SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10
Amendment No. 2

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)

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

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

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

(Title of class)

TABLE OF CONTENTS

        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.

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Item 1. Business.

        Prospect Medical Holdings, Inc. (we, or the "company") is a health care management services organization that provides management services to affiliated physician organizations that specialize in providing medical services to individuals enrolled in managed care programs offered by health maintenance organizations ("HMOs"). Our affiliated physician organizations are professional corporations that operate as independent physician associations ("IPAs") or medical clinics. The affiliated physician organizations enter into agreements with HMOs for the provision of a full range of medical services in consideration for the HMOs' payment of 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.

        We enter into long-term management services agreements with each affiliated physician organization through one of our two wholly owned subsidiaries, Prospect Medical Systems and Sierra Medical Management or through the wholly owned subsidiary of Prospect Medical Systems, Pinnacle Health Resources (collectively, "management subsidiaries"). The management services agreements provide for payment by each affiliated physician organization of a management fee in consideration of the management services. 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, 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."

        We have an affiliate relationship with each physician organization that we manage through the ownership of all or a significant portion of the capital stock of each physician organization by either Prospect Medical Group, which is one of our affiliated IPAs, or, in the case of Prospect Medical Group, by Jacob Y. Terner, our Chief Executive Officer and the Chief Executive Officer of all of our affiliated physician organizations, except our affiliated physician organization which is a joint venture partnership, in which case Dr. Terner is the Chief Executive Officer of one of the two general partners. We generally refer to this arrangement as a "single shareholder model."

        In order to ensure continued control of each affiliated physician organization, Prospect Medical Systems has an assignable option agreement with Prospect Medical Group and Dr. Terner which provides Prospect Medical Systems the right to designate a physician to purchase, for nominal consideration, all of the capital stock of Prospect Medical Group from Dr. Terner, thereby guaranteeing us, through our management subsidiary, the ability to control the capital stock of Prospect Medical Group and thus all capital stock of our affiliated physician organizations owned by Prospect Medical Group. 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.

        We currently manage twelve affiliated physician organizations, consisting of eight IPAs wholly owned by Prospect Medical Group or Dr. Terner, 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 arrangement in which Prospect Medical Group owns a 50% interest. The twelve affiliated physician organizations provide medical services to a combined total of approximately

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213,000 HMO enrollees, and have estimated annualized proforma consolidated total revenues of approximately $120 million as of June 30, 2004.

        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 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.

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        Prospect Medical Group has recently acquired the following four IPAs:

(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 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, we may advance to the affiliated physician organization all or a portion of any cash consideration to be paid to the acquisition candidate or may subsequently advance the cash to repay any promissory notes that were issued to the acquisition candidate as part of the acquisition transaction. We have also on occasion issued stock or options to acquire stock in the company which it advanced, in the same manner that a cash advance is advanced, to its primary affiliated physician organization, Prospect Medical Group, for use in Prospect Medical Group's acquisition of the professional assets or stock of an acquisition candidate. Alternatively, our affiliated physician organizations may advance funds to us when one of the management subsidiaries is acquiring the stock or the non-medical assets of a management company of the acquisition candidate as part of 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 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 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 from our affiliated physician organization to us or a management subsidiary or vice versa are inter-company in nature and are eliminated in

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consolidation of our financial statements, and the financial statements of our management subsidiaries and our affiliated physician organizations.

        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 are 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.

        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, as are advances by our affiliated physician organizations, 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.

        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.

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Summary of the Structure of our Business

1.

Jacob Y. Terner is the nominee shareholder of PMG. Dr. Terner is the CEO of PMH, SMM, PMS, PHR and all the affiliated physician organizations except AMVI/Prospect Health Network, which is a joint venture partnership where Dr. Terner is the CEO of Santa Ana-Tustin Physicians Group which is a 50% partner.

2.

PMG owns all of the stock of each affiliated physician organization except Nuestra Familia Medical Group where it owns a 55% interest and AMVI/Prospect Health Network where it owns 100% of the 50% joint venture partner, Santa Ana-Tustin Physicians Group.

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. With respect to AMVI/Prospect Health Network, only 50% of the results of this entity are consolidated due to PMG's 50% interest in this partnership.

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.

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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 administer 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 169 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 250,000 HMO enrollees, although no assurance can be given of our ability to acquire any of those IPAs. We select our acquisition candidates based in large part on the following broad criteria:

•

A history of profitable operations or a predictable synergy such as opportunities for economies of scale through a consolidation of management functions;



•

A competitive environment with respect to a high concentration of hospitals and physicians; and



•

A geographic proximity to current operations or a material share of the potential acquisition candidate's own local market.

        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 provides management services exclusively to StarCare Medical Group and APAC Medical Group, and it is our intent to consolidate

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Pinnacle Health Resources with Prospect Medical Systems by September 30, 2004. As of June 30, 2004, our affiliated physician organizations are listed below:

(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 Medicaid 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"). 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.

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

•

Clinical operations, including case management, medically related member services and quality control;



•

Claims, including financially related member services;



•

Contracting and credentialing, including provider relations;



•

Eligibility;



•

Finance and accounting;



•

HMO relations;

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•

Information technology;



•

Physician networks, including business development and marketing.

        On behalf of our affiliated physician organizations, we manage data for approximately 213,000 HMO enrollees. 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 latest survey by Cattaneo and Stroud, Inc. (a non-profit California managed care industry research group funded by the California Healthcare Foundation), the population of California was approximately 35,500,000 as of March, 2003, and approximately 17,700,000 residents of California were enrolled in HMOs, representing approximately 49.9% HMO penetration. HMO enrollment in California, however, has declined over the past three years, which has been attributed to the downturn in the economy and rising unemployment, and a consumer move to preferred provider organizations ("PPOs"), which are modeled after the original fee-for-service indemnity plans. PPO customers are experiencing higher premiums, co-payments and increased deductibles in exchange for low initial premiums and the perceived benefit of choosing their own physicians, whereas HMO enrollees receive virtually all necessary healthcare coverage with minimal co-payments and/or deductibles.

        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 approximately 50% of the population of California utilizing either HMOs or PPOs, managed care is now commonplace. As such, physicians are now accustomed to requesting prior authorizations from our affiliated physician organizations before proceeding with various procedures or patient referrals and recognize that authorization is given only when medically necessary. The high concentration of medical providers accustomed to managed care in Southern California allows us to concentrate our growth in relatively "small" areas. So far Prospect

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

(1)

Excludes 12 full time physicians and 1 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.

Enrollment Statistics
As of September 30 (and June 30, 2004)

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Revenue Concentration Statistics of our Affiliated Professional Organizations
For the Fiscal Year Ended September 30, 2003 and Nine Months Ended June 30, 2004

        For the fiscal year ended September 30, 2003 and the nine months ended June 30, 2004, our affiliated physician organizations recognized capitation revenue of $66,436,079 and $94,352,841, 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 81% and 78% of total capitation revenue for the fiscal year ended 2003, and the nine months ended June 30, 2004, respectively:

        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 June 30, 2004, our affiliated physician organizations had a combined market share (based on number of HMO enrollees served) of approximately eight percent in Orange County, California, and less than two percent in Los Angeles County, California.

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:

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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.

        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.

        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.

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The remaining 30% of the medical costs of our affiliated physician organizations are controlled in the following ways:

•

FLEXIBILITY:    As a general policy, we do not undertake the management of IPAs which we do not control through the single shareholder model. As a result, we can better control costs due to the absence of competing interests or diverse agendas between the affiliated IPAs and our management subsidiaries.



•

SUB-CAPITATING AND CONTRACTING:    For those specialties for which our affiliated physician organizations cannot or do not choose to obtain a sub-capitated contract, we negotiate discounted fee-for-service contracts. The reimbursement mode of these contracts is approximately 80% of the amount Medicare allows. The range is 65% to 120% of Medicare allowable.



•

SERVICE AREA RESTRICTION:    In negotiating contracts for our affiliated physician organizations with the HMOs, we have been able to define the service area of our affiliated physician organizations as a 30-mile radius around the office of the HMO enrollee's primary care physician. By contract, our affiliated physician organizations generally do not assume responsibility for medical costs that occur outside of their service area. The out-of-area and non-physician components of hospitalization costs are generally the responsibility of the HMO.



•

REFERRAL REVIEW:    All non-emergent care requires the prior authorization of our affiliated physician organizations. Consequently, our affiliated physician organizations have the ability to limit unnecessary procedures and to direct the enrollees requiring care to their contracted physicians and the most cost effective facility.



•

AUTOMATION:    Our information technology systems allow us generally to analyze medical cost distribution by the fifteenth day following the month in which claims are paid, facilitating a rapid response to any perceived distortion in medical costs.



•

EFFICIENT USE OF HOSPITALS:    Our affiliated physician organizations contract with hospitalists to see all of our physician groups' patients who are hospitalized. Hospitalists are board certified pulmonologists and internists who are trained in intensive care. They effectively maintain control over the patient's stay in the hospital, cutting down unnecessary consultations and facilitating the patient's treatment and discharge.

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        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 "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 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.

        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).

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        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 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 June 30, 2004, our affiliated physician organizations employed 13 physicians (including one part time physician), and had independent contracts with approximately 4,498 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 gives us, through 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 in a professional corporation.

        The assignable option agreement provides that we, through our management subsidiaries, 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 physician organizations, control over the ownership of Prospect Medical Group ensures that we, through our management subsidiaries, can control the ownership of each of our affiliated physician organizations.

        Execution of the assignable option agreement was a requirement of the management services agreement between Prospect Medical Systems and Prospect Medical Group. We paid nominal consideration ($100.00) for the assignable option agreement. The management services agreement and the assignable option agreement with Prospect Medical Group were executed in 1996 when we commenced our affiliation with Prospect Medical Group. The assignable option agreement terminates or expires coterminous with the management services agreement, which has a thirty-year term with successive automatic ten-year renewal terms. The assignable option agreement additionally provides that if the management services agreement is terminated for any reason, then Prospect Medical

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Systems' option is automatically and immediately exercised. We, through Prospect Medical Systems, intend to continue the term of the management services agreement with Prospect Medical Group for successive ten-year terms after the completion of the initial thirty-year term. We believe the automatic term renewal provisions of the management services agreement, coupled with the protections afforded us by the automatic option exercise provision in the assignable option agreement, will ensure the continued availability of the option under the assignable option agreement.

        Jacob Y. Terner, M.D. is currently the sole shareholder, sole director and Chief Executive Officer of Prospect Medical Group, as well as a director and Chief Executive Officer of Prospect Medical Holdings, Inc., Prospect Medical Systems and each of our other affiliated physician organizations, with the exception of AMVI/Prospect Health Network which is a joint venture partnership, in which case Dr. Terner is the Chief Executive Officer and director of one of the two general partners. Between October 1996 and December 1999, the shares of Prospect Medical Group were held by Gregg DeNicola, M.D. under the assignable option agreement. In January 2000, after having received Dr. DeNicola's resignation, we exercised our rights under the assignable option agreement, and for nominal consideration, Dr. DeNicola transferred the shares of Prospect Medical Group to Dr. Terner.

        Furthermore, since Dr. Terner is also an officer and director of each of the company, our management subsidiaries and our affiliated physician organizations, Dr. Terner has a fiduciary duty to protect the interests of each entity and its shareholders.

        At any time when Prospect Medical Systems determines that it is necessary to change the sole shareholder of Prospect Medical Group, with or without cause, Prospect Medical Systems may exercise its rights under the assignable option agreement and replace the sole shareholder of Prospect Medical Group with another licensed physician selected by our Board of Directors. Since we and Prospect Medical Systems are fully aware of the revenues which are earned by Prospect Medical Group (as well as the other affiliated physician organizations) and the expenses to be paid from such revenue, and further since we prepare regular financial statements and reports of Prospect Medical Group, we are confident that we would be well aware of any potential insolvency, liquidation or dissolution of Prospect Medical Group before it occurred, and if we conclude that this situation, or any other type of situation, necessitated the removal of Dr. Terner as the sole shareholder of Prospect Medical Group, then Prospect Medical Systems would exercise its option under the assignable option agreement and appoint a successor to Dr. Terner. Additionally, if at the time of any potential insolvency, liquidation or dissolution Prospect Medical Group was no longer acting in a professional capacity, we would consider converting Prospect Medical Group to a non-professional corporation, which would allow Prospect Medical Systems to own the shares of Prospect Medical Group directly rather than through a nominee physician.

        We believe that the cumulative effect of the assignable option agreement and the fiduciary duty imposed on the single physician shareholder of Prospect Medical Group is sufficient to safeguard our control over all business decisions of the affiliated physician organizations, including any currently unforeseeable insolvency, liquidation or dissolution of Prospect Medical Group.

Provider Agreements

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

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medical directors. Each affiliated physician organization enters into the following types of contracts for the provision of physician and ancillary health services:

Primary Care Physician Agreement

        A primary care physician agreement provides for primary care physicians contracting with independent physician associations to be responsible for both the provision of primary care services to enrollees and for the referral of enrollees to specialists affiliated with the independent physician association, when appropriate. Primary care physicians receive monthly sub-capitation for the provision of primary care services to enrollees. An independent physician association can terminate the primary care physician agreement immediately upon the occurrence of certain specified events, including suspension, restriction or revocation of the physician's license to practice medicine in California, denial, restriction or revocation of medical staff privileges at any hospital for medical disciplinary reasons, and the loss of professional liability insurance. Either party to the primary care physician agreement may terminate the agreement without cause upon ninety days' prior written notice.

Specialist Agreement

        A specialist agreement provides for a specialty care physician contracting with the independent physician association to receive either sub-capitated payments or discounted fee-for-service payments for the provision of specialty services to those enrollees referred to them by the independent physician association's primary care physician. An independent physician association can terminate the specialist agreement immediately upon the occurrence of certain specified events, including suspension, restriction or revocation of the physician's license to practice medicine in California, denial, restriction or revocation of medical staff privileges at any hospital for medical disciplinary reasons, and the loss of professional liability insurance. Either party to a specialist agreement may terminate the agreement without cause, upon ninety days' prior written notice.

Ancillary Provider Agreement

        An ancillary provider agreement provides for ancillary service providers—generally non-physician providers such as physical therapists, laboratories, etc.—to contract with an independent physician association to receive either monthly sub-capitated, discounted fee-for service or case rate payments for the provision of service to enrollees on an as-needed basis. Generally, either party can terminate the ancillary provider agreement with or without cause upon sixty or ninety days' written notice.

Management Services Agreements

        Our management subsidiaries, Prospect Medical Systems, Sierra Medical Management and Pinnacle Health Resources, enter into exclusive ten to thirty year management services agreements with each of our affiliated physician organizations, pursuant to which we, through such subsidiaries, provide them with management and administrative support services in return for management fees generally ranging from 8.5% to 15% of each affiliated physician organization's gross revenues. We also receive an incentive bonus approximating 40% of the profit of our affiliated physician organizations; in the event of a loss, our management fee is reduced by approximately 50% of the affiliated physician organization's loss.

        The management services agreements with our affiliated physician organizations that are 100% owned by Prospect Medical Group or Dr. Terner each have a thirty-year term and renew automatically for successive ten-year terms unless either party elects to terminate them 90 days prior to the end of their term. The management services agreements with those affiliated physician organizations in which we Prospect Medical Group has only a 50% interest (or slightly more, in the case of Nuestra Familia) have different terms. Our contract with Nuestra Familia is for only ten years; however, because

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Prospect Medical Group is a 55% shareholder, any renewal or termination must be approved by us. Similarly, our joint venture with AMVI is year-to-year, but because Prospect Medical Group is a 50% owner of that joint venture, we cannot be terminated without approval of the board of directors, of which Prospect Medical Group represents 50%. The management services agreements are terminable by the unilateral action of the particular physician organization prior to their normal expiration if we materially breach our obligations under the agreements or become subject to bankruptcy-related events, and we are unable to cure the material breach within sixty days of the occurrence. All management fees are eliminated in the consolidation in our financial statements.

        Under the management services agreements, we, through our management subsidiaries, provide management functions only. Under these agreements, each affiliated physician organization delegates to us the non-physician support activities that are required by the affiliated physician organizations in the practice of medicine. The management services agreements require us to provide suitable facilities, fixtures and equipment and non-physician support personnel to each affiliated physician organization. The primary services that we provide under management services agreements include the following:

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Utilization Management and Quality Assurance.    We assist each affiliated physician organization with the development and implementation of a utilization and quality management plan. We implement systems, programs and procedures necessary for the affiliated physician organizations and their physicians to perform utilization and quality management, organize procedures for prior authorization of elective procedures, urgent and emergent outpatient ambulatory surgery and hospital procedures, assist the physicians with their prospective, concurrent and retrospective reviews of medical procedures in accordance with their policies and HMO health plan requirements, provide data on the use of outpatient and inpatient services by the physicians to the affiliated physician organizations and the use of non-contracting physicians, and assist the medical director and the utilization review/quality assurance committee of each affiliated physician organization in responding to HMO member grievances, based on the instructions of the medical director.



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Medical Management.    We have a medical management department that administers the processes by which referrals to specialists and ancillary health care providers are evaluated, coordinated and implemented on an ongoing basis for both acute illnesses and enrollees experiencing chronic disability, complex medical cases or problems requiring long-term care. The goal of medical management is to provide a continuum of quality care throughout the enrollee's treatment period.



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Physician Contracting.    We negotiate agreements with primary care physicians, specialists and ancillary service providers on behalf of our affiliated physician organizations. We also negotiate agreements with hospitals and hospital based physicians for those hospital costs that are the financial responsibility of the affiliated physician organization.



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Physician Credentialing.    Our physician credentialing program seeks to screen physician's credentials prior to their entry into the independent physician association network, and maintain credentialing standards once the physician has been accepted into the independent physician association through a re-credentialing process every three years. The physician credentialing program includes the investigation and verification of physicians' qualifications, credentials, proof of malpractice insurance and medical staff privileges at the time they are brought into the network, as well as periodically reviewing competency and continuing medical education.



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HMO Contracting.    We evaluate, negotiate and administer agreements with HMOs on behalf of our affiliated physician organizations. The contracts with the HMOs generally contain two-year terms, and can be terminated by the HMO with cause, subject to notice provisions. The contracts can also generally be terminated without cause within four to six months immediately preceding the end of the term. Many of these HMO contracts were first entered into by our

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affiliated physician organizations ten to twenty years ago, and are renegotiated 90-180 days in advance of the contract expiration dates. Negotiations with HMOs include increased capitation rates, the division of financial responsibility, which describes the HMO enrollee's covered benefits that our affiliated physician organizations will be financially responsible for, as opposed to the covered benefits which are the responsibility of the HMO, along with various other terms and conditions.

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Claims Administration.    We possess complete medical claims processing capabilities including determining whether enrollees are eligible and whether services are authorized, identifying appropriate benefits, issuing payments to providers and analyzing encounter data.



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Financial Services.    We have exclusive decision-making authority with respect to the establishment and preparation of annual budgets for each of our affiliated physician organizations. In consultation with each affiliated physician organization, we establish bank accounts for the deposit of all sums received by each affiliated physician organization for services provided to its enrollees. In addition, we may endorse all checks made payable to each of our affiliated physician organizations and make deposits to its bank account, prepare financial statements on a monthly basis, calculate primary care and specialist sub-capitation payments, pay claims by non-capitated providers, invoice other payers for the coordination of benefits and other third party liability payments, such as workers' compensation claims and automobile insurance claims, administer capitation and other distributions from HMOs including auditing and monitoring of HMO incentive payments, negotiate and settle the affiliated physician organization's share of such payments, and establish and maintain reserves for our affiliated physician organizations.



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Provider Relations.    We maintain a provider relations department that orients individual providers to managed care policies and procedures, assists each of our affiliated physician organizations in developing and updating provider operations manuals, and resolves day-to-day operational situations that may arise.



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Management Information Systems.    Our management information system, IDX, is a software system specifically designed with a managed care application. The management information system maintains an on-line database that provides inpatient and outpatient utilization statistics and patient encounter reporting. Patient encounter reporting consists of the information received from each physician on patient encounter forms for each patient visit, which sets forth what services the patient received from the physician during that visit. Utilization statistics are the patterns of patient encounters for various procedures for specific segments of the patient population. The availability of timely information on utilization patterns improves physician effectiveness. This data also plays an integral role in the physician utilization control process by enabling the medical directors and utilization management nurses to monitor medical management decisions, evaluate patient outcomes and monitor utilization trends. In addition, the management information system is capable of performing various administrative functions including enrollee eligibility verification, outside service referrals and verifications, and claims processing.



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Patient Eligibility and Services.    We provide a variety of services related to patient eligibility, including obtaining eligibility lists from HMOs, assisting with the determination of eligibility of patients for health care coverage prior to the provision of medical services, maintaining a computerized eligibility database to distribute eligibility reports, and insuring that enrollee eligibility and HMO capitation payments are synchronized.



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Member Services.    Our staff is trained to aid patients in understanding managed care and the nature and extent of health plan coverage, assist patients in making informed decisions

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concerning their medical care and treatment alternatives, and provide support in resolving patient-physician difficulties and/or qualified financial issues.

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Physician Recruiting.    We seek to recruit primary care physicians in each of our affiliated physician organizations. Additionally, we add specialists in each of our affiliated physician organizations as vacancies arise or based upon financial considerations.

Marketing and Public Relations

        Our marketing, public relations and advertising of health care services is conducted in accordance with the laws, rules, regulations and guidelines of all applicable governmental and quasi-governmental agencies, including but not limited to the Medical Board of California. In addition to primary care physician recruitment, our marketing staff seeks to increase enrollment through attendance at employer group health fairs and HMO enrollment meetings.

Competition

        The managed care industry is highly competitive and is subject to continuing changes with respect to the manner in which services are provided and how providers are selected and paid. We are subject to significant competition both with respect to physicians affiliating with our physician organizations and in seeking contracts to manage other physician organizations. Generally, both we and our affiliated physician organizations compete with any entity that enters into contracts with HMOs for the provision of prepaid health care services, including:

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Other companies that provide management services to health care providers but do not own the affiliated physician organization;



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Hospitals that affiliate with one or more physician organizations;