General

We were incorporated in Delaware in 1994 to consolidate the ownership of several sports and fitness clubs. We currently own and operate four Clubs under "The Sports Club/LA" name in Los Angeles, Beverly Hills, Orange County and at Rockefeller Center in New York City. Our Clubs offer a wide range of fitness and recreation options and amenities, and are marketed to affluent, health conscious individuals who desire a service-oriented, state-of-the-art club. Our Clubs are widely recognized as being among the finest sports and fitness clubs in the country.

Our Clubs (hereinafter referred to as "Clubs" or The Sports Club/LA) are conveniently located and are spacious, modern facilities that typically include spas, restaurants, fitness centers, swimming pools and basketball courts. The Sports Club/LA sites are designed as "urban country clubs," and our three large Clubs range in size from 90,000 to 140,000 square feet. The Sports Club/LA - Beverly Hills is approximately 40,000 square feet. Initiation fees and monthly membership dues at The Sports Club/LA are higher than those charged by most other sports and fitness clubs. Income from ancillary services and products, including private training, food and beverage and spa services, also constitutes a significant portion of our revenues. Our subsidiary, The SportsMed Company ("SportsMed"), operates physical therapy facilities in our Clubs in Los Angeles and Orange County.

According to the International Health, Racquet & Sportsclub Association ("IHRSA"), the industry's leading trade organization, it is estimated that 41.3 million Americans were members of more than 23,000 sports and fitness clubs at December 31, 2004. Revenues generated by the United States sports and fitness club industry increased at a compound annual rate of 7.7% from $7.8 billion in 1995 to $14.8 billion in 2004. The industry has benefited from the general public's increasing awareness of the importance of physical exercise. Among other groups, we target members age 35 and older who, according to IHRSA, represent 54% of all memberships and are the fastest growing segment of the industry.

Recent Events

Sale of Assets and Debt Restructuring

On January 13, 2006, we completed the sale of five of our nine sports and fitness Clubs to an affiliate of Millennium Entertainment Partners (collectively with its affiliates "Millennium") for $80.0 million pursuant to the terms of an Asset Purchase Agreement dated October 28, 2005 as amended by a First Amendment to the Asset Purchase Agreement dated January 13, 2006. Millennium is our largest stockholder and was the landlord at four of these Clubs. Concurrent with the sale, we completed a $60.0 million financing of The Sports Club/LA - Los Angeles property. Proceeds from these transactions were used to retire our $100.0 million Senior Secured Notes that were due to mature in March 2006.

The Clubs we sold to Millennium include our interest in Reebok Sports Club/NY, and The Sports Club/LA in Washington D.C., Boston, San Francisco and the Upper East Side in New York. Our management agreement covering the Club in Miami was also terminated. We received $50.0 million in cash upon closing the sale (before transaction related costs) and received two Notes from Millennium. The first note of $22.2 million was due and collected by us on January 31, 2006. The second Note of $7.8 million is due in 2013 and is secured by a pledge of the Series C and Series D Preferred Stock owned by Millennium. Following the sale, we continue to own and operate four Clubs: The Sports Club/LA - Los Angeles, The Sports Club/LA - Beverly Hills, The Sports Club/LA - Orange County and The Sports Club/LA - New York at Rockefeller Center.

The financing of The Sports Club/LA - Los Angeles was provided by Bank of America, N.A. The mortgage note, which matures in January 2016, is secured by all the real estate and other assets at The Sports Club/LA - Los Angeles, bears interest at 6.48% per annum and requires monthly payments of

$404,375 which amortizes the loan over a twenty-five year period. Rex Licklider, our Chief Executive Officer and D. Michael Talla, our chairman of the Board, executed limited guarantees under which the lender has recourse to Messrs. Licklider and Talla in certain circumstances. The Company, Millennium and Kayne Anderson, one of our principal shareholders have agreed to indemnify Messrs. Licklider and Talla under certain circumstances for losses under their guarantee.

The Sports Club/LA

The Sports Club/LA ranges in size from 40,000 to 140,000 square feet and typically includes the following features:

o large, fully equipped gyms with state-of-the-art fitness equipment, including weight training, cardio- vascular equipment, flexibility centers and functional performance areas,

o basketball, volleyball, racquetball, squash, tennis and paddle tennis courts,

o group exercise studios featuring classes throughout the day and evening, seven days a week, including aerobics, yoga, dance, muscle conditioning, boxing, martial arts, bootcamps, pilates and bodymind,

o group cycling studios,

o boxing studios,

o swimming pools, sundecks, golf practice nets and running tracks,

o destination city spa offering massage, facials and full body treatments,

o men's and women's locker rooms featuring wood lockers,

o steam rooms, saunas and Jacuzzis,

o restaurants, sports bars, private dining/conference rooms and media centers,

o valet parking, pro shops, hair salons and childcare services,

o sports medicine and physical therapy facilities,

o personal trainers to develop and supervise members' exercise routines,

o registered dietitians for nutritional consultations,

o FitLab assessment centers,

o interactive children's classes, as well as supervised age-specific junior recreation rooms and junior programs such as gymnastics, martial arts and dance,

o instruction in racquet sports, golf, swimming, boxing and martial arts,

o full-time activities directors responsible for social and media events for members, including organizing trips, lectures and charity events,

o sports instructors who present sports tournaments, leagues and classes, and

o wellness protocols such as exercise regimens designed for specific groups of members.

We currently have four Sports Clubs in operation. The original Sports Club/LA opened in 1987 in West Los Angeles, California, near the affluent communities of Santa Monica, Brentwood, Beverly Hills, Bel Air, Westwood and Century City. We opened The Sports Club/LA-Beverly Hills in October 2003. This 40,000 square foot Club is located in the heart of Beverly Hill's retail and commercial district. The Sports Club/LA - Orange County opened in 1990 in Irvine, California near Newport Beach.

We operate one Club in New York City. The Sports Club/LA - New York at Rockefeller Center was opened in February 2000. This Club was designed to service the executive business community in midtown Manhattan.

The SportsMed Company, Inc.

Our SportsMed subsidiary operates physical therapy facilities within The Sports Club/LA in Los Angeles and Orange County. The clinics are staffed by exercise physiologists, physical therapists and registered dietitians who provide services to members and others. We believe that SportsMed provides valuable services, which are complementary to the other services provided by the Clubs.

Development of New Clubs

Club Developments. In October 2003, we opened The Sports Club/LA - Beverly Hills. This 40,000 square foot Club is located in the heart of the Beverly Hills retail and commercial district. This Club may serve as the prototype for smaller size Clubs to be built in locations near existing Sports Club/LA sites.

Performance of Newly Developed Clubs. Based on our experience, a newly developed Club tends to achieve significant increases in revenues until a mature membership level is reached. In the past, recently opened Clubs that have not yet achieved mature membership levels have operated at a negative cash flow or only a slight positive cash flow during the first two years of operation as a result of fixed expenses that, together with variable operating expenses, approximate or exceed membership fees and other revenues. The Sports Club/LA - Beverly Hills has been open since October 2003 and is approaching its optimum membership level. The Club started generating positive cash flows after its first year of operation and has steadily increased its cash flow as the membership levels have increased.

Future New Club Developments

Our Clubs are spacious modern facilities that include a wide range of amenities. Accordingly, we spend significant amounts to construct a new facility. Our current debt levels make it difficult for us to secure the financing to develop additional new sites. Therefore we would expect any new Clubs to be structured as joint ventures, partnership agreements or management arrangements. We are currently pursuing several potential new Club developments that would structured in that manner. This structure allows us to expand our brand and receive an immediate earnings stream and cash flow, with the potential for additional profits, without making the significant capital investment required to develop a club without a partner.

Sales and Marketing

Strategy. The Sports Club/LA is marketed as an "urban country club" offering personalized attention and multiple amenities and services. We believe that the facilities and services provided and the image of The Sports Club/LA as the leader in the sports and fitness industry justifies charging a premium. Our members include professionals, sports and entertainment personalities and business people. The Sports Club/LA emphasizes personalized service and instruction and the creation of an "urban country club" atmosphere in which members can relax and socialize. Our marketing efforts at The Sports Club/LA emphasize retaining existing members, replacing members who leave with new members and increasing ancillary revenues from services such as private training and spa services.

Referrals, Endorsements and Advertising. Word-of-mouth referrals and endorsements by existing members are The Sports Club/LA's most important source of new members. In addition, The Sports Club/LA utilizes targeted marketing programs, which include advertisements, promotions, public relations and community events. The principal marketing media for the Clubs are direct mail and print advertisements. Special events and special membership programs supplement the print advertisements. The Sports Club/LA hosts corporate parties and charity benefits and often donates free or discounted memberships to charitable organizations. We also conduct periodic membership drives whereby referring members are entitled to receive special gifts and other incentives. We believe that we will be able to continue to utilize these marketing strategies.

Targeted Members. The largest segment of the membership base for The Sports Club/LA consists of health-conscious individuals. We target four other groups in order to expand membership: corporate members, medical referrals, families, and seniors. Each of these groups requires specialized exercise/fitness programs and we have developed specific programs to attract members of these groups.

Corporate Programs. We believe the corporate market is a significant source of new members, due to the proximity of The Sports Club/LA to business centers. Our members use the Clubs to conduct business and to develop and maintain business contacts. We employ several Corporate Membership Directors whose principal responsibilities are to solicit corporate memberships from businesses operating in the vicinity of the Clubs. The Sports Club/LA offers corporate group-discounted initiation fees depending upon the number of new members involved. We believe that corporations are favorably disposed to The Sports Club/LA because of the positive impact regular exercise and overall fitness can have on employee absenteeism, morale and productivity.

Medical Referrals. We target members from the medical referral market through our SportsMed subsidiary by offering specific rehabilitation and exercise protocols to complement other forms of physical therapy recommended by a physician or medical group. We also offer a "next-step" program for SportsMed patients who complete their physical therapy programs and are looking for an option to complete their rehabilitation by becoming members of The Sports Club/LA.

Family Programs. We believe that the family market has considerable potential, as younger members grow older, marry and have children and seek recreational activities in which the entire family can participate. To attract the family market, we have implemented Fun-N-Fit programs that offer programs to children between the ages of 6 months and 15 years and involve youth sports camps and clinics, fitness programs, art classes and birthday parties. The Sports Club/LA's weight-training, basketball and swimming pool facilities are made available to children and their parents during Family Day, and specially-designed movement classes utilizing a variety of fitness equipment are offered to younger children. The Sports Club/LA provides individualized sports instruction and offers multiple fitness activities such as gymnastics, martial arts and dance that are age appropriate.

Senior Programs. We anticipate that as the current core membership group ages, we will meet the changing fitness needs of seniors and attract additional members from the senior population. We maintain training and exercise protocol manuals for the senior market (that we generally define as members who are over 60 years old) that include a description of exercise and fitness programs specifically designed for seniors. These manuals also contain discussions of the biological, psychological and medical aspects of aging and the benefits of regular exercise. We believe this market will expand as the "baby boomers" mature.

Employee Training

We believe that a key component of our operating strategy is a well-trained and knowledgeable staff. We have comprehensive training programs to enhance the effectiveness of our personnel. All newly hired employees are required to attend an orientation seminar that is led by members of our management staff and a personnel instructor. Topics include our history and philosophy, The Sports Club/LA policies and procedures, member service, interaction skills and product knowledge. These orientation seminars are held weekly.

To aid in the development and continuing education of our management staff, we offer a workshop entitled "Introduction to Management" for newly hired management personnel and other employees demonstrating management skills. The workshop is intended to educate managers in the areas of instilling our Company philosophy, policies and procedures, safety, workers' compensation, managing people, communication, group problem solving, training, coaching, motivation, feedback, recognition, counseling, evaluations, as well as time and stress management. Topics are added periodically to reflect new management techniques or operating issues. These seminars, generally consisting of three eight-hour sessions, are held six times a year or as needed for new employees. Additionally, our management personnel are required to participate in our Manager on Duty Program and other management and sales seminars to maintain and develop their skills.

We provide additional seminars specifically designed for targeted employee groups. Seminars providing specialized instruction for program directors, private trainers, group exercise instructors and sales/marketing personnel are offered at various times during the year, for which attendance on the part of newly hired personnel is mandatory. We place particular emphasis on our sales/marketing training seminars that are given once every two months by a personnel instructor. In these seminars, all new membership directors complete 20 hours of participation and all other membership directors are expected to complete four hours of participation every two months. Our fitness instructors are trained to assist in the sales function and to implement fitness testing and individually tailored exercise programs. Most instructors are college-educated and all trainers are required to be certified by the National Academy of Sports Medicine. Our group exercise instructors hold nationally recognized certifications and must have at least one year of teaching experience before they are permitted to teach at The Sports Club/LA. They are also required to participate in ongoing training and periodic re-evaluation.

In addition, all line staff can voluntarily participate in quarterly workshops that are offered through our human resources department. Workshop topics include conflict resolution, communication and member service; topics vary depending on the Club's current training needs.

Membership Programs

Membership at The Sports Club/LA requires an initiation fee plus monthly membership dues. Initiation fees are required to be paid upfront or during the member's first year. Members are currently required to pay their dues on a monthly basis by electronic funds transfer, by which each member is automatically debited each month for dues either through a checking account or credit card.

The Sports Club/LA offers three types of memberships: executive, health and racquet sports. The Sports Club/LA's initiation fees and monthly membership dues vary depending on the location of the Club and the type of membership. The Sports Clubs' market rate for initiation fees range from $500 to $2,500 and monthly membership dues range from $125 to $300. Corporate, bicoastal and spousal memberships are also available. We offer the following membership options:

Executive Membership. Executive membership offers the greatest number of amenities and services, including unlimited use of all facilities, racquet sports privileges, personal locker assignments within an executive locker room, laundry service, free valet parking and charge privileges for dining and other Club services. Executive membership entitles a member to use all The Sports Club/LA locations.

Health Membership. Health membership is the basic membership offering unlimited use of the facility excluding those privileges associated with a racquet membership; courts are available to holders of health memberships for an additional fee. We also offer a bi-coastal membership that entitles a member to use all The Sports Club/LA locations throughout the country and an Access West membership that allows a member the ability to use all of our Clubs located on the west coast.

Racquet Sports Membership. Racquet sports memberships are currently offered at The Sports Club/LA - Orange County. In addition to use of the Club's facilities, this membership includes unlimited use of racquetball, squash and paddle tennis.

Competition

Although the sports and fitness industry is still fragmented, the industry has experienced significant consolidation in recent years and certain of our competitors are significantly larger and have greater financial and operating resources than we do. In addition, a number of individual and regional operators compete with us in our existing markets. Many of these sports and fitness clubs attract the same types of members we target. We also compete with recreational facilities established by governments and businesses, the YMCA and YWCA, country clubs and weight-reducing salons, as well as products and services that can be used in the home. As the general public becomes increasingly aware of the benefits of regular exercise, we expect that additional sports and fitness businesses will emerge. We believe that there will continue to exist a market for The Sports Club/LA and that our operating experience, our highly visible image, the professionalism of our staff and our state-of-the-art equipment and exercise facilities afford us an advantage over our competitors. However, we may be unable to maintain our membership fees or membership levels in areas where another sports and fitness club offers competitive facilities and services at a lower cost.

Trademarks and Trade Names

We have registered our "flying lady" logo as a stand-alone design and in combination with The Sports Club/LA name under federal trademark laws. Internationally, we have registered The Sports Club/LA name and logo in Japan and throughout Europe under a joint "European Community" trademark.

We have also obtained federal protection for our food and nutritional products that are marketed under the trade names of Private Trainer System and PTS.

Additionally, we have received trademark approval for several of our fitness programs, including BodyArt, REV and others. We have obtained full protection under Federal trademark laws for our SportsMed subsidiary name, Splash, the name of our spas, and For Kids Only, our childcare and children's fitness program, as each such name is used in conjunction with its stylized design. We believe our trademarks and other proprietary rights are significant elements in our marketing and branding strategies and we aggressively protect all such rights.

Government Regulation

Our operations and business practices are subject to regulation at the federal, state and, in some cases, local levels. State and local consumer protection laws and regulations govern our advertising, sales and other trade practices.

Statutes and regulations affecting the fitness industry have been enacted or proposed in both California and New York. Typically, these statutes and regulations prescribe certain forms and provisions of membership contracts, limit the amount of prepaid revenues we can collect, afford members the right to cancel the contract within a specified time period after signing, require an escrow of funds received from pre-opening sales or the posting of a bond or proof of financial responsibility and may impose numerous limitations on the terms of membership contracts. In addition, we are subject to numerous other types of federal and state regulations governing the sale of memberships. These laws and regulations are subject to varying interpretations by a number of state and federal enforcement agencies and courts. We maintain internal review procedures in order to comply with these requirements and believe that our activities are in substantial compliance with all applicable statutes, rules and decisions.

Under so-called state "cooling-off" statutes, a member has the right to cancel his or her membership for a period of three to ten days (depending on the applicable state law) and, in such event, is entitled to a refund of any down payment. In addition, our membership contracts provide that a member may cancel his or her membership at any time upon death, disability or relocation beyond a certain distance from our nearest Club. The specific procedures for cancellation in these circumstances vary due to differing state laws. In each instance, the canceling member is entitled to a refund of prepaid amounts only.

Furthermore, where permitted by law, a cancellation fee is due to us upon cancellation and we may offset such amount against any refunds owed.

Employees

At December 31, 2005, prior to the Millennium transaction, we had 2,619 employees, most of whom were employed on a part-time basis. At March 31, 2006, we had 1,148 employees, most of whom are employed on a part-time basis in Club operating activities such as group exercise, private training and food and beverage services. At March 31, 2006, we employed 397 full-time employees, 327 of whom were involved in The Sports Club/LA operations such as sales, management, private training, food and beverage or support staff, 25 of whom work for our SportsMed subsidiary and 45 of whom were in general and administrative functions. We are not a party to any collective bargaining agreement with our employees. Although we experience high turnover of non-management personnel, we have never experienced any labor shortages nor had any difficulty in obtaining adequate replacements for departing employees. We consider our relations with our employees to be good.

Available Information

Quarterly and annual reports on Form 10-Q and Form 10-K can be accessed through the SEC website at http://www.sec.gov/edgar/searchedgar/webusers.htm. The website for the Public Company Accounting Oversight Board is http://www.pcaobus.org/.

ITEM 1A. RISK FACTORS

Our future success is dependent upon our ability to attract and retain members.

Our profitability is dependent on our ability to attract and maintain membership levels at our Clubs, and there can be no assurance that we will be successful in these efforts, or that the membership levels at one or more of our Clubs will not decline. There are numerous factors that could lead to a decline in membership levels or that could prevent us from increasing our membership at newer Clubs, including the public image of the Clubs, the ability of the Clubs to deliver quality service at a competitive cost, the presence of direct and indirect competition in the areas in which the Clubs are located, the public's interest in Clubs and general economic conditions. In addition, from time to time we may close a Club and attempt to move members of such Club to a different Club or may have to temporarily relocate members if a Club is closed for remodeling or due to fire, earthquake or other casualty. In such cases, our inability to successfully transfer and retain members will lead to an overall membership decline. Additionally, conditions in the markets in which we operate may limit our ability to maintain or increase membership pricing without a material loss in membership. As a result of these factors, there can be no assurance that the Clubs' membership levels will be adequate to maintain or permit the expansion of their operations.

The sports and fitness industry is highly competitive and some of our competitors may have advantages over us.

The sports and fitness industry is highly competitive. Despite recent consolidation activities, the industry remains highly fragmented. Some of our competitors are significantly larger and have greater financial and operating resources than we do. In addition, a number of individual and regional operators compete with us throughout our existing markets. These competitors compete with us both for members and for employees. We also compete with recreational facilities established by governments and businesses, the YMCA and YWCA, country clubs and weight-reducing salons, as well as products and services that can be used in the home. Other entertainment and retail businesses also compete with us for the discretionary income of our target market. We believe that additional sports and fitness competitors will emerge in the future some of which may be larger and have greater financial and operating resources than us. There can be no assurance that such competition will not have a material adverse effect on our financial condition and results of operations.

We must hire and retain qualified personnel.

We are dependent upon the available labor pool of semi and unskilled employees. We are also subject to the Fair Labor Standards Act, which governs such matters as a minimum wage, overtime and other working conditions. A shortage in the labor pool or other general inflationary pressures or changes in applicable laws and regulations could require us to enhance our wage and benefits packages. There can be no assurance that labor costs will not increase. Any increase in such costs could have a material adverse effect on our financial condition and results of operations.

If our key management leaves the Company, it could have an adverse effect on us.

We are dependent upon the efforts and skills of our executive officers, who have substantial experience in the sports and fitness club industry. The loss of one or more of such officers could have a material adverse impact on our operations. In addition, the development and expansion of the Company's business will require additional experienced management and operations personnel. No assurance can be given that we will be able to hire or retain such employees.

We have significant debt levels that would adversely affect our financial health.

After the sale of five of our sports and fitness Clubs in January 2006, we continue to have approximately $80.0 million of long-term debt that is secured by our real estate in Los Angeles and Orange County, California. Our debt levels could contribute to any of the following:

o A substantial portion of our cash flows from operations will be needed to pay our prinicipal and interest obligations, leaving less cash for capital expansion or to return to shareholders.

o A decrease in our cash flows from operations could make it more difficult for us to meet our debt service requirements or force us to sell assets or raise additional equity.

o Our debt levels may make it more difficult to secure additional long-term debt if we elected to finance any future expansions with debt.

o Our loan agreements contain provisions that we must comply with or we could be declared in default of the agreements.

o We may be more highly leveraged than some of our competitors which could put us at a competitive disadvantage.

o Our two loans have maturity dates in 2008 and 2016 at which time we will be required to refinance a significant portion of the current debt amount. If we are unable to do so, it could have a material adverse effect on our financial position.

If we develop new Clubs their success is dependent on our ability to locate suitable sites, meet construction schedules and budgets and negotiate favorable leases or management agreements.

We are currently pursuing several potential new Club sites. Due to our current debt levels and the significant amount of capital required to construct a new facility, we expect any new Clubs would be structured as joint ventures, partnership agreements or management agreements. Our ability to successfully develop new Clubs is dependent upon the following:

o Our ability to find development partners,

o Our ability to locate suitable sites for development,

o Our ability to finance any capital we would be required to invest,

o Our ability to attract members to a newly developed Club, which will depend upon how receptive potential members are to our brand, policies and pricing,

o Our ability to negotiate satisafactory leases and other contracts, and

o Our ability to meet construction schedules and budgets.

Expanding via partnership, joint ventures or management agreements present certain inherent risks.

We have expressed our interest in pursuing partnership, joint ventures and management agreements to expand in the future. Partnership, joint ventures and management agreements may under certain circumstances, present certain risks to us including the possibility that our partners or co-venturers might become bankrupt and that such partners or co-venturers might have economic or other business interests or objectives that are inconsistent with our interests or objectives. Such partners or co-venturers may also be in a position to take actions contrary to our interests and objectives and cause delays or impasses which may prevent us from implementing business decisions with respect to the partnerships and joint ventures. These risks are heightened in Clubs where partners or owners may, under certain circumstances, have the right to assert control over the day-to-day operations of the Clubs. There can be no assurance that the foregoing factors will not have a material adverse effect on our results of operations and financial condition.

Our Asset Purchase Agreement with Millennium prevents us from operating in certain markets.

Until January 2011, we agreed not to own, manage or operate any sports and fitness facilities other than The Sports Club/LA - New York at Rockefeller Center in any of Millennium's territories. Those territories include all of the United States located East of the Mississippi River and several counties located in the San Francisco area. Therefore, without a waiver of that condition by Millennium we will be unable to consider any expansion opportunities in these geographical areas.

We are subject to various regulatory requirements that we can not control.

Our operations and business practices are subject to regulation at federal, state and, in some cases, local levels. General rules and regulations of the Federal Trade Commission, and of state and local consumer protection agencies, and state statutes apply to our advertising, sales and other trade practices, including the sale of memberships and the financing and collection of membership fees. Although we are not aware of any proposed material changes in any such statutes, rules or regulations, any changes could have a material adverse effect on our financial condition and results of operations.

Our voting control is concentrated in a small shareholder base.

Our principal shareholders, officers, directors and their affiliates beneficially own, in the aggregate, approximately 73.1% of the outstanding shares of the Common Stock and 81.4% of the voting stock after consideration of the voting rights of our Preferred Stock. As a result, such persons, acting together, have control over all matters requiring shareholder approval.

We have engaged in numerous related party transactions and such transactions present possible conflicts of interest.

Over the last few years the Company has entered into several related party transactions. (These transactions are disclosed in Item 13 of this Form 10-K). All such transactions were approved by our independent Board of Directors who believed they were in our best interest. Transactions of this nature present the possibility of a conflict of interest whereby the other party may advance its economic or business interests or objectives which may conflict with or be contrary to our best interest. Any such conflit could have a material adverse effect on our financial conditions and results of operations.

Our Common Stock is very thinly traded.

A relatively small amount of our Common Stock is not owned by our four major stockholders. As a result, there is very limited daily trading in our Common Stock. This may make it difficult for a current stockholder to dispose of the stock they currently own or for a new stockholder to acquire shares of Common Stock. Also, the market price of our Common Stock could be subject to significant fluctuations that are unrelated to our operating performance or financial condition.

Our Preferred Stockholders have rights that are senior to our Common Stockholders.

We currently have outstanding $24.0 million of Preferred Stock, some of which is convertible into shares of Common Stock at the election of the holder. At December 31, 2005, dividends of $6.4 million have accrued on such stock and are payable to the stockholders. The Preferred Stockholders have rights that are senior to our Common Stockholders and are entitled to convert their Preferred Shares into Common Stock or redeem their Preferred Stock and receive all accumulated dividends prior to any distribution to our Common Stockholders.

Our Clubs are concentrated in two geographic areas and therefore are subject to factors that impact the local economics, including natural or man made disasters.

We currently operate three Clubs in Southern California and one in New York City and thus our operating results are susceptible to events in those areas, including disasters such as earthquakes or acts of terrorism. All of the Clubs maintain comprehensive casualty, liability and business interruption insurance and all Clubs located in California maintain earthquake insurance. We believe our insurance coverage is in accordance with industry standards. There are, however, certain types of losses which may be either uninsurable or not economically insurable. Accordingly, there can be no assurance that any insurance proceeds will adequately compensate us for all economic consequences of any loss. Should an uninsured loss occur, we could lose both our invested capital in a particular Club or Clubs and the anticipated profits from such Club or Clubs. Any such event could have a material adverse effect on our financial condition and results of operations.

We could be subject to claims related to health or safety risks at our Clubs.

Use of our Clubs poses some potential health risks to members or guests through exertion and use of our services and facilities including exercise equipment. There can be no assurance that a claim against us for death or an injury suffered by members or their guests while exercising at a Club will not be asserted or that we would be able to successfully defend any claim that might be asserted. We currently maintain general liability coverage; however, there can be no assurance that we will be able to maintain such liability insurance on acceptable terms in the future or that such insurance will provide adequate coverage against potential claims.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.