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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10
Amendment No. 4

GENERAL FORM FOR REGISTRATION OF SECURITIES
Pursuant to Section 12(b) or (g) of the Securities Exchange Act of 1934

PROSPECT MEDICAL HOLDINGS, INC.
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of incorporation or organization) 		  330564370
(IRS Employer Identification No.)

6083 Bristol Parkway, Suite 100
Culver City, California
(Address of principal executive offices)
 
90230
(Zip Code)

(310) 338-8677
(Registrant's telephone number, including area code)

Securities to be registered pursuant to Section 12(b) of the Act:

 
Title of each class
to be so registered:
  Name of each exchange on which
each class is to be registered:
Common stock,
Par value $0.01 per share 		  American Stock Exchange

Securities to be registered pursuant to Section 12(g) of the Act:

(Title of class)

TABLE OF CONTENTS

 
   
  Page
Item 1.   Business   3
Item 2.   Financial Information   39
Item 3.   Properties   72
Item 4.   Security Ownership of Certain Beneficial Owners and Management   73
Item 5.   Directors and Executive Officers   77
Item 6.   Executive Compensation   82
Item 7.   Certain Relationships and Related Transactions   85
Item 8.   Legal Proceedings   87
Item 9.   Market Price of and Dividends on the Registrant's Common Equity and Related Stockholder Matters   87
Item 10.   Recent Sales of Unregistered Securities   89
Item 11.   Description of Registrant's Securities to Be Registered   91
Item 12.   Indemnification of Directors and Officers   97
Item 13.   Financial Statements and Supplementary Data   99
Item 14.   Changes in and Disagreements with Accountants and Financial Disclosure   99
Item 15.   Financial Statements and Exhibits   100

        Some of the statements under Item 1, "Business," Item 2, "Financial Information—Management's Discussion and Analysis of Financial Condition and Results of Operations," and elsewhere in this Form 10 constitute forward-looking statements. These statements relate to future events or our future financial performance, and are identified by words such as "may," "will," "should," "expect," "scheduled," "plan," "intend," "anticipate," "believe," "estimate," "potential," or "continue" or the negative of such terms or other similar words. You should read these statements carefully because they discuss our future expectations, and we believe that it is important to communicate these expectations to our investors. However, these statements are only anticipations. Actual events or results may differ materially. In evaluating these statements, you should specifically consider various factors, including the factors discussed under "Risk Factors." These factors may cause our actual results to differ materially from any forward-looking statement.

        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. Moreover, we do not assume any responsibility for the accuracy and completeness of such statements in the future. Subject to applicable law, we do not plan to update any of the forward-looking statements after the date of this report to conform such statements to actual results.


Item 1. Business.

        Prospect Medical Holdings, Inc. (we, or the "company") is a health care management services organization. We provide management services to affiliated physician organizations that operate as independent physician associations ("IPAs") or medical clinics. Our affiliated physician organizations enter into agreements with health maintenance organizations ("HMOs") to provide enrollees of the HMOs with a full range of medical services in exchange for fixed, prepaid monthly fees known as "capitation" payments.

        The IPAs contract with physicians (primary care and specialist) and other health care providers to provide all of their medical services. The medical clinics employ their primary care physicians, which provide the vast majority of their medical services, while contracting with specialist physicians and other health care providers to provide other required medical services.

        Through our three management subsidiaries—Prospect Medical Systems, Sierra Medical Management and Pinnacle Health Resources—we have entered into long-term agreements to provide management services to each of our affiliated physician organizations in exchange for a management fee. The management services we provide include negotiation of contracts with physicians and HMOs, physician recruiting and credentialing, human resources services, claims administration, financial services, provider relations, member services, case management including utilization management and quality assurance, data collection, and management information systems. For further discussion of these services, see Item 1, "Business—Management Services Agreements."

        Our three management subsidiaries currently provide management services to twelve affiliated physician organizations, including Prospect Medical Group, ten other affiliated physician organizations that Prospect Medical Group owns or controls, and one affiliated physician organization that is a joint venture in which Prospect Medical Group owns a 50% interest. We have utilized Prospect Medical Group, which was our first affiliated physician organization, to acquire the ownership interest in all of our other affiliated physician organizations. Thus, while Prospect Medical Group is itself an affiliated physician organization that does the same business in its own service area as all of our other affiliated physician organizations do in theirs, Prospect Medical Group also serves as a holding company for our other affiliated physician organizations.

        We have designated Jacob Y. Terner, M.D., our Chairman and Chief Executive Officer, to be the owner of all of the capital stock of Prospect Medical Group. As such he indirectly controls Prospect Medical Group's ownership interest in each of our other affiliated physician organizations. Dr. Terner is also the Chief Executive Officer of Prospect Medical Group and all of our other affiliated physician organizations that Prospect Medical Group owns. Dr. Terner is the Chief Executive Officer of one of the two general partners of our joint venture affiliated physician organization.

        We control each affiliated physician organization through an assignable option agreement that we have entered into through our management subsidiary, Prospect Medical Systems, with Dr. Terner and Prospect Medical Group. The assignable option agreement gives us the right to designate a successor physician to buy the capital stock of Prospect Medical Group from Dr. Terner for nominal consideration. The assignable option agreement allows us to control who owns the stock of Prospect Medical Group and indirectly control each affiliated physician organization that Prospect Medical Group controls. We refer to this arrangement as a "single shareholder model."

        For financial reporting purposes, we are also deemed to control Prospect Medical Group under U.S. generally accepted accounting principles (see Item 2, "Financial Information—Management's Discussion and Analysis of Financial Condition and Results of Operations and Critical Accounting Policies—Consolidation of Financial Statements") and are therefore required to consolidate the financial statements of Prospect Medical Group with those of our management subsidiaries.

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        The twelve affiliated physician organizations that we currently manage through our subsidiaries include Prospect Medical Group, which is an IPA wholly owned by Dr. Terner, seven IPAs wholly owned by Prospect Medical Group, two medical clinics wholly owned by Prospect Medical Group, one IPA in which Prospect Medical Group has a 55% controlling interest, and one IPA which is a joint venture in which Prospect Medical Group owns a 50% interest through another affiliated physician organization. In July 1999, we entered into the joint venture partnership agreement with an unrelated third party, AMVI/IMC Health Network, Inc. ("AMVI"), in order to aggregate sufficient Medicaid enrollees to qualify for participation in the CalOPTIMA Medicaid (Medi-Cal in California) program in Orange County, California. We own a 50% interest in the joint venture partnership, although our portion of the business is operated autonomously. In accordance with the joint venture partnership agreement, profits and losses are not split in accordance with the partnership ownership interest, but rather, are directly tied to whatever results are generated by our portion of the business. Separate from any earnings we generate from our portion of business within the joint venture, we also earn fees for management services we provide to our partner in the joint venture. We account for our interest in the joint venture using the equity method of accounting. We include in our financial statements only the net results attributable to those Medicaid enrollees specifically identified as assigned to us, together with the management fee that we charge for managing those Medicaid enrollees specifically assigned to the other joint venture partner. Operations for the joint venture are similar to our other affiliated physician organizations, with the distinction that all enrollees are Medicaid beneficiaries. That enrollee assignment is determined at the time an individual applies for Medicaid health coverage and the local agency (CalOPTIMA) asks the individual to choose a primary care provider (PCP). AMVI/INC Health Network and Prospect have no common PCP's, so when CalOPTIMA notifies the joint venture of the new enrollee and the name of their PCP, it is clear which of the joint venture partners' businesses the new enrollee has been assigned to. In a very limited number of cases, the member omits to select a PCP, and CalOPTIMA simply assigns the member to one of the, geographically appropriate, organizations participating in the CalOPTIMA program. In those few cases where there is no identified PCP, the joint venture looks first at the zip code of the new member and secondly at the nationality of the new member, then assigns them to a PCP. The appropriate assignment in these few cases is simplified by the fact that AMVI, which is short for American Vietnamese, operates in a largely Vietnamese area, using largely Vietnamese PCPs to serve almost exclusively Vietnamese enrollees; whereas Prospect's membership in the CalOPTIMA program more closely parallels the overall ethnic makeup of the CalOPTIMA program as a whole.

        For discussion of the various agreements between our management subsidiaries and our affiliated physician organizations, see page 6 (security agreement), pages 15-16 (assignable option agreement), and pages 17-19 (management services agreements.

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        Information about our twelve affiliated physician organizations is listed in the table below:  

Affiliated Physician Organizations of Prospect Medical Holdings

Name of Affiliated
Physician Organization
  Type
  Owned By
  Managed By(1)
Prospect Medical Group   IPA   Jacob Y. Terner, M.D. (100%)   Prospect Medical Systems
Prospect Health Source Medical Group   IPA   Prospect Medical Group (100%)   Prospect Medical Systems
Prospect Professional Care Medical Group   IPA   Prospect Medical Group (100%)   Prospect Medical Systems
Prospect NWOC Medical Group   IPA   Prospect Medical Group (100%)   Prospect Medical Systems
Santa Ana/Tustin Physicians Group   IPA   Prospect Medical Group (100%)   Prospect Medical Systems
Nuestra Familia Medical Group   IPA   Prospect Medical Group (55%)   Prospect Medical Systems
AMVI Prospect Health Network   IPA   Prospect Medical Group, through Santa Ana/Tustin Physician's Group (50% joint venture)   Prospect Medical Systems
Sierra Primary Care Medical Group   Medical Clinic   Prospect Medical Group (100%)   Sierra Medical Management
Pegasus Medical Group   Medical Clinic   Prospect Medical Group (100%)   Sierra Medical Management
Antelope Valley Medical Associates   IPA   Prospect Medical Group (100%)   Sierra Medical Management
APAC Medical Group   IPA   Prospect Medical Group (100%)   Pinnacle Health Resources
StarCare Medical Group   IPA   Prospect Medical Group (100%)   Pinnacle Health Resources
(1)
Prospect Medical Systems and Sierra Medical Management are wholly owned direct subsidiaries of Prospect Medical Holdings. Pinnacle Health Resources is a wholly-owned subsidiary of Prospect Medical Systems.

        The twelve affiliated physician organizations provide medical services to a combined total of approximately 198,000 HMO enrollees at September 30, 2004. AMVI Prospect Health Network enrollees include approximately 5,700 enrollees that we managed for our own economic benefit, and 7,100 enrollees that we manage for the economic benefit of our partner in this joint venture, for which we earn management fee income. Currently, our affiliated physician organizations have contracts with approximately ten HMOs, from which our revenue is primarily derived. HMOs offer a comprehensive health care benefits package in exchange for a capitation fee per enrollee that does not vary through the contract period regardless of the quantity of medical services required or used. HMOs enroll members by entering into contracts with employer groups or directly with individuals to provide a broad range of health care services for a prepaid charge, with minimal deductibles or co-payments required of the members. All of the contracts between our affiliated physician organizations and the HMOs provide for the provision of medical services by the affiliated physician organization to the HMO enrollees in consideration for the prepayment of the fixed monthly capitation fee per enrollee paid by the HMOs.

        We, through our management subsidiaries, control the expense for the medical component of the costs of our affiliated physician organizations by "sub-capitating" all primary care physicians and many of the specialist physicians that provide the medical services to the HMO enrollees. Sub-capitation is an

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arrangement that exists when an organization being paid under capitated contracts with an HMO, in turn contracts with other providers on a capitated basis, sharing a portion of the original capitated premium. For those specialties for which we cannot, or do not, choose to obtain a sub-capitated contract, we negotiate discounted fee-for-service contracts. By contract, our affiliated physician organizations generally do not assume responsibility for the costs of providing medical services ("medical costs") that occur outside of their service area, which has been defined as a 30-mile radius around the office of the HMO enrollee's primary care physician. All non-emergent care requires prior authorization in order to limit unnecessary procedures and to direct the HMO enrollee requiring care to the physicians of our affiliated physician organizations and the most cost effective facility. Our affiliated physician organizations utilize board certified pulmonologists and internists, trained in intensive care to maintain control over the patient's stay in the hospital, reducing unnecessary consultations and facilitating the patient's treatment and discharge. We also review medical costs monthly on a region by region basis and compare those costs to the trend of patient utilization of medical services in each region. In those instances where the patient utilization is trending very low, we determine whether it would be less expensive for our affiliated physician organizations to pay their providers on a discounted fee-for-service basis rather than a fixed capitation payment for each enrollee per month. See Item 1, "Business—Risk Management".

        Our consolidated business has grown through the acquisition of IPAs by Prospect Medical Group. Our plan is for Prospect Medical Group to continue to acquire additional IPAs. We do not intend to further acquire any individual or small medical practices, clinics or medical group practices.

        We believe that different IPAs present different medical cultures and are best served by local medical management. Therefore, we typically attempt to retain the senior medical management of the entities that we acquire or with which we affiliate.

        We have chosen to concentrate our growth geographically by limiting our acquisitions to IPAs in Orange County, California and Los Angeles County, California.

        Prospect Medical Group has recently acquired the following four IPAs. The enrollment noted here is the ending enrollment at September 30, 2004 for each of the acquisitions:

Name of IPA
   
Enrollment as of
September 30, 2004
  Date of Acquisition
Professional Care Medical Group(1)   38,400   September 30, 2003
StarCare Medical Group   35,600   February 1, 2004
APAC Medical Group   4,200   February 1, 2004
Northwest Orange County Medical Group(2)   13,300   February 1, 2004
   
   
Total Increased Enrollment—As of our fiscal year ended September 30, 2004   91,500    
   
   
(1)
Effective with the acquisition, the name was changed to Prospect Professional Care Medical Group, Inc.

(2)
Effective with the acquisition, the name was changed to Prospect NWOC Medical Group, Inc.

        Our profit growth as a consolidated business is primarily driven by increasing our revenue through acquisitions by Prospect Medical Group, and in parallel, reducing the administrative expenses of our affiliated physician organizations and management subsidiaries. We select our acquisition candidates based in large part on a history of profitable operations or where we can foresee a synergy, such as, opportunities for economies of scale through a consolidation of management functions, a competitive environment with respect to hospital and physician services, and a geographic proximity to current operations or a material share of the potential acquisition candidate's own local market. Upon

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completion of every IPA acquisition, one of our management subsidiaries enters into a long-term management services agreement with the newly-acquired physician organization.

        In effecting an acquisition, our affiliated physician organizations generally acquire medical assets, including such things as HMO contracts, provider contracts and patient records. If related non-medical assets are to be acquired as part of the acquisition, such as, management contracts, furniture, fixtures or equipment, non-medical personnel or real property leases, these are acquired by one of our management subsidiaries. In some cases, the stock of an acquisition candidate is acquired rather than its assets.

        With respect to any acquisition of assets or stock of an acquisition candidate that is being acquired by one of our affiliated physician organizations, we, or one or more of our affiliated entities, may advance cash, or in some cases stock or options, to that affiliated physician organization, for use in consummating the acquisition.

        Advances from our management subsidiaries to the affiliated physician organization are covered by the terms of the respective management services agreement, which obligate the affiliated physician organization to repay the advance. Specifically, our management services agreements give the manager the authority to advance funds to the affiliated physician organization in order for the affiliated physician organization to meet its financial obligations. The management services agreements allow the manager and the affiliated physician organization to set the terms of such advances. The advances, initially evidenced through the issuance of a Note between the entities, are deemed loans that are reflected as a payable or receivable, as applicable, in the financial statements of each entity and are repayable upon demand. Cash advances among our affiliated physician organizations are inter-company in nature and are eliminated in consolidation in our financial statements.

        Furthermore, Prospect Medical Group, our affiliate physician organization which is the owner of all or a significant portion of the capital stock of each of our other affiliated physician organizations, has executed a security agreement with its manager, Prospect Medical Systems, covering all of Prospect Medical Group's obligations to Prospect Medical Systems under its management services agreement. The collateral pledged under such security agreement is all accounts and other assets of Prospect Medical Group. The manager could technically foreclose on such collateral if its loan was not repaid. However, because of our affiliate relationship with the physician organizations that we manage, we are able to control the timing of the repayment of any loans by our affiliated physician organizations. The security interest of Prospect Medical Systems has, however, been subordinated to our loans under our senior secured credit facility until such time as the loans under our credit facility have been paid in full.

        Advances from our affiliated physician organization to us or one of our management subsidiaries are covered by the terms of a cash management agreement, which obligates the recipient of the advance to repay it. These advances, like advances from our management subsidiaries to our affiliated physician organizations, are reflected in an intercompany note and are reflected in the financial statements of each entity as a payable or receivable, as applicable.

        Our executive management team consists of seasoned operational, physician, financial, contracting, and administration executives, who have extensive experience in the healthcare industry. Jacob Y. Terner, M.D., our Chairman, Chief Executive Officer and a Director since November 1996, has held positions as a physician, medical professor, and corporate executive. Dr. Terner was a member of the voluntary faculty at the University of Southern California, School of Medicine for approximately thirty years and holds the title of Emeritus Clinical Professor of Obstetrics and Gynecology. Prior to his tenure with our company, Dr. Terner served as Chairman of the Board and Chief Executive Officer of Century MediCorp, Inc., a publicly-traded HMO and vertically integrated health-management organization until its October 1992 merger with Foundation Health Corporation. Each of our senior executives has more than ten years of general business and/or health care experience.

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        Our principal place of business is 6083 Bristol Parkway, Suite 100, Culver City, CA 90230. Our telephone number is (310) 338-8677. Our web site address is www.prospectmedicalholdings.com. A copy of this registration statement is posted on our web site. Other information contained in or accessible through our website is not a part of this registration statement.

        A chart of the organizational structures of both the company and Prospect Medical Group is set forth on the next page.

8

GRAPHIC

9

Summary of the Structure of our Business

        

1.
Jacob Y. Terner is the nominee shareholder of PMG; CEO of PMH, SMM, and PHR; Secretary and Director of Nuestra Familia Medical Group, which is 55% owned by Prospect Medical Group; and CEO of Santa Ana-Tustin Physicians Group, which is a 50% joint venture partner in AMVI/Prospect Health Network.

2.
PMG is an affiliated physician organization and owns 100% of the stock of all of our other affiliated physician organizations, 55% of Nuestra Familia Medical Group, and a 50% interest in AMVI/Prospect Health Network.

3.
PMS, PMG and Dr. Terner are parties to an Assignable Option Agreement whereby PMS can change the owner/shareholder of PMG at any time. PMS and PMH are deemed to control all the affiliated physician organizations, except AMVI/Prospect Health Network, for financial accounting purposes, dictating a consolidation of the financial statements of all these entities with PMH and its management subsidiaries. We account for our interest in AMVI/Prospect Health Network using the equity method of accounting and we record only the net results derived from our specifically identified portion of the joint venture's operations. In addition, we record the management fee revenue we earn for providing management services to our partner's specifically identified portion of the joint venture operations.

4.
All of the affiliated physician organizations operate as independent physician associations (IPAs) except Sierra Primary Care Medical Group and Pegasus Medical Group, which operate as medical clinics.

10

Managed Care Industry Overview

        We operate our business in the rapidly evolving managed health care industry. Historically, the substantial majority of medical services were provided on a fee-for-service (indemnity) basis, with insurance companies or individuals assuming responsibility for paying all or a portion of such fees. The costs of medical services have historically risen at a higher rate than the consumer price index. As a result, insurers, employers, state and federal governments and other health insurance payers have sought to reduce or control the sustained increases in health care costs. The response to these cost increases has been a shift away from the traditional fee-for-service method of paying for health care to managed health care models, such as HMOs, that rely on the concept that pre-payment based on prior negotiation is an effective way of controlling health care costs.

        HMOs offer a comprehensive health care benefits package in exchange for a fixed prepaid monthly fee or premium per enrollee that does not vary through the contract period regardless of the quantity of medical services required or used. HMOs enroll members by entering into contracts with employer groups or directly with individuals to provide a broad range of health care services for a prepaid charge, with minimal deductibles or co-payments required of the members. HMOs contract directly with medical clinics, independent physician associations, hospitals and other health care providers to provide medical care to HMO enrollees. In California, it is customary for the HMOs to delegate the responsibility for managing the provision of medical services to independent physician associations or medical clinics with which the HMOs have contracts. In states such as California, a provider can only accept risk from an HMO for those services that the provider is authorized to perform within the scope of its licensure. For example, a physician organization cannot accept risk for the provision of hospital services, and a hospital cannot accept risk for professional medical services. The affiliated physician organization contracts with the HMOs provide for payment to the affiliated physician organizations of a fixed monthly fee per enrollee, which is called a capitation payment. Once negotiated, the total payment is based on the number of enrollees covered, regardless of the actual need for and utilization of covered services. Under these contracts, we, through our affiliated physician organizations and management subsidiaries, assume the financial risk that all necessary health care services and the management costs associated with the provision of those services can be provided at a cost less than the amount paid to our affiliated physician organizations by the HMOs.

        The management services we provide, through our management subsidiaries, include the negotiation of contracts with physicians and HMOs, physician recruiting and credentialing, human resources services, claims administration, financial services, provider relations, member services, medical management including utilization management and quality assurance, data collection and management information systems. Physicians have not been equipped by training or experience to handle all of these functions. Accordingly, physicians have either hired staff and purchased the necessary equipment to support these functions within their practice, or hired an outside management company.

        Physicians, including those in small to mid-sized physician groups, find themselves at a competitive disadvantage in the current managed care environment. They generally do not have a significant market presence and lack the capital to purchase sophisticated management information systems required to manage risk arrangements. Administrative burdens have been exacerbated by the presence of multiple HMOs, requiring physicians to comply with multiple formats for claims processing, credentialing and medical management. Additionally, a proliferation of state and federal regulations has increased the paper-work burden and hampered the application of the traditional controls used by managed care organizations. Physicians increasingly are responding to these pressures within the managed care industry by affiliating with organizations such as our company to mitigate their economic risk and perform the non-medical management and administrative tasks that arise from the delegated managed care model.

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Our Strategy

        Our business strategy is to target geographical regions with many IPAs and to achieve growth and scale within those regions, primarily through the acquisition of selected IPAs by Prospect Medical Group.

        As of December 31, 2003, there were approximately 170 small, medium and large IPAs in California. Many of these IPAs cannot obtain or have been unwilling to pursue the acquisition of capital with which to enhance their facilities or the human resources and information technology in order to grow. They are disadvantaged by pricing pressures, high fixed costs and increasing governmental regulation, and because of their size, many IPAs do not have any leverage in physician and HMO contracting. IPAs that fall into this category likewise have no exit strategy and are generally amenable to considering fair offers for their assets or capital ownership.

        To date, we have focused on acquisition candidates in Southern California. We have identified potential IPA acquisition candidates in Southern California having an aggregate of approximately 200,000 HMO enrollees, although no assurance can be given of our ability to acquire any of those IPAs. We select acquisition candidates based in large part on the following broad criteria:

        Our subsidiary Prospect Medical Systems conducts more than 95% of its operations in Orange and Los Angeles Counties of Southern California, while our subsidiary Sierra Medical Management conducts certain medical management operations in the Antelope Valley region in northern Los Angeles County, and shares some functions with Prospect Medical Systems in Orange County. As of February 1, 2004, we acquired Pinnacle Health Resources, which provided management services exclusively to StarCare Medical Group and APAC Medical Group. By September 30, 2004, we had

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consolidated substantially all of Pinnacle Health Resources' functions with Prospect Medical Systems. As of September 30, 2004, our affiliated physician organizations are listed below:

Affiliated Physician Organizations
   
Percentage Owned
By Prospect Medical
Group, Inc.(1)
  Area of Operations
Prospect Medical Group, Inc.(1)(4)   —   Orange, Los Angeles and Riverside Counties
Sierra Primary Care Medical Group, Inc.(2)   100%   Antelope Valley (Los Angeles County)
Santa Ana-Tustin Physicians Group, Inc.(4)(5)   100%   Orange County
Pegasus Medical Group, Inc.(2)   100%   Antelope Valley (Los Angeles County)
Antelope Valley Medical Associates, Inc.(4)   100%   Antelope Valley (Los Angeles County)
Nuestra Familia Medical Group, Inc.(4)   55%   East Los Angeles
AMVI/Prospect Health Network(3)(4)   50%   Orange County
Prospect Health Source Medical Group, Inc.(4)   100%   West Los Angeles
Prospect Professional Care Medical Group, Inc.(4)(6)   100%   North Orange County and East Los Angeles
Prospect NWOC Medical Group, Inc.(4)(7)   100%   North Orange County
StarCare Medical Group, Inc.(4)(7)   100%   North Orange County
APAC Medical Group, Inc.(4)(7)   100%   Central Orange County
(1)
A medical corporation owned by a single shareholder, currently, Jacob Y. Terner, M.D.

(2)
Medical clinic.

(3)
Joint venture partnership with AMVI/IMC Health Network to service only enrollees of CalOPTIMA which are all Medi-Cal enrollees.

(4)
IPA.

(5)
Consolidated into Prospect Medical Group, Inc. (November 1998).

(6)
Acquired as of September 30, 2003.

(7)
Acquired as of February 1, 2004.

        To support our growth strategy, we have invested over $2,000,000 in the expansion of our operational infrastructure by purchasing a sophisticated management information system called IDX Systems Managed Care Application ("IDX"). In addition, we pay monthly IDX maintenance fees of approximately $11,000. We are currently negotiating the renewal of our IDX licenses for existing andadditional software modules. We expect to pay approximately $500,000 during our second fiscal 2005 quarter to renew all required software licenses for a ten year period. Purchase of the licenses to operate additional software modules will also increase our monthly maintenance fees to approximately $16 ,000. IDX processes and monitors virtually all facets of our management operations. IDX provides our company all the pertinent details regarding claims management eligibility of our affiliated physician organizations. IDX also integrates several different functions of our management operations into one and provides all the information on a timely basis so that we can make rapid management decisions by identifying trends as soon as possible.

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        Additionally, we have developed significant knowledge capital with separate departments to manage the key areas of our affiliated physician organizations operations. These departments include:

        On behalf of our affiliated physician organizations, we manage data for approximately 198,000 HMO enrollees as of September 30, 2004. We estimate that our IDX system has the capacity to process the data of at least an additional 350,000 HMO enrollees. Therefore, we believe that the cost per enrollee of adding a large number of new enrollees would be significantly less than our current cost per enrollee.

Our Market

        Southern California is a mature managed care market. According to the California Department of Finance (Demographic Research Unit), the California population was 36,144,000 as of January 1, 2004. According to the latest survey by Cattaneo and Stroud, Inc. (a for-profit California managed care industry research group funded, in part, by the California Healthcare Foundation), 17,056,235 individuals, or approximately 47% of California residents were enrolled in HMOs as of March 2004, representing a decrease of 653,832 HMO enrollees compared to March 2003 . HMO enrollment in California has declined over the past three years, which has been attributed to the economy, unemployment, and a consumer move to preferred provider organizations ("PPOs"), which are another type of managed care plan modeled after the original fee-for-service indemnity plans, but require physicians to accept discounted fees. PPO customers experience higher premiums, co-payments and increased deductibles in exchange for lower initial premiums and the perceived benefit of choosing their own physicians, whereas HMO enrollees receive virtually all necessary healthcare coverage with minimal co-payments.

        Another reason we believe that California offers more economic opportunity for us is because physicians and hospitals have established practice and referral patterns that are consistent with providing services within a managed care framework. With a substantial portion of the California population utilizing either an HMO or a PPO (discounted fee-for-service), managed care is commonplace.

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        So far Prospect Medical Group has limited its acquisition of physician organizations to the following organizations in Orange County, California and Los Angeles County, California:

 
   
As of September 30, 2004
Affiliated Physician Organizations
  Primary
Care
Physicians
  Specialists
  Enrollees
  Area of Operations
Prospect Medical Group, Inc.   282   602   37,700   Orange, Los Angeles & Riverside Counties
Prospect Health Source Medical Group, Inc.   91   97   23,700   West Los Angeles
Sierra Primary Care Medical Group, Inc.(1)   14   174   13, 300   Antelope Valley (Los Angeles County)
Pegasus Medical Group, Inc.   3   127   3,600   Antelope Valley (Los Angeles County)
Nuestra Familia Medical Group, Inc.   95   150   6 300   East Los Angeles
Antelope Valley Medical Associates, Inc.   14   125   9,400   Antelope Valley (Los Angeles County)
AMVI / Prospect Health Network(5)   167   158   12, 800   Orange County
Prospect Professional Care Medical Group(2)   184   271   38,400   East Los Angeles & Orange County
Prospect NWOC Medical(3) Group, Inc.   124   148   13,300   North Orange County
StarCare Medical Group, Inc.(3)(4)   170   493   35,700   North Orange County
APAC Medical Group, Inc.(3)(4)   133   211   4,200   Central Orange County
   
 
 
   
Totals   1,277   2,556   198,400    
   
 
 
   
(1)
Excludes 11 full time physicians and 2 part time physician employed by Sierra Primary Care Medical Group and Pegasus Medical Group.

(2)
Acquisition completed as of September 30, 2003.

(3)
Acquisition completed as of February 1, 2004.

(4)
StarCare and APAC share specialist physicians.

(5)
Includes approximately 5,700 enrollees that we manage for our own economic benefit, and 7,100 enrollees that we manage for the economic benefit of our partner in this joint venture, for which we earn management fee income.  

Enrollment Statistics
As of September 30

 
  1996
  1997
  1998
  1999
  2000
  2001
  2002
  2003
  2004
Commercial   33,100   62,000   83,000   87,000   83,000   105,000   102,000   136,200   168,500
Medicare   1,700   7,300   8,200   8,800   7,800   9,800   7,000   11,200   15,500
Medi-Cal   —   6,000   6,700   7,600   6,700   6,300   8,500   13,700   14,400
   
 
 
 
 
 
 
 
 
  Totals   34,800   75,300   97,900   103,400   97,500   121,100   117,500   161,100   198,400
   
 
 
 
 
 
 
 
 

        The Medi-Cal enrollment statistics above include both enrollees that we manage for our own economic benefit, and enrollees that, starting in 1999, we manage for the economic benefit of our partner in the AMVI/Prospect Health Network joint venture. The number of enrollees included in the above table for which we provide management services to our joint venture partner, but in which we have no beneficial ownership interest, was 4,300, 4,200, 4,000, 5,600, 7,100 and 7,100 as of September 30, 1999, 2000, 2001, 2002, 2003 and 2004, respectively.

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Revenue Concentration Statistics of our Affiliated Professional Organizations
For the Fiscal Years Ended September 30, 2003 and 2004

        For the fiscal years ended September 30, 2003 and 2004, our affiliated physician organizations recognized capitation revenue of $ 63,512,597 and $125,860,567, respectively. The four largest clients of our affiliated physician organizations, PacifiCare of California, Health Net of California, Blue Cross of California and Blue Shield of California accounted for approximately 84% and 80% of total capitation revenue for the fiscal years ended September 30, 2003 and 2004, respectively:

 
   
Capitation Revenue
   
  Capitation Revenue
   
 
 
  Year Ended
September 30, 2003
  % of Total
Capitation Revenue
  Year Ended
September 30, 2004
  % of Total
Capitation Revenue
 
PacifiCare   $ 19,238,866   30 % $ 40,903,464   32 %
Health Net     15,318,402   24 %   25,933,742   21 %
Blue Cross     11,850,966   19 %   19,899,135   16 %
Blue Shield     7,399,387   11 %   13,467,152   11 %
   
 
 
 
 
Totals   $ 53,807,621   84 % $ 100,203,493   80 %
   
 
 
 
 

        See Item 1, "Business—Competition" and "Item 2, Financial Information—Management's Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors" for additional details regarding concentration.

        As of November 30, 2004, the most recent date for which data was available, our affiliated physician organizations had a combined market share (based on number of HMO enrollees served) of approximately 7.3 percent in Orange County (109,561 enrollees compared to 1,492,920 total enrollees in Orange County), and approximately 1.7 percent in Los Angeles County (85,025 enrollees compared to 4,934,216 total enrollees in Los Angeles County).  

Management Fees and Revenue Generation

        We, through our management subsidiaries, provide management and administrative support services to each of our affiliated physician organizations in return for management fees generally ranging from 8.5% to 15% of each organization's gross revenues. The specific management fee paid by each affiliated physician organization is set forth below:

Affiliated Physician Organization
  Management
Fee
 
Prospect Medical Group   15 %
Nuestra Familia Medical Group   12 %
AMVI/Prospect Health Network(1)   8.5 %
Prospect Health Source Medical Group   12.5 %
Prospect Professional Care Medical Group   15 %
Prospect NWOC Medical Group   15 %
Starcare Medical Group   15 %
APAC Medical Group   15 %
Sierra Primary Care Medical Group   15 %
Pegasus Medical Group, Inc.   15 %
Antelope Valley Medical Associates   15 %
(1)
AMVI/Prospect Health Network has an agreement with Prospect Medical Systems which is based upon a per member/per month management fee that equates to approximately 8.5% of AMVI/Prospect Health Network's gross revenues.

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        In addition to the management fees described above, we also receive an incentive bonus based on the net profit or loss of each wholly-owned affiliated physician organization. With the exception of Prospect Health Source Medical Group, we are allocated a 50% residual interest in the profits above 8% of the profits or a 50% residual interest in the net losses, after deduction for costs to the management subsidiary and physician compensation. For Prospect Health Source Medical Group, we are allocated a 40% residual interest in its profits or losses.

        Because of the ownership of a controlling financial interest by Prospect Medical Group or Dr. Terner in all of our affiliated physician organizations, other than AMVI/Prospect Health Network, should we determine that an adjustment to our management fees is appropriate (other than AMVI/Prospect Health Network), we are able to accomplish this adjustment due to our controlling financial interest in the affiliated physician organization. In the case of AMVI/Prospect Health Network, because Prospect Medical Group's ownership interest is a 50% interest, in the event we determine that an adjustment of the management fee for AMVI/Prospect Health Network is appropriate, an adjustment would require negotiation with the joint venture partner.

        Notwithstanding our ability to control the management fee adjustment process, we are limited by laws affecting management fees of health care management service companies. Such laws require that our management fees reflect fair market value for the services being rendered, giving consideration however to the costs of providing the services. Such laws also limit our ability to increase our management fees more frequently than once a year.

        The management fees received by our management subsidiaries and the revenue of our affiliated physician organizations (other than AMVI/Prospect Health Network) are consolidated in our financial statements due to our controlling financial interest. In the case of AMVI/Prospect Health Network, only that portion of the results which are allocated to us are consolidated in the accompanying financial statements, together with the management fee that we charge our joint venture partner, AMVI, for managing AMVI's share of the joint venture operations.

        The management fee percentage listed above for the AMVI/Prospect Health Network joint venture approximates the following specifically determined management fees. There are two primary CalOPTIMA programs; basic Medicaid and a related program called Healthy Families, focused on health coverage for children. For the management services we provide to enrollees assigned to AMVI's division of the joint venture, one of our management companies, Prospect Medical Systems, is compensated $4.36 per member per month for the Medicaid enrollees, and 11% of hospital capitation revenues received by them for Healthy Families enrollees. We record these amounts as revenue. For the management services we provide to enrollees assigned to our division of the joint venture, Prospect Medical Systems is compensated $4.70 per member per month for the Medicaid enrollees and 11% of hospital capitation revenues received for Healthy Families enrollees. We eliminate these intercompany amounts in consolidation. The fee we charge AMVI is lower than our own, as a result of matching a competing management services proposal that AMVI received from another management company. AMVI does not receive any management fees from the joint venture.

        Revenues of our affiliated IPAs and affiliated medical clinics are generated under their contracts with the HMOs. Substantially all of the capitation revenue paid by the HMOs is received by our IPAs between the 10th and the 25th day of each month. The amount of the revenue is determined by the contract with the various HMOs, which pay the affiliated physician organizations a predetermined amount of money per enrollee, per month (known as a capitation payment).

        Our three management subsidiaries have the right, under their management services agreements, to control the depository accounts of the affiliated physician organizations they manage. Our management subsidiaries make disbursements on behalf of each affiliated physician organization to pay for all physician medical expenses for the HMO enrollees.

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        The payments include primary care and specialist sub-capitation, and fee-for-service payments for those physicians who are not sub-capitated. Sub-capitation is an arrangement whereby a physician accepts a single payment per patient per month which is a portion of the capitation payment received by the affiliated physician organizations from the HMO in exchange for which the physician provides all services in his area of expertise or specialty.

Risk Management

        We must control the medical expense or medical risk of our affiliated physician organizations. We use sub-capitation as one technique to control this risk. Approximately 50% of the medical costs of our affiliated physician organizations are sub-capitated. Another 20% of the medical costs are not sub-capitated because the patient utilization is so low that sub-capitation would be counter-productive. The remaining 30% of the medical costs of our affiliated physician organizations are controlled in the following ways:

        In addition, our affiliated physician organizations' agreements with HMOs and hospitals contain risk-sharing arrangements under which the affiliated physician organizations can earn additional compensation by coordinating the provision of high quality, cost-effective health care to enrollees, but they may also be required to assume a portion of any loss sustained from these arrangements. Risk-sharing arrangements are based upon the cost of hospital services or other services for which our physician organizations are not capitated. The terms of the particular risk-sharing arrangement allocate responsibility to the respective parties when the cost of services exceeds a budget, which results in a

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"deficit," and permit the parties to share in any amounts remaining in the budget, known as a "surplus," which occurs when actual cost is less than the budgeted amount. The amount of non-capitated and hospital costs in any period could be affected by factors beyond our control, such as changes in treatment protocols, new technologies and inflation. To the extent that such non-capitated and hospital costs are higher than anticipated, revenue paid to our affiliated physician organizations may not be sufficient to cover the risk-sharing deficits they are responsible for paying, which could reduce our revenues and profitability. It is our experience that "deficit" amounts for hospital costs are applied to offset any "surplus" amount we would otherwise be entitled to receive. We have historically not been required to reimburse the HMOs for any hospital cost deficit amount. Most of our contracts with HMOs specifically provide that we will not have to reimburse the HMO for hospital cost deficit amounts.

        In addition to hospital risk-sharing arrangements, many HMOs also provide a risk-sharing arrangement for pharmaceutical costs. Unlike hospital pools where nearly all the HMO contracts mandate participation by our affiliated physician organizations in the risk sharing for hospital costs, a lesser number of the HMO contracts mandate participation in a pharmacy risk-sharing arrangement, and although (unlike hospital pools) our affiliated physician organizations are generally responsible for their 50% allocation of pharmacy cost deficits, the deficit amounts of pharmacy costs have to date not been material.

        HMOs often insist on withholding negotiated amounts from the affiliated physician organizations' professional capitation payments, which the HMOs are permitted to retain, in order to cover the affiliated physician organizations' share of any risk-sharing deficits; and hospitals often demand cash settlements of risk sharing deficits as a "quid pro quo" for joining in these arrangements. Whenever possible, we seek to contractually reduce or eliminate our affiliated physician organizations' liability for risk-sharing deficits.

Our Affiliated Physician Organizations

        Our affiliated physician organizations consist of affiliated IPAs and affiliated medical clinics. Our affiliated IPAs contract with physicians (primary care and specialist) and other health care providers, to provide all of their medical services. Our affiliated medical clinics employ their primary care physicians to provide the vast majority of their medical services, while contracting with specialist physicians and other health care providers to provide other required medical services.

        All of our affiliated physician organizations enter into contracts with HMOs to provide medical services to enrollees of the HMOs. Most of the HMO agreements have an initial term of two years renewing automatically for successive one-year terms. However, because the HMO agreements generally do not provide for any increased capitation rates after the initial term, we generally renegotiate the HMO agreements on behalf of our affiliated physician organizations at the end of the initial term of such HMO agreements and enter into new agreements or amendments for additional two-year terms. This provides our affiliated physician organizations with more favorable rates than allowing their HMO agreements to renew pursuant to the automatic successive renewal provisions which would require our affiliated physician organizations to continue to provide services at the same rates as the initial term during such successive term(s).

        The HMO agreements generally provide for a termination by the HMOs for cause at any time, although we have never experienced a for cause termination. The HMO agreements generally allow either the HMOs or the affiliated physician organizations to terminate the HMO agreements without cause within a four to six month period immediately preceding the expiration of the term of the agreement.

        Our management subsidiaries provide management services to our affiliated IPAs and affiliated medical clinics under management services agreements that transfer control of all non-medical

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components of the business of the affiliated physician organizations to our management subsidiaries to the full extent permissible under federal and state law. When combined with the single shareholder model, which includes the assignable option agreement among Prospect Medical Systems, Prospect Medical Group and Dr. Terner, we have an established affiliate relationship with our affiliated physician organizations.

        As of September 30, 2004, our affiliated physician organizations employed 13 physicians (including two part time physicians), and had independent contracts with approximately 3,833 physicians.

        The physicians of the affiliated physician organizations are exclusively in control of and responsible for all aspects of the practice of medicine, subject to specialist guideline referrals developed by multi-specialty medical committees composed of our contracted physicians and chaired by one of our medical directors.

        We have entered into a management services agreement with each of our affiliated physician organizations, each of which is for a ten to thirty year term. When our existing affiliated physician organizations acquire other affiliated physician organizations that have contracts with HMOs, we enter into a management services agreement with each newly acquired affiliated physician organization as well.

        The management of our affiliated physician organizations is conducted by our three management subsidiaries, Prospect Medical Systems, Sierra Medical Management and Pinnacle Health Resources.

Assignable Option Agreement

        The assignable option agreement is an essential element of our "single shareholder model." The assignable option agreement provides our management subsidiary, Prospect Medical Systems, the right at will and on an unlimited basis, to designate a successor physician to purchase the capital stock of Prospect Medical Group for nominal consideration ($1,000) and thereby determine the ownership of Prospect Medical Group. There is no limitation on whom we may name as a successor shareholder except that any successor physician must be duly licensed as a physician in the State of California or otherwise be permitted by law to be a shareholder of a professional corporation.

        As a result of the assignable option agreement and our control of Prospect Medical Systems, we have control over the ownership of Prospect Medical Group. Because Prospect Medical Group is the owner of all or a significant amount of the capital stock of all of the other affiliated physic