================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (Mark One) [X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended March 31, 2008; or [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 Commission File Number 0-23511 ---------------- INTEGRATED HEALTHCARE HOLDINGS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) Nevada 87-0573331 (STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NO.) 1301 North Tustin Avenue, Santa Ana, California 92705 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) Registrant's telephone number, including area code: (714) 953-3503 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.001 par value (TITLE OF CLASS) ---------------- Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes[ ] No[X] Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes[ ] No[X] Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting company [X] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes [ ] No [X] The aggregate market value of voting stock held by non-affiliates of the registrant was $3,596,300 as of September 28, 2007 (computed by reference to the last sale price of a share of the registrant's common stock on that date as reported by the Over the Counter Bulletin Board). For purposes of this computation, it has been assumed that the shares beneficially held by directors and officers of registrant were "held by affiliates"; this assumption is not to be deemed to be an admission by such persons that they are affiliates of registrant. There were 137,095,716 shares outstanding of the registrant's common stock as of June 16, 2008. DOCUMENTS INCORPORATED BY REFERENCE: No portions of other documents are incorporated by reference into this Annual Report. ================================================================================ INTEGRATED HEALTHCARE HOLDINGS, INC. FORM 10-K ANNUAL REPORT FOR THE YEAR ENDED MARCH 31, 2008 TABLE OF CONTENTS PART I.........................................................................3 ITEM 1. BUSINESS............................................................3 ITEM 1A. RISK FACTORS......................................................19 ITEM 2. PROPERTIES.........................................................25 ITEM 3. LEGAL PROCEEDINGS..................................................26 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS................27 PART II.......................................................................28 ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES....28 ITEM 6. SELECTED FINANCIAL DATA............................................30 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS........................................31 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........49 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA........................50 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE ........................................50 ITEM 9A. CONTROLS AND PROCEDURES...........................................50 ITEM 9B. OTHER INFORMATION.................................................51 PART III......................................................................52 ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE............52 ITEM 11. EXECUTIVE COMPENSATION............................................56 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS ................................61 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE....................................................63 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES............................65 ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES........................66 SIGNATURES....................................................................69 PART I FORWARD-LOOKING INFORMATION This Annual Report on Form 10-K contains forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential" or "continue" or the negative of these terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including the risks discussed under the caption "Risk Factors" herein that may cause our Company's or our industry's actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by these forward-looking statements. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Except as may be required by applicable law, we do not intend to update any of the forward-looking statements to conform these statements to actual results. As used in this report, the terms "we," "us," "our," "the Company," "Integrated Healthcare Holdings" or "IHHI" mean Integrated Healthcare Holdings, Inc., a Nevada corporation, unless otherwise indicated. EXPLANATORY NOTE REGARDING CHANGE IN FISCAL YEAR On December 21, 2006 the Company changed its fiscal year end from December 31 to March 31. Unless specifically indicated otherwise, any reference to "2008" and "2007" or "fiscal 2008" and "fiscal 2007" relate to March 31, 2008 and 2007 and the years then ended, respectively, and any reference to "2005" or "fiscal 2005" relates to December 31, 2005 or the year ended December 31, 2005. The transition period, January 1 to March 31, 2006, is referred to as the "transition period". ITEM 1. BUSINESS BACKGROUND Integrated Healthcare Holdings, Inc. is a predominantly physician owned company that, on March 8, 2005, acquired and began operating the following four hospital facilities in Orange County, California (referred to as the "Hospitals"): o 282-bed Western Medical Center in Santa Ana o 188-bed Western Medical Center in Anaheim o 178-bed Coastal Communities Hospital in Santa Ana o 114-bed Chapman Medical Center in Orange Together we believe that the Hospitals represent approximately 12.2% of all hospital available beds in Orange County, California (based on the most recent data on the Office of Statewide Health Planning and Development for California web site as of June 15, 2008) Prior to March 8, 2005, we were primarily a development stage company with no material operations. On November 18, 2003, members of our current and former executive management purchased a controlling interest in the Company and redirected its focus towards acquiring and operating hospitals and healthcare facilities that are financially distressed and/or underperforming. On September 29, 2004, the Company entered into a definitive agreement to acquire the four Hospitals from subsidiaries of Tenet Healthcare Corporation ("Tenet"), and the transaction closed on March 8, 2005. The transaction included operations of four licensed general acute care hospitals with a total of 762 beds. All four hospitals are accredited by the Joint Commission on Accreditation of Healthcare Organizations and other appropriate accreditation agencies that accredit specific programs. All properties are in Orange County California, and operate as described below. 3 WESTERN MEDICAL CENTER - SANTA ANA. Western Medical Center - Santa Ana, located at 1001 North Tustin Avenue, Santa Ana, CA 92705, is Orange County's first hospital, founded over 100 years ago. The hospital is one of IHHI's two hospitals in Santa Ana, which are the only two general acute care hospitals in this city of 350,000 people. The hospital has 282 beds and provides quaternary, tertiary and secondary services. It serves the entire county as one of only three designated trauma centers in Orange County along with other tertiary services such as burn center, kidney transplantation, emergency and scheduled neurosurgical care, cardiac surgical services, a paramedic base station and receiving center. The hospital also maintains Intensive Care Units for adults and pediatrics, and a Neonatal Intensive Care Unit. Additionally the hospital offers telemetry, neurosurgical definitive observation, geriatric, psychiatric, medical, surgical, pediatric and obstetric inpatient services. Supporting these services the hospital offers operating and recovery rooms, radiology services, respiratory therapy services, clinical laboratories, pharmacy, physical and occupational therapy services on an inpatient and most on an outpatient basis. The hospital has approximately 175 active physicians and 535 employee nurses, and hospital staff. WESTERN MEDICAL CENTER - ANAHEIM. Western Medical Center - Anaheim, located at 1025 South Anaheim Boulevard, Anaheim, CA 92805, offers a full range of acute medical and psychiatric care services serving northern Orange County and providing tertiary services to Riverside County residents. The hospital offers special expertise in the tertiary services of The Heart and Vascular Institute, and Behavioral Health Services. Additionally, the hospital provides the Women and Children Health Services, and 24-hour Emergency Services. Supporting these services the hospital offers critical care, medical, surgical and psychiatric services supported by operating and recovery rooms, radiology services, respiratory therapy services, clinical laboratories, pharmacy, physical and occupational therapy services on an inpatient and most on an outpatient basis. The hospital has approximately 75 active physicians and 295 employee nurses, and hospital staff. COASTAL COMMUNITIES HOSPITAL - SANTA ANA. Coastal Communities Hospital, located in Santa Ana at 2701 South Bristol Street, Santa Ana, CA 92704, has served the community for more than 30 years, providing comprehensive medical and surgical services in a caring and compassionate environment. The hospital is one of IHHI's two hospitals in Santa Ana, which are the only two general acute care hospitals in this city of 350,000 people. The hospital has tailored its services to meet the changing needs of the community. The hospital's staff reflects the cultural diversity of the community and is particularly responsive and sensitive to diverse healthcare needs. While services continue to expand, the 178-bed facility is small enough to retain the family atmosphere associated with a community hospital. The hospital offers critical care, medical, surgical obstetric, psychiatric and sub acute services supported by operating and recovery rooms, radiology services, respiratory therapy services, clinical laboratories, pharmacy, physical and occupational therapy services on an inpatient and most on an outpatient basis. The hospital has approximately 55 active physicians and 260 employee nurses, and hospital staff. CHAPMAN MEDICAL CENTER - ORANGE. Founded in 1969, Chapman Medical Center is a 114-bed acute care facility located at 2601 East Chapman Avenue, Orange, CA 92869. The hospital's advanced capabilities position the facility as a leader in specialty niche programs, including the following centers: Chapman Center for Obesity (surgical weight loss program); Center for Heartburn and Swallowing; Chapman Lung Center; Chapman Family Health Center; Doheny Eye Center; House Ear Clinic; Center for Senior Mental Health; and Positive Action Center (Adult and Adolescent Chemical Dependency Program). Supporting these services the hospital offers critical care, medical, surgical and geriatric psychiatric services supported by operating and recovery rooms, radiology services, respiratory therapy services, clinical laboratories, pharmacy, physical and occupational therapy services on an inpatient and most on an outpatient basis. The hospital has approximately 45 active physicians and 115 employee nurses, and hospital staff. On March 8, 2005, the Company assumed management responsibility and control over the Hospitals. All primary systems and controls have been successfully transitioned to our Company for the effective management of the Hospitals. 4 EMPLOYEES AND MEDICAL STAFF At March 31, 2008, the Company had approximately 3,075 employees. Of these employees, approximately 620 are represented by two labor unions, the California Nurses Association and SIEU-United Healthcare Workers, who are covered by collective bargaining agreements. We believe that our relations with our employees are good. The Company also had approximately 170 individuals from contracting agencies at March 31, 2008, consisting primarily of nursing staff. Our hospitals are fully staffed by physicians and other independently practicing medical professionals licensed by the state, who have been admitted to the medical staff of the individual hospital. Under state laws and licensing standards, hospitals' medical staffs are self-governing organizations subject to ultimate oversight by the hospital's local governing board. None of these physicians are employees of the hospitals. Physicians are not limited to medical staff membership at our hospitals, and many are on staff at our other hospitals, or hospitals not owned or operated by us. Physicians on our medical staffs are free to terminate their membership on our medical staffs and admit their patients to other hospitals, owned, or not owned by us. Non-physician staff, including nurses, therapists, technicians, finance, registration, maintenance, clerical, housekeeping, and administrative staff are generally employees of the hospital, unless the service is provided by a third party contracted entity. We are subject to federal minimum wage and hour laws and various state labor laws and maintain an employee benefit plan. Our hospitals' operations depend on the abilities, efforts, experience and loyalty of our employees and physicians, most of who have no long-term contractual relationship. Our ongoing business relies on our attraction of skilled, quality employees, physicians and other healthcare professionals in all disciplines. We strive to successfully attract and retain key employees, physicians and healthcare professionals. Our operations, financial position and cash flows could be materially adversely affected by the loss of key employees or sufficient numbers of qualified physicians and other healthcare professionals. The relations we have with our employees, physicians, and other healthcare professionals are key to our success and they are a priority in our management philosophy. Nursing can have a significant effect on our labor costs. The national nursing shortage continues and is serious in California. The nursing shortage is a significant issue for hospitals, as it is for us. The result has been an increase in the cost of nursing personnel, thus affecting our labor expenses. Additionally, California instituted mandatory nurse staffing ratios, thus setting a high level of nurses to patients, but also requiring nursing staff ratios be maintained at all times even when on breaks or lunch. These requirements in the environment of a severe nursing shortage may cause the limiting of patient admissions with an adverse effect on our revenues. The vast majority of hospitals in California, including ours, are not at all times meeting the state mandated nurse staffing ratios. Our plan is to improve compliance and reduce the cost of contract labor needed to achieve the nurse staffing ratios. 5 COMPETITION Hospital competition is a community issue and unique to each facility. The first factor is the services the hospital offers and the other hospitals in the area offering the same or similar service. The hospital is dependent on the physicians to admit the patients to the hospital. The number of physicians around the hospital, their specialties, and the quality of medicine they practice will have a major impact on the hospital competition. The ability of the hospital to employ and retain qualified nurses, other healthcare professionals, and administrative staff will affect the hospitals' competitiveness in the market place. A hospital's reputation and years of service to the community affects its competitiveness with patients, physicians, employees, and contracting health plans. Southern California is a highly competitive managed healthcare market therefore the contracting relationships with managed care organizations is a key factor in a hospital's competitiveness. The hospital's location, the community immediately surrounding it and the access to the hospital will affect the hospital's competitiveness. Other hospitals or healthcare organizations serving the same locations determine the intensity of the competition. The condition of the physical plant and the ability to invest in new equipment and technology can affect the communities and physicians desire to use the facility. The amount the hospital charges for services is also a factor in the hospital's competitiveness. The funding sources of the competition can also be a factor if a competitor is tax exempt; it has advantages not available to our Hospitals, such as endowments, chartable contributions, tax-exempt financing, and exemptions from taxes. Since these factors are individual to each hospital, each hospital must develop its own strategies, to address the competitive factors in its local. OUR STRATEGY Our goal is to provide high quality healthcare services in a community setting that are responsive to the needs of the communities that we serve. To accomplish our mission in the complex and competitive healthcare industry, our operating strategies are to (1) improve the quality of care provided at our hospitals by identifying best practices and implementing those best practices, (2) improve operating efficiencies and reduce operating costs while maintaining or improving the quality of care provided, (3) improve patient, physician and employee satisfaction, and (4) improve recruitment and retention of nurses and other employees. We continue to integrate and efficiently operate the four Hospitals in order to achieve profitability from operations. We may also seek additional acquisitions of hospitals or health facilities in the future when opportunities for profitable growth arise. HEALTHCARE REGULATION CERTAIN BACKGROUND INFORMATION. Health care, as one of the largest industries in the United States, continues to attract much legislative interest and public attention. Changes in the Medicare and Medicaid programs and other government healthcare programs, hospital cost containment initiatives by public and private payers, proposals to limit payments and healthcare spending, and industry wide competitive factors greatly impact the healthcare industry. The industry is also subject to extensive federal, state and local regulation relating to licensure, conduct of operations, ownership of facilities, physician relationships, addition of facilities and services, and charges and effective reimbursement rates for services. The laws, rules and regulations governing the healthcare industry are extremely complex, and the industry often has little or no regulatory or judicial interpretation for guidance. Compliance with such regulatory requirements, as interpreted and amended from time to time, can increase operating costs and thereby adversely affect the financial viability of our business. Failure to comply with current or future regulatory requirements could also result in the imposition of various civil and criminal sanctions including fines, restrictions on admission, denial of payment for all or new admissions, the revocation of licensure, decertification, imposition of temporary management or the closure of a facility. 6 MEDICARE GENERALLY. Each of the Hospitals participates in the Medicare program. Healthcare providers have been and will continue to be affected significantly by changes that have occurred in the last several years in federal healthcare laws and regulations pertaining to Medicare. The purpose of much of the recent statutory and regulatory activity has been to reduce the rate of increase in Medicare payments and to make such payments more accurately reflect patient resource use at hospitals. In addition, important amendments to the Medicare law were made by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 ("MMA") and the Deficit Reduction Act of 2005 ("DRA"). Although the most significant provisions of MMA relate to an expansion of Medicare's coverage for pharmaceuticals and changes intended to expand managed care under the Medicare program, MMA also made many changes in the laws that are relevant to how Medicare makes payments to hospitals, some of which could have an adverse impact on the Hospitals' Medicare reimbursement. One focus of the DRA, which may affect the Hospitals, is the requirement for hospitals to increase quality of care reporting and an increased penalty for hospitals that fail to properly submit quality data. INPATIENT OPERATING COSTS. Medicare pays acute care hospitals, such as the Hospitals, for most services provided to inpatients under a system known as the Prospective Payment System ("PPS") pursuant to which hospitals are paid for services based on predetermined rates. Medicare payments under PPS are based on the Diagnosis Related Group ("DRG") to which each Medicare patient is assigned. The DRG is determined by the patient's primary diagnosis and other factors for each particular Medicare inpatient stay. The amount to be paid for each DRG is established prospectively by the Centers for Medicare and Medicaid Services ("CMS"). The DRG amounts are not related to a hospital's actual costs or variations in service or length of stay. Therefore, if a hospital incurs costs in treating Medicare inpatients that exceed the DRG level of reimbursement plus any outlier payments, then that hospital will experience a loss from such services, which will have to be made up from other revenue sources. Payment limitations implemented by other third party payers may restrict the ability of a hospital to engage in such "cost-shifting." In October 2006, CMS implemented significant changes to the Medicare program's inpatient acute care PPS that (1) altered the way that DRG weights are calculated, abandoning the charge-based weight system in favor of a cost-based weight system and (2) expanded the number of DRGs so that the severity of a given illness is taken into account for purposes of payment. Such systemic changes took affect for discharges occurring on and after October 1, 2006 and are being phased in over a three year period through federal fiscal year ("FFY") 2008 which began on October 1, 2007. CMS determined that hospitals would respond to the new MS DRG system with improvements in documentation and coding procedures that would result in a 4.8% national increase in payments (the impact on individual hospitals could not be determined as it would vary based on the services provided by the hospital). To offset this, the FFY 2008 final rule included reductions in payments of 1.2% for FFY 2008, 1.8% for FFY 2009, and 1.8% for FFY 2010. CMS has proposed an adjustment to the reduction for FFY 2009 from 1.8% to 0.9% in their proposed FFY 2009 PPS rules, published April 30, 2008 in the Federal Register. At this time, it is not known if the proposed reduction will be adopted, or if adopted, what the affect will be on the Hospitals. For certain Medicare beneficiaries who have unusually costly hospital stays (also known as "outliers"), CMS currently provides additional payments above those specified for the DRG. To determine whether a case qualifies for outlier payments, hospital-specific cost-to-charge ratios are applied to the total covered charges for the case. Operating and capital costs for the case are calculated separately by applying separate operating and capital cost-to-charge ratios and combining these costs to compare them with a defined fixed-loss outlier threshold for the specific DRG. PPS payments are adjusted annually using an inflation index, based on the change in a "market basket" of hospital costs of providing healthcare services. There can be no assurance that future updates in PPS payments will keep pace with inflation or with the increases in the cost of providing hospital services. It is also possible that the prospective payment for capital costs at a Hospital will not be sufficient to cover the actual capital-related costs of the Hospital allocable to Medicare patients' stays. 7 OUTPATIENT SERVICES. All services paid under the outpatient PPS are classified into groups called Ambulatory Payment Classifications ("APC"). Services in each APC are similar clinically and in terms of the resources they require. A payment rate is established for each APC. Depending on the services provided, hospitals may be paid for more than one APC for an encounter. CMS will make additional payment adjustments under outpatient PPS, including "outlier" payments for services where the hospital's cost exceeds 2.5 times the APC rate for that service. In addition, certain other changes have reduced coinsurance payments below what they would have originally been under outpatient PPS. MEDICARE BAD DEBT. Medicare beneficiaries have a coinsurance payment and annual deductible for most inpatient and outpatient hospital services. Hospitals must first seek payment of any such coinsurance and deductible amounts from the Medicare beneficiary. If, after reasonable collection efforts, a hospital is unable to collect these coinsurance and deductible amounts, Medicare currently reimburses hospitals 70 percent of the uncollected coinsurance and deductible amount (known as "Medicare bad debt"). The President's fiscal year 2009 proposed budget would phase out the reimbursement of most Medicare bad debt. It is not possible to determine at this time whether such changes will be adopted by Congress as proposed. MEDICARE CONDITIONS OF PARTICIPATION. Hospitals must comply with provisions called "Conditions of Participation" in order to be eligible for Medicare reimbursement. CMS is responsible for ensuring that hospitals meet these regulatory Conditions of Participation. Under the Medicare rules, hospitals accredited by the Joint Commission on Accreditation of Healthcare Organizations ("JCAHO") are deemed to meet the Conditions of Participation. The Hospitals are each currently accredited by JCAHO and are therefore deemed to meet the Conditions of Participation. MEDICARE AUDITS. Medicare participating hospitals are subject to audits and retroactive audit adjustments with respect to reimbursement claimed under the Medicare program. Medicare regulations also provide for withholding Medicare payments in certain circumstances. Any such withholding with respect to the Hospitals could have a material adverse effect on the Company. In addition, contracts between hospitals and third party payers often have contractual audit, setoff and withhold language that may cause substantial, retroactive adjustments. Medicare requires certain financial information be reported on a periodic basis, and with respect to certain types of classifications of information, penalties are imposed for inaccurate reports. As these requirements are numerous, technical and complex, there can be no assurance that the Company will avoid incurring such penalties. Such penalties could materially and adversely affect the Company. MEDICARE MANAGED CARE. The Medicare program allows various managed care plans, now known as Medicare Advantage Plans, offered by private companies to engage in direct managed care risk contracting with the Medicare program. Under the Medicare Advantage program, these private companies agree to accept a fixed, per-beneficiary payment from the Medicare program to cover all care that the beneficiary may require. Generally, in order to engage in risk contracting, a Medicare Advantage Plan must be licensed at the state level. In recent years, many private companies have discontinued their Medicare Advantage Plans. The result has been that the beneficiaries who were covered by the now-discontinued Medicare plan have been shifted back into the Medicare fee-for-service program or into a Medicare cost plan. Also, the decrease in the number of Medicare beneficiaries enrolled in the Medicare Advantage program has not gone unnoticed by Congress and CMS. Congress has recently increased payments to such plans and made other changes to Medicare managed care to encourage beneficiary enrollment in managed care plans. Future legislation or regulations may be created that attempt to increase participation in the Medicare Advantage program. The effect of these recent changes and any future legislation/regulation is unknown but could materially and adversely affect the Company. 8 MEDI-CAL (CALIFORNIA'S MEDICAID PROGRAM) FEE-FOR-SERVICE PROGRAM. The Medi-Cal program is a joint federal/state program that provides healthcare services to certain persons who are financially needy. Each of the Hospitals participates in the Medi-Cal program. The Medi-Cal program includes both a fee-for-service component and a managed care component. Inpatient hospital services under the fee-for-service component are reimbursed primarily under the Selective Provider Contracting Program ("SPCP"), which are negotiated by the California Medical Assistance Commission ("CMAC"). The SPCP and CMAC system for payments to hospitals are designed to pay hospitals below their costs of services to Medi-Cal beneficiaries. The Company is located in an area which is currently a "closed area" under the SPCP. In SPCP closed areas, private hospitals must hold a contract with the Medi-Cal program in order to be paid for their inpatient services (other than services performed in an emergency to stabilize a patient so that they can be transferred to a contracting hospital and additional care rendered to emergency patients who cannot be so stabilized for transfer or where no contracting hospital accepts the patient). Contracting hospitals are generally paid for these services on the basis of all inclusive per diem rates they negotiate under their SPCP/CMAC contracts. Outpatient hospital services under the fee-for service-component are paid for on the basis of a fee schedule, and it is not necessary for hospitals to hold SPCP/CMAC contracts in order to be paid for their outpatient services. Each Hospital currently has an SPCP/CMAC contract in which it is contractually bound to continue until November 26, 2009, and there can be no assurance that the Hospital will maintain SPCP status thereafter or that the current Medi-Cal payment arrangements will continue. There can be no assurance that the SPCP/CMAC contract rates paid to the Hospitals will cover each Hospital's cost of providing care. The Medi-Cal payment rates for outpatient services cover only a small portion of a Hospital's cost of providing care. MEDI-CAL MANAGED CARE. In addition to the fee-for-service component of Medi-Cal, Orange County, California (where the Hospitals are located) participates in the Medi-Cal managed care program. Many Medi-Cal beneficiaries in Orange County are covered under Medi-Cal managed care, and not under fee-for-service Medi-Cal. Medi-Cal managed care in Orange County is provided through a County Organized Health System known as CalOptima. An Orange County hospital that wants to participate in Medi-Cal managed care on a capitated basis must contract with CalOptima, and is typically paid a capitated amount each month to provide, or arrange for the provision of, specified services to CalOptima members assigned to the hospital. The capitated hospital is financially responsible for a predetermined list of services, whether those services are provided at the capitated hospital or another service provider, provided during the term of the contract, including allowable claims received after contract termination. Western Medical Center - Santa Ana had a capitated contract with CalOptima which terminated as of June 2006. Coastal Communities Hospital had a capitated contract with CalOptima which terminated in April 2007. There can be no assurance that the capitated payments received by Western Medical Center - Santa Ana and Coastal Communities Hospital were adequate to reimburse its costs of providing care under its CalOptima contract, or that the capitated payments that have been received will be adequate to cover its costs of providing care under its capitated contract. Mid-year 2006, CalOptima began entering into contracts with hospitals on a fee-for-services basis for managed care Medi-Cal enrollees managed directly by CalOptima and CalOptima's capitated hospitals. The rates in these contracts are based on the greater of an Orange County average SPCP/CMAC rate or the individual hospital's SPCP/CMAC rate. Chapman Medical Center, Coastal Communities Hospital, Western Medical Center - Anaheim and Western Medical Center - Santa Ana entered into these CalOptima fee for service contracts effective June 2006. A hospital which does not have a contract with CalOptima may provide covered services. However, there are ongoing disputes between CalOptima and hospitals in Orange County concerning the amount CalOptima is obligated to pay for emergency services furnished by non-contracting hospitals. An amendment to the federal Medicaid Act which became effective January 1, 2007, appears to set reimbursement from Medi-Cal managed care plans, like CalOptima, to hospital providers of emergency services that do not have contracts with those plans at an average SPCP/CMAC contracted rate for general acute care hospitals or the average contract rate for tertiary hospitals. The State of California has not established a definition differentiating general acute care hospitals from tertiary hospitals or the mechanism for determining the rates specified in the amendment. It is unclear how this amendment will ultimately be interpreted and applied. There can be no assurance that the amount paid to any of the Hospitals for services covered under CalOptima which are covered or not covered under a contract between CalOptima and the Hospital will be adequate to reimburse a Hospital's costs of providing care. 9 MEDI-CAL DSH PAYMENTS. Some of the Hospitals receive substantial additional Medi-Cal reimbursement as a disproportionate share ("DSH") hospital from the DSH Replacement Fund and the Private Hospital Supplemental Fund. Hospitals qualify for this additional funding based on the proportion of services they provide to Medi-Cal beneficiaries and other low-income patients. Payments to a hospital from the State's DSH Replacement Fund are determined on a formula basis set forth in California law and the Medi-Cal State Plan. Hospitals receive funds from the Private Hospital Supplemental Fund pursuant to amendments to their SPCP contracts negotiated with CMAC. The Medi-Cal funding for DSH hospitals, however, is dependent on state general fund appropriations, and there can be no assurance that the state will fully fund the Medi-Cal DSH payment programs. There also can be no assurance that the Hospitals which qualify for DSH will be able to negotiate SPCP contract amendments for Private Hospital Supplemental Fund Payments, although state law currently provides that a qualifying hospital may not receive less from the Private Hospital Supplemental Fund than it received from predecessor funds in the State's 2002-03 fiscal year. The state programs under which special payments are made to DSH hospitals are set to expire as of June 30, 2010. There can be no assurance the programs will be extended or replaced by similar programs. In addition, the federal government has recently proposed regulations which could have a significant negative affect on DSH reimbursement to California hospitals, including the Hospitals, if they become effective. Such changes could materially and adversely affect the Company. WORKERS' COMPENSATION REIMBURSEMENT FEE SCHEDULES. A portion of the Hospitals' revenues are expected to come from Workers' Compensation program reimbursements. As part of an effort in 2003 to control costs under the Workers' Compensation program, the California legislature enacted Labor Code Section 5307.1, which sets reimbursement for hospital inpatient and outpatient services, including outpatient surgery services, at a maximum of 120% of the current Medicare fee schedule for hospitals. The Administrative Director of the Division of Workers' Compensation is authorized to develop and, after public hearings, to adopt a fee schedule for outpatient surgery services, but this schedule may not be more than 120% of the current Medicare fee schedule for hospitals. This fee limitation limits the amount that the Hospitals will be paid for their services provided to Workers' Compensation patients. PROVIDER NETWORKS. Under California law, employers may establish medical provider networks for Workers' Compensation patients and may restrict their employees' access to medical services to providers that are participants in those networks. Employers are free to choose which providers will and will not participate in their networks, and employers pay participating providers on the basis of negotiated rates that may be lower than those that would otherwise be provided for by the Workers' Compensation fee schedules. Employers may also choose to contract with licensed Health Maintenance Organizations ("HMO") and restrict access by their employees to participating providers of these HMOs. The Hospitals are participating providers in several Workers' Compensation networks, and to the extent that the Hospitals are required to negotiate and accept lower reimbursement rates to participate in these networks, there may be an adverse financial impact on the Company. Also, network providers are required to provide treatment in accordance with utilization controls to be established by the Department of Workers' Compensation. Therefore, as network participants, such utilization controls may limit the services for which the Hospital is reimbursed, which would have an adverse financial impact on the Company. FURTHER REFORM. There will likely continue to be substantial activity in the California Workers' Compensation reform area. In the past, the legislature has considered a number of bills, some of which would further reduce the maximum reimbursement for medical services, including hospital services. It is expected that any revisions to the Workers' Compensation fee schedule, when and if implemented, will reduce the fees the Hospitals receive for Workers' Compensation patients. The impact of such possible future fee schedule changes cannot be estimated at this time. It is also possible that the profitability of the Company could be impacted by other future Workers' Compensation cost control efforts. 10 COMMERCIAL INSURANCE Many private insurance companies contract with hospitals on a "preferred" provider basis, and many insurers have introduced plans known as preferred provider organizations ("PPO"). Under preferred provider plans, patients who use the services of contracted providers are subject to more favorable copayments and deductibles than apply when they use non-contracted providers. In addition, under most HMOs, private payers limit coverage to those services provided by selected hospitals. With this contracting authority, private payers direct patients away from nonselected hospitals by denying coverage for services provided by them. The Hospitals currently have several managed care contracts. If the Company's managed care contract rates are unfavorable or are reduced in the future, this may negatively impact the Company's profitability. EMTALA In response to concerns regarding inappropriate hospital transfers of emergency patients based on the patient's inability to pay for the services provided, Congress enacted the Emergency Medical Treatment and Labor Act ("EMTALA") in 1986. This so-called "anti-dumping" law imposes certain requirements on hospitals with Medicare provider agreements to (1) provide a medical screening examination for any individual who comes to the hospital's emergency department, (2) provide necessary stabilizing treatment for emergency medical conditions and labor, and (3) not transfer a patient until the individual is stabilized, unless the benefits of transfer outweigh the risks or the patient gives informed consent to the transfer. Since the Hospitals must provide emergency services without regard to a patient's ability to pay, complying with EMTALA could have an adverse impact on the profitability of the Hospitals, depending upon the number of patients treated in or through the emergency room who are unable to pay. Failure to comply with the law can result in exclusion of the physician from the Medicare and/or Medicaid programs or termination of the hospital's Medicare provider agreements, as well as civil penalties. ANTI-KICKBACK, FRAUD AND SELF-REFERRAL REGULATIONS FEDERAL ANTI-KICKBACK LAW. The Social Security Act's illegal remuneration provisions (the "Anti-kickback Statute") prohibit the offer, payment, solicitation or receipt of remuneration (including any kickback, bribe or rebate), directly or indirectly, overtly or covertly, in cash or in kind, for (a) the referral of patients or arranging for the referral of patients to receive services for which payment may be made in whole or in part under a federal healthcare program, which includes Medicare, Medicaid and TRICARE (formerly CHAMPUS, which provides benefits to dependents of members of the uniformed services) and any state healthcare program, or (b) the purchase, lease, order, or arranging for the purchase, lease or order of any good, facility, service or item for which payment may be made under the above payment programs. The Anti-kickback Statute contains both criminal and civil sanctions, which are enforced by the Office of Inspector General ("OIG") of Department of Health & Human Services ("DHHS") and the United States Department of Justice. The criminal sanctions for a conviction under the Anti-kickback Statute are imprisonment for not more than five years, a fine of not more than $50,000 for each offense, or both, with higher penalties potentially being imposed under the federal Sentencing Guidelines. In addition to the imposition of criminal sanctions, the Secretary of DHHS may exclude any person or entity that commits an act described in the Anti-kickback Statute from participation in the Medicare program and direct states to also exclude that person from participation in state healthcare programs. The Secretary of DHHS can exercise this authority based on an administrative determination, without obtaining a criminal conviction. The burden of proof for the exclusion would be one that is customarily applicable to administrative proceedings, which is a lower standard than that required for a criminal conviction. In addition, violators of the Anti-kickback Statute may be subjected to civil money penalties of $50,000 for each prohibited act and up to three times the total amount of remuneration offered, paid, solicited, or received, without regard to whether a portion of such remuneration was offered, paid, solicited, or received for a lawful purpose. 11 There is ever-increasing scrutiny by federal and state law enforcement authorities, OIG, DHHS, the courts, and Congress of arrangements between healthcare providers and potential referral sources to ensure that the arrangements are not designed as a mechanism to exchange remuneration for patient care referrals and opportunities. The law enforcement authorities, the courts, and Congress have also demonstrated a willingness to look behind the formalities of an entity's structure to determine the underlying purpose of payments between healthcare providers and potential referral sources. Enforcement actions have been increased and, generally, the courts have broadly interpreted the scope of the Anti-kickback Statute and have held, for example, that the Anti-kickback Statute may be violated if merely one purpose of a payment arrangement is to induce referrals. In addition, the OIG has long been on record that it believes that physician investments in healthcare companies can violate the Anti-kickback Statute and the OIG has demonstrated an aggressive attitude toward enforcement of the Anti-kickback Statute in the context of ownership relationships. The OIG has issued regulations specifying certain payment practices that will not be treated as a criminal offense under the Anti-kickback Statute and that will not provide a basis for exclusion from the Medicare or Medicaid programs (the "Safe Harbor Regulations"). These regulations include, among others, safe harbors for certain investments in both publicly traded and non-publicly traded companies. However, investments in the Company will not be protected by either of these safe harbor regulations. Nevertheless, the fact that a specific transaction does not meet all of the criteria of a "safe harbor" does not mean that such transaction constitutes a violation of the Anti-kickback Statute, and the OIG has indicated that any arrangement that does not meet all of the elements of a safe harbor will be evaluated on its specific facts and circumstances to determine whether the Anti-kickback Statute has been violated and, thus, if prosecution is warranted. The OIG is authorized to issue advisory opinions which interpret the Anti- kickback Statute and has issued several advisory opinions addressing investments by physicians in healthcare businesses. Based upon those opinions, it appears unlikely that the OIG would be willing to issue an advisory opinion protecting physician investments in the Company, and no such opinion has been requested by the Company. The Company nevertheless believes, based upon a federal court decision involving physician investments in clinical laboratories, that investments in it by physicians are not automatically prohibited by the Anti- kickback Statute, depending upon the circumstances surrounding such investment. The Company has reviewed the terms of the purchase of ownership interests in the Company by Orange County Physician Investment Network, LLC ("OC-PIN") (which is owned by physicians that refer patients to the Hospitals) and has determined that the purchase should not violate the Anti-kickback Statute. The OIG also has identified many hospital-physician compensation arrangements that are potential violations of the Anti-kickback Statute, including: (a) payment of any incentive for the referral of patients; (b) use of free or discounted office space or equipment; (c) provision of free or discounted services, such as billing services; (d) free training; (e) income guarantees; (f) loans which are not fair market value or which may be forgiven; (g) payment for services which require few, if any substantive duties by the physician or payment for services in excess of fair market value of the services; and (h) purchasing goods or services from physicians at prices in excess of fair market value. The Company has reviewed many of its compensation relationships with physicians, and on-going reviews are occurring, in an effort to ensure that such relationships do not violate the Anti-kickback Statute. 12 CALIFORNIA ANTI-KICKBACK PROHIBITIONS. California law prohibits remuneration of any kind in exchange for the referral of patients regardless of the nature of the payer of such services, and is therefore broader in this regard than is the federal statute. Nevertheless, this statute specifically provides that a medically necessary referral is not illegal solely because the physician that is making the referral has an ownership interest in the healthcare facility to which the referral is made if the physician's return on investment is based upon the amount of the physician's capital investment or proportional ownership and such ownership is not based upon the number or value of patients referred. Further, opinions of the California Attorney General indicate that distributions paid to physicians who invest in entities that conduct health related businesses generally do not violate California's anti-kickback law when the entity conducts a bona fide business, services performed are medically needed, and profit distributions are based upon each investor's proportional ownership interest, rather than the relative volume of each investor's utilization of the entity's business. California has a separate anti-kickback statute which applies only under the Medi-Cal program and which largely parallels the prohibitions of the federal Anti-kickback Statute. The Company believes that analysis under this Medi-Cal anti-kickback statue will be the same as under the federal Anti-kickback Statute discussed above. FALSE AND OTHER IMPROPER CLAIMS. The federal government is authorized to impose criminal, civil, and administrative penalties on any person or entity that files a false claim for payment from the Medicare or Medi-Cal programs. In addition to other federal criminal and civil laws which punish healthcare fraud, the federal government, over the past several years, has accused an increasing number of healthcare providers of violating the federal Civil False Claims Act. The False Claims Act imposes civil liability (including substantial monetary penalties and damages) on any person or corporation which (1) knowingly presents a false or fraudulent claim for payment to the federal government; (2) knowingly uses a false record or statement to obtain payment; or (3) engages in a conspiracy to defraud the federal government to obtain allowance for a false claim. False claims allegations could arise, for example, with respect to the Hospital's billings to the Medicare program for its services or the submission by the Hospital of Medicare cost reports. Specific intent to defraud the federal government is not required to act with knowledge. Instead, the False Claims Act defines "knowingly" to include not only actual knowledge of a claim's falsity, but also reckless disregard for or intentional ignorance of the truth or falsity of a claim. Because the Hospitals perform hundreds of procedures a year for which they are paid by Medicare, and there is a relatively long statute of limitations, a billing error or cost reporting error could result in significant civil or criminal penalties. Under the qui tam, or whistleblower, provisions of the False Claims Act, private parties may bring actions on behalf of the federal government. These private parties, often referred to as relators, are entitled to share in any amounts recovered by the government through trial or settlement. Both direct enforcement activity by the government and whistleblower lawsuits have increased significantly in recent years and have increased the risk that a healthcare company, like us, will have to defend a false claims action, pay fines or be excluded from the Medicare and Medicaid programs as a result of an investigation resulting from a whistleblower case. Although the Company intends that the operations of the Hospitals will materially comply with both federal and state laws related to the submission of claims, there can be no assurance that a determination that we have violated these claims-related laws will not be made, and any such determination would have a material adverse effect on the Company. In addition to the False Claims Act, federal civil monetary penalties provisions authorize the imposition of substantial civil money penalties against an entity which engages in activities including, but not limited to, (1) knowingly presenting or causing to be presented, a claim for services not provided as claimed or which is otherwise false or fraudulent in any way; (2) knowingly giving or causing to be given false or misleading information reasonably expected to influence the decision to discharge a patient; (3) offering or giving remuneration to any beneficiary of a federal healthcare program likely to influence the selection of a particular provider, practitioner or supplier for the ordering or receipt of reimbursable items or services; (4) arranging for reimbursable services with an entity which is excluded from participation from a federal healthcare program; (5) knowingly or willfully soliciting or receiving remuneration for a referral of a federal healthcare program beneficiary; or (6) using a payment intended for a federal healthcare program beneficiary for another use. The 13 Secretary of DHHS, acting through the OIG, also has both mandatory and permissive authority to exclude individuals and entities from participation in federal healthcare programs pursuant to this statute. Also, it is a criminal federal healthcare fraud offense to: (1) knowingly and willfully execute or attempt to execute any scheme to defraud any healthcare benefit program, including any private or governmental program; or (2) to obtain, by means of false or fraudulent pretenses, any property owned or controlled by any healthcare benefit program. Penalties for a violation of this federal law include fines and/or imprisonment, and a forfeiture of any property derived from proceeds traceable to the offense. In addition, if an individual is convicted of a criminal offense related to participation in the Medicare program or any state healthcare program, or is convicted of a felony relating to healthcare fraud, the Secretary of DHHS is required to bar the individual from participation in federal healthcare programs and to notify the appropriate state agencies to bar the individuals from participation in state healthcare programs. While the criminal statutes are generally reserved for instances of fraudulent intent, the federal government is applying its criminal, civil, and administrative penalty statutes in an ever-expanding range of circumstances. For example, the government has taken the position that a pattern of claiming reimbursement for unnecessary services violates these statutes if the claimant merely should have known the services were unnecessary, even if the government cannot demonstrate actual knowledge. The government has also taken the position that claiming payment for low-quality services is a violation of these statutes if the claimant should have known that the care was substandard. In addition, some courts have held that a violation of the Stark Law or the Anti-kickback Statute can result in liability under the federal False Claims Act. Noncompliance with other regulatory requirements can also lead to liability under the False Claims Act if it can be established that compliance with those requirements is necessary in order for a hospital to be paid for its services. Claims filed with private insurers can also lead to criminal and civil penalties under federal law, including, but not limited to, penalties relating to violations of federal mail and wire fraud statutes and of the Health Insurance Portability and Accountability Act of 1996 and its implementing regulations ("HIPAA") provisions which have made the defrauding of any healthcare insurer, whether public or private, a crime. The Hospitals are also subject to various state insurance statutes and regulations that prohibit the Hospitals from submitting inaccurate, incorrect or misleading claims. The Company intends that the Hospitals will comply with all state insurance laws and regulations regarding the submission of claims. IHHI cannot assure, however, that each Hospital's insurance claims will never be challenged or that the Hospitals will in all instances comply with all laws regulating its claims. If a Hospital were found to be in violation of a state insurance law or regulation, the Hospital could be subject to fines and criminal penalties, which would have an adverse effect on IHHI's business and operating results. FEDERAL PHYSICIAN SELF-REFERRAL LAW. Provisions of the Social Security Act commonly referred to as the Stark Law prohibit referrals by a physician of Medicare patients to providers for a broad range of health services if the physician (or his or her immediate family member) has an ownership or other financial arrangement with the provider, unless an exception applies. The "designated health services" to which the Stark Law applies include all inpatient and outpatient services provided by hospitals. Hospitals cannot bill for services they provide as a result of referrals that are made in violation of the Stark Law. In addition, a violation of the Stark Law may result in a denial of payment, require refunds to patients and to the Medicare program, civil monetary penalties of up to $15,000 for each violation, civil monetary penalties of up to $100,000 for certain "circumvention schemes" and exclusion from participation in Medicare, Medicaid, and other federal programs. Violations of the Stark Law may also be actionable as violations of the federal False Claims Act. 14 Notwithstanding the breadth of the Stark Law's general prohibition, the law contains an exception which protects ownership interests held by physicians in hospitals where the referring physician is authorized to perform services at the hospital and the physician's ownership is in the hospital itself, and not merely in a subdivision of the hospital. The Hospitals intend to rely upon this exception to protect the ownership interests that physicians hold in them. Although the Company does not believe that any of its Hospital's will be considered to be "specialty hospitals", changes in this area of the law that would affect the classification of the Hospitals as "specialty hospitals" may affect the Company's operations. Furthermore, in the fiscal year 2009 Inpatient Prospective Payment System proposed rule issued on April 14, 2008, CMS proposed to require hospitals to disclose to patients whether they are owned in part or in whole by physicians, and if so, to make available the names of the physician owners. In addition, CMS proposed that as a condition of continued medical staff membership, physicians would be required to inform patients of their ownership interests in a hospital at the time they refer patients to that hospital. However, because similar disclosure requirements are already imposed by California law (see "Disclosure of Financial Interests" section below), it is unlikely that CMS' implementation of such requirement would have a material affect on the Company's operations. Also, CMS will require hospitals to disclose information concerning physician investment and compensation arrangements, and by July 2007, approximately 500 hospitals will be required to complete a Financial Relationship Disclosure Report ("Report") and submit the information to CMS for review. CMS has indicated that it may implement a regular mandatory disclosure process that will apply to all Medicare participating hospitals. The Company is unaware of whether any of its Hospitals will be required to submit such Reports, however, the Company does not anticipate that any such reporting requirements will materially affect the Company's operations. In addition to physician ownership, the Hospitals have arrangements by which they compensate various physicians for services. Payments by the Company to such physicians will constitute financial relationships for purposes of the Stark Law. Exemptions exist under the Stark Law and its implementing regulations for various types of compensation relationships. The Company will endeavor to ensure that all of its financial relationships qualify for one or more exemptions under the Stark Law. However, there can be no assurance that the Company will be successful in structuring all of its relationships with physicians so as to qualify for protection under one or more of the Stark Law's exceptions. CALIFORNIA PHYSICIAN SELF-REFERRAL LAW RESTRICTIONS. Restrictions on financial relationships between physicians and businesses to which they refer patients for specified types of services, including some services which will be provided by the Hospitals, also exist under California law. As is the case under federal law, the California self-referral restrictions can be triggered by financial relationships other than ownership. However, these laws contain a broad exemption permitting referrals to be made to a hospital so long as the referring physician is not compensated by the hospital for the referral and any equipment lease between the hospital and the physician satisfies certain requirements. An additional requirement imposed by California's self-referral laws is that any non-emergency imaging services performed for a Workers' Compensation patient with equipment that, when new, had a value of $400,000 or more must be pre-approved by the Workers' Compensation insurer or self-insured employer. This provision may require that preauthorization be obtained for MRI services ordered by the Hospitals' physician owners and others who have financial relationships with the Company. It is possible that insurers may refuse to provide any required preauthorizations in connection with referrals of Workers' Compensation patients made to the Hospitals by physicians who have financial relationships with it. However, given that MRI services for Workers' Compensation patients are not anticipated to represent a material portion of the Hospitals' services, the Company does not believe that any such refusals to provide required preauthorizations would have a material impact upon it. 15 LICENSING Health facilities, including the Hospitals, are subject to numerous legal, regulatory, professional, and private licensing, certification, and accreditation requirements. These include requirements relating to Medicare participation and payment, state licensing agencies, private payers and the Joint Commission on Accreditation of Healthcare Organizations ("Joint Commission"). Renewal and continuance of certain of these licenses, certifications and accreditations are based on inspections, surveys, audits, investigations or other reviews, some of which may require or include affirmative action or response by the Company. These activities generally are conducted in the normal course of business of health facilities. Nevertheless, an adverse determination could result in a loss or reduction in a Hospital's scope of licensure, certification or accreditation, or could reduce the payment received or require repayment of amounts previously remitted. Any failure to obtain, renew or continue a license, certification or accreditation required for operation of a Hospital could result in the loss of utilization or revenues, or the loss of the Company's ability to operate all or a portion of a Hospital, and, consequently, could have a material and adverse effect on the Company. DISCLOSURE OF FINANCIAL INTERESTS California law provides that it is unlawful for a physician to refer a patient to an organization in which the physician or the physician's immediate family has a significant beneficial interest unless the physician first discloses in writing to the patient that there is such an interest and advises the patient regarding alternative services, if such services are available. A "significant beneficial interest" means any financial interest equal to or greater than the lesser of five percent of the total beneficial interest or $5,000. This disclosure requirement may be satisfied by the posting of a conspicuous sign likely to be seen by all patients who use the facility or by providing patients with written disclosure statements. Physicians must also make disclosure of entities in which they hold significant financial interests to a patient's payer upon the request of the payer (not to be made more than once a year). A violation of this disclosure requirement constitutes "unprofessional conduct," and is grounds for the suspension or revocation of the physician's license. Further, it is deemed a misdemeanor punishable by imprisonment not to exceed six months, or by a fine not to exceed $2,500. In addition, California's general self-referral laws require that any physician who refers a person to, or seeks consultation from an organization in which the physician has a financial interest, must disclose the financial interest to the patient, or the parent or legal guardian of the patient, in writing, at the time of the referral or request for consultation. This requirement applies regardless of whether the financial interest is otherwise protected by one of the exemptions under the self-referral law. There is no minimum threshold of ownership required in order for this disclosure requirement to be triggered, and this disclosure requirement cannot be satisfied by the posting of a sign. A violation of this disclosure requirement may be subject to civil penalties of up to $5,000 for each offense. Physician investors in the Company will be individually responsible for complying with these disclosure requirements with respect to their referrals to the Hospital. The obligation of physicians with financial interests in the Company to make such disclosures or the effect of such disclosures on patients may have an adverse impact on the Company. HIPAA HIPAA mandated the adoption of standards for the exchange of health information in an effort to encourage overall administrative simplification and enhance the effectiveness and efficiency of the healthcare industry. Under HIPAA, healthcare providers and other "covered entities" such as health insurance companies and other third-party payers, must adopt uniform standards for the electronic transmission of billing statements and insurance claims forms. These standards require the use of standard data formats and code sets when electronically transmitting information in connection with health claims and equivalent encounter information, healthcare payment and remittance advice and health claim status. If we or our payers are unable to exchange information in connection with the specified transactions because of an inability to comply fully with the regulations, we are required to exchange the information using paper. If we are forced to submit paper claims to payers, it will significantly increase our costs associated with billing and could delay payment of claims. 16 On January 23, 2004, DHHS published a final rule that adopted the National Provider Identifier ("NPI") as the standard unique health identifier for healthcare providers. When the NPI is implemented, healthcare providers, including our Hospitals, must use only the NPI to identify themselves in connection with electronic transactions. Legacy numbers, such as Medicaid numbers, CHAMPUS numbers, and Blue Cross-Blue Shield numbers, will not be permitted. Healthcare providers will no longer have to keep track of multiple numbers to identify themselves in the standard electronic transactions with one or more health plans. The NPI is a 10-digit all numeric number that will be assigned to eligible healthcare providers, including our hospitals, by the National Provider System ("NPS"), an independent government contractor. Our hospitals have obtained and are using NPIs in connection with the standard electronic transactions. DHHS also has promulgated security standards and privacy standards which are aimed, in part, at protecting the confidentiality, availability and integrity of health information by health plans, healthcare clearinghouses and healthcare providers that receive, store, maintain or transmit health and related financial information in electronic form, regardless of format. The privacy standards require compliance with rules governing the use and disclosure of patient health and billing information. They create new rights for patients in their health information, such as the right to amend their health information, and they require us to impose these rules, by contract, on any business associate to which we disclose such information to perform functions on our behalf. These provisions required us to implement expensive computer systems, employee training programs and business procedures to protect the privacy and security of each patient health information and enable electronic billing and claims submissions consistent with HIPAA. The security standards require us to maintain reasonable and appropriate administrative, technical, and physical safeguards to ensure the integrity, confidentiality and the availability of electronic health and related financial information. The security standards were designed to protect electronic information against reasonably anticipated threats or hazards to the security or integrity of the information and to protect the information against unauthorized use or disclosure. HIPAA provides both criminal and civil fines and penalties for covered entities that fail to comply. Violations of the privacy or security standards could result in civil penalties of up to $25,000 per violation in each calendar year and criminal penalties of up to $250,000 per violation. In addition, the Hospitals are also subject to state privacy laws, which in some cases are more restrictive than HIPAA and impose additional penalties. Compliance with the HIPAA privacy, security and electronic transmission regulations will require significant changes in information and claims processing practices utilized by healthcare providers, including the Company. Estimates vary widely on the economic cost of implementing these provisions of HIPAA. DHHS estimates the total nationwide cost of compliance with the privacy rule alone at approximately five billion dollars; the Blue Cross and Blue Shield Association estimated that the nationwide cost of compliance may exceed forty billion dollars. As such, the future financial effect of these regulations on the Company is uncertain at this time. CORPORATE PRACTICE OF MEDICINE California has laws that prohibit non-professional corporations and other entities from employing or otherwise controlling physicians or that prohibits certain direct and indirect payment arrangements between healthcare providers. Although we intend to exercise care in structuring our arrangements with healthcare providers to comply with relevant California law, and we believe that such arrangements will comply with applicable laws in all material respects, we cannot give you any assurance that governmental officials charged with responsibility for enforcing these laws will not assert that the Company, or certain transactions that we are involved in, are in violation of such laws, or that the courts will ultimately interpret such laws in a manner consistent with our interpretations. 17 CERTAIN ANTITRUST CONSIDERATIONS The addition of physician-investors in the Company could affect competition in the geographic area in which its Hospitals operate in various ways. Such effects on competition could give rise to claims that the Hospitals, their arrangements with consumers and business entities or with physicians violate federal and state antitrust and unfair competition laws under a variety of theories. Accordingly, there can be no assurance that the activities or operations of the Hospitals will comply with federal and state antitrust or unfair competition laws, or that the Federal Trade Commission, the Antitrust Division of the Department of Justice, or any other party, including a physician participating in the Company's business, or a physician denied participation in the Company's business, will not challenge or seek to delay or enjoin the activities of the Company on antitrust or other grounds. If such a challenge is made, there can be no assurance that such challenge would be unsuccessful. We have not obtained an analysis of any possible antitrust implications of the activities of the Company or of the continuing arrangements and anticipated operations of the Hospitals. ENVIRONMENTAL REGULATIONS Our healthcare operations generate medical waste that must be disposed of in compliance with federal, state, and local environmental laws, rules, and regulations. Our operations, as well as our purchases and sales of facilities, also are subject to compliance with various other environmental laws, rules, and regulations. Remediation costs relating to toxic substances, if encountered during construction, could be material to the Company. CORPORATE HISTORY The Company was originally incorporated under the laws of the State of Utah on July 31, 1984 under the name "Aquachlor Marketing Inc." On December 23, 1988, the Company reincorporated in the State of Nevada. From 1989 until 2003, the Company was a development stage company with no material assets, revenues or business operations. On November 18, 2003, a group of investors purchased a controlling interest in the Company (then known as First Deltavision) with the objective of transforming the Company into a leading provider of high quality, cost-effective health care through the acquisition and management of financially distressed and/or underperforming hospitals and other healthcare facilities. On September 29, 2004, the Company entered into a definitive agreement to acquire the four Hospitals from Tenet and the transaction closed on March 8, 2005 In the first quarter of 2004, the Company changed its fiscal year end from June 30 to December 31, and changed the Company's name to "Integrated Healthcare Holdings, Inc." On December 21, 2006, the Company changed its fiscal year end from December 31 to March 31. Our principal executive offices are located at 1301 North Tustin Avenue, Santa Ana, California 92705, and our telephone number is (714) 953-3503. ITEM 1A. RISK FACTORS An investment in our common stock involves a high degree of risk. You should consider carefully the following information about these risks, together with the other information contained in this report. Our business is subject to a number of risks and uncertainties - many of which are beyond our control - that may cause our actual operating results or financial performance to be materially different from our expectations. You should consider carefully the following information about these risks, together with the other information contained in this report, before you decide to buy our common stock. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our operations. If any of the following risks actually occur, our business would likely suffer and our results could differ materially from those expressed in any forward-looking statements contained in this Annual Report on Form 10-K including our consolidated financial statements and related notes. In such case, the trading price of our common stock could decline, and shareholders could lose all or part of their investment. WE MUST OBTAIN ADDITIONAL CAPITAL WHICH, IF AVAILABLE, WILL LIKELY RESULT IN SUBSTANTIAL DILUTION TO OUR CURRENT SHAREHOLDERS. We will require additional capital to fund our business. If we raise additional funds through the issuance of common or preferred equity, warrants or convertible debt securities, these securities will likely substantially dilute the equity interests and voting power of our current shareholders, and may have rights, preferences or privileges senior to those of the rights of our current shareholders. We cannot predict whether additional financing will be available to us on favorable terms or at all. WE ARE CURRENTLY INVOLVED IN LITIGATION WITH VARIOUS CURRENT AND FORMER MEMBERS OF OUR BOARD OF DIRECTORS AND A SIGNIFICANT SHAREHOLDER. On May 14, 2007, IHHI filed suit in Orange County Superior Court against three of the six members of its Board of Directors (as then constituted) and also against IHHI's largest shareholder, OC-PIN. Among other things, the suit alleges that the defendants breached fiduciary duties owed to IHHI by putting their own economic interests above those of IHHI, its other shareholders, creditors, employees and the public-at-large. The suit also alleges that the defendants' attempt to change IHHI's management and control of the existing Board could trigger an "Event of Default" under the express terms of IHHI's existing credit agreements with its secured lender. 18 On May 17, 2007, OC-PIN filed a separate suit against IHHI in Orange County Superior Court. Both actions have been consolidated so they can be heard before one judge. This litigation is ongoing, and is discussed in further detail below under "Item 3. Legal Proceedings." The circumstances underlying this litigation have been a significant distraction to Company management and the Board of Directors, and may have prevented the Company from pursuing a successful restructuring of its business and other profitable business opportunities. A trial date has been set for January 26, 2009, and the parties are currently moving forward with discovery. On June 19, 2008 the Company received a demand from OC-PIN requesting that it provide notice of a special shareholders meeting by no later than June 26, 2008, with the meeting to occur on a date during the week of July 21-25, 2008. OC PIN stated that the business to be conducted at the special shareholders meeting is to (1) repeal the amendment to the Company's bylaws on June 3, 2008 establishing a procedure for nominating candidates for election as director, (2) remove the entire Board of Directors of the Company, and (3) nominate and elect a new slate of individuals to the Board of Directors. On June 24, 2008, OC-PIN's counsel sent the Company an additional letter demanding that the Company immediately close its stock transfer books or immediately set the Record Date for the requested special shareholders meeting, and waive the record search required under Rule 14a-13(a)(3) of the Securities and Exchange Commission. On June 26, 2008, the Company sent OC-PIN a letter indicating that the Company could not comply with this demand because, among other reasons, OC-PIN has not furnished the consent of the Company's principal lender, which consent is required under the Company's Credit Agreements, aggregating up to $140.7 million, prior to taking any of the actions proposed to be taken by OC-PIN at the special shareholders meeting. In the absence of the lender's consent, the actions proposed by OC-PIN would entitle the lender to certain remedies which would have a material adverse effect on the Company and its shareholders. Further, OC-PIN had not followed the procedures contained in the Company's bylaws for nominating and electing directors of the Company, making the demand defective under the bylaws. Regarding the setting of a record date, the Company is obligated under Rule 14a-13(a)(3) to provide at least 20 business days prior notice to all banks, brokers and other "street name" holders of its stock in advance of the record date for any shareholder meeting at which the Company intends to solicit proxies or consents, and the Company would be in violation of this requirement if it acceded to the demand of OC-PIN's counsel to waive this requirement. The Company believes its positions are justified, and intends to vigorously oppose any attempt by OC-PIN to force the Company to take actions that would put it in default with its lender or cause it to violate the federal securities laws. On July 8, 2008, in a separate action, OC-PIN filed a complaint against the Company in Orange County Superior Court alleging causes of action for breach of contract, specific performance, reformation, fraud, negligent misrepresentation and declaratory relief. The complaint alleges that the Stock Purchase Agreement that the Company executed with OC-PIN on January 28, 2005 "inadvertently omitted" an anti-dilution provision (the "Allegedly Omitted Provision") which would have allowed OC-PIN a right of first refusal to purchase common stock of the Company on the same terms as any other investor in order to maintain OC-PIN's holding at no less than 62.4% of the common stock on a fully diluted basis. The complaint further alleges that the Company has issued stock options under a Stock Incentive Plan and warrants to its lender in violation of the Allegedly Omitted Provision. The complaint further alleges that the issuance of warrants to purchase the Company's stock to Dr. Kali P. Chaudhuri and William Thomas, and their exercise of a portion of those warrants, were improper under the Allegedly Omitted Provision. The Company believes that this lawsuit is wholly without merit and intends to contest these claims vigorously. However, at this early stage, the Company is unable to determine the cost of defending this lawsuit or the impact, if any, that this lawsuit may have on the Company's results of operations or financial condition. WE HAVE INCURRED A SIGNIFICANT LOSS IN OPERATIONS TO DATE. IF OUR SUBSTANTIAL LOSSES CONTINUE, THE MARKET VALUE OF OUR COMMON STOCK WILL LIKELY DECLINE FURTHER AND WE MAY LACK THE ABILITY TO CONTINUE AS A GOING CONCERN. As of March 31, 2008, we had an accumulated deficit of $104,553,000. We incurred a net loss of $ 39,163,000 for the year ended March 31, 2008. A component of this loss relating to warrants, totaling $25,677,000, was reclassified in accordance with generally accepted accounting principles from a liability to equity, so its impact on our stockholders' deficiency was zero. This loss, among other things, has had a material adverse effect on our stockholders' equity and working capital. We are attempting to improve our operating results and financial condition through a combination of contract negotiations, expense reductions, and new issues of equity. However, new issues of equity are encumbered by warrant anti-dilution provisions and there can be no assurance that we will achieve profitability in the future. The Company's $50.0 million Revolving Credit Agreement provides an estimated additional liquidity as of March 31, 2008 of $27.4 million based on eligible receivables, as defined. If we are unable to achieve and maintain profitability, the market value of our common stock will likely decline further, and we will lack the ability to continue as a going concern. 19 WE HAVE A HIGH DEGREE OF LEVERAGE AND SIGNIFICANT DEBT SERVICE OBLIGATIONS. The debt service requirements on our $96 million in debt amount (as of March 31, 2008) to approximately $0.9 million per month. Our relatively high level of debt and debt service requirements have several effects on our current and future operations, including the following: (i) we will need to devote a significant portion of our cash flow to service debt, reducing funds available for operations and future business opportunities and increasing our vulnerability to adverse economic and industry conditions and competition; (ii) our leveraged position increases our vulnerability to competitive pressures; (iii) the covenants and restrictions contained in agreements relating to our indebtedness restrict our ability to borrow additional funds, dispose of assets, issue additional equity or pay dividends on or repurchase common stock; and (iv) funds available for working capital, capital expenditures, acquisitions and general corporate purposes are limited. Any default under the documents governing our indebtedness could have a significant adverse effect on our business and the market value of our common stock. THE SUCCESS OF THE COMPANY WILL DEPEND ON PAYMENTS FROM THIRD PARTY PAYERS, INCLUDING GOVERNMENT HEALTH CARE PROGRAMS. IF THESE PAYMENTS ARE REDUCED OR DELAYED, OUR REVENUE WILL DECREASE. We are largely dependent upon private and governmental third party sources of payment for the services provided to patients in the Hospitals. The amount of payment a hospital receives for the various services it renders will be affected by market and cost factors, perhaps adversely, as well as other factors over which we have no control, including political concerns over the cost of medical care, Medicare and Medicaid regulations, and the cost containment and utilization decisions of third party payers. Any meaningful reduction in the amounts paid by these third party payers for services rendered at the Hospitals will have a material adverse effect on our revenues and cash flows. IF WE ARE UNABLE TO ENTER INTO MANAGED CARE PROVIDER ARRANGEMENTS ON ACCEPTABLE TERMS, OR IF WE HAVE DIFFICULTY COLLECTING FROM MANAGED CARE PAYERS, OUR RESULTS OF OPERATIONS COULD BE ADVERSELY AFFECTED. It would harm our business if we were unable to enter into managed care provider arrangements on acceptable terms. Any material reductions in the payments that we receive for our services, coupled with any difficulties in collecting receivables from managed care payers, could have a material adverse effect on our financial condition, results of operations or cash flows. CHANGES IN THE MEDICARE AND MEDICAID PROGRAMS OR OTHER GOVERNMENT HEALTH CARE PROGRAMS COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS. The Medicare and Medicaid programs are subject to statutory and regulatory changes, administrative rulings, interpretations and determinations concerning patient eligibility requirements, funding levels and the method of calculating payments or reimbursements, among other things; requirements for utilization review; and federal and state funding restrictions, all of which could materially increase or decrease payments from these government programs in the future, as well as affect the cost of providing services to our patients and the timing of payments to our facilities. We are unable to predict the effect of future government health care funding policy changes on our operations. If the rates paid by governmental payers are reduced, if the scope of services covered by governmental payers is limited or if we, or one or more of our subsidiaries' hospitals, are excluded from participation in the Medicare or Medicaid program or any other government health care program, there could be a material adverse effect on our business, financial condition, results of operations or cash flows. OUR BUSINESS CONTINUES TO BE ADVERSELY AFFECTED BY A HIGH VOLUME OF UNINSURED AND UNDERINSURED PATIENTS. Like other organizations in the health care industry, we continue to provide services to a high volume of uninsured patients and more patients than in prior years with an increased burden of co-payments and deductibles as a result of changes in their health care plans. We continue to experience a high level of uncollectible accounts, and, unless our business mix shifts toward a greater number of insured patients or the trend of higher co-payments and deductibles reverses, we anticipate this high level of uncollectible accounts to continue. 20 COST CONTAINMENT, PAY FOR PERFORMANCE, AND OTHER PROGRAMS IMPOSED BY THIRD-PARTY PAYERS, INCLUDING GOVERNMENT HEALTH CARE PROGRAMS, MAY DECREASE THE COMPANY'S REVENUE. The health care industry is currently undergoing significant changes and is regularly subject to regulatory and political intervention. We expect to derive a considerable portion of the Company's revenue through the Hospitals from government-sponsored health care programs and third-party payers (such as employers, private insurers, HMOs or preferred provider organizations). The health care industry is experiencing a trend toward cost containment as government and private third-party payers seek to impose lower payment and utilization rates and negotiate reduced payment schedules with service providers. The Company believes that these trends will continue to result in a reduction from historical levels in per-patient revenue for hospitals. It is distinctly possible that reimbursement from government and private third-party payers for many procedures performed at the Hospital may be reduced in the future. Further reductions in payments or other changes in reimbursement for health care services could have a material adverse effect on the Company's business, financial condition and/or results of operations. Further, rates paid by private third-party payers are generally higher than Medicare, Medicaid and HMO payment rates. Any decrease in the relative number of patients covered by private insurance would have a material adverse effect on the Company's revenues and operations. PROVIDING QUALITY MEDICAL SERVICES FROM TALENTED PHYSICIANS IS CRITICAL TO OUR BUSINESS. Our business depends, in large part, upon the efforts and success of the physicians who will perform services at the Hospitals and the strength of our relationships with these physicians. Any failure of these physicians to maintain the quality of medical care provided or to otherwise adhere to professional guidelines at the Hospitals, or any damage to the reputation of a key physician or group of physicians, could damage the Company's and the Hospitals' reputations in the medical marketplace and may subject us to liability and significantly reduce our revenue and increase our costs. Like many hospitals, we face a growing shortage of primary care and specialty physicians. Should this shortage continue or worsen, the utilization of our hospitals may be adversely impacted. This could have a negative impact on our revenues and profitability. MEDICAL STAFF The primary relationship between a hospital and physicians who practice in it is through the hospital's organized medical staff. Medical staff bylaws, rules and policies establish the criteria and procedures at acute care hospitals, by which a physician may have his or her privileges, participation or membership curtailed, denied or revoked. Physicians who are denied medical staff membership or certain clinical privileges, or who have such membership, participation or privileges curtailed, denied or revoked often file legal actions against hospitals. Such actions may include a wide variety of claims, some of which could result in substantial uninsured damages to a hospital. In addition, failure of the governing body to adequately oversee the conduct of its medical staff may result in hospital liability to third parties. NURSING SHORTAGE Health care providers depend on qualified nurses to provide quality service to patients. There is currently a nationwide shortage of qualified nurses. This shortage and the more stressful working conditions it creates for those remaining in the profession are increasingly viewed as a threat to patient safety and may trigger the adoption of state and federal laws and regulations intended to reduce that risk. For example, California has adopted legislation and regulations mandating a series of specific minimum patient-to-nurse ratios in all acute care hospital nursing units. Any failure by the Hospital to comply with nurse staff ratios could result in action by licensure authorities and may constitute evidence of negligence per se in the event any patient is harmed as the result of inadequate nurse staffing. The vast majority of hospitals in California, including ours, are not at all times meeting the state mandated nurse staffing ratios. 21 In response to the shortage of qualified nurses, health care providers have increased-and could continue to increase-wages and benefits to recruit or retain nurses; many providers have had to hire expensive contract nurses. The shortage could also limit the operations of healthcare providers by limiting the number of patient beds available. The Company has likewise increased and is likely to have to continue to increase-wages and benefits to recruit and retain nurses. The Company may also need to engage expensive contract nurses until permanent staff nurses can be hired to replace any departing nurses. UNION CONTRACTS HAVE BEEN RENEWED BUT THERE CAN BE NO ASSURANCE THAT THE CONTRACTS WILL BE RENEWED IN THE FUTURE. Approximately 20% of the Company's employees are represented by labor unions as of March 31, 2008. On December 31, 2006, the Company's collective bargaining agreements with the California Nurses Association ("CNA") covering certain of our nursing staff and with the Service Employee International Union ("SEIU") expired. Negotiations with both the SEIU and CNA led to agreements being reached on May 9, 2007, and October 16, 2007, for the respective unions. Both contracts were ratified by their respective memberships. The new SEIU Agreement will run until December 31, 2009, and the Agreement with the CNA will run until February 28, 2011. Both Agreements have "no strike" provisions and compensation caps which provide the Company with long term compensation and workforce stability. We do not anticipate the new agreements will have a material adverse effect on our results of operations. Both unions filed grievances under the prior collective bargaining agreements, in connection with allegations the agreements obligated the Company to contribute to Retiree Medical Benefit Accounts. The Company does not agree with this interpretation of the agreements but has agreed to submit the matters to arbitration. Under the new agreements negotiated this year, the Company has agreed to meet with each Union to discuss how to create a vehicle which would have the purpose of providing a retiree medical benefit, not to exceed one percent (1%) of certain employee's payroll. CNA has also filed grievances related to the administration of increases at one facility, change in pay practice at one facility and several wrongful terminations. Those grievances are still pending as of this date, but the Company does not anticipate resolution of the arbitrations will have a material adverse effect on our results of operations. IF EITHER THE COMPANY OR THE HOSPITALS FAIL TO COMPLY WITH APPLICABLE LAWS AND REGULATIONS, WE MAY SUFFER PENALTIES OR BE REQUIRED TO MAKE SIGNIFICANT CHANGES TO OUR OPERATIONS. The health care industry is required to comply with extensive and complex laws and regulations at the federal, state and local government levels relating to, among other things: o Hospital billing practices and prices for services; o Relationships with physicians and other referral sources; o Adequacy of medical care and quality of medical equipment and services; o Ownership of facilities; o Qualifications of medical and support personnel; o Confidentiality, maintenance and security issues associated with health-related information and patient records; o The screening, stabilization and transfer of patients who have emergency medical conditions; o Licensure and accreditation of our facilities; o Operating policies and procedures; and o Construction or expansion of facilities and services. Among these laws are the False Claims Act, HIPAA, the federal anti-kickback statute and the Stark Law. These laws, and particularly the anti-kickback statute and the Stark Law, impact the relationships that we may have with physicians and other referral sources. We have a variety of financial relationships with physicians who refer patients to our facilities. We also provide financial incentives, including minimum revenue guarantees, to recruit physicians into communities served by our hospitals. The OIG has enacted safe harbor regulations that outline practices that are deemed protected from prosecution under the anti-kickback statute. A number of our current arrangements, including financial relationships with physicians and other referral sources, may not qualify for safe harbor protection under the anti-kickback statute. While the failure to meet a safe harbor does not mean that the arrangement necessarily violates the anti-kickback statute, the arrangement may be subject to greater scrutiny. We cannot assure that practices that are outside of a safe harbor will not be found to violate the anti-kickback statute. 22 These laws and regulations are extremely complex and, in some cases, we do not have the benefit of definitive interpretations by either regulators or courts. In the future, it is possible that different interpretations or enforcement of these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to make changes in our facilities, equipment, personnel, services, capital expenditure programs and operating expenses. A finding that we have violated one or more of these laws or regulations, or even public announcement that we are being investigated for possible violations could have a material adverse effect on our business and our business reputation could suffer significantly. Additionally, we cannot predict with any certainty whether new legislation or regulation, at either the state or federal level, will be implemented and whether those developments will impact our operations or finances. THE COMPANY CONDUCTS ON-GOING REVIEWS OF ITS COMPLIANCE WITH VARIOUS LAWS RELATED TO PHYSICIAN ARRANGEMENTS, WHICH MAY REVEAL VIOLATIONS THAT COULD SUBJECT THE COMPANY TO FINES OR PENALTIES. The Company and the Hospitals have entered into a variety of relationships with physicians. In an increasingly complex legal and regulatory environment, these relationships may pose a variety of legal or business risks. The Company conducts reviews of its compliance with the federal Anti-kickback Statute, Stark law and other applicable laws as they relate to the Company's relationships with referring physicians. The Company's largest shareholder, OC-PIN, is owned and controlled by physicians who also refer to and practice at the Hospitals. OC-PIN may receive dividends as a shareholder. In addition, one of the members of OC-PIN serves as Chairman of the Board of Directors of the Company. As a director, he receives payment from the Company for his service as Chairman. In addition, the Hospitals have various relationships with physicians who are not owners of the Company, as well as with OC-PIN physicians, including medical directorships, sharing in risk pools and service arrangements. The Company entered into a sale leaseback transaction for substantially all of the real estate with Pacific Coast Holdings Investment, LLC ("PCHI") whereby the Company leases substantially all of the real property of the acquired Hospitals from PCHI. PCHI is owned by two LLC's, namely West Coast and Ganesha; which are co-managed by physician investors. The Company has undertaken a review of its agreements with physicians and has a review process in place to ensure that such agreements are in writing and comply with applicable laws. Although there may have been arrangements in the past with physicians that may not have been memorialized in a written agreement or may have expired and not been timely renewed or may have been entered into after services commenced, each of which may have lead to violations of the Stark law, the Company's current review process should prevent such occurrences. Additionally, the Company has reviewed the terms of the purchase of ownership interests in the Company by OC-PIN (which is owned by physicians that refer patients to the Hospitals) and has determined that the purchase should be determined to be permissible under applicable law. The Company has also reviewed certain related party transactions, such as director fees for physician directors and payment of the employment severance package to Dr. Anil Shah, an OC-PIN member. If the Company or the Hospitals are not in compliance with federal and state fraud and abuse laws and physician self-referral laws, the Company could be subject to repayment obligations, fines, penalties, exclusive from participation in federal health care programs, and other sanctions which would have a material adverse effect on the Company's profitability. LICENSING, SURVEYS, INVESTIGATIONS AND AUDITS Health facilities, including the Hospitals, are subject to numerous legal, regulatory, professional and private licensing, certification and accreditation requirements. These include requirements relating to Medicare and Medi-Cal participation and payment, state licensing agencies, private payers and the Joint Commission. Renewal and continuance of certain of these licenses, certifications and accreditations are based on inspections, surveys, audits, investigations or other reviews, some of which may require or include affirmative action or response by the Company. These activities generally are conducted in the normal course of business of health facilities. Nevertheless, an adverse determination could result in a loss or reduction in a Hospital's scope of licensure, certification or accreditation, or could reduce the payment received or require repayment of amounts previously remitted. Any failure to obtain, renew or continue a license, certification or accreditation required for operation of a Hospital could result in the loss of utilization or revenues, or the loss of the Company's ability to operate all or a portion of a Hospital, and, consequently, could have a material and adverse effect on the Company. 23 EARTHQUAKE SAFETY COMPLIANCE The Hospitals are located in an area near active and substantial earthquake faults. The Hospitals carry earthquake insurance with a policy limit of $50 million. A significant earthquake could result in material damage and temporary or permanent cessation of operations at one or more of the Hospitals. In addition, the State of California has imposed new hospital seismic safety requirements. Under these new requirements, the Hospitals must meet stringent seismic safety criteria in the future, and, must complete one set of seismic upgrades to each facility by January 1, 2013. This first set of upgrades is expected to require the Company to incur substantial seismic retrofit expenses. In addition, there could be other remediation costs pursuant to this seismic retrofit. The State of California has introduced a new seismic review methodology known as HAZUS. The HAZUS methodology may preclude the need for some structural modifications. Three of the four Hospitals have requested HAZUS review and one of them has already received a favorable notice pertaining to structural reclassification. There are additional requirements that must be complied with by 2030. The costs of meeting these requirements have not yet been determined. Compliance with seismic ordinances will be a costly venture and could have a material adverse effect on our cash flow. WE FACE INTENSE COMPETITION IN OUR BUSINESS. The healthcare industry is highly competitive. We compete with a variety of other organizations in providing medical services, many of which have greater financial and other resources and may be more established in their respective communities than we are. Competing companies may offer newer or different centers or services than we do and may thereby attract patients or customers who are presently patients, customers or are otherwise receiving our services. Some of the hospitals that compete with our hospitals are owned by government agencies or not-for-profit organizations. Tax-exempt competitors may have certain financial advantages not available to our facilities, such as endowments, charitable contributions, tax-exempt financing, and exemptions from sales, property and income taxes. In certain states, including California, some not-for-profit hospitals are permitted by law to directly employ physicians while for-profit hospitals are prohibited from doing so. We also face increasing competition from physician-owned specialty hospitals and freestanding surgery, diagnostic and imaging centers for market share in high margin services and for quality physicians and personnel. If competing health care providers are better able to attract more patients, recruit and retain physicians, expand services or obtain favorable managed care contracts at their facilities, we may continue to experience a decline in patient volume levels. A SIGNIFICANT PORTION OF OUR BUSINESS IS CONCENTRATED IN CERTAIN MARKETS AND THE RESPECTIVE ECONOMIC CONDITIONS OR CHANGES IN THE LAWS AFFECTING OUR BUSINESS IN THOSE MARKETS COULD HAVE A MATERIAL ADVERSE EFFECT ON THE COMPANY. We receive all of our inpatient services revenue from operations in Orange County, California. The economic condition of this market could affect the ability of our patients and third-party payers to reimburse us for our services, through its effect on disposable household income and the tax base used to generate state funding for Medicaid programs. An economic downturn, or changes in the laws affecting our business in our market and in surrounding markets, could have a material adverse effect on the Company. WE MAY BE LIABLE FOR LOSSES NOT COVERED BY OR IN EXCESS OF OUR INSURANCE. An increasing trend in malpractice litigation claims, rising costs of malpractice litigation, losses associated with these malpractice lawsuits and a constriction of insurers have caused many insurance carriers to raise the cost of insurance premiums or refuse to write insurance policies for hospital facilities. Accordingly, we have increased on retention limits and our estimated reserves may not be adequate. ITEM 1B. UNRESOLVED STAFF COMMENTS None. 24 ITEM 2. PROPERTIES In March 2005, the Company completed the acquisition of the Hospitals and their associated real estate from Tenet. At the closing of the acquisition, the Company transferred all of the fee interests in the acquired real estate to PCHI, a company owned indirectly by two of the Company's largest shareholders. The Company entered into a Triple Net Lease dated March 7, 2005 (amended and restated as of October 1, 2007) under which it leased back from PCHI all of the real estate that it transferred to PCHI. Additionally, the Company leases property from other lessors. As of March 31, 2008, the Company's principal facilities are listed in the following table: <TABLE> <CAPTION> APPROXIMATE AGGREGATE SQUARE LEASE INITIAL LEASE PROPERTY FOOTAGE RATE EXPIRATION -------- ------- ---- ---------- <S> <C> <C> <C> Western Medical Center-Santa Ana 360,000 See note 1. February 28, 2030 1001 North Tustin Avenue Santa Ana, CA 92705 Administrative Building 40,000 See note 1. February 28, 2030 1301 N. Tustin Avenue Santa Ana, CA Western Medical Center-Anaheim 132,000 See note 1. February 28, 2030 1025 South Anaheim Boulevard Anaheim, CA 92805 Coastal Communities Hospital 115,000 See note 1. February 28, 2030 2701 South Bristol Street Santa Ana, CA 92704 Chapman Medical Center 140,000 See note 2. December 31, 2023 2601 East Chapman Avenue Orange, CA 92869 </TABLE> 1. Effective October 1, 2007, the Company entered into an amended and restated lease with PCHI. The amended lease terminates on the 25-year anniversary of the original lease (March 8, 2005), grants the Company the right to renew for one additional 25-year period, and requires annual base rental payments of $8.3 million. However, until the Company refinances its $50.0 million Revolving Line of Credit Loan with a stated interest rate less than 14% per annum or PCHI refinances the $45.0 million Term Note, the annual base rental payments are reduced to $7.1 million. In addition, the Company may offset against its rental payments owed to PCHI interest payments that it makes to the Lender under certain of its indebtedness discussed above. The amended lease also gives PCHI sole possession of the medical office buildings located at 1901/1905 North College Avenue, Santa Ana, California that are unencumbered by any claims by or tenancy of the Company. Lease payments to PCHI are eliminated in consolidation. 2. Leased from an unrelated party. Monthly lease payments are approximately $112,000. The State of California has established standards intended to ensure that all hospitals in the state withstand earthquakes and other seismic activity without collapsing or posing the threat of significant loss of life. The Hospitals are located in an area near active and substantial earthquake faults. The Hospitals carry earthquake insurance with a policy limit of $50 million. A significant earthquake could result in material damage and temporary or permanent cessation of operations at one or more of the Hospitals. In addition, the State of California has imposed new hospital seismic safety requirements. Under these new requirements, the Hospitals must meet stringent seismic safety criteria in the future, and, must complete one set of seismic upgrades to each facility by January 1, 2013. This first set of upgrades is expected to require the Company to incur substantial seismic retrofit expenses. In addition, there could be other remediation costs pursuant to this seismic retrofit. The State of California has introduced a new seismic review methodology known as HAZUS. The HAZUS methodology may preclude the need for some structural modifications. Three of the four Hospitals have requested HAZUS review and one of them has already received a favorable notice pertaining to structural reclassification. 25 There are additional requirements that must be complied with by 2030. The costs of meeting these requirements have not yet been determined. Compliance with seismic ordinances will be a costly venture and could have a material adverse effect on our cash flow. The Company believes that its current leased space is adequate for its current purposes and for the next fiscal year. ITEM 3. LEGAL PROCEEDINGS From time to time, health care facilities receive requests for information in the form of a subpoena from licensing entities, such as the Medical Board of California, regarding members of their medical staffs. Also, California state law mandates that each medical staff is required to perform peer review of its members. As a result of the performance of such peer reviews, action is sometimes taken to limit or revoke an individual's medical staff membership and privileges in order to assure patient safety. In August 2007, the Company received such a subpoena from the Medical Board of California concerning a member of the medical staff of one of the Company's facilities. The facility has responded to the subpoena and is in the process of reviewing the matter. Approximately 20% of the Company's employees are represented by labor unions as of September 30, 2007. On December 31, 2006, the Company's collective bargaining agreements with SEIU and CNA expired. Negotiations with both the SEIU and CNA led to agreements being reached on May 9, 2007, and October 16, 2007, for the respective unions. Both contracts were ratified by their respective memberships. The new SEIU Agreement will run until December 31, 2009, and the Agreement with the CNA will run until February 28, 2011. Both Agreements have "no strike" provisions and compensation caps which provide the Company with long term compensation and workforce stability. Both unions filed grievances under the prior collective bargaining agreements, in connection with allegations the agreements obligated the Company to contribute to Retiree Medical Benefit Accounts. The Company does not agree with this interpretation of the agreements but has agreed to submit the matters to arbitration. Under the new agreements negotiated this year, the Company has agreed to meet with each Union to discuss how to create a vehicle which would have the purpose of providing a retiree medical benefit, not to exceed one percent (1%) of certain employee's payroll. CNA has also filed grievances related to the administration of increases at one facility, change in pay practice at one facility, change in medical benefits at two facilities, and several wrongful terminations. Those grievances are still pending as of this date, but the Company does not anticipate resolution of the arbitrations will have a material adverse effect on our results of operations. On May 14, 2007, the Company filed suit in Orange County Superior Court against three of the six members of its Board of Directors (as then constituted) and also against the Company's largest shareholder, OC-PIN. The suit sought damages, injunctive relief and the appointment of a provisional director. Among other things, the Company alleges the defendants breached fiduciary duties owed to the Company by putting their own economic interests above those of the Company, its other shareholders, creditors, employees and the public-at-large. The suit further alleges the defendants' then threatened attempts to change the composition of the Company's management and Board (as then constituted) threatened to trigger multiple "Events of Default" under the express terms of the Company's existing credit agreements with its secured Lender. On May 17, 2007, OC-PIN filed a separate suit against the Company in Orange County Superior Court. OC-PIN's suit sought injunctive relief and damages. OC-PIN alleges the management issue referred to above, together with issues related to monies claimed by OC-PIN, needed to be resolved before completion of the Company's then pending refinancing of its secured debt. OC-PIN further alleges that the Company's President failed to call a special shareholders' meeting, thus denying OC-PIN the opportunity to elect a new member to the Company's Board of Directors. 26 Both actions have since been consolidated before one judge. On July 11, 2007, the Company's motion seeking the appointment of an independent provisional director to fill a vacant seventh Board seat was granted. On the same date, OC-PIN's motion for a mandatory injunction forcing the Company's President to notice a special shareholders meeting was denied. All parties to the litigation thereafter consented to the Court's appointment of the Hon. Robert C. Jameson, retired, as a member of the Company's Board. In December 2007, the Company entered into a mutual dismissal and tolling agreement with OC-PIN. The consolidation suits between the Company, on the one hand, and three members of its former Board are still pending. On April 16, 2008, the Company filed an amended complaint, alleging that the defendant directors' failure to timely approve a refinancing package offered by the Company's largest lender caused the Company to default on its then-existing loans. Also on April 16, 2008, these directors filed cross-complaints against the Company for alleged failures to honor its indemnity obligations to them in this litigation. Given the favorable rulings on July 11, 2007 and other factors, the Company continues to prosecute its original action in hopes of recouping all, or at least a substantial portion, of the economic losses caused by the defendants' alleged multiple breaches of fiduciary duty and other wrongful conduct. A trial date has been set for January 26, 2009, and the parties are currently moving forward with discovery. The Company does not anticipate the resolution of these ongoing claims for damages will have a material adverse effect on its results of operations. On June 19, 2008 the Company received a demand from OC-PIN requesting that it provide notice of a special shareholders meeting by no later than June 26, 2008, with the meeting to occur on a date during the week of July 21-25, 2008. OC PIN stated that the business to be conducted at the special shareholders meeting is to (1) repeal the amendment to the Company's bylaws on June 3, 2008 establishing a procedure for nominating candidates for election as director, (2) remove the entire Board of Directors of the Company, and (3) nominate and elect a new slate of individuals to the Board of Directors. On June 24, 2008, OC-PIN's counsel sent the Company an additional letter demanding that the Company immediately close its stock transfer books or immediately set the Record Date for the requested special shareholders meeting, and waive the record search required under Rule 14a-13(a)(3) of the Securities and Exchange Commission. On June 26, 2008, the Company sent OC-PIN a letter indicating that the Company could not comply with this demand because, among other reasons, OC-PIN has not furnished the consent of the Company's principal lender, which consent is required under the Company's Credit Agreements, aggregating up to $140.7 million, prior to taking any of the actions proposed to be taken by OC-PIN at the special shareholders meeting. In the absence of the lender's consent, the actions proposed by OC-PIN would entitle the lender to certain remedies which would have a material adverse effect on the Company and its shareholders. Further, OC-PIN had not followed the procedures contained in the Company's bylaws for nominating and electing directors of the Company, making the demand defective under the bylaws. Regarding the setting of a record date, the Company is obligated under Rule 14a-13(a)(3) to provide at least 20 business days prior notice to all banks, brokers and other "street name" holders of its stock in advance of the record date for any shareholder meeting at which the Company intends to solicit proxies or consents, and the Company would be in violation of this requirement if it acceded to the demand of OC-PIN's counsel to waive this requirement. The Company believes its positions are justified, and intends to vigorously oppose any attempt by OC-PIN to force the Company to take actions that would put it in default with its lender or cause it to violate the federal securities laws. On July 8, 2008, in a separate action, OC-PIN filed a complaint against the Company in Orange County Superior Court alleging causes of action for breach of contract, specific performance, reformation, fraud, negligent misrepresentation and declaratory relief. The complaint alleges that the Stock Purchase Agreement that the Company executed with OC-PIN on January 28, 2005 "inadvertently omitted" an anti-dilution provision (the "Allegedly Omitted Provision") which would have allowed OC-PIN a right of first refusal to purchase common stock of the Company on the same terms as any other investor in order to maintain OC-PIN's holding at no less than 62.4% of the common stock on a fully diluted basis. The complaint further alleges that the Company has issued stock options under a Stock Incentive Plan and warrants to its lender in violation of the Allegedly Omitted Provision. The complaint further alleges that the issuance of warrants to purchase the Companys stock to Dr. Kali P. Chaudhuri and William Thomas, and their exercise of a portion of those warrants, were improper under the Allegedly Omitted Provision. The Company believes that this lawsuit is wholly without merit and intends to contest these claims vigorously. However, at this early stage, the Company is unable to determine the cost of defending this lawsuit or the impact, if any, that this lawsuit may have on the Company's results of operations or financial condition. We and our subsidiaries are involved in various other legal proceedings most of which relate to routine matters incidental to our business. We do not believe that the outcome of these matters is likely to have a material adverse effect on the Company. 27 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Our 2007 annual meeting of stockholders was held on September 5, 2007. Of the 137,095,716 shares eligible to vote, 128,537,092 appeared in person or by proxy and established a quorum for the meeting. The matters listed in the table below were approved by the requisite votes. ELECTION OF DIRECTORS VOTES FOR VOTES WITHHELD NOT VOTED --------- --------- -------------- --------- Maurice J. DeWald 69,436,662 2,000 59,098,430 Hon. C. Robert Jameson 69,437,662 1,000 59,098,430 Ajay Meka, M.D. 69,436,662 2,000 59,098,430 Michael Metzler 69,437,662 1,000 59,098,430 Bruce Mogel 69,436,662 2,000 59,098,430 J. Fernando Niebla 69,436,662 2,000 59,098,430 William E. Thomas 69,437,662 1,000 59,098,430 RATIFICATION OF THE APPOINTMENT OF BDO SEIDMAN, LLP AS INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM FOR THE YEAR ENDING MARCH 31, 2008 VOTES FOR VOTES AGAINST VOTES WITHHELD NOT VOTED --------- ------------- -------------- --------- 123,265,903 3,089 5,268,100 0 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES The Company's common stock is listed for trading on the OTC Bulletin Board under the symbol "IHCH.OB." The trading market for the Company's common stock has been extremely thin. In view of the extreme thinness of the trading market, the prices reflected on the chart below as reported on the OTC Bulletin Board may not be indicative of the price at which any prior or future transactions were or may be effected in the Company's common stock. Stockholders are cautioned against drawing any conclusions from the data contained herein, as past results are not necessarily indicative of future stock performance. The following table sets forth the quarterly high and low bid price for the Company's common stock for each quarter for the period from April 1, 2006 through March 31, 2008, as quoted on the Over-the-Counter Bulletin Board. Such Over-the-Counter market quotations reflect inter dealer prices, without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions. --------------------- ------------------- ------------------- PERIOD HIGH LOW ------ ---- --- --------------------- ------------------- ------------------- Apr 2006 - Jun 2006 $0.40 $0.15 --------------------- ------------------- ------------------- Jul 2006 - Sep 2006 $0.25 $0.08 --------------------- ------------------- ------------------- Oct 2006 - Dec 2006 $0.50 $0.10 --------------------- ------------------- ------------------- Jan 2007 - Mar 2007 $0.40 $0.20 --------------------- ------------------- ------------------- Apr 2007 - Jun 2007 $0.32 $0.12 --------------------- ------------------- ------------------- Jul 2007 - Sep 2007 $0.23 $0.12 --------------------- ------------------- ------------------- Oct 2007 - Dec 2007 $0.33 $0.14 --------------------- ------------------- ------------------- Jan 2008 - Mar 2008 $0.25 $0.10 --------------------- ------------------- ------------------- As of the date of this report, there were approximately 223 record holders of the Company's common stock; this number does not include an indeterminate number of stockholders whose shares may be held by brokers in street name. The Company has not paid and does not expect to pay any dividends on its shares of common stock for the foreseeable future, as any earnings will be retained for use in the business.