ITEM 1: BUSINESS
OVERVIEW
Physician Partners, Inc. ("PPI" or "Company") is a physician practice management ("PPM") company that operates primary care and multi-specialty clinics in the Pacific Northwest. PPI was formed in June 1996 in connection with certain reorganization and merger transactions (the "Transactions") contemplated by the Amended and Restated Agreement and Plan of Reorganization and Merger (the "Reorganization and Merger Agreement") among Medford Clinic, PC ("Old Medford"), HealthFirst Medical Group, PC ("Old HealthFirst"), The Corvallis Clinic, PC ("Old Corvallis" and, together with Old Medford and Old HealthFirst, referred to herein, collectively, as the "Old PCs"), and PPI, which Transactions were consummated on February 1, 1997.
The Transactions resulted in a separation of operations of each of the Old PCs between medical professional services activities (i.e., Old providers of medical services) and the physician practice management activities of the business. Pursuant to the Merger, the physician practice management business, along with substantially all of the assets and liabilities of the Old PCs (including cash, receivables, inventories, prepaids, property, plant and equipment, payables, accruals, debt, and certain contractual commitments) became the assets and liabilities of PPI. The New PCs are responsible for providing medical services and incur the related costs for provider compensation and benefits. The assets transferred to the New PCs, which had nominal value, include the employment agreements between each Old PC and its providers, certain provider contracts under which the New PCs will be receiving fee-for-service compensation and patient medical records.
As an integral part of the Transactions, PPI and each of the New PCs entered into a 40-year management agreement (the "Management Agreement") whereby PPI provides physician practice management services to such New PCs. PPI provides to the new PCS, among other things, management and administrative services, capital resources, facilities, equipment and supplies. As consideration, PPI is entitled to (a) reimbursement of all management costs and expenses ("Manager's Expenses") incurred by PPI in connection with the Management Agreement and (b) a management fee equal to 16% of (i) net revenues relating to services provided by the New PCs less (ii) Manager's Expenses.
The Management Agreement provides for the establishment of the Joint Management Board of the New PC. The Joint Management Board is designed to represent the clinical and physician perspective and the management and business perspective. The Joint Management Board consists of six members, with three members appointed by the New PC (physician members of the New PC) and three members appointed by PPI (one of whom must be a local PPI group practice administrator). The Medical Director of the New PC serves as a seventh ex officio, non-voting member of the Joint Management Board. The Joint Management Board provides local expertise and develops and approves all proposals submitted to PPI for it's approval regarding the New PC's growth, annual budgets, payor relations, local strategic initiatives and capital improvements.
GENERAL
The mission of PPI is to pioneer innovative health care delivery into the 21st century as a leading primary care-based multi-specialty physician practice management company. To achieve such goal, PPI endeavors to enable its affiliated clinics to deliver health care with sound ethical standards by involving physicians at every level of PPI, including clinical and business policy development and decisions. PPI continuously seeks to innovate to enable the New PCs to deliver quality patient care and services efficiently. PPI also actively seeks opportunities to grow through acquisition of quality primary care based multi-specialty group practices. PPI operates as a PPM organization, focusing on the long-term management of high quality, well-positioned primary care based multi-specialty group practices. PPI typically acquires certain assets of established medical groups, such as their equipment and accounts receivable, and manages such medical groups under a long-term management agreement. Because PPI does not employ physicians and does not practice medicine, it does not acquire provider professional services business assets such as Medicare provider numbers.
While PPI is similar to other multi-specialty group practice PPMs, PPI can be distinguished and differentiated in several important aspects. PPI is the first PPM to originate in the Pacific Northwest. As of December 31, 1997, PPI has significant geographical presence and strength in the State of Oregon with nearly 302 providers practicing in the New PCs and various clinical delivery sites. PPI is also distingushable in that it is owned by group practice physicians. PPI employs a full-time Chief Medical Officer responsible for managing the clinician and clinical issues with each New PC's Medical Director. PPI's business and clinical managers have extensive experience with managed care under a variety of payment methodologies due to the fact that PPI is the surviving corporation of a merger of three successful primary care-based multi-specialty groups which have, collectively, more than 150 years of group practice and group practice management experience.
PPI also has a Medical Ethicist as an advisor to the Board of Directors in order to assist the physicians affiliated with PPI in adherence with the fundamental principles of medical ethics, acting as advocates for their patients and providing quality patient care. The Medical Ethicist attends board meetings of PPI and advises the Board regarding ethical implications of the issues with which the PPI Board must deal.
Business Strategy
PPI's strategy is to consolidate medical group practices into networks of health care providers. Although PPI's operations are currently concentrated in the Pacific Northwest, PPI intends to explore growth opportunities nationally. Within each of its managed clinics, PPI seeks to achieve a mix of primary care and specialty physicians who can provide services necessary to establish a significant market presence. PPI enhances medical group operations by standardizing financial reporting; centralizing contract negotiations; seeking best administrative and clinical practice; improved data management; group purchasing, and capital investment.
PPI seeks to affiliate with highly productive medical groups with significant market share where they practice and which have strong reputations among patients, payors and peers for providing quality medical care. PPI seeks to acquire the operating assets of these practices and contract with the medical groups for 40 years for management services in exchange for a management fee. PPI's profitability then depends, to a certain extent, on enhancing operating efficiency, expanding health care services provided, increasing market share and assisting affiliated providers in managing the delivery of health care. PPI's network integrates practices via financial and clinical systems and offers groups the opportunity to maintain market competitive compensation, to gain increased access to capital, greater management expertise, more sophisticated information systems and more attractive managed care contracts.
The key elements of PPI's strategy include:
Strengthen Operational Efficiencies. Cost reductions can be made through economies of scale in purchasing supplies, equipment, insurance and services.
Operational efficiencies may also be achieved by expanding PPI's market coverage and number of health maintenance organization ("HMO") enrollees, refining utilization management programs, increasing standardization, developing additional in-house specialty and ancillary services, increasing emphasis on outpatient care and utilizing sophisticated information systems to make available detailed clinical data that can ensure both quality and cost containment.
Expanding the Existing Markets of the New PCs. Growth in greater Portland, Corvallis and Medford, Oregon may occur through the acquisition of or affiliation with physicians and medical groups within those markets. PPI has invested capital in each of the three New PCS and intends to assist these practices in acquiring existing local medical groups. Such new groups will have the opportunity to be incorporated into the governance and leadership structure of the existing PPI hub clinic.
Expansion into New Hub Markets. Expansion into new areas is anticipated to occur primarily through the acquisition of physician groups. New PPI hub clinics are expected to be primary care-based multi-specialty groups with (i) more than 30 physicians, (ii) potential for a significant market share, (iii) a strong group practice culture, (iv) experience or interest in managed care and (v) a strong reputation for providing high quality medical care in its community.
Developing and Acquiring Small Physician Practice Groups. In markets including the Pacific Northwest, many communities are too small to support the typical PPI primary care-based multi-specialty group practice hub. There are many primary care-based medical groups with fewer providers that have significant market presence. Opportunities for growth may arise in market segments other than the physician-owned, primary care-based multi-specialty groups, such as independent practice associations ("IPAs") and provider hospital organizations ("PHOs"). PPI may consider acquiring the assets of physicians from hospital systems, HMOs or academic medical centers.
SERVICES
Each clinic affiliated with PPI offers a wide range of primary and specialty physician care and ancillary services through organized physician groups. Approximately 52% of the providers affiliated with PPI are primary care providers and approximately 48% practice various medical and surgical specialties. The primary care physicians are those concentrating in family practice, internal medicine and pediatrics.
Medical and surgical specialties include:
Allergy and Asthma Neurology Behavioral Health Obstetrics Cardiology Occupational Medicine Critical Care Oncology Dietician Ophthalmology Dermatology Optometry Endocrinology Orthopedics Gastroenterology Otolaryngology Gynecology Podiatry Hematology Rheumatology Immunology Surgery- General and Vascular Infectious Disease Urology Nephrology
In addition to medical services, the clinics affiliated with PPI offer a number of ancillary services through facilities within their offices, including cardiopulmonary and clinical laboratories, renal dialaysis, physical therapy and radiology facilities, optical dispensary and pharmacies.
GOVERNMENT REGULATION
Many aspects of the health care industry are presently subject to extensive federal and state governmental regulation. Applicable federal and state laws include the fraud and abuse provisions of the federal Medicare and Medicaid statutes, which prohibit the solicitation, payment, receipt or offering of any remuneration, either direct or indirect, in exchange for or with the intent to induce the referral, of Medicare or Medicaid patients or for the recommendation, arranging, leasing or purchasing of goods or services for which payment may be made under the Medicare or Medicaid programs. Violation of the fraud and abuse laws is punishable with criminal and civil penalties. Federal law also imposes significant penalties for false or improper billings for physician services. In addition, the federal "Stark" law generally prohibits referrals by physicians for designated health services reimbursable under the Medicare and Medicaid programs to entities with which such physicians or their immediate family members have a financial interest.
There can be no assurance that review of the operations of the Old PCs prior to the Merger, or the operations of the New PCs and PPI after the Merger, by courts or regulatory authorities will not result in a determination or further action that could have a material adverse effect on PPI. Moreover, there can be no assurance that existing laws and regulations will not be amended, interpreted or applied in the future in such a way as to have a material adverse effect on PPI, or that additional laws will not be enacted.
Significant risk factors relating to the business of the Old PCs, the New PCs and PPI are described in more detail below.
Fraud and Abuse Laws
Certain provisions of the Social Security Act, commonly referred to as the "Anti-Kickback Statute," prohibit the offer, payment, solicitation, or receipt of any form of remuneration in return for the referral of Medicare or state health program patients or patient care opportunities, or in return for the recommendation, arrangement, purchase, lease or order of items or services that are covered by Medicare or state health programs. In recent years, there has been increasing scrutiny by law enforcement authorities, the United States Department of Health and Human Services, various state agencies, the federal and state courts and Congress, of financial arrangements between health care providers and potential sources of patient referrals to ensure that such arrangements are not disguised mechanisms to pay for patient referrals. The Anti-Kickback Statute is broad in scope and interpretations by various courts have been ambiguous or conflicting in certain respects. To the extent PPI is deemed to be either a referral source or a separate provider under the New PC Management Agreements that is in a position to influence referrals to or from physicians, the financial arrangements under these agreements could be subject to scrutiny and prosecution under the Anti-Kickback Statute.
Furthermore, each of the Old PCs has had a history of receiving and making referrals to providers in their respective communities. There can be no assurance that the business practices of the Old PCs prior to the consummation of the Merger would be construed to comply with the fraud and abuse laws in all respects by applicable federal and state authorities. PPI or the New PCs, as successors in interest to the Companies, would be subject to liability in connection with any enforcement action taken against the Old PCs by a regulatory enforcement agency with respect to such laws.
Physician Self-Referral Law Significant prohibitions against physician self-referrals for services covered by Medicare and Medicaid programs were enacted, subject to certain exceptions, by Congress in the Omnibus Budget Reconciliation Act of 1993. These prohibitions, commonly known as Stark II, amended prior physician self-referral legislation known as Stark I (which applied only to clinical laboratory referrals) by enlarging the list of services and investment interests to which the self-referral prohibitions apply. Effective January 1, 1995, Stark II prohibits a physician, or a member of his or her immediate family, from making referrals for certain "Designated Health Services" to entities in which the physician has an ownership or investment interest, or with which the physician has a compensation arrangement. In addition to the conduct directly prohibited by the law, the statute also prohibits schemes that are designed to obtain referrals indirectly that cannot be made directly. The penalties for violating the law include (i) a refund of any Medicare or Medicaid payments for services that resulted from an unlawful referral, (ii) civil fines, and (iii) exclusion from the Medicare and Medicaid programs. "Designated Health Services" include, among other things, clinical laboratory services, radiology and other diagnostic services, radiation therapy services, durable medical equipment, prosthetics, outpatient prescription drugs, home health services and inpatient and outpatient hospital services. Stark II prohibitions include referrals within the physician's own group practice (unless the practice satisfies the "in-office ancillary services" exception) and referrals in connection with physicians' employment arrangements (unless the arrangement satisfies the "in-office ancillary services" or "employment" exceptions). In addition, Stark II applies to indirect financial arrangements. To the extent physicians managed by the Company are determined to have an indirect financial relationship with physicians in separate practices which are managed by the Company, absent a Stark II exception, referrals for Designated Health Services between physicians in different practices could be prohibited. Stark II also prohibits billing the Medicare or Medicaid programs for services rendered in conjunction with prohibited referrals. Noncompliance with, or violation of, Stark II can result in exclusion from the Medicare and Medicaid programs and civil penalties. The Company believes that its operations and those of the New PCs as presently conducted do not pose a material risk of liability under Stark II, primarily because PPI does not currently provide "Designated Health Services." Nevertheless, there can be no assurance that Stark II will not be interpreted or hereafter amended in a manner that has a material adverse effect on the Company's operations as presently conducted.
In this regard, on January 9, 1998, the Health Care Financial Administration published proposed regulations interpreting the scope and refining the application of the Stark II law. These regulations provide, in the case of Designated Health Services provided by a "group practice," that the overhead expenses and income from such group practice must be distributed according to methods that indicate that the practice is a unified business and not based on each satellite office operating as if it were a separate enterprise. Only "group practices" as defined by Stark II can utilize the general exception under the law for "in-office ancillary services." There can be no assurance that the distribution methodology of the New PCs will meet the unified business requirement or that each of the New PCs otherwise will be deemed to be a "group practice" if challenged. A determination that sharing of overhead expenses and income by the New PCs does not comply with Stark II or failure to satisfy any other criteria necessary to qualify for the "in-office ancillary services" exception to the Stark II prohibition would preclude physician owners of a New PC from referring Medicare/Medicaid patients to such New PC for Designated Health Services, and could have a material adverse effect on the Company.
In addition, the proposed regulations contemplate that the issuance to physicians of stock in a company prior to such company being publicly traded may not satisfy the Stark exception for ownership interests in publicly traded companies. Thus, to the extent PPI becomes a provider of Designated Health Services, the New PC physicians who have received stock in PPI before it is public may be precluded from them making Medicare/Medicaid referrals to the Company and, under certain circumstances, to other affiliated medical groups, for Designated Health Services, which could have a material adverse impact on the Company.
The Corporate Practice of Medicine
Certain laws prohibit the practice of medicine by corporations other than professional corporations. It is possible that the operations of PPI could be challenged on grounds that PPI, a business corporation, will participate in operations or revenues of the New PCs and other PPI-managed medical practices to a prohibited extent. Oregon law regarding the corporate practice of medicine does not specifically approve or forbid practice management companies from contracting with professional corporations and has been subjected to limited judicial and regulatory interpretation. Therefore, no assurance can be given that PPI's activities will be found to be in compliance with state law if challenged. In the event of a prohibition against the PPI form of business, the relationship between PPI and each of the New PCs may have to be modified, possibly resulting in a reduction of revenues received by PPI for managing the New PCs.
Fee-Splitting Laws
The laws of many states prohibit physicians from splitting fees with non-physicians. Although Oregon currently does not have such a prohibition, there is no assurance that Oregon will not enact new laws or interpret existing laws in a manner that would require modifications to PPI's business in order to comply with such a law. In addition, expansion of the operations of PPI to jurisdictions that have laws that could be deemed to restrict or prohibit PPI's form of arrangement with managed medical groups may require structural and organizational modifications to PPI's form of management relationship, which could have an adverse effect on PPI.
Medicare/Medicaid Reimbursement
State and federal civil and criminal statutes impose substantial penalties, including civil and criminal fines and imprisonment, upon health care providers who fraudulently or wrongfully bill governmental or other third-party payors for health care services. The federal law prohibiting false billings allows a private person to bring a civil action in the name of the United States government for violations of its provisions. While management of each New PC has attempted to comply with billing requirements, there is no assurance that PPI's or the New PCs' activities will not be challenged or scrutinized by governmental authorities. Moreover, Medicare and other reimbursement rules impact the fee structure of medical billing. To the extent PPI's or the New PCs' billing arrangements may need to be modified to comply with existing or modified regulations, there could be a material adverse financial effect on PPI.
Oregon Insurance Law
The Oregon Department of Consumer and Business Affairs, Insurance Division (the "Insurance Division"), regulates the transaction of insurance pursuant to the Oregon Insurance Code. Pursuant to Insurance Division Bulletin 96-2 (the "Bulletin") issued in April 1996 by the Oregon Insurance Commissioner, health care providers that are compensated on a capitated basis by a health insurer or health care service contractor ("HCSC") are not required to obtain a certificate of authority to transact insurance if the capitation is internal to a policy of insurance that is delivered by an authorized insurer or HCSC. The Bulletin also states that discounted fee-for-service arrangements with reasonable limits on discounts (i.e., not open-ended discounts) also do not require a certificate of authority. PPI arrangements should fall into these categories and therefore be exempt from regulation as an insurance company. There is no assurance, however, that the position of the Insurance Division will not change in the future. In such an event, PPI may be required to restructure its New PC Management Agreements or apply for a certificate of authorization, which could have a material adverse effect on PPI.
Antitrust Laws
Because the New PCs are separate legal entities they may be deemed competitors subject to a range of antitrust laws which prohibit anti-competitive conduct, including price fixing, concerted refusals to deal and division of market. There is no assurance that the review of the businesses of the New PCs and PPI by courts or regulatory authorities will not result in a determination that could have a material adverse effect on PPI.
Proposed Legislation
In addition to current federal regulations, the Clinton Administration and several members of Congress have proposed legislation for significant reforms affecting the payment for and availability of health care services. Aspects of certain such health care proposals, such as reductions in Medicare and Medicaid payments and additional prohibitions on direct or indirect physician ownership of facilities to which they refer patients, if adopted, could have a material adverse effect on PPI. There can be no assurance as to the ultimate content,
timing or effect of any health care reform legislation, nor is it possible at this time to estimate the impact of potential legislation on PPI.
COMPETITION
In general, both the physician management industry and the health care provider industry are highly competitive. Competition in the provision of medical services in the markets where PPI operates come from an increasing variety of providers who are in or have recently entered the physician provider business (e.g., other group practices, hospital systems, IPAs, HMOs, and academic medical centers). In the three markets presently served by the New PCs, hospital systems employ primary care physicians who compete directly against the New PCs. While PPI seeks to acquire groups with significant market presence, there can be no assurance that PPI or the New PCs can successfully compete with other provider competitors.
With respect to physician practice management companies, only three, MedPartners, Inc. ("MedPartners"), American Oncology Resources ("AORI") and PhyCor , Inc. ("PhyCor") have a presence in any of the markets currently served by the New PCs. All of these publicly traded PPMs have holdings in the Portland, Oregon market. MedPartners manages a multi-specialty group practice of approximately 70 physicians in the Portland market. MedPartners has been an aggressive suitor of physician groups in the Portland market. AORI has oncology providers in the Portland market which are in direct competition with HealthFirst's oncology practice and PhyCor has an indirect presence in the Portland market at the Vancouver Clinic in Vancouver, Washington. In the larger context of PPI's regional and national strategic growth plan in the pursuit of quality primary care-based multi-specialty group practice acquisitions, PPI directly competes with public as well as private physician practice management companies. There can be no assurance that PPI can successfully compete against other PPMs in such markets in the future.
EMPLOYEES
As of December 31, 1997, the Company employed approximately 1,600 people including 17 in the corporate office. None of the Company's employees is in a labor union and the Company considers its relations with its employees to be excellent.
INSURANCE
The business of the Company entails an inherent risk of claims of provider professional liability. To protect its overall operations from such potential liabilities, the Company maintains professional liability insurance and general liability insurance on a claims-made basis. Management does not believe professional liability exposure is significant; however, there can be no assurance that a future claim will not exceed the limits of available insurance coverage or that such coverage will continue to be available. The Company carries worker's compensation insurance and maintains multiperil liability, fiduciary liability, employee dishonesty, professional liability, general liability and directors and officers' insurance. The Company believes these types of insurance to be customary and reasonable for a business of its kind.
ITEM 2:
ITEM 2: PROPERTIES
The Company's executive office is located at 111 SW Columbia Street, Portland, Oregon. The Company believes these arrangements and the additional locations discussed below are adequate for its current uses and anticipated growth.
In addition to the corporate office, the Company leases and occupies clinics, offices or facilities in 24 locations throughout the Portland, Corvallis and Medford, Oregon areas.
In connection with the Medford Clinic, PC, two other properties, the Redwood Dialysis Center and the Rogue Valley Dialysis Center facilities, are currently owned by PPI. The mortgages of these properties were assumed by the Company as a result of the Merger.
ITEM 3:
ITEM 3: LEGAL PROCEEDINGS
Physicians, hospitals and other participants in the health care industry are subject to an increasing number of lawsuits alleging medical malpractice and related claims. Many of these lawsuits involve large claims and substantial defense costs. Although neither PPI nor its employees practice medicine, it is subject to the risks associated with medical malpractice and related litigation. PPI along with the New PCs are currently engaged in the defense of lawsuits arising in the ordinary course and conduct of its business. PPI believes that such actions will not have a material effect on its business.
ITEM 4:
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The 1997 Annual Meeting of Stockholders of PPI was held on January 28, 1998. Three Class 1 Directors, Tim E. Dupell, Michael F. Bonazzola, M.D. and Mark Leavitt, M.D., were elected to the Board of Directors of PPI at such meeting. The term of the new directors commences on January 28,1998 and expires at the annual meeting of stockholders to be held in 2000. David M. Goldberg, M.H.A., Bruce E. Van Zee, M.D., David H. Cutsforth, Jr., M.D., Russell A. Dow, M.D. and Douglas M. Mancino, Esq. and Dan Gregorie, M.D. continued as directors after the 1997 Annual Meeting of Stockholders. The following chart tabulates the number of votes cast for and against each director nominated for election at such Annual Meeting; there were no abstentions.
For Against
Tim E. Dupell 3,844,203 419,798
Michael F. Bonazzola, M.D. 4,122,522 141,479
Mark Leavitt, M.D. 4,149,349 114,652
PART II
ITEM 5:
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
There is no public trading market for the Company's common stock.
ITEM 6:
ITEM 6: SELECTED FINANCIAL DATA
ITEM 7:
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion includes some forward-looking statements that involve a number of risks and uncertainties. Actual results may differ materially from historical results or from the results discussed in such forward-looking statements or outcomes otherwise currently expected or sought by PPI.
OVERVIEW
PPI is a physician practice management company ("PPM") that operates primary care and multi-specialty clinics in the Pacific Northwest. PPI was formed in June 1996 in connection with certain reorganization and merger transactions (the "Transactions") contemplated by the Amended and Restated Agreement and Plan of Reorganization and Merger (the "Reorganization and Merger Agreement") among Medford Clinic, PC ("Old Medford"), HealthFirst Medical Group, PC ("Old HealthFirst"), The Corvallis Clinic, PC ("Old Corvallis," and, together with Old Medford and Old HealthFirst, referred to herein, collectively as "the Old PCs", and PPI, which transactions were consummated on February 1, 1997. Pursuant to the terms of the Reorganization and Merger Agreement, each Old PC affected (a) a reorganization (the "New PC Reorganization") of its corporate structure by (i) incorporating a wholly-owned professional corporation subsidiary ( a "New PC"), (ii) transferring to the
New PC certain assets and liabilities relating to the provider professional services business, (iii) making a pro rata distribution to its shareholders of all of the capital stock of the New PC, (iv) converting such Old PC from a professional corporation to a business corporation and (v) entering into a 40-year management agreement (the "Management Agreement") with PPI and (b) a merger (the "Merger") with and into PPI, resulting in consolidation of the operations (other than the provider professional services businesses) of the Old PCs.
In exchange for providing management services under the Management Agreement, and certain facilities and equipment to the managed clinics, PPI is reimbursed for all managerial costs and expenses ("Manager's Expenses") incurred by PPI and is paid a management fee. The management fee is 16% of (i) net revenues relating to services provided by the New PCs less (ii) Manager's Expenses. PPI has a Management Agreement with each of the three New PCs, i.e., HealthFirst Medical Group, PC, Medford Clinic, PC and The Corvallis Clinic, PC
The three New PCs have 25 clinical delivery sites and nearly 302 providers. PPI's strategy is to pioneer innovative health care delivery into the 21st century as a leading primary care-based multi-specialty group PPM. PPI endeavors to deliver high quality health care by involving physicians at every level of the organization. The majority of PPI's common stock is owned by physicians and the Board of Directors maintains a physician majority.
To increase revenues, PPI is working with the New PCs to recruit additional physicians, merge other physician groups in the area into the New PCs, and aid in the negotiation of managed care contracts. PPI is working on initiatives anticipated to reduce the New PCs' Manager's Expenses through regional purchasing and insurance contracts and through the consolidation of various services. PPI intends to expand its presence in the Pacific Northwest through acquisitions of physician groups in new areas.
In 1997, PPI began modifying its computer system programming to process transactions in the year 2000. Anticipated spending for this modification will be expensed as incurred and is not expected to have a significant impact on the Company's onging results of operations.
RESULTS OF OPERATIONS
Reorganization costs of $0.7 million in the year ended December 31, 1997 and $1.3 million in the period ended December 31, 1996 were incurred to complete the Transactions. These costs consisted of legal, accounting and printing expenses and will not continue after 1997. Corporate costs of $2.8 million and $.7 million in 1997 and 1996, respectively, consisted of the Salaries, Wages and Benefits of PPI management, outside professional expenses, and the operating expenses of the corporate office. These costs will increase in 1998 as PPI continues to build its management team.
PRO FORMA INFORMATION
As previously discussed, the Merger of the Old PCs with and into PPI became effective February 1, 1997. As a result of the Merger, PPI succeeded to the ownership of substantially all of the assets and liabilities of the Old PCs. Also, an integral part of the Merger was the Management Agreement that calls for PPI providing physician practice management services to each of the three New PCs.
The actual results reflect only eleven months of post Merger operating activities in the twelve months ended December 31, 1997 and no operating activities for 1996. Summarized unaudited pro forma financial information
is presented below. The pro forma balance sheet is presented as if the Merger had occurred on December 31, 1996, and the pro forma income statements are presented as if the Merger had taken place on January 1, 1996.
Summarized Unaudited Pro Forma Balance Sheet as of December 31, 1996 (all amounts are in thousands):
Summarized Unaudited Pro Forma Income Statement as of December 31, 1996 and 1997 (all amounts are in thousands, except earnings per share):
This pro forma financial information has been prepared by PPI based on the historical financial statements of PPI and the Old PCs. The pro forma income statements reflects the following adjustments to historical results:
a. Elimination of net revenues of the Old PCs from providing medical services as these revenues will be retained by the New PCs for the year ended December 31, 1996 and the period ended January 31, 1997.
b. Elimination of historical costs for provider compensation and benefits as such costs will be the responsibility of the New PCs for the year ended December 31, 1996 and the period ended January 31, 1997.
c. Addition of the revenues to be earned by PPI under the terms of the Management Agreement for the year ended December 31, 1996 and the period ended January 31, 1997.
d. PPI's corporate overhead costs in 1997 were adjusted to include the costs in January 1997. The 1996 results were adjusted to reflect corporate overhead costs similar to 1997.
e. Elimination of nonrecurring costs related to the New PC Reorganization and Merger.
f. Elimination of historical provision for income taxes and addition of provision for income taxes based on pro forma pretax net income.
g. Elimination of $1.5 million of transition plan expenses and $1.0 million provision against the receivables from the New PCs in 1997.
The pro forma income statements may not be indicative of actual results if the Transactions had occurred on the dates indicated or which may be realized in the future.
PRO FORMA RESULTS:
The increase in the reimbursement of Manager's Expenses of $4.0 million, or 3.7%, to $111.6 million for the twelve months ended December 31, 1997 from $107.6 million for the twelve months of 1996 is mainly attributable to increases in Purchased Medical Services and General and Administrative expenses. Purchased Medical Services increased $1.7 million or 8.4% to $21.9 million in 1997 compared to $20.2 million in 1996 due to an increase in capitated lives in the various managed care plans and higher utilization. Manager's Expenses will continue to increase as the New PCs' revenues increase, however, they are expected to remain relatively stable as a percentage of net revenues. The $1.5 million increase in General and Administrative expenses is due to various consulting projects completed in 1997.
The $0.7 million increase in management fees for the year ended December 31, 1997 compared to 1996 is due to an increase in the New PCs' revenues of $8.1 million only partially offset by the increase in Manager's Expenses of $4.0 million. PPI anticipates that management fee revenue will continue to increase as the New PCs' operating results improve and PPI acquires the assets of additional clinics.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity
Working capital increased from a $.1 million deficit at December 31, 1996 to a surplus of $.9 million at December 31, 1997 which is due to the assumption of the Old PCs' assets and liabilities on February 1, 1997. Based on the pro forma December 31, 1996 balance sheet, working capital increased $9.8 million to a $.9 million surplus from an $8.9 million deficit at December 31, 1996. The increase is due to a construction loan classified as short-term at December 31, 1996 being converted to long-term debt in the second quarter 1997 and the use of the proceeds from the sale of preferred stock to reduce current liabilities. Cash flows from operations used $4.1 million in the year ended December 31, 1996 and used $2.3 million in the year ended December 31, 1997. The use of funds in the year ended December 31, 1996 is primarily due to the net increase in the Receivable from New PCs of $3.0 million and the $2.5 million decrease in accrued compensation which were partially offset by an increase in drafts. The decrease in accrued compensation is due to funding the 1996 employer's portion of HealthFirst's and Medford's defined contribution plans with proceeds from the sale of preferred stock to First Union (see subsequent section - "Redeemable Preferred Stock").
At December 31, 1997, PPI had cash and cash equivalents of approximately $1.8 million and $9.5 million available under its operating line of credit. PPI believes that the cash and cash equivalents, combined with the line of credit and cash flows from operations is sufficient to meet PPI's planned capital expenditures and working capital needs for the next 12 months.
Capital Expenditures
Capital expenditures in the year ended December 31, 1997 were $2.6 million. Capital expenditures during 1997 consist mainly of purchases of medical and office equipment. Capital expenditures in 1998 could increase if certain investments are made in ancillary services.
Line of Credit
The Transactions resulted in PPI assuming all debt obligations of the Old PCs. The Old PCs previously had separate lines of credit with an aggregate $5.5 million limit. In February 1997, the individual lines of credit were consolidated into one operating line of credit with a $7.5 million limit made available by U.S. Bank of Oregon. In August 1997, the line of credit was increased to $15.0 million in anticipation of potential acquisitions. PPI, at it's discretion, may make borrowings at prime rate or in $.5 million increments at LIBOR plus LIBOR margin. At December 31, 1997, $5.5 million was outstanding under the line of credit with an effective interest rate of 8.5%. The line has an annual commitment fee on the unused portion of .375%. The line of credit contains certain covenants which amoung other things, require PPI to meet certain fininancial obligations. However, subsequent to year-end the Bank agreed to waive the covenant violations for the year ended December 31, 1997. At December 31, 1997, PPI had approximately $9.5 million available under the operating line of credit.
Redeemable Preferred Stock
On July 10, 1997, PPI and First Union Capital Partners, Inc. ("First Union") entered into the Preferred Stock and Warrant Purchase Agreement (the "Purchase Agreement"). Pursuant to the Purchase Agreement, First Union purchased from PPI, for a total purchase price of $15 million (i) 15,000 shares of Series B Cumulative Redeemable Preferred Stock of PPI ("Preferred Shares") and (ii) a Common Stock Purchase Warrant (the "Warrant") to purchase up to 1,799,893 shares (the "Warrant Shares") of Class B Common Stock of PPI at an exercise price of $.01 per share. The Preferred Shares rank senior to all other classes of capital stock of PPI as to liquidation, dividends, redemptions and any other payment or distribution with respect to capital stock. Any portion of the Preferred Shares may be redeemed at any time at a price equal to $1,000 per share plus accrued and unpaid dividends, which accrues at the annual rate of 9%, provided that all Preferred Shares must be redeemed by June 30, 2005 or earlier upon the occurrence of certain enumerated events (including change in control of PPI, public offering by PPI, failure by PPI to meet certain financial covenants or a material breach under the Purchase Agreement).
The number of Warrant Shares that First Union may purchase under the Warrant may be reduced to 687,919 shares if the Preferred Shares are redeemed in full by June 30, 1998, to 942,784 if redeemed in full by June 30, 1999 and to 1,212,228 if redeemed in full by June 30, 2000. First Union has the right to sell to PPI the Warrant and the Warrant Shares at a price equal to fair market value after June 30, 2002 or, if earlier, upon the occurrence of certain enumerated events, which events are similar to those that piggyback and other registration rights. First Union and any subsequent holders of Preferred Shares, the Warrant and Warrant Shares are prohibited from transferring such securities to any competitor of PPI.
The warrant was valued at $6,115 at July 10, 1997. The value was based on probability factors assigned to the various share amounts which may be issued and the fair market value per share. The warrants and preferred stock are being accreted up to their fair market value to the earliest potential redemption date. At December 31, 1997 the value of the warrants approximates the redemption value at June 30, 1998. The preferred stock was valued at $8,590 at July 10, 1997. The preferred stock is being accreted up to its redemption value of $15,000 by June 30, 1998. Accordingly, $3,205 of accretion has been charged to Retained Earnings in 1997.
Of the available proceeds (net of $.3 million of transaction costs) $13.3 million were used during the year ended December 31, 1997 to retire debt of $9.9 million and fund accrued pension contributions of $3.4 million assumed by PPI in the Transactions. The retirement of debt will reduce future interest expense and principal payments.
It is uncertain at this time what funds will be used to redeem the preferred stock. Management will continue to evaluate the various sources of financing available, including but not limited to, traditional commercial bank debt, private debt, private equity, public equity and public debt.
Acquisitions
PPI is currently involved in acquisition discussions with various medical clinics. PPI has entered into an initial agreement with one clinic and is currently negotiating letters of intent with other clinics. Management anticipates consummating a transaction in the second quarter of 1998. Management believes the existing line of credit of $15.0 million, with availability of $9.5 million as of December 31, 1997, is adequate to fund these acquisitions.
Management continues to evaluate various alternatives to finance potential acquisitions which may exceed the existing available funding. Such alternatives include but are not limited to, traditional commercial bank debt, private debt, private equity, public equity and public debt. The availability and timing of these alternatives depend on market and other conditions and the acceptability of the terms of such financing alternatives to PPI.
ITEM 8:
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and accompanying notes to financial statements, together with the report of independent public accountants are located on the following pages.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of Physician Partners, Inc.:
We have audited the accompanying balance sheets of Physician Partners, Inc. (a Delaware corporation) as of December 31, 1996 and 1997, and the related statements of operations, stockholders' equity and cash flows for the period from inception (June 20, 1996) to December 31, 1996 and for the year ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Physician Partners, Inc. as of December 31, 1996 and 1997, and the results of its operations and its cash flows for the period from inception (June 20, 1996) to December 31, 1996 and for the year ended December 31, 1997 in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Portland, Oregon, March 27, 1998
PHYSICIAN PARTNERS, INC.
BALANCE SHEETS--DECEMBER 31, 1996 AND 1997
(All dollar amounts are expressed in thousands)
ASSETS
PHYSICIAN PARTNERS, INC.
BALANCE SHEETS--DECEMBER 31, 1996 AND 1997 (CONTINUED)
(All dollar amounts are expressed in thousands)
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
The accompanying notes are an integral part of these balance sheets.
PHYSICIAN PARTNERS, INC.
STATEMENTS OF OPERATIONS
FOR THE PERIOD FROM INCEPTION (JUNE 20, 1996) TO DECEMBER 31, 1996
AND THE YEAR ENDED DECEMBER 31, 1997
(All dollar amounts are expressed in thousands except loss per share)
The accompanying notes are an integral part of these statements.
PHYSICIAN PARTNERS, INC.
STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
FOR THE PERIOD FROM INCEPTION (JUNE 20, 1996) TO DECEMBER 31, 1996
AND THE YEAR ENDED DECEMBER 31, 1997
(All dollar amounts are expressed in thousands)
The accompanying notes are an integral part of this statement.
PHYSICIAN PARTNERS, INC.
STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT) (CONTINUED)
FOR THE PERIOD FROM INCEPTION (JUNE 20, 1996) TO DECEMBER 31, 1996
AND THE YEAR ENDED DECEMBER 31, 1997
(All dollar amounts are expressed in thousands)
The accompanying notes are an integral part of this statement.
PHYSICIAN PARTNERS, INC.
STATEMENT OF CASH FLOWS
FOR THE PERIOD FROM INCEPTION (JUNE 20, 1996) TO DECEMBER 31, 1996
AND THE YEAR ENDED DECEMBER 31, 1997
(All dollar amounts are expressed in thousands)
PHYSICIAN PARTNERS, INC.
STATEMENT OF CASH FLOWS (CONTINUED)
FOR THE PERIOD FROM INCEPTION (JUNE 20, 1996) TO DECEMBER 31, 1996
AND THE YEAR ENDED DECEMBER 31, 1997
(All dollar amounts are expressed in thousands)
The accompanying notes are an integral part of this statement.
PHYSICIAN PARTNERS, INC.
NOTES TO FINANCIAL STATEMENTS
(All dollar amounts are expressed in thousands, except loss per share)
1. BUSINESS AND ORGANIZATION:
Physician Partners, Inc. (PPI), is a Delaware corporation formed on June 20, 1996 for the purpose of effecting a reorganization transaction between PPI and HealthFirst Medical Group, PC ("HealthFirst"), The Corvallis Clinic, PC ("Corvallis") and The Medford Clinic, PC ("Medford"), (collectively, "The Founding Clinics").
This transaction, which was consummated on February 1, 1997, resulted in a separation of operations of the three Founding Clinics between medical professional services activities (i.e., providers of medical services) and the physician practice management activities of the business. The professional services activities were spun off into newly formed professional corporations ("New PCs"). The physician practice management business, along with substantially all of the assets and liabilities of the three Founding Clinics, i.e., cash, receivables, inventories, prepaids, property, plant and equipment, payables, accruals, debt, and certain contractual commitments, were transferred to PPI at historical cost. As consideration, the stockholders of the existing Founding Clinics received stock of PPI.
An integral part of the reorganization is a 40-year management agreement that calls for PPI to provide physician practice management services to the New PCs. Services provided include management and administrative services, capital resources, facilities, equipment and supplies. PPI is entitled to (a) reimbursement of all managerial costs and expenses (Manager's Expenses) incurred by PPI and (b) a management fee equal to 16% of (i) net revenues relating to services provided by the New PCs less (ii) Manager's Expenses.
The New PCs are responsible for providing medical services and the related costs for provider compensation and benefits.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Selected accounting policies are discussed below. Other significant accounting policies regarding revenues, income taxes, professional liability and deferred compensation are discussed in specific notes that follow.
Cash Equivalents
Cash equivalents consist of all highly liquid investments with original maturities of three months or less.
Restricted Investments
Under Medford Clinic, P.C.'s agreement with Oregon Health Management System ("OHMS"), PPI is required to maintain $250 in a restricted or segregated account. PPI can use these funds for purchased medical services only with approval by OHMS.
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Concentration of Credit Risk
PPI extends credit to patients covered by commercial insurance, Medicare and Medicaid. PPI manages credit risk with the various public and private insurance providers, as deemed appropriate by management. Allowances for contractual discounts and uncollectable accounts have been made for potential losses, where appropriate. Per the terms of the Management Agreement the New PCS bear the risk of potential losses.
Healthcare Receivables
Certain of PPI's contracts with health plans include risk-sharing features involving PPI, participating hospital and the health plan. Amounts recorded at year-end represent management's estimates of the net settlement amounts expected. Differences between management's estimates and the ultimate settlement for each health plan are recorded in the year final settlement occurs.
Receivables from New PCs
Receivables from New PCs include advances made during 1997 to the New PCs. The receivables bear interest at 7.6% with interest only payments due in 1998 and principal and interest payments due over a three year period beginning January 1999. A $ 1,000 allowance has been recorded against the receivable.
Inventories of Drugs and Supplies
Inventories are stated at the lower of cost or market, determined by the first-in, first-out (FIFO) method.
Property, Plant and Equipment
Property, plant and equipment are stated at cost. Maintenance, repairs and minor replacements are expensed as incurred. When properties are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts and any gain or loss on disposition is recorded as other income or expense.
Depreciation is computed using the straight-line method over the estimated useful lives of the respective assets. Equipment under capital lease is amortized using straight-line methods over the shorter of the period of the lease term or the estimated useful life of the equipment. Estimated lives are as follows:
Buildings and leasehold improvements 7-40 years Furniture and equipment 3-15 years
Accrued Healthcare Costs
Accrued healthcare costs are calculated based on reported claims and an estimate based on historical data of incurred but not reported claims.
Fair Value of Financial Instruments
The carrying amounts of cash equivalents, receivables, accounts payable and accrued expenses are a reasonable estimate of their fair value based on the short maturities of these instruments.
Interest rates that are currently available to PPI for issuance of debt with similar terms and remaining maturities were used to estimate fair value for debt issues. The current carrying value of debt approximates fair value.
PPI does not hold or issue financial instruments or derivative financial instruments for trading purposes.
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Notes Receivable from Stockholders
PPI maintains various agreements with stockholders for their purchase of common stock. These agreements were originally made by The Founding Clinics and were transferred to PPI in the Reorganization Transaction. The notes mature at various stages through 2008.
Transition Plan Expenses
In 1997, PPI made one-time payments totalling $1,500 to the Founding Clinics.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Reclassifications
Certain prior year amounts have been reclassified to conform with the current year presentation.
3. NET REVENUES:
4. PROPERTY, PLANT AND EQUIPMENT:
Property, plant and equipment consists of the following:
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5. FINANCING:
Long-term debt at December 31, 1997 is as follows:
Maturities of long-term debt for the next five years, including current maturities, are as follows:
PPI maintains an unsecured revolving line-of-credit agreement providing up to $15,000. PPI, at its discretion, may make borrowings at prime rate or in $500 increments at LIBOR plus LIBOR margin. At December 31, 1997, $5,460 was outstanding under the line of credit with an effective interest rate of 8.5%. The line has an annual commitment fee on the unused portion of .375% and expires in July 1999.
Under terms of the revolving line of credit agreement, certain financial ratios and other covenants are required to be met. PPI was not in compliance with certain of these debt covenants due to the recognition of a $1,500 transition plan expense and $1,000 provision against the Receivables from New PCs as of December 31, 1997. Subsequent to year-end, the Bank agreed to waive the covenant violations for the year ended December 31, 1997. As the violation was due to one-time adjustments made in 1997, PPI anticipates being in compliance with all debt covenants at the next measurement date, March 31, 1998.
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6. LEASE COMMITMENTS:
Capital Leases
PPI leases certain medical equipment and facilities under agreements which are classified as capital leases. The equipment leases have original terms of five years and have either a bargain purchase option or a transfer of title at the end of the lease. The building lease is with Gateway Properties LLC for a term of 21 years. Leased capital assets included in property, plant and equipment at December 31, 1997 are as follows:
Operating Leases
Leases that do not meet the criteria for capitalization are classified as operating leases. Such lease commitments are primarily for facilities and equipment, and the related rentals are charged to operations as incurred.
Future Minimum Lease Payments
Future minimum lease payments, by year and in the aggregate, under noncancellable capital and operating leases with initial or remaining terms of one year or more consist of the following at December 31, 1997.
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Direct Financing Lease Obligations
In June of 1995, Corvallis contributed land, buildings, construction in process and related notes payable to HealthCare Partners, LLC (Note 6). At the date of transfer, Corvallis entered into 30-year lease agreements for the Asbury, Aumann and other buildings and a 5-year lease agreement for the Albany building. Monthly rental payments under these leases are $184. The assets were sold under a sale/leaseback arrangement and, therefore, this was accounted for as a financing transaction wherein the assets remain on Corvallis' books and continue to be depreciated. Corvallis recorded a direct financing lease obligation for cash received by Corvallis and obligations assumed by the LLC as part of the transaction which was assumed by PPI at February 1, 1997. The liability for this lease obligation was $13,922 at December 31, 1997.
Scheduled principal payments at December 31, 1997 are as follows.
1998 $242 1999 266 2000 287 2001 244 2002 810 Thereafter 12,073 ------ 13,922 ======
In May 1996, HealthFirst sold three facilities to HealthFirst Properties LLC (Note 6) under a sale/leaseback arrangement. The facilities were sold for $12,550, of which $11,550 is due in the form of an 8% interest-bearing note receivable due in monthly installments through April 2016. The remainder was received in cash. The transaction was accounted for as a financing, wherein the property and related debt remains on Healthfirst's books and will continue to be depreciated. A financing obligation representing the proceeds of $1,000 has been recorded and will be reduced based on payments under the lease. As sales proceeds are received from the LLC, they will be credited to a financing obligation, and amortized as a reduction of operating expenses over the remaining life of the lease. The amount owed on the financing obligation at December 31, 1997 was $894 of which $8 is due within one year. The lease has a term of 20 years and requires minimum annual rental payments of $1,318 in 1998, 1999, 2000, 2001 and 2002 and $17,680 thereafter. PPI assumed the financing lease obligation and the lease payments at February 1, 1997.
7. INCOME TAXES:
Income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109 (SFAS 109). SFAS 109 requires that PPI follow the liability method of accounting for deferred income taxes. Differences between accounting rules and tax laws cause differences between the bases of certain assets and liabilities for financial reporting purposes and tax purposes. The tax effect of these differences, to the extent they are temporary, are recorded as deferred tax assets and liabilities and consisted of the following:
PPI maintains a valuation allowance in an amount equal to its net deferred tax assets because of uncertainty with respect to the realization of the related tax benefits in future years.
The provision for income taxes, which is substantially federal expense (benefit), is as follows:
The differences between the provision (benefit) for income taxes and the amount computed by applying the statutory federal income tax rate to income before taxes were as follows:
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8. COMMON STOCK TRANSACTIONS:
The Founding Clinics were issued the initial 3,000 shares of PPI Class A common stock for $3 in 1996.
Stock awards aggregating 108,000 shares of PPI were granted to four officers of the Company in October 1996. The estimated fair value of these awards in the aggregate amount of $595 was recognized as compensation expense in 1996.
A director of the Company purchased 27,000 shares of PPI Class A common stock for $51. The price paid for the shares was based upon an independent appraisal. However, the estimated fair value of these shares for accounting purposes exceeded the purchase price by $98,740 and this amount was recognized as compensation expense in 1996.
In 1996, HealthFirst sold shares of common stock to selected providers at prices below their estimated fair value for accounting purposes. The terms of the related Restricted Stock Agreements require forfeiture of the stock unless the grantee remains employed by HealthFirst until February 1, 2002. The Unamortized value of the stock was recorded as a contra-equity account which was assumed by PPI in the Merger. The stock was exchanged for PPI common stock at February 1, 1997.
At February 1, 1997, 6,337,607 shares were issued to the shareholders of The Founding Clinics in connection with the Reorganization Transaction.
9. STOCK OPTION PLANS:
The reorganization plan included various stock option plans for PPI employees and directors, as well as providers employed by the new PCs. These plans have reserved a total of 2,500,000 shares of PPI Class A common stock for issuance under the plans. As of December 31, 1997 a total of 1,632,710 options had been granted. None were cancelled or exercised during 1997.
The Company applies APB No. 25 and related Interpretations in accounting for the plans. For SFAS No. 123 purposes, the fair value of each option grant has been estimated using the Black-Scholes option-pricing model with the following weighted average assumptions for grants in 1997: Dividend yield of 0%, expected volatility of 0%, risk-free interest rate of 6%, expected life of six years. Had compensation expense been determined consistent with SFAS No. 123. The weighted average fair value of options granted during 1997 was $2.17. Utilizing the assumptions detailed above, the Company's net loss per share for the year ended December 31, 1996 and 1997, would have increased as reflected in the following pro forma amounts:
The resulting pro forma compensation costs may not be representative of that expected in future years.
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The following table summarizes information about fixed stock options outstanding at December 31, 1997.
10. EARNINGS PER SHARE:
Effective December 31, 1997, the Company adopted SFAS 128, Earnings Per Share. SFAS 128 prescribes new calculations for Basic and Diluted Earnings Per Share (EPS), which replaces the former calculations for Primary and Fully Diluted EPS. Basic EPS is computed by dividing net income (loss) by the weighted average shares outstanding; no dilution for any potentially dilutive securities is included. Diluted EPS is calculated differently than the fully diluted EPS calculation under the old rules. When applying the treasury stock method for diluted EPS to compute dilution for options, SFAS 128 requires use of the average share price for the period, rather than the greater of the average share price or end-of-period share price. EPS is computed as follows:
(1) The effect of potential common stock equivalents is excluded from the dilutive calculation for the year ended December 31, 1996 and 1997 as their effect would be antidilutive.
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11. RETIREMENT PLANS:
PPI maintains several retirement plans for its employees. The various plans were originally set up by The Founding clinics. Descriptions of the various plans as of December 31, 1997 are as follows:
401(k) Profit Sharing Plan - Former Corvallis Employees
PPI has a 401(k) Profit-Sharing Plan (the 401(k) Plan) in which all former Corvallis employees are eligible to participate subject to certain eligibility criteria. The 401(k) Plan permits employees to contribute up to 10% of their annual compensation (not to exceed certain annual limits imposed by the Internal Revenue Code). PPI is required to make matching contributions equal to 50% of employee contributions up to 8% of the employee's compensation. PPI may also make discretionary contributions. All contributions are 100% vested.
Money-Purchase Pension Plan - Former Corvallis Employees
PPI has a Money-Purchase Pension Plan in which all former Corvallis employees are eligible to participate subject to certain eligibility criteria. PPI contributes 5.4% of the employee's eligible earnings up to $48 and 10.8% of eligible earnings in excess of $48. These contributions are 100% vested upon eligibility.
PPI's contributions for these plans for the year ended December 31, 1997, were $620.
Deferred Compensation
The Corvallis Clinic, P.C. provides compensation to eligible shareholders who retire based upon average shareholder income, as defined in the Employment Agreement, for the first three years following retirement. Provider/shareholder retirees who have 20-1/2 years of service while in service with Corvallis are eligible to receive such deferred retirement compensation. PPI assumed the liability as of February 1, 1997 in the reorganization transaction.
401(k) Profit-Sharing Plan - Former Medford Employees
PPI has a 401(k) Profit-Sharing Plan (the 401(k) Plan) in which all former Medford employees are eligible to participate subject to certain eligibility criteria. The 401(k) Plan permits employees to contribute up to 15% of their annual compensation (not to exceed certain annual limits imposed by the Internal Revenue Service). PPI may also make discretionary contributions, which are immediately 100% vested.
Money Purchase Pension Plans - Former Medford Employees
PPI also has a Money Purchase Pension Plan in which all former Medford employees are eligible to participate subject to certain eligibility criteria. PPI contributes 5.7% of the employee's eligible earnings up to $63 and 11.4% of eligible earnings in excess of limitations imposed by the Internal Revenue Service. These contributions are 100% vested upon eligibility.
PPI's contributions for these plan for the year ended December 31, 1997 were $1,107.
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401(k) Plan - Former HealthFirst Employees
PPI has a 401(k) plan covering all former HealthFirst employees who are eligible subject to certain requirements. Employees contribute between 2% to 10% of their annual compensation. PPI matches employee contributions at a rate of 10% plus a discretionary percentage determined by the Board of Directors. The contributions to the Plan were $122 in 1997.
Money Purchase Plans - Former HealthFirst Employees
PPI has a defined contribution money purchase plan which is a plan in which all former HealthFirst employees are eligible to participate subject to certain requirements. PPI contributes 3% of the employee's compensation for the plan year. Contributions in 1997 were $362.
Supplemental Pension Plan - Former HealthFirst Employees
In 1987, HealthFirst entered into a supplemental pension plan with eight of its physicians providing for fixed monthly payments over five years commencing with the physicians' retirements or terminations. The physicians receive payments upon retirement or termination if certain vesting requirements have been met. HealthFirst had accrued $176 for the plan at February 1, 1997. The accrual was assumed by PPI in the reorganization transaction.
Bonus Compensation Plan - Former HealthFirst Shareholders
In February 1996, HealthFirst established a bonus compensation plan for eligible Shareholders. Employees are vested after five years of employment with credit for price service. A substantial portion of the employees were fully vested as of December 31, 1996. The total payout of approximately $5.25 million will be over a period of eight years. PPI is accruing for the estimated present value of the bonus compensation over the estimated period of the employees' active employment from the date the contract was signed until the date they are fully vested. PPI assumed the liability at February 1, 1997. The amount accrued at December 31, 1997 is $3,357, of which $589 is included in current liabilities and the remainder is included in deferred compensation.
12. PROFESSIONAL LIABILITY:
PPI maintains a claims-made professional liability insurance policy for the providers employed by the New PCs. The policy includes full prior act coverage for claims incurred but not reported prior to February 1, 1997. The claims-made policy has no deductible. Management feels the coverage limits are adequate to cover any claims exposure. PPI accrues an estimate of the future liability for claims incurred but not reported prior to the end of the accounting period.
13. COMMITMENTS AND CONTINGENCIES:
Legal Proceedings
PPI is subject to various legal proceedings and claims which arise in the ordinary course of business. In the opinion of management, although the ultimate dispositions of these proceedings are not determinable, adverse determinations in any or all of such proceedings would not have a material adverse effect upon the financial position or results of operations of PPI.
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Compliance with Rules and Regulations
The healthcare industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government healthcare program participation requirements, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. Recently, government activity has increased with respect to investigations and allegations concerning possible violations of fraud and abuse statutes and regulations by healthcare providers. Violations of these laws and regulations could result in expulsion from government healthcare programs, together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Management believes that PPI is in compliance with the fraud and abuse regulations, as well as other applicable government laws and regulations. Compliance with such laws and regulations can be subject to future government review and interpretation, as well as regulatory actions unknown or unasserted at this time.
Employment Agreements
Several officers of PPI have employment agreements which establish annual compensation levels and also provide for an annual incentive bonuses. In the event the officers are terminated by PPI without cause, they would be entitled to termination benefits equivalent to one year of their base salary, and health and disability insurance for one year.
14. TREASURY STOCK:
Six shareholders of the Old PCs exercised their dissenters rights under the Oregon Business Corporation Act. Accordingly, they were entitled to receive the fair value of the shares they owned. PPI repurchased the dissenters' shares for an aggregate amount of $748.
15. PREFERRED REDEEMABLE STOCK:
PPI has authorized 50,000,000 shares of preferred stock, at $.01 par value. At December 31, 1996 and 1997, there were 0 and 15,000 shares outstanding, respectively.
On July 10, 1997, PPI and First Union Capital Partners, Inc. (First Union) entered into the Preferred Stock and Warrant Purchase Agreement (the Purchase agreement). Pursuant to the Purchase Agreement, First Union purchased from PPI, for a total purchase price of $15 million (i) 15,000 shares of Series B Cumulative Redeemable Preferred Stock of PPI (Preferred Shares) and (ii) a Common Stock Purchase Warrant (the Warrant) to purchase up to 1,799,893 shares (the Warrant Shares) of Class B Common Stock of PPI at an exercise price of $.01 per share. The Preferred Shares rank senior to all other classes of capital stock of PPI as to liquidation, dividends, redemptions and any other payment of distribution with respect to capital stock. Any portion of the Preferred Shares may be redeemed at any time at a price equal to $1,000 per share plus accrued and unpaid dividends, which accrue at the annual rate of 9%, provided that all Preferred Shares must be redeemed by June 30, 2005 or earlier upon the occurrence of certain enumerated events (including change in control of PPI, public offering by PPI, failure of PPI to meet certain financial covenants or a material breach under the Purchase Agreement).
The number of Warrant Shares that First Union may purchase under the Warrant may be reduced to 687,919 shares if the Preferred Shares are redeemed in full by June 30, 1998, to 942,784 if redeemed in full by June 30, 1999, and to 1,212,228 if redeemed in full by June 30, 2000. First Union has the right to sell to PPI the Warrant and the Warrant Shares at a price equal to fair market value after June 30, 2002 or, if earlier, upon the occurrence of certain enumerated events, which events are similar to those that require PPI to redeem Preferred Shares in full. First Union has certain demand, piggyback and other registration rights. First Union and any subsequent holders of Preferred Shares, the Warrant and Warrant Shares are prohibited from transferring such securities to any competitor of PPI.
The warrant was valued at $6,115 at July 10, 1997. The value was based on probability factors assigned to the various share amounts which may be issued and the fair market value per share. The warrants and preferred stock are being accreted up to their fair market value to the earliest potential redemption date. At December 31, 1997 the value of the warrants approximates the redemption value at June 30, 1998. The preferred stock was valued at $8,590 at July 10, 1997. The preferred stock is being accreted up to its redemption value of $15,000 by June 30, 1998. Accordingly, $3,205 of accretion has been charged to Retained Earnings in 1997. -12-
16. RELATED PARTY TRANSACTIONS:
HealthFirst Properties LLC
HealthFirst Properties LLC (HPLLC) was formed by certain shareholders of HealthFirst in 1996 to acquire three clinic buildings from HealthFirst. HPLLC purchased these properties from HealthFirst for an aggregate purchase price of $12,550, to be paid under an installment sale contract with a 20-year term. HPLLC made a $1,000 down payment to HealthFirst. Simultaneous with the execution of the installment sale contract, HealthFirst agreed to lease back the three buildings from HPLLC under a 20-year lease agreement. This transaction has been recorded as a direct financing lease. Accordingly, the monies received from HPLLC have been recorded as a direct financing lease obligation and the related property is included in property, plant and equipment in the accompanying financial statements.
Gateway Properties LLC
Gateway Properties LLC (Gateway) is owned by several former shareholders of The Suburban Medical Clinic, P.C. ("Suburban"). Throughout 1995, Suburban recorded notes receivable for various payments made on behalf of Gateway. The note receivable at December 31, 1997 was $94. The terms of the note include monthly installments of principal and interest of $5 through August 1999 with interest accruing at 7%. PPI assumed a capital lease to occupy a new clinic building for a term expiring in August 2015.
Investments in Affiliates
The Company's investments in affiliates consist of investments in various entities which are accounted for on the equity method. The names of these entities, carrying values and the percent of ownership held by PPI are summarized below:
Additional information regarding these investments is discussed below.
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Corvallis MRI:
Corvallis held a one-third interest in Corvallis MRI which was transferred to PPI on February 1, 1997. Corvallis MRI is a partnership organized in 1988 which owns and operates a magnetic resonance imaging (MRI) scanner. The MRI unit is housed in facilities leased from Good Samaritan Hospital Corvallis, another partner, and operated by Corvallis Radiology, P.C., the third partner.
During 1997, payments to Corvallis MRI for services provided to Corvallis were $156 and are included in purchased services.
HealthCare Partners, LLC
During the year ended November 30, 1995, Corvallis entered into a joint venture agreement with Good Samaritan Hospital, Corvallis to form a limited liability company to own and manage Corvallis' buildings and real properties and to serve as a vehicle for financing future property expansion for Corvallis. Corvallis contributed assets and liabilities in exchange for a 50% membership interest in the limited liability company. On February 1, 1997, Corvallis transferred their membership interest in HealthCare Partners, LLC to PPI.
The net book value of assets and liabilities contributed by Corvallis was $13,805 for buildings, land and construction in progress and $8,363 for related debt. In addition, Corvallis received $2,734 in cash reimbursements for the market value of the above contributed net assets in excess of the Hospital's contributed equity, as measured at the date of formation of the limited liability company.
This transaction has been accounted for as a financing due to the continuing involvement of Corvallis in the assets through its ownership interest in the limited liability company. Accordingly, the contributed property remains as an asset of Corvallis. The debt at the transaction date, together with the cash received for the excess value of the contributed net assets, has been included in the related financing obligations (Note 16).
Concurrent with the formation of the limited liability company, Corvallis entered into a lease agreement relating to buildings and properties which were contributed to the limited liability company which was assumed by PPI in the merger.
PPI has guaranteed approximately $6,100 of long-term debt associated with the above joint venture.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of The Corvallis Clinic, P.C.:
We have audited the accompanying balance sheets of The Corvallis Clinic, P.C. (an Oregon professional corporation) as of December 31, 1996 and 1997, and the related statements of operations, accumulated deficit and cash flows for the year ended November 30, 1995, the thirteen-month period ended December 31, 1996 and the year ended December 31, 1997. These financial statements are the responsibility of Corvallis' management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Corvallis Clinic, P.C. as of December 31, 1996 and 1997, and the results of its operations and its cash flows for the year ended November 30, 1995, the thirteen-month period ended December 31, 1996, and the year ended December 31, 1997 in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Portland, Oregon, February 12, 1998
THE CORVALLIS CLINIC, P.C.
BALANCE SHEETS - AS OF DECEMBER 31, 1996 AND 1997
(All dollar amounts are expressed in thousands)
The accompanying notes are an integral part of these balance sheets.
THE CORVALLIS CLINIC, P.C.
STATEMENTS OF OPERATIONS
FOR THE YEAR ENDED NOVEMBER 30, 1995, THE THIRTEEN MONTHS
ENDED DECEMBER 31, 1996 AND YEAR ENDED DECEMBER 31, 1997
(All dollar amounts are expressed in thousands, except earnings per share)
The accompanying notes are an integral part of these statements.
THE CORVALLIS CLINIC, P.C.
STATEMENTS OF CASH FLOWS
FOR THE YEAR ENDED NOVEMBER 30, 1995, THE THIRTEEN MONTHS
ENDED DECEMBER 31, 1996 AND THE YEAR ENDED DECEMBER 31, 1997
(All dollar amounts are expressed in thousands)
(continued)
THE CORVALLIS CLINIC, P.C.
STATEMENTS OF CASH FLOWS (CONTINUED)
FOR THE YEAR ENDED NOVEMBER 30, 1995, FOR THE THIRTEEN MONTHS
ENDED DECEMBER 31, 1996 AND THE YEAR ENDED DECEMBER 31, 1997
(All dollar amounts are expressed in thousands)
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES:
During 1995, Corvallis formed a limited liability company by contributing certain real property and associated debt in exchange for a 50% ownership interest in the new entity (Note 13).
Notes receivable from shareholders for purchase of stock during 1995 and 1996 were $23 and $13, respectively.
Corvallis received a noncash distribution from an affiliate during 1996 of $69.
Redemption of common stock in exchange for a payable of $132 during 1996.
In February 1997, Corvallis assigned all assets and liabilities to PPI as part of the reorganization and merger transaction. The book value of Corvallis' assets and liabilities at the date of the transaction are presented below:
The accompanying notes are an integral part of these statements.
THE CORVALLIS CLINIC, P.C.
STATEMENTS OF ACCUMULATED DEFICIT
FOR THE YEAR ENDED NOVEMBER 30, 1995, THE THIRTEEN MONTHS
ENDED DECEMBER 31, 1996 AND YEAR ENDED DECEMBER 31, 1997
(All dollar amounts are expressed in thousands)
The accompanying notes are an integral part of these statements.
THE CORVALLIS CLINIC, P.C.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1996 AND 1997 (All dollar amounts are expressed in thousands)
1. BUSINESS AND ORGANIZATION:
The Corvallis Clinic, PC (Corvallis), an Oregon professional corporation, was incorporated on September 18, 1996 under the name Physician Partners Corvallis, PC for the purpose of effecting a reorganization transaction between Physician Partners, Inc. (PPI) and three Oregon professional corporations (the Founding Clinics).
This transaction, which was consummated on February 1, 1997, resulted in a separation of operations of the three Founding Clinics between medical professional services activities (i.e., providers of medical services) and the physician practice management activities of the business. The professional services activities were spun off into newly formed professional corporations (New PCs). Corvallis is one of the new PCs. The physician practice management business, along with substantially all of the assets and liabilities of the three Founding Clinics, i.e., cash, receivables, inventories, prepaids, property, plant and equipment, other assets, payables, accruals, debt, and certain contractual commitments were transferred to PPI. The New PCs are responsible for providing medical services and the related costs for provider compensation and benefits. The assets transferred to the New PCs, which had zero carrying value, include the employment agreements between each Company and its providers, certain provider contracts under which the New PCs will be receiving fee-for-service compensation and patient medical records.
An integral part of the reorganization is a 40-year management agreement whereby PPI provides physician practice management services to the New PCs. Services to be provided include management and administrative services, capital resources, facilities, equipment and supplies. As consideration, PPI is entitled to (a) reimbursement of all managerial costs and expenses (Manager's Expenses) incurred by PPI and (b) a management fee equal to 16% of (i) net revenues relating to services provided by the New PCs less (ii) Manager's Expenses.
Essentially all of the cash remaining in the New PC after the payments to PPI under the management agreement will fund the compensation and benefits of providers employed by the New PCs.
Corvallis consists of approximately 83 professional providers who offer a wide range of primary and specialty care. In addition, Corvallis offers ancillary services such as physical therapy, optical, pharmacy, laboratory and imaging.
The majority of Corvallis operations are located in two facilities in Corvallis, Oregon. In addition, Corvallis operates four satellite offices: Albany Family Medicine, Corvallis Family Medicine, Philomath Family Medicine and Research Park. A significant change in the demographics of this area may have an adverse impact on the business.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OTHER INFORMATION:
Selected accounting policies are discussed below. Other significant accounting policies regarding revenues, income taxes, professional liability, deferred compensation and investments in affiliates are discussed in specific notes that follow.
Change in Fiscal Year End
Effective December 1, 1995, Corvallis changed its fiscal year end from November 30 to December 31. Accordingly, the 1996 fiscal year ended December 31, includes the results of operations for thirteen months.
Cash Equivalents
Cash equivalents consist of all highly liquid investments with original maturities of three months or less.
Concentration of Credit Risk
Corvallis extends credit to patients covered by commercial insurance, Medicare and Medicaid. Corvallis manages credit risk with the various public and private insurance providers, as deemed appropriate by management. Allowances for contractual discounts and uncollectible accounts have been made for potential losses, where appropriate.
Prepaid Provider Compensation
Prepaid provider compensation includes the amount paid to providers which are in excess of the earned amount computed in accordance with the Management Agreement (Note 1). The balance will be reversed in future years when the amount paid is less than the earned amount.
Inventories of Drugs and Supplies
Inventories are stated at the lower of cost or market, determined by the first-in, first-out (FIFO) method.
Property, Plant and Equipment
Property, plant and equipment are stated at cost. Maintenance, repairs and minor replacements are expensed as incurred. When properties are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts and any gain or loss on disposition is recorded as other income or expense.
Depreciation is computed using both accelerated and straight-line methods over the estimated useful lives of the respective assets. Equipment under capital lease is amortized using the straight-line method over the shorter of the period of the lease term or the estimated useful life of the equipment. Estimated lives are as follows:
Building and building improvements 7-40 years Furniture and equipment 5-15 years
Accrued Healthcare Costs
Accrued healthcare costs are calculated based on reported claims and an estimate based on historical data of incurred but not reported claims. These accrued healthcare cost estimates will vary from actual results and the differences may be significant.
Payable to PPI
Corvallis signed a note payable to PPI, bearing interest at 7.6%. Interest only payments are due in 1998 and monthly installments of principal and interest payments are due beginning January 1999 for three years.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, patient accounts receivable, accounts payable and accrued expenses are a reasonable estimate of their fair value based on the short maturities of these instruments.
Interest rates that are currently available to Corvallis for issuance of debt with similar terms and remaining maturities were used to estimate fair value for debt issues. The current carrying value of debt approximates fair value.
Corvallis does not hold or issue financial instruments or derivative financial instruments for trading purposes.
Notes Receivable from Stockholders
Corvallis maintains various agreements with stockholders for their purchase of common stock. The notes bear interest at 6.52% and mature at various stages through the year 2006.
Other Income
Other income includes a $600 one time payment from PPI. The payment was part of a transition plan developed by PPI to assist Corvallis in its transition to the Management Agreement.
Provider Compensation and Benefits
Provider compensation and benefits consist of the direct costs of patient care providers such as physicians and other allied health professionals. A substantial portion of these costs are paid to providers who are stockholders.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Financial Statement Presentation
The accompanying financial statements reflect the assets and liabilities as of December 31, 1996 and results of operations for the year ended November 30, 1995, the thirteen months ended December 31, 1996 for The Corvallis Clinic, P.C. prior to the reorganization transaction ("Old Corvallis"). The Statement of Operations and Cash Flows for the year ended December 31, 1997, include results of operations for Old Corvallis from January 1 to January 31, 1997. The remainder of the period represents the operations of The Corvallis Clinic, P.C. ("New PC") subsequent to the effective date of the reorganization transaction, February 1, 1997.
Reclassifications
Certain prior year amounts have been reclassified to conform with the current year presentation.
3. REVENUES:
Corvallis reports its revenues according to two principal types of payment methodologies as discussed below:
Prepaid Healthcare
Corvallis contracts with various Health Maintenance Organizations (HMOs) to provide care to plan enrollees. These programs provide for a prepaid monthly fixed capitation payment on a per member basis to Corvallis by the HMO for plan enrollees.
The majority of the HMO contracts are delegated professional risk with limited institutional risk based upon utilization parameters mutually agreed upon by the hospital health plan and Corvallis.
Corvallis has accrued the claims associated with services provided by outside providers for which Corvallis is responsible, and an estimate of incurred but not reported claims is included in accrued healthcare cost in the accompanying financial statements.
Corvallis follows the policy of netting prepaid healthcare revenues and purchased medical services expenses for the institutional portion of capitated agreements. Liabilities associated with these contracts are included in accrued healthcare costs in the accompanying financial statements. Corvallis' revenue associated with these contracts was approximately $11,945, $16,699 and $16,235 for the year ended November 30, 1995, thirteen months ended December 31, 1996 and the year ended December 31, 1997, respectively.
Fee-For-Service
Patient service revenues are recorded in the period in which services are provided at established rates. Corvallis has agreements with third-party payors that provide payments to Corvallis at amounts different from its established rates. The difference between the established rates and the related payment amounts are reflected as contractual discounts, as shown below:
A summary of the most significant fee-for-service arrangements is as follows:
Medicare
A significant portion of Corvallis' services are provided to Medicare patients. Payments for Medicare outpatient services which are not covered under capitated contracts are based on a prevailing fee schedule. Approximately 15%, 16% and 14% of net patient service revenues were derived from services provided to fee-for-service Medicare patients in 1995, 1996 and 1997, respectively.
Medicaid
Payments for Medicaid outpatient services which are not covered under capitated contracts are based on a prevailing fee schedule. Approximately 3%, 2% and 2% of net patient service revenues were derived from services provided to fee-for-service Medicaid patients in 1995, 1996 and 1997, respectively.
Other Payors
Corvallis has also entered into payment agreements with certain commercial insurance carriers and preferred provider organizations. The basis for payment to Corvallis under these agreements includes discounts from established charges.
Major Customers
The following customers represented individually more than 10% of Corvallis' net revenue as follows:
4. PROPERTY, PLANT AND EQUIPMENT:
Property, plant and equipment consists of the following at December 31, 1996:
5. INCOME TAXES:
Income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109 (SFAS 109). SFAS 109 requires that Corvallis follow the liability method of accounting for deferred income taxes. Differences between financial reporting and income tax net operating losses are due primarily to the use of the cash method of accounting for income tax purposes. Corvallis has adopted a December 31 year-end for income tax purposes.
Deferred income taxes reflect the net tax effects of temporary differences between the amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of Corvallis' deferred tax assets and liabilities are as follows at December 31, 1996:
The differences between the provision (benefit) for income taxes and the amount computed by applying the statutory federal income tax rate to income before taxes were as follows:
Nonrealized future tax benefits referred to above represent tax benefits related to net operating loss (NOL) carryforwards. These benefits have not been recognized in the accompanying financial statements because there is no assurance these NOLs can be utilized in the future.
As of December 31, 1997, the net income before provision for income taxes represents the results of operations for Old Corvallis from January 1 to January 31, 1997. The valuation reserve against the deferred tax assets was reversed in an amount equal to the current tax expense, resulting in no tax provision being reflected in the 1997 statement of operations. The operations of Corvallis for the remainder of the period have resulted in no net income and, accordingly, no current tax expense is necessary.
6. LONG-TERM DEBT:
Long-term debt consists of the following at December 31, 1996:
Lines of Credit
Corvallis maintained a revolving line-of-credit agreement with a bank providing up to $2,500, secured by accounts receivable and inventory. At February 1, 1997, the revolving line of credit was consolidated into a $7,500 line-of-credit as a result of the reorganization transaction (Note 1).
7. LEASE COMMITMENTS:
Capital Lease
Corvallis leases certain equipment under an agreement which is classified as a capital lease. The lease has an original term of five years and includes a bargain purchase option. The lease was assigned to PPI on February 1, 1997. Lease equipment included in property, plant and equipment is as follows at December 31, 1996:
Operating Leases
Leases that do not meet the criteria for capitalization are classified as operating leases. Such lease commitments are primarily for facilities and equipment and the related rentals are charged to operations as incurred.
Direct Financing Lease Obligation
In June of 1995, Corvallis contributed land, buildings, construction in process and related notes payable to HealthCare Partners, LLC (Note 13). At the date of transfer, Corvallis entered into 30-year lease agreements for the Asbury, Aumann, CFM and PFM buildings and a 5-year lease agreement for the Albany building. Monthly rental payments under these leases are $184. The assets were sold under a sale/leaseback arrangement and, therefore, this is being accounted for as a financing transaction wherein the assets remain on the books and continue to be depreciated. Corvallis recorded a direct financing lease obligation for cash received by Corvallis and obligations assumed by the LLC as part of the transaction.
The liability for this lease obligation was $14,142 at December 31, 1996 and was assumed by PPI at February 1, 1997.
8. RETIREMENT PLANS:
401(k) Profit Sharing Plan
Corvallis has a 401(k) Profit-Sharing Plan (the 401(k) Plan) in which all employees are eligible to participate subject to certain eligibility criteria. The 401(k) Plan permits employees to contribute up to 10% of their annual compensation (not to exceed certain annual limits imposed by the Internal Revenue Code). Corvallis is required to make matching contributions equal to 50% of employee contributions up to 8% of the employee's compensation. Corvallis may also make discretionary contributions. Clinic contributions are 100% vested.
Money-Purchase Pension Plan
Corvallis also has a Money-Purchase Pension Plan in which all employees are eligible to participate subject to certain eligibility criteria. Corvallis contributes 5.4% of the employee's eligible earnings up to $48 and 10.8% of eligible earnings in excess of $48. These contributions are 100% vested upon eligibility.
Corvallis' contributions for these plans for the year ended November 30, 1995 and the 13-month period ended December 31, 1996 were approximately $2,010 and $1,494, respectively.
9. PROFESSIONAL LIABILITY:
At February 1, 1997, Corvallis' professional liability insurance policy was consolidated into a PPI policy as a result of the reorganization transaction (Note 1). The consolidated claims-made policy has no deductible and includes full prior acts coverage. Management believes the coverage is adequate to cover any potential claims.
10. REDEEMABLE STOCK:
Corvallis has three classes of stock which are redeemable at the option of the shareholders upon retirement, termination of employment and certain other events. A summary of the activity in these stock accounts for the period November 30, 1995 through December 31, 1997, together with other information, is presented below:
The carrying value of the Class A and Class B shares were being increased (accreted) to the redemption price using the effective interest rate through the earliest estimated redemption date. At February 1, 1997, Corvallis' stock was exchanged for PPI stock.
In 1997, Corvallis issued 63 shares of no par value common stock with a total value of $1.
11. DEFERRED COMPENSATION:
Corvallis provides compensation to eligible shareholders who retire based upon average shareholder income, as defined in the Employment Agreement, for the first three years following retirement. Provider/shareholder retirees who have 20-1/2 years of service while in service with Corvallis are eligible to receive such deferred retirement compensation. The deferred compensation recorded in the accompanying financial statements is the net present value of the future obligations recognized for the years of service.
12. COMMITMENTS AND CONTINGENCIES:
Legal Proceedings
Corvallis is subject to various legal proceedings and claims which arise in the ordinary course of business. In the opinion of management, although the ultimate dispositions of these proceedings are not determinable, adverse determinations in any or all of such proceedings would not have a material adverse effect upon the financial position or results of operations of Corvallis.
Compliance with Rules and Regulations
The healthcare industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government healthcare program participation requirements, reimbursement for patient services and Medicare and Medicaid fraud and abuse. Recently, government activity has increased with respect to investigations and allegations concerning possible violations of fraud and abuse statutes and regulations by healthcare providers. Violations of these laws and regulations could result in expulsion from government healthcare programs, together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Management believes that Corvallis is in compliance with the fraud and abuse regulations as well as other applicable government laws and regulations. Compliance with such laws and regulations can be subject to future government review and interpretation as well as regulatory actions unknown or unasserted at this time.
Other Commitments
References of other commitments are made in the discussion of various lease commitments and related debt guarantees in Notes 7 and 13.
13. INVESTMENTS IN AFFILIATES:
The Company's investments in affiliates consist of investments in various entities which are accounted for on the equity method. The names of these entities, carrying values and the percent of ownership held by Corvallis are summarized below:
Additional information regarding these investments is discussed below.
Corvallis MRI:
Corvallis held a one-third interest in Corvallis MRI which was transferred to PPI on February 1, 1997. The partnership was organized in 1988 and owns and operates a magnetic resonance imaging (MRI) scanner. The MRI unit is housed in facilities leased from Good Samaritan Hospital, another partner, and operated by Corvallis Radiology, P.C., the third partner. Summarized financial information of Corvallis MRI as of and for the year ended December 31, 1996 is presented below:
During 1995 and 1996, payments to Corvallis MRI for services provided to Corvallis were $62 and $143, respectively, and are included in purchased services.
HealthCare Partners, LLC
During the year ended November 30, 1995, Corvallis entered into a joint venture agreement with Good Samaritan Hospital, Corvallis to form a limited liability company to own and manage Corvallis' buildings and real properties and to serve as a vehicle for financing future property expansion for Corvallis. Corvallis contributed assets and liabilities in exchange for a 50% membership interest in the limited liability company. On February 1, 1997, Corvallis transferred their membership interest in HealthCare Partners, LLC to PPI.
The net book value of assets and liabilities contributed by Corvallis was $13,805 for buildings, land and construction in progress and $8,363 for related debt. In addition, Corvallis received $2,734 in cash reimbursements for the market value of the above contributed net assets in excess of the Hospital's contributed equity, as measured at the date of formation of the limited liability company.
This transaction has been accounted for as a financing due to the continuing involvement of Corvallis in the assets through its ownership interest in the limited liability company. Accordingly, the contributed property remains as an asset of Corvallis. The debt at the transaction date, together with the cash received for the excess value of the contributed net assets, has been included in the related financing obligations (Note 7).
Summarized financial information of HealthCare Partners, LLC as of and for the year ended December 31, 1996 is presented below:
Operations data-
Revenues include interest income of $1,149 for the period ended December 31, 1995 and $1,902 for the year ended December 31, 1996, relating to the financing lease with Corvallis. As a substantial portion of the joint venture's income is derived from payments made by Corvallis for this interest income, Corvallis' share of earnings from the joint venture is offset against interest expense in the accompanying statements of income.
Concurrent with the formation of the limited liability company, Corvallis has entered into a lease agreement relating to buildings and properties which were contributed to the limited liability company and are occupied by Corvallis.
PPI has guaranteed approximately $6,100 of long-term debt associated with the above joint venture.
Healthquest
During 1996, Corvallis' sold their interest in Healthquest to one of the other partners. Corvallis recognized a loss on the sale of their investment of $18 included in the accompanying financial statements.
14. EARNING PER SHARE:
All share and per share data have been retroactively restated to give effect to the recapitalization resulting from the transactions.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of Medford Clinic, P.C.:
We have audited the accompanying balance sheets of Medford Clinic, P.C. (an Oregon professional service corporation) as of December 31, 1996 and 1997, and the related statements of operations, cash flows and stockholders' equity for each of the years in the three-year period ended December 31, 1997. These financial statements are the responsibility of Medford's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Medford Clinic, P.C. as of December 31, 1996 and 1997, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1997 in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Portland, Oregon, February 13, 1998
MEDFORD CLINIC, P.C.
BALANCE SHEETS - AS OF DECEMBER 31, 1996 AND 1997
(All dollar amounts are expressed in thousands)
ASSETS
The accompanying notes are an integral part of these balance sheets.
MEDFORD CLINIC, P.C.
STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
(All dollar amounts are expressed in thousands, except earnings per share)
The accompanying notes are an integral part of these statements.
MEDFORD CLINIC, P.C.
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
(All dollar amounts are expressed in thousands)
MEDFORD CLINIC, P.C.
STATEMENTS OF CASH FLOWS (CONTINUED)
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
(All dollar amounts are expressed in thousands)
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES:
In February 1997, Medford assigned all assets and liabilities to Physician Partners, Inc. as part of the reorganization and merger transaction. The book value of Medford's assets and liabilities, including $200 cash, at the date of the transaction are presented below:
The accompanying notes are an integral part of these statements.
MEDFORD CLINIC, P.C.
STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
(All dollar amounts are expressed in thousands)
The accompanying notes are an integral part of these statements.
MEDFORD CLINIC, P.C.
NOTES TO FINANCIAL STATEMENTS
(All dollar amounts are expressed in thousands)
1. BUSINESS AND ORGANIZATION:
The Medford Clinic, PC (Medford), an Oregon professional corporation, was incorporated on September 18, 1996 under the name Physician Partners Medford, PC, for the purpose of effecting a reorganization transaction between Physician Partners, Inc. (PPI) and three Oregon professional corporations (the Founding Clinics).
This transaction, consummated on February 1, 1997, resulted in a separation of operations of the three Founding Clinics between medical professional services activities (i.e., providers of medical services) and the physician practice management activities of the business. The professional services activities were spun off into newly formed professional corporations (New PCs). Medford is one of the New PCs. The physician practice management business, along with substantially all of the assets and liabilities of the three Founding Clinics, i.e., cash, receivables, inventories, prepaids, property, plant and equipment, other assets, payables, accruals, debt, and certain contractual commitments were transferred to PPI. The New PCs are responsible for providing medical services and the related costs for provider compensation and benefits. The assets transferred to the New PCs, which had zero carrying value, include the employment agreements between each Company and its providers, certain provider contracts under which the New PCs will be receiving fee-for-service compensation and patient medical records.
An integral part of the reorganization is a 40-year management agreement whereby PPI provides physician practice management services to the New PCs. Services to be provided include management and administrative services, capital resources, facilities, equipment and supplies. As consideration, PPI is entitled to (a) reimbursement of all managerial costs and expenses (Manager's Expenses) incurred by PPI and (b) a management fee equal to 16% of (i) net revenues relating to services provided by the New PCs less (ii) Manager's Expenses.
Essentially all of the cash remaining in the New PC after the payments to PPI under the management agreement will fund the compensation and benefits of providers employed by the New PCs.
Medford consists of approximately 75 professional providers who offer a wide range of primary and specialty care. In addition, Medford offers ancillary services such as radiology, pharmacy and laboratory.
Medford also provides clinical dialysis services through its Rogue Valley Dialysis Center division. Medford's sites are located in Southern Oregon. A significant change in the demographics of this area may have an adverse impact on the business.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OTHER INFORMATION:
Selected accounting policies are discussed below. Other significant accounting policies, regarding revenues, income taxes and professional liability are discussed in specific notes that follow.
Cash Equivalents
Cash equivalents consist of all highly liquid investments with original maturities of three months or less.
Investments
Short-term and restricted investments are readily convertible to cash and have original maturity dates that exceed three months. They are classified as held-to-maturity and mature within one year of the financial statement date. These investments are in commercial paper and the carrying value approximates the fair value.
Concentration of Credit Risk
Medford extends credit to patients covered by commercial insurance, Medicare and Medicaid. Medford manages credit risk with the various public and private insurance providers, as deemed appropriate by management. Allowances for contractual discounts and uncollectible accounts have been made for potential losses, where appropriate.
Inventories of Drugs and Supplies
Inventories are stated at the lower of cost or market, determined by the first-in, first-out (FIFO) method.
Property, Plant and Equipment
Property, plant and equipment are stated at cost. Maintenance, repairs and minor replacements are expensed as incurred. When properties are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts and any gain or loss on disposition is recorded as other income or expense. There were no disposals in 1995, 1996 and 1997.
Depreciation is computed using the straight-line method over the estimated useful lives of the respective assets. Estimated lives are as follows:
Restricted Investments
Under the agreements with Oregon Health Plan (OMAP) and Oregon Health Management System (OHMS), Medford is required to maintain $250 in a restricted or segregated account for each agreement. Medford can use these funds for purchased medical services only with approval by OMAP or OHMS as appropriate. The restriction for the OMAP agreement lapsed in 1997.
Accrued Healthcare Costs
Accrued healthcare costs are calculated based on reported claims and an estimate based on historical data of incurred but not reported claims. These accrued healthcare cost estimates will vary from actual results and the differences may be significant.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, short-term investments, patient accounts receivable, restricted investments, accounts payable and accrued liabilities are a reasonable estimate of their fair value based on the short maturities of these instruments.
Interest rates that are currently available to Medford for issuance of debt with similar terms and remaining maturities were used to estimate fair value for debt issues. The current carrying value of debt approximates fair value.
Medford does not hold or issue financial instruments or derivative financial instruments for trading purposes.
Other Income
Other income includes a $300 one time payment from PPI. The payment was part of a transition plan developed by PPI to assist Medford in its transition to the Management Agreement.
Provider Compensation and Benefits
Provider compensation and benefits consists of the direct costs of patient care providers such as physicians and other allied health professionals. A substantial portion of these costs are paid to providers who are stockholders.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Reclassifications
Certain prior year amounts have been reclassified to conform with the current year presentation.
Financial Statement Presentation
The accompanying financial statements reflect the assets and liabilities as of December 31, 1996 and results of operations for the years ended December 31, 1995 and 1996 for the Medford Clinic, P.C. prior to the reorganization transaction ("Old Medford"). The Statement of Operations and Cash Flows for the year ended December 31, 1997 include the results of operations for Old Medford from January 1 to January 31, 1997. The remainder of the period represents the operations of Medford Clinic, P.C. ("New PC") subsequent to the effective date of the reorganization transaction, February 1, 1997.
3. REVENUES:
Medford reports its revenues according to two principal types of payment methodologies as discussed below:
Prepaid Healthcare
Medford contracts with various Health Maintenance Organizations (HMOs) to provide care to plan enrollees. These programs provide for a prepaid monthly fixed capitation payment on a per member basis to Medford by the HMO for plan enrollees.
The majority of the HMO contracts are delegated professional risk with limited institutional risk based upon utilization parameters mutually agreed upon by the hospital health plan and Medford.
Medford has accrued the claims associated with services provided by outside providers for which Medford is responsible, and an estimate of incurred but not reported claims is included in accrued healthcare costs in the accompanying financial statements.
Medford follows the policy of netting prepaid healthcare revenues and purchased medical services expenses for the institutional portion of capitated agreements. Liabilities associated with these contracts are included in accrued healthcare costs in the accompanying financial statements. Medford's revenue associated with these contracts was $553 and $2,233 for 1996 and 1997, respectively. There was no revenue associated with these contracts for 1995.
Fee-For-Service
Patient service revenues are recorded in the period in which services are provided at established rates. Medford has agreements with third-party payors that provide payments to Medford at amounts different from its established rates. The difference between charges generated from agreements with third-party payors and the related payment amounts are reflected as contractual discounts, as shown below:
A summary of the most significant fee-for-service arrangements is as follows:
Medicare
A significant portion of Medford's services are provided to Medicare patients. Payments for Medicare outpatient services which are not covered under capitated contracts are based on a prevailing fee schedule. Approximately 27%, 27% and 26% of net patient service revenues were derived from services provided to fee-for-service Medicare patients in 1995, 1996 and 1997, respectively.
Medicaid
Payments for Medicaid outpatient services which are not covered under capitated contracts are based on a prevailing fee schedule. Approximately 2%, 1% and 2% of net patient service revenues were derived from services provided to fee-for-service Medicaid patients in 1995, 1996 and 1997, respectively.
Other Payors
Medford has also entered into payment agreements with certain commercial insurance carriers and preferred provider organizations. The basis for payment to Medford under these agreements includes discounts from established charges.
Major Customer
The following customers represented individually more than 10% of Medford's net revenue as follows:
4. PROPERTY, PLANT AND EQUIPMENT:
Property, plant and equipment consists of the following as of December 31, 1996:
5. INCOME TAXES:
Income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109 (SFAS 109). SFAS 109 requires that Medford follow the liability method of accounting for deferred income taxes. Differences between financial reporting and tax basis is primarily due to the use of the cash method of accounting for income tax purposes. At December 31, 1996, Medford had approximately $326 and $733 of net operating loss carryforwards for federal and state income tax purposes, respectively, that expire in the year 2009.
Deferred income taxes reflect the net tax effects of temporary differences between the amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of Medford's deferred tax assets and liabilities are as follows at December 31, 1996:
The net deferred tax liability is reflected in the accompanying balance sheet as follows at December 31, 1996:
The provision (benefit) for income taxes is as follows:
The differences between the provision (benefit) for income taxes and the amount computed by applying the statutory federal income tax rate to income before taxes were as follows:
As of December 31, 1997, the net income before provision for income taxes represents the results of operations for Old Medford from January 1 to January 31, 1997. The valuation reserve against the deferred tax assets was reversed in an amount equal to the current tax benefit, resulting in no tax benefit being reflected in the 1997 statement of operations. The operations of the New PC for the remainder of the period have resulted in no net income and, accordingly, no current tax expense is necessary.
6. LONG-TERM DEBT:
Long-term debt at December 31, 1996 was as follows:
Medford maintained a revolving line-of-credit agreement with a bank providing up to $500 secured by accounts receivable. The line-of-credit bore interest at the lender's prime rate (8.5% at December 31, 1997) plus .25%.
At February 1, 1997, the long-term debt was assumed by Physician Partners, Inc. and the $500 revolving line-of-credit was consolidated into a $7,500 line-of-credit as a result of the reorganization transaction (Note 1).
7. RETIREMENT PLANS:
Medford has a 401(k) Profit-Sharing Plan (the 401(k) Plan) in which all employees are eligible to participate subject to certain eligibility criteria. The 401(k) Plan permits employees to contribute up to 15% of their annual compensation (not to exceed certain annual limits imposed by the Internal Revenue Service). Medford may also make discretionary contributions, which are immediately 100% vested. Medford also has a Money Purchase Pension Plan in which all employees are eligible to participate subject to certain eligibility criteria. Medford contributes 5.7% of the employee's eligible earnings up to $63 and 11.4% of eligible earnings in excess of limitations imposed by the Internal Revenue Service. These contributions are 100% vested upon eligibility.
Medford's contributions for these plans for the years ended December 31, 1995, 1996 and 1997 were $1,529, $1,656 and $0, respectively.
8. PROFESSIONAL LIABILITY:
At February 1, 1997, Medford's professional liability insurance policy was consolidated into a Physician Partners, Inc. policy as a result of the reorganization transaction (Note 1). The consolidated claims-made policy has no deductible and includes full prior acts coverage. Management believes the coverage is adequate to cover any potential claims.
9. COMMITMENTS AND CONTINGENCIES:
Legal Proceedings
Medford is subject to various legal proceedings and claims which arise in the ordinary course of business. In the opinion of management, although the ultimate dispositions of these proceedings are not determinable, adverse determinations in any or all of such proceedings would not have a material adverse effect upon the financial position or results of operations of Medford.
Compliance with Rules and Regulations
The healthcare industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government healthcare program participation requirements, reimbursement for patient services and Medicare and Medicaid fraud and abuse. Recently, government activity has increased with respect to investigations and allegations concerning possible violations of fraud and abuse statutes and regulations by healthcare providers. Violations of these laws and regulations could result in expulsion from government healthcare programs, together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Management believes that Medford is in compliance with the fraud and abuse regulations as well as other applicable government laws and regulations. Compliance with such laws and regulations can be subject to future government review and interpretation as well as regulatory actions unknown or unasserted at this time.
10. EARNINGS PER SHARE:
All share and per share data have been retroactively restated to give effect to the recapitalization resulting from the transactions.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of HealthFirst Medical Group, P.C.:
We have audited the accompanying balance sheets of HealthFirst Medical Group, P.C. (an Oregon professional corporation) as of December 31, 1996 and 1997, and the related statements of operations, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1997. These financial statements are the responsibility of HealthFirst's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of HealthFirst Medical Group, P.C. as of December 31, 1996 and 1997, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1997 in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Portland, Oregon, February 20, 1998
HEALTHFIRST MEDICAL GROUP, P.C.
BALANCE SHEETS - AS OF DECEMBER 31, 1996 AND 1997
(All dollar amounts expressed in thousands)
ASSETS
HEALTHFIRST MEDICAL GROUP, P.C.
BALANCE SHEETS - AS OF DECEMBER 31, 1996 AND 1997 (CONTINUED)
(All dollar amounts expressed in thousands)
LIABILITIES AND STOCKHOLDERS' EQUITY
The accompanying notes are an integral part of these balance sheets.
HEALTHFIRST MEDICAL GROUP, P.C.
STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
(All dollar amounts expressed in thousands, except earnings (loss) per share)
The accompanying notes are an integral part of these statements.
HEALTHFIRST MEDICAL GROUP, P.C.
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
(All dollar amounts expressed in thousands)
HEALTHFIRST MEDICAL GROUP, P.C.
STATEMENTS OF CASH FLOWS (CONTINUED)
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
(All dollar amounts expressed in thousands)
In 1996, HealthFirst acquired all of the outstanding stock of Suburban in exchange for 2,200 shares of HealthFirst Series 2 Class A stock. The acquisition was recorded under the purchase method of accounting. The fair values of Suburban's assets, including $231 of cash, and liabilities at the date of acquisition are presented below:
In February 1997, HealthFirst assigned all assets and liabilities to Physician Partners, Inc. as part of the reorganization and merger transaction. The book value of HealthFirst's assets and liabilities, including $1,200 of cash at the date of the transaction are presented below:
The accompanying notes are an integral part of these statements.
HEALTHFIRST MEDICAL GROUP, P.C.
STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
(All dollar amounts expressed in thousands)
The accompanying notes are an integral part of these statements.
HEALTHFIRST MEDICAL GROUP, P.C.
NOTES TO FINANCIAL STATEMENTS
1. DESCRIPTION OF BUSINESS:
HealthFirst Medical Group, P.C. (HealthFirst), an Oregon professional corporation, was incorporated on September 18, 1996 under the name Physician Partners HealthFirst, PC for the purpose of effecting a reorganization transaction between Physician Partners, Inc. (PPI) and three Oregon professional corporations (the Founding Clinics).
This transaction, which was consummated on February 1, 1997, resulted in a separation of operations of the three Founding Clinics between medical professional services activities (i.e., providers of medical services) and the physician practice management activities of the business. The professional services activities were spun off into newly formed professional corporations (New PCs). HealthFirst is one of the new PCs. The physician practice management business, along with substantially all of the assets and liabilities of the three Founding Clinics, i.e., cash, receivables, inventories, prepaids, property, plant and equipment, other assets, payables, accruals, debt, and certain contractual commitments were transferred to PPI. The New PCs are responsible for providing medical services and the related costs for provider compensation and benefits. The assets transferred to the New PCs, which had zero carrying value, include the employment agreements between each Company and its providers, certain provider contracts under which the New PCs will be receiving fee-for-service compensation and patient medical records.
An integral part of the reorganization is a 40-year management agreement whereby PPI provides physician practice management services to the New PCs. Services to be provided include management and administrative services, capital resources, facilities, equipment and supplies. As consideration, PPI is entitled to (a) reimbursement of all managerial costs and expenses (Manager's Expenses) incurred by PPI and (b) a management fee equal to 16% of (i) net revenues relating to services provided by the New PCs less (ii) Manager's Expenses.
Essentially all of the cash remaining in the New PC after the payments to PPI under the management agreement will fund the compensation and benefits of providers employed by the New PCs.
HealthFirst consists of approximately 159 providers who offer a wide range of primary and specialty care services including allergy, dermatology, gastroenterology, hematology/oncology, infectious disease, pediatrics, geriatrics, obstetrics/gynecology, podiatry, rheumatology and surgery.
HealthFirst operates clinics in eleven locations in and around Portland, Oregon including: Tualatin, Tigard, Westside, Lake Oswego, Broadway, Northwest Portland, Wilshire, Gateway, Gresham, Hollywood and Powell Valley. A significant change in the demographics of this area may have an adverse impact on the business.
The accompanying financial statements reflect the assets and liabilities as of December 31, 1996 and results of operations for the years ended December 31, 1995 and 1996, for the HealthFirst Medical Group, P.C. prior to the reorganization transaction (Old HealthFirst). The Statements of Operations and Cash Flows for the year ended December 31, 1997 include the results of operations for Old HealthFirst from January 1 to January 31, 1997. The remainder of the period represents the operations of HealthFirst Medical Group, P.C. (New PC) subsequent to the effective date of the reorganization transaction, February 1, 1997.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OTHER INFORMATION:
Selected accounting policies are discussed below. Other significant accounting policies regarding revenues, income taxes, professional liability and deferred compensation are discussed in specific notes that follow.
Cash Equivalents
Cash equivalents consist of all highly liquid investments with original maturities of three months or less.
Concentration of Credit Risk
HealthFirst extends credit to patients covered by commercial insurance, Medicare and Medicaid. HealthFirst manages credit risk with the various public and private insurance providers, as deemed appropriate by management. Allowances for contractual discounts and uncollectible accounts have been made for potential losses, where appropriate.
Prepaid Provider Compensation
Prepaid provider compensation includes the amount paid to providers that is in excess of the earned amount computed in accordance with the Management Agreement (Note 1). The balance will be reversed in future years when the amount paid is less than the earned amount.
Inventories of Drugs and Supplies
Inventories are stated at the lower of cost or market, determined by the first-in, first-out (FIFO) method. In 1996, HealthFirst began using a just-in-time method with its major supply vendors.
Property, Plant and Equipment
Property, plant and equipment are stated at cost. Maintenance, repairs and minor replacements are expensed as incurred. When properties are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts and any gain or loss on disposition is recorded as other income or expense.
Depreciation is computed using the straight-line method over the estimated useful lives of the respective assets. Equipment under capital lease is amortized using straight-line methods over the shorter of the period of the lease term or the estimated useful life of the equipment. Estimated lives are as follows:
Buildings and leasehold improvements 7-45 years Furniture and equipment 3-15 years
Payable to PPI
HealthFirst signed a note payable to PPI, bearing interest at 7.6%. Interest only monthly payments are due in 1998 and principal and interest monthly payments are due beginning January 1999 for 36 months.
Accrued Healthcare Costs
Accrued healthcare costs are calculated based on reported claims and an estimate based on historical data of incurred but not reported claims. These accrued healthcare cost estimates may vary from actual results and the differences may be significant.
Fair Value of Financial Instruments
The carrying amounts of cash equivalents, patient accounts receivable, accounts payable and accrued expenses are a reasonable estimate of their fair value based on the short maturities of these instruments.
Interest rates that are currently available to HealthFirst for issuance of debt with similar terms and remaining maturities were used to estimate fair value for debt issues. The current carrying value of debt approximates fair value.
HealthFirst does not hold or issue financial instruments or derivative financial instruments for trading purposes.
Other Income
Other income includes a $600 one time payment from PPI. The payment was part of a transition plan developed by PPI to assist HealthFirst in its transition to the Management Agreement.
Financial Statement Presentation
The accompanying financial statements reflect the assets and liabilities as of December 31, 1996 and results of operations for the year ended December 31, 1996 for the HealthFirst Medical Group, P.C. prior to the reorganization transaction ("Old HealthFirst"). The Statement of Operations and Cash Flows for the year ended December 31,1997 include the results of operations for Old HealthFirst from January 1 to January 31, 1997. The remainder of the period represents the operations of HealthFirst Medical Group, P.C. ("New PC") subsequent to the effective date of the reorganization transaction, February 1, 1997.
Provider Compensation and Benefits
Provider compensation and benefits consists of the direct costs of patient care providers such as physicians and other allied health professionals. A substantial portion of these costs are paid to providers who are stockholders.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Reclassifications
Certain prior year amounts have been reclassified to conform with the current year presentation.
3. REVENUES:
HealthFirst reports its revenues according to two principal types of payment methodologies as discussed below:
Prepaid Healthcare
HealthFirst contracts with various Health Maintenance Organizations (HMOs) to provide care to plan enrollees. These programs provide for a prepaid monthly fixed capitation payment on a per member basis to HealthFirst by the HMO for plan enrollees.
The majority of the HMO contracts are delegated professional risk with limited institutional risk based upon utilization parameters mutually agreed upon by the hospital health plan and HealthFirst.
HealthFirst has accrued the claims associated with services provided by outside providers for which HealthFirst is responsible, and an estimate of incurred but not reported claims is included in accrued healthcare cost in the accompanying financial statements.
Fee-For-Service
Patient service revenues are recorded in the period in which services are provided at established rates. HealthFirst has agreements with third-party payors that provide payments to HealthFirst at amounts different from its established rates. The difference between the established rates and the related payment amounts are reflected as contractual discounts, as shown below:
A summary of the most significant fee-for-service arrangements is as follows:
Medicare
A significant portion of HealthFirst's services are provided to Medicare patients. Payments for Medicare outpatient services which are not covered under capitated contracts are based on a prevailing fee schedule. Approximately 8%, 6%, and 6% of net patient service revenues were derived from services provided to fee-for-service Medicare patients in 1995, 1996 and 1997, respectively.
Medicaid
Payments for Medicaid outpatient services which are not covered under capitated contracts are based on a prevailing fee schedule. Approximately 1% of net patient service revenues were derived from services provided to fee-for-service Medicaid patients in 1995, 1996 and 1997.
Other Payors
HealthFirst has also entered into payment agreements with certain commercial insurance carriers and preferred provider organizations. The basis for payment to HealthFirst under these agreements includes discounts from established charges.
Major Customers
The following customers represented individually more than 10% of HealthFirst's net revenue as follows:
4. PROPERTY, PLANT AND EQUIPMENT:
Property, plant and equipment consists of the following at December 31, 1996:
5. INCOME TAXES:
Income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109 (SFAS 109). SFAS 109 requires that HealthFirst follow the liability method of accounting for deferred income taxes. Differences between financial reporting and tax basis is primarily due to the use of the cash method of accounting for income tax purposes.
Deferred income taxes reflect the net tax effects of temporary differences between the amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of HealthFirst's deferred tax assets and liabilities are as follows at December 31, 1996:
The provision (benefit) for income taxes is as follows:
The differences between the provision (benefit) for income taxes and the amount computed by applying the statutory federal income tax rate to income before taxes were as follows:
In 1996, HealthFirst recognized a valuation allowance in an amount equal to its net deferred tax assets of $328 because of uncertainty with respect to the realization of the related tax benefits in future years.
As of December 31, 1997, the net income before provision for income taxes represents the results of operations for Old HealthFirst from January 1 to January 31, 1997. The valuation reserve against the deferred tax assets was reversed in an amount equal to the current tax expense, resulting in no tax provision being reflected in the 1997 statement of operations. The operations of the New PC for the remainder of the period have resulted in no net income and, accordingly, no current tax expense is necessary.
6. LONG-TERM DEBT:
Long-term debt at December 31, 1996 is as follows:
Management converted the construction loan to a mortgage loan in 1997, extending the maturity of the loan to February 2017.
HealthFirst maintained a revolving line-of-credit agreement with a bank providing up to $2,500, secured by inventory, accounts receivable and equipment. The line-of-credit bore interest at the lender's prime rate (8.25% at December 31, 1996) plus .5% and matures April 30, 1997. At February 1, 1997, the line-of-credit was consolidated into a $7,500 line-of-credit as a result of the reorganization transaction (Note 1).
7. LEASE COMMITMENTS:
Capital Leases
HealthFirst leases certain medical equipment and facilities under agreements which are classified as capital leases. The equipment leases have original terms of five years and have either a bargain purchase option or a transfer of title at the end of the lease. The building lease is with Gateway Properties LLC (Note 12) for a term of 21 years. Leased capital assets included in property, plant and equipment are as follows at December 31, 1996:
Operating Leases
Leases that do not meet the criteria for capitalization are classified as operating leases. Such lease commitments are primarily for facilities and equipment, and the related rentals are charged to operations as incurred.
Direct Financing Lease Obligation
In May 1996, HealthFirst sold three facilities to HealthFirst Properties LLC (Note 12) under a sale/leaseback arrangement. The facilities were sold for $12,550, of which $11,550 is due in the form of an 8% interest-bearing note receivable due in monthly installments through April 2016. The remainder was received in cash. The transaction has been accounted for as a financing, wherein the property and related debt remains on the books and will continue to be depreciated. A financing obligation representing the proceeds of $1,000 has been recorded and will be reduced based on payments under the lease. As sales proceeds are received from the LLC, they will be credited to a financing obligation, and amortized as a reduction of operating expenses over the remaining life of the lease. The amount owed on the financing obligation at December 31, 1996 was $929 of which $76 is due within one year. The lease has a term of 20 years and requires minimum annual rental payments of $1,318 in 1998, 1999, 2000, 2001 and 2002 and $17,680 thereafter. The financing obligation and lease payments were assumed by PPI at February 1, 1997.
8. EMPLOYEE BENEFIT PLANS:
Retirement Plans
HealthFirst has a noncontributory profit sharing plan covering all employees who are eligible subject to certain requirements. HealthFirst, at the discretion of the Board of Directors, contributes an annual amount not to exceed the maximum allowed under the Internal Revenue Code. No contributions to the Plan were made in 1997, 1996 and 1995. HealthFirst does not foresee making contributions to the profit sharing plan in the future.
HealthFirst has a 401(k) plan covering all employees who are eligible subject to certain requirements. Employees contribute between 2% to 10% of their annual compensation. HealthFirst matches employee contributions at a rate of 10% plus a discretionary percentage determined by the Board of Directors. The contributions to the Plan were $69 and $110 in 1995 and 1996, respectively.
HealthFirst also has a defined contribution money purchase pension plan which is a plan in which all employees are eligible to participate subject to certain requirements. HealthFirst contributes 8% of employees' compensation which does not exceed the Social Security integration level ($62 at December 31, 1996), plus a higher percentage of the amount in excess of the integration level for the Plan year. Contributions in 1995 and 1996 were $1,133 and $1,523, respectively.
Supplemental Pension Plan
In 1987, HealthFirst entered into a supplemental pension plan with eight of its physicians providing for fixed monthly payments over five years commencing with the physicians' retirements or terminations. The physicians receive payments upon retirement or termination if certain vesting requirements have been met. The liability under this agreement is being accrued over the physicians' estimated remaining service periods before becoming fully vested. On the vesting date, the present value of the future benefit payments will have been accrued. HealthFirst has accrued $176 for the plan at December 31, 1996.
Suburban Profit-Sharing Plan
As part of the 1996 acquisition of Suburban, HealthFirst assumed a profit-sharing plan in which all former employees of Suburban are eligible to participate subject to certain requirements. The plan is funded by discretionary employer contributions as determined by the Board of Directors on an annual basis. The amount of employer contributions, if any, is allocated to eligible employees based on employee compensation. HealthFirst's contribution for 1996 was $390.
Bonus Compensation Plan
In February 1996, HealthFirst established a bonus compensation plan for eligible employees. Employees are vested after five years of employment with credit for prior service. A substantial portion of the participants were fully vested as of December 31, 1996. The total payout of approximately $5.25 million will be over a period of eight years. HealthFirst is accruing for the estimated present value of the bonus compensation over the estimated period of the employees' active employment from the date the contract was signed until the date they are fully vested. Compensation expense recognized during 1996 was approximately $3,900, a portion of which has been paid. The expense was recorded to provider compensation and benefits. The amount accrued at December 31, 1996, is $3,502, of which $502 is included in current liabilities and the remainder is included in deferred compensation. The liability was assumed by PPI at February 1, 1997.
9. PROFESSIONAL LIABILITY:
HealthFirst maintained a claims-made professional liability insurance policy.
At February 1, 1997, HealthFirst's professional liability insurance policy was consolidated into a Physician Partners, Inc. policy as a result of the reorganization transaction (Note 1). The consolidated claims-made policy has no deductible and includes full prior acts coverage. Management believes the coverage is adequate to cover any potential claims.
10. COMMITMENTS AND CONTINGENCIES:
Legal proceedings
HealthFirst is subject to various legal proceedings and claims which arise in the ordinary course of business. In the opinion of management, although the ultimate dispositions of these proceedings are not determinable, adverse determinations in any or all of such proceedings would not have a material adverse effect upon the financial position or results of operations of HealthFirst.
Compliance with Rules and Regulations
The healthcare industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government healthcare program participation requirements, reimbursement for patient services and Medicare and Medicaid fraud and abuse. Recently, government activity has increased with respect to investigations and allegations concerning possible violations of fraud and abuse statutes and regulations by healthcare providers. Violations of these laws and regulations could result in expulsion from government healthcare programs, together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Management believes that HealthFirst is in compliance with the fraud and abuse regulations as well as other applicable government laws and regulations. Compliance with such laws and regulations can be subject to future government review and interpretation as well as regulatory actions unknown or unasserted at this time.
11. EARNINGS PER SHARE:
All share and per share data have been retroactively restated to give effect to the recapitalization resulting from the Transactions.
12. RELATED PARTY TRANSACTIONS:
Coordinated Health Network, Inc.
In December 1993, HealthFirst became a one-third shareholder in Coordinated Health Network, Inc. (CHN). CHN was formed to obtain patient contracts under the Oregon Health Plan and generate purchasing discounts. The investment in CHN was accounted for under the equity method. In 1995, HealthFirst paid premiums to CHN of $106 and CHN paid HealthFirst $622 in 1995 for claims. No premiums were paid or received in 1996 or 1997. CHN was legally dissolved in 1996.
Northwest Physicians Alliance
In 1995, HealthFirst invested $52 for a one-third share in Northwest Physicians Alliance (the Alliance), which was formed with Blue Cross/Blue Shield of Oregon, two local hospital systems and several physician groups. The Alliance has been accounted for under the equity method. The Alliance is intended to be the primary delivery network for Blue Cross/Blue Shield's HMO Oregon product in the Portland area. The Alliance was legally dissolved in 1998.
HealthFirst Properties LLC
HealthFirst Properties LLC (HPLLC) was formed by certain shareholders of HealthFirst in 1996 to acquire three clinic buildings from HealthFirst. HPLLC purchased these properties from HealthFirst for an aggregate purchase price of $12,550, to be paid under an installment sale contract with a 20-year term. HPLLC made a $1,000 down payment to HealthFirst. Simultaneous with the execution of the installment sale contract, HealthFirst agreed to lease back the three buildings from HPLLC under a 20-year lease agreement. This transaction has been recorded as a direct financing lease. Accordingly, the monies received from HPLLC have been recorded as a direct financing lease obligation and the related property is included in property, plant and equipment in the accompanying financial statements.
Gateway Properties LLC
Gateway Properties LLC (Gateway) is owned by several former shareholders of Suburban. Throughout 1995, Suburban recorded notes receivable for various payments made on behalf of Gateway. The note receivable at December 31, 1996 was $144. The terms of the note include monthly installments of principal and interest of $5 through August 1999 with interest accruing at 7%. HealthFirst has signed a capital lease to occupy a new clinic building for a term expiring in August 2015.
Stock Subscriptions
HealthFirst has notes receivable from certain stockholders for their purchase of common stock. The notes mature at various stages through the year 2008.
Restricted Stock Awards
During 1996, HealthFirst sold shares of Series 1 Class A common stock to ten providers at prices below their estimated fair value for accounting purposes. The terms of the related Restricted Stock Agreements require forfeiture of the stock unless the grantee remains employed by HealthFirst until February 1, 2002.
The excess of the estimated fair value of the stock over the amount to be paid of $1,756 is to be recognized as compensation expense. Of this amount, $502 and $348 has been recognized as compensation expense in 1996 and 1997, respectively. The remaining amount will be amortized ratably to income over the next five years.
13. BUSINESS ACQUISITION:
On February 1, 1996, HealthFirst acquired all of the outstanding stock of Suburban in exchange for 2,200 shares of HealthFirst Series 2 Class A stock. Following the acquisition, the name of Suburban was changed to HealthFirst Management Services Organization, P.C. Results of operations after the acquisition date are included in the December 31, 1996 statement of operations. The following pro forma information has been prepared assuming that this acquisition had taken place at the beginning of 1995. Because fair values of purchased assets approximated their carrying values, no material pro forma adjustment was necessary to adjust historical depreciation and amortization.
The pro forma financial information is not necessarily indicative of the results of operations as they would have been had the acquisition been consummated on the assumed dates.
ITEM 9:
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10:
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information about the persons who serve as Directors and Officers of PPI:
DAVID M. GOLDBERG joined PPI as its Chief Executive Officer in 1996. Mr. Goldberg earned a B.A. degree in Sociology in 1970 from the University of Colorado at Boulder and a Masters of Science degree in Health Care Administration in 1977 from the University of Colorado Medical Center, Denver, Colorado. From 1993 until joining PPI as its founding CEO, Mr. Goldberg was employed as President of Simmonds Consulting, Inc., a national group practice strategic planning and merger and acquisition consulting company that he helped found. Mr. Goldberg was employed by Medical Management, Inc. as senior consultant from 1986-1992. In this capacity he managed all group practice management and strategic planning consulting and was instrumental in developing standardized management, strategic and financial reporting systems for all of the managed group practices, for the oldest (and then largest) contract group practice management company in the U.S. The Old PCs engaged Mr. Goldberg as a consultant through Simmonds Consulting, Inc. before he was employed by PPI. From 1983-1986, Mr. Goldberg served in a variety of senior management positions at Lovelace Medical Center and Lovelace Health Plan, then a 250,000 member group model HMO; Director of Planning for all of the Lovelace organizations and Director of Primary Care and Associated Group Practices for Lovelace Medical Center. Mr. Goldberg was the founding executive Director of New Mexico Health Resources, Inc., a private company which was the predecessor to the New Mexico State Office of Rural Health. After receiving his graduate education under the guidance of Dr. Leland Kaiser, Mr. Goldberg was a recipient of a Robert Wood Johnson Foundation grant to co-found a model rural primary care group practice. During the past 15 years, Mr. Goldberg has been a frequent speaker and lecturer for the Medical Group Management Association as well as for other national and regional professional and trade organizations.
TIM E. DUPELL joined PPI as its Chief Financial Officer in 1996. Prior to joining PPI, Mr. Dupell served as Chief Financial Officer for Corvallis Clinic beginning in March 1994. From 1988 to 1994, Mr. Dupell held concurrent positions in Finance, Operations and Risk Sharing Plans with Blue Cross/Blue Shield of Oregon and
with the Blue Cross/Blue Shield health maintenance organization, HMO Oregon. From 1984-1988, Mr. Dupell was a senior auditor in the Portland, Oregon office of Ernst & Young, LLP. Mr. Dupell holds a Bachelor's degree in Business from Pacific University. In addition, Mr. Dupell is a Certified Public Accountant, Certified Management Accountant, and a Certified Internal Auditor. He is a member of the Oregon Society of Certified Public Accountants, The American Institute of Certified Public Accountants, The Institute of Management Accountants, The Institute of Internal Auditors and the National Association of Accountants.
MICHAEL F. BONAZZOLA, M.D. joined PPI as Senior Vice President and Chief Medical Officer in 1996. Dr. Bonazzola practiced general internal medicine at Medford Clinic from 1982 to 1996. Dr. Bonazzola holds a Bachelor's degree in Natural Sciences from Lewis and Clark College and a Doctor of Medicine degree from University of Oregon Medical School and served as Chief Medical Resident at St. Vincent Hospital and Medical Center (Portland, Oregon). He is Board Certified in Internal Medicine. He was a member of the Board of Directors of Medford Clinic from 1983-1991 and served as its President from 1989-1991. When Dr. Bonazzola became Medford Clinic's Medical Director in 1991, Medford Clinic grew from 35 physicians, with no managed care contracts, to 64 physicians with approximately 35% of the overall business provided under managed care contracts. Between 1992 and 1995, Dr. Bonazzola served on the Board of Directors of HMO Oregon. He is a Trustee of the Oregon Medical Professional Review Organization.
BRUCE E. VAN ZEE, M.D. joined PPI as a founding member of the Board of Directors in 1996. Dr. Van Zee is a practicing physician of Medford Clinic committed to physician involvement in the governance and management of innovative health care organizations. He received his medical degree magna cum laude at the University of Oregon in 1970. He is Board Certified in Internal Medicine and Nephrology, having completed his post graduate education at the University of Rochester. Dr. Van Zee has served in a variety of medical management roles which include Chair of the Department of Medicine and President of the medical society in his community. He has received advanced post graduate training in physician management issues and in biomedical ethics.
DAVID H. CUTSFORTH, JR., M.D. joined PPI as a founding member of the Board of Directors in 1996. He practiced as a Philomath Family Medicine physician before that entity merged with Corvallis Clinic and currently practices at Corvallis Clinic. Dr. Cutsforth has been active in local and statewide health forums. He served as a Board Director for Western Oregon IPA from 1989-1993. He served as an original committee member in the formulation of the Oregon Health Plan, a national model for Medicaid reform. Dr. Cutsforth received his medical degree from the University of Oregon in 1973. He is Board Certified in Family Medicine, having completed his residency training at the University of Texas in Houston. Dr. Cutsforth has served in a variety of management roles including chair of the Department of Family Medicine and Peer Review Committee of Good Samaritan Hospital, Corvallis. He received a superior service award from the U.S. Public Health Service in 1977 and was recognized as America's Family Doctor of the Year in 1994.
RUSSELL A. DOW, M.D. joined PPI as a founding member of the Board of Directors in 1996. Dr. Dow is a HealthFirst physician practicing Obstetrics and Gynecology and has been involved in medical leadership and governance for many years. He received his medical degree from Tufts University School of Medicine in Boston, Massachusetts in 1974. He is Board Certified in Obstetrics and Gynecology, having completed his post-graduate training at the Oregon Health Sciences University.
DOUGLAS M. MANCINO, ESQ. joined PPI as a founding outside member of the Board of Directors in 1996. Mr. Mancino is an attorney and a partner in McDermott, Will & Emery's Los Angeles office. He has had more than 20 years of experience representing a broad variety of health care organizations. Mr. Mancino has been recognized by THE NATIONAL LAW JOURNAL as one of the country's leading managed care lawyers, and by the LOS ANGELES BUSINESS JOURNAL as one of Southern California's top 100 health care executives. Mr. Mancino is the author of a new book, TAXATION OF HOSPITALS AND HEALTH CARE ORGANIZATIONS (Warren, Gorham & Lamont 1995) and a co-author of NAVIGATING YOUR WAY THROUGH THE FEDERAL SELF-REFERRAL LAW: A GUIDEBOOK TO STARK II (Atlantic Information Systems, Inc. 1995). He has also co-authored a 1987 Aspen Systems book, JOINT VENTURES BETWEEN HOSPITALS AND PHYSICIANS and has written more than 30 articles on a variety of health care and taxation topics. Mr. Mancino received his law degree, summa cum laude, from The Ohio State University of Law in 1974. He is an active member and officer of several national legal organizations and publications and is a Fellow of the
American College of Tax Counsel. Mr. Mancino also has served as a Director of Health Systems International, Inc., including acting on its Compensation Committee.
FREDERICK W. EUBANK, II joined PPI as a Director in 1997. Mr. Eubank a Bachelor of Science degree in Business Administration from the Wake Forest University School of Business in Accountancy in 1986. In 1993, Mr. Eubank graduated with honors from the executive program at Duke University's Fuqua School of Business where he earned a Master of Business Administration degree. Mr. Eubank joined First Union Corporation in 1986 and was an Assistant Vice President in the Specialized Industries Group before joining First Union Capital Partners in 1989.
DAN GREGORIE, M.D. joined PPI as a Director in 1997. Dr. Gregorie received his undergraduate degree from Duke University and his medical degree from Tufts University in Boston, Massachusetts. He completed his internship and residency in Internal Medicine at Mount Auburn Hospital in Cambridge, Massachusetts. Following his residency, Dr. Gregorie attended the Sloan School of Management at MIT where he received his master's degree in management. Dr. Gregorie has served as special assistant to the Medical Director of Georgetown University Community Health Plan, Vice President and Associate Regional Medical Director of Capital Area Permanente Medical Group and President, CEO and Regional Medical Director of Northeast Permanente medical Group in Hartford, Connecticut. Since 1989, he has been President, CEO and Chairman of the Board of ChoiceCare.
MARK LEAVITT, M.D., PH.D., joined PPI as a Director in 1997. Dr. Leavitt founded MedicaLogic, Inc. in 1985 and has been its CEO since inception. From 1992 to 1994, Dr. Leavitt served as Medical Director of Information Systems for Providence Health System. He practiced internal medicine full-time in Portland, Oregon from 1982 to 1992. Dr. Leavitt holds a Bachelor's degree from the University of Arizona, a Doctorate from Stanford University in Electronic Engineering and a Doctorate from the University of Miami in Medicine. He is Board Certified in Internal Medicine and Geriatrics. Dr. Leavitt served as President of the Oregon Society of Internal Medicine from 1993 to 1994 and is a member of the American Society of Internal Medicine, the American College of Physicians and the Medical Informatics Association.
JON D. NESS joined PPI as a Senior Vice President in 1996 and concurrently serves as Chief Executive Officer of Medford Clinic. Before employed by Medford Clinic in 1995, he acted as Vice President of Deaconess-Billings Clinic Health System. Mr. Ness is a member of MGMA and a member of the certified medical practice executive program. Mr. Ness received his Master of Arts in Urban Planning from North Dakota State University in 1984. He acted as a corporate planner of St. Luke's Hospital, affiliated with Fargo Clinic, a 250 physician multi-specialty clinic, from 1986 to 1989.
RALPH PROWS, M.D. joined PPI as a Senior Vice President and concurrently serves as Chief Executive Officer of the Corvallis Clinic, PC Dr. Prows received his medical degree from Tulane University and completed specialty training at Ochsner Foundation Hospital in New Orleans. He is Board Certified in Internal Medicine. Dr. Prows had been the Corvallis Clinic's Medical Director since 1993 and was responsible for physician recruitment, clinical quality assurance and utilization management. Prior to joining the Corvallis Clinic, he served for seven years as Senior Vice President for Medical Affairs for Central Massachusetts Health Care, a 100,000 member non-profit health maintenance organization. Dr. Prows has also served on the Board of Directors of the Unified Medical Group Association (now the American Medical group Association).
KERRY BARNETT joined PPI as Senior Vice President in February 1998 and concurrently serves as Chief Executive Officer of HealthFirst Medical Group, PC. Mr. Barnett received an undergraduate degree from the University of Rochester in New York in 1978 and received his Juris Doctor from Yale School of Law in 1987. From 1990 to 1993, he was the Oregon governor's legal counsel and senior policy advisor. From 1993 until the end of 1997, Mr. Barnett served as Director of the Department of Consumer and Business Services, Insurance Commissioner and Superintendent of Banking. In this capacity he had primary responsibility for all aspects of Oregon's largest business regulatory agency.
JERALD W. ERSTGAARD was a Senior Vice President of PPI. He obtained a Bachelor of Arts degree from the University of South Dakota with a concentration in business. In 1973, he received a Masters degree in Business Administration from the University of Wyoming. Mr. Erstgaard worked as an assistant administrator at Corvallis Clinic from 1979 to 1986. He joined Metropolitan as an administrator in 1986. Since February 1, 1996, at the time of the business combination of Metropolitan and Suburban, Mr. Erstgaard held the administrative
position of Chief Executive Officer of HealthFirst. During Mr. Erstgaard's tenure, HealthFirst grew from an organization of 15 physicians to an entity with approximately 120 physicians. In addition to his role in management at HealthFirst, Mr. Erstgaard acted as a member of the Board of Directors of the American Medical Group Association and of the Northwest Group Practices Association. He is a Member of Medical Group Management Association. He previously served as President of Oregon Medical Group Management Association. His employment with PPI ended in August 1997.
ITEM 11:
ITEM 11: EXECUTIVE COMPENSATION
The following table summarizes the annual and long-term compensation of the Company's Chief Executive Officer and the six highest paid executive officers for 1997, 1996 and 1995.
(1) Jerald Erstgaard`s employment with PPI was terminated in August 1997. Pursuant to the severance agreement, Mr. Erstgaard will continue to be paid at an annual rate of $132,000 for 14 months following the termination date.
(2) Annual bonuses are earned and accrued during the fiscal years indicated and paid in the following year.
(3) Amounts consist of an automobile allowance paid by the Company.
(4) This column sets forth the dollar value, as of the grant date, of restricted stock awarded. The stock awards aggregating 108,000 were granted in October 1996 to four officers of the Company. These awards were initially subject to a three-year vesting requirement. In the case of three of the officers, the requirement has subsequently been eliminated. The fourth officer is no longer employed, but will be entitled to retain the stock award as long as the terms of his separation agreement are adhered to. David Goldberg, Tim Dupell and Jon Ness were each rewarded 27,000 shares at an exercise price of $5.51 per share. The estimated fair value of these awards in the aggregate amount of $595,080 was recognized as compensation expense in 1996.
(5) Amounts represent matching contributions from the New PC's defined contribution plans to Tim Dupell and Ralph Prows from the Corvallis Clinic, PC , to Michael Bonazzola from Medford Clinic, PC, and to Jerald Erstgaard from HealthFirst Medical Group, PC
The following table sets forth information concerning options granted to the named executive officers in 1997.
(1) The potential realizable values shown are based on the actual market price of the options at grant date, $8.00 per share, and the indicated assumed annual rates of appreciation compounded annually.
(2) Options granted in 1997 did not include stock appreciation rights ("SARs").
The Securities and Exchange Commission regulations require information as to the potential realizable value of each of these options, assuming that the market price of Company Common Stock appreciates in value from the date of grant to the end of the option term at annual rates of zero, five and ten percent. The shares granted above were issued at a below-market price, therefore, the potential realizable values of the options granted at the assumed annual rates were based on the actual market value of the stock options at grant date, $8.00 per share. If zero appreciation occurs over the term of the options, the value of the options granted is listed above under the column detailing a 0% appreciation. The value is determined as the difference between the market price of the options and the base price of those options granted.
Actual gains, if any, on stock option exercises and Company Common Stock holdings will depend on overall market conditions and the future performance of the Company and its Common Stock. There can be no assurance that the amounts reflected in this table will be realized.
FISCAL YEAR END OPTION VALUES
PPI's common stock is not publicly traded, therefore, the basis of the option valuation is the price of the Common stock as of July 10, 1997, the last date of valuation in the year ending December 31, 1997. No options were exercised in 1997 by any named executive officer. The following table details information concerning the value of unexercised stock options held by each named executive officer. The value of the unexercised options reflect the increase in the granted value of the Company's Common Stock on the date of the grant through the last date of stock valuation on 7/10/97. As of July 10, 1997, PPI's Common Stock was valued at $8.00 per share. The value actually
realized upon the future exercise of options by the named executive officers will depend on the value of the Company Common Stock at the time of exercise.
(1) Jerald Erstgaard's employment with PPI was terminated on August 20, 1997. According to the terms of Mr. Erstgaard's Separation and Release Agreement, Mr. Erstgaard forfeited the right to purchase the 35,000 shares of PPI Common Stock granted to him at that time.
DIRECTOR COMPENSATION
PPI Directors are entitled to receive compensation for serving as Directors in an amount equal to $1,000 per board meeting or $5,000 per fiscal quarter of PPI, whichever is greater. In addition, Directors are entitled to receive $750 per meeting attended for various committee purposes if the meeting is not held on a date on which the Board holds a meeting. Furthermore, Directors may be reimbursed for reasonable and actual out-of-pocket expenses incurred in connection with their duties as Directors.
INDEMNIFICATION AGREEMENTS
Pursuant to Article VII of the PPI Bylaws, PPI is obligated to indemnify each of its Directors and officers that could require PPI, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as Directors and officers and to advance expenses incurred by them as a result of any proceeding against them as to which they could be indemnified.
CHANGE-IN-CONTROL ARRANGEMENTS
PPI has established the Physician Partners, Inc. Change In Control Plan (the "Plan") to enable PPI to provide severance benefits to eligible executive or management employees whose employment is terminated following a Change in Control (as such term is defined in the Plan) of the Company. Pursuant to agreements entered into under the Plan, David Goldberg, Tim Dupell, Michael Bonazzola, Ralph Prows and Jon Ness are entitled to separation pay and benefits following a change of control of PPI and the employee's subsequent termination of employment with PPI unless such termination is voluntary or results from death, disability, retirement or cause. The eligible termination must occur within 24 months of the Change in Control or the agreement is void. Each agreement continues for three years from such date the agreement is executed and automatically renews every three years from such date unless the employee receives written notice of termination at least ninety days prior to the renewal date. The separation pay under each agreement (including those for each of the named executive officers) equals three years' annualized base salary and maximum target bonus. In addition, upon the occurrence of an eligible termination, all outstanding options to purchase PPI Common Stock will immediately vest and become exercisable. In the event that any payments to be made to an employee in connection with a change in control of PPI under the Plan or any other plan or arrangement would not be deductible by PPI for federal income tax purposes, then the
payments under the Plan and the employee's agreement will be reduced as necessary to eliminate the disallowance of the deduction.
EMPLOYMENT AGREEMENTS
DAVID GOLDBERG entered into an agreement with the Company on September 19, 1996 to be employed as President and Chief Executive Officer of PPI for a term of three years. From July 1, 1996 until February 1, 1997, i.e., the effective date of the Merger ("Effective Time"), Mr. Goldberg was paid a base salary at an annual rate of $300,000; from and after the Effective Time, he will be paid a base salary at an annual rate of $225,000 and options to purchase 150,000 shares of PPI Common Stock. Pursuant to his employment agreement, on October 30, 1996, Mr. Goldberg received a restricted stock award of 27,000 shares of PPI Common Stock. In the event Mr. Goldberg's employment is terminated without cause, he shall receive his base salary and medical, health and accident and disability insurance for a term of 12 months after the date of such termination. The obligations of PPI under the employment agreement with Mr. Goldberg are guaranteed by the New PCs.
TIM DUPELL entered into an agreement with the Company on September 19, 1996 to be employed as Senior Vice President and Chief Financial Officer of PPI for a term of three years. From July 29, 1996 until the Effective Time, Mr. Dupell was paid a base salary at an annual rate of $175,000; from and after the Effective Time, Mr. Dupell has received options to purchase 100,000 shares of PPI Common Stock. Pursuant to his employment agreement, on October 30, 1996 Mr. Dupell received a restricted stock award for 27,000 shares of PPI Common Stock. In the event Mr. Dupell's employment is terminated without cause, he shall receive his base salary and medical, health and accident and disability insurance for a term of 12 months after the date of such termination. The obligations of PPI under the employment agreement of Mr. Dupell are guaranteed by the New PCs.
MICHAEL BONAZZOLA, M.D. entered into an agreement with the Company on September 19, 1996 to be employed as Senior Vice President and Chief Medical Officer of PPI for a term of three years. On the Effective Date, Dr. Bonazzola received a bonus award of $25,000. Commencing at the Effective Time, Dr. Bonazzola has been paid a base salary at an annual rate of $190,000, and received options to purchase 100,000 shares of PPI Common Stock. In the event Dr. Bonazzola's employment is terminated without cause, he shall receive his base salary and medical, health and accident and disability insurance for a term of 12 months after the date of such termination. The obligations of PPI under the employment agreement of Dr. Bonazzola are guaranteed by the New PCs.
JON NESS entered into an agreement with the Company on September 19, 1996 to be employed as Senior Vice President of PPI for a term of three years. Commencing at the Effective Time, Mr. Ness has been paid a base salary at an annual rate of $175,000 and received an option to purchase 35,000 shares of PPI Common Stock. Pursuant to his employment agreement, Mr. Ness received on October 30, 1996 a restricted stock award for 27,000 shares of PPI Common Stock. In the event Mr. Ness' employment is terminated without cause, he shall receive his base salary and medical, health and accident and disability insurance for a term of 12 months after the date of such termination.
JERALD ERSTGAARD entered into an agreement with the Company on September 19, 1996 to be employed as Senior Vice President of PPI. Mr. Erstgaard's position was voluntarily terminated as of August 20, 1997. Mr. Erstgaard's employment agreement was for a term of three years. Commencing at the Effective Time, Mr. Erstgaard was paid a base salary at an annual rate of $132,000 and at the time of termination of Mr. Erstgaard employment with PPI, PPI agreed to provide the following compensation and benefits to Mr. Erstgaard: For a period of 14 months from the termination date, in addition to the salary which had been paid to him for the month of August 1997, PPI will pay Mr. Erstgaard an the annual rate of $132,000 as though Mr. Erstgaard's employment with PPI had continued, payable in regular installments and subject to applicable withholding and deductions. In addition, PPI agreed to provide Mr. Erstgaard with (a) medical, health and accident and disability insurance and other benefits at the same coverage level maintained for Erstgaard's benefit immediately prior to the termination, and (b) participation in any 1997 and 1998 contribution that PPI makes on behalf of its employees to any retirement or pension plan, with respect to severance payments through October 19, 1998.
KERRY BARNETT entered into an employment agreement on February 9, 1998 to be employed as Senior Vice President of PPI for a term of three years. Kerry Barnett assumed the responsibilities of Jerald Erstgaard. Mr. Barnett will be paid a base salary at an annual rate of $158,000 with a potential annual bonus of $32,000 and receive an option to purchase 10,000 shares of PPI Common Stock. In the event that Mr. Barnett's employment is terminated without cause, he shall receive his base salary and medical, health and accident and disability insurance for a term of 6 months after the date of such termination.
RALPH PROWS, M.D. entered into an agreement with the Company on June 1, 1997 to be employed as Senior Vice President of PPI for a term of three years. Mr. Prows will be paid a base salary at an annual rate of $162,650 and receive an option to purchase 35,000 shares of PPI Common Stock. In the event Mr. Prows' employment is terminated without cause, he shall receive his base salary and medical, health and accident and disability insurance for a term of 12 months after the date of such termination.
ITEM 12:
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Set forth below is information concerning beneficial ownership of the Company Common Stock as of March 30, 1998 by (i) each of the nominees and current Directors, (ii) each of the named executive officers, (iii) all current Directors and executive officers of the Company as a group, and (iv) all persons known by the Company to be the beneficial owners of five percent or more of Company Common Stock.
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(1) Includes shares which may be acquired on February 1, 1997 upon exercise of stock options (10,000 shares for David Goldberg, 7,000 shares for Tim Dupell and Jon Ness, 7,442 shares for Michael Bonazzola, M.D., 442 shares for Bruce Van Zee, M.D., 1,135 shares for David Cutsworth, Jr., M.D., 1,500 shares for Douglas Mancino, Esq. and 8,195 shares for Ralph Prows, M.D.). Holders exercise neither voting nor investment power over unexercised option shares.
ITEM 13:
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
None.
PART IV
ITEM 14:
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Financial Statements, Financial Statement Schedules and Exhibits
(1) Financial Statements
The following financial statements of Physician Partners, Inc. are included in Part II, Item 8 of this report:
(2) Financial Statement Schedules
None required.
(3) Exhibits
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* Previously filed connection with Registration Statement No. 333-15595 and hereby incorporated by reference
** Previously filed and hereby incorporated by reference