to close additional underperforming facilities in 2004. The net gain on disposal of assets in 2003 primarily resulted from the sale of our inpatient facility in Reno, Nevada.
As part of our reconstruction process for the year ended December 31, 2002, we performed a complete physical inventory of our facilities. We removed all items we could not locate from the fixed assets system and adjusted the general ledger accordingly. For facilities that were closed, we removed any asset not physically located from the fixed asset system and the general ledger as of the facilitys closure date. As a result of this procedure, we incurred a charge of approximately $35.6 million, which is included in Loss (gain) on disposal of assets in our 2002 consolidated statement of operations. The remainder of the 2002 loss on disposal of assets is primarily attributable to the sale of the Wentworth Nursing Home by our inpatient segment.
Interest Expense and Amortization of Debt Discounts and Fees
We are a highly leveraged company with over $3.5 billion of debt as of December 31, 2004. This high debt level results in high debt service costs, with cash paid for interest expense approximating $281 million in 2004.
The increase in interest expense from 2003 to 2004 was the result of higher average borrowing rates in 2004. In 2003, our average borrowing rate was 7.6% compared to an average rate of 8.7% in 2004. The average borrowing rate increased due to the repayment of our 3.25% convertible subordinated debentures with proceeds from a 10.375% senior subordinated credit agreement. For more information regarding the 3.25% convertible subordinated debentures and 10.375% senior subordinated credit agreement, see Note 9, Long-term Debt, to our accompanying consolidated financial statements.
Interest expense increased during 2003 primarily due to increased average interest rates on our borrowings. As a result of the events of March 19, 2003, our interest rate increased to default rates on our then-existing credit agreement. Our average borrowing rate on all debt in 2003 was 7.6% compared to 7.2% in 2002. These increased rates resulted in an increase in interest expense of approximately $14.6 million in 2003. Increased interest expense related to higher rates was offset by lower average borrowings during 2003. Average borrowings declined by approximately $16.8 million in 2003 over 2002, providing an offset of approximately $1.2 million to interest expense.
(Gain) Loss on Sale of Investments
In each year presented in our consolidated statements of operations, the net gain or loss on sale of investments was primarily comprised of numerous individually insignificant transactions related to less than 100% owned entities, including investments in nonconsolidated affiliates. In 2004, the net gain on sale of investments was solely comprised of these types of transactions. In 2002 and 2003, the net gain or loss on sale of investments also includes the realized gains and losses recorded on the sale of marketable securities, as discussed in more detail below. In 2002, the net gain on sale of investments also includes the termination of an interest rate swap. For more information regarding this interest rate swap, see Note 9, Long-term Debt, to our accompanying consolidated financial statements.
During 2003, we sold our investment in HealthTronics for approximately $3.7 million and recognized a gain on the sale of approximately $0.7 million. With the sale of this investment, we eliminated all of our investments in marketable securities. During 2002, we sold our investment in BEI Medicals common stock for approximately $1.2 million, realizing a gain on this sale of approximately $0.7 million. For more information regarding our marketable securities, see Note 5, Marketable Securities, to our accompanying consolidated financial statements.
Equity in Net Income of Nonconsolidated Affiliates
The decrease in Equity in Net Income of Nonconsolidated Affiliates from 2003 to 2004 is primarily due to higher year-over-year operating expenses at three of our nonconsolidated surgery centers.
Minority Interests in Earnings of Consolidated Affiliates
Minority interests in earnings of consolidated affiliates represent the share of net income or loss allocated to members or partners in our consolidated entities. For 2002 through 2004, the number and average external ownership interest in these consolidated entities were as follows:
Of our active consolidated affiliates at December 31, 2004, approximately 78% of them are in our inpatient and surgery centers segments. Fluctuations in Minority interests in earnings of consolidated affiliates generally follow the same trends as our inpatient and surgery centers segments.
Loss from Continuing Operations Before Income Tax Expense (Benefit) and Cumulative Effect of Accounting Change
The decrease in our Loss from continuing operations before income tax expense (benefit) and cumulative effect of accounting change (loss from continuing operations) from 2003 to 2004 is primarily due to the 12.9% decrease in operating expenses year over year. Operating expenses decreased as a result of the $412.1 million decrease in impairment charges and a $170.9 million decrease in Government and class actions settlements expense offset by a $135.7 million increase in Professional feesreconstruction and restatement. Increased interest expense during 2004 (as a result of higher average borrowing rates), as discussed above, also offset the decrease in operating expenses.
The increase in our loss from continuing operations from 2002 to 2003 is due to the 1.4% increase in total operating expenses while our net operating revenues remained relatively flat. In addition to the increase in our operating expenses, we incurred increased interest expense (as a result of higher average borrowing rates) and an increased loss on sale of investments (due to the interest rate swap gain recorded in 2002).
Provision for Income Tax Expense (Benefit)
We realized an $11.9 million tax expense from continuing operations in 2004 as compared to a $39.8 million tax benefit in 2003. HealthSouth Corporation and its subsidiaries file separate income tax returns in a number of states, some of which result in current state income tax liabilities. Such state income taxes increased in 2004 by approximately $3.0 million. Further, intraperiod allocation of taxes between continuing operations and discontinued operations resulted in an $11.3 million tax benefit to continued operations in 2003 as a result of tax expense associated with discontinued operations. Finally, deferred taxes increased by approximately $20 million to reflect the change in the noncurrent deferred taxes associated with certain indefinite lived assets.
We realized a $39.8 million tax benefit from continuing operations in 2003 as compared to a $20.3 million tax expense in 2002. Substantially all of this difference relates to the fact that we realized a $25.6 million deferred tax benefit due to the reduction of the deferred tax liability associated with certain indefinite lived assets. This reduction was the result of an impairment of goodwill in 2003. In 2002, a deferred tax expense of $30.6 million was initially provided to reflect the increase in the deferred tax liability associated with these assets. Additionally, HealthSouth Corporation and its subsidiaries file separate income tax returns in a number of states, some of which result in current state income tax liabilities. The current state income tax liability in 2003 is approximately $11.0 million less than in 2002 as a function of decreased pre-tax state income.
In 2002, a net tax expense of $20.3 million was provided on continuing operations. The current portion is comprised of a tax benefit which results from our estimate that we will be able to carry back a portion of our current federal net operating loss pursuant to the provisions of the Job Creation and Worker Assistance Act of 2002 (the Worker Assistance Act), enacted by Congress on March 9, 2002. The Worker Assistance Act extended the carryback period to 5 years for net operating losses incurred in 2001 and 2002 only. Additionally, HealthSouth Corporation and its subsidiaries file separate income tax returns in a number of states, some of which result in current state income tax liabilities. The current state income tax liability in 2002 increased approximately $13.4 million from 2001 as a function of increased pre-tax state income. A deferred tax expense of $30.6 million was provided in 2002 to reflect the increase in a deferred tax liability associated with certain indefinite life assets, as compared to a deferred tax expense of $9.4 million provided on these assets in 2001. This liability is recorded as it is not able to be relieved through the realization of deferred tax assets.
Consolidated Adjusted EBITDA
Management continues to believe that an understanding of Consolidated Adjusted EBITDA is an important measure of operating performance, leverage capacity, our ability to service our debt, and our ability to make capital expenditures for our stakeholders.
We use Consolidated Adjusted EBITDA on a consolidated basis to assess our operating performance. We believe it is meaningful because it provides investors a means to basis using criteria that are used by our internal decision makers. Our internal decision makers believe Consolidated Adjusted EBITDA is a meaningful measure, because it represents a transparent view of our recurring operating performance and allows management to readily view operating trends, perform analytical comparisons and benchmarking between segments. Additionally, our management believes the inclusion of professional fees associated with litigation, financial restructuring, government investigations, forensic accounting, creditor advisors, accounting reconstruction, audit and tax work associated with the reconstructions process, and the implementation of Sarbanes-Oxley Section 404 and non-ordinary course charges incurred after March 19, 2003 and related to our overall corporate restructuring distort within EBITDA their ability to efficiently assess and view the core operating trends on a consolidated basis and within segments. Additionally, we use Consolidated Adjusted EBITDA as a significant criterion in our determination of performance-based cash bonuses and stock awards. We reconcile consolidated Adjusted EBITDA to loss from continuing operations.
We also use Consolidated Adjusted EBITDA on a consolidated basis as a liquidity measure. We believe this financial measure on a consolidated basis is important in analyzing our liquidity because it is also a component of certain material covenants contained within and defined by our amended and restated credit agreement, as discussed in more detail in Note 9, Long-term Debt, to our accompanying consolidated financial statements. These covenants are material terms of these agreements because they govern several of our credit agreements, which in turn represent a substantial portion of our capitalization. Non-compliance with these financial covenants under our credit facilitiesour interest coverage ratio and our leverage ratiocould result in the lenders requiring us to immediately repay all amounts borrowed. Any such acceleration could also lead the investors in our public debt to accelerate their maturity. In addition, if we cannot satisfy these financial covenants in the indenture governing the credit agreements, we cannot engage in certain activities, such as incurring additional indebtedness, making certain payments, acquiring and disposing of assets. Consequently, Consolidated Adjusted EBITDA is critical to our assessment of our liquidity.
In general terms, the definition of Consolidated Adjusted EBITDA, per our amended and restated credit agreement, allows us to add back to Consolidated Adjusted EBITDA charges of the type classified as Restructuring Charges on or prior to June 30, 2005. Costs which we classify as Restructuring Charges include professional fees associated with certain litigation, financial restructuring, government investigations, forensic accounting, creditor advisors, accounting reconstruction, audit and tax work associated with the reconstruction process, and the implementation of Sarbanes-Oxley §404 and non-ordinary course charges incurred after March 19, 2003 related to our overall corporate restructuring. In addition, we are permitted under various credit agreements to continue to add back to EBITDA professional fees associated with the class action and shareholder derivative litigation.
However, Consolidated Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles in the United States of America, and the items excluded from Consolidated Adjusted EBITDA are significant components in understanding and assessing financial performance. Therefore, Consolidated Adjusted EBITDA should not be considered a substitute for net loss from continuing operations or cash flows from operating, investing, or financing activities. Because Consolidated Adjusted EBITDA is not a measurement determined in accordance with generally accepted accounting principles in the United States of America and is thus susceptible to varying calculations, Consolidated Adjusted EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Revenue and expenses are measured in accordance with the policies and procedures described in Note 1, Summary of Significant Accounting Policies, to our accompanying consolidated financial statements.
From 2002 through 2004, our Consolidated Adjusted EBITDA was as follows:
Reconciliation of Loss from Continuing Operations to Consolidated Adjusted EBITDA
Reconciliation of Consolidated Adjusted EBITDA to Net Cash Provided by Operating Activities
Consolidated Adjusted EBITDA decreased from 2003 to 2004 due primarily to the decrease in our net operating revenues, as discussed above. Consolidated Adjusted EBITDA in 2003 increased primarily as a result of our efforts to reduce discretionary spending during the year and headcount reductions at our corporate headquarters.
Impact of Inflation
Overall, inflation has not had a material impact on our operations during recent years. Unless inflation increases significantly, it is not expected to materially adversely affect our results of operations in the near term.
Relationships and Transactions with Related Parties
HealthSouth and its prior management and board of directors engaged in numerous relationships and transactions with related parties. These transactions involved certain venture capital firms, investments, real property, and indebtedness of management. For more information on our historic relationships and transactions with related parties, please see Item 13, Certain Relationships and Related Transactions, of this report, and Note 8, Investment in and Advances to Nonconsolidated Affiliates, Note 11, Shareholders Deficit, and Note 19, Related Party Transactions, to our accompanying consolidated financial statements.
As part of our restructuring process, we have eliminated our interests in and relationships with related parties. These types of transactions are not material to our ongoing operations, and therefore, will not be presented as a separate discussion within this Item. When these relationships or transactions were significant to our results of operations during the years ended December 31, 2004, 2003, or 2002, information regarding the relationship or transaction(s) have been included within this Item.
Segment Results of Operations
Our internal financial reporting and management structure is focused on the major types of services provided by HealthSouth. We currently provide various patient care services through four operating divisions and certain other services through a fifth division, which correspond to our five reporting business segments: (1) inpatient, (2) surgery centers, (3) outpatient, (4) diagnostic, and (5) corporate and other. For additional information regarding our business segments, including a detailed description of the services we provide and financial data for each segment, please see Item 1, Business, and Note 23, Segment Reporting, to our accompanying consolidated financial statements. Future changes to this organizational structure may result in changes to the reportable segments disclosed.
We are the nations largest provider of inpatient rehabilitation services. Our inpatient rehabilitation facilities provide comprehensive services to patients who require intensive institutional rehabilitation care. Patient care is provided by nursing and therapy staff as directed by a physician order. Internal case managers monitor each patients progress and provide documentation of patient status, achievement of goals, functional outcomes and efficiency.
Our inpatient segment operates IRFs, LTCHs, and skilled nursing units and provides treatment on both an inpatient and outpatient basis. As of December 31, 2004, our inpatient segment operated 94 freestanding IRFs, 9 LTCHs, and 152 outpatient facilities near our IRFs or LTCHs. In addition to HealthSouth facilities, our inpatient segment manages 13 inpatient rehabilitation units and 2 gamma knives. Our inpatient segment also has 11 therapy staffing contracts with acute care providers. Our inpatient facilities are located in 28 states, with a concentration of facilities in Texas, Pennsylvania, Florida, Tennessee, and Alabama. We also have facilities in Puerto Rico and Australia.
For the years ended December 31, 2004, 2003, and 2002, our inpatient segment comprised approximately 53.8%, 51.1%, and 48.3%, respectively, of consolidated net operating revenues. For 2002 through 2004, this segments operating results were as follows:
During 2004, 2003, and 2002, inpatients net operating revenues were derived from the following payor sources:
Our inpatient segments payor mix is weighted heavily towards Medicare. Effective January 1, 2002, our IRFs began receiving Medicare reimbursements under PPS. Under IRF-PPS, our IRFs receive fixed payment amounts per discharge based on certain rehabilitation impairment categories established by the Department of Health and Human Services. With PPS, our facilities retain the difference, if any, between its fixed payment from Medicare and its operating costs. Thus, our facilities are rewarded for being high quality, low cost providers. During 2003, the segment operated seven LTCHs that converted to LTCH-PPS and began receiving fixed payment amounts per discharge based on diagnosis-related groups determined by the Department of Health and Human Services. For additional information regarding Medicare reimbursement, please see the Sources of Revenue section of Item 1, Business, of this annual report.
Over the past few years, the portion of our inpatient segments net operating revenues attributable to Medicare has grown, with Medicare contributing approximately 70% of inpatients net operating revenues in 2003 and 2004. This was due in part to the fact that many of the health conditions treated at our inpatient facilities are associated with aging, and increased marketing efforts have focused on these areas, such as the stroke campaign which began in 2002. As a result, new business has come from Medicare patients. Furthermore, we now have 9 LTCHs in operation. These LTCHs provide specialized acute care for medically complex patients who are critically ill with multi-system complications and/or failures and require long hospitalizations. The majority of these patients are covered by the Medicare program since Medicare utilization in an LTCH can exceed 90%.
Due to the significance of Medicare payments to our inpatient facilities, the number of patient discharges is a key metric utilized by the segment to monitor and evaluate its performance. The number of outpatient visits is also tracked in order to measure the volume of outpatient activity within the segment. The segments primary operating expenses include salaries and benefits and supplies. Salaries and benefits represents the most significant cost to the segment and includes all amounts paid to full- and part-time employees, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Supply costs include all expenses associated with supplies used while providing patient care. These costs include pharmaceuticals, needles, bandages, food, and other similar items.
On May 7, 2004, the United States Centers for Medicare and Medicaid Services (formerly the Healthcare Financing Administration) (CMS) issued a final rule that stipulates revised Medicare classification criteria that a facility is required to meet to be considered an IRF by Medicare. The 75% Rule, as revised, became effective July 1, 2004. It is discussed in more detail in Item 1, Business, Sources of Revenue. The 75% Rule generally provides that to be considered an IRF, and to receive reimbursement for services under the IRF-PPS methodology, 75% of a facilitys total patient population must require intensive rehabilitation services associated with treatment of at least one of 13 designated medical conditions. The 75% Rule is being phased in over a three-year period that began on July 1, 2004. Thus, full compliance will be required for cost reporting periods beginning on or after July 1, 2007.
Our inpatient division has begun to reduce or refocus admissions at most locations to ensure continued compliance with the phase-in schedule for the 75% Rule. We project this reduction in census, unless mitigated, will have a materially adverse impact on the inpatient segments net operating revenues. We previously estimated that the 75% Rule could negatively impact our net operating revenues by $95 million to $100 million in 2005. Our inpatient division is taking steps to mitigate the impact of the 75% Rule, and we previously estimated the impact to our net operating revenues to be approximately $50 million to $55 million when our mitigation strategies are taken into consideration. In our recently filed 2003 annual report, we noted that at the end of the second quarter of 2005, as many of our facilities approached the end of their cost reporting years, we saw a greater than anticipated decline in inpatient volumes, a significant portion of which we believed to be attributable to the 75% Rule. We continue to see decline in inpatient volumes which we believe to be attributable to the 75% Rule and weakness in acute care volumes. Accordingly, the financial impact of the 75% Rule we previously estimated will be greater than previously estimated, but it is difficult to separate the impact of the 75% Rule from other factors affecting inpatient volume. Our mitigation strategy is discussed in Item 1, Business, Operating DivisionsInpatient. We are also participating with the rest of the industry to help educate various governmental agencies and policy makers about the efficacy of inpatient rehabilitative care.
PPS Final Rule
On August 15, 2005, CMS published a final rule, as amended by the subsequent correction notice published on September 30, 2005, that updates the IRF-PPS for the federal fiscal year 2006 (which covers discharges occurring on or after October 1, 2005 and on or before September 30, 2006). Although the final rule increases market basket payments by 3.6%, it makes several other adjustments that we estimate will result in a net reduction in reimbursement to us. For example, the final rule (1) reduces the standard payment rates by 1.9%, (2) implements changes to Case-Mix Groups, comorbidity tiers, and relative weights, (3) updates the formula for the low income patient payment adjustment, (4) adopts the new geographic labor market area definitions based on the definitions created by the Office of Management and Budget known as Core-Based Statistical Areas, (5) implements new and revised payment adjustments on a budget-neutral basis, (6) implements a new indirect medical education teaching adjustment, and (7) incorporates several other modifications to Medicare reimbursement for IRFs. Although CMS predicted that overall payments to IRFs nationwide would increase by 3.4%, we estimate that the revised IRF-PPS will reduce Medicare reimbursement to our IRFs by 3.5% to 4%, primarily owing to the changes to Case-Mix Groups, comorbidity tiers, and relative weights. We estimate this net impact on reimbursement will reduce our inpatient divisions net operating revenues by approximately
$10 million during the fourth quarter of 2005 and approximately $40 million on an annualized basis. These estimates do not take into account potential changes in our case-mix resulting from our compliance with the 75% Rule, which could have the effect of increasing the acuity of our case-mix and therefore reducing the overall net impact of the IRF-PPS changes.
Net Operating Revenues
Net operating revenues of our inpatient segment increased by 1.1% from 2003 to 2004. This increase is primarily due to the higher net revenue per discharge, or improvement in our reimbursement per case, as well as a 2.3% increase in discharges. The increase in net operating revenues per discharge is due primarily to the 1.4% increase in the segments Case Mix Index (CMI). An increase in CMI indicates that our patients have a higher acuity. For Medicare, which was 70% of inpatients 2004 net operating revenues, the result of an increase in CMI is an increased payment to the segment. In addition, a market basket adjustment of 3.1% was received from Medicare in October 2004. A market basket adjustment is made to Medicare rates by the Department of Health and Human Services to provide an economic adjustment that is often passed on to providers. The increased reimbursements were offset by a 6.5% decrease in outpatient visits due primarily to increased competition from physicians offering physical therapy within their own offices. Due to this increased competition and resulting decrease in outpatient visits, we evaluated our outpatient satellite sites and closed 23 sites during 2004.
In 2003, our inpatient segment yielded an approximate 5.9% increase in net operating revenues due to higher net revenue per discharge, or improvement in our reimbursement per case, as well as a 1.0% increase in discharges. The increase in net operating revenues per discharge is due primarily to the increase in the segments CMI during the year. In addition, a market basket adjustment of 3.0% was received from Medicare in October 2003. The increased reimbursements were offset by a 7.6% decrease in outpatient visits. The decrease in outpatient net operating revenue occurred as a result of a clarification in Medicare outpatient billing regulations that resulted in more therapy being provided in group settings verses individual sessions. Competition from physicians offering physical therapy within their own offices also contributed to the decrease in outpatient visits in 2003.
Salaries and Benefits
Salaries and benefits comprised over 55% of inpatients operating expenses in each year.
From 2003 to 2004, s