PZZ Prospect Medical Holdings,

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the quarterly period ended June 30, 2009

or

For the transition period from                  to                 

Commission file number: 1-32203

Prospect Medical Holdings, Inc.

(Exact name of registrant as specified in its charter)

(310) 943-4500
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x   No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  o   No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): Yes  o   No  x

The number of shares of the issuer’s Common Stock, par value $0.01 per share, outstanding as of August 12, 2009 was 20,575,111.

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PROSPECT MEDICAL HOLDINGS, INC.

Index

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PART I—FINANCIAL INFORMATION

Item 1.  Financial Statements.

PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(Unaudited)

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

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PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

(Unaudited)

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

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PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(Unaudited)

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

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PROSPECT MEDICAL HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

The accompanying notes are an integral part of the unaudited condensed consolidated financial statements.

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PROSPECT MEDICAL HOLDINGS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2009

(Unaudited)

1. Business

Prospect Medical Holdings, Inc. (“Prospect” or the “Company”) is a Delaware corporation. Prior to the August 8, 2007 acquisition of Alta Hospitals System, LLC (“Alta”), which was previously known as Alta Healthcare System, Inc., the Company was primarily engaged in providing management services to affiliated physician organizations that operate as independent physician associations (“IPAs”) or medical clinics. Inclusive of the acquisition of a majority stake in Brotman Medical Center, Inc., a California corporation (“Brotman”) on April 14, 2009 (see Note 8), as of June 30, 2009, the Company owns and operates five community-based hospitals in Southern California, and its operations are organized into three primary reportable segments: Hospital Services, IPA, and Corporate as discussed below.

Liquidity and Recent Operating Results

As discussed in Note 7, prior to the July 29, 2009 refinancing, the Company was subject to certain financial and administrative covenants, cross default provisions and other conditions required by the loan agreements with its prior lenders. While the Company met all debt service requirements timely, it did not comply with certain financial and administrative covenants as of September 30, 2007, December 31, 2007 and March 31, 2008. On May 15, 2008, the credit agreements were formally modified to waive past defaults, amend certain covenant provisions prospectively and make changes to the interest rates and payment terms. These changes resulted in a substantial modification to the credit facilities, which was accounted for as an extinguishment of the existing debt during the quarter ended June 30, 2008, with the modified debt recorded as new debt.

The Company met all of the May 15, 2008 amended financial covenant provisions for all subsequent reporting periods. However, on March 19, 2009, the Company received notices from its lenders asserting that the Company was in default of a requirement to sell certain assets by a specified date; and on April 17, 2009, the Company received notices from its lenders asserting that the Company’s April 14, 2009 increase in ownership of Brotman (see Note 8) violated certain provisions of the amended credit agreements. Effective with the first asserted default, the lenders began assessing interest at default rates on all loans. The Company contested both asserted events of default. On June 30, 2009, the Company entered into loan amendments whereby, among other things, the lenders waived all alleged events of default, and stopped assessing default interest rates. In connection with these amendments, the Company also entered into an amendment and waiver related to its swap agreements which provide that the alleged events of default under the existing credit facility would not trigger an event of default under the swap agreements. The amendments required the Company to refinance all debt no later than October 31, 2009.

On July 29, 2009, the Company issued $160.0 million in the aggregate principal amount of 12.75% senior secured notes due 2014 (the “Notes”) with net proceeds, after original issue discount and expenses, of $141.4 million, which amount was used to repay all amounts outstanding under prior debt and, together with the Company’s existing cash, terminate the  interest rate swap agreements. Based on such refinancing, all amounts owing under the prior borrowing arrangements were reclassified as long-term in the June 30, 2009 unaudited condensed consolidated balance sheet. Given the Company’s subsequent termination and repayment, the interest rate swap liabilities continued to be classified as current at June 30, 2009.

Following the Company’s acquisition of a majority stake in Brotman effective April 14, 2009, all Brotman debt has been included in the Company’s condensed consolidated financial statements. However, the Company has no obligation and only limited ability to fund Brotman’s operations post acquisition.

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Hospital Services Segment

Alta, which was acquired on August 8, 2007, owns (i) Alta Hollywood Hospitals, Inc., a California corporation dba Hollywood Community Hospital and Van Nuys Community Hospital; and (ii) Alta Los Angeles Hospitals, Inc., a California corporation dba Los Angeles Community Hospital and Norwalk Community Hospital. On April 14, 2009 (the “Acquisition Date”), the Company increased its approximately 33.1% ownership stake in Brotman, to approximately 71.9% via an incremental investment of approximately $2.5 million, all of which was paid as of June 30, 2009. As of June 30, 2009, Alta and Brotman (collectively, the “Hospital Services segment”) owns and operates five hospitals in the greater Los Angeles area, with a combined 759 licensed beds, served by 787 on-staff physicians. The hospitals in Hollywood, Los Angeles, Norwalk and Culver City offer a comprehensive range of medical and surgical services, including inpatient, outpatient, skilled nursing and urgent care services. The hospital in Van Nuys provides acute inpatient and outpatient psychiatric services to patients who are admitted on a voluntary basis. Admitting physicians are primarily practitioners in the local area. The hospitals have payment arrangements with Medicare, Medi-Cal (the California version of Medicaid) and other third-party payers, including some commercial insurance carriers, health maintenance organizations (“HMOs”) and preferred provider organizations (“PPOs”).

IPA Segment

The IPA segment is comprised of two management services organizations, Prospect Medical Systems, Inc. and ProMed Health Care Administrators, that provide management services to affiliated physician organizations that operate as IPAs. The affiliated physician organizations enter into agreements with 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 necessary medical services.

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in conformity with generally accepted accounting principles in the United States of America (“U.S. GAAP”) for interim consolidated financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. In accordance with the instructions and regulations of the Securities and Exchange Commission (“SEC”) for interim reports, certain information and footnote disclosures normally included in financial statements prepared in conformity with U.S. GAAP for annual reports have been omitted or condensed. All adjustments (consisting of normal recurring adjustments) and disclosures considered necessary for fair presentation have been included in the accompanying interim unaudited condensed consolidated financial statements.

The results of operations for the three months and nine months ended June 30, 2009 are not necessarily indicative of the results to be expected for the full year. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the audited consolidated financial statements for the year ended September 30, 2008 and notes thereto included in the Company’s Annual Report on Form 10-K filed with the SEC on December 29, 2008 and Form 8-K filed with the SEC on July 8, 2009 and, relating to the Brotman transaction, as included in Form 8-K/A filed with the SEC on July 8, 2009.

Principles of Consolidation

The unaudited interim condensed consolidated financial statements include the accounts of the Company and all majority owned subsidiaries and controlled entities under Emerging Issues Task Force (“EITF”) No. 97-2, “ Application of FASB Statement No. 94 and APB Opinion No. 16 to Physician Practice Management Entities and Certain Other Entities with Contractual Management Arrangements” and Financial Accounting Standards Board (“FASB”) Interpretation No. 46, “ Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 ” (“FIN 46”). All adjustments considered necessary for a fair presentation of the results as of the date of, and for the interim periods presented, which consist solely of normal recurring adjustments, have been included. Effective April 14, 2009, the results of operations and financial position of Brotman have been included in the accompanying unaudited interim condensed consolidated financial statements. All significant inter-company balances and transactions have been eliminated in consolidation.

Restricted Cash

Restricted cash is established at Brotman pursuant to Brotman’s Amended Plan of Reorganization, consisting of contingency reserves, totaling $525,000 held in escrow in satisfaction of a certain pre-emergence bankruptcy creditor of Brotman; property tax, maintenance and an emergency room construction reserves set aside in connection with Brotman’s JHA loan agreements (see Note 7); and the Class 4 cash, in the amount of $987,000 that was received in June 2009 in satisfaction of the discharge of Class 4 claims (see below). Additionally, $233,000 was held in restricted account pursuant to workers compensation arrangements at June 30, 2009.

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Payable to Creditors’ Trust

On April 14, 2009 (the “Effective Date”), pursuant to the confirmation of Brotman’s Plan, in exchange for their new equity stakes in Brotman, the Company and certain holders of pre-reorganized Brotman’s securities committed to contribute cash totaling approximately $3.5 million ($2.5 million as of the Effective Date and $1 million within six months of the Effective Date), which amount was to be used solely for the satisfaction of holders of Class 4 claims. As of June 30, 2009, the remaining approximately $1 million of Class 4 cash that was received in June 2009 was recorded in the accompanying unaudited condensed consolidated balance sheet as payable to Creditors’ Trust.

Due to governmental payers and third party settlements

Following the acquisition of Brotman, effective April 14, 2009, the Company recorded a liability to the Centers for Medicare and Medicaid Services (“CMS”) arising out of payments for services provided by Brotman to Medicare eligible inpatients for the last four months of calendar 2005, all of calendar 2006, and approximately six weeks of calendar 2007 (ending February 15, 2007).

While Brotman reports financial statements on a fiscal year ending September 30, Medicare cost reports are filed on a calendar year basis. Acute care hospitals receive Medicare reimbursement payments pursuant to a prospective payment methodology based on diagnosis of the patient, but are entitled to receive additional payments, referred to as “outliers” for patients whose treatment is unusually costly. When Brotman acquired the hospital in 2005, CMS provided a ratio of cost to charges (the “RCC”) based on the average prevailing market rate in Southern California. This RCC was an interim estimate provided by CMS, subject to final determination upon filing of the hospital’s cost reports. Upon filing cost reports, subsequent information called into question whether the interim RCC provided by CMS was supportable, giving rise to a potential claim for return of overpayments. Brotman filed its cost reports with CMS for 2005, 2006 and 2007, respectively, which have been tentatively reviewed by the fiscal intermediary exclusive of any outlier reconciliation to be conducted directly by CMS. CMS has not conducted any outlier reconciliations, has not notified the hospital of any pending reconciliation to be conducted and has not determined the amount of any liability at this point related to possible overpayments. As of June 30, 2009, an estimated liability of $13,834,000 was included in the accompanying unaudited condensed consolidated balance sheet related to this matter. Brotman and Alta have accrued estimated settlement net receivables in the amount of $2,990,000 for as filed cost reporting years and estimates for the nine months ended June 30, 2009.

Government program receivables

Brotman receives supplemental payments from the California Medical Assistance Commission (“CMAC”). The contract between CMAC and Brotman was entered into on September 1, 2005 (“Agreement”).  That Agreement has an “evergreen” provision that requires at least 120 days notice for either side to provide the other with termination notice.  On June 10, 2009, Brotman entered into an Amendment of this Agreement which extends the earliest termination notice date to July 1, 2010.  Thus, the earliest possible termination of this Agreement could be November 1, 2010.  At June 30, 2009, the Company had accrued CMAC Distressed Hospital Funds in the amount of $2,000,000, which amount was included as receivable in the accompanying unaudited condensed consolidated balance sheet. In addition to the aforementioned  receivable the Company accrued an additional $1,606,000 in Disproportionate Share Revenue (DSH) under the Medi-Cal DSH Program.

Reclassifications

Certain prior amounts have been reclassified to conform to current period presentation. These reclassifications primarily relate to the discontinued operations treatment of the AV Entities, following their sale on August 1, 2008.

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Discontinued Operations

As discussed in Note 4, effective August 1, 2008, the Company sold all of the issued and outstanding stock of Sierra Medical Management (“SMM”), Sierra Primary Care Medical Group, Antelope Valley Medical Associates, Inc. and Pegasus Medical Group, Inc., (collectively, the “AV Entities”) to a third party. As required under U.S. GAAP, the assets and liabilities of the AV Entities and their operations have been presented in the condensed consolidated financial statements as discontinued operations for all periods presented. All references to operating results reflect the ongoing operations of the Company, excluding the AV Entities, unless otherwise noted.

Revenues

Revenues by reportable segment are comprised of the following amounts (in thousands):

(1)           The above amounts for the IPA segment exclude revenue related to the AV Entities, given their classification as discontinued operations in the accompanying unaudited condensed consolidated financial statements.

(2)           Brotman revenues have been included in the accompanying unaudited condensed consolidated financial statements effective April 14, 2009, when the Company acquired a majority stake in that entity.

The Company presents segment information externally the same way management uses financial data internally to make operating decisions and assess performance. Following the acquisition of Alta in August 2007, the Company’s operations are organized into three reporting segments: (i) Hospital Services, (ii) IPA (Managed Care), and (iii) Corporate (see Note 9). Corporate represents expenses incurred in Prospect Medical Holdings, Inc., which were not allocated to the IPA or Hospital Services segments.

Comprehensive Income (Loss)

Comprehensive income (loss) includes net income (loss) and changes in the fair value of interest rate swaps subject to hedge accounting that were recorded as other comprehensive income. As of April 1, 2008, the swaps ceased to be eligible for hedge accounting under SFAS No. 133, “ Accounting For Derivatives And Hedging Activities ” (“SFAS No. 133”). As a result, all subsequent changes in the fair value of the swaps were recorded in the condensed consolidated statements of operations and the effective portion of the swaps of approximately $5.4 million, after tax, that was recorded in other comprehensive income through June 30, 2008 was being amortized to interest expense, using the effective interest method, over the remaining life of the interest rate swaps.  (See Note 15 for subsequent termination of interest rate swap arrangements, effective July 23, 2009.)

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The components of comprehensive income (loss) for the periods ended June 30, 2009 and 2008 are as follows (in thousands):

3. Equity-Based Compensation Plans

On August 13, 2008, following stockholder approval, the Company adopted the 2008 Omnibus Equity Incentive Plan (“2008 Plan”) to provide flexibility in implementing equity awards, including incentive stock options (“ISO”), non-qualified stock options (“NQSO”), restricted stock grants, stock appreciation rights (“SAR”) and performance based awards to employees, directors and outside consultants, as determined by the Compensation Committee of the Board of Directors (the “Committee”). In conjunction with the adoption of the 2008 Plan, effective August 13, 2008, additional equity awards under the Company’s 1998 Stock Option Plan (“1998 Plan”) have been discontinued and new equity awards are now granted under the 2008 Plan. Remaining authorized shares under the 1998 Plan that were not subject to outstanding awards as of August 13, 2008, were canceled on August 13, 2008. The 1998 Plan will remain in effect as to outstanding equity awards granted under the 1998 Plan prior to August 13, 2008. At the inception of the 2008 Plan, 4,000,000 shares were reserved for issuance under the 2008 Plan. As of June 30, 2009, there were 1,746,250 shares available for future grants under the 2008 Plan.

Under the terms of the 2008 Plan, the exercise price of an ISO may not be less than 100% of the fair market value of the Company’s Common Stock on the date of grant and, if granted to a shareholder owning more than 10% of the Company’s Common Stock, then not less than 110%. Stock options granted under the 2008 Plan have a maximum term of 10 years from the grant date, and were exercisable at such time and upon such terms and conditions as determined by the Committee. Stock options granted to employees generally vest over four years, while options granted to certain executives typically vest over a shorter period, subject to continued service. In the case of an ISO, the amount of the aggregate fair market value of Common Stock (determined at the time of grant) with respect to which ISO are exercisable for the first time by an employee during any calendar year may not exceed $100,000.

The base price, above which any appreciation of a SAR issued under the 2008 Plan is measured, will in no event be less than 100% of the fair market value of the Company’s stock on the date of grant of the SAR or, if the SAR is granted in tandem with a stock option, the exercise price under the associated option. The restrictions imposed on shares granted under a restricted stock award will lapse in accordance with the vesting requirements specified by the Committee in the award agreement. Such vesting requirements may be based on the continued service of the participant with the Company for a specified time, or on the attainment of specified performance goals established by the Committee in its discretion. If the vesting requirements of a restricted stock award are not satisfied prior to the termination of the participant’s service, the unvested portion of the award will be forfeited and the shares of Common Stock subject to the unvested portion of the award will be returned to the Company.

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Stock Options Activities

The following table summarizes information about our stock options outstanding at June 30, 2009 and activity during the nine-month period then ended:

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of our common stock for those awards that have an exercise price currently below the quoted value.

Stock-Based Compensation Expense

Under SFAS No. 123(R), “ Share-Based Payments ,” compensation cost for all share-based payments in exchange for employee services (including stock options and restricted stock) is measured at fair value on the date of grant, estimated using an option pricing model.

Compensation costs for stock-based awards are measured and recognized in the financial statements, net of estimated forfeitures over the awards’ requisite service period. The Company uses the Black-Scholes option pricing model and a single option award approach to estimate the fair value of options granted. Estimated forfeitures will be revised in future periods if actual forfeitures differ from the estimates and will impact compensation cost in the period in which the change in estimate occurs. The determination of fair value using the Black-Scholes option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables, including expected stock price volatility, risk-free interest rate, expected dividends and projected employee stock option exercise behaviors. Equity-based compensation is classified within the same line items as cash compensation paid to employees. Cash retained as a result of excess tax benefits relating to share-based payments are presented in the statement of cash flows as a financing cash inflow.

The weighted average assumptions used in determining the value of options granted and a summary of the methodology applied to develop each assumption are as follows:

Expected Term—The expected term of options granted represents the period of time that they are expected to be outstanding. The Company has adopted the “simplified method” of determining the expected term for “plain vanilla” options, as allowed under Staff Accounting Bulletin (SAB) No. 107. The “simplified method” states that the expected term is equal to the sum of the vesting term plus the contract term, divided by two. “Plain vanilla” options are defined as those granted at-the-money, having service time vesting as a condition to exercise, providing that non-vested options are forfeited upon termination and that there is a limited time to exercise the vested options after termination of service, usually 90 days, and providing the options are non-transferable and non-hedgeable. We will continue to gather additional information about the exercise behavior of participants and will adjust the expected term of our option awards to reflect the actual exercise experience when such historical experience becomes sufficient.

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Expected Volatility—The Company estimates the volatility of the common stock at the date of grant based on the average of the historical volatilities of a group of peer companies. Since the Company’s shares did not become publicly traded until May 2005 and trading volume has been limited, management believes there is currently not enough historical volatility data available to predict the stock’s future volatility. The Company has identified a group of comparable companies to calculate historical volatility from publicly available data for sequential periods approximately equal to the expected terms of the option grants. In selecting comparable companies, management considered several factors including industry, stage of development, size and market capitalization.

Risk-Free Interest Rate—The Company bases the risk-free interest rate on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon issues with equivalent remaining terms.

Dividends—The Company has never paid any cash dividends on its common stock and does not anticipate paying any cash dividends in the foreseeable future.

Forfeitures—Share-based compensation is recognized only for those awards that are ultimately expected to vest. Compensation expense is recorded net of estimated forfeitures. Those estimates are revised in subsequent periods if actual forfeitures differ from those estimates. The Company used historical data since May 2005 to estimate pre-vesting option forfeitures.

Stock-based compensation expense for stock options recognized in the nine months ended June 30, 2009 and 2008 was approximately $665,000 and $86,645, respectively. At June 30, 2009, there were 1,688,919 unvested options with related compensation expense of approximately $683,000, which will be recognized ratably over a weighted average remaining vesting period of 52 months.

Restricted Stock Award Activities

On August 15, 2008, the Company granted 200,000 shares of restricted stock with a grant date fair value of $2.40. As of June 30, 2009, there were no unvested shares of restricted stock outstanding. Compensation expense relating to restricted stock of approximately $113,000 was recorded during the nine months ended June 30, 2009.

4. Discontinued Operations

On August 1, 2008, the Company sold all of the outstanding stock of Sierra Medical Management, Inc. (“SMM”), a management subsidiary, and all of the outstanding stock of Sierra Primary Care Medical Group, Antelope Valley Medical Associates, Inc. and Pegasus Medical Group, Inc., (collectively with SMM, the “AV Entities”). As part of the sale, the Company entered into a non-competition agreement in the Antelope Valley region of Los Angeles County for the benefit of the buyer.

Total consideration paid by the buyer was $8,000,000, of which $2,000,000 was paid into an escrow account to fund certain AV Entities’ liabilities and approximately $815,000 was paid directly to AV Entities’ vendors, employees and physicians. Of the remaining amount totaling approximately $5,185,000, $4,219,000 was paid directly to the Company’s lenders, and approximately $966,000 was retained by the Company for transaction expenses and the required balance sheet reconciliation items.

The Company recorded a gain of approximately $7.1 million in connection with this transaction in the fourth quarter of fiscal 2008. The sale documents contain certain post-closing purchase price adjustment provisions for working capital and claims liabilities which require a final determination by August 10, 2010. Once the sale price has been finalized and the net gain on the transaction determined, any adjustment to the gain will be recorded in discontinued operations.

The AV Entities have been classified as discontinued operations for all periods presented. As discontinued operations, revenues and expenses of the AV Entities have been aggregated and stated separately from the respective captions of continuing operations in the unaudited interim condensed consolidated statements of operations. Expenses include direct costs of the business that will be eliminated from future operations as a result of the sale. The Company also allocated interest expense associated with the portion of debt required to be repaid for the nine months ended June 30, 2008 to discontinued operations in accordance with EITF Issue 87-24, “ Allocation of Interest to Discontinued Operations. ”

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The results of operations of the AV Entities reported as discontinued operations are summarized as follows (in thousands):

5. Earnings per Share

The Company calculates basic net income (loss) per share by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding. Diluted earnings (loss) per share is computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding, after giving effect to potentially dilutive shares computed using the treasury stock method. Such shares are excluded if determined to be anti-dilutive.

The calculations of basic and diluted net income (loss) per share for the three months and nine months ended June 30, 2009 and 2008 are as follows (in thousands, except per share amounts):

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Due to net losses, all potentially dilutive securities were excluded from the calculation of diluted loss per share attributable to common stockholders during the three and nine months ended June 30, 2009 and 2008, as their effect would be anti-dilutive. The number of stock options and warrants excluded from the computation of diluted earnings per share during the three and nine months ended June 30, 2009 were 4,819,851 and 4,819,851, and during the three and nine months ended June 30, 2008 were 1,785,000, and 1,017,000, respectively. 1,672,880 Series B preferred shares were also excluded from diluted earnings per share during the three months and nine months ended June 30, 2008, since their conversion was contingent upon stockholder approval and would have been anti-dilutive.

Following stockholder approval on August 13, 2008, the holders of all of the outstanding shares of Series B Preferred Stock elected to convert their preferred shares into Common Stock. The former holders also ceased to have any right to receive dividends on the preferred shares. All such dividends terminated and ceased to accrue, and all previously accrued dividends through August 13, 2008 were forgiven and the liability was recorded to additional paid-in capital. Accordingly, an adjustment to additional paid-in-capital in the amount of $7,881,890 was recorded as of that date.

The following pro forma basic and diluted earnings per share assume the conversion of preferred shares into common stock at a ratio of 1:5 at the beginning of the fiscal 2008 year (in thousands, except per share amounts):

6. Related Party Transactions

Prospect has a controlling financial interest in the affiliated physician organizations included in its unaudited interim condensed consolidated financial statements which are owned by a nominee physician shareholder designated by the Company. The control is effectuated through assignable option agreements and management services agreements, which provide the Company a unilateral right to establish or effect a change of the nominee shareholder for the affiliated physician organizations at will, and without the consent of the nominee, on an unlimited basis and at nominal cost through the term of the management agreement. Jacob Y. Terner, M.D. was, through August 8, 2008, the sole shareholder, sole director and Chief Executive Officer of Prospect Medical Group, Inc. (“PMG”) and was the Chief Executive Officer of each of PMG’s subsidiary physician organizations, except for AMVI/Prospect Health Network. Dr. Terner also served as the sole shareholder and a director and officer of Nuestra Familia Medical Group, Inc. (“Nuestra”), an affiliated physician organization. Dr. Terner is a shareholder of the Company, and formerly served as its Chairman and Chief Executive Officer through part of fiscal 2008.

The Company had an employment agreement with Dr. Terner that expired on August 1, 2008 and provided for base compensation (most recently $400,000 per year) and further provided that if the Company terminated Dr. Terner’s employment without cause, the Company would be required to pay him $12,500 for each month of past service as the Chief Executive Officer, commencing as of July 31, 1996, up to a maximum of $1,237,500. Dr. Terner resigned as the Chief Executive Officer of the Company effective March 19, 2008 and resigned as the chairman of the board of directors effective May 12, 2008. In consideration of Dr. Terner’s resignation and other provisions in his resignation agreement, the Company agreed to pay to his family trust the sum of $19,361 each month during the twelve-month period ending on April 30, 2009 and the sum of $42,694 each month during the twenty-four month period ending on April 30, 2011, for the total sum of $1,257,000, which amount was recorded as a general and administrative expense in fiscal 2008.

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Dr. Arthur Lipper currently serves as the nominee shareholder of PMG and Nuestra and as the sole director of PMG and its subsidiary physician organizations and the Chief Executive Officer, President and Treasurer of all legacy subsidiary physician organizations (i.e., not including the ProMed Entities).  Dr. Lipper serves as one of two directors of Nuestra, as the sole director of the ProMed Entities, and as a Vice President of Nuestra and the ProMed Entities.

Through the ProMed Acquisition (see Note 8), the Company acquired the lease of an office facility which is jointly owned by a former officer of the ProMed Entities. The total lease payments during the nine months ended June 30, 2009 and 2008 under that lease were approximately $362,000 and $350,000, respectively.

On August 1, 2005 and subsequently amended on October 25, 2007, Prospect Medical Management, Inc. (now known as Prospect Hospital Advisory Services, Inc.), an affiliate of the Company, had entered into a consulting services agreement, to provide administrative, financial and management consulting services to Brotman for a monthly fee of $100,000 plus expenses. The agreement had an initial term of one year and automatically renewed for additional one-year terms unless terminated by either party with 90 days written notice. As discussed in Note 8, Brotman, which filed a voluntary petition for bankruptcy protection under Chapter 11 of the U. S. Bankruptcy Code on October 25, 2007, emerged from the Chapter 11 bankruptcy proceeding on April 14, 2009 (the “Effective Date”).  On the Effective Date, the Company increased its approximately 33.1% ownership stake in Brotman, to approximately 71.9% via an incremental investment of approximately $2.5 million. For the three and nine months ended June 30, 2008, total fees earned under the consulting services agreement were approximately $300,000 and $820,000, of which $300,000 and $620,000 were paid, respectively, and none of which were compromised, pursuant to Brotman’s Chapter 11 Plan of Reorganization. For the period October 1, 2008 through April 13, 2009, total fees earned under the agreement were approximately $650,000, of which $50,000 was paid, and none of which was compromised pursuant to Brotman’s Chapter 11 Plan of Reorganization.  Beginning April 14, 2009, amounts earned under the agreement have been eliminated in consolidation.

PMG, a controlled affiliate of the Company (see description of assignable option agreements and management services agreements above) had entered into a risk pool sharing agreement, dated May 1, 2005, with Brotman. Under the agreement, PMG and Brotman agreed to establish a Hospital Control Program (as defined) to serve HMO enrollees and would earn incentive revenue or incur penalties by sharing in the risk for hospitalization based on inpatient services utilized. Risk pools are generally settled in the following year. For the three and nine months ended June 30, 2008, all incentive revenue earned under the agreement was compromised pursuant to Brotman’s Chapter 11 Plan of Reorganization. For the period October 1, 2008 through April 13, 2009, no incentive revenue was earned under the agreement.  Beginning April 14, 2009, all amounts earned under the agreement have been eliminated in consolidation.

In connection with the above-described risk-sharing agreement, Prospect Medical Systems, Inc. (“PMS”) and Brotman entered into an Administrative Services Agreement, dated October 1, 2005, that provides for the administration by PMS of the payment of claims under such risk-sharing arrangement.

On August 31, 2005, PMG, entered into a joint marketing agreement with Brotman. The agreement is for an initial term of 20 years, renewable for successive five-year terms unless terminated by either party with 180 days written notice.  During the term, Brotman will contract exclusively with PMG with regard to full risk contracting with HMOs for all lines of business, including Medicare, Medicaid and commercial enrollees.  Brotman will not merge into, consolidate with, or sell substantially all assets (unless the purchaser or surviving entity expressly assumes these managed care exclusivity arrangements), alter such agreements without the consent of PMG, and agrees to be bound by the exclusivity provision.

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7. Debt

Debt at June 30, 2009 and September 30, 2008, respectively, consists of the following (in thousands):

Prospect’s Debt

Senior Secured Credit Facilities

On August 8, 2007, the Company entered into a $155,000,000 syndicated senior secured credit facility, comprised of a $95,000,000 seven-year first-lien term loan at LIBOR plus 400 basis points, with quarterly principal payments of $1,250,000 and an annual principal payment of 50% of excess cash flow, as defined in the loan agreement; a $50,000,000 seven and one-half year second-lien term loan at LIBOR plus 825 basis points, with all principal due at maturity and a revolving credit facility of $10,000,000 bearing interest at prime plus a margin that ranged from 275 to 300 basis points based on the consolidated leverage ratio. The Company capitalized approximately $6.9 million in deferred financing costs on the $155 million credit facility in August 2007, which was being amortized over the term of the related debt using the effective interest method.

The Company was subject to certain financial and administrative covenants, cross default provisions and other conditions required by the loan agreements, including a maximum senior debt/EBITDA (earnings before interest, taxes, depreciation and amortization) ratio, and a minimum fixed-charge coverage ratio, and a minimum EBITDA level, based on consolidated trailing twelve-month operating results. Substantially all of the Company’s assets were pledged to secure the credit facilities.

Default and Debt Modification

The Company exceeded the maximum senior debt/EBITDA ratio of 3.75 as of September 30, 2007, December 31, 2007 and March 31, 2008, failed to meet the minimum fixed charge coverage ratio of 1.25 as of and for the trailing twelve-month periods ended December 31, 2007 and March 31, 2008, and did not comply with certain administrative covenants.

The Company and its lenders entered into various forbearance agreements, whereby the lenders assessed default interest and permanently increased the applicable margins on the first and second-lien term loans to 750 and 1,175 basis points, respectively, and the range of applicable margins on the revolving line of credit from 500 to 750 basis points effective April 10, 2008. The modified agreements also stipulated that the LIBOR rate would not be less than 3.5% for the term of the credit facilities. Additionally, the available line of credit under the revolving credit facility was permanently reduced from $10,000,000 to $7,250,000. The Company also agreed to pay certain fees and expenses to the lenders and their advisors.

On May 15, 2008, the Company and its lenders entered into agreements to waive past covenant violations and amended the financial covenant provisions prospectively, starting in April 2008, to modify the required ratios and to increase the frequency of compliance reporting from quarterly to monthly for a specified period. Effective May 15, 2008, the maximum senior debt/EBITDA ratios were increased to levels ranging from 3.90 to 7.15 for future monthly reporting periods from April 30, 2008 through June 30, 2009 and were increased to levels ranging from 3.30 to 3.75 beginning with the September 30, 2009 quarterly reporting period, through maturity of the term loan. The minimum fixed charge coverage ratios were reduced to levels ranging from 0.475 to 0.925 for monthly reporting periods from April 30, 2008 through June 30, 2009 and were reduced to levels ranging from 0.85 to 0.90 beginning with the September 30, 2009 quarterly reporting period, through maturity of the term loan. The Company was also required to meet a new minimum EBITDA requirement for monthly reporting periods from April 30, 2008 through June 30, 2009 and the remaining quarterly reporting periods through maturity of the term loan.

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In connection with obtaining forbearance and waivers, during the second and third quarters of fiscal 2008, the Company paid $450,000 in fees to Bank of America, N.A., which was included in general and administrative expenses and $1,525,000 in forbearance fees to the lenders, which was included in interest expense. In addition, the Company incurred $860,000 in legal and consulting fees paid to the lenders’ advisors in connection with the forbearance activities, which was included in general and administrative expenses. Pursuant to the amended senior credit facility agreement, the Company was also required to pay an amendment fee of $758,000 in cash and to add 1% to the principal balance of the first and second-lien debt and the revolving line of credit, totaling $1,514,000. The amendment fees were expensed as loss on debt extinguishment in the third quarter of 2008. The Company also began to incur an additional 4% payment-in-kind (“PIK”) interest expense on the second-lien debt, which was accrued and added to the principal balance on a monthly basis. The 4% could be reduced on a quarterly basis by 0.50% for each 0.25% reduction in the Company’s consolidated leverage ratio. Effective January 2009, the Company’s consolidated leverage ratio had been sufficiently reduced to end this PIK interest accrual.

In the third quarter of fiscal 2008, the Company accounted for the modifications of its first and second-lien term debt in accordance with EITF Issue 96-19, “ Debtor’s Accounting for a Modification or Exchange of Debt Instruments ,” and the modification of its revolving credit facility in accordance with EITF Issue 98-14, “ Debtor’s Accounting for Changes in Line-of-Credit or Revolving Debt Arrangements .” Pursuant to EITF Issue 96-19 and EITF Issue 98-14, the Company accounted for these modifications as debt extinguishments, given that the terms of the debt had changed substantially, as defined. A substantial modification occurs when the discounted future cash flows have changed by more than 10% before and after the modification in the case of the term loans; and if the product of the remaining term and the maximum available credit (i.e. the borrowing capacity) of the new revolver has decreased in relation to the existing line of credit. As a result of the increased interest and principal payments (including PIK interest) under the term loans, and reduction in the maximum borrowing limit for the revolver, the Company determined that these modifications should be accounted for as an extinguishment of the existing credit facilities effective April 10, 2008. The modified facilities were recorded as new debt instruments at fair value, which equaled their face value.

In connection with the modifications of the first and second-lien term debt and the revolving line of credit, considered as an early extinguishment of debt, the Company wrote off the remaining unamortized discount and debt issuance costs of $6,036,000, and expensed as debt extinguishment loss $758,000 in amendment fees paid to lenders and $1,514,000 of PIK interest added to the new debt, resulting in a total charge of $8,308,000 in connection with this debt extinguishment. Additionally, the Company capitalized $327,000 of deferred financing costs related to the new credit agreements, which was being amortized over their remaining terms.

The Company was in compliance with the amended financial covenant provisions for the April 2008 through March 2009 monthly reporting periods. While the Company continued to meet all debt service requirements on a timely basis, on March 19, 2009, the Company received written notices from its lenders asserting that the Company was in default of a requirement to sell certain assets by a specified date. Additionally, on April 17, 2009, the Company received notices from its lenders asserting that the Company’s April 14, 2009 increase in ownership of Brotman violated certain provisions of the amended credit agreements. Effective with the first asserted default, the lenders began assessing interest at default rates on all loans. The Company contested the asserted events of default. On June 30, 2009, the Company entered into amendments to its loan agreements, whereby, among other things, the lenders agreed to waive all alleged events of default and stop assessing default interest rates. In connection with these amendments, the Company also entered into an amendment and waiver related to its swap agreements which provided that the alleged events of default under the Existing Credit Facility would not trigger an event of default under the swap agreements. The amendments required the Company to refinance all existing debt no later than October 31, 2009.

On July 29, 2009, the Company closed the offering of $160 million in 12.75% senior secured notes due 2014 (the “Notes”) at an issue price of 92.335%.  Concurrent with the issuance of the Notes, the Company entered into a three-year $15 million revolving credit facility, which was undrawn at close, with any future borrowings bearing interest at LIBOR plus 7.00%, with a LIBOR floor of 2.00%.  The Company used the net proceeds from the sale of the Notes to repay all remaining amounts outstanding under the $155 million senior secured credit facility, plus a prepayment premium of approximately $2.6 million (see Note 15).  In accordance with Statement of Financial Accounting Standards No. 6, “ Classification of Short-Term Obligations Expected to be Refinanced ,” all debt amounts outstanding at June 30, 2009 that were refinanced by the Notes have been classified as long-term in the accompanying unaudited condensed consolidated balance sheet.

Interest Rate Swaps

As set forth below, on July 29, 2009, the Company terminated the interest rate swap arrangements that were previously required by the credit facilities entered into during fiscal 2007.  In connection with those facilities, the Company entered into a $48 million interest rate swap, to effectively convert the variable interest rate (the LIBOR component) of $48 million of borrowings to a fixed rate of 5.3%, and a $97.8 million interest rate swap agreement to effectively convert the variable interest rate (the LIBOR component) of $97.8 million of borrowings to a fixed rate of 5.05%. The notional amounts of these interest rate swaps were scheduled to decline as the principal balances owing under the term loans declined. Under these swaps, the Company was required to make monthly fixed-rate payments to the swap counterparties calculated on the notional amount of the swaps and the interest rates for the swaps, while the swap counterparties were obligated to make certain monthly floating rate payments to the Company referencing the

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same notional amounts. These interest rate swaps effectively fixed the LIBOR component of the weighted average annual interest rate payable on the term loans to 5.13%.

The interest rate swap agreements contained cross-default provisions whereby, in the event the Company was in default under its credit agreements, the Company was also deemed to be in default under the swap agreements.

The interest rate swap agreements were designated as cash flow hedges of expected interest payments on the term loans with the effective date of the $48 million swap being December 31, 2007 and the effective date of the $97.8 million swap being September 6, 2007. Prior to the hedge effective dates, all mark-to-market adjustments in the value of the swaps were charged to expense. After the hedge effective date, the effective portions of the fair value gains or losses on these cash flow hedges were recorded as a component of other comprehensive income, net of tax, to be subsequently reclassified into earnings when the forecasted transaction affects earnings. Effective April 1, 2008, in anticipation of changes to the loan agreements that would impact recording of interest rate swaps, the Company elected to discontinue hedge accounting. Changes in the fair value of the interest rate swaps after March 31, 2008 are recorded as other income or expense. Total net gain (loss) on the interest rate swaps included in earnings for the nine months ended June 30, 2009 and 2008 were approximately $5,018,000 and $(4,072,000), respectively. The effective portion of the swaps of approximately $5,400,000 after tax, that was recorded in other comprehensive income through March 31, 2008 was continued to be amortized as expense over the remaining life of the swaps. Approximately $1,097,000 was amortized to expense for the nine months ended June 30, 2009.

On July 29, 2009, the Company paid Bank of America, N.A. $11.7 million in final settlement of all amounts owed under the swap arrangements (see Note 15).  Given the asserted credit agreement default and subsequent pay-off and termination, the interest rate swap liability has been classified as a current liability at June 30, 2009.

Brotman’s Debt

The Brotman entity has debt under a Senior Secured Revolving Credit Facility, Secured Term Loans and Unsecured Promissory Note entered into in conjunction with effecting the Plan of Reorganization described in Note 8. The Company has not guaranteed any portion of Brotman’s debt or other obligations; however, given the Company’s majority ownership in Brotman effective April 14, 2009, all Brotman debt is included in the Company’s unaudited consolidated financial statements. However, the Company has no obligation and has limited ability to fund Brotman’s operations post acquisition.

Senior Secured Revolving Credit Facility

On April 14, 2009, the Effective Date of the Plan of Reorganization, Brotman obtained a commitment from Gemino Healthcare Finance, LLC (“Gemino”) for a three-year, $6.0 million, senior credit facility secured by Brotman’s accounts receivable. The facility expires on the earlier of April 14, 2012 and the Los Angeles Jewish Home for the Aging (“JHA”) loan (see below) maturity date and bears interest at Libor plus 7% per annum (11.0% at June 30, 2009) with a LIBOR floor of 11%. Interest is incurred based on the greater of $2 million or the outstanding principal balance. The agreement also includes an unused line fee of 0.5% per annum and a collateral line fee, based on the average outstanding principal balance, of 0.5% per annum. Loan fees associated with the Gemino loan totaling approximately $120,000, were capitalized and have been included as deferred financing costs in the accompanying unaudited condensed consolidated balance sheet as of June 30, 2009, and the amount is being amortized over the term of the related debt using the effective interest method. The senior credit facility agreement contains customary covenants for facilities of this type including restrictions on the payment of dividends, change in ownership and management, asset sales, incurrence of additional indebtedness, sale-leaseback transactions, and related party transactions. In addition, Brotman must also comply with financial covenants, including a fixed charge coverage ratio of not less than (i) 1.10:1.00 for the fiscal quarter ending June 30, 2009, (ii) 1.15:1.00 for the fiscal quarter ending September 30, 2009; and (iii) 1.20:1.00 for each fiscal quarter ending thereafter. As of June 30, 2009, Brotman did not have borrowings outstanding under the Gemino financing and was not in compliance with the required financial covenants. As of June 30, 2009, Gemino has collected $243,000 in excess of amount due under the revolving credit facility, which is reflected as other receivables on the unaudited condensed consolidated balance sheet.

Secured Credit Facilities Term Loan: A and B

On April 14, 2009, the effective date of the Plan of Reorganization, Brotman consummated the transactions contemplated in the JHA financing and the JHA loan documents. Under the terms of the JHA loan agreements, JHA agreed to provide Brotman with up to $23 million in financing, consisting of two term loans: (i) a Term A loan of $16 million (the “Term A Loan”) with a 24-month term and (ii) a Term B loan of up to $7 million, with a term of 36 months (the “Term B Loan”). S ubject to the notification requirements set forth in the loan agreements, the term of the Term A Loan can be extended up to 36 months. Interest on the Term A Loan is payable at 10% per annum for the first year of the loan, and 7.5% thereafter. Interest on the Term B Loan is payable at 10% per annum for the term of the loan. The Term A Loan and Term B Loan is secured by certain of Brotman’s personal property, and a mortgage on certain Brotman’s real property. The proceeds of the JHA loans were used to repay all existing senior secured loans at Brotman as of April 14, 2009. Loan fees associated with the JHA loans totaling approximately $1,549,000, were capitalized and have been included as deferred financing costs in the accompanying unaudited condensed consolidated balance sheet as of June 30, 2009, and the amount is being amortized over the term of the related debt using the effective interest method.

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With respect to the Term A loan, JHA was granted the right (“Put Right”) to declare the unpaid loan amount, including remaining interest and any other amounts due and payable under the loan agreements, immediately due and payable at any time following the first twelve months of the Closing Date and prior to the date which is twenty-four months after the Closing Date, subject to JHA providing written notification to Brotman of its exercise of the Put Right at least 180 days in advance. JHA may not however provide notification of its exercise of the Put Right prior to the first anniversary of the April 14, 2009 closing date.

As part of the JHA financing, Brotman has granted JHA an option to purchase certain Brotman-owned land adjacent to the hospital, where JHA plans to construct a senior living facility, for a purchase price equal to the outstanding principal balance of the Term A Loan plus any prepaid amounts. In connection with JHA’s option right, Brotman is required to deposit $130,000 monthly into a reserve account (up to a maximum of $3,120,000), with such funds specifically earmarked for the construction of a new emergency room.  Additionally, Brotman is required to deposit $10,000 monthly into a reserve account for capital improvements and a Tax and Insurance Deposit Account to be funded monthly, for purposes of Brotman’s annual real estate tax assessments.

In accordance with relevant accounting pronouncements, the Term A Loan, which contains a real estate purchase option, is recorded at its present value, with any excess of the proceeds over that amount to be recorded as an option deposit liability account. The present value of the loan is estimated using discounted cash flow analyses based on market rates obtained from independent third parties for similar type debt. Based on an estimated market interest rate of 10.0%, the present value of the loan was estimated to be approximately $15,667,000 at inception. The difference of $345,000 between the recorded present value and the carrying value of the loan has been recorded as a discount against the loan and is amortized, using the effective interest rate method, to interest expense, over the term of the loan.

Subordinated Promissory Note

On April 14, 2009, the Effective Date of the Plan of Reorganization, Brotman executed a $4,000,000 unsecured Class 4 Note , to be held by the Creditor Trust (as defined in the Plan of Reorganization) for the benefit of holders of allowed Class 4 claims (as defined in the Plan of Reorgnization) and paid pro rata to holders of allowed Class 4 claims. The Note bears interest at 7.50% per annum and is payable in sixteen equal quarterly installments of principle and accrued interest through February 15, 2013. The Note contains a covenant which, so long as amounts remain outstanding under the Note, restricts Brotman from paying Prospect Medical Holdings, Inc. a consulting fee of more than $100,000 per month, as specified in the consulting services agreement (see Note 6).

In addition to the subordinated promissory note pursuant to the confirmation of the Plan of Reorganization, Brotman owes approximately $1.0 million to the Creditors Trust at June 30, 2009. In exchange for their new equity stakes in Brotman, the Company and certain holders of pre-reorganized Brotman’s securities committed to contribute cash totaling $3,500,000 ($2,500,000 as of the Effective Date and $1,000,000 within six months of the Effective Date), which amount was to be used solely to satisfy holders of Class 4 claims. As of June 30, 2009, the remaining approximately $1,000,000 of Class 4 cash that was received in June 2009.

8. Acquisitions

ProMed Health Services Company

On June 1, 2007, the Company and Prospect Medical Group, Inc. (“PMG”), one of its affiliated physician organizations, acquired ProMed Health Services Company and its subsidiary, ProMed Health Care Administrators (“PHCA”) (collectively “ProMed Health Care Administrators”), and two affiliated IPAs: Pomona Valley Medical Group, Inc. dba ProMed Health Network (“Pomona Valley Medical Group”), and Upland Medical Group, a Professional Medical Corporation (“Upland Medical Group” and together with Pomona Valley Medical  Group, the “ProMed Entities”). PHCA manages the medical care of HMO enrollees served by Pomona Valley Medical Group and Upland Medical Group. Total purchase consideration of $48,000,000 included $41,040,000 of cash and 1,543,237 shares of Prospect Medical Holdings, Inc. common stock valued at $6,960,000, or $4.51 per share. The transaction is referred to as the “ProMed Acquisition.”

The ProMed Acquisition, and $392,000 in related transaction costs, was financed by $48,000,000 in borrowings (less $896,000 in debt issuance costs) and $2,379,000 from cash reserves. The debt proceeds and cash reserves were used to fund the cash consideration of $41,040,000 and to repay all existing debt of Prospect Medical Holdings, Inc. ($7,842,000 plus $209,000 of prepayment penalties). The $48,000,000 in borrowings used to finance the acquisition of the ProMed Entities was refinanced in August 2007, using proceeds from the $155,000,000 credit facility entered into in connection with the Alta transaction, described below. The purchase agreements provide for certain post-closing working capital, medical claims reserve and other adjustments, which the Company is currently negotiating. During fiscal 2008, the Company recorded a post-closing working capital adjustment of approximately $560,000 as a reduction in goodwill.

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Alta Hospitals System, LLC

On August 8, 2007, the Company acquired all of the outstanding common shares of Alta Hospitals System, LLC (“Alta”), which was formerly known as Alta Healthcare System, Inc.  Alta is a for-profit hospital management company that, through two subsidiary corporations, owns and operates four community-based hospitals—Van Nuys Community Hospital, Hollywood Community Hospital, Los Angeles Community Hospital and Norwalk Community Hospital. These hospitals provide a comprehensive range of medical, surgical and psychiatric services and have a combined 339 licensed beds served by 315 on-staff physicians. Total purchase consideration, including transaction costs, was approximately $154,935,000, comprised of repayment of approximately $41,500,000 of Alta’s existing debt, payment of approximately $51,300,000 in cash to the former Alta shareholders, issuance of 1,887,136 shares of Prospect common stock, issuance of 1,672,880 shares of Prospect convertible preferred stock valued, for purposes of the transaction, at $61,030,000, and payment of transaction costs of approximately $1.2 million. Each share of preferred stock was convertible into five common shares upon stockholder approval (which occurred on August 13, 2008). Prior to conversion, each share of preferred stock accrued dividends at 18% per year, compounding annually. Such dividends (amounting to $7,881,890) were canceled upon conversion to common shares on August 13, 2008, and the related liability reclassified to additional paid in capital. For purposes of determining the number of shares to be issued in connection with the transaction, Prospect common stock was valued at $5.00 per share and Prospect preferred stock was valued at $25.00 per share. However, for purposes of recording the transaction, (i) the value per share of common stock was estimated at $5.58, based on the average of the stock’s closing prices before and after the acquisition announcement date of July 25, 2007, and (ii) the value per share of preferred stock was estimated at $30.19, based on the closing stock price of a common share on the acquisition date, plus a premium for the preference features of the stock. As such, total recorded purchase consideration, exclusive of transaction costs, was approximately $153,772,000.

The Alta Acquisition, the extinguishment of Alta’s existing debt and the refinancing of the ProMed Acquisition debt described above were financed by a $155,000,000 senior secured credit facility, comprised of $145,000,000 in term loans and a $10,000,000 revolver, of which $3,000,000 was drawn at closing (see Note 7 for discussion of debt). Net proceeds of $141.1 million (net of issuance discount and financing costs of $6.9 million) were used to repay Alta’s existing borrowings of $41.5 million, refinance $47.0 million in outstanding ProMed Acquisition debt, pay the cash portion of the purchase price of $51.3 million and fund approximately $1.2 million in transaction costs.  As set forth in Note 7, the new senior secured facility was repaid and terminated on July 29, 2009.

Brotman Medical Center, Inc.

On August 31, 2005, the Company invested $1 million for an approximately 33.1% stake in Brotman. Brotman is a 420 bed licensed and accredited acute care hospital, located in Culver City, California. The Company made the investment with the intention that it, with Brotman, would be able to offer joint contracting to HMOs operating in Brotman’s service area. Brotman incurred significant losses before and after the Company’s initial investment and, on October 25, 2007(the “Petition Date”), Brotman filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code, at which point, the initial investment was considered fully impaired.  On the Petition Date, the Company entered into an amendment to its existing consulting services agreement with Brotman, providing for an increased level of service and responsibility (see Note 6).  Additionally, effective April 22, 2008, Samuel S. Lee (Prospect’s CEO and Chairman of the Board) was appointed as the Chairman of the Board of Directors of Brotman.  On April 14, 2009 (The “Effective Date”), the U.S. Bankruptcy Court confirmed and declared effective the final Chapter 11 Plan of Reorganization (the “Plan”) of Brotman whereby, among other things, all of Brotman’s outstanding securities were canceled and, in exchange for their pro rata share of the New Value Contribution (as defined in the Plan) totaling $3,500,000, holders of Brotman’s securities would receive New Common Stock in Brotman in the same percentage as their pro rata share of the New Value Contribution. Pursuant to the terms of the Plan, the Company made a $1,814,000 investment in Brotman on January 13, 2009 and $705,000 on June 30, 2009, totaling $2,519,000 while the minority shareholders made a total cash investment of $981,000 . Based on such contributions, Prospect acquired an additional 38.86% ownership interest in Brotman, effective April 14, 2009, which brought its total interest to 71.96%.

For financial accounting purposes, the additional investment in Brotman was referred to as the “Brotman Acquisition” and in accordance with Statement of Financial Accounting Standards No. 141, “ Business Combinations ” (“SFAS No. 141”), the business combination, which was achieved in stages, provides for recognition of assets at current fair value with respect to the proportion of the Company’s incremental ownership interest in Brotman. Under SFAS No. 141, the aggregate cost of the acquired assets, which includes cash paid of $2.5 million and expenses incurred in connection with the acquisition totaling $37,000, were preliminarily allocated to the assets acquired and liabilities assumed. The excess of the consideration over the estimated fair value of the assets and liabilities assumed has been allocated to goodwill. Due to negative net book value of assets acquired, goodwill attributable to the minority interest is not recognized. The purchase price allocation will be adjusted upon completion of the final valuation studies and may differ materially from the information presented herein. The results of operations and financial position of Brotman have been included in the unaudited condensed consolidated financial statements since the April 14, 2009 acquisition date.  Brotman’s operations for the period from April 14, 2009 to June 30, 2009 reflected a net loss of $2,760,000. The Company does not have the intent or ability, including under the terms of its debt agreement, to provide significant financial support to Brotman. A pro rata (approximately 28%) share of net income attributable to Brotman will be included under Minority Interest in the Company’s statement of operations, once

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the cumulative minority share of such income exceeds their cumulative share of prior losses absorbed by the Company, as its majority interest holder; this would be through the implementation of new relevant accounting literature (see Note 13).

The following is an analysis of the preliminary goodwill amount recognized in connection with the Brotman Acquisition based on the April 14, 2009 balance sheet of Brotman (in thousands):

Goodwill from the Brotman Acquisition is primarily related to new capacity for future growth, new geographic coverage, management team and in-place workforce. Through the Brotman Acquisition, the Company expanded into a new service market in the West Los Angeles, California area. As a stock purchase, the goodwill acquired in the Brotman Acquisition is not deductible for income tax purposes.  Brotman recorded income related to discharge of debt upon emergence from the Chapter 11 Bankruptcy reorganization.  Under Internal Revenue Code 108 (“IRC 108”), an insolvent taxpayer can exclude from its taxable income computation, the income related to discharge of debt to the extent of the insolvency amount.  Brotman’s tax provision reflects that the entire amount of debt discharge income is qualified for the exclusion under IRC 108.  Also, under current tax law, a taxpayer is required to reduce its tax attribute to the extent of the excluded debt discharge income, and this attribute reduction occurs on the first day of the tax year after the debt discharge occurs.  In addition, a taxpayer is allowed an election to use an alternative tax reduction ordering rules.  As of June 30, 2009, management has not concluded on the attribute reduction ordering, however, tax attribute reduction may create additional deferred tax liabilities for which the tax impact will be recognized through purchase accounting.

The following unaudited pro forma financial information for the three-month and nine-month periods ended June 30, 2009 and 2008 gives effect to the acquisition of Brotman as if it had occurred on October 1, 2007. Such unaudited pro forma information is based on historical financial information with respect to the acquisition and does not include synergies, operational or other changes that might have been effected by the Company. Significant proforma adjustments include increased depreciation related to fixed assets acquired.