ADVOCAT INC
Introductory Summary.  Advocat Inc. provides long-term care services to nursing home patients in eight states, primarily in the Southeast. Unless the context indicates otherwise, references herein to “Advocat,” “the Company,” “we,” “us” and “our” include Advocat Inc. and all of our subsidiaries.  The long-term care profession encompasses a broad range of non-institutional and institutional services. For those among the elderly requiring temporary or limited special services, a variety of home care options exist. As needs for assistance in activities of daily living develop, assisted living facilities become the most viable and cost effective option. For those among the elderly requiring much more intensive care, skilled nursing facility care becomes the only viable option. With the plan to divest our assisted living facilities, we have chosen to focus on our skilled nursing centers and to specialize in this aspect of the long term care continuum.  Our objective is to become the provider of choice of health care and related services to the elderly in the communities in which we operate. We will continue to implement our operating strategy of (i) providing a broad range of cost-effective elder care services; (ii) increasing occupancy in our nursing centers through physical plant improvements and an increased emphasis on marketing efforts; (iii) improving the quality of payor mix; and (iv) clustering our operations on a regional basis.  Our principal executive offices are located at 1621 Galleria Boulevard, Brentwood, TN 37027. Our telephone number at that address is 615.771.7575, and our facsimile number is 615.771.7409. Our web-site is located at www.irinfo.com/AVC. The information on our web-site does not constitute part of this Annual Report on Form 10-K.  Nursing Centers and Services.  Advocat provides a broad range of long-term care services to the elderly including skilled nursing, ancillary health care services and assisted living. In addition to the nursing and social services usually provided in long-term care centers, we offer a variety of rehabilitative, nutritional, respiratory, and other specialized ancillary services. As of December 31, 2005, our continuing operations include 43 nursing centers containing 4,505 licensed nursing beds and 78 assisted living units.  The nursing centers included in our continuing operations range in size from 48 to 180 licensed nursing beds. The following table summarizes certain information with respect to the nursing centers we own or lease as part of continuing operations as of December 31, 2005:  2    Table of Contents                                      Number of   Licensed   Assisted Living       Centers   Nursing Beds   Units     Operating Locations:                           Alabama     6       711       52     Arkansas     13       1,411       24     Florida     5       502       0     Kentucky     6       474       2     Ohio     1       151       0     Tennessee     5       617       0     Texas     5       489       0     West Virginia     2       150       0                                       43       4,505       78                                                                       Number of   Licensed   Assisted Living       Centers   Nursing Beds   Units     Classification:                           Owned     9       942       17     Leased     34       3,563       61                                 Total     43       4,505       78                                   Our nursing centers provide skilled nursing health care services, including room and board, nutrition services, recreational therapy, social services, and housekeeping and laundry services. Our nursing centers dispense medications prescribed by the patients’ physicians, and a plan of care is developed by professional nursing staff for each resident. We also provide for the delivery of ancillary medical services at the nursing centers we operate. These specialty services include rehabilitation therapy services, such as audiology, speech, occupational and physical therapies, which are provided through licensed therapists and registered nurses, and the provision of medical supplies, nutritional support, infusion therapies, and related clinical services. The significant majority of these services are provided using our internal resources and clinicians.  Within the framework of a nursing center, we may provide other specialty care, including:  Life Steps Unit. Six of our nursing centers have units designated as Life Steps Units, our designation for patients requiring short term rehabilitation following an incident such as a stroke or bone fracture. These units specialize in short term rehabilitation with the goal of returning the patient to their previous level of functionality. These units provide enhanced services with emphasis on upgraded amenities including electric beds, televisions, phones at bedside and feature a separate entrance for guests and visitors. The design and programming on the unit appeals to the generally younger resident who intends to return home following intensive rehabilitation. Specialized therapeutic treatment regimens include orthopedic rehabilitation, neurological rehabilitation and complex medical rehabilitation. While these patients generally have a shorter length of stay, the intensive level of rehabilitation generally results in higher levels of reimbursement.  Lighthouse Unit. Thirteen of our nursing centers have Lighthouse Units, our designation for advanced care for dementia related disorders, including Alzheimer’s disease. The goal of the units is to provide a safe, homelike and supportive environment for cognitively impaired patients, utilizing a interdisciplinary team approach, Family and community involvement compliment structured programming in the secure environment instrumental in fostering as much resident independence as possible despite diminished capacity.  3    Table of Contents  Assisted Living Units. Five of our nursing centers have units designated for assisted living patients, ranging in size from 2 to 35 units. These units may be a subset of the facility or a separate freestanding building on the nursing center campus. Services and accommodations include central dining facilities, recreational areas, social programs, housekeeping, laundry and maintenance service, emergency call systems, special features for handicapped persons and transportation to shopping and special events. Generally, basic care and support services can be offered more economically in an assisted living facility than either in a nursing home or through home health care assistance.  Other Specialty Programming. We implement other specialty programming based on a center’s specific needs. We have developed one adult day care center on the campus of a nursing center. We have developed specialty programming for bariatric patients (generally, patients weighing more than 350 pounds). These individuals have unique psychosocial and equipment needs.  Continuous Quality Improvement. We have in place a Continuous Quality Improvement (“CQI”) program, which is focused on identifying opportunities for improvement of all aspects of the care provided in a center, as well as overseeing the initiation and effectiveness of interventions. The CQI program was designed to meet accreditation standards and to exceed state and federal government regulations. We conduct monthly audits to monitor adherence to the standards of care established by the CQI program at each center which we operate. The facility administrator, with assistance from regional nursing personnel, is primarily responsible for adherence to our quality improvement standards. In that regard, the annual operational objectives established by each facility administrator include specific objectives with respect to quality of care. Performance of these objectives is evaluated quarterly by the regional vice president or manager, and each facility administrator’s incentive compensation is based, in part, on the achievement of the specified quality objectives. Issues regarding quality of care and resident care outcomes are addressed routinely by senior management. A major component of our CQI program is employee empowerment initiatives, with particular emphasis placed on selection, recruitment, retention and recognition programs. Our administrators and managers include employee retention and turnover goals in the annual facility, regional and personal objectives. We also have established a quality improvement committee consisting of nursing representatives from each region. This committee periodically reviews our quality improvement programs and conducts facility audits.  Organization. Our long-term care facilities are currently organized into six regions, each of which is supervised by a regional vice president. The regional vice president is generally supported by specialists in several functions, including nursing, human resources, marketing, receivable management and clerical, all of whom are employed by us. The day-to-day operations of each owned or leased nursing center are supervised by an on-site, licensed administrator. The administrator of each nursing center is supported by other professional personnel, including a medical director, who assists in the medical management of the facility, and a director of nursing, who supervises a staff of registered nurses, licensed practical nurses, and nurses aides. Other personnel include therapy, dietary, activities and social service, housekeeping, laundry and maintenance, and a business office staff. All personnel at the leased or owned facilities, including the administrators, are our employees.  4    Table of Contents  Operating and Growth Strategy.  Our operating objective is to be the provider of choice of health care and related services to the elderly in the communities in which we operate. To achieve our objective we:  Provide a broad range of cost-effective services. Our objective is to provide a variety of services in a broad continuum of care which will meet the ever changing needs of the elderly. Our expanded service offering currently includes skilled nursing, comprehensive rehabilitation services, programming for Life Steps and Lighthouse units, other specialty programming and medical supply and nutritional support services. By addressing varying levels of acuity, we work to meet the needs of the elderly population we serve for a longer period of time and to establish a reputation as the provider of choice in a particular market. Furthermore, we believe we are able to deliver quality services cost-effectively, thereby expanding the elderly population base that can benefit from our services, including those not otherwise able to afford private-pay assisted living services.  Increase occupancy through physical plant improvements and emphasis on marketing efforts. We believe we can increase occupancy in our nursing homes through improved physical plants and an increased emphasis on and an improved program for attracting and retaining patients and residents. We emphasize strong corporate and regional support for local facility based marketing efforts.  Improve quality of payor mix. We believe we can improve profitability by improving the payor mix of our patients. Quality payor sources include Medicare, HMO, managed care and private pay. These payor sources typically provide a better margin per revenue dollar or patient day.  Cluster operations on a regional basis. We have developed regional concentrations of operations in order to achieve operating efficiencies, generate economies of scale and capitalize on marketing opportunities created by having multiple operations in a regional market area.  Key elements of our growth strategy are to:  Increase revenues and profitability at existing facilities. Our strategy includes increasing center revenues and profitability levels through increasing occupancy levels, improving quality payor mix, maximizing reimbursement rates and containing costs. Ongoing initiatives to promote higher occupancy levels and improved payor and case mixes at our nursing centers include programs to improve customer service, new contracts for insurance and other services, and units for specialized care services developed at certain centers.  Improve physical plants. Our nursing centers have an average age of approximately 30 years as of December 31, 2005. We have completed a major renovation at one facility and plan several more in 2006. Major renovations result in significant cosmetic upgrades, including new flooring, wall coverings, lighting, ceilings and furniture throughout the facility. It includes certain external work to improve curb appeal, including concrete work, landscaping, roof, and signage enhancements.  5    Table of Contents  Development of additional specialty services. Our strategy includes the development of additional specialty units and programming in facilities that could benefit from these services. The specialty programming will vary depending on the needs of the specific marketplace, and may include Life Steps and Lighthouse Units and other specialty programming. A center specific assessment of the market is conducted related to specialty programming to determine if unmet needs exist as a predictor of the success of particular niche offerings.  Marketing.  At a local level, our sales and marketing efforts are designed to promote higher occupancy levels and optimal payor mix. We believe that the long-term care profession is fundamentally a local business in which both patients and residents and the referral sources for them are based in the immediate geographic area in which the facility is located. Our marketing plan and related support activities emphasize the role and performance of administrators, admissions coordinators and social services directors of each nursing center, all of whom are responsible for contacting various referral sources such as doctors, hospitals, hospital discharge planners, churches, and various community organizations. Administrators are evaluated based on their ability to meet specific goals and performance standards that are tied to compensation incentives. Our regional managers and marketing coordinators assist local marketing personnel and administrators in establishing relationships and follow-up procedures with such referral sources.  In addition to soliciting admissions from these sources, we emphasize involvement in community affairs in order to promote a public awareness of our nursing centers and services. We have ongoing family councils and community based “family night” functions where organizations come to the facility to educate the public on various topics such as Medicare benefits, powers of attorney, and other matters of interest. We also promote effective customer relations and seek feedback through family surveys. In addition, we have regional marketing coordinators to support the overall marketing program in each local facility, in order to promote higher occupancy levels and improved payor and case mixes at our nursing centers.  We have an internally-developed marketing program that focuses on the identification and provision of services needed by the community. The program assists each facility administrator in analysis of local demographics and competition with a view toward complementary service development. We believe that the primary referral area in the long-term care industry generally lies within a five-to-fifteen-mile radius of each facility depending on population density; consequently, local marketing efforts are more beneficial than broad-based advertising techniques.  Divestitures.  We have undertaken several divestitures through sale of assets and lease terminations. The divested operations have generally been poor performing properties. In November 2005, we entered into a definitive agreement to sell certain assets of eleven assisted living facilities located in North Carolina. The sale is contingent on the purchaser’s ability to obtain licenses to operate the buildings, and is expected to close in the second quarter of 2006, although no assurances can be given. We have entered into an agreement to sell our only remaining assisted living facility in North Carolina. The sale is subject to customary contingencies, including the purchaser  6    Table of Contents  obtaining financing and completing due diligence. We sold two nursing centers in Texas effective February 1, 2005. A lease covering three nursing centers in Texas expired in December 2004 and was not renewed. In November 2004, we sold certain assets of our medical supply business, Advocat Distribution Services. In May 2004, we sold the stock of our Canadian subsidiary, Diversicare Canada Management Services Co., Inc. (“DCMS”).  In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” our consolidated financial statements have been reclassified to reflect these divestitures as discontinued operations.  Recent Developments.  As of December 31, 2005, we had $31.5 million of scheduled debt maturities in 2006 that must be repaid or refinanced during the next twelve months. In addition, as of December 31, 2005 we were not in compliance with certain financial covenants and we have not obtained waivers of the non-compliance. As a result, we have classified $47.4 million of debt as current liabilities as of December 31, 2005. However, we are actively working with our lenders to address these issues.  As we previously announced, on March 17, 2006, we entered into a two year renewal of our term notes and working capital line of credit agreements with our primary bank lender. In addition, the lender agreed to amend certain covenants of the notes to bring us into compliance with such covenants. We expect that our term notes with this lender will be repaid in full during the course of the two year term of this agreement.  As was described above, we have entered into an agreement to sell 11 of our assisted living facilities in North Carolina for approximately $11.0 million. We expect to close this transaction in the second quarter of 2006, although no assurances can be given. We have entered into an agreement to sell our remaining assisted living facility in North Carolina. The sale is subject to customary contingencies, including the purchaser obtaining financing and completing due diligence. These facilities and three nursing centers are collateral for mortgage debt with a commercial finance company that totals approximately $27.7 million as of December 31, 2005. These mortgages mature on April 1, 2006. We have entered into a 60 day extension for $17.7 million in mortgage loans that are secured by the assisted living facilities. We are engaged in negotiations with the lender, and anticipate that once the sale of the facilities is completed, we will be able to refinance the remaining debt with the lender for a longer term. We have also entered into a 90 day extension of $10.0 million in mortgage loans that are secured by the three nursing centers with this lender, and are engaged in discussions with the lender to refinance those loans for a longer term. No agreement has been reached, and no assurances can be made that these efforts will be successful.  We have filed an application seeking listing of our shares on The NASDAQ Capital Market. The application is currently under review by The NASD stock market.  Nursing Center Profession.  We believe there are a number of significant trends within the long term care industry that will support the continued growth of the nursing home segment of the long-term care industry. These trends are also likely to impact our business. These factors include:       Demographic trends. The primary market for our long-term health care services is comprised of persons aged 75 and older. This age group is one of the fastest growing  7    Table of Contents  segments of the United States population. As the number of persons aged 75 and over continues to grow, we believe that there will be corresponding increases in the number of persons who need skilled nursing.       Cost containment pressures. In response to rapidly rising health care costs, governmental and other third-party payors have adopted cost-containment measures to reduce admissions and encourage reduced lengths of stays in hospitals and other acute care settings. The federal government had previously acted to curtail increases in health care costs under Medicare by limiting acute care hospital reimbursement for specific services to pre-established fixed amounts. Other third-party payors have begun to limit reimbursement for medical services in general to predetermined reasonable charges, and managed care organizations (such as health maintenance organizations) are attempting to limit hospitalization costs by negotiating for discounted rates for hospital and acute care services and by monitoring and reducing hospital use. In response, hospitals are discharging patients earlier and referring elderly patients, who may be too sick or frail to manage their lives without assistance, to nursing homes where the cost of providing care is typically lower than hospital care. In addition, third-party payors are increasingly becoming involved in determining the appropriate health care settings for their insureds or clients based primarily on cost and quality of care.       Limited supply of centers. As the nation’s elderly population continues to grow, life expectancy continues to expand, and there continue to be limitations on granting Certificates of Need (“CON’s”) for new skilled nursing centers, we believe that there will be continued demand for skilled nursing beds in the markets in which we operate. The majority of states have adopted CON, or similar statutes, requiring that prior to adding new skilled beds or any new services, or making certain capital expenditures, a state agency must determine that a need exists for the new beds or proposed activities. We believe that this CON process tends to restrict the supply and availability of licensed skilled nursing center beds. High construction costs, limitations on state and federal government reimbursement for the full costs of construction, and start-up expenses also act to restrict growth in the supply for such centers. At the same time, skilled nursing center operators are continuing to focus on improving occupancy and expanding services to include high acuity subacute patients, who require significantly higher levels of skilled nursing personnel and care.       Reduced reliance on family care. Historically, the family has been the primary provider of care for seniors. We believe that the increase in the percentage of women in the work force, the reduction of average family size, and the increased mobility in society will reduce the role of the family as the traditional care-giver for aging parents. We believe that this trend will make it necessary for many seniors to look outside the family for assistance as they age.  Competition.  The long-term care business is highly competitive. We face direct competition for additional centers, and our centers face competition for employees, patients and residents. Some of our present and potential competitors for acquisitions are significantly larger and have or may obtain greater financial and marketing resources. Competing companies may offer new or more  8    Table of Contents  modern centers or new or different services that may be more attractive to patients, residents or facility owners than some of the services we offer.  The nursing centers operated by us compete with other facilities in their respective markets, including rehabilitation hospitals, other “skilled” and personal care residential facilities. In the few urban markets in which we operate, some of the long-term care providers with which our facilities compete are significantly larger and have or may obtain greater financial and marketing resources than our facilities. Some of these providers are not-for-profit organizations with access to sources of funds not available to our centers. Construction of new long-term care facilities near our existing centers could adversely affect our business. We believe that the most important competitive factors in the long-term care business are: a facility’s local reputation with referral sources, such as acute care hospitals, physicians, religious groups, other community organizations, managed care organizations, and a patient’s family and friends; physical plant condition; the ability to identify and meet particular care needs in the community; the availability of qualified personnel to provide the requisite care; and the rates charged for services. There is limited, if any, price competition with respect to Medicaid and Medicare patients, since revenues for services to such patients are strictly controlled and are based on fixed rates and cost reimbursement principles. Although the degree of success with which our centers compete varies from location to location, we believe that our centers generally compete effectively with respect to these factors.  Payor Sources.  We classify our revenues from patients and residents into three major categories: Medicaid, Medicare and private pay. In addition to traditional Medicaid revenues, we include within the Medicaid classification revenues from other programs established to provide benefits to those in need of financial assistance in the securing of medical services. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. We classify payments from individuals who pay directly for services without government assistance as private pay revenue. The private pay classification also includes revenues from commercial insurers, HMOs, and other charge-based payment sources. Veterans Administration payments are included in private pay and are made pursuant to renewable contracts negotiated with these payors.  The following table sets forth net patient and resident revenues related to our continuing operations by payor source for the years presented:                                                              Year Ended December 31,         (Dollars in thousands)         2005     2004     2003       Medicaid   $ 118,117       58.0 %   $ 113,553       59.4 %   $ 106,537       61.9 %   Medicare     61,057       30.0       56,018       29.3       45,700       26.5     Private Pay     24,484       12.0       21,653       11.3       19,907       11.6                                             Total   $ 203,658       100.0 %   $ 191,224       100.0 %   $ 172,144       100.0 %                                             Patient service is generally provided and charged in daily service units, commonly referred to as patient days. The following table sets forth patient days by payor source for our continuing operations for the years presented:  9    Table of Contents                                                              Year Ended December 31,         2005     2004     2003       Medicaid     910,052       71.5 %     923,746       72.6 %     930,637       74.0 %   Medicare     165,914       13.0       161,030       12.7       144,015       11.5     Private Pay     196,232       15.5       187,156       14.7       182,948       14.5                                             Total     1,272,198       100.0 %     1,271,932       100.0 %     1,257,600       100.0 %                                             Consistent with the nursing home industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare, and private pay can significantly affect the profitability of the facility’s operations.  Reimbursement.  A significant portion of our revenues is derived from government-sponsored health insurance programs. Our nursing centers derive revenues under Medicaid, Medicare and private pay sources. We employ specialists in reimbursement at the corporate level to monitor regulatory developments, to comply with reporting requirements, and to maximize payments to our operated nursing centers. It is generally recognized that all government-funded programs have been and will continue to be under cost containment pressures, but the extent to which these pressures will affect our future reimbursement is unknown.  The Balanced Budget Act enacted during 1997 (the “BBA”) phased in the prospective payment system for nursing centers and contained numerous Medicare and Medicaid cost-saving measures. As initially implemented, the BBA negatively impacted the entire long-term care industry. During 1999 and 2000, certain amendments to the BBA were enacted, which helped restore some of the Medicare funding originally eliminated under the BBA. However, certain provisions in the amendments expired on September 30, 2002 and December 31, 2005.  In 2005, the Centers for Medicare and Medicaid (“CMS”) issued the final rule for the refinement of the Resource Utilization Group (“RUG”) system and provided for the elimination of the reimbursement add-ons for high acuity patients. In addition, Congress implemented a market basket adjustment of approximately 3.1% designed to increase reimbursement for the effects of inflation. The market basket adjustment became effective October 1, 2005, and increased our revenue and operating cash flow by approximately $1.6 million annually. The eliminations of the add-ons and other offsetting adjustments were effective January 1, 2006, and were originally expected to decrease our revenue and operating cash flow by an estimated $2.5 million annually. We originally estimated that the net effect of the CMS rule would be to reduce our revenue and operating cash flow by approximately $0.9 million per year. However, we have seen in 2006 a continuing shift to higher acuity patients result in higher reimbursement. We now expect the effect of the elimination of the add-ons and RUG refinement to have no material impact on us.  Certain per person annual Medicare Part B reimbursement limits on therapy services became effective January 1, 2006. Subject to certain exceptions, the limits impose a $1,740 per patient annual ceiling on physical and speech therapy services, and a separate $1,740 per patient annual ceiling on occupational therapy services. The exception process is still being defined by CMS, but we believe the majority of services provided by us will be reimbursed under the exceptions. The exception process is currently only effective through December 31, 2006. If the exception  10    Table of Contents  process is discontinued for 2007, it is expected that the reimbursement limitations will reduce therapy revenues, and negatively impact our operating results and cash flows.  The Federal Deficit Reduction Act of 2005 mandates the reduction by 30% the amount that Medicare reimburses nursing centers and other non-hospital providers for bad debts arising from uncollectible Medicare coinsurance and deductibles for those individuals that are not dually eligible for Medicare and Medicaid. The reduction is to be phased in over a three year period with 10% during fiscal 2006, 20% during fiscal 2007 and 30% thereafter. This provision is not expected to have a material impact on the Company.  The budget proposed by President Bush for the government’s 2007 fiscal year includes a number of proposed reductions to Medicare reimbursement for nursing homes and also appears to challenge certain Federal matching programs that benefit many of the state Medicaid programs, including several of the states in which we operate nursing facilities. We are unable to quantify the impact that these possible reimbursement cuts would have on us.  Reduction in health care spending has become a national priority in the United States, and the field of health care regulation and reimbursement is a rapidly evolving one. For the fiscal year ended December 31, 2005, we derived 30.0% and 58.0% of our total patient and resident revenues related to continuing operations from the Medicare and Medicaid programs, respectively. Any health care reforms that significantly limit rates of reimbursement under these programs could, therefore, have a material adverse effect on our profitability. We are unable to predict which reform proposals or reimbursement limitations will be adopted in the future, or the effect such changes would have on our operations. We will attempt to maximize the revenues available from governmental sources within the changes that have occurred and will continue to occur.  We will also attempt to increase revenues from non-governmental sources to the extent capital is available to do so, if at all. However, private payors, including managed care payors, are increasingly demanding that providers accept discounted fees or assume all or a portion of the financial risk for the delivery of health care services. Such measures may include capitated payments, which can result in significant losses to health care providers if patients require expensive treatment not adequately covered by the capitated rate.  Description of Lease Agreements.  Our current operations include 34 nursing centers subject to operating leases, including 33 owned or financed by Omega Healthcare Investors, Inc. (“Omega”) and one owned by another party. In our role as lessee, we are responsible for the day-to-day operations of all operated centers. These responsibilities include recruiting, hiring, and training all nursing and other personnel, and providing resident care, nutrition services, marketing, quality improvement, accounting, and data processing services for each facility. The lease agreements pertaining to our 34 leased facilities are “triple net” leases, requiring us to maintain the premises, pay taxes and pay for all utilities. The leases typically provide for an initial term of 4 to 10 years with renewal options up to 10 years. The average remaining term of our lease agreements, including renewal options, is approximately 13 years.  11    Table of Contents  Omega Master Lease. We lease 29 nursing centers from Omega pursuant to one lease agreement dated October 1, 2000 (the “Omega Master Lease”). All of the accounts receivable, equipment, inventory and other assets of the facilities leased have been pledged as security under the Omega Master Lease. The initial term of the Omega Master Lease is ten years, expiring September 30, 2010, with an additional ten-year renewal term at our option, assuming no defaults. We are not currently in compliance with certain covenants of the Omega Master Lease. Lease payments were $12.3 million for the year ended December 31, 2005. Each year, increases in the lease payments are equal to the lesser of two times the consumer price index or 3.0%. The Omega Master Lease requires us to fund capital expenditures equal to $325 per licensed bed over the initial lease term, subject to adjustment for increases in the Consumer Price Index (annual required capital expenditures of $0.7 million in 2006). Upon expiration of, or in the event of a default under the Omega Master Lease, we are required to transfer all of the leasehold improvements, equipment, furniture and fixtures of the leased facilities to Omega. In the event that we do not transfer all of the facility assets to Omega, we will be required to pay Omega $5 million plus accrued interest at 11.00% from the effective date of the Omega Master Lease. We intend to transfer the facility assets to Omega at the end of the lease term.  In June 2005, we entered into an amendment of the master lease with Omega. The amendment provides financing of up to $5 million to be used to fund renovations to several nursing centers leased from Omega. The annual base rent related to these facilities will be increased to reflect the amount of capital improvements made to the respective facilities. The amendment also included provisions to amend certain professional liability insurance requirements in order to cure certain defaults under the Omega Master Lease.  The Omega Master Lease requires us to maintain a minimum tangible net worth and prohibits us from operating any additional facilities within a certain radius of each leased facility. We are generally required to maintain comprehensive insurance covering the facilities we lease as well as personal and real property damage insurance and professional liability insurance. The failure to pay rentals within a specified period or to comply with the required operating and financial covenants, including insurance coverage, generally constitutes a default, which default, if uncured, permits Omega to terminate the lease and assume the property and the contents within the facilities. In addition, as of December 31, 2005, we were not in compliance with certain covenants under our debt agreements, which could lead to actions by the lenders that could result in an event of default under the Omega Master Lease.  Florida Leases. Effective April 1, 2003, we entered into leases for four nursing centers in Florida that had previously been managed by us under management contracts. Accordingly, the results of operations of these facilities are included in our results of operations beginning April 1, 2003. Omega holds mortgages on these properties and we make the lease payments directly to Omega. In December 2005, we extended the term of the leases through February 2010. Lease payments will be $1,543,000 during 2006, with increases equal to the lesser of two times the consumer price index or 3.0% in subsequent years. We are also required to fund annual capital expenditures equal to $350 per licensed bed over the initial lease term, subject to adjustment for increases in the Consumer Price Index.  12    Table of Contents  Professional Liability and Other Liability Insurance.  Due to our past claims experience and increasing cost of claims throughout the long-term care industry, the premiums paid by us for professional liability and other liability insurance to cover future periods exceeds the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, we have purchased professional liability insurance coverage for our facilities that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. As a result, we are effectively self-insured and expect to remain so for the foreseeable future.  We have essentially exhausted all general and professional liability insurance available for claims first made during the period from March 9, 2001 through March 9, 2006. For claims made during the period from March 10, 2006 through March 9, 2007, we maintain insurance with coverage limits of $100,000 per medical incident and total aggregate policy coverage limits of $500,000.  Reserve for Estimated Self-Insured Professional Liability Claims.  Because we anticipate that our actual liability for existing and anticipated claims will exceed our limited professional liability insurance coverage, we have recorded total liabilities for professional liability and other claims of $34.5 million as of December 31, 2005. This accrual includes estimates of liability for incurred but not reported claims, estimates of liability for reported but unresolved claims, actual liabilities related to settlements, including settlements to be paid over time, and estimates of legal costs related to these claims. We do not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof.  We record our estimated liability for these professional liability claims based on the results of a third-party actuarial analysis. Each quarter, amounts are added to the accrual for estimates of anticipated liability for claims incurred during that period. These estimates are assessed and adjusted quarterly as claims are actually reported, as lawsuits are filed, and as those actions are actually resolved. As indicated by the chart of reserves by policy year set forth below, final determination of our actual liability for claims incurred in any given period is a process that takes years. At each quarter end, we record any revisions in estimates and differences between actual settlements and reserves, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period. Although we retain a third-party actuarial firm to assist us in estimating the appropriate accrual for these claims, professional liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. As a result, our actual liabilities may vary significantly from the accrual, and the amount of the accrual has and may continue to fluctuate by a material amount in any given quarter. Each change in the amount of this accrual will directly affect our reported earnings and financial position for the period in which the change in accrual is made.  While each quarterly adjustment to the recorded liability for professional liability claims affects reported income, these changes do not directly affect our cash position because the accrual for these liabilities is not funded. We do not have cash or available resources to pay these accrued  13    Table of Contents  professional liability claims or any significant portion thereof. In the event a significant judgment is entered against us in one or more legal actions in which there is no or insufficient professional liability insurance, we anticipate that payment of the judgment amounts would require cash resources that would be in excess of our available cash or other resources. Any such judgment could have a material adverse impact on our financial position and cash flows.  The following summarizes our accrual for professional liability and other claims for each policy year as of the end of the period:                              December 31,         2005     2004       Policy Year End March 9,                   2006   $ 10,492,000     $ —     2005     12,722,000       12,068,000     2004     6,351,000       15,626,000     2003     3,137,000       10,041,000     2002     859,000       3,292,000     Other     966,000       1,873,000                         $ 34,527,000     $ 42,900,000                       Other Insurance.  With respect to workers’ compensation insurance, substantially all of our employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. Prior to that time, we were self-insured for the first $250,000, on a per claim basis, for workers’ compensation claims in a majority of our facilities. However, the insurance carrier providing coverage above our self insured retention has been declared insolvent by the applicable state insurance agency. As a result, we are completely self-insured for workers compensation exposures prior to May 1997. We have been and remain a non-subscriber to the Texas workers’ compensation system and are, therefore, completely self-insured for employee injuries with respect to our Texas operations. For the policy period July 1, 2002 through June 30, 2003, we entered into a “high deductible” workers compensation insurance program covering the majority of our employees. Under the high deductible policy, we are self insured for the first $25,000 per claim, subject to an aggregate maximum out of pocket cost of $1.6 million, for the 12 month policy period. We have a letter of credit of $0.4 million securing our self insurance obligations under this program. The letter of credit is secured by a certificate of deposit of $0.4 million, which is included in “restricted cash” in the accompanying balance sheet. The reserve for the high deductible policy is based on known claims incurred and an estimate of incurred but not reported claims determined by an analysis of historical claims incurred. We have provided reserves for the settlement of outstanding self-insured claims at amounts believed to be adequate. The liability we recorded for the self-insured obligations under these plans is $0.6 million as of December 31, 2005.  Effective June 30, 2003, we entered into new workers compensation insurance programs that provide coverage for claims incurred, with premium adjustments depending on incurred losses. We account for premium expense under these policies based on our estimate of the level of claims expected to be incurred. As of December 31, 2005, we have recorded estimated premium refunds due under these programs totaling approximately $3.7 million, with $1.3 million included in “prepaid expenses and other current assets” and the balance included in “other  14    Table of Contents  noncurrent assets” in the accompanying balance sheet, based upon expected settlement dates. Any adjustments of future premiums for workers compensation policies and differences between actual settlements and reserves for self-insured obligations are included in expense in the period finalized.  We are self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 per individual annually. We provide reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate. The liability for reported claims and estimates for incurred but unreported claims is $1.0 million at December 31, 2005. The differences between actual settlements and reserves are included in expense in the period finalized.  Employees.  As of February 1, 2006, we employed a total of approximately 4,682 individuals in connection with our continuing operations. We also employed approximately 414 employees in connection with our assisted living subsidiary, which has been classified in discontinued operations. We believe that our employee relations are good. Approximately 145 of our employees are represented by a labor union.  Although we believe we are able to employ sufficient nurses and therapists to provide our services, a shortage of health care professional personnel in any of the geographic areas in which we operate could affect our ability to recruit and retain qualified employees and could increase our operating costs. We compete with other health care providers for both professional and non-professional employees and with non-health care providers for non-professional employees. During 2005, we faced increased competition for workers due to tight labor markets and nursing shortages in most of the areas in which we operate.  Supplies and Equipment.  We purchase drugs, solutions and other materials and lease certain equipment required in connection with our business from many suppliers. We have not experienced, and do not anticipate that we will experience, any significant difficulty in purchasing supplies or leasing equipment from current suppliers. In the event that such suppliers are unable or fail to sell us supplies or lease equipment, we believe that other suppliers are available to adequately meet our needs at comparable prices. National purchasing contracts are in place for all major supplies, such as food, linens, and medical supplies. These contracts assist in maintaining quality, consistency and efficient pricing.  Government Regulation.  The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Over the last several years, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse statutes and regulations as well as laws and regulations governing quality of care  15    Table of Contents  issues in the skilled nursing profession in general. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations is subject to ongoing government review and interpretation, as well as regulatory actions in which government agencies seek to impose fines and penalties. The Company is involved in regulatory actions of this type from time to time. Additionally, changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, have had a material adverse effect on the industry and our consolidated financial position, results of operations, and cash flows. Future federal budget legislation and federal and state regulatory changes may further negatively impact us.  Licensure and Certification. All our nursing centers must be licensed by the state in which they are located in order to accept patients, regardless of payor source. In most states, nursing homes are subject to certificate of need laws, which require us to obtain government approval for the construction of new nursing homes or the addition of new licensed beds to existing homes. Our nursing centers must comply with detailed statutory and regulatory requirements on an ongoing basis in order to qualify for licensure, as well as for certification as a provider eligible to receive payments from the Medicare and Medicaid programs. Generally, the requirements for licensure and Medicare/Medicaid certification are similar and relate to quality and adequacy of personnel, quality of medical care, record keeping, dietary services, resident rights, and the physical condition of the facility and the adequacy of the equipment used therein. Each facility is subject to periodic inspections, known as “surveys” by health care regulators, to determine compliance with all applicable licensure and certification standards. Such requirements are both subjective and subject to change. If the survey concludes that there are deficiencies in compliance, the facility is subject to various sanctions, including but not limited to monetary fines and penalties, suspension of new admissions, non-payment for new admissions and loss of licensure or certification. Generally, however, once a facility receives written notice of any compliance deficiencies, it may submit a written plan of correction and is given a reasonable opportunity to correct the deficiencies. There can be no assurance that, in the future, we will be able to maintain such licenses and certifications for our facilities or that we will not be required to expend significant sums in order to comply with regulatory requirements.  Medicare and Medicaid. Medicare is a federally-funded and administered health insurance program for the aged and for certain chronically disabled individuals. Part A of the Medicare program covers inpatient hospital services and certain services furnished by other institutional providers such as skilled nursing facilities. Part B covers the services of doctors, suppliers of medical items, various types of outpatient services, and certain ancillary services of the type provided by long term and acute care facilities. Medicare payments under Part A and Part B are subject to certain caps and limitations, as provided in Medicare regulations. Medicare benefits are not available for intermediate and custodial levels of nursing home care, nor for assisted living facility arrangements.  Medicaid is a medical assistance program for the indigent, operated by individual states with financial participation by the federal government. Criteria for medical indigence and available Medicaid benefits and rates of payment vary somewhat from state to state, subject to certain federal requirements. Basic long-term care services are provided to Medicaid beneficiaries, including nursing, dietary, housekeeping and laundry and restorative health care services, room  16    Table of Contents  and board, and medications. Previously, under legislation known as the Boren Amendment, federal law required that Medicaid programs pay to nursing home providers amounts adequate to enable them to meet government quality and safety standards. However, the BBA repealed the Boren Amendment, and the BBA requires only that a state Medicaid program must provide for a public process for determination of Medicaid rates of payment for nursing facility services. Under this process, proposed rates, the methodologies underlying the establishment of such rates, and the justification for the proposed rates are published. This public process gives providers, beneficiaries and concerned state residents a reasonable opportunity for review and comment. Certain of the states in which we now operate are actively seeking ways to reduce Medicaid spending for nursing home care by such methods as capitated payments and substantial reductions in reimbursement rates.  HIPAA Compliance. The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) has mandated an extensive set of regulations to standardize electronic patient health, administrative and financial data transactions, and to protect the privacy of individually identifiable health information. We have a HIPAA Compliance Committee and designated privacy and security officers.  The HIPAA transaction standards are intended to simplify the electronic claims process and other healthcare transactions by encouraging electronic transmission rather than paper submission. These regulations provide for uniform standards or data reporting, formatting and coding that we must use in certain transactions with health plans. The HIPAA security regulations establish detailed requirements for safeguarding protected health information that is electronically transmitted or electronically stored. Some of the security regulations are technical in nature, while others are addressed through policies and procedures. We implemented or upgraded computer and information systems as we believed necessary to comply with the new regulations.  The HIPAA regulations related to privacy establish comprehensive federal standards relating to the use and disclosure of individually identifiable health information or protected health information. The privacy regulations establish limits on the use and disclosure of protected health information, provide for patients’ rights, including rights to access, request amendment of, and receive an accounting of certain disclosures of protected health information, and require certain safeguards for protected health information. In addition, each covered entity must contractually bind individuals and entities that furnish services to the covered entity or perform a function on its behalf, and to which the covered entity discloses protected health information, to restrictions on the use and disclosure of that information. In general, the privacy regulations do not supersede state laws that are more stringent or grant greater privacy rights to individuals. Thus, we must reconcile the privacy regulations and other state privacy laws.  Although we believe that we are in material compliance with these HIPAA regulations, the HIPAA regulations are expected to continue to impact us operationally and financially and may pose increased regulatory risk.  Self-Referral and Anti-Kickback Legislation. The health care industry is subject to state and federal laws which regulate the relationships of providers of health care services, physicians, and other clinicians. These self-referral laws impose restrictions on physician referrals to any entity with which they have a financial relationship, which is a broadly defined term. We believe our  17    Table of Contents  relationships with physicians are in compliance with the self-referral laws. Failure to comply with self-referral laws could subject us to a range of sanctions, including civil monetary penalties and possible exclusion from government reimbursement programs. There are also federal and state laws making it illegal to offer anyone anything of value in return for referral of patients. These laws, generally known as “anti-kickback” laws, are broad and subject to interpretations that are highly fact dependent. Given the lack of clarity of these laws, there can be no absolute assurance that any health care provider, including us, will not be found in violation of the anti-kickback laws in any given factual situation. Strict sanctions, including fines and penalties, exclusion from the Medicare and Medicaid programs and criminal penalties, may be imposed for violation of the anti-kickback laws.  Available Information.  We file reports with the Securities and Exchange Commission (“SEC”), including annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K. Copies of our reports filed with the SEC may be obtained by the public at the SEC’s Public Reference Room by calling the SEC at 1-800-SEC-0330. We file such reports with the SEC electronically, and the SEC maintains an Internet site at www.sec.gov that contains our reports, proxy and information statements, and other information filed electronically. Our website address is www.irinfo.com/AVC. We also makes available, free of charge through our website, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and other materials filed with the SEC as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. The information provided on our website is not part of this report, and is therefore not incorporated by reference unless such information is otherwise specifically referenced elsewhere in this report.
There have been a number of material developments both within the Company and the long-term care industry. These developments have had and are likely to continue to have a material impact on us. This section summarizes these developments, as well as other risks, that should be considered by our shareholders and prospective investors.  We are substantially self-insured and have significant potential professional liability exposure.  The provision of health care services entails an inherent risk of liability. Participants in the health care industry are subject to an increasing number of lawsuits alleging malpractice, product liability, or related legal theories, many of which involve large claims and significant defense costs. The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence in providing care to its patients and we are no exception in this regard. We have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. We expect to continue to be subject to such suits as a result of the nature of our business. See “Item 1. Business – Professional Liability and Other Liability Insurance.” for a more detailed discussion of our professional liability insurance. See “Item 3. Legal Proceedings.” for further descriptions of pending claims, and see “Item 7. Management’s Discussion and Analysis of Financial Condition – Liquidity and Capital Resources.” for discussion of our ability to meet our anticipated cash needs.  18    Table of Contents  Due to our past claims experience and increasing cost of claims throughout the long-term care industry, the premiums we pay for professional liability and other liability insurance to cover future periods exceeds the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, we have purchased professional liability insurance coverage for our facilities that, based on historical claims experience, is likely to be substantially less than the claims we expect to incur. As a result, we are effectively self-insured and expect to remain so for the foreseeable future. See “Item 1. Business – Professional Liability and Other Liability Insurance.”  We have significant deferred tax assets which we may not be able to realize.  We have net deferred tax assets of $13.9 million included in our balance sheet as of December 31, 2005. Our ability to realize these deferred tax assets depends on our future taxable income. We reported taxable income for 2004 and expect to do so for 2005 when our tax returns are filed. While the sale of certain assets included in discontinued operations will result in a taxable loss in the year of sale (expected to be 2006), we expect remaining operations will continue to result in taxable income that will allow these deferred tax assets to be realized. However, no assurance can be given that we will be able to generate taxable income in future periods or realize these deferred tax assets.  We have had substantial adjustments to our accrual for professional liability claims which has caused significant fluctuations in our earnings or losses.  In the years ended December 31, 2005 and 2004, we recorded downward adjustments in our accrual for self-insured risks associated with professional liability claims. While these adjustments to the accrual resulted in reported income, they did not generate cash because the accrual is not funded. These self-insurance reserves are assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period. Our actual liabilities may vary significantly from the accrual, and the amount of the accrual has and may continue to fluctuate by a material amount in any given quarter. Each change in the amount of this accrual will directly affect our reported earnings and financial position for the period in which the change in accrual is made. No assurance can be given that the accrual will decline during 2006, and it may increase during this period  We have significant current debt maturities and are not in compliance with certain of our financial covenants.  We have $31.5 million of scheduled debt maturities in 2006. In addition, certain of our debt agreements contain various financial covenants, the most restrictive of which relate to cash flow, net income (loss), and limits on the payment of dividends to shareholders. As of December 31, 2005, we were not in compliance with certain of these financial covenants. We have not obtained waivers of the non-compliance. Cross-default or material adverse change provisions contained in the debt agreements allow the holders of debt totaling approximately $46.3 million to demand immediate repayment. We would not be able to repay this indebtedness if the applicable lenders demanded repayment. Although we do not anticipate that such demands will be made, the continued forbearance on the part of our lenders cannot be assured at this time. As  19    Table of Contents  a result of these debt maturities and defaults, we have classified $47.4 million of debt as current liabilities. Accordingly, we have a working capital deficit of $40.0 million as of December 31, 2005. The failure to close the pending sale of our assisted living facilities in North Carolina could adversely affect our ability to repay or restructure our secured debt. Any demands for repayment by lenders or the inability to obtain waivers or refinance the related debt would have a material adverse impact on our financial position, results of operations and cash flows. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Financial Resources.”  We have cross-default provisions under certain of our debt agreements and leases, which could lead to additional defaults.  As noted above, as of December 31, 2005, we not in compliance with certain of our debt covenants. An event of default under our debt agreements could lead to actions by the lenders that could result in an event of default under our lease agreements with Omega covering a majority of our nursing facilities. The Omega Master Lease also provides that a default with respect to one facility is a default with respect to all facilities leased from Omega. In addition, certain of our debt agreements provide that a default under any of our leases constitutes a default under the debt agreements.  We are highly dependent on reimbursement by third-party payors.  Substantially all of our nursing center revenues are directly or indirectly dependent upon reimbursement from third-party payors, including the Medicare and Medicaid programs, and private insurers. For the year ended December 31, 2005, our patient revenues from continuing operations derived from Medicaid, Medicare and private pay (including private insurers) sources were approximately 58.0%, 30.0%, and 12.0%, respectively. Changes in the mix of our patients among Medicare, Medicaid and private pay categories and among different types of private pay sources may affect our net revenues and profitability. Our net revenues and profitability are also affected by the continuing efforts of all payors to contain or reduce the costs of health care. Efforts to impose reduced payments, greater discounts and more stringent cost controls by government and other payors are expected to continue.  The federal Government makes frequent changes to the reimbursement provided under the Medicare program. These changes could reduce significantly the reimbursement we receive. Also, a number of state governments, including several of states in which we operate, have announced projected budget shortfalls and/or deficit spending situations. In addition, the President’s proposed budget calls for a significant reduction in the amount of Federal funds provided to the state Medicaid systems. Possible actions by these states include reductions of Medicaid reimbursement to providers such as us or the failure to increase Medicaid reimbursements to cover increased operating costs.  Any changes in reimbursement levels or in the timing of payments under Medicare, Medicaid or private pay programs and any changes in applicable government regulations could have a material adverse effect on our net revenues, net income and cash flows. We are unable to predict what reform proposals or reimbursement limitations will be adopted in the future or the effect such changes will have on our operations. No assurance can be given that such reforms will not  20    Table of Contents  have a material adverse effect on us. See “Item 1. Business – Government Regulation and Reimbursement.”  We are subject to significant government regulation.  The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Various federal and state laws regulate relationships among providers of services, including employment or service contracts and investment relationships. The operation of long-term care centers and the provision of services are also subject to extensive federal, state, and local laws relating to, among other things, the adequacy of medical care, distribution of pharmaceuticals, equipment, personnel, operating policies, environmental compliance, compliance with the Americans with Disabilities Act, fire prevention and compliance with building codes.  Long-term care facilities are also subject to periodic inspection to assure continued compliance with various standards and licensing requirements under state law, as well as with Medicare and Medicaid conditions of participation. The failure to obtain or renew any required regulatory approvals or licenses could adversely affect our growth and could prevent us from offering our existing or additional services. In addition, health care is an area of extensive and frequent regulatory change. Changes in the laws or new interpretations of existing laws can have a significant effect on methods and costs of doing business and amounts of payments received from governmental and other payors. Our operations could be adversely affected by, among other things, regulatory developments such as mandatory increases in the scope and quality of care to be afforded patients and revisions in licensing and certification standards. We attempt at all times to comply with all applicable laws; however, there can be no assurance that new legislation or administrative or judicial interpretation of existing laws or regulations will not have a material adverse effect on our operations or financial condition. Changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, have had a material adverse effect on the profession and our consolidated financial position, results of operations, and cash flows. Future federal budget legislation, federal or state regulatory actions seeking to impose fines and penalties, and federal and state regulatory changes may negatively impact us. See “Item 1. Business – Government Regulation.”  The health care industry has been the subject of increased regulatory scrutiny recently.  The Office of Inspector General (“OIG”), the enforcement arm of the Medicare program, formulates a formal work plan each year for nursing homes. The OIG’s most recent work plan indicates that access to care, quality of care, survey deficiencies, compliance with minimum data set reporting, resident assessment and care planning, and the medical necessity of services billed will be an investigative focus in 2006. We cannot predict the likelihood, scope or outcome of any such investigations on our facilities.  21    Table of Contents  We are subject to claims under the self-referral and anti-kickback legislation.  In the United States, various state and federal laws regulate the relationships between providers of health care services, physicians, and other clinicians. These self-referral laws impose restrictions on physician referrals for designated health services to entities with which they have financial relationships. These laws also prohibit the offering, payment, solicitation or receipt of any form of remuneration in return for the referral of Medicare or state health care program patients or patient care opportunities for the purchase, lease or order of any item or service that is covered by the Medicare and Medicaid programs. To the extent that we, any of our facilities with which we do business, or any of the owners or directors have a financial relationship with each other or with other health care entities providing services to long-term care patients, such relationships could be subject to increased scrutiny. There can be no assurance that our operations will not be subject to review, scrutiny, penalties or enforcement actions under these laws, or that these laws will not change in the future. Violations of these laws may result in substantial civil or criminal penalties for individuals or entities, including large civil monetary penalties and exclusion from participation in the Medicare or Medicaid programs. Such exclusion or penalties, if applied to us, could have a material adverse effect on our profitability.  Our stock has limited liquidity.  During 1999, the New York Stock Exchange de-listed our common stock. Trading of our common stock is currently conducted on the over-the-counter market (“OTC”) or, on application by broker-dealers, in the NASD’s Electronic Bulletin Board using our current trading symbol, AVCA. As a result of the de-listing, the liquidity of our common stock and its price have been adversely affected, which may limit our ability to raise additional capital.  We operate in an industry that is highly competitive.  The long-term care industry generally, and the nursing home business particularly, is highly competitive. We face direct competition for the acquisition of facilities. In turn, our facilities face competition for employees, patients and residents. Some of our present and potential competitors are significantly larger and have or may obtain greater financial and marketing resources than we can. Some hospitals that provide long-term care services are also a potential source of competition. In addition, we may encounter substantial competition from new market entrants. Consequently, there can be no assurance that we will not encounter increased competition in the future, which could limit our ability to attract patients or residents or expand our business, and could materially and adversely affect our business or decrease our market share.  We have a number of policies in place that could be considered anti-takeover protections.  We have adopted a Shareholder Rights Plan (the “Plan”). In March 2005, the Board of Directors amended the Plan to extend the expiration date of the Plan to March 20, 2010 and change the exercise price of the rights under the Plan to $15. The Plan is intended to encourage potential acquirers to negotiate with our Board of Directors and to discourage coercive, discriminatory and unfair proposals. Our Certificate of Incorporation (the “Certificate”) provides for the classification of our Board of Directors into three classes, with each class of directors serving  22    Table of Contents  staggered terms of three years. Our Certificate requires the approval of two-thirds of the outstanding shares to amend certain provisions of the Certificate. Section 203 of the Delaware General Corporate Law restricts the ability of a Delaware corporation to engage in any business combination with an interested shareholder. We are also authorized to issue up to 400,000 shares of preferred stock, the rights of which may be fixed by the Board of Directors without shareholder approval. In November 2000, we issued 393,658 shares of our Series B Redeemable Convertible Preferred Stock to Omega in connection with a restructuring of the Omega Master Lease. Provisions in certain of our executive officers’ employment agreements provide for post-termination compensation, including payment of amounts up to 2.5 times their annual salary, following certain changes in control. Our stock incentive plans provide for the acceleration of the vesting of options in the event of certain changes in control (as defined in such plans). Certain changes in control also constitute an event of default under our bank credit facility. The foregoing matters may, together or separately, have the effect of discouraging or making more difficult an acquisition or change of control of us.
None.
We own 9 and lease 34 long-term care facilities. See “Item 1. Business – Description of Lease Agreements” and “– Facilities.” We lease approximately 25,000 square feet of office space in Brentwood, Tennessee, that houses our executive offices, centralized management support functions, and the ancillary services supply operations. In addition, we lease our regional office with approximately 4,000 square feet of office space in Ashland, Kentucky. Lease periods on these facilities generally range up to seven years. Regional executives for Alabama, Arkansas, Florida, Tennessee and Texas work from offices of up to 1,500 square feet each. We believe that our leased properties are adequate for our present needs and that suitable additional or replacement space will be available as required.
The provision of health care services entails an inherent risk of liability. Participants in the health care industry are subject to an increasing number of lawsuits alleging malpractice, product liability, or related legal theories, many of which involve large claims and significant defense costs. The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence in providing care to its patients and we are no exception in this regard. We have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. It is expected that we will continue to be subject to such suits as a result of the nature of our business. Further, as with all health care providers, we are periodically subject to regulatory actions seeking fines and penalties for alleged violations of health care laws and are potentially subject to the increased scrutiny of regulators for issues related to compliance with health care fraud and abuse laws.  23    Table of Contents  As of December 31, 2005, we are engaged in 16 professional liability lawsuits. None of these matters are currently scheduled for trial within the next year. The ultimate results of any of our professional liability claims and disputes cannot be predicted. We have limited, and sometimes no, professional liability insurance with regard to most of these claims. In the event a significant judgment is entered against us in one or more of these legal actions in which there is no or insufficient professional liability insurance, we would not have available cash resources to satisfy the judgment. Further, settlement of these and other cases may require cash resources that would be in excess of our available cash or other resources. These potential future payments, whether of a judgment or in settlement of a disputed claim, could have a material adverse impact on our financial position and cash flows.  On September 8, 2004, we entered into a settlement agreement with the attorney General of the State of Arkansas setting forth the terms by which we resolved all civil claims and investigations commenced by the State of Arkansas prior to the entry of the agreement, including seven lawsuits then pending in the Circuit Court of Pulaski County, Arkansas alleging violations of the Arkansas Abuse of Adults Act and violation of the Arkansas Medicaid False Claims Act with respect to certain residents of our facilities in Arkansas. This agreement was subsequently amended to settle one additional case. Under the terms of the settlement, we are obligated (i) to pay $417,000 in equal monthly installments of $16,667 beginning on September 1, 2004 and ending on September 1, 2006, and (ii) to pay by no later than September 1, 2007, no less than $600,000 to install sprinkler systems in nursing centers we select within the State of Arkansas. We have incurred expenditures of approximately $391,000 through December 31, 2005 toward the requirement to install sprinkler systems.  In 2003, our insurance carriers for claims incurred in 1997 and 1998 were ordered to pay one-half respectively of a final judgment entered against us in a professional liability case tried in Mena, Arkansas in 2001. Our 1997 policy included primary coverage of up to $1 million through one carrier that has been declared insolvent. The umbrella carrier has demanded that we pay this $1 million portion of the judgment. We have denied responsibility for this liability, and the carrier has not filed any action seeking to recover this amount.  We cannot currently predict with certainty the ultimate impact of any of the above cases on our financial condition, cash flows or results of operations. An unfavorable outcome in any of the lawsuits, any regulatory action, any investigation or lawsuit alleging violations of fraud and abuse laws or of elderly abuse laws or any state or Federal False Claims Act case could have a material adverse impact on our financial condition, cash flows or results of operations and could also subject us to fines, penalties and damages. Moreover, we could be excluded from the Medicare, Medicaid or other state or federally-funded health care programs, which would also have a material adverse impact on our financial condition, cash flows or results of operations.
There were no matters submitted to a vote of security holders during the fourth quarter (October 1, 2005 through December 31, 2005) of the fiscal year covered by this Annual Report on Form 10-K.  24    Table of Contents    PART II           ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES    Our Common Stock was listed on the New York Stock Exchange under the symbol “AVC” through November 9, 1999. Since that time, our Common Stock has been traded on NASD’s OTC Bulletin Board under the symbol “AVCA.” The following table sets forth the high and low bid prices of the common stock for each quarter in 2004 and 2005:                          Period   High   Low     2004 — 1st Quarter     1.78       .22     2004 — 2nd Quarter     2.02       1.18     2004 — 3rd Quarter     4.40       1.78     2004 — 4th Quarter     5.15       3.05     2005 — 1st Quarter     5.50       4.20     2005 — 2nd Quarter     5.09       3.40     2005 — 3rd Quarter     4.90       3.80     2005 — 4th Quarter     5.77       3.76       Our Common Stock has been traded since May 10, 1994. On March 10, 2006, the closing price for our Common Stock was $7.15, as reported by PCQuote.com.  On March 10, 2006, there were approximately 301 holders of record of the Common Stock. Most of our shareholders have their holdings in the street name of their broker/dealer.  We have not paid cash dividends on our Common Stock and anticipate that, for the foreseeable future, any earnings will be retained for use in our business and no cash dividends will be paid. We are currently prohibited from issuing dividends under certain of our debt instruments.  We made no purchases of our stock during the fourth quarter of the year ended December 31, 2005.
The selected financial data of Advocat as of December 31, 2005, 2004, 2003, 2002 and 2001 and for the years ended December 31, 2005, 2004, 2003, 2002 and 2001 have been derived from our financial statements, and should be read in conjunction with the annual financial statements and related Notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations. This selected financial data for all periods shown have been reclassified to present the effects of certain divestitures as discontinued operations.  25    Table of Contents                                                      Year Ended December 31,         2005     2004     2003     2002     2001         (in thousands, except per share amounts)       Statement of Operations Data                                           REVENUES:                                           Patient revenues, net   $ 203,658     $ 191,224     $ 172,144     $ 150,232     $ 140,708     Management fees     —       —       82       —       93                                             203,658       191,224       172,226       150,232       140,801                                                                                   EXPENSES:                                           Operating     155,512       147,842       135,479       114,827       106,755     Lease     15,836       15,283       14,883       13,684       13,679     Professional liability     (3,962 )     (1,834 )     15,154       15,054       19,293     General and administrative     13,311       11,692       10,628       10,705       10,289     Depreciation     3,493       3,228       3,170       3,077       2,979     Asset impairment and other charges     —       219       177       970       307                                             184,190       176,430       179,491       158,317       153,302                                       OPERATING INCOME (LOSS)     19,468       14,794       (7,265 )     (8,085 )     (12,501 )                                     OTHER INCOME (EXPENSE):                                           Foreign currency transaction gain     161       784       —       —       —     Interest income     534       286       102       17       30     Interest expense     (3,382 )     (3,069 )     (3,091 )     (3,717 )     (4,735 )                                           (2,687 )     (1,999 )     (2,989 )     (3,700 )     (4,705 )                                                                                 INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES     16,781       12,795       (10,254 )     (11,785 )     (17,206 )   PROVISION (BENEFIT) FOR INCOME TAXES     (13,820 )     266       —       (387 )     —                                       NET INCOME (LOSS) FROM CONTINUING OPERATIONS     30,601       12,529       (10,254 )     (11,398 )     (17,206 )   LOSS FROM DISCONTINUED OPERATIONS, net of taxes     (5,299 )     (9,748 )     (967 )     (1,605 )     (4,838 )                                     NET INCOME (LOSS)   $ 25,302     $ 2,781     $ (11,221 )   $ (13,003 )   $ (22,044 )                                                                                 INCOME (LOSS) PER COMMON SHARE:                                           Basic-                                           Continuing operations and Diluted   $ 5.29     $ 2.16     $ (1.92 )   $ (2.12 )   $ (3.17 )   Discontinued operations and Diluted     (0.93 )     (1.72 )     (0.17 )     (0.30 )     (0.89 )                                     Net per common share   $ 4.36     $ 0.44     $ (2.09 )   $ (2.42 )   $ (4.06 )                                     Diluted-                                           Continuing operations and Diluted   $ 4.69     $ 1.93     $ (1.92 )   $ (2.12 )   $ (3.17 )   Discontinued operations and Diluted     (0.81 )     (1.51 )     (0.17 )     (0.30 )     (0.89 )                                     Net per common share   $ 3.88     $ 0.42     $ (2.09 )   $ (2.42 )   $ (4.06 )                                     WEIGHTED AVERAGE COMMON SHARES:                                           Basic     5,725       5,660       5,493       5,493       5,493                                       Diluted     6,498       6,437       5,493       5,493       5,493                                         26    Table of Contents                                                      December 31,         2005     2004     2003     2002     2001         (in thousands)       Balance Sheet Data                                                                                       Working capital deficit   $ (39,970 )   $ (45,489 )   $ (54,302 )   $ (58,845 )   $ (64,429 )                                               Total assets   $ 93,762     $ 72,392     $ 94,934     $ 88,871     $ 91,070                                                 Short-term borrowings and long-term debt including current portion   $ 47,547     $ 47,024     $ 52,544     $ 53,926     $ 58,615                                                 Shareholders’ deficit   $ (16,870 )   $ (41,854 )   $ (42,759 )   $ (33,828 )   $ (20,619 )
Overview  Advocat Inc. provides long-term care services to nursing center patients in eight states, primarily in the Southeast. Our centers provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care centers, we offer a variety of comprehensive rehabilitation services as well as nutritional support services.  As of December 31, 2005, our continuing operations consist of 43 nursing centers with 4,505 licensed nursing beds and 78 assisted living units. As of December 31, 2005, our continuing operations included nine owned nursing centers and 34 leased nursing centers.  Effective April 1, 2003, we entered into leases for four nursing centers in Florida that we had previously managed under management contracts. Accordingly, the results of operations of these facilities are included in our results of operations beginning April 1, 2003.  Divestitures. We have undertaken several divestitures through sale of assets and lease terminations. The divested operations have generally been poor performing properties. In November 2005, we entered into a definitive agreement to sell certain assets of eleven assisted living facilities located in North Carolina. The sale is contingent on the purchaser’s ability to obtain licenses to operate the buildings, and is expected to close in the second quarter of 2006, although no assurances can be given. We have entered into an agreement to sell our only remaining assisted living facility in North Carolina. The sale is subject to customary contingencies, including purchaser obtaining financing and completing due diligence. In February 2005, we sold two nursing centers in Texas. A lease covering three nursing centers in Texas expired in December 2004 and was not renewed. In November 2004, we sold certain assets of our medical supply business, Advocat Distribution Services. In May 2004, we sold the stock of our Canadian subsidiary, Diversicare Canada Management Services Co., Inc. (“DCMS”).  27    Table of Contents  In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” our consolidated financial statements have been reclassified to reflect these divestitures as discontinued operations.  Basis of Financial Statements. Our patient revenues consist of the fees charged for the care of patients in the nursing centers we own and lease. Our operating expenses include the costs, other than lease, depreciation and amortization expenses, incurred in the operation of the nursing centers we owned and leased. Our general and administrative expenses consist of the costs of the corporate office and regional support functions. Our depreciation and interest expenses include all such expenses across the range of our operations.  Operating Data  The following table summarizes the Advocat statements of continuing operations for the years ended December 31, 2005, 2004 and 2003, and sets forth this data as a percentage of revenues for the same years.                                                              Year Ended December 31,         (Dollars in thousands)         2005     2004     2003       Revenues:                                                   Patient revenues, net   $ 203,658       100.0 %   $ 191,224       100.0 %   $ 172,144       100.0 %   Management fees     —       —       —       —       82       —                                                   203,658       100.0       191,224       100.0       172,226       100.0                                                                                                 Expenses:                                                   Operating     155,512       76.4       147,842       77.3       135,479       78.7     Lease     15,836       7.8       15,283       8.0       14,883       8.6     Professional liability     (3,962 )     (2.0 )     (1,834 )     (0.9 )     15,154       8.8     General & administrative     13,311       6.5       11,692       6.1       10,628       6.2     Depreciation     3,493       1.7       3,228       1.7       3,170       1.8     Asset impairment and other charges     —       —       219       0.1       177       0.1                                                   184,190       90.4       176,430       92.3       179,491       104.2                                             Operating income (loss)     19,468       9.6       14,794       7.7       (7,265 )     (4.2 )                                           Other income (expense):                                                   Foreign currency transaction gain     161       0.1       784       0.4       —       —     Interest income     534       0.2       286       0.2       102       —     Interest expense     (3,382 )     (1.7 )     (3,069 )     (1.6 )     (3,091 )     (1.8 )                                                 (2,687 )     (1.4 )     (1,999 )     (1.0 )     (2,989 )     (1.8 )                                           Income (loss) from continuing operations before income taxes     16,781       8.2       12,795       6.7       (10,254 )     (6.0 )   Provision (benefit) for income taxes     (13,820 )     (6.8 )     266       0.1       —       —                                             Net income (loss) from continuing operations   $ 30,601       15.0 %   $ 12,529       6.6 %   $ (10,254 )     (6.0 )%                                             28    Table of Contents  The following table presents data about the facilities we operated as part of our continuing operations as of the dates or for the years indicated:                                      December 31,         2005     2004     2003       Licensed Nursing Home Beds:                           Owned     942       822       822     Leased     3,563       3,683       3,683                           Total     4,505       4,505       4,505                           Assisted Living Units:                           Owned     17       17       17     Leased     61       63       63                           Total     78       80       80                           Total Beds/Units:                           Owned     959       839       839     Leased     3,624       3,746       3,746                           Total     4,583       4,585       4,585                           Facilities:                           Owned     9       8       8     Leased     34       35       35                           Total     43       43       43                           Average Occupancy-                           Nursing centers     76.2 %     75.9 %     76.9 %   Assisted living facilities     64.6       69.4       76.6                           Total     76.0 %     75.8 %     76.9 %                           Critical Accounting Policies and Judgments  A “critical accounting policy” is one which is both important to the understanding of our financial condition and results of operations and requires management’s most difficult, subjective or complex judgments often of the need to make estimates about the effect of matters that are inherently uncertain. Our accounting policies that fit this definition include the following:  Revenues  Patient Revenues  The fees we charge patients in our nursing centers include fees with respect to individuals receiving benefits under federal and state-funded cost reimbursement programs. These revenues are based on approved rates for each facility that are either based on current costs with retroactive settlements or prospective rates with no cost settlement. Amounts earned under federal and state programs with respect to nursing home patients are subject to review by the third-party payors. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. Final cost settlements, if any, are recorded when objectively determinable, generally within three years of the close of a reimbursement year depending upon the timing of appeals and third-party settlement reviews or audits.  29    Table of Contents  Allowance for Doubtful Accounts  Our allowance for doubtful accounts is estimated utilizing current agings of accounts receivable, historical collections data and other factors. We monitor these factors and determine the estimated provision for doubtful accounts. Historical bad debts have generally resulted from uncollectible private balances, some uncollectible coinsurance and deductibles and other factors. Receivables that are deemed to be uncollectible are written off. The allowance for doubtful accounts balance is assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified.  Self-Insurance Reserves  Self-insurance reserves primarily represent the accrual for self insured risks associated with general and professional liability claims, employee health insurance and workers compensation. The self insurance reserves include estimates of liability for incurred but not reported claims, estimates of liability for reported but unresolved claims, actual liabilities related to settlements, including settlements to be paid over time, and estimates of legal costs incurred and expected to be incurred. Our policy with respect to a significant portion of the general and professional liability claims is to use a third-party actuary to support the estimates recorded for the development of known claims and incurred but unreported claims. Our health insurance reserve is based on known claims incurred and an estimate of incurred but unreported claims determined by an analysis of historical claims paid. Our workers compensation reserve relates to periods of self insurance prior to May 1997 and a high deductible policy issued July 1, 2002 through June 30, 2003 covering most of our employees. The reserve for workers compensation self insurance prior to May 1997 consists only of known claims incurred and the reserve is based on an estimate of the future costs to be incurred for the known claims. The reserve for the high deductible policy issued July 1, 2002 is based on known claims incurred and an estimate of incurred but not reported claims determined by an analysis of historical claims incurred. Expected insurance coverages are reflected as a reduction of the reserves.  Because we anticipate that our actual liability for existing and anticipated claims will exceed our limited professional liability insurance coverage, we have recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $34.5 million as of December 31, 2005. We do not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof.  Our self insurance reserves are assessed on a quarterly basis based on currently available information. The amounts recorded for professional and general liability claims are adjusted for revisions in estimates and differences between actual settlements and reserves as determined each period with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period.  We retain a third-party actuarial firm to estimate the appropriate accrual for incurred professional liability claims. The actuarial estimate represents the ultimate cost for all professional liability claims incurred in a period and includes estimates for both claims  30    Table of Contents  reported and claims incurred but not reported. All losses are projected on an undiscounted basis.  We provide the actuary information with regard to historical losses we incurred for professional liability claims. The actuary uses losses covering a 10 year period as the basis for estimates. Based on this historical data, the actuary develops estimates of the average cost per claim and the frequency of claims per occupied bed. The average cost per claim includes legal and other expenses incurred. These averages are used to generate the initial estimate of the ultimate professional liability cost for a given period in relation to our occupancy for that period.  The actuary evaluates claims and potential claims incurred for periods beginning March 9, 2000. Prior to that time, we had adequate insurance in place to cover claims on a claims-incurred basis without significant uninsured risk. Beginning with the March 9, 2000 policy period, insurance coverage was on a claims made basis. See “Item 1. Business — Professional Liability and Other Liability Insurance” for a description of our insurance coverage.  On a quarterly basis, as claims are reported and lawsuits filed, we obtain reports of claims we have incurred from insurers and a third party claims administrator. These reports contain information relevant to the liability actually incurred to date with that claim as well as the third-party administrator’s estimate of the anticipated total cost of the claim (this estimate is initially developed based on the third-party administrator’s initial review of the facts giving rise to the claim). This information is reviewed by us and provided to the actuary. The actuary uses this information to determine the timing of claims reporting and the development of reserves, and compares the information obtained to its original estimates of liability based on the average-frequency and cost-per-claim methodology. Based on the actual claim information obtained and on estimates regarding the number and cost of additional claims anticipated in the future, the reserve estimate for a particular period may be revised upward or downward on a quarterly basis. Thus, the accrual for older periods is determined by using currently-known information to adjust the initial reserve that was created almost exclusively by the “frequency times severity” methodology. For information regarding the amount of accrual by period, see “Item 1. Business — Reserve for Estimated Self-Insured Professional Liability Claims.”  Any estimate of our exposure for professional liability claims is inherently uncertain. Some key factors that could lead to differences between amounts estimated and the ultimate amount of any loss are addressed below. One of the key assumptions in the actuarial analysis is that historical losses provide an accurate forecast of future losses. The loss data is developed from ten years of historical data, and includes losses incurred in periods with significant insurance coverage. Our ability to pay may limit losses in periods of lower insurance or self insurance. Our ability to pay in the future is not considered in the actuarial estimates. Changes in legislation such as tort reform may affect the severity and frequency of claims incurred in future periods. Changes in risk management practices may also affect the frequency of future claims.  Another key assumption is the limit of claims to a maximum of $4.5 million. The actuary has selected this limit based on our historical data. While most of our claims have been for amounts less than the $4.5 million, there have been claims at higher amounts, and there may  31    Table of Contents  be claims above this level in the future. The facts and circumstances of each claim vary significantly, and the amount of ultimate liability for an individual claim may vary due to many factors, including whether the case can be settled by agreement, the quality of legal representation, the individual jurisdiction in which the claim is pending, and the views of the particular judge or jury deciding the case. To date, we have not experienced an uninsured loss in excess of this limit. Our policy is to review the actuary report and assumptions each quarter. In the event that we believe we have incurred a loss in excess of this limit, an adjustment to the reserves determined by the actuary would be necessary.  We believe that the use of actuarial methods described above provides a valid and reasonable method to estimate our liability for professional and general liability claims. We also believe that expertise in actuarial methodologies is required to estimate liabilities using this methodology and thus employ a third-party actuary to provide this service. Because of the difficulties discussed above, any estimate of our professional liability claims is inherently uncertain; therefore, actual professional liability costs may differ materially from the accrual, regardless of the assumptions or methodology used. Professional liability costs are material to our financial position, and differences between estimates and the ultimate amount of loss may cause a material fluctuation in our reported results of operations. The liability recorded at December 31, 2005, was $34.5 million, compared to current assets of $32.0 million and total assets of $93.8 million. For the years ended December 31, 2005, 2004 and 2003, our professional liability expense was negative $4.0 million, negative $1.8 million and positive $15.2 million, respectively, with negative amounts representing net benefits resulting from downward revisions in previous estimates and positive amounts representing net expenses. These amounts are material in relation to our reported net income (loss) from continuing operations for the related periods of $30.6 million, $12.5 million and ($10.3) million, respectively.  While each quarterly adjustment to the recorded liability for professional liability claims affects reported income, these changes do not directly affect our cash position because the accrual for these liabilities is not funded. We do not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof. In the event a significant judgment is entered against us in one or more of these legal actions in which there is no or insufficient professional liability insurance, we anticipate that payment of the judgment amounts would require cash resources that would be in excess of our available cash or other resources. Any such judgment could have a material adverse impact on our financial position and cash flows.  Asset Impairment   In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we evaluate the recoverability of the carrying values of our properties on a property by property basis. On a quarterly basis, we review our properties for recoverability when events or circumstances, including significant physical changes in the property, significant adverse changes in general economic conditions, and significant deteriorations of the underlying cash flows of the property, indicate that the carrying amount of the property may not be recoverable. The need to recognize an impairment is based on estimated future cash flows from a property compared to the carrying  32    Table of Contents  value of that property. If recognition of an impairment is necessary, it is measured as the amount by which the carrying amount of the property exceeds the fair value of the property.  Income Taxes  We follow SFAS No. 109, “Accounting for Income Taxes,” which requires an asset and liability approach for financial accounting and reporting of income taxes. Under this method, deferred tax assets and liabilities are determined based upon differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax laws that will be in effect when the differences are expected to reverse. We assess the need for a valuation allowance to reduce the deferred tax assets by the amount we believe is more likely not to be utilized through the turnaround of existing temporary differences, future earnings, or a combination thereof, including certain net operating loss carryforwards we do not expect to realize due to change in ownership limitations.  Contractual Obligations and Commercial Commitments  We have certain contractual obligations of continuing operations as of December 31, 2005, summarized by the period in which payment is due, as follows (dollar amounts in thousands):                                                              Less than   1 to 3   4 to 5   After   Contractual Obligations   Total   1 year   Years   Years   5 Years     Long-term debt   $ 18,609     $ 2,736     $ 15,873     $ —     $ —     Settlement promissory notes   $ 1,234     $ 1,106     $ 128     $ —     $ —     Short-term debt   $ 27,704     $ 27,704     $ —     $ —     $ —     Other settlement obligations   $ 613     $ 523     $ 90     $ —     $ —     Series B Preferred Stock   $ 4,750     $ —     $ 4,750     $ —     $ —     Operating leases   $ 236,085     $ 15,184     $ 31,733     $ 32,290     $ 156,878     Required capital expenditures under operating leases   $ 14,196     $ 833     $ 1,814     $ 1,481     $ 10,068     Total   $ 303,191     $ 48,086     $ 54,388     $ 33,771     $ 166,946       Due to events of default, we have classified all of our long-term debt in current liabilities.  Future cash obligations for interest expense have been excluded from the above table. In 2005, our cash payments for interest were approximately $3.0 million.  We have employment agreements with certain members of management that provide for the payment to these members of amounts up to 2.5 times their annual salary in the event of a termination without cause, a constructive discharge (as defined), or upon a change of control of the Company (as defined). The maximum contingent liability under these agreements is approximately $1.2 million. The terms of such agreements are from one to three years and automatically renew for one year if not terminated by us or the employee. In addition, upon the occurrence of any triggering event, certain executives may elect to require that we purchase options granted to them for a purchase price equal to the difference in the fair market value of our common stock at the date of termination versus the stated option exercise price.  33    Table of Contents  Asset Impairment and Other Charges  In 2005, 2004 and 2003, we recorded asset impairment and other charges as shown below.                                      2005     2004     2003       Impairment of long-lived assets   $ 4,397,000     $ 8,419,000     $ 1,703,000     Lease terminations     —       341,000       389,000                                 4,397,000       8,760,000       2,092,000     Less – amount included in discontinued operations     4,397,000       8,541,000       1,915,000                           Asset impairment and other charges included in continuing operations   $ —     $ 219,000     $ 177,000                                  In 2005, 2004 and 2003, we recorded asset impairment charges of $4,397,000, $8,419,000 and $1,703,000, respectively, for the impairment of certain long-lived assets in accordance with the provisions of SFAS 144. A detail of the impaired asset charges is as follows:                                  Description of Impairment   2005     2004     2003       Assisted Living Facilities Impairment Charges – As a result of projected cash flows, impairment charges were recorded in 2005 for eleven assisted living facilities, were recorded in 2004 for six owned assisted living facilities and were recorded in 2003 for three owned assisted living facilities.   $ 4,397,000     $ 7,500,000     $ 1,525,000                                 Nursing Center Impairment charges – As a result of projected cash flows, impairment charges were recorded in 2004 for five nursing centers, including three leased and two owned facilities, and were recorded in 2003 for one leased nursing center.     —       919,000       178,000                                                       Total impaired asset charges   $ 4,397,000     $ 8,419,000     $ 1,703,000                             We terminated facility leases for three nursing centers in 2004 and one assisted living facility in 2003. We incurred lease termination charges of approximately $341,000 and $389,000 in 2004 and 2003, respectively, consisting of the remaining net book value of these facilities, costs of completing the transactions and settlement charges.  Payor Sources.  We classify our revenues from patients and residents into three major categories: Medicaid, Medicare and private pay. In addition to traditional Medicaid revenues, we include within the Medicaid classification revenues from other programs established to provide benefits to those in need of financial assistance in the securing of medical services. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. We classify payments from individuals who pay directly for services without government assistance as private pay revenue. The private pay classification also includes revenues from commercial insurers, HMOs, and other charge-based payment sources. Veterans Administration payments are included in private pay and are made pursuant to renewable contracts negotiated with these payors.  34    Table of Contents  Medicare represented approximately 30.0%, 29.3%, and 26.5% of our net revenues during 2005, 2004, and 2003, respectively. Approximately 58.0%, 59.4%, and 61.9% of our net revenues were derived from Medicaid during 2005, 2004, and 2003, respectively. Private pay represented approximately 12.0%, 11.3% and 11.6% of our net revenues during 2005, 2004, and 2003, respectively.  Consistent with the nursing home industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare, and private pay can significantly affect the profitability of the facility’s operations.  Year Ended December 31, 2005 Compared With Year Ended December 31, 2004  As noted in the overview, we have entered into several divestiture and lease termination transactions in recent periods, and our consolidated financial statements have been reclassified to present such transactions as discontinued operations. Accordingly, the related revenue, expenses, assets, liabilities and cash flows have been reported separately, and the discussion below addresses principally the results of our continuing operations.  Revenues. Net revenues increased to $203.7 million in 2005 from $191.2 million in 2004, an increase of $12.5 million, or 6.5%. The increase in revenues is due to Medicare rate increases, increased Medicare utilization and increased Medicaid rates in certain states. As a percentage of total census, Medicare days increased to 13.0% in 2005 from 12.7% in 2004. Medicare revenues were 30.0% of patient revenue in 2005 and 29.3% in 2004, while Medicaid and similar programs were 58.0% in 2005 compared to 59.4% in 2004.  Ancillary service revenues, prior to contractual allowances, increased to $42.2 million in 2005 from $36.7 million in 2004, an increase of $5.5 million, or 14.9%. The increase is primarily attributable to increased Medicare census and higher acuity patients.  Operating expense. Operating expense increased to $155.5 million in 2005 from $147.8 million in 2004, an increase of $7.7 million, or 5.2%. As a percentage of patient and resident revenues, operating expense decreased to 76.4% in 2005 from 77.3% in 2004. The increase in operating expense is primarily attributable to cost increases related to wages and benefits, partially offset by a decrease in employee health insurance costs. The decrease in operating costs as a percent of patient and resident revenues is primarily due to the effects of increases in Medicare and Medicaid rates and increased Medicare utilization, as discussed above.  The largest component of operating expenses is wages, which increased to $92.0 million in 2005 from $86.2 million in 2004, an increase of $5.8 million, or 6.7%. This increase is primarily attributable to an increase in wages as a result of competitive labor markets in most of the areas in which we operate and increased Medicare census. This increase was partially offset by a reduction in employee health insurance costs, which were $1.4 million lower in 2005 compared to 2004. Employee health insurance costs can vary significantly from year to year, and this large decrease is not expected to continue in 2006.  Lease expense. Lease expense increased to $15.8 million in 2005 from $15.3 million in 2004. The increase in rent expense is primarily due to contingent rent expense incurred in connection with certain leases, and to increased expense in connection with a lease for one facility that was  35    Table of Contents  renewed effective April 2005. These increases were partially offset by reduced rent following the purchase of a leased facility in 2005.  Professional liability. Professional liability expense in 2005 resulted in a net benefit of $4.0 million, compared to a benefit of $1.8 million in 2004, an increase in net benefit of $2.2 million. During 2005, we reduced our total recorded liabilities for self-insured professional liability risks to $34.5 million, down from $42.9 million at December 31, 2004. Downward adjustments in the liability primarily resulting from the quarterly actuarial valuations were partially offset by the provision for current liability claims recorded during 2005, resulting in a net benefit of $4.0 million in the period. These reductions were primarily the result of the effects of settlements of certain claims for amounts less than had been reserved in prior periods and the resulting effect of these settlements on the assumptions inherent to the actuarial estimate. These self-insurance reserves are assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Professional liability costs include cash and non-cash charges recorded based on current actuarial reviews. The actuarial reviews include estimates of known claims and an estimate of claims that may have occurred, but have not yet been reported to us.  General and administrative expense. General and administrative expense increased to $13.3 million in 2005 from $11.7 million in 2004, an increase of $1.6 million or 13.8%. The increase is primarily attributable to increased compensation costs, compliance costs and travel expenses. As a percentage of total net revenues, general and administrative expense was approximately 6.5% in 2005 and 6.1% and 2004.  Asset impairment and other charges. During 2005 and 2004, we recorded impairment charges in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and certain other charges as follows:                              2005     2004       Impairment of long-lived assets   $ 4,397,000     $ 8,419,000     Assisted living lease terminations     —       341,000                           4,397,000       8,760,000     Less–amount included in discontinued operations     4,397,000       8,541,000                     Asset impairment and other charges included in continuing operations   $ —     $ 219,000                       During 2005, an impairment charge of $4.4 million was recorded for eleven assisted living facilities to reduce the net book value of these properties to their estimated net realizable value. These properties are expected to be sold in the second quarter of 2006. As a result of projected cash flows, impairment charges of $8.4 million were recorded in 2004 for five nursing centers, including three leased facilities and two owned facilities, and for six owned assisted living facilities.  During 2004, we terminated leases covering three nursing centers, and settled a dispute related to an assisted living facility lease termination from 2002. We incurred lease termination charges of approximately $341,000 in 2004, consisting of the remaining net book value of the related  36    Table of Contents  facilities, costs of completing the transactions and settlement charges. These lease termination charges are included in the results of discontinued operations.  Depreciation. Depreciation expense increased to $3.5 million in 2005 from $3.2 million in 2004, an increase of $0.3 million or 8.2%. The increase was primarily due to capital expenditures made during the periods.  Foreign currency transaction gain. A foreign currency transaction gain of $161,000 was recorded in 2005, compared to a gain of $784,000 in 2004. These gains result from foreign currency translation of a note receivable from the sale of our Canadian operations.  Interest income. Interest income increased to $534,000 in 2005 from $286,000 in 2004, an increase of $248,000. The majority of this interest income is non-cash interest income related to amortization of discount on a note receivable recorded in connection with the May 2004 sale of our Canadian subsidiary.  Interest expense. Interest expense increased to $3.4 million in 2005 from $3.1 million in 2004, an increase of $0.3 million or 10.2%. Interest expense increased as a result of new notes issued in connection with the acquisition of a facility and the settlement of certain professional liability claims and other disputes, and interest rate increases on our variable rate debt. These increases were offset by reduction in interest as a result of the payment of debt.  Income from continuing operations before income taxes; income from continuing operations per common share. As a result of the above, continuing operations reported income before income taxes of $16.8 million in 2005 compared to income before income taxes of $12.8 million in 2004. The benefit for income taxes was $13.8 million in 2005, compared to a provision for income taxes of $0.3 million in 2004. Our effective tax rate differs materially from the statutory rate mainly due to changes in our valuation allowance for net deferred tax assets. During 2005, we reduced the valuation allowance and recorded a deferred tax benefit of $13.9 million based on our belief that it is more likely than not that some of our deferred tax assets will be realized due to the Company’s achieved earnings trend and outlook. We have provided a valuation allowance where the turnaround of existing temporary differences will more likely result in additional net operating loss carry forward credits, for existing net operating loss carry forward credits, and for existing temporary differences the turnaround of which are not likely. In future periods, we will continue to assess the need for and adequacy of the remaining valuation allowance of $17.6 million. Any such change may be material in the period in which the change is recorded. The basic and diluted income per share from continuing operations were $5.29 and $4.69, respectively, in 2005, as compared to a basic and diluted income per share from continuing operations of $2.16 and $1.93, respectively, in 2004.  Income from discontinued operations. As discussed in the overview at the start of Management’s Discussion and Analysis of Financial Condition and Results of Operations, we have completed several divestitures, and have reclassified our consolidated financial statements to present these divestitures as discontinued operations for all periods presented. Loss from discontinued operations, net of taxes, was approximately $5.7 million in 2005 compared to a loss of $10.0 million in 2004. The reduction in the loss is due primarily to a reduction in the amount of impairment charges recorded related to our assisted living operations and the sale of nursing centers in Texas in 2004 and 2005. In addition, gains from the disposition of discontinued operations of $0.4 million and $0.3 million, net of related taxes, were recorded in 2005 and 2004, respectively.  37    Table of Contents  Year Ended December 31, 2004 Compared With Year Ended December 31, 2003  As noted in the overview, during 2003 we entered into a lease for four Florida nursing centers. As also noted in the overview, we have entered into several divestiture and lease termination transactions in recent periods, and our consolidated financial statements have been reclassified to present such transactions as discontinued operations. Accordingly, the related revenue, expenses, assets, liabilities and cash flows have been reported separately, and the discussion below addresses principally the results of our continuing operations.  Revenues. Net revenues increased to $191.2 million in 2004 from $172.2 million in 2003, an increase of $19.0 million, or 11.0%. The increase in revenues is due to the new lease for four Florida nursing centers, increased Medicare utilization, Medicare rate increases and increased Medicaid rates in certain states, partially offset by a 1.4% decline in census in 2004 as compared to 2003. As a percentage of total census, Medicare days increased to 12.7% in 2004 from 11.5% in 2003. Medicare revenues were 29.3% of patient revenue in 2004 and 26.5% in 2003, while Medicaid and similar programs were 59.4% in 2004 compared to 61.9% in 2003.  Ancillary service revenues, prior to contractual allowances, increased to $36.7 million in 2004 from $32.0 million in 2003, an increase of $4.7 million, or 14.7%. The increase is primarily attributable to increased Medicare census with higher acuity patients and the new lease for four Florida nursing centers. Certain per person annual Medicare reimbursement limits on therapy services were implemented for approximately three months in late 2003, but were subsequently suspended.  Operating expense. Operating expense increased to $147.8 million in 2004 from $135.5 million in 2003, an increase of $12.3 million, or 9.1%. As a percentage of patient and resident revenues, operating expense decreased to 77.3% in 2004 from 78.7% in 2003. The increase in operating expenses is primarily attributable to cost increases related to wages and benefits and the operating costs of the four new leased Florida nursing centers. The decrease in operating expense as a percent of patient and resident revenues is primarily due to the effects of increases in Medicare and Medicaid rates and increased Medicare utilization, as discussed above.  The largest component of operating expenses is wages, which increased to $86.2 million in 2004 from $76.7 million in 2003, an increase of $9.5 million, or 12.4%. This increase is primarily attributable to costs of the four new leased Florida nursing centers, an increase in wages as a result of competitive labor markets in most of the areas in which we operate and increased Medicare census. Partially offsetting this increase, we experienced a decrease in wages as a result of reduced costs associated with reduced Medicaid census.  Lease expense. Lease expense increased to $15.3 million in 2004 from $14.9 million in 2003, an increase of $0.4 million, or 2.7%. The increase in lease expense is primarily attributable to the additional rent for the new Florida leased facilities.  Professional liability. Professional liability expense in 2004 resulted in a net benefit of $1.8 million, compared to an expense of $15.2 million in 2003, a decrease in expense of $17.0 million. During 2004, we reduced our total recorded liabilities for self-insured professional liability risks associated with the settlement of certain professional liability claims to $42.9 million, down from $47.2 million at December 31, 2003. Downward adjustments in the liability  38    Table of Contents  primarily resulting from the quarterly actuarial valuations were partially offset by the provision for current liability claims recorded during 2004, resulting in a net benefit of $1.8 million in 2004. These reductions were primarily the result of the effects of settlements of certain claims for amounts less than previously estimated. These self-insurance reserves are assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Professional liability costs include cash and non-cash charges recorded based on current actuarial reviews. The actuarial reviews include estimates of known claims and an estimate of claims that may have occurred, but have not yet been reported to us.  General and administrative expense. General and administrative expense increased to $11.7 million in 2004 from $10.6 million in 2003, an increase of $1.1 million, or 10.0%. The increase is primarily due to increased compensation costs. As a percentage of total revenue, general and administrative expense decreased to 6.1% in 2004 from 6.2% in 2003.  Asset impairment and other charges. During 2005 and 2004, we recorded impairment charges in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and certain other charges as follows:                              2004     2003       Impairment of long-lived assets   $ 8,419,000     $ 1,703,000     Assisted living lease terminations     341,000       389,000                           8,760,000       2,092,000     Less–amount included in discontinued Operations     8,541,000       1,915,000                     Asset impairment and other charges included in continuing operations   $ 219,000     $ 177,000                       As a result of projected cash flows, impairment charges of $8.4 million were recorded in 2004 for five nursing centers, including three leased facilities and two owned facilities, and for six owned assisted living facilities. During 2003, we recorded impairment charges of $1.7 million for one leased nursing center and three owned assisted living facilities.  We terminated leases covering three nursing centers in 2004 and one assisted living facility in 2003. In addition, during 2004, we settled a dispute related to an assisted living facility lease termination from 2002. We incurred lease termination charges of approximately $341,000 in 2004 and $389,000 in 2003, consisting of the remaining net book value of the related facilities, costs of completing the transactions and settlement charges. These lease termination charges are included in the results of discontinued operations.  Depreciation. Depreciation expense was approximately $3.2 million in 2004 and 2003.  Foreign currency transaction gain. A foreign currency transaction gain of $784,000 in 2004 was the result of foreign currency translation of a note receivable from the sale of our Canadian operations.  Interest income. Interest income increased to $286,000 in 2004 from $102,000 in 2003, an increase of $184,000. The increase in interest income is primarily due to non-cash interest  39    Table of Contents  income related to a note receivable recorded in connection with the sale of our Canadian operations.  Interest expense. Interest expense was approximately $3.1 million in 2004 and 2003. Interest expense increased as a result of promissory notes issued in connection with the settlement of certain professional liability claims and other disputes, and interest rate increases on our variable rate debt. These increases were offset by reduction in interest as a result of the payment of debt with proceeds from the sale of our Canadian operations.  Income (loss) from continuing operations before income taxes; income (loss) from continuing operations per common share. As a result of the above, continuing operations reported income before income taxes of $12.8 million in 2004 compared to a loss before income taxes of $10.3 million in 2003. The provision for income taxes was $0.3 million in 2004, while no income tax provision was required in 2003. Our effective tax rate differs materially from the statutory rate mainly due to changes in our valuation allowance for net deferred tax assets. The basic and diluted income per share from continuing operations were $2.16 and $1.93, respectively, in 2004, as compared to a basic and diluted loss per share from continuing operations of $1.92 each in 2003.  Income (loss) from discontinued operations. As discussed in the overview at the start of Management’s Discussion and Analysis of Financial Condition and Results of Operations, we have completed several divestitures, and have reclassified our consolidated financial statements to present these divestitures as discontinued operations for all periods presented. Loss from discontinued operations, net of taxes, was approximately $10.0 million in 2004 compared to $1.0 million in 2003. The increase in the loss from discontinued operations in 2004 is primarily due to impairment charges recorded in 2004 related to the assisted living operations, and the sale of the Canadian operations in May 2004. In addition, gains from the disposition of discontinued operations of $0.3 million, net of related taxes, were recorded in 2004.  Liquidity and Capital Resources  As of December 31, 2005, we had $31.5 million of scheduled debt maturities in 2006 that must be repaid or refinanced during the next twelve months. In addition, as of December 31, 2005 we were not in compliance with certain financial covenants and we have not obtained waivers of the non-compliance. As a result, we have classified $47.4 million of debt as current liabilities as of December 31, 2005. However, we are actively working with our lenders to address these issues.  On March 17, 2006, we entered into a two year renewal of our term notes and working capital line of credit agreements with our primary bank lender. In addition, the lender agreed to amend certain covenants of the notes to bring us into compliance with such covenants. We expect that our term notes with this lender will be repaid in full during the course of the two year term of this agreement.  We have entered into an agreement to sell 11 of our assisted living facilities in North Carolina for approximately $11.0 million. We expect to close this transaction in the second quarter of 2006, although no assurances can be given. We have entered into an agreement to sell the remaining assisted living facility in North Carolina. The sale is subject to customary contingencies, including the purchaser obtaining financing and completing due diligence.  40    Table of Contents  These facilities and three nursing centers are collateral for mortgage debt with a commercial finance company that totals approximately $27.7 million as of December 31, 2005. These mortgages mature on April 1, 2006. We have entered into a 60 day extension for $17.7 million in mortgage loans that are secured by the assisted living facilities. We are engaged in negotiations with the lender, and anticipate that once the sale of the facilities is completed, we will be able to refinance the remaining debt with the lender for a longer term. We have also entered into a 90 day extension of $10.0 million in mortgage loans that are secured by the three nursing centers with this lender, and are engaged in discussions with the lender to refinance those loans for a longer term. No agreement has been reached, and no assurances can be made that these efforts will be successful.  Certain of our debt agreements contain various financial covenants, the most restrictive of which relate to cash flow, debt service coverage ratios, and limits on the payment of dividends to shareholders. As of December 31, 2005, we were not in compliance with certain of the financial covenants contained in our debt and lease agreements. We have not obtained waivers of the non-compliance. Cross-default or material adverse change provisions contained in the debt agreements allow the holders of debt totaling approximately $46.3 million to demand immediate repayment. We would not be able to repay this indebtedness if the applicable lenders demanded repayment.  The existing events of default under our debt agreements could lead to actions by the lenders that could result in an event of default under our lease agreements covering a majority of our nursing facilities. Should such a default occur in the related lease agreements, the lessor would have the right to terminate the lease agreements and assume operating rights with respect to the leased properties. The net book value of property and equipment, including leasehold improvements, related to these facilities total approximately $4.2 million as of December 31, 2005. A default in these lease agreements would also give the holder of the Series B Redeemable Convertible Preferred Stock the right to require us to redeem those shares.  We have numerous pending liability claims, disputes and legal actions for professional liability and other related issues. We have limited, and sometimes no, professional liability insurance with respect to many of these claims. As of December 31, 2005, we have recorded total liabilities for reported and settled professional liability claims and estimates for incurred but unreported claims of $34.5 million. We do not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof. In the event a significant judgment is entered against us in one or more of these legal actions in which there is no or insufficient professional liability insurance, we do not anticipate that we will have the ability to pay such a judgment or judgments. As of December 31, 2005, future committed settlements total $1.6 million over the next twelve months, and $1.9 million in total. Certain of these commitments have been evidenced by promissory notes which have been included with debt in the accompanying balance sheet. Settlements of currently pending claims will require additional cash expenditures. These payments made or due in connection with settlement of disputed claims could have a material adverse impact on our ability to meet our obligations as they become due.  As of December 31, 2005, and for the year then ended, we had no borrowings under our working capital line of credit. The maximum outstanding balance of the working capital line of credit is $2.3 million. There are certain limitations based on borrowing base restrictions. The working  41    Table of Contents  capital line of credit matures in January 2008 with interest at either LIBOR plus 2.5% or the bank’s prime rate plus 0.50% (up to a maximum of 9.5%).  As a result of the factors discussed above, at December 31, 2005, we had negative working capital of $40.0 million and a current ratio of 0.44, compared with negative working capital of $45.5 million and a current ratio of 0.36 at December 31, 2004.  The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset carrying amounts or the amounts of liabilities that might result should we be unable to continue as a going concern. The report of the independent registered public accounting firm on our financial statements at December 31, 2005, 2004 and 2003 includes a paragraph with regards to the uncertainty of our ability to continue as a going concern.  Net cash provided by operating activities of continuing operations totaled $9.6 million, $5.6 million and $1.5 million in 2005, 2004 and 2003, respectively. These amounts primarily represent the cash flows from net operations plus changes in non-cash components of operations and by working capital changes. Discontinued operations used $0.6 million of cash in 2005, and provided cash of $2.0 million and $4.1 million in 2004 and 2003, respectively.  Investing activities of continuing operations used $8.3 million and $2.2 million of cash in 2005 and 2003, respectively, and provided $2.8 million of cash in 2004. These amounts primarily represent purchases of property, plant and equipment, the purchase of a facility in 2005 and proceeds from the sale of our Canadian operations in 2004. We have used between $2.1 million and $3.4 million for capital expenditures of continuing operations in the three calendar years ending December 31, 2005. Such expenditures were primarily for facility improvements and equipment, which were financed principally through working capital. For the year ending December 31, 2006, we anticipate that capital expenditures for improvements and equipment for our existing facility operations will require approximately $2.9 million of cash. Investing activities of discontinued operations used cash of $0.8 million, $1.3 million and $0.9 million in 2005, 2004 and 2003, respectively.  Financing activities of continuing operations provided $1.4 million of cash in 2005, and used $8.0 million and $1.4 million of cash in 2004 and 2003, respectively. In 2005, proceeds of debt issuance provided cash of $11.7 million. These funds were used to acquire a facility and retire existing debt. Proceeds from the sale of our Canadian operations in 2004 were used to repay debt. Financing activities of discontinued operations used no cash in 2005 and used cash of $44,000 and $158,000 in 2004 and 2003, respectively.  Receivables  Our operations could be adversely affected if we experience significant delays in reimbursement of our labor and other costs from Medicare, Medicaid and other third-party revenue sources. Our future liquidity will continue to be dependent upon the relative amounts of current assets (principally cash, accounts receivable and inventories) and current liabilities (principally accounts payable and accrued expenses). In that regard, accounts receivable can have a significant impact on our liquidity. Continued efforts by governmental and third-party payors to  42    Table of Contents  contain or reduce the acceleration of costs by monitoring reimbursement rates, by increasing medical review of bills for services, or by negotiating reduced contract rates, as well as any delay by us in the processing of our invoices, could adversely affect our liquidity and results of operations.  Accounts receivable of continuing operations attributable to the provision of patient and resident services at December 31, 2005 and 2004 totaled $18.9 million and $17.6 million, respectively, representing approximately 32 and 30 days in accounts receivable at each year end, respectively. The allowance for bad debt was $1.7 million at both December 31, 2005 and 2004.  We continually evaluate the adequacy of our bad debt reserves based on patient mix trends, aging of older balances, payment terms and delays with regard to third-party payors, collateral and deposit resources, as well as other factors. We continue to evaluate and implement additional procedures to strengthen our collection efforts and reduce the incidence of uncollectible accounts.  Inflation  We do not believe that our operations have been materially affected by inflation. We expect salary and wage increases for our skilled staff to continue to be higher than average salary and wage increases, as is common in the health care industry.  Recent Accounting Pronouncements  In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets — An Amendment of APB Opinion No. 29. This Statement amends APB Opinion No. 29, Accounting for Non-monetary Transactions. The amendments made by SFAS No. 153 are based on the principle that exchanges of non-monetary assets should be measured based on the fair value of the assets exchanged. The provisions of SFAS 153 are effective for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We adopted SFAS 153 beginning July 1, 2005. The future effect of SFAS 153 on our financial statements will depend on whether we enter into certain non-monetary transactions. We, however, do not expect the adoption of this Statement to have a significant impact on our financial position or results of operations.  In December 2004, the FASB issued SFAS No. 123 (Revised 2004), Share-Based Payment. SFAS 123R requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. We will be required to apply this Statement beginning January 1, 2006. The scope of SFAS 123R includes a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. We plan to adopt SFAS No. 123R using the modified prospective method, in which compensation cost is recognized beginning with the effective date (a) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date. We have no unvested awards granted to employees on the effective date. However, we have adopted a new stock option plan  43    Table of Contents  and have granted options subject to shareholder approval. If this plan is approved, we will record expense for awards under this plan in accordance with the provisions of SFAS No. 123R.  In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections. This new standard replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. Among other changes, SFAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. Statement 154 also provides that (1) a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a “restatement.” The new standard is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005. Thus, the statement becomes effective for us for accounting changes and error corrections made on or after January 1, 2006. Early adoption of this standard is permitted for accounting changes and error corrections made in fiscal years beginning after June 1, 2005. We do not expect the adoption of Statement 154 to have a significant impact on our financial position or results of operations.  Forward-Looking Statements  The foregoing discussion and analysis provides information deemed by Management to be relevant to an assessment and understanding of our consolidated results of operations and financial condition. This discussion and analysis should be read in conjunction with our consolidated financial statements included herein. Certain statements made by or on behalf of us, including those contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere, are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements involve risks and uncertainties including, but not limited to, uncertainty regarding our ability to complete all of the described transactions and restructure the remaining debt, changes in governmental reimbursement, government regulation and health care reforms, the increased cost of borrowing under our credit agreements, covenant waivers from our lenders, possible amendments to our credit agreements, ability to control ultimate professional liability costs, the accuracy of our estimate of our anticipated professional liability expense, the impact of future licensing surveys, the outcome of regulatory proceedings alleging violations of laws and regulations governing quality of care or violations of other laws and regulations applicable to our business, changing economic conditions as well as others. Investors also should refer to the risks identified in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as risks identified in “Part 1. Item 1A. Risk Factors” for a discussion of various risk factors of the Company and that are inherent in the health care industry. Given these risks and uncertainties, we can give no assurances that these forward-looking statements will, in fact, transpire and, therefore, cautions investors not to place undue reliance on them. Actual results may differ materially from those described in such forward-looking statements. Such cautionary statements identify important factors that could cause our actual results to materially differ from those projected in forward-looking statements. In addition, we disclaim any intent or obligation to update these forward-looking statements.  44    Table of Contents
The chief market risk factor affecting our financial condition and operating results is interest rate risk. As of December 31, 2005, we had outstanding borrowings of approximately $47.5 million, including $2.9 million in fixed-rate borrowings and $44.6 million in variable-rate borrowings. In the event that interest rates were to change 1%, the impact on future cash flows would be approximately $446,000 annually, representing the impact of increased interest expense on variable rate debt.  We have a note receivable denominated in Canadian dollars related to the sale of our Canadian operations. This note is currently recorded on our balance sheet at $5.7 million US based on the outstanding balance of the note and the exchange rate as of December 31, 2005. The carrying value of the note in our financial statements will be increased or decreased each period based on fluctuations in the exchange rate between US and Canadian currencies, and the effect of such changes will be included as income or loss in our statement of operations in the period of change. In 2005 and 2004, we reported transaction gains of $161,000 and $784,000, respectively, as a result of the effect of changes in the currency exchange rates on this note. A further change of 1% in the exchange rate between US and Canadian currencies would result in a corresponding increase or decrease to earnings of approximately $57,000.
Audited financial statements are contained on pages F-1 through F-36 of this Annual Report on Form 10-K and are incorporated herein by reference. Audited supplemental schedule data is contained on pages S-1 and S-2 of this Annual Report on Form 10-K and is incorporated herein by reference.
None.
Advocat, with the participation of our principal executive and financial officers has evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of December 31, 2005. Based on this evaluation, the principal executive and financial officers have determined that such disclosure controls and procedures are effective to ensure that information required to be disclosed in our filings under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.  There has been no change (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal control over financial reporting that has occurred during our  45    Table of Contents  fiscal quarter ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect our internal control over financial reporting.
None.  46    Table of Contents    PART III
Information concerning our Directors and Executive Officers is incorporated herein by reference to our definitive proxy materials for our 2006 Annual Meeting of Shareholders.
Information concerning Executive Compensation is incorporated herein by reference to our definitive proxy materials for our 2006 Annual Meeting of Shareholders.    ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS  Information concerning Security Ownership of Certain Beneficial Owners and Management is incorporated herein by reference to our definitive proxy materials for our 2006 Annual Meeting of Shareholders.
Information concerning Certain Relationships and Related Transactions is incorporated herein by reference to our definitive proxy materials for our 2006 Annual Meeting of Shareholders.
Information concerning the fees and services provided by our principal accountant is incorporated herein by reference to our definitive proxy materials for our 2006 Annual Meeting of Shareholders.  47    Table of Contents    PART IV
The Financial statements and schedules for us and our subsidiaries required to be included in Part II, Item 8 are listed below.                      Form 10-K         Pages       Financial Statements           Report of Independent Registered Public Accounting Firm     F-1                 Consolidated Balance Sheets as of December 31, 2005 and 2004     F-2                 Consolidated Statements of Operations for the Years Ended December 31, 2005, 2004 and 2003     F-3                 Consolidated Statements of Shareholders’ Deficit for the Years Ended December 31, 2005, 2004 and 2003     F-4                 Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2005, 2004 and 2003     F-5                 Consolidated Statements of Cash Flows for the Years Ended December 31, 2005, 2004 and 2003     F-6                 Notes to Consolidated Financial Statements as of December 31, 2005, 2004 and 2003   F-8 to F-36               Financial Statement Schedules           Schedule II – Valuation and Qualifying Accounts   S-1 to S-2     Exhibits  The exhibits filed as part of this Report on Form 10-K are listed in the Exhibit Index immediately following the financial statement pages.  48    Table of Contents    SIGNATURES  Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.  ADVOCAT INC.  /s/Wallace E. Olson                                         Wallace E. Olson Chairman of the Board March 29, 2006       /s/William R. Council, III                                         William R. Council, III President and Chief Executive Officer (Principal Executive Officer) March 29, 2006       /s/L. Glynn Riddle, Jr.                                         L. Glynn Riddle, Jr. Vice President, Chief Financial Officer, Secretary (Principal Financial and Accounting Officer) March 29, 2006   Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.                /s/Wallace E. Olson    /s/William C. O’Neil            Wallace E. Olson    William C. O’Neil   Chairman of the Board    Director   March 29, 2006    March 29, 2006           /s/William R. Council, III    /s/Richard M. Brame            William R. Council, III    Richard M. Brame   President and Chief Executive Officer    Director   Director    March 29, 2006   March 29, 2006               /s/Robert Z. Hensley               Robert Z. Hensley       Director       March 29, 2006         49    Table of Contents  ADVOCAT INC. AND SUBSIDIARIES  Consolidated Financial Statements For the Years Ended December 31, 2005, 2004 and 2003 Together with Report of Independent Registered Public Accounting Firm        Table of Contents  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS                Report of Independent Registered Public Accounting Firm    F-1           Consolidated Balance Sheets    F-2           Consolidated Statements of Operations    F-3           Consolidated Statements of Shareholders’ Deficit    F-4           Consolidated Statements of Comprehensive Income (Loss)    F-5           Consolidated Statements of Cash Flows    F-6           Notes to Consolidated Financial Statements    F-8           Schedule II – Valuation and Qualifying Accounts    S-1          Table of Contents  REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM  To the Board of Directors and Shareholders Advocat Inc. Brentwood, Tennessee:   We have audited the accompanying consolidated balance sheets of Advocat Inc. as of December 31, 2005 and 2004 and the related consolidated statements of operations, comprehensive income (loss), shareholders’ deficit and cash flows for each of the three years in the period ended December 31, 2005. We have also audited the financial statement schedules listed in the accompanying index. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.  We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedules are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits include consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement and schedule presentation. We believe that our audits provide a reasonable basis for our opinion.  In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Advocat Inc. as of December 31, 2005 and 2004 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.  Also, in our opinion, the financial statement schedules present fairly, in all material respects, the information set forth therein.  The accompanying consolidated financial statements and schedules have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2, the Company is not in compliance with certain debt covenants that allow the holders to demand immediate repayment and has limited resources, including working capital, available to fund the reserve recorded for retained professional liability risk and to meet its debt service requirements during 2006. These matters raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 2. The consolidated financial statements and schedules do not include any adjustments that might result from the outcome of this uncertainty.  As explained in Note 2 to the financial statements, the Company has retroactively presented the operating, investing and financing portions of the cash flows attributable to its discontinued operations, which in prior periods were reported on a combined basis as a single amount.  /s/BDO Seidman, LLP   Memphis, Tennessee March 28, 2006   F - 1    Table of Contents  ADVOCAT INC. AND SUBSIDIARIES  CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2005 AND 2004                          ASSETS   2005     2004       CURRENT ASSETS:                   Cash and cash equivalents   $ 7,070,000     $ 5,829,000     Restricted cash     625,000       773,000     Receivables, less allowance for doubtful accounts of $1,722,000 and $1,712,000, respectively     18,147,000       16,073,000     Current portion of note receivable     497,000       481,000     Prepaid expenses and other current assets     4,681,000       2,808,000     Deferred income taxes     1,004,000       —     Discontinued operations     2,000       36,000                     Total current assets     32,026,000       26,000,000                                         PROPERTY AND EQUIPMENT, at cost     57,052,000       47,433,000     Less accumulated depreciation     (30,327,000 )     (27,378,000 )   Discontinued operations, net     12,696,000       16,780,000                     Property and equipment, net     39,421,000       36,835,000                                         OTHER ASSETS:                   Deferred income taxes     12,856,000       —     Note receivable, net of current portion     5,198,000       5,214,000     Deferred financing and other costs, net     362,000       78,000     Deferred lease costs, net     165,000       1,174,000     Other assets     3,734,000       3,091,000                     Total other assets     22,315,000       9,557,000                         $ 93,762,000     $ 72,392,000                                               LIABILITIES AND SHAREHOLDERS’ DEFICIT   2005     2004       CURRENT LIABILITIES:                   Current portion of long-term debt   $ 18,609,000     $ 8,741,000     Current portion of settlement promissory notes     1,106,000       1,374,000     Short-term debt     27,704,000       35,838,000     Trade accounts payable     4,415,000       4,905,000     Accrued expenses:                   Payroll and employee benefits     8,495,000       6,826,000     Interest     1,024,000       790,000     Current portion of self-insurance reserves     5,952,000       10,002,000     Other current liabilities     4,691,000       3,013,000                     Total current liabilities     71,996,000       71,489,000                                         NONCURRENT LIABILITIES:                   Settlement promissory notes, less current portion     128,000       1,071,000     Self-insurance reserves, less current portion     29,041,000       32,695,000     Other noncurrent liabilities     4,717,000       4,559,000                     Total noncurrent liabilities     33,886,000       38,325,000                     COMMITMENTS AND CONTINGENCIES                                       SERIES B REDEEMABLE CONVERTIBLE PREFERRED STOCK, authorized 600,000 shares, $.10 par value, 393,658 shares issued and outstanding, at redemption value     4,750,000       4,432,000                         SHAREHOLDERS’ DEFICIT:                   Series A preferred stock, authorized 400,000 shares, $.10 par value, none issued and outstanding             —     Common stock, authorized 20,000,000 shares, $.01 par value, 5,725,000 and 5,493,000 shares issued and outstanding, respectively     57,000       57,000     Paid-in capital     16,022,000       16,022,000     Accumulated deficit     (32,949,000 )     (57,933,000 )                   Total shareholders’ deficit     (16,870,000 )     (41,854,000 )                       $ 93,762,000     $ 72,392,000                       The accompanying notes are an integral part of these consolidated financial statements.  F - 2    Table of Contents  ADVOCAT INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS                                      Year Ended December 31,         2005     2004     2003       REVENUES:                           Patient revenues, net   $ 203,658,000     $ 191,224,000     $ 172,144,000     Management fees     —       —       82,000                                 203,658,000       191,224,000       172,226,000                                                       EXPENSES:                           Operating     155,512,000       147,842,000       135,479,000     Lease     15,836,000       15,283,000       14,883,000     Professional liability     (3,962,000 )     (1,834,000 )     15,154,000     General and administrative     13,311,000       11,692,000       10,628,000     Depreciation     3,493,000       3,228,000       3,170,000     Asset impairment and other charges     —       219,000       177,000                                 184,190,000       176,430,000       179,491,000                           OPERATING INCOME (LOSS)     19,468,000       14,794,000       (7,265,000 )                         OTHER INCOME (EXPENSE):                           Foreign currency transaction gain     161,000       784,000       —     Interest income     534,000       286,000       102,000     Interest expense     (3,382,000 )     (3,069,000 )     (3,091,000 )                               (2,687,000 )     (1,999,000 )     (2,989,000 )                         INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES     16,781,000       12,795,000       (10,254,000 )   PROVISION (BENEFIT) FOR INCOME TAXES     (13,820,000 )     266,000       —                           NET INCOME (LOSS) FROM CONTINUING OPERATIONS     30,601,000       12,529,000       (10,254,000 )                         INCOME (LOSS) FROM DISCONTINUED OPERATIONS:                           Operating loss, net of tax provision of $359,000, $88,000 and $691,000, respectively     (5,698,000 )     (10,038,000 )     (967,000 )   Gain on sale, net of tax provision of $ 0, $436,000 and $0, respectively     399,000       290,000       —                           NET LOSS FROM DISCONTINUED OPERATIONS     (5,299,000 )     (9,748,000 )     (967,000 )                         NET INCOME (LOSS)     25,302,000       2,781,000       (11,221,000 )   PREFERRED STOCK DIVIDENDS, ACCRUED BUT NOT PAID      318,000       297,000       277,000                           NET INCOME (LOSS) FOR COMMON STOCK   $ 24,984,000     $ 2,484,000     $ (11,498,000 )                         NET INCOME (LOSS) PER COMMON SHARE:                           Per common share – basic                           Income (loss) from continuing operations   $ 5.29     $ 2.16     $ (1.92 )   Loss from discontinued operations     (0.93 )     (1.72 )     (0.17 )                             $ 4.36     $ 0.44     $ (2.09 )                         Per common share – diluted                           Income (loss) from continuing operations   $ 4.69     $ 1.93     $ (1.92 )   Loss from discontinued operations     (0.81 )     (1.51 )     (0.17 )                             $ 3.88     $ 0.42     $ (2.09 )                         WEIGHTED AVERAGE COMMON SHARES:                           Basic     5,725,000       5,660,000       5,493,000                           Diluted     6,498,000       6,437,000       5,493,000                             The accompanying notes are an integral part of these consolidated financial statements.  F - 3    Table of Contents  ADVOCAT INC. AND SUBSIDIARIES  CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ DEFICIT                                                                                              Cumulative               Common Stock     Paid-in     Accumulated     Translation               Shares     Amount     Capital     Deficit     Adjustment     Total       BALANCE, December 31, 2002     5,493,000     $ 55,000     $ 15,908,000     $ (48,919,000 )   $ (872,000 )   $ (33,828,000 )                                                       Net loss     —       —       —       (11,221,000 )     —       (11,221,000 )   Preferred stock dividends     —       —       —       (277,000 )     —       (277,000 )   Translation loss, net of tax     —       —       —       —       2,567,000       2,567,000                                                                                                 BALANCE, DECEMBER 31, 2003     5,493,000       55,000       15,908,000       (60,417,000 )     1,695,000       (42,759,000 )                                                       Exercise of stock options     232,000       2,000       114,000       —       —       116,000     Net income     —       —       —       2,781,000       —       2,781,000     Preferred stock dividends     —       —       —       (297,000 )     —       (297,000 )   Translation loss, net of tax     —       —       —       —       (1,695,000 )     (1,695,000 )                                                                                               BALANCE, DECEMBER 31, 2004     5,725,000       57,000       16,022,000       (57,933,000 )     —       (41,854,000 )                                                       Net income     —       —       —       25,302,000       —       25,302,000     Preferred stock dividends                             (318,000 )             (318,000 )                                                                                               BALANCE, DECEMBER 31, 2005     5,725,000     $ 57,000     $ 16,022,000     $ (32,949,000 )   $ —     $ (16,870,000 )                                             The accompanying notes are an integral part of these consolidated financial statements.  F - 4    Table of Contents  ADVOCAT INC. AND SUBSIDIARIES  CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)                                      Year Ended December 31,         2005     2004     2003       NET INCOME (LOSS) FOR COMMON STOCK   $ 24,984,000     $ 2,484,000     $ (11,498,000 )                               OTHER COMPREHENSIVE INCOME (LOSS):                           Foreign currency translation adjustments     —       (2,685,000 )     3,889,000     Related income tax benefit (provision)     —       990,000       (1,322,000 )                               —       (1,695,000 )     2,567,000                                                       COMPREHENSIVE INCOME (LOSS)   $ 24,984,000     $ 789,000     $ (8,931,000 )                           The accompanying notes are an integral part of these consolidated financial statements.  F - 5    Table of Contents  ADVOCAT INC. AND SUBSIDIARIES  CONSOLIDATED STATEMENTS OF CASH FLOWS                                      Year Ended December 31,         2005     2004     2003                   Revised – See Note 2   Revised – See Note 2   OPERATING ACTIVITIES:                           Net income (loss)   $ 25,302,000     $ 2,781,000     $ (11,221,000 )   Loss from discontinued operations     (5,299,000 )     (9,748,000 )     (967,000 )                         Net income (loss) from continuing operations     30,601,000       12,529,000       (10,254,000 )   Adjustments to reconcile net income (loss) from continuing operations to net cash provided by continuing operations:                           Depreciation     3,493,000       3,228,000       3,170,000     Provision for doubtful accounts     1,560,000       1,359,000       1,534,000     Deferred income tax provision     4,196,000       —       —     Reduction in valuation allowance for deferred tax assets     (18,056,000 )     —       —     Provision for self-insured professional liability, net of benefit from reduction in related accrual     (4,569,000 )     (2,560,000 )     14,053,000     Payment of professional liability costs     (4,111,000 )     (3,286,000 )     (2,699,000 )   Amortization of deferred balances     342,000       386,000       381,000     Provision for leases in excess of cash payments     158,000       467,000       815,000     Asset impairment and other charges     —       219,000       177,000     Foreign currency transaction gain     (161,000 )     (784,000 )     —     Non-cash interest income     (428,000 )     (229,000 )     —     Non-cash interest expense     164,000       153,000       162,000                           Net cash provided by operating activities before changes in other assets and liabilities     13,189,000       11,482,000       7,339,000     Changes in other assets and liabilities affecting operating activities:                           Receivables, net     (3,798,000 )     (1,856,000 )     (5,061,000 )   Prepaid expenses and other assets     (2,516,000 )     (1,546,000 )     (1,752,000 )   Trade accounts payable and accrued expenses     2,745,000       (2,516,000 )     993,000                           Net cash provided by continuing operations     9,620,000       5,564,000       1,519,000     Net cash provided (used) by discontinued operations     (629,000 )     1,980,000       4,102,000                           Net cash provided by operating activities     8,991,000       7,544,000       5,621,000                             (Continued)  F - 6    Table of Contents  ADVOCAT INC. AND SUBSIDIARIES  CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)                                      Year Ended December 31,         2005     2004     2003                   Revised – See Note 2   Revised – See Note 2   INVESTING ACTIVITIES:                           Purchases of property and equipment   $ (3,410,000 )   $ (2,992,000 )   $ (2,109,000 )   Purchase of skilled nursing center     (6,753,000 )     —       —     Proceeds from sale of property and subsidiary     399,000       5,318,000       179,000     Decrease in restricted cash deposits     148,000       479,000       —     Note receivable collection     589,000       —       —     Proceeds from sale of lessor’s property     780,000       —       —     Deposits and other deferred balances     (84,000 )     —       (258,000 )                         Net cash provided (used) by continuing operations     (8,331,000 )     2,805,000       (2,188,000 )   Net cash used by discontinued Operations     (840,000 )     (1,280,000 )     (879,000 )                         Net cash provided (used) in investing activities     (9,171,000 )     1,525,000       (3,067,000 )                                                     FINANCING ACTIVITIES:                           Repayment of debt obligations     (9,966,000 )     (6,826,000 )     (2,658,000 )   Proceeds from issuance of debt     11,700,000       —       —     Financing costs     (313,000 )     (28,000 )     (43,000 )   Net proceeds from (repayment of) lines of credit     —       (1,275,000 )     1,275,000     Proceeds from exercise of stock options     —       116,000       —                           Net cash provided by (used for) continuing operations     1,421,000       (8,013,000 )     (1,426,000 )   Net cash used by discontinued operations     —       (44,000 )     (158,000 )                         Net cash provided by (used for) financing activities     1,421,000       (8,057,000 )     (1,584,000 )                                                     NET INCREASE IN CASH AND CASH EQUIVALENTS     1,241,000       1,012,000       970,000                                 CASH AND CASH EQUIVALENTS, beginning of period     5,829,000       4,817,000       3,847,000                                                       CASH AND CASH EQUIVALENTS, end of period   $ 7,070,000     $ 5,829,000     $ 4,817,000                                                       SUPPLEMENTAL INFORMATION:                           Cash payments of interest   $ 3,029,000     $ 2,652,000     $ 2,732,000                           Cash payments of income taxes, net of refunds   $ 111,000     $ 140,000     $ —                             NON-CASH TRANSACTIONS:       In 2005, 2004 and 2003, the Company accrued, but did not pay, preferred stock dividends of $318,000, $297,000 and $277,000, respectively.       During 2005 and 2004, promissory notes totaling $481,000 and $3,331,000, respectively, were issued in connection with the settlement of certain professional liability claims and other disputes.  The accompanying notes are an integral part of these consolidated financial statements.  F - 7    Table of Contents  ADVOCAT INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  DECEMBER 31, 2005, 2004 AND 2003  1. COMPANY AND ORGANIZATION  Advocat Inc. (together with its subsidiaries, “Advocat” or the “Company”) provides long-term care services to nursing center patients in eight states, primarily in the Southeast. The Company’s centers provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care centers, the Company offers a variety of comprehensive rehabilitation services as well as nutritional support services.  As of December 31, 2005, the Company’s continuing operations consist of 43 nursing centers with 4,505 licensed nursing beds and 78 assisted living units. The Company’s continuing operations include nine owned nursing centers and 34 leased nursing centers. The Company’s continuing operations include centers in Alabama, Arkansas, Florida, Kentucky, Ohio, Tennessee, Texas and West Virginia.  The Company has undertaken several divestitures through sale of assets and lease terminations, as more fully described in Notes 10 and 14. The divested operations have generally been poor performing properties. In November 2005, the Company entered into a definitive agreement to sell certain assets of eleven assisted living facilities located in North Carolina. The sale is contingent on the purchaser’s ability to obtain licenses to operate the buildings, and is expected to close in the second quarter of 2006, although no assurances can be given. In March 2006, the Company entered into an agreement to sell its only remaining assisted living facility in North Carolina. The sale is subject to customary contingencies, including the purchaser obtaining financing and completing due diligence. In February 2005, the Company sold two nursing centers in Texas. A lease covering three nursing centers in Texas expired in December 2004 and was not renewed. In November 2004, the Company sold certain assets of its medical supply business, Advocat Distribution Services. In May 2004, the Company sold the stock of its Canadian subsidiary, Diversicare Canada Management Services Co., Inc. (“DCMS”). The Company terminated one assisted living facility lease in 2003 and closed another assisted living facility in 2003. Each of these facilities and businesses constitute components under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and, accordingly, the Company has reclassified the operations of each of these components to discontinued operations.  Effective April 1, 2003, the Company entered into leases for four nursing centers in Florida that had previously been managed by the Company under management contracts as described in Note 14.  2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  Consolidation  The consolidated financial statements include the operations and accounts of Advocat and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. As discussed in Note 10, the consolidated financial statements of the Company have been reclassified to present the results of certain operations as discontinued operations.  Basis of Accounting  The accompanying consolidated financial statements have been prepared assuming that Advocat will continue as a going concern. The Company has a net working capital deficit of $40.0 million as of December 31, 2005. As discussed in Note 14, the Company has recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $34.5 million as of December 31, 2005. The Company does not have cash or available resources to pay these accrued  F - 8    Table of Contents  professional liability claims or any significant portion thereof. The Company has $31.5 million of scheduled debt maturities (including short term debt, settlement promissory notes and current portions of long term debt) during 2006, and is in default of certain debt covenants contained in debt agreements that allow the holders of substantially all of the Company’s debt to demand immediate repayment, and has not obtained waivers of the non-compliance. Although the Company does not anticipate that such demands will be made, the continued forbearance on the part of the Company’s lenders cannot be assured. If the Company’s lenders force immediate repayment, the Company would not be able to repay the related debt outstanding. Accordingly, the Company has classified the related debt principal amounts as current liabilities in the accompanying consolidated financial statements as of December 31, 2005. Of the total $31.5 million of matured or scheduled debt maturities during the next twelve months, the Company intends to repay approximately $4.0 million from cash generated from operations and will attempt to refinance the remaining balance. The Company has entered into an agreement to sell eleven assisted living facilities for a sales price of $11.0 million. These facilities secure loans with an outstanding balance of approximately $17.7 million as of December 31, 2005, and the net proceeds from the sale of the facilities will be used to repay this debt. The Company has entered into negotiations with the lender to refinance the remaining balance of this debt, but no assurances can be given these negotiations will be successful. Events of default under the Company’s debt agreements could lead to additional events of default under the Company’s lease agreements covering a majority of its nursing centers. A default in the lease agreements allows the lessor the right to terminate the lease agreements and assume operating rights with respect to the leased properties. The net book value of property and equipment, including leasehold improvements, related to these facilities total approximately $4.2 million as of December 31, 2005. A default in these lease agreements also allows the holder of the Series B Redeemable Convertible Preferred Stock the right to require the Company to redeem such stock.  The Company’s management has implemented a plan to enhance revenues related to the operations of the Company’s nursing centers. Management is focused on increasing the occupancy in its nursing centers through an increased emphasis on improving physical plants and attracting and retaining patients and residents. Management is also attempting to minimize professional liability claims in future periods through supervision and training of staff employees and by vigorously defending itself against all such claims. In the last two years, the Company has been able to reduce its outstanding debt through funds generated by internal cash flow and asset sales. The Company continues to demonstrate the ability to work with its lenders and landlords, and has entered into or amended its leases and has entered into new financing arrangements with its lenders, including agreements for the extension of leases and loans and agreements for new loans to refinance its facilities. The Company is unable to predict if it will be successful in enhancing revenues, minimizing professional liability claims, in negotiating waivers, amendments, or refinancings of outstanding debt, or if the Company will be able to meet any amended financial covenants in the future.  Regardless of the effectiveness of management’s efforts, any demands for repayment by lenders, the inability to obtain waivers or refinance the related debt, reductions in revenues from government funded programs, the termination of lease agreements or entry of a final judgment in a material amount for a professional or general liability claim would have a material adverse impact on the financial position, results of operations and cash flows of the Company. The independent registered public accounting firm’s report on the Company’s financial statements at December 31, 2005, 2004 and 2003 includes an explanatory paragraph concerning the Company’s ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset carrying amounts or the amounts of liabilities that might result should the Company be unable to continue as a going concern.  Revenues  Patient Revenues  The fees charged by the Company to patients in its nursing centers include fees with respect to individuals receiving benefits under federal and state-funded cost reimbursement programs. These revenues are based on approved rates for each facility that are either based on current costs with retroactive settlements or prospective rates with no cost settlement. Amounts earned under federal and state programs with respect to nursing home patients are subject to review by the third-party payors. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. Final cost settlements, if any, are recorded when  F - 9    Table of Contents  objectively determinable, generally within three years of the close of a reimbursement year depending upon the timing of appeals and third-party settlement reviews or audits. During the years ended December 31, 2005, 2004 and 2003, the Company recorded $315,000, $146,000 and $647,000 of net favorable estimated settlements from federal and state programs for periods prior to the beginning of fiscal 2005, 2004 and 2003, respectively.  Allowance for Doubtful Accounts  The Company’s allowance for doubtful accounts is estimated utilizing current agings of accounts receivable, historical collections data and other factors. Management monitors these factors and determines the estimated provision for doubtful accounts. Historical bad debts have generally resulted from uncollectible private balances, some uncollectible coinsurance and deductibles and other factors. Receivables that are deemed to be uncollectible are written off. The allowance for doubtful accounts balance is assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified.  The Company includes provisions for doubtful accounts in operating expenses in its consolidated statements of operations. The provisions for doubtful accounts of continuing operations were $1,560,000, $1,359,000 and $1,534,000 for 2005, 2004 and 2003, respectively.  Lease Expense  As of December 31, 2005, the Company operates 34 long-term care facilities under operating leases, including 33 owned or financed by Omega Healthcare Investors, Inc. (“Omega”) and one owned by another party. The Company’s operating leases generally require the Company to pay stated rent, subject to increases based on changes in the Consumer Price Index, a minimum percentage increase, or increases in the net revenues of the leased properties. Beginning October 1, 2001, the Company’s Omega leases required the Company to pay certain scheduled rent increases. Such scheduled rent increases are recorded as additional lease expense on a straight-line basis over the term of the related leases. The Company’s leases are “triple-net,” requiring the Company to maintain the premises, pay taxes, and pay for all utilities. The Company generally grants its lessor a security interest in the Company’s personal property located at the leased facility. The leases generally require the Company to maintain a minimum tangible net worth and prohibit the Company from operating any additional facilities within a certain radius of each leased facility. The Company is generally required to maintain comprehensive insurance covering the facilities it leases as well as personal and real property damage insurance and professional malpractice insurance. The failure to pay rentals within a specified period or to comply with the required operating and financial covenants generally constitutes a default, which default, if uncured, permits the lessor to terminate the lease and assume the property and the contents within the facility. In all cases where mortgage indebtedness exists with respect to a leased facility, the Company’s interest in the premises is subordinated to that of the lessors’ mortgage lenders.  See Note 14 for a discussion regarding the termination of leases for certain facilities during 2004 and 2003.  Classification of Expenses  The Company classifies all expenses (except interest, depreciation and lease expenses) that are associated with its corporate and regional management support functions as general and administrative expenses. All other expenses (except interest, depreciation and lease expenses) incurred by the Company at the facility level are classified as operating expenses.  F - 10    Table of Contents  Property and Equipment  Property and equipment are recorded at cost with depreciation being provided over the shorter of the remaining lease term (where applicable) or the assets’ estimated useful lives on the straight-line basis as follows:                    Buildings and improvements   —   5 to 40 years   Leasehold improvements   —   2 to 10 years   Furniture, fixtures and equipment   —   2 to 15 years   Vehicles   —   5 years     Interest incurred during construction periods is capitalized as part of the building cost. Maintenance and repairs are expensed as incurred, and major betterments and improvements are capitalized. Property and equipment obtained through purchase acquisitions are stated at their estimated fair value determined on the respective dates of acquisition.  In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company evaluates the recoverability of the carrying values of its properties on a property by property basis. On a quarterly basis, the Company reviews its properties for recoverability when events or circumstances, including significant physical changes in the property, significant adverse changes in general economic conditions, and significant deteriorations of the underlying cash flows of the property, indicate that the carrying amount of the property may not be recoverable. The need to recognize an impairment is based on estimated future cash flows from a property compared to the carrying value of that property. If recognition of an impairment is necessary, it is measured as the amount by which the carrying amount of the property exceeds the fair value of the property. See Note 5 for discussion of impairment provisions recorded in 2005, 2004 and 2003.  Cash and Cash Equivalents  Cash and cash equivalents include cash on deposit with banks and all highly liquid investments with original maturities of three months or less.  Restricted Cash  Restricted cash consists of funds on deposit with a bank securing certain obligations. See Note 14.  Deferred Financing and Other Costs  Financing costs are amortized on a straight-line basis over the term of the related debt. The amortization is reflected as interest expense in the accompanying consolidated statements of operations.  Deferred Lease Costs  Deferred lease costs represent costs incurred in conjunction with the Company’s restructuring of its Omega leases during 2000 (see Note 4) and costs incurred in connection with new leases entered or renewed in 2005 and 2003 (see Note 14). Deferred lease costs are amortized on a straight-line basis over the term of the related leases.  Self Insurance  Self insurance reserves primarily represent the accrual for self insured risks associated with general and professional liability claims, employee health insurance and workers compensation. The self insurance reserves include estimates of liability for incurred but not reported claims, estimates of liability for reported but unresolved claims, actual liabilities related to settlements, including settlements to be paid over time, and estimates of legal costs incurred and expected to be incurred. The Company’s policy with respect to a significant portion of the general and professional liability claims is to use a third-party actuary to support the estimates recorded for incurred but unreported claims. The Company’s health insurance reserve is based on known claims incurred and an estimate of incurred but unreported claims determined by an analysis of historical claims paid. The Company’s workers compensation reserve relates to periods  F - 11    Table of Contents  of self insurance prior to May 1997 and a high deductible policy issued July 1, 2002 through June 30, 2003 covering most of the Company’s employees. The reserve for workers compensation self insurance prior to May 1997 consists only of known claims incurred and the reserve is based on an estimate of the future costs to be incurred for the known claims. The reserve for the high deductible policy issued July 1, 2002 is based on known claims incurred and an estimate of incurred but not reported claims determined by an analysis of historical claims incurred. Expected insurance coverages are reflected as a reduction of reserves. Professional liability claims are inherently uncertain and actual results could differ from estimates and cause the Company’s reported net income to vary significantly from period to period. The self insurance reserves are assessed on a quarterly basis based on currently available information. The amounts recorded for professional and general liability claims are adjusted for revisions in estimates and differences between actual settlements and reserves as determined each period with changes in estimated losses being recorded in the consolidated statements of operations in the period identified.  The Company retains a third-party actuarial firm to estimate the appropriate accrual for incurred professional liability claims. The actuarial estimate represents the ultimate cost for all professional liability claims incurred in a period and includes estimates for both claims reported and claims incurred but not reported. All losses are projected on an undiscounted basis. The actuary uses losses covering a 10 year period as the basis for estimates. Based on this historical data, the actuary develops estimates of the average cost per claim and the frequency of claims per occupied bed. The average cost per claim includes legal and other expenses incurred. These averages are used to generate the initial estimate of the ultimate professional liability cost for a given period in relation to the Company’s occupancy for that period.  A key assumption is the limit of claims to a maximum of $4.5 million. The actuary has selected this limit based on our historical data. While most of the Company’s claims have been for amounts less than the $4.5 million, there have been claims at higher amounts, and there may be claims above this level in the future. The facts and circumstances of each claim vary significantly, and the amount of ultimate liability for an individual claim may vary due to many factors, including whether the case can be settled by agreement, the quality of legal representation, the individual jurisdiction in which the claim is pending, and the views of the particular judge or jury deciding the case. To date, the Company has not experienced an uninsured loss in excess of this limit. The Company’s policy is to review the actuary report and assumptions each quarter. In the event that the Company believes it has incurred a loss in excess of this limit, an adjustment to the reserves determined by the actuary would be necessary.  Income Taxes  The Company utilizes SFAS No. 109, “Accounting for Income Taxes,” which requires an asset and liability approach for financial accounting and reporting of income taxes. Under this method, deferred tax assets and liabilities are determined based upon differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax laws that will be in effect when the differences are expected to reverse. The Company assesses the need for a valuation allowance to reduce the deferred tax assets by the amount that is believed is more likely not to be utilized through the turnaround of existing temporary differences, future earnings, or a combination thereof, including certain net operating loss carryforwards we do not expect to realize due to change in ownership limitations. See Note 13 for additional information related to the provision for income taxes.  Disclosure of Fair Value of Financial Instruments  The carrying amounts of cash and cash equivalents, receivables, trade accounts payable and accrued expenses approximate fair value because of the short-term nature of these accounts. The carrying amount of the Company’s debt approximates fair value because the interest rates approximate the current rates available to the Company and its individual facilities. The Company’s self-insurance reserves are reported on an undiscounted basis as the timing of estimated settlements cannot be determined.  F - 12    Table of Contents  Use of Estimates  The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.  Foreign Operations and Currency Translation Policies  The results of operations and the financial position of the Canadian operations have been prepared from records maintained in Canada and translated at the respective average rates (for purposes of the consolidated statements of operations) and respective year-end rates (for purposes of the consolidated balance sheets). Translation gains and losses are reported as a component of accumulated other comprehensive (loss) in shareholders’ equity (deficit). As discussed in Note 10, these foreign operations were sold in 2004 and are presented as a discontinued operation.  Accumulated foreign currency translation unrealized gains (losses) are as follows:                                      2005     2004     2003       Beginning balance   $ —     $ 1,695,000     $ (872,000 )   Current period change, net of tax     —       (1,695,000 )     2,567,000                           Ending balance   $ —     $ —     $ 1,695,000                             The accumulated foreign currency translation gain (loss) was related to DCMS, and was recognized in income from discontinued operations as part of the gain on sale at the time of the disposal of DCMS. See Note 10.  Net Income (Loss) per Common Share  The Company utilizes SFAS No. 128, “Earnings Per Share,” for the financial reporting of net income (loss) per common share. Basic earnings (loss) per common share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings (loss) per common share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or otherwise resulted in the issuance of common stock that then shared in the earnings of the Company. The potentially dilutive effect of the Company’s stock options and Series B Redeemable Convertible Preferred Stock, representing 1,500,000 shares in 2003, have been excluded from the computation of net loss per share because of anti-dilution.  Guarantees  The Company accounts for obligations under guarantee agreements entered into prior to 2003 in accordance with the provisions of SFAS No. 5, “Accounting for Contingencies.” The Company accounts for such obligations entered into or modified after 2002 in accordance with the provisions of FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”).  Other Comprehensive Income (Loss)  The Company has adopted SFAS No. 130, “Reporting on Comprehensive Income,” which requires the reporting of comprehensive income (loss) in addition to net income (loss) from operations. All transactions representing comprehensive income (loss) are included in the consolidated statements of comprehensive loss.  F - 13    Table of Contents  Stock-Based Compensation  During 2005, the Company granted options to purchase approximately 332,000 shares of the Company’s common stock. These options were granted pursuant to a newly adopted incentive plan that is subject to shareholder approval. As a result, the compensation cost related to such options will not be determined until shareholder approval is obtained. In addition, the Company has stock options outstanding under its prior plans that expired in 2004. The Company did not issue any employee stock based awards during 2004 or 2003.  SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended, encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company elected to continue to account for stock based compensation using the intrinsic value method as prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, and the related Interpretations (all herein referred to as “APB No. 25”).  Under APB No. 25, no compensation cost related to stock options has been recognized because all options are issued with exercise prices equal to the fair market value at the date of grant. Had compensation cost for the Company’s stock-based compensation plans been determined consistent with SFAS No. 123, the Company’s net income (loss) for common stock and net income (loss) per common share would not have differed materially from the amounts reported.  In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment,” which revises SFAS No. 123 and supersedes APB Opinion No. 25. This statement will require all share-based payments to employees to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. This statement is effective for the Company beginning January 1, 2006.  The Company plans to adopt SFAS No. 123R using the modified prospective method, in which compensation cost is recognized beginning with the effective date (a) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date. The Company has no unvested awards granted to employees on the effective date.  See Note 11 for additional disclosures about the Company’s stock-based compensation plans.  New Accounting Pronouncements  In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets — An Amendment of APB Opinion No. 29. This Statement amends APB Opinion No. 29, Accounting for Non-monetary Transactions. The amendments made by SFAS No. 153 are based on the principle that exchanges of non-monetary assets should be measured based on the fair value of the assets exchanged. The provisions of SFAS 153 are effective for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The Company adopted SFAS 153 beginning July 1, 2005. The adoption of this Statement did not have a significant impact on the Company’s financial position or results of operations.  In December 2004, the FASB issued SFAS No. 123 (Revised 2004), Share-Based Payment. SFAS 123R requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. The Company will be required to apply this Statement beginning January 1, 2006. The scope of SFAS 123R includes a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. The Company’s accounting policy regarding share-based awards, as described above, discusses in further detail the provisions of SFAS 123R, the permitted methods of adoption, the method the Company expects to utilize, and the estimated impact for 2006.  In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections. This new standard replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. Among other changes, SFAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. Statement 154 also provides that (1) a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a  F - 14    Table of Contents  “restatement.” The new standard is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005. Thus, the statement becomes effective for the Company for accounting changes and error corrections made on or after January 1, 2006. Early adoption of this standard is permitted for accounting changes and error corrections made in fiscal years beginning after June 1, 2005. The Company does not expect the adoption of this Statement to have a significant impact on its financial position or results of operations.  Reclassifications  As discussed in Note 10, the consolidated financial statements of the Company have been reclassified to reflect as discontinued operations certain divestitures and lease terminations. Certain amounts in the 2004 and 2003 financial statements related to continuing operations have also been reclassified to conform to the 2005 presentation.  In 2005, the Company has separately disclosed the operating, investing and financing portions of the cash flows attributable to its discontinued operations, which in prior periods were reported on a combined basis as a single amount.  3. RECEIVABLES  Receivables, before the allowance for doubtful accounts, consist of the following components:                              December 31,         2005     2004       Medicare   $ 7,466,000     $ 6,534,000     Medicaid and other non-federal programs     8,563,000       8,393,000     Other patient and resident receivables     2,904,000       2,669,000     Other receivables and advances     936,000       189,000                         $ 19,869,000     $ 17,785,000                       The Company provides credit for a substantial portion of its revenues and continually monitors the credit-worthiness and collectibility from its clients, including proper documentation of third-party coverage. The Company is subject to accounting losses from uncollectible receivables in excess of its reserves.  Substantially all receivables are provided as collateral on the Company’s debt and lease obligations.  4. DEFERRED LEASE COSTS  During 1992, the Company entered into an agreement with Omega whereby 19 of the Company’s facilities were sold to Omega and leased back to the Company. In conjunction with this sale/leaseback transaction, the Company entered into a participating mortgage with Omega on three other facilities. The net gain on the sale/leaseback was deferred in accordance with sale/leaseback accounting and was being amortized by the Company over the related lease term as a reduction in lease expense. As of September 30, 2000, the net deferred gain totaled $2,862,000. Effective October 1, 2000, the Company restructured the lease agreement covering all nursing centers leased from Omega (the “Omega Master Lease”), issued a $1,700,000 subordinated note payable to Omega (the ‘Subordinated Note;” see Note 9), and issued Series B Redeemable Convertible Preferred Stock with a stated value of $3,300,000 to Omega (see Note 11). Pursuant to the amended Omega Master Lease and the issuance of the Subordinated Note and the Series B Redeemable Convertible Preferred Stock to Omega effective October 1, 2000, total deferred lease costs of $5,000,000 were recorded by the Company. The $2,862,000 of remaining deferred gain on the 1992 sale/leaseback has been reflected as a reduction of the $5,000,000 in new deferred lease costs, resulting in net deferred lease costs of $2,138,000 as of October 1, 2000. The net deferred lease costs are being amortized as lease expense over the initial ten-year term of the Omega Master Lease.  F - 15    Table of Contents  Pursuant to the October 2000 restructured lease agreement, Omega and the Company entered into an agreement with regard to two facilities formerly leased by the Company from a third party. Under this agreement, Omega agreed to pay the Company 20% of any sales proceeds received on the sale of the properties. In April 2005, Omega sold these buildings and paid the Company $780,000 pursuant to this agreement. The Company has recorded these proceeds as a reduction of the deferred lease costs incurred in connection with the restructured master lease.  5. ASSET IMPAIRMENT AND OTHER CHARGES  The Company has recorded various asset impairment and other charges as presented below:                                      2005     2004     2003       Impairment of long-lived assets   $ 4,397,000     $ 8,419,000     $ 1,703,000     Lease terminations     —       341,000       389,000                                 4,397,000       8,760,000       2,092,000     Less – amount included in discontinued operations     4,397,000       8,541,000       1,915,000                           Asset impairment and other charges included in continuing operations   $ —     $ 219,000     $ 177,000                             In 2005, 2004 and 2003, the Company recorded asset impairment charges of $4,397,000, $8,419,000 and $1,703,000, respectively, for the impairment of certain long-lived assets in accordance with the provisions of SFAS 144. A detail of the impaired asset charges is as follows:                                  Description of Impairment   2005     2004     2003       Assisted Living Facilities Impairment Charges – As a result of projected cash flows, impairment charges were recorded in 2005 for eleven assisted living facilities, were recorded in 2004 for six owned assisted living facilities and were recorded in 2003 for three owned assisted living facilities.   $ 4,397,000     $ 7,500,000     $ 1,525,000                                 Nursing Center Impairment Charges – As a result of projected cash flows, impairment charges were recorded in 2004 for five nursing centers, including three leased and two owned facilities, and were recorded in 2003 for one leased nursing center.     —       919,000       178,000                                                       Total impairment of long-lived assets   $ 4,397,000     $ 8,419,000     $ 1,703,000                             The Company terminated facility leases for three nursing centers in 2004 and one assisted living facility in 2003. The Company incurred lease termination charges of approximately $341,000 and $389,000 in 2004 and 2003, respectively, consisting of the remaining net book value of these facilities, costs of completing the transactions and settlement charges.  6. PROPERTY AND EQUIPMENT  Property and equipment, at cost, consists of the following:                              December 31,         2005     2004       Land   $ 1,573,000     $ 1,411,000     Buildings and leasehold improvements     37,770,000       29,582,000     Furniture, fixtures and equipment     17,709,000       16,440,000                         $ 57,052,000     $ 47,433,000                       F - 16    Table of Contents  In August 2005, the Company purchased a 120-bed skilled nursing center in Oak Ridge, Tennessee. The Company had operated this facility since 1990 under a lease agreement that was to expire in February 2006. The Company purchased the nursing home for approximately $6.7 million with financing provided by a commercial finance company. The purchase price was allocated to land, buildings and improvements.  Substantially all of the Company’s property and equipment are provided as collateral for debt obligations. The Company capitalizes leasehold improvements which will revert back to the lessor of the property at the expiration or termination of the lease, and depreciates these improvements over the shorter of the remaining lease term or the assets’ estimated useful lives.  7. SHORT-TERM DEBT  Short-term debt consists of the following:                              December 31,         2005     2004       Mortgages payable to a commercial finance company; secured by 12 assisted living properties; interest payable monthly at 3.35% above LIBOR (7.64% and 5.64% at December 31, 2005 and 2004, respectively); matures in April 2006.   $ 17,690,000     $ 22,260,000     Mortgages payable to a commercial finance company; secured by two nursing centers; interest payable monthly at 3.50% above LIBOR (7.79% and 5.79% at December 31, 2005 and 2004, respectively); matures in April 2006; classified as long term debt at December 31, 2004.     6,885,000       —     Promissory note payable to a bank; classified as long term debt at December 31, 2005.     —       5,087,000     Promissory note payable to a commercial finance company; secured by one nursing center; interest payable monthly at 3.5% above LIBOR (7.79% and 5.79% at December 31, 2005 and 2004, respectively); matures in April 2006.     3,129,000       3,234,000     Promissory note payable to a bank; classified as long term debt at December 31, 2005.     —       3,193,000     Mortgages payable to banks; secured by one nursing center; interest and principal payable monthly; interest rate of 6.5%; repaid in April 2005.     —       2,064,000     Working capital line of credit payable to a bank; maximum availability $2,300,000; secured by certain accounts receivable and substantially all other Company assets; interest payable monthly at bank prime rate plus 0.50% up to a maximum of 9.50%; matures in January 2008.     —       —                         $ 27,704,000     $ 35,838,000                       As of December 31, 2005, the Company’s weighted average interest rate on short term debt was 7.7%.  F - 17    Table of Contents  As described in Note 10, the Company has entered into an agreement to sell 11 assisted living facilities in North Carolina for approximately $11,000,000, and expects to close this transaction in the second quarter of 2006, although no assurances can be given. The Company has entered into an agreement to sell its only remaining assisted living facility in North Carolina. The sale is subject to customary contingencies, including the purchaser obtaining financing and completing due diligence. These facilities and three nursing centers are collateral for mortgage debt with a commercial finance company listed above that totals $27,704,000 as of December 31, 2005. These mortgages mature on April 1, 2006. The Company has entered into a 60 day extension for $17,690,000 in mortgage loans that are secured by the assisted living facilities. The Company is engaged in negotiations with the lender, and anticipates that once the sale of the facilities is completed, it will be able to refinance the remaining debt with the lender for a longer term. The Company has also entered into a 90 day extension of $10,014,000 in mortgage loans that are secured by the three nursing centers with this lender, and is engaged in discussions with the lender to refinance those loans for a longer term. No agreement has been reached, and no assurances can be made that these efforts will be successful.  Cross-default provisions exist in a majority of the Company’s debt agreements. In addition, certain of the Company’s debt agreements provide that a default under certain of the Company’s leases constitutes a default under the debt agreements. Certain of the Company’s debt agreements also contain various financial covenants, the most restrictive of which relate to cash flow, net income (loss), limits on the payment of dividends to shareholders. As of December 31, 2005, the Company was not in compliance with certain of the financial covenants contained in the Company’s debt and lease agreements. Cross-default or material adverse change provisions contained in the debt agreements allow the holders of substantially all of the Company’s debt to demand repayment. The Company has not obtained waivers of the noncompliance.     8.   SETTLEMENT PROMISSORY NOTES    Promissory notes were issued during 2005 and 2004 in settlement of certain professional liability claims and other disputes. The majority of these notes were non-interest bearing, and were discounted at 7.5%, which approximated the Company’s borrowing rate, as shown below:                              December 31,         2005     2004       Promissory notes; non-interest bearing; net of unamortized discount of $44,000, imputed at 7.5%; monthly payments through February 2007.   $ 1,057,000     $ 2,106,000                         Promissory note; interest rate of 7%; principal and interest due in monthly payments through February 2007.     177,000       339,000                           1,234,000       2,445,000     Less current portion     (1,106,000 )     (1,374,000 )                       $ 128,000     $ 1,071,000                       Scheduled principal payments of settlement promissory notes are as follows:                    2006   $ 1,106,000     2007     128,000               Total   $ 1,234,000                 F - 18    Table of Contents     9.   LONG-TERM DEBT    Long-term debt consists of the following:                              December 31,         2005     2004       Mortgage payable to a commercial finance company; issued in September 2005; secured by one nursing center; interest payable monthly at 4.0% above LIBOR (8.29% at December 31, 2005); matures in September 2008.   $ 7,974,000     $ —                         Mortgages payable to a commercial finance company; issued in April 2005; secured by one nursing center; interest payable monthly at 4.0% above LIBOR (8.29% at December 31, 2005); matures in May 2008.     3,671,000       —                         Promissory note payable to a bank; secured by certain accounts receivable and substantially all other Company assets; interest and principal payable monthly, interest at bank prime rate plus 0.5% up to a maximum of 7.5%(7.5% at December 31, 2005); matures January 2008; classified as short term debt at December 31, 2004.     3,052,000       —                         Promissory note payable to a bank; secured by certain property, accounts receivable and substantially all other Company assets; interest and principal payable monthly, interest at bank prime rate plus 0.5% up to a maximum of 7.5% (7.5% at December 31, 2005); matures April 2007; classified as short term debt at December 31, 2004.     2,212,000       —                         Mortgages payable to a commercial finance company; secured by two nursing centers; interest payable monthly at 3.50% above LIBOR (5.79% at December 31, 2004); matures in April 2006, reclassified to short term debt at December 31, 2005.     —       7,041,000                         Subordinated note payable to Omega; secured by accounts receivable and other assets of the facilities leased from Omega; interest at 7.00%; balloon maturity in September 2007.     1,700,000       1,700,000                           18,609,000       8,741,000     Less current portion     (18,609,000 )     (8,741,000 )                       $ —     $ —                       As of December 31, 2005, the Company’s weighted average interest rate on long-term debt was 7.9%.  Scheduled principal payments of long-term debt (assuming no accelerations by the lenders) are as follows:                    2006   $ 2,736,000     2007     4,428,000     2008     11,445,000                   $ 18,609,000                 The security interests on the $2,212,000 promissory note payable to a bank include four Texas nursing centers. The Company has also agreed to apply against the promissory note indebtedness any net proceeds realized from the sale of the collateral comprising the additional security interests.  F - 19    Table of Contents  At maturity, the $1,700,000 Subordinated note payable to Omega may, at the Company’s option, be converted into: (i) shares of the Company’s Series B Redeemable Convertible Preferred Stock, if Omega holds shares of such preferred stock at that time (see Note 11); or (ii) into shares of the Company’s Common Stock if Omega does not hold shares of Series B Redeemable Convertible Preferred Stock. The conversion is subject to certain limitations, and the conversion to Common Stock is generally on the same terms as those for the Series B Redeemable Convertible Preferred Stock.  Cross-default provisions exist in a majority of the Company’s debt agreements. In addition, certain of the Company’s debt agreements provide that a default under certain of the Company’s leases constitutes a default under the debt agreements. Certain of the Company’s debt agreements also contain various financial covenants, the most restrictive of which relate to cash flow, net income (loss), and limits on the payment of dividends to shareholders. As of December 31, 2005, the Company was not in compliance with certain of the financial covenants contained in the Company’s debt and lease agreements. Cross-default or material adverse change provisions contained in the debt agreements allow the holders of substantially all of the Company’s debt to demand repayment. The Company has not obtained waivers of the noncompliance. Based on regularly scheduled debt service requirements, the Company has a total of $2,736,000 of long-term debt, $27,704,000 of short-term debt and $1,106,000 of settlement promissory notes that must be repaid or refinanced during 2006. As a result of the covenant noncompliance and other cross-default provisions, the Company has classified a total of $15,873,000 of debt with scheduled maturities beginning in 2007 as current liabilities as of December 31, 2005. The Company would not be able to repay this indebtedness if the applicable lenders demanded repayment.     10.   DISCONTINUED OPERATIONS    In November 2005, the Company entered into an agreement to sell certain assets of eleven assisted living facilities located in North Carolina for a sales price of $11.0 million. The sale is contingent on the purchaser’s ability to obtain licenses to operate the buildings, and is expected to close in the second quarter of 2006, although no assurances can be given. In the fourth quarter of 2005, the Company recorded an impairment charge of $4,397,000 to reduce the net book value of these properties to their estimated realizable value.  The Company has entered into an agreement to sell its only remaining assisted living facility in North Carolina. The sale is subject to customary contingencies, including the purchaser obtaining financing and completing due diligence.  In May 2004, the Company sold the stock of its Canadian subsidiary DCMS to DCMS Holding, Inc. (“Holding”), a privately-owned Ontario corporation. DCMS operated 14 nursing centers and 24 assisted living facilities in the Canadian provinces of Ontario, British Columbia and Alberta. The sales price was $16.5 million Canadian (approximately $11.8 million US at the May 11, 2004 exchange rate). Approximately $8.5 million Canadian ($6.1 million US) was received at closing, with the balance, $8.0 million Canadian ($5.7 million US), scheduled to be received in annual installments of $600,000 Canadian ($428,000 US) on the anniversary of the closing for the first four years and a final installment of $5.6 million Canadian ($4.0 million US) on the fifth anniversary of closing. The future payments may be accelerated upon the occurrences of certain events. The installment portion of the purchase price is evidenced by a promissory note that has been discounted to estimated fair value and was initially recorded in the accompanying balance sheet at $4.7 million US. The Company received the first installment under this note in May 2005.  Effective February 2005, the Company sold two nursing centers in Texas that were operating with low occupancy and experiencing operating losses. The net proceeds from the transactions were approximately $375,000. In periods prior to the sale, the Company had recorded impairment provisions and reduced the property to its estimated realizable value, and no material gain or loss was realized on the transactions.  In November 2004, the Company sold certain assets of its medical supply business, Advocat Distribution Services. The initial sales price was $225,000, with additional consideration based on the results of operations of the business over the two years following the sale. No material gain or loss was realized from the proceeds. A total of $46,000 additional consideration has been received as of December 31,  F - 20    Table of Contents  2005, and recognized as income in the period earned. Any further additional consideration received in the future under the terms of the agreement will be recorded when determined.  In October 2004, the Company sold an assisted living facility in North Carolina that had been closed in 2003. The net proceeds were approximately $60,000 and there was no material gain or loss resulting from the sale.  Proceeds from each of these divestiture transactions were used to pay transaction costs and repay debt. In addition to these divestiture transactions, the Company has terminated leases covering certain nursing centers and assisted living facilities, as further discussed in Note 14. Each of these facilities and businesses constitute components under the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and, accordingly, the Company has reclassified the operations and disposed property of each of these components as discontinued operations for all periods presented in the Company’s consolidated financial statements. The results of discontinued operations do not reflect any allocation of corporate general and administrative expense or any allocation of corporate interest expense.  Assets and liabilities of discontinued operations  Current assets of discontinued operations at December 31, 2005 and 2004 consist of prepaid expenses and other current assets. Property and equipment of discontinued operations consist of the following:                              December 31,         2005     2004       Land   $ 2,792,000     $ 2,913,000     Buildings and leasehold improvements     16,711,000       21,017,000     Furniture, fixtures and equipment     4,683,000       5,512,000                           24,186,000       29,442,000     Less accumulated depreciation     (11,490,000 )     (12,662,000 )                   Total property and equipment, net   $ 12,696,000     $ 16,780,000                       Apart from the sale of the Canadian operations, the other divestiture and lease termination transactions described above generally resulted in the surrender of property and equipment in the facilities, but did not result in the sale of accounts receivable or other current assets or the assumption of current liabilities or debt. Accordingly, such current assets and liabilities were not reclassified to discontinued operations. The current assets and liabilities of continuing operations include the following amounts retained by the Company related to these discontinued operations:                              December 31,         2005     2004       Current assets-                   Receivables, net   $ 202,000     $ 520,000     Prepaid expenses and other current assets     19,000       66,000                     Total current assets   $ 221,000     $ 586,000                                         Current liabilities-                   Trade accounts payable   $ 180,000     $ 376,000     Accrued payroll and employee benefits     387,000       355,000     Other current liabilities     956,000       299,000                     Total current liabilities   $ 1,523,000     $ 1,030,000                       The Company maintains certain accruals related to its accruals for self insured risks on a consolidated basis, and does not allocate these liabilities to individual facilities. These liabilities were not assumed in any of the divestiture or lease termination transactions described above.  F - 21    Table of Contents     11.   SHAREHOLDERS’ EQUITY, STOCK PLANS AND SERIES B REDEEMABLE CONVERTIBLE PREFERRED STOCK    Shareholders’ Rights Plan  In March 2005, the Company approved an amendment to its shareholders rights plan (the “Plan”), which was originally adopted in 1995. The amendment extends the expiration date of the Plan to March 20, 2010 and changes the exercise price of the rights under the Plan to $15. The Plan is designed to protect the Company’s shareholders from unfair or coercive takeover tactics. The rights under the Plan were effective for all shareholders of record at the close of business March 20, 1995. The amendment approved in March 2005 extended the term of the plan for an additional five years. The Plan, as previously amended in December 7, 1998, provides for one right with respect to each share of common stock. The rights may be exercised only upon the occurrence of certain triggering events, including the acquisition of, or a tender offer for, 15.0% or more of the Company’s common stock without the Company’s prior approval.  Stock-Based Compensation Plans  In 1994, the Company adopted the 1994 Incentive and Nonqualified Stock Option Plan for Key Personnel (the “Key Personnel Plan”). Under the Key Personnel Plan, as amended in May 1998, 1,060,000 shares of the Company’s common stock have been reserved for issuance upon exercise of options granted thereunder. In 1994, the Company also adopted the 1994 Nonqualified Stock Option Plan for the Directors (the “Director Plan”). Under the Director Plan, as amended in May 1996, 190,000 shares of the Company’s common stock have been reserved for issuance upon exercise of options granted thereunder.  Under both plans, the option exercise price equals the stock’s closing market price on the day prior to the grant date. The maximum term of any option granted pursuant to either the Key Personnel Plan or to the Director Plan is ten years. Options issued under either plan are one-third vested at the grant date with an additional one-third vesting on each of the next two anniversaries of the grant date. Shares subject to options granted under either plan that expire, terminate, or are canceled without having been exercised in full become available again for future grants.  In accordance their terms, the Key Personnel Plan and the Director Plan expired in May 2004. Accordingly, no further grants can be made under these plans.  The following table summarizes information regarding stock options outstanding as of December 31, 2005:                              Weighted       Range of   Average   Options   Exercise Prices   Exercise Prices   Outstanding     $8.31 to $10.06    $ 9.85       35,000     $0.15 to $7.13    $ 0.42       151,000                                         186,000                            As of December 31, 2005, the outstanding options have a weighted average remaining life of 4.8 years.  F - 22    Table of Contents  Summarized activity of the stock option plans is presented below:                                      Shares     Weighted         Key Personnel     Director     Average         Plan     Plan     Exercise Price       Outstanding,                           December 31, 2002     1,025,000       137,000     $ 4.33     Expired or canceled     (438,000 )     (71,000 )     5.04                           Outstanding,                           December 31, 2003     587,000       66,000       3.78     Exercised     (217,000 )     (15,000 )     0.50     Expired or canceled     (217,000 )     (16,000 )     8.22                           Outstanding,                           December 31, 2004     153,000       35,000       2.31     Exercised     —       —       —     Expired or canceled     (1,000 )     (1,000 )     12.06                           Outstanding,                           December 31, 2005                                 152,000       34,000     $ 2.20                                                       Exercisable, December 31, 2005     152,000       34,000     $ 2.20                             In December 2005, the Compensation Committee of the Board of Directors adopted the 2005 Long-Term Incentive Plan (the 2005 Plan). The 2005 Plan allows the Company to issue stock options and other share and cash based awards. Under the 2005 Plan, 700,000 shares of the Company’s common stock have been reserved for issuance upon exercise of options granted thereunder.  At the time of adoption, the Board approved the issuance of options to purchase approximately 332,000 shares of the Company’s common stock at a purchase price of $5.44 per share, the closing price of the Company’s common stock on the date the options were authorized, subject to shareholder approval of the 2005 Plan. Options for the purchase of approximately 305,000 shares will be vested on the grant date, and the remainder will vest one-half each on the next two anniversaries of the grant date.  The adoption of the 2005 Plan and the issuance of any shares under the 2005 Plan remains subject to shareholder approval. The Company will seek approval of the 2005 Plan at its 2006 Annual Shareholders’ Meeting, which is scheduled to be held in June 2006. If approved by the Company’s shareholders, the Company will recognize an expense at that time for the fair value of the options granted based on the requirements of SFAS No. 123R with respect to the options described above.  Series A Preferred Stock  The Company is authorized to issue up to 400,000 shares of Series A preferred stock. The Company’s Board of Directors is authorized to establish the terms and rights of each series, including the voting powers, designations, preferences, and other special rights, qualifications, limitations, or restrictions thereof.  Series B Redeemable Convertible Preferred Stock  As part of the consideration paid to Omega for a restructuring the terms of the Omega Master Lease in November 2000, the Company issued to Omega 393,658 shares of the Company’s Series B Redeemable Convertible Preferred Stock. The Company’s Series B Redeemable Convertible Preferred Stock has a stated value of $3,300,000 and carries an annual dividend rate of 7% of the stated value. The dividends accrue on a daily basis whether or not declared by the Company and compound quarterly. Dividend payments on the Series B Redeemable Convertible Preferred Stock are subordinated to the payment in full of certain bank debt. The Series B Redeemable Convertible Preferred Stock shares have preference in liquidation but do not have voting rights. The total redemption value is equal to the stated value plus any accrued but unpaid dividends. The liquidation preference value is equal to the redemption value. The holders of the Series B Redeemable Convertible Preferred Stock may convert their preferred shares  F - 23    Table of Contents  and accrued dividends to common stock at their option at any time based on a conversion price per share of $4.67, subject to adjustment and certain other limitations.  Beginning on the earlier of a default under the Omega Master Lease agreement or September 30, 2007, Omega has the right to require the Company to redeem the Series B Redeemable Convertible Preferred Stock shares at the redemption price of $3,300,000 plus accrued and unpaid dividends. These rights with regard to redemption are subject to applicable provisions of Delaware law, which restrict the Company’s ability to pay dividends or redeem shares of stock in certain circumstances. At December 31, 2005 and 2004, total accrued but unpaid dividends amounted to $1,450,000 ($3.68 per share) and $1,132,000 ($2.88 per share), respectively, and, accordingly, the aggregate redemption value on the Series B Redeemable Convertible Preferred Stock was $4,750,000 and $4,432,000, respectively and the per share redemption value was approximately $12.07 and $11.26, respectively.     12.   NET INCOME (LOSS) PER COMMON SHARE    Information with respect to the calculation of basic and diluted net income ( loss) per common share is presented below:                                      2005     2004     2003       Basic net income (loss) per common share                           Net income (loss) from continuing operations   $ 30,601,000     $ 12,529,000     $ (10,254,000 )   Preferred stock dividends     (318,000 )     (297,000 )     (277,000 )                         Net income(loss) from continuing operations for common stock     30,283,000       12,232,000       (10,531,000 )                         Income (loss) from discontinued operations:                           Operating loss, net of taxes     (5,698,000 )     (10,038,000 )     (967,000 )   Gain on sale     399,000       290,000       —                           Net loss from discontinued operations     (5,299,000 )     (9,748,000 )     (967,000 )                         Net income (loss) for common stock   $ 24,984,000     $ 2,484,000     $ (11,498,000 )                         Basic average common shares outstanding     5,725,000       5,660,000       5,493,000                           Basic net income (loss) per common share:                           Net income (loss) from continuing operations   $ 5.29     $ 2.16     $ (1.92 )                         Loss from discontinued operations     (1.00 )     (1.77 )     (0.17 )   Gain on sale of discontinued operations     0.07       0.05       —                           Net loss from discontinued operations     (0.93 )     (1.72 )     (0.17 )                         Basic net income (loss) per common share   $ 4.36     $ 0.44     $ (2.09 )                                                     Diluted net income (loss) per common share                           Net income (loss) from continuing operations for common stock   $ 30,283,000     $ 12,232,000     $ (10,531,000 )   Add dilutive preferred stock dividends, for effect of assumed conversion of preferred stock     318,000       297,000       —     Assumed interest on unpaid dividends     (105,000 )     (92,000 )     —                           Net loss from continuing operations for diluted net income (loss) per common share      30,496,000       12,437,000       (10,531,000 )                           F - 24    Table of Contents                                      2005     2004     2003       Income (loss) from discontinued operations:                           Operating loss, net of taxes   $ (5,698,000 )   $ (10,038,000 )   $ (967,000 )   Gain on sale     399,000       290,000       —                           Net income (loss) from discontinued operations      (5,299,000 )     (9,748,000 )     (967,000 )                         Net income (loss) for diluted net income (loss) per common share   $ 25,197,000     $ 2,689,000     $ (11,498,000 )                         Basic average common shares outstanding     5,725,000       5,660,000       5,493,000     Incremental shares from assumed exercise Of stock options     137,000       167,000       —     Incremental shares from assumed conversion Of preferred stock     636,000       610,000       —                           Diluted average common shares outstanding     6,498,000       6,437,000       5,493,000                           Diluted net income (loss) per common share Net income (loss) from continuing operations   $ 4.69     $ 1.93     $ (1.92 )                         Loss from discontinued operations     (0.87 )     (1.56 )     (0.17 )   Gain on sale of discontinued operations     0.06       0.05       —                           Net loss from discontinued operations     (0.81 )     (1.51 )     (0.17 )                         Diluted net income (loss) per common share   $ 3.88     $ 0.42     $ (2.09 )                           For 2005 and 2004, the dilutive effects of the Company’s stock options and Series B Redeemable Convertible Preferred Stock are included in the computation of diluted income per common share. Under the applicable provisions of the Internal Revenue Code, Omega, as a Real Estate Investment Trust, is limited in the amount of ownership in the Company it can hold. The terms of the Series B Redeemable Convertible Preferred Stock limit the amount of common stock that Omega may receive on such conversion. Any preferred shares not converted to Common Stock shall be redeemed with cash or, in certain circumstances, a promissory note with substantially the same terms as the $1,700,000 Subordinated Note payable to Omega (see Note 9). The computation of diluted earnings per share reflects the effect of these limitations on the number of common shares issued and the effects of interest expense from the assumed issuance of a promissory note for the balance of preferred shares not converted to common stock.  For 2003, the potentially dilutive effects of stock options and Series B Redeemable Convertible Preferred Stock that would have otherwise qualified for inclusion, representing 1,500,000 shares, have been excluded from the computation of net loss per share because of anti-dilution.     13.   INCOME TAXES    The provision (benefit) for income taxes of continuing operations is composed of the following components:                                      Year Ended December 31,         2005     2004     2003       Current payable (benefit):                           Federal   $ 19,000     $ 202,000     $ —     State     21,000       64,000       —                                 40,000       266,000       —                           Deferred tax provision (benefit):                           Federal     (13,860,000 )     —       —     State     —       —       —                                 (13,860,000 )     —       —                           Provision (benefit) for income taxes of continuing operations    $ (13,820,000 )   $ 266,000     $ —                             F - 25    Table of Contents  A reconciliation of taxes computed at statutory income tax rates on income from continuing operations is as follows:                                      Year Ended December 31,         2005     2004     2003       Provision (benefit) for federal income taxes at statutory rates   $ 5,706,000     $ 4,350,000     $ (3,486,000 )   Provision (benefit) for state income taxes at statutory rates, net of federal benefit     671,000       512,000       (410,000 )   Tax on earnings distributed from foreign subsidiary             1,320,000       —     Valuation allowance changes affecting the provision (benefit) for income taxes     (20,264,000 )     (5,734,000 )     3,696,000     Other     67,000       (182,000 )     200,000                           Provision (benefit) for income taxes   $ (13,820,000 )   $ 266,000     $ —                             The net deferred tax assets and liabilities, at the respective income tax rates, are as follows:                              December 31,         2005     2004       Current deferred assets:                   Allowance for doubtful accounts   $ 564,000     $ 541,000     Accrued liabilities     4,478,000       5,220,000                           5,042,000       5,761,000     Less valuation allowance     (2,462,000 )     (4,060,000 )                         2,580,000       1,701,000     Current deferred liabilities:                   Prepaid expenses     (1,576,000 )     (1,701,000 )                       $ 1,004,000     $ —                                         Noncurrent deferred assets:                   Net operating loss and other carryforwards   $ 5,160,000     $ 8,106,000     Deferred lease costs     840,000       625,000     Depreciation     1,604,000       1,592,000     Tax goodwill and intangibles     2,967,000       3,650,000     Impairment of long-lived assets     5,439,000       4,696,000     Noncurrent self-insurance reserves     11,426,000       13,041,000                           27,436,000       31,710,000     Less valuation allowance     (13,395,000 )     (31,628,000 )                         14,041,000       82,000                         Noncurrent deferred liabilities:                   Note receivable     (256,000 )     (82,000 )   Other noncurrent assets     (929,000 )     —                         $ 12,856,000     $ —                       The Company has maintained a valuation allowance for its deferred tax assets, as the absence of pre-tax income in the past created uncertainty surrounding the realization of the benefits of the Company’s deferred tax assets in future periods. In 2005, the Company recorded a provision for deferred income taxes of approximately $4,196,000 and a decrease in net deferred tax assets. In 2004, the Company utilized valuation allowances of approximately $2,656,000, to offset a corresponding decrease in net deferred tax assets. The valuation allowance increased by $4,848,000 during 2003.  In 2005, the Company also recorded a deferred tax benefit to reverse approximately $18,056,000 of the valuation allowance on deferred tax assets based on Management’s belief that it is more likely than not that some of the Company’s net deferred tax assets will be realized due to the Company’s achieved  F - 26    Table of Contents  earnings trend and outlook. The Company reported taxable income for 2004 and expects to do so for 2005 when its tax returns are filed. While the sale of certain assets included in discontinued operations will result in a taxable loss in the year of sale (expected to be 2006), the Company expects its remaining operations will continue to result in taxable income that will allow the net deferred tax assets to be realized. The Company continues to maintain a valuation allowance to reduce the deferred tax assets by the amount management believes is more likely not to be utilized through the turnaround of existing temporary differences, future earnings, or a combination thereof. After determining the deferred tax assets that are more likely than not to be realized, the Company provided a valuation allowance where the turnaround of existing temporary differences will more likely result in additional net operating loss carry forward credits, for existing net operating loss carry forward credits, and for existing temporary differences the turnaround of which are not likely. In future periods, the Company will continue to assess the need for and adequacy of the remaining valuation allowance of $15,857,000. Any such change may be material in the period in which the change is recorded.  The Company received previously undistributed earnings from its Canadian subsidiary in connection with the sale of the subsidiary in 2004, as discussed in Note 10. Deferred income taxes on these undistributed earnings had not been recognized prior to the sale, as they were intended to be permanently reinvested.  At December 31, 2005, the Company had $17,968,000 of net operating losses, which expire at various dates beginning in 2019 and continuing through 2023. During 2005, the Company completed an evaluation of the effect of change in ownership provisions of the Federal tax code on its net operating loss carryforwards, and determined that its net operating losses generated prior to February 2001 are limited by these provisions. At December 31, 2005, losses totaling $11,908,000 are limited by these change in ownership provisions, and their usage is limited to a maximum of approximately $7,237,000. These losses expire at various dates beginning in 2019 and continuing through 2021. The Company had provided a full valuation allowance against the net deferred asset related to these operating losses. As of December 31, 2005, the Company has reduced the deferred tax asset and the corresponding valuation allowances by approximately $1,775,000 for net operating loss deductions permanently lost as a result of the change in ownership provisions. At December 31, 2005, the Company had $6,060,000 of net operating losses that are not subject to these limitations, which expire in 2022 and 2023.  The United States Internal Revenue Code limits the amount of taxable income that may be offset by net operating losses. As a result of these limitations, the Company recorded a current provision for federal income taxes of continuing operations of $19,000 and $202,000 in 2005 and 2004, respectively.  The Canada Customs and Revenue Agency audited the Canadian federal tax return of DCMS, the Company’s Canadian subsidiary sold in 2004 (see Note 10) for the years ended December 31, 2003 and 2002 and proposed certain adjustments to the Company’s tax returns. The adjustments related to the Company’s deductions related to allocation of overhead charges of United States management to DCMS. Under the terms of the sale of DCMS, the Company is liable for any liability that arises from these adjustments. In the fourth quarter of 2005, the Company recorded a charge for its estimated liability for additional tax, interest and professional fees resulting from these proposed adjustments. The charge is included in discontinued operations.     14.   COMMITMENTS AND CONTINGENCIES    Lease Commitments  The Company is committed under long-term operating leases with various expiration dates and varying renewal options. Minimum annual rentals, including renewal option periods (exclusive of taxes, insurance, and maintenance costs) under these leases for the next five years beginning January 1, 2006, are as follows for continuing operations:                    2006   $ 15,184,000     2007     15,594,000     2008     16,139,000     2009     16,659,000     2010     15,631,000     Thereafter     156,878,000                   $ 236,085,000                 F - 27    Table of Contents  Under lease agreements with Omega and others, the Company’s lease payments are subject to periodic annual escalations as described below and in Note 2. Total lease expense for continuing operations was $15,836,000, $15,283,000 and $14,883,000 for 2005, 2004 and 2003, respectively.  Omega Leases  Effective October 1, 2000, the Company entered into a 10-year restructured lease agreement (the “Settlement and Restructuring Agreement”) with Omega that amended the Omega Master Lease. The Omega Master Lease includes all facilities currently leased from Omega. All of the accounts receivable, equipment, inventory and other related assets of the facilities leased pursuant to the Omega Master Lease have been pledged as security under the Omega Master Lease. The initial term of the Omega Master Lease is ten years, expiring September 30, 2010, with an additional ten-year renewal term at the option of the Company, assuming no defaults. As discussed below, the Company is not in compliance with certain covenants of the Omega Master Lease. Lease payments were $10,875,000 during each of the first two years of the Omega Master Lease. During subsequent years, increases in the lease payments are equal to the lesser of two times the consumer price index or 3.0%. The Company is recording all scheduled rent increases, including the 3.0% rent increases, as additional lease expense on a straight-line basis over the initial lease term.  The Omega Master Lease required the Company to fund capital expenditures related to the leased facilities totaling $1,000,000 during the first two years of the initial lease term. The Company is also required to fund annual capital expenditures equal to $325 per licensed bed over the initial lease term (annual required capital expenditures of $994,000). The Company is in compliance with the capital expenditure requirements. Total required capital expenditures over the initial lease term are $10,940,000. These capital expenditures are being depreciated on a straight-line basis over the initial lease term beginning October 1, 2000.  Upon expiration of the Omega Master Lease or in the event of a default under the Omega Master Lease, the Company is required to transfer all of the leasehold improvements, equipment, furniture and fixtures of the leased facilities to Omega. In the event that the Company does not transfer all of the facility assets to Omega, the Company will be required to pay Omega $5,000,000 plus accrued interest at 11.00% from the effective date of the Settlement and Restructuring Agreement. The Company’s management intends to transfer the facility assets to Omega at the end of the lease term; consequently, the Company has not recorded a liability for the potential $5,000,000 payment and has not recorded any interest expense related to the potential $5,000,000 payment. The assets to be transferred to Omega are being depreciated on a straight-line basis over the initial lease term beginning October 1, 2000, and will be fully depreciated upon the expiration of the lease.  In June 2005, the Company further amended the master lease with Omega. The amendment provides financing of up to $5,000,000 to be used to fund renovations to several nursing centers leased from Omega. The annual base rent related to these facilities will be increased to reflect the amount of capital improvements made to the respective facilities. The increase will be based on a rate of 10.25% per year of the amount financed under this amendment. The amendment also included provisions to amend certain professional liability insurance requirements of the master lease agreement in order to cure certain defaults under the master lease agreement. As of December 31, 2005, the Company had incurred expenditures of $695,000 for these improvements and had received reimbursements totaling $693,000 from Omega.  As of December 31, 2005, the Company is not in compliance with certain debt covenants. Such events of default under the Company’s debt agreements could lead to actions by the lenders that could result in events of default under the Company’s Omega Master Lease. A default in the Omega Master Lease allows the lessor the right to terminate the lease agreements and assume operating rights with respect to the leased properties. The net book value of property and equipment, including leasehold improvements, related to these facilities total approximately $4.2 million as of December 31, 2005.  F - 28    Table of Contents  Florida Leases  Effective April 1, 2003, the Company entered into leases for four nursing centers in Florida that had previously been managed by the Company under management contracts. Accordingly, the results of operations of these facilities are included in the Company’s results of operations beginning April 1, 2003. Omega holds mortgages on these properties and the Company makes the lease payments directly to Omega. Through December 31, 2005, the lease provided for additional rent to be imposed based on the profitability of the facilities. The Company evaluates such additional rentals each quarter and records additional expense as incurred. Additional rent totaling $412,000 was imposed in 2005. There was no additional rent incurred in 2003 or 2004.  The term of the leases were extended in December 2005 through February 2010. Lease payments will be $1,543,000 during 2006, with increases equal to the lesser of two times the consumer price index or 3.0% in subsequent years. The amendment eliminated the additional rents imposed based on the profitability of the facilities beginning January 1, 2006. The Company is recording all scheduled rent increases as additional lease expense on a straight-line basis over the remaining lease term. The Company is also required to fund annual capital expenditures equal to $350 per licensed bed over the initial lease term, subject to adjustment for increases in the Consumer Price Index. These required capital expenditures are depreciated on a straight-line basis over the remaining lease term.  Under the terms of the previous management contracts, the Company was required to obtain professional liability insurance coverage for the four facilities and received reimbursement for the facilities’ pro rata share of premiums paid as well as any claims paid on behalf of the owner. Due to the deteriorated financial condition of the owner and the terms of the owner’s mortgage on the facilities, the Company does not believe that the owner of the four facilities will in the future be able to reimburse the Company for costs incurred in connection with professional liability claims arising out of events occurring at the four facilities prior to the entry of the lease. As a result, the Company recorded a liability of approximately $4.3 million in the second quarter of 2003 to record obligations for estimated professional liability claims relating to these facilities for which the Company does not anticipate receiving reimbursement from the owner of the facilities.  Counsel Leases  The Company leased three nursing centers located in Texas from Counsel Corporation (together with its affiliates, “Counsel”) with an initial term of ten years through April 2004 and one ten-year renewal option. At the expiration of the initial term of this lease, the Company declined to exercise the renewal option, but continued to lease these facilities on a month to month basis until December 2004, when Counsel sold the properties. The Company terminated its operations in these facilities and cooperated in an orderly transition to the new owner.  The Company leased five additional facilities in Canada from Counsel with a remaining term expiring in April 2004. The Canadian facilities are also part of the discontinued operations. As discussed in Note 10, the Company sold its Canadian operations in May 2004 and no longer leases the Canadian facilities from Counsel.  Insurance Matters  Professional Liability and Other Liability Insurance  Due to the Company’s past claims experience and increasing cost of claims throughout the long-term care industry, the premiums paid by the Company for professional liability and other liability insurance to cover future periods exceeds the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2001, the Company has purchased professional liability insurance coverage for its facilities that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. As a result, the Company is effectively self-insured and expects to remain so for the foreseeable future.  F - 29    Table of Contents  The Company has essentially exhausted all general and professional liability insurance available for claims first made during the period from March 9, 2001 through March 9, 2006. For claims made during the period from March 10, 2006 through March 9, 2007, the Company maintains insurance with coverage limits of $100,000 per medical incident and total aggregate policy coverage limits of $500,000.  Reserve for Estimated Self-Insured Professional Liability Claims  Because the Company anticipates that its actual liability for existing and anticipated claims will exceed the Company’s limited professional liability insurance coverage, the Company has recorded total liabilities for professional liability and other claims of $34.5 million as of December 31, 2005. This accrual includes estimates of liability for incurred but not reported claims, estimates of liability for reported but unresolved claims, actual liabilities related to settlements, including settlements to be paid over time, and estimates of legal costs related to these claims. The Company does not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof.  The Company records its estimated liability for these professional liability claims based on the results of a third-party actuarial analysis. Each quarter, amounts are added to the accrual for estimates of anticipated liability for claims incurred during that period. These estimates are assessed and adjusted quarterly as claims are actually reported, as lawsuits are filed, and as those actions are actually resolved. As indicated by the chart of reserves by policy year set forth below, final determination of the Company’s actual liability for claims incurred in any given period is a process that takes years. At each quarter end, the Company records any revisions in estimates and differences between actual settlements and reserves, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period. Although the Company retains a third-party actuarial firm to assist management in estimating the appropriate accrual for these claims, professional liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. As a result, the Company’s actual liabilities may vary significantly from the accrual, and the amount of the accrual has and may continue to fluctuate by a material amount in any given quarter. Each change in the amount of this accrual will directly affect the Company’s reported earnings and financial position for the period in which the change in accrual is made.  While each quarterly adjustment to the recorded liability for professional liability claims affects reported income, these changes do not directly affect the Company’s cash position because the accrual for these liabilities is not funded. The Company does not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof. In the event a significant judgment is entered against the Company in one or more legal actions in which there is no or insufficient professional liability insurance, the Company anticipates that payment of the judgment amounts would require cash resources that would be in excess of the Company’s available cash or other resources. Any such judgment could have a material adverse impact on the Company’s financial position and cash flows.  The following summarizes the Company’s accrual for professional liability and other claims for each policy year as of the end of the period:                              December 31,         2005     2004       Policy Year End March 9,                   2006   $ 10,492,000     $ —     2005     12,722,000       12,068,000     2004     6,351,000       15,626,000     2003     3,137,000       10,041,000     2002     859,000       3,292,000     Other     966,000       1,873,000                         $ 34,527,000     $ 42,900,000                       F - 30    Table of Contents  Other Insurance  With respect to workers’ compensation insurance, substantially all of the Company’s employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. Prior to that time, the Company was self-insured for the first $250,000, on a per claim basis, for workers’ compensation claims in a majority of its facilities. However, the insurance carrier providing coverage above the Company’s self insured retention has been declared insolvent by the applicable state insurance agency. As a result, the Company is completely self-insured for workers compensation exposures prior to May 1997. The Company has been and remains a non-subscriber to the Texas workers’ compensation system and is, therefore, completely self-insured for employee injuries with respect to its Texas operations. For the policy period July 1, 2002 through June 30, 2003, the Company entered into a “high deductible” workers compensation insurance program covering the majority of the Company’s employees. Under the high deductible policy, the Company is self insured for the first $25,000 per claim, subject to an aggregate maximum out of pocket cost of $1.6 million, for the 12 month policy period. The Company has a letter of credit of $0.4 million securing its self insurance obligations under this program. The letter of credit is secured by a certificate of deposit of $0.4 million, which is included in “restricted cash” in the accompanying balance sheet. The reserve for the high deductible policy is based on known claims incurred and an estimate of incurred but not reported claims determined by an analysis of historical claims incurred. The Company has provided reserves for the settlement of outstanding self-insured claims at amounts believed to be adequate. The liability recorded by the Company for the self-insured obligations under these plans is $0.6 million as of December 31, 2005.  Effective June 30, 2003, the Company entered into new workers compensation insurance programs that provide coverage for claims incurred, with premium adjustments depending on incurred losses. The Company accounts for premium expense under these policies based on its estimate of the level of claims expected to be incurred. As of December 31, 2005, the Company has recorded estimated premium refunds due under these programs totaling approximately $3.7 million, with $1.3 million included in “prepaid expenses and other current assets” and the balance included in “other noncurrent assets” in the accompanying balance sheet, based upon expected settlement dates. Any adjustments of future premiums for workers compensation policies and differences between actual settlements and reserves for self-insured obligations are included in expense in the period finalized.  The Company is self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 per individual annually. The Company provides reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate. The liability for reported claims and estimates for incurred but unreported claims is $1.0 million at December 31, 2005. The differences between actual settlements and reserves are included in expense in the period finalized.  Employment Agreements  The Company has employment agreements with certain members of management that provide for the payment to these members of amounts up to 2.5 times their annual salary in the event of a termination without cause, a constructive discharge (as defined), or upon a change in control of the Company (as defined). The maximum contingent liability under these agreements is approximately $1.2 million. In addition, upon the occurrence of any triggering event, certain executives may elect to require the Company to purchase options granted to them for a purchase price equal to the difference in the fair market value of the Company’s common stock at the date of termination versus the stated option exercise price. The terms of such agreements are from one to three years and automatically renew for one year if not terminated by the employee or the Company.  Health Care Industry and Legal Proceedings  The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse. Changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, have had a material adverse effect on the Company’s financial position, results of operations, and cash flows. Future federal budget legislation and federal and state regulatory changes may negatively impact the Company.  F - 31    Table of Contents  All of the Company’s nursing centers must be licensed by the state in which they are located in order to accept patients, regardless of payor source. In most states, nursing homes are subject to certificate of need laws, which require the Company to obtain government approval for the construction of new nursing homes or the addition of new licensed beds to existing homes. The Company’s nursing centers must comply with detailed statutory and regulatory requirements on an ongoing basis in order to qualify for licensure, as well as for certification as a provider eligible to receive payments from the Medicare and Medicaid programs. Generally, the requirements for licensure and Medicare/Medicaid certification are similar and relate to quality and adequacy of personnel, quality of medical care, record keeping, dietary services, resident rights, and the physical condition of the facility and the adequacy of the equipment used therein. Each facility is subject to periodic inspections, known as “surveys” by health care regulators, to determine compliance with all applicable licensure and certification standards. Such requirements are both subjective and subject to change. If the survey concludes that there are deficiencies in compliance, the facility is subject to various sanctions, including but not limited to monetary fines and penalties, suspension of new admissions, non-payment for new admissions and loss of licensure or certification. Generally, however, once a facility receives written notice of any compliance deficiencies, it may submit a written plan of correction and is given a reasonable opportunity to correct the deficiencies. There can be no assurance that, in the future, the Company will be able to maintain such licenses and certifications for its facilities or that the Company will not be required to expend significant sums in order to comply with regulatory requirements.  Over the last several years, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse statutes and regulations as well as laws and regulations governing quality of care issues in the skilled nursing profession in general. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations is subject to ongoing government review and interpretation, as well as regulatory actions which may be unknown or unasserted at this time. The Company is involved in regulatory actions of this type from time to time.  As of December 31, 2005, the Company is engaged in 16 professional liability lawsuits. None of these matters are currently scheduled for trial within the next year. The ultimate results of these or any other of the Company’s professional liability claims and disputes cannot be predicted. The Company has limited, and sometimes no, professional liability insurance with regard to most of these claims. In the event a significant judgment is entered against the Company in one or more of these legal actions in which there is no or insufficient professional liability insurance, the Company would not have available cash resources to satisfy the judgment. Further, settlement of these and other cases may require cash resources that would be in excess of the Company’s available cash or other resources. These potential future payments, whether of a judgment or in settlement of a disputed claim, could have a material adverse impact on the Company’s financial position and cash flows.  On September 8, 2004, the Company entered into a settlement agreement with the attorney General of the State of Arkansas setting forth the terms by which the Company resolved all civil claims and investigations commenced by the State of Arkansas prior to the entry of the agreement, including seven lawsuits then pending in the Circuit Court of Pulaski County, Arkansas alleging violations of the Arkansas Abuse of Adults Act and violation of the Arkansas Medicaid False Claims Act with respect to certain residents of facilities operated by the Company in Arkansas. This agreement was subsequently amended to settle one additional case. Under the terms of the settlement, the Company is obligated (i) to pay $417,000 in equal monthly installments of $16,667 beginning on September 1, 2004 and ending on September 1, 2006, and (ii) to pay by no later than September 1, 2007, no less than $600,000 to install sprinkler systems in nursing centers within the State of Arkansas to be selected by the Company. The Company has incurred expenditures of approximately $391,000 through December 31, 2005 toward the requirement to install sprinkler systems.  In 2003, the Company’s insurance carriers for claims incurred in 1997 and 1998 were ordered to pay one-half respectively of a final judgment entered against the Company in a professional liability case tried in Mena, Arkansas in 2001. The Company’s 1997 policy included primary coverage of up to $1 million  F - 32    Table of Contents  through one carrier that has been declared insolvent. The umbrella carrier has demanded that the Company pay this $1 million portion of the judgment. The Company has denied responsibility for this liability, and the carrier has not filed any action seeking to recover this amount.  The Company cannot currently predict with certainty the ultimate impact of any of the above cases on the Company’s financial condition, cash flows or results of operations. An unfavorable outcome in any of the lawsuits, any investigation or lawsuit alleging violations of fraud and abuse laws or of elderly abuse laws or any state or Federal False Claims Act case could have a material adverse impact on the Company’s financial condition, cash flows or results of operations   Reimbursement  The Balanced Budget Act enacted during 1997 (the “BBA”) phased in the prospective payment system for nursing centers and contained numerous Medicare and Medicaid cost-saving measures. As initially implemented, the BBA negatively impacted the entire long-term care industry. During 1999 and 2000, certain amendments to the BBA were enacted, which helped restore some of the Medicare funding originally eliminated under the BBA. However, certain provisions in the amendments expired on September 30, 2002 and December 31, 2005.  In 2005, the Centers for Medicare and Medicaid (“CMS”) issued the final rule for the refinement of the Resource Utilization Group (“RUG”) system and provided for the elimination of the reimbursement add-ons for high acuity patients. In addition, Congress implemented a market basket adjustment of approximately 3.1% designed to increase reimbursement for the effects of inflation. The market basket adjustment became effective October 1, 2005, and increased the Company’s revenue and operating cash flow by approximately $1.6 million annually. The eliminations of the add-ons and other offsetting adjustments were effective January 1, 2006, and were originally expected to decrease the Company’s revenue and operating cash flow by an estimated $2.5 million annually. It was originally estimated that the net effect of the CMS rule would be to reduce the Company’s revenue and operating cash flow by approximately $0.9 million per year. However, the Company has seen in 2006 a continuing shift to higher acuity patients result in higher reimbursement. It is now expected that the effect of the elimination of the add-ons and RUG refinement will have no material impact on the Company.  Certain per person annual Medicare Part B reimbursement limits on therapy services became effective January 1, 2006. Subject to certain exceptions, the limits impose a $1,740 per patient annual ceiling on physical and speech therapy services, and a separate $1,740 per patient annual ceiling on occupational therapy services. The exception process is still being defined by CMS, but we believe the majority of services provided by the Company will be reimbursed under the exceptions. The exception process is currently only effective through December 31, 2006. If the exception process is discontinued for 2007, it is expected that the reimbursement limitations will reduce therapy revenues, and negatively impact the Company’s operating results and cash flows.  The Federal Deficit Reduction Act of 2005 mandates the reduction by 30% the amount that Medicare reimburses nursing centers and other non-hospital providers for bad debts arising from uncollectible Medicare coinsurance and deductibles for those individuals that are not dually eligible for Medicare and Medicaid. The reduction is to be phased in over a three year period with 10% during fiscal 2006, 20% during fiscal 2007 and 30% thereafter. This provision is not expected to have a material impact on the Company.  The budget proposed by President Bush for the governments 2007 fiscal years includes a number of proposed reductions to Medicare reimbursement for nursing homes and also appears to challenge certain Federal matching programs that benefit many of the state Medicaid programs, including several of the states in which the Company operates nursing facilities. The Company is unable to quantify the impact that these possible reimbursement cuts would have on it.  Reduction in health care spending has become a national priority in the United States, and the field of health care regulation and reimbursement is a rapidly evolving one. For the fiscal year ended December 31, 2005, the Company derived 30.0% and 58.0% of its total patient and resident revenues related to continuing operations from the Medicare and Medicaid programs, respectively. Any health care reforms that significantly limit rates of reimbursement under these programs could, therefore, have a material  F - 33    Table of Contents  adverse effect on the Company’s profitability. The Company is unable to predict which reform proposals or reimbursement limitations will be adopted in the future, or the effect such changes would have on its operations. The Company will attempt to maximize the revenues available from governmental sources within the changes that have occurred and will continue to occur.  The Company will also attempt to increase revenues from non-governmental sources to the extent capital is available to do so, if at all. However, private payors, including managed care payors, are increasingly demanding that providers accept discounted fees or assume all or a portion of the financial risk for the delivery of health care services. Such measures may include capitated payments, which can result in significant losses to health care providers if patients require expensive treatment not adequately covered by the capitated rate.  15. RELATED PARTIES  The Company commenced operations effective with an initial public offering of common stock in May 1994. The Company’s predecessor operations were in companies owned or controlled by Counsel. From the Company’s inception through November 1996, the Company had two directors who are directors and key executives of Counsel. Until the sale of DCMS, as discussed in Note 14, the Company provided management services for nine facilities owned by two Canadian limited partnerships. Management fees from these facilities totaled $522,000 and $2,029,000 for 2004 and 2003, respectively, and are included in Income from Discontinued Operations in the accompanying consolidated financial statements. Counsel leased seven of these facilities from one of the partnerships.  The Company leased 8 facilities from Counsel. As discussed in Note 14, following the sale of DCMS and the expiration of leases for facilities in the United States, the Company no longer leases any facilities from Counsel. Lease expense related to the facilities leased from Counsel totaled $590,000 and $1,306,000 in 2004 and 2003, respectively, and are included in Income from Discontinued Operations in the accompanying consolidated financial statements.  F - 34    Table of Contents  16. QUARTERLY FINANCIAL INFORMATION (Unaudited)  Selected quarterly financial information for each of the quarters in the years ended December 31, 2005 and 2004 is as follows:                                              Quarter     2005   First     Second     Third     Fourth         Net revenues   $ 48,884,000     $ 49,607,000     $ 51,423,000     $ 53,744,000                                 Professional liability expense (benefit)(1)     (7,242,000 )     1,461,000       968,000       851,000                                 Net income from continuing operations(2)     8,941,000       1,761,000       2,017,000       17,882,000 (2)                               Income (loss) from discontinued operations(3)     23,000       (127,000 )     (246,000 )     (4,949,000 )(3)                               Net income for common stock   $ 8,886,000     $ 1,556,000     $ 1,690,000     $ 12,852,000                                                                     Basic net income (loss) per common share:                                   Net income from continuing operations   $ 1.55     $ 0.29     $ 0.34     $ 3.11     Income (loss) from discontinued operations     —       (0.02 )     (0.05 )     (0.87 )                               Net income per common share   $ 1.55     $ 0.27     $ 0.29     $ 2.24                                                                     Diluted net income (loss) per common share:                                   Net income from continuing operations   $ 1.37     $ 0.27     $ 0.31     $ 2.75     Income (loss) from discontinued operations     0.01      (0.02 )     (0.04 )     (0.76 )                               Net income per common share   $ 1.38     $ 0.25     $ 0.27     $ 1.99                                              (1)   The Company’s quarterly results are significantly affected by the amounts recorded for professional liability expense, as discussed further in Note 14. The amount of expense (benefit) recorded for professional liability in each quarter of 2004 is set forth in the table above.     (2)   Includes $13.9 million deferred tax benefit, as further discussed in Note 13.     (3)   Includes asset impairment and other charges of $4.4 million, as further discussed in Note 5.   F - 35    Table of Contents                                              Quarter     2004   First     Second     Third     Fourth         Net revenues   $ 45,725,000     $ 46,046,000     $ 48,779,000     $ 50,674,000                                 Professional liability expense (benefit)(1)     (2,935,000 )     (1,668,000 )     2,505,000       264,000                                 Net income from continuing operations     4,745,000       3,602,000       369,000       3,813,000                                 Loss from discontinued operations(2)     (53,000 )     (1,134,000 )     (583,000 )     (7,978,000 )(2)                               Net income (loss) for common stock(3)   $ 4,620,000     $ 2,394,000     $ (289,000 )   $ (4,241,000 )                                                                   Basic net income (loss) per common share:                                   Net income from continuing operations   $ 0.84     $ 0.62     $ 0.05     $ 0.66     Loss from discontinued operations     (0.01 )     (0.20 )     (0.10 )     (1.40 )                               Net income (loss) per common share    $ 0.83     $ 0.42     $ (0.05 )   $ (0.74 )                               Diluted net income (loss) per common share:                                   Net income from continuing operations   $ 0.72     $ 0.56     $ 0.05     $ 0.58     Loss from discontinued operations     (0.01 )     (0.18 )     (0.10 )     (1.23 )                               Net income (loss) per common share   $ 0.71     $ 0.38     $ (0.05 )   $ (0.65 )                                            (1)   The Company’s quarterly results are significantly affected by the amounts recorded for professional liability expense, as discussed further in Note 14. The amount of expense (benefit) recorded for professional liability in each quarter of 2004 is set forth in the table above.     (2)   Includes asset impairment and other charges of $8.5 million, as further discussed in Note 5.   F - 36    Table of Contents  ADVOCAT INC.  SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS OF CONTINUING OPERATIONS (in thousands)                                                          Column A   Column B             Column C             Column D     Column E                         Additions             Deductions                                             Balance                                             at     Charged                             Balance     Description   Beginning     to     Charged             (Write-offs)     at         of     Costs and     to Other             net of     End of         Period (1)     Expenses     Accounts(1)     Other     Recoveries     Period             Year ended December 31, 2005:                                                   Allowance for doubtful accounts   $ 1,712     $ 1,560     $ 164     $ —     $ (1,714 )   $ 1,722                                                         Year ended December 31, 2004:                                                   Allowance for doubtful accounts   $ 1,799     $ 1,359     $ 384     $ —     $ (1,830 )   $ 1,712                                                         Year ended December 31, 2003:                                                   Allowance for doubtful accounts   $ 2,192     $ 1,534     $ 173     $ —     $ (2,100 )   $ 1,799                      (1)   As discussed in Note 10 of the Consolidated Financial Statements, the Company has reclassified its financial statements for 2005 and all prior periods to present the results of certain divestiture and lease termination transactions as discontinued operations. Apart from the sale of the Canadian operations, the other divestiture and lease termination transactions generally resulted in the surrender of property and equipment in the facilities, but did not result in the sale of accounts receivable or other current assets or the assumption of current liabilities or debt. Accordingly, such current assets and liabilities were not reclassified to discontinued operations. This schedule sets forth amount of provision for doubtful accounts charged to discontinued operations separately for discontinued operations other than the Canadian operations. The amounts related to the Canadian operations are disclosed separately in the next schedule.   S - 1    Table of Contents  ADVOCAT INC.  SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS OF DISCONTINUED CANADIAN OPERATIONS (in thousands)                                                          Column A   Column B             Column C             Column D     Column E                         Additions             Deductions                                             Balance                                             at     Charged                             Balance     Description   Beginning     to     Charged             (Write-offs)     at         of     Costs and     to Other             net of     End of         Period (1)     Expenses     Accounts     Other(2)     Recoveries     Period             Year ended December 31, 2005:                                                   Allowance for doubtful accounts   $ —     $ —     $ —     $ —     $ —     $ —                                                         Year ended December 31, 2004:                                                   Allowance for doubtful accounts   $ 29     $ 5     $ —     $ (28 )   $ (6 )   $ —                                                         Year ended December 31, 2003:                                                   Allowance for doubtful accounts   $ 23     $ 12     $ —     $ —     $ (6 )   $ 29                      (1)   As discussed in Note 10 of the Consolidated Financial Statements, the Company has reclassified its financial statements for 2005 and all prior periods to present the results of certain divestitures as discontinued operations. The receivables and related allowance for doubtful accounts of the Canadian operations were reclassified to discontinued operations. This schedule sets forth the amounts related solely to Canadian operations.     (2)    The Canadian operations were sold in May 2004, and all related accounts were removed in recording the sale.   S - 2    Table of Contents                  Exhibit       Number   Description of Exhibits       2.1     Asset Purchase Agreement among the Company, Pierce Management Group First Partnership and others dated July 23, 1997 (incorporated by reference to Exhibit 2 to the Company’s quarterly report on Form 10-Q for the quarter ended June 30, 1997).                 3.1     Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Company’s Registration Statement No. 33-76150 on Form S-1).                 3.2     Certificate of Designation of Registrant (incorporated by reference to Exhibit 3.4 to the Company’s quarterly report on Form 10-Q for the quarter ended March 31, 2001).                 3.3     Bylaws of the Company (incorporated by reference to Exhibit 3.2 to the Company’s Registration Statement No. 33-76150 on Form S-1).                 3.4     Amendment to Certificate of Incorporation dated March 23, 1995 (incorporated by reference to Exhibit A of Exhibit 1 to the Company’s Form 8-A filed March 30, 1995).                 3.5     Certificate of Designation of Registrant (incorporated by reference to Exhibit 3.4 to the Company’s quarterly report on Form 10-Q for the quarter ended March 31, 2001).                 4.1     Form of Common Stock Certificate (incorporated by reference to Exhibit 4 to the Company’s Registration Statement No. 33-76150 on Form S-1).                 4.2     Rights Agreement dated March 13, 1995, between the Company and Third National Bank in Nashville (incorporated by reference to Exhibit 1 to the Company’s Current Report on Form 8-K dated March 13, 1995).                 4.3     Summary of Shareholder Rights Plan adopted March 13, 1995 (incorporated by reference to Exhibit B of Exhibit 1 to Form 8-A filed March 30, 1995).                 4.4     Rights Agreement of Advocat Inc. dated March 23, 1995 (incorporated by reference to Exhibit 1 to Form 8-A filed March 30, 1995).                 4.5     Amended and Restated Rights Agreement dated as of December 7, 1998 (incorporated by reference to Exhibit 1 to Form 8-A/A filed December 7, 1998).                 10.1     1994 Incentive and Non-Qualified Stock Plan for Key Personnel (incorporated by reference to Exhibit 10.3 to the Company’s Registration Statement No. 33-76150 on Form S-1).                 10.2     1994 Non-Qualified Stock Option Plan for Directors (incorporated by reference to Exhibit 10.4 to the Company’s Registration Statement No. 33-76150 on Form S-1).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.3     Master Agreement and Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.6 to the Company’s Registration Statement No. 33-76150 on Form S-1).                 10.4     Form of Director Indemnification Agreement (incorporated by reference to Exhibit 10.8 to the Company’s Registration Statement No. 33-76150 on Form S-1).                 10.5     Consent, Assignment and Amendment Agreement between Diversicare Corporation of America, Counsel Nursing Properties, Inc., Advocat Inc., Diversicare Leasing Corporation and Omega Healthcare Investors, Inc. dated May 10, 1994 (incorporated by reference to Exhibit 10.10 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1994).                 10.6     Advocat Inc. Guaranty in favor of Omega Healthcare Investors, Inc. dated May 10, 1994 (incorporated by reference to Exhibit 10.11 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1994).                 10.7     Demand Master Promissory Note by Advocat Inc. to the order of Diversicare Corporation of America dated May 10, 1994 (incorporated by reference to Exhibit 10.23 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1994).                 10.8     Lease Agreement between HealthCare Ventures and Wessex Care Corporation dated October 23, 1989, as assigned effective May 10, 1994, to Diversicare Leasing Corp. (incorporated by reference to Exhibit 10.40 to the Company’s Registration Statement No. 33-76150 on Form S-1).                 10.9     Lease Agreement between Osborne & Wilson Development Corp., Inc. and Diversicare Corporation of America dated July 7, 1989, as assigned effective May 10, 1994, to Diversicare Leasing Corp. (incorporated by reference to Exhibit 10.41 to the Company’s Registration Statement No. 33-76150 on Form S-1).                 10.10     Master Credit and Security Agreement dated December 27, 1996, between First American National Bank, GMAC-CM Commercial Mortgage Corporation, Advocat Inc., Management Services Co. and the Subsidiaries (as defined) (incorporated by reference to Exhibit 10.58 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1996).                 10.11     Project Loan Agreement (Afton Oaks) dated December 27, 1996 between GMAC-CM Commercial Mortgage Corporation, Advocat Inc., Diversicare Management Services Co. and the Subsidiaries (as defined) (incorporated by reference Exhibit 10.60 to the Company’s Annual Report on Form for the fiscal year ended December 31, 1996).                 10.12     Amendment to 1994 Incentive and Non-Qualified Stock Plan for Key Personnel (incorporated by reference to Exhibit A to the Company’s Schedule 14A filed March 31, 1997).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.13     Amendment to 1994 Non-Qualified Stock Option Plan for Directors (incorporated by reference to Exhibit A to the Company’s Schedule 14A filed April 19, 1996).                 10.14     Amendment No. 3 Advocat Inc. 1994 Incentive and Nonqualified Stock Option Plan For Key Personnel (incorporated by reference to Exhibit A to the Company’s Schedule 14A filed April 3, 1998).                 10.15     Renewal and Modification Promissory Note dated March 31, 1998, between the Company and AmSouth Bank. (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1998).                 10.16     Renewal and Modification Promissory Note dated March 31, 1998, between the Company and First American National Bank (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1996).                 10.17     Second Amendment to Loan and Negative Pledge Agreement dated March 31, 1998, between Diversicare Assisted Living Services NC, LLC and First American National Bank, both individually and as Agent for AmSouth Bank (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1996).                 10.18     Loan Agreement dated the 4th day of June, 1999, by and between Diversicare Assisted Living Services NC II, LLC, a Delaware limited liability company and GMAC Commercial Mortgage Corporation, a California corporation (incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 1999).                 10.19     Loan Agreement dated the 4th day of June, 1999, by and between Diversicare Assisted Living Services NC I, LLC, a Delaware limited liability company and GMAC Commercial Mortgage Corporation, a California corporation (incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 1999).                 10.20     Fourth Amendment to Master Credit and Security Agreement dated as of April 14, 1999 (incorporated by reference to Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 1999).                 10.21     Form of Fifth Amendment to Master Credit and Security Agreement between Diversicare Management Services Co. and First American National Bank (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1999).                 10.22     Fourth Amendment to Loan and Negative Pledge Agreement dated October 1, 1999 between Diversicare Assisted Living Services NC, LLC. and First American National          Table of Contents                  Exhibit       Number   Description of Exhibits             Bank along with AmSouth Bank (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form10-Q for the quarter ended September 30, 1999).                 10.23     Line of Credit Note (Overline Facility) dated October 1, 1999 between Diversicare Management Services Co. and First American National Bank (incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1999).                 10.24     Fifth Amendment to Loan and Negative Pledge Agreement dated December 1, 1999 between Diversicare Assisted Living Services PC, LLC and First American National Bank along with AmSouth Bank (incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q/A for the quarter ended September 30, 1999).                 10.25     Sixth Amendment to Master Credit and Security Agreement dated December 1, 1999 between Diversicare Management Services Co. and First American National Bank along with GMAC Commercial Mortgage Company (incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q/A for the quarter ended September 30, 1999).                 10.26     Amendments to Promissory Notes dated November 30, 1999 between Diversicare Management Services Co. and GMAC Commercial Mortgage Corporation. (Four amendments extending the term to April 30, 2000 on four notes totaling $11.1 million.) (incorporated by reference to Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q/A for the quarter ended September 30, 1999).                 10.27     Settlement and Restructuring Agreement dated as of October 1, 2000 among Registrant, Diversicare Leasing Corp., Sterling Health Care Management, Inc., Diversicare Management Services Co., Advocat Finance, Inc., Omega Healthcare Investors, Inc. and Sterling Acquisition Corp. (incorporated by reference to Exhibit 10.83 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).                 10.28     Consolidated Amended and Restated Master Lease dated November 8, 2000, effective October 1, 2000, between Sterling Acquisition Corp. (as Lessor) and Diversicare Leasing Corp. (as Lessee) (incorporated by reference to Exhibit 10.84 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).                 10.29     Management Agreement effective October 1, 2000, between Diversicare Leasing Corp. and Diversicare Management Services Co. (incorporated by reference to Exhibit 10.85 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.30     Amended and Restated Security Agreement dated as of November 8, 2000 between Diversicare Leasing Corp and Sterling Acquisition Corp. (incorporated by reference to Exhibit 10.86 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).                 10.31     Security Agreement dated as of November 8, 2000 between Sterling Health Care Management, Inc. and Sterling Acquisition Corp. (incorporated by reference to Exhibit 10.87 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).                 10.32     Guaranty given as of November 8, 2000 by Registrant, Advocat Finance, Inc., Diversicare Management Services Co., in favor of Sterling Acquisition Corp. (incorporated by reference to Exhibit 10.88 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).                 10.33     Reaffirmation of Obligations (Florida Managed Facilities) by Registrant and Diversicare Management Services Co. to and for the benefit of Omega Healthcare Investors (incorporated by reference to Exhibit 10.89 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).                 10.34     Subordinated Note dated as of November 8, 2000 in the amount of $1,700,000 to Omega Healthcare Investors, Inc. from Registrant (incorporated by reference to Exhibit 10.90 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).                 10.35     Master Amendment to Loan Documents and Agreement dated as of November 8, 2000, effective October 1, 2000, among Registrant, its subsidiaries and AmSouth Bank (incorporated by reference to Exhibit 10.91 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).                 10.36     Second Amendment to Intercreditor Agreement among GMAC, AmSouth, Registrant and its subsidiaries (incorporated by reference to Exhibit 10.93 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).                 10.37     Renewal Promissory Note dated October 1, 2000 in the amount of $3,500,000 to AmSouth Bank from Diversicare Management Services Co. (incorporated by reference to Exhibit 10.94 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).                 10.38     Renewal Promissory Note dated October 1, 2000 in the amount of $9,412,383.87 to AmSouth Bank from Diversicare Assisted Living Services NC, LLC (incorporated by reference to Exhibit 10.95 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).                 10.39     Renewal Promissory Note dated October 1, 2000 in the amount of $4,500,000 made payable to AmSouth Bank from Diversicare Management Services Co. (incorporated          Table of Contents                  Exhibit       Number   Description of Exhibits             by reference to Exhibit 10.96 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2000).                 10.40     Termination, Assignment And Release Agreement is dated as of the 30th day of September, 2001 and is by and among (i) Counsel Nursing Properties, Inc., a Delaware corporation and Counsel Corporation [US], a Delaware corporation and the successor by name change to Diversicare Corporation of America, (ii) Diversicare Leasing Corp., a Tennessee corporation and Advocat Inc., a Delaware corporation, and (iii) Omega Healthcare Investors, Inc., a Maryland corporation, OHI Sunshine, Inc., a Florida corporation, and Sterling Acquisition Corp., a Kentucky corporation (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001).                 10.41     Fifth Amendment to Project Loan Agreement and Comprehensive Amendment of All Other Loan Documents dated as of the 28th day of February, 2001, by and between the Company, certain of its subsidiaries and GMAC Commercial Mortgage Corporation. (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).                 10.42     Sixth Amendment to and Assumption of Promissory Note dated as of the 28th day of February, 2001, by certain subsidiaries of the Company and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).                 10.43     Guaranty Agreement re Pinedale dated as of the 29th day of March, 2001, by the Company, for the benefit of GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).                 10.44     Loan Agreement re Pinedale dated as of the 29th day of March, 2001, by and between a subsidiary of the Company, and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).                 10.45     Mortgage and Security Agreement re Pinedale dated as of the 29th day of March, 2001, by and between a subsidiary of the Company, and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).                 10.46     Promissory Note dated 29th day of March 2001, in the amount of $2,913,000.00 in the favor of GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.47     Guaranty Agreement re Windsor House dated as of the 29th day of March, 2001, by the Company, for the benefit of GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).                 10.48     Loan Agreement re Windsor House dated as of the 29th day of March, 2001, by and between a subsidiary of the Company, and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.8 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).                 10.49     Mortgage and Security Agreement re Windsor House dated as of the 29th day of March, 2001, by and between a subsidiary of the Company, and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.9 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).                 10.50     Promissory Note dated 29th day of March 2001, in the amount of $4,709,000.00 in the favor of GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.10 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2001).                 10.51     Revenue Sharing Agreement as of the 30 day of September, 2001, by and among Advocat Inc., Diversicare Leasing Corp., Omega Healthcare Investors, Inc. and OHI Sunshine, Inc. (incorporated by reference to Exhibit 10.125 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001)                 10.52     First Amendment to Consolidated Amended and Restated Master lease dated September 30, 2001 by and between Sterling Acquisition Corp and Diversicare Leasing Corporation. (incorporated by reference to Exhibit 10.126 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001)                 10.53     Lease Termination and Operations Transfer Agreement dated the 31st day of March, 2002 by and between (i) Diversicare Assisted Living Services NC, LLC, a Tennessee limited liability company and Advocat Inc., a Delaware corporation, and (ii) Pierce Management Group First Partnership, a North Carolina general partnership, Pierce Management Group Fifth Partnership, a North Carolina general partnership, Pierce, Pierce And Hall, a North Carolina general partnership, Guy S. Pierce, individually, A. Steve Pierce and wife Mary Lou Pierce and A. Steve Pierce, individually. (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2002)                 10.54     Lease Termination and Operations Transfer Agreement made and entered into as of the 31st day of March, 2002 by and between (i) Diversicare Assisted Living Services, Inc., a Tennessee corporation, and (ii) Guy S. Pierce, an individual, and any person or entity to whom the Agreement is assigned in accordance with Section 17 thereof.          Table of Contents                  Exhibit       Number   Description of Exhibits             (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002)                 10.55     First Amendment to Lease Termination and Operations Transfer Agreement made and entered into as of the 31st day of May, 2002 by and between (i) Diversicare Assisted Living Services, Inc., a Tennessee corporation and Diversicare Assisted Living Services NC, LLC, a Tennessee limited liability company and (ii) Guy S. Pierce, an individual. (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002)                 10.56     Purchase and Sale Agreement dated as of the 25th day of July, 2002 by and between Diversicare Leasing Corp. and Sterling Healthcare, Inc. (incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002)                 10.57     Second Amendment to Loan Agreement dated as of October 1, 2002, by and between Diversicare Assisted Living Services NC II, LLC, and GMAC Commercial Mortgage Corporation. (incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002)                 10.58     Second Amendment to Loan Agreement dated as of October 1, 2002, by and between Diversicare Assisted Living Services NC I, LLC, and GMAC Commercial Mortgage Corporation. (incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002)                 10.59     Second Amendment to Promissory Note dated as of the 1st day of October, 2002, by and between Diversicare Assisted Living Services NC I, LLC, and GMAC Commercial Mortgage Corporation. (incorporated by reference to Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002)                 10.60     Second Amendment to Promissory Note dated as of the 1st day of October, 2002, by and between Diversicare Assisted Living Services NC II, LLC, and GMAC Commercial Mortgage Corporation. (incorporated by reference to Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002)                 10.61     Renewal Reimbursement Promissory Note dated December 15, 2002 from the Company to AmSouth Bank (incorporated by reference to Exhibit 10.134 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2002).                 10.62     Second Amendment to Master Amendment to Loan Documents and Agreement by and between AmSouth Bank, the Company, Diversicare Management Services and other subsidiaries of the Company (incorporated by reference to Exhibit 10.135 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2002).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.63     Second Amendment dated December 15, 2002 to Renewal Promissory Note by and among AmSouth Bank and Diversicare Assisted Living Services, NC, LLC (incorporated by reference to Exhibit 10.136 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2002).                 10.64     Second Amendment to Renewal Promissory Note (Overline Facility) by and among AmSouth Bank and Diversicare Management Services, Co (incorporated by reference to Exhibit 10.137 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2002).                 10.65     Reduced and modified Renewal Revolving Promissory Note dated December 15, 2002 from Diversicare Management Services Co. to AmSouth Bank (incorporated by reference to Exhibit 10.134 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2002).                 10.66     Seventh Amendment to Promissory Note dated as of the 23rd day of December, 2002, by Diversicare Afton Oaks, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.139 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2002).                 10.67     Amendment to Deed of Trust and Security Agreement dated as of the 23rd day of December, 2002, by and between Diversicare Afton Oaks, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.140 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2002).                 10.68     Amended and Restated Employment Agreement dated as of March 28, 2003, by and among Advocat Inc., a Delaware corporation, and William R. Council, III (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2003).                 10.69     Third Amendment to Loan Agreement dated as of January 1, 2003 by and between Diversicare Assisted Living Services NC II, LLC, a Delaware limited liability company and GMAC Commercial Mortgage Corporation, a California corporation (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2003).                 10.70     Fourth Amendment to $12,770,000 Promissory Note dated as of January 1, 2003 by and between Diversicare Assisted Living Services NC I, LLC, a Delaware limited liability company and GMAC Commercial Mortgage Corporation, a California corporation (incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2003).                 10.71     Fourth Amendment to $12,480,000 Promissory Note dated as of January 1, 2003 by and between Diversicare Assisted Living Services NC II, LLC, a Delaware limited liability company and GMAC Commercial Mortgage Corporation, a California          Table of Contents                  Exhibit       Number   Description of Exhibits             corporation (incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2003).                 10.72     Third Amendment to Loan Agreement dated as of January 1, 2003 by and between Diversicare Assisted Living Services NC I, LLC, a Delaware limited liability company and GMAC Commercial Mortgage Corporation, a California corporation (incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2003).                 10.73     Share Purchase Agreement dated as of August 25, 2003 by and between Diversicare Leasing Corp., a Tennessee corporation, Advocat Inc., a Delaware corporation, Diversicare Canada Management Services Co., Inc., an Ontario corporation, and DCMS Holdings Inc., an Ontario corporation (incorporated by reference to Annex A to the Company’s Proxy Statement filed October 6, 2003).                 10.74     Lease Termination Agreement dated as of May 29, 2003, by and among (i) Diversicare Assisted Living Services, Inc., a Tennessee corporation, and Advocat Inc., a Delaware corporation, and (ii) 570 Center Street, LLC, a South Carolina limited liability company, and Albert M. Lynch, an individual (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.75     Fourth Amendment to Revenue Bond Lease Agreement and Mortgage and Indenture of Trust dated as of May 2, 2003 by and between The Medical Clinic Board of the City of Hartford, Alabama; Diversicare Leasing Corp.; Colonial Bank; City Bank of Hartford and Slocomb National Bank (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.76     Fourth Amendment to Loan Agreement dated as of June 18, 2003 by and between Diversicare Assisted Living Services NC I, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.77     Fifth Amendment to Promissory Note dated as of June 18, 2003 by and between Diversicare Assisted Living Services NC I, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.78     Fifth Amendment to Promissory Note dated as of June 18, 2003 by and between Diversicare Assisted Living Services NC II, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.79     Fourth Amendment to Loan Agreement dated as of June 18, 2003 by and between Diversicare Assisted Living Services NC II, LLC and GMAC Commercial Mortgage          Table of Contents                  Exhibit       Number   Description of Exhibits             Corporation (incorporated by reference to Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.80     Cross-Collateralization and Cross-Default Agreement dated as of June 18, 2003 by and among Diversicare Windsor House, LLC, a Delaware limited liability company; Diversicare Pinedale, LLC, a Delaware limited liability company; Diversicare Afton Oaks, LLC, a Delaware limited liability company; Diversicare Assisted Living Services NC I, LLC, a Delaware limited liability company and Diversicare Assisted Living Services NC II, LLC a Delaware limited liability company in favor of GMAC Commercial Mortgage Corporation, a California corporation (incorporated by reference to Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.81     Sixth Amendment to Promissory Note dated as of the 1st day of July, 2003, by and between Diversicare Assisted Living Services NC II, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.8 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.82     Fifth Amendment to Loan Agreement dated as of July 1, 2003, by and between Diversicare Assisted Living Services NC II, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.9 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.83     Sixth Amendment to Promissory Note dated as of the 1st day of July, 2003, by and between Diversicare Assisted Living Services NC I, LLC, and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.10 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.84     Fifth Amendment to Loan Agreement dated as of July 1, 2003, by and between Diversicare Assisted Living Services NC I, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.11 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.85     Contract to Purchase Real Property in Morehead City, North Carolina between Ronald F. McManus and Diversicare Assisted Living Services NC, LLC for Carteret Care (incorporated by reference to Exhibit 10.12 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.86     Master Lease Agreement dated as of May 1, 2003 by and between Emerald-Cedar Hills, Inc. Emerald-Golfview, Inc., Emerald-Southern Pines, Inc. and Emerald-Golfcrest, Inc. and Senior Care Florida Leasing, LLC (incorporated by reference to Exhibit 10.13 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.87     Working Capital Loan Agreement dated as of April 1, 2003, between Omega Healthcare Investors, Inc., a Maryland corporation, and Senior Care Florida Leasing, LLC, a Delaware limited liability company, Senior Care Golfview, LLC, a Delaware limited liability company, Senior Care Golfcrest, LLC, a Delaware limited liability company, Senior Care Southern Pines, LLC, a Delaware limited liability company, and Senior Care Cedar Hills, LLC (incorporated by reference to Exhibit 10.14 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.88     Secured Working Capital Promissory Note dated April 1, 2003 from Senior Care Florida Leasing, LLC, a Delaware limited liability company, Senior Care Golfview, LLC, a Delaware limited liability company, Senior Care Golfcrest, LLC, a Delaware limited liability company, Senior Care Southern Pines, LLC, a Delaware limited liability company, Senior Care Cedar Hills, LLC, a Delaware limited liability company, to Omega Healthcare Investors, Inc., a Maryland corporation(incorporated by reference to Exhibit 10.15 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.89     Security Agreement as of April 1, 2003 by and between Senior Care Florida Leasing, LLC, a Delaware limited liability company, Senior Care Golfview, LLC, a Delaware limited liability company, Senior Care Golfcrest, LLC, a Delaware limited liability company, Senior Care Southern Pines, LLC, a Delaware limited liability company, Senior Care Cedar Hills, LLC, a Delaware limited liability company and Omega Healthcare Investors, Inc., a Maryland corporation (incorporated by reference to Exhibit 10.16 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.90     First Amendment to Reduced and Modified Renewal Revolving Promissory Note dated July 11, 2003 by and among AmSouth Bank and Diversicare Management Services Co. (incorporated by reference to Exhibit 10.17 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.91     First Amendment to Renewal Promissory Note dated as of July 11, 2003 by and among AmSouth Bank and Advocat Inc., a Delaware corporation (incorporated by reference to Exhibit 10.18 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.92     Third Amendment to Renewal Promissory Note dated as of July 11, 2003 by and among AmSouth Bank and Diversicare Assisted Living Services, NC, LLC, a Tennessee limited liability company (incorporated by reference to Exhibit 10.19 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.93     Third Amendment to Renewal Promissory Note (Overline Facility) dated July 11, 2003 by and among AmSouth Bank and Diversicare Management Services, Co., a Tennessee corporation (incorporated by reference to Exhibit 10.20 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.94     Second Amendment to Reduced And Modified Renewal Revolving Promissory Note dated as of July 11, 2003 by and among AmSouth Bank and Diversicare Management Services Co., a Tennessee corporation (incorporated by reference to Exhibit 10.21 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.95     Third Amendment to Master Amendment to Loan Documents And Agreement dated as of July 11, 2003 by and between AmSouth Bank, successor in interest by merger to First American National Bank, Advocat Inc., a Delaware corporation and various subsidiaries of Advocat Inc. (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003).                 10.96     Third Amendment to Reduced and Modified Renewal Revolving Promissory Note dated January 9 2004 by and among AmSouth Bank and Diversicare Management Services Co., a Tennessee corporation (incorporated by reference to Exhibit 10.137 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003).                 10.97     Second Amendment to Renewal Promissory Note dated as of January 9, 2004 by and among AmSouth Bank and Advocat, Inc., a Delaware corporation (incorporated by reference to Exhibit 10.138 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003).                 10.98     Fourth Amendment to Renewal Promissory Note dated as of January 9, 2004 by and among AmSouth Bank and Diversicare Assisted Living Services, NC, LLC, a Tennessee limited liability company (incorporated by reference to Exhibit 10.139 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003).                 10.99     Fourth Amendment to Renewal Promissory Note (the “Overline Facility”) dated as of January 9, 2004 by and among AmSouth Bank and Diversicare Management Services, Co., a Tennessee corporation (incorporated by reference to Exhibit 10.140 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003).                 10.100     Fifth Amendment by and between The Medical Clinic Board Of The City Of Hartford, Alabama, Diversicare Leasing Corp., Colonial Bank, N.A. (formerly Colonial Bank), City Bank of Hartford and Slocomb National Bank, effective as of November 2, 2003 (incorporated by reference to Exhibit 10.141 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003).                 10.101     First Amendment to Share Purchase Agreement dated as of February ___, 2004, among Diversicare Leasing Corp., a corporation incorporated under the laws of Tennessee, and Advocat Inc., a corporation incorporated under the laws of Delaware, and Diversicare Canada Management Services Co., Inc., a corporation incorporated under the laws of Ontario, and DCMS Holdings Inc., a corporation incorporated under the laws of Ontario (incorporated by reference to Exhibit 10.142 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.102     Fourth Amendment to Master Amendment to Loan Documents And Agreement dated as of May 10, 2004 by and between AmSouth Bank, successor in interest by merger to First American National Bank, Advocat Inc., a Delaware corporation and various subsidiaries of Advocat Inc. (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).                 10.103     Fourth Amendment to Reduced and Modified Renewal Revolving Promissory Note dated April 16, 2004 by and among AmSouth Bank and Diversicare Management Services, Co., a Tennessee corporation (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).                 10.104     Third Amendment to Renewal Promissory Note dated as of April 16, 2004 by and among AmSouth Bank and Advocat, Inc., a Delaware corporation (incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).                 10.105     Fifth Amendment to Renewal Promissory Note dated as of April 16, 2004 by and among AmSouth Bank and Diversicare Assisted Living Services, NC, LLC, a Tennessee limited liability company (incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).                 10.106     Fifth Amendment to Renewal Promissory Note (the “Overline Facility”) dated as of April 16, 2004 by and among AmSouth Bank and Diversicare Management Services, Co., a Tennessee corporation (incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).                 10.107     Seventh Amendment to Promissory Note dated as of the 30th day of June, 2004, by and between Diversicare Assisted Living Service NC II, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).                 10.108     Sixth Amendment to Loan Agreement dated as of June 30, 2004 by and between Diversicare Assisted Living Services NC II, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).                 10.109     Seventh Amendment to Promissory Note dated as of the 30th day of June, 2004 by and between Diversicare Assisted Living Service NC I, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.8 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).                 10.110     Sixth Amendment to Loan Agreement dated as of June 30, 2004 by and between Diversicare Assisted Living Services NC I, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.9 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.111     Seventh Amendment to Project Loan Agreement (Afton Oaks) dated as of March 31, 2004 by and between GMAC Commercial Mortgage Corporation and Diversicare Afton Oaks, LLC (incorporated by reference to Exhibit 10.10 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).                 10.112     Eighth Amendment to Promissory Note (Afton Oaks) dated as of March 31, 2004 by Diversicare Afton Oaks, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.11 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2004).                 10.113     Sixth Amendment to Renewal Promissory Note dated July 16, 2004 by and among AmSouth Bank and Diversicare Assisted Living Services, NC, LLC, a Tennessee limited liability company (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2004).                 10.114     Fifth Amendment to Reduced and Modified Renewal Revolving Promissory Note dated July 16, 2004 by and among AmSouth Bank and Diversicare Management Services Co., a Tennessee corporation (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2004).                 10.115     Sixth Amendment to Renewal Promissory Note (the “Overline Facility”) dated July 16, 2004 by and among AmSouth Bank and Diversicare Management Services, Co., a Tennessee corporation (incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2004).                 10.116     Fifth Amendment to Master Amendment to Loan Documents And Agreement dated as of October 29, 2004 by and between AmSouth Bank, successor in interest by merger to First American National Bank, Advocat Inc., a Delaware corporation and various subsidiaries of Advocat Inc. (incorporated by reference to Exhibit 10.116 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).                 10.117     Seventh Amendment to Renewal Promissory Note dated October 29, 2004 by and among AmSouth Bank and Diversicare Assisted Living Services, NC, LLC, a Tennessee limited liability company (incorporated by reference to Exhibit 10.117 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).                 10.118     Replacement Reduced and Modified Renewal Revolving Promissory Note dated October 29, 2004 from Diversicare Management Services Co. to AmSouth Bank (incorporated by reference to Exhibit 10.118 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.119     Seventh Amendment to Renewal Promissory Note (the “Overline Facility”) dated October 29, 2004 into by and among AmSouth Bank and Diversicare Management Services, Co., a Tennessee corporation (incorporated by reference to Exhibit 10.119 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).                 10.120     Sixth Amendment is entered into by and between The Medical Clinic Board Of The City Of Hartford, Alabama, Diversicare Leasing Corp., Colonial Bank, N.A., City Bank Of Hartford and Slocomb National Bank, and is effective as of November 2, 2004 (incorporated by reference to Exhibit 10.120 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).                 10.121     Purchase and Sale Agreement dated as of 4th day of November, 2004, by and between McKesson Medical-Surgical Minnesota Supply Inc. a Minnesota corporation, Advocat Distribution Services, Inc., a Tennessee corporation and Diversicare Management Services, Inc. (incorporated by reference to Exhibit 10.121 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).                 10.122     Purchase and Sale Agreement made and entered into as of the 14th day of November, 2003 with Addendum dated as of October 14, 2004 by and between Diversicare Assisted Living Services NC II, LLC, a Delaware limited liability company, and Margaret Sutton (incorporated by reference to Exhibit 10.122 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).                 10.123     Purchase Agreement made and entered into as of the 14th day of January, 2005, by and between (i) Diversicare Leasing Corp., a Tennessee corporation, and (ii) Salt Creek Holding Company, Inc., a Texas corporation, and Goliad Manor, Inc., a Texas corporation (incorporated by reference to Exhibit 10.123 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).                 10.124     Purchase Agreement made and entered into as of the 14th day of January, 2005, by and between (i) Diversicare Leasing Corp., a Tennessee corporation and (ii) Devil’s Run Holding Company, Inc., a Texas corporation and Refugio Nursing and Rehabilitation Center, Inc., a Texas corporation. (incorporated by reference to Exhibit 10.124 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).                 10.125     Eighth Amendment to Promissory Note dated as of the 1st day of January, 2005, by and between Diversicare Assisted Living Services NC I, LLC, a Delaware limited liability company and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.125 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.126     Seventh Amendment to Loan Agreement effective as of January 1, 2005, by and between Diversicare Assisted Living Services NC I, LLC, a Delaware limited liability company, and GMAC Commercial Mortgage Corporation, a California corporation (incorporated by reference to Exhibit 10.126 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).                 10.127     Eighth Amendment To Promissory Note entered into as of the 1st day of January, 2005, by and between Diversicare Assisted Living Services NC II, LLC, a Delaware limited liability company and GMAC Commercial Mortgage Corporation, a California corporation (incorporated by reference to Exhibit 10.127 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).                 10.128     Seventh Amendment to Loan Agreement effective as of January 1, 2005, by and between Diversicare Assisted Living Services NC II, LLC, a Delaware limited liability company and GMAC Commercial Mortgage Corporation, a California corporation (incorporated by reference to Exhibit 10.128 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).                 10.129     Lease Termination Agreement dated December 1, 2004 by and between Counsel Nursing Properties, Inc., a Delaware corporation and Diversicare Leasing Corp., a Tennessee corporation (incorporated by reference to Exhibit 10.129 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004).                 10.130     First Amendment to Replacement Reduced and Modified Renewal Revolving Promissory Note dated as of January 29, 2005 by and among AmSouth Bank and Diversicare Management Services, Co. (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2005).                 10.131     Eighth Amendment to Renewal Promissory Note (the Overline Facility) dated as of January 29, 2005 by and among AmSouth Bank and Diversicare Management Services, Co. 10.1 (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2005).                 10.132     Eighth Amendment to Renewal Promissory Note dated as of January 29, 2005 by and among AmSouth Bank and Diversicare Assisted Living Services, NC, LLC. (incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2005).                 10.133     Sixth Amendment to Master Amendment to Loan Documents and Agreement dated as of January, 29, 2005 by and between AmSouth Bank, the Company, Diversicare Management Services, Co. and other subsidiaries of the Company (incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2005).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.134     Promissory Note dated as of April 28, 2005 in the amount of $3,700,000 from Diversicare Hartford, LLC to GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2005).                 10.135     Loan Agreement Dated as of April 28, 2005 by and among Diversicare Hartford, LLC to GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2005).                 10.136     Payment and Performance Guaranty Agreement dated April 28, 2005 by Advocat Inc. for the benefit of to GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.7 to the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2005).                 10.137     Second Amendment to Consolidated Amended and Restated Master Lease dated as of June 15, 2005 by and between Sterling Acquisition Corp. and Diversicare Leasing Corporation (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005).                 10.138     Eighth Amendment to Loan Agreement effective as of April 1, 2005 by and between Diversicare Assisted Living Services NC I, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005).                 10.139     Ninth Amendment to Promissory Note dated as of April 1, 2005 by and between Diversicare Assisted Living Services NC I, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005).                 10.140     Eighth Amendment to Loan Agreement effective as of April 1, 2005 by and between Diversicare Assisted Living Services NC II, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005).                 10.141     Ninth Amendment to Promissory Note dated as of April 1, 2005 by and between Diversicare Assisted Living Services NC II, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005).                 10.142     Eighth Amendment to Project Loan Agreement (Afton Oaks) effective as of April 1, 2005 by and between GMAC Commercial Mortgage Corporation and Diversicare Afton Oaks, LLC (incorporated by reference to Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005).          Table of Contents                  Exhibit       Number   Description of Exhibits       10.143     Ninth Amendment to Promissory Note (Afton Oaks) effective as of April 1, 2005 by and between Diversicare Afton Oaks, LLC and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005).                 10.144     Loan Agreement re Briarcliff Health Care Center dated as of August 31, 2005, by and between a subsidiary of the Company, and GMAC Commercial Mortgage Corporation (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005).                 10.145     Purchase and Sale Agreement dated July 5, 2005 by and between Osborne F. Wilson Development Corp., Inc. and a subsidiary of the Company (incorporated by reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005).                 10.146     Asset Purchase Agreement dated as of November 28, 2005, by and among Diversicare Assisted Living Services NC I, LLC, a Delaware limited liability company, Diversicare Assisted Living Services NC II, LLC, a Delaware limited liability company, and Agemark Acquisition, LLC, a North Carolina limited liability company.                 10.147     First Amendment to Amended and Restated Master Lease Agreement dated as of December 31, 2005 by and between Florida Lessor-Emerald, Inc. and Senior Care Florida Leasing, LLC.                 10.148     First Amendment to Master Lease Agreement dated as of December 31, 2005 by and between Emerald-Cedar Hills, Inc., Emerald-Golfview, Inc., Emerald-Southern Pines, Inc. and Emerald-Golfcrest, Inc. and Senior Care Florida Leasing, LLC.                 21        Subsidiaries of the Registrant.                 23.1     Consent of BDO Seidman.                 31.1     Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a).                 31.2     Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a).                 32        Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(b) or Rule 15d-14(b).             EX-10.146 2 g00369exv10w146.txt EX-10.146  ASSET PURCHASE AGREEMENT  11/28/05                                                                     Exhibit 10.146                              ASSET PURCHASE AGREEMENT        THIS ASSET PURCHASE AGREEMENT ("AGREEMENT"), is made effective as of November 28, 2005, by and among DIVERSICARE ASSISTED LIVING SERVICES NC I, LLC, a Delaware limited liability company ("DALS I"), DIVERSICARE ASSISTED LIVING SERVICES NC II, LLC, a Delaware limited liability company ("DALS II") (DALS I and DALS II are collectively, "SELLERS"), and AGEMARK ACQUISITION, LLC, a North Carolina limited liability company ("BUYER").       A. Sellers own and operate certain adult care home facilities located in the State of North Carolina, as more fully described on Exhibit A (collectively, the "FACILITIES").       B. Sellers desire to sell and transfer the assets of the Facilities to Buyer and Buyer desires to purchase the same from Sellers subject to the terms and conditions of this Agreement.       In consideration of the mutual covenants contained in this Agreement and of other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties intending to be legally bound hereby agree as follows:                            ARTICLE 1. PURCHASE AND SALE       1.1 Purchase and Sale. Sellers agree at Closing (as defined herein), to sell, transfer, assign, convey and deliver to Buyer, and Buyer agrees to purchase, acquire and accept from Sellers all right, title and interest in and to certain assets of Sellers related to the Facilities (collectively, the "ASSETS"), as set forth below, but expressly excluding the "Excluded Assets" (as defined in Section 1.2 below):            (1) All right, title and interest of Sellers in and to all of the land and real estate owned by Sellers and used in connection with the Facilities as listed on Exhibit 1.1(1) attached hereto and in and to all structures, improvements, fixed assets and fixtures including fixed machinery and fixed equipment situated thereon or forming a part thereof and all appurtenances, easements and rights-of-way related thereto (collectively, the "REAL ESTATE");            (2) All tangible personal property, medical and other equipment, machinery, data processing and computer hardware and software, furniture, furnishings, appliances, vehicles and other tangible personal property owned by Sellers and located at the Facilities (collectively, the "EQUIPMENT AND FURNISHINGS");            (3) All inventory of goods and supplies used or maintained in connection with the Facilities including food, cleaning materials, disposables, linens, consumables, office supplies, and medical supplies (collectively, the "INVENTORY");            (4) All personnel, resident/occupant and other records related to the Facilities (including hard, electronic and microfiche copies) and all manuals, books and records used in operating the Facilities including, without limitation, personnel policies and files and manuals, accounting records, and computer files;               (5) To the extent transferable, all licenses, permits, registrations, certificates, accreditations and approvals necessary to operate the Facilities;            (6) All plans and surveys, including "as-built" plans, those relating to utilities, easements and roads, and plats, specifications, engineers' drawings, architectural renderings and similar items in Sellers' possession;            (7) All goodwill and, to the extent assignable by Sellers, all warranties (express or implied) and rights and claims related to the Assets or the operation of the Facilities, including those set forth on Exhibit 1.1(7) attached;            (8) All resident escrows, deposits and any prepaid rent or any other fees paid by Facility residents related to the Facilities (the "DEPOSITS"), including those set forth on Exhibit 1.1(8) attached;            (9) The Leases and Contracts, as defined in Section 3.9, and as set forth on Exhibit 3.(9) attached; and            (10) Sellers' interest in any intellectual property owned, leased or licensed by either Seller and utilized in connection with the Facilities, including without limitation, all names used by the Facilities and all derivatives thereof.       1.2 Excluded Assets. Sellers are not selling and Buyer is not purchasing or assuming obligations with respect to the following (collectively, the "EXCLUDED ASSETS"):            (1) Sellers' corporate and fiscal records and other records that Sellers are required by law to retain in their possession and that are not included in Section 1.1(4) above;            (2) All accounts not included in Section 1.1(8) above, notes and other receivables;            (3) All cash, cash equivalents, cash deposits and escrows, bank accounts, money market accounts, other accounts, certificates of deposit and other investments of Sellers other than the Facilities' petty cash;            (4) Sellers' provider agreements with Medicaid or any other governmental payor program and any corresponding provider numbers;            (5) Sellers' wide area network and associated software provided on the Diversicare wide area network;            (6) Sellers' continuous quality improvement program, manuals and materials, management information systems, policy, procedure and educational manuals and materials and similar proprietary property of Sellers;            (7) Any rights in or to the use of the name "Advocat" or "Diversicare" or any derivative thereof, except as set forth in Section 10.5 below;                                           2             (8) Any rights in or to the adult care home facility located at 400 Goldsboro Avenue, Carolina Beach, New Hanover County, North Carolina, known as "Diversicare Assisted Living of Carolina Beach", including all real and personal property related thereto;           (9) The National Contracts, as defined in Section 3.9 below;           (10) The regional office of Sellers' parent, Diversicare Assisted Living Services NC, LLC, a Tennessee limited liability company ("DALS"), located at 770-D Park Centre Drive, Kernersville, North Carolina 27284 (the "REGIONAL OFFICE"), including DALS's lease of real property for said Regional Office and all tangible personal property located at the Regional Office; and           (11) Any other items listed on Exhibit 1.2.       1.3 Assumed Contracts, Leases and Liabilities.           (1) At Closing, Buyer will assume and agree to pay or perform, as the case may be, those obligations of Sellers (i) arising from and after Closing under the Leases and Contracts (as defined in Section 3.9 below) and (ii) arising from all accrued vacation and sick leave for Employees (as defined in Section 3.13) who are hired by Buyer or Buyer's agent at Closing (collectively, the "ASSUMED LIABILITIES").           (2) Except for the Assumed Liabilities, Buyer shall not assume, and shall not be liable for, any debt, liability or obligation of Sellers of any type or description whatsoever, whether related or unrelated to the Assets, the Facilities or the transactions contemplated within this Agreement and Sellers shall remain liable and responsible for the payment or performance, as the case may be, of all such debts, liabilities and obligations.       1.4 Excluded Liabilities. Without limiting the foregoing, Sellers shall remain responsible for all debts, liabilities and obligations not expressly assumed by Buyer (collectively, the "Excluded Liabilities"), including but not limited to the following:           (1) All obligations pursuant to or related to any loan or debt obligations;           (2) Liabilities, indebtedness, commitments or obligations and responsibilities of any kind whatsoever (other than the Assumed Liabilities) of Sellers arising from operations of the Facilities, relating to the time through Closing;           (3) All liabilities and commitments relating to the time periods through Closing for income tax and other taxes; all employee (and former employee) wages, salaries and benefits (unless specifically referred to in Section 1.3(1)),           (4) any liabilities of the Sellers under this Agreement;           (5) any liability of the Sellers arising out of the injury to or death of any person, or damage to or destruction of any property, whether based on negligence, breach of warranty, strict liability, enterprise liability or any other legal or equitable theory arising from or related to services provided by the Sellers, to the extent any of such liabilities arose on or prior to the Closing; and                                          3            (6) amounts owed by Sellers to any third party payors, including Medicare and Medicaid, for the periods through Closing as a result of any settlement or other adjustment process used by such third party payors, including cost reports filed or to be filed.                      ARTICLE 2. PURCHASE PRICE; ALLOCATIONS;                      ACCOUNTS RECEIVABLE AND RESIDENT FUNDS       2.1 Purchase Price. The purchase price payable by Buyer to Sellers for the Assets shall be Eleven Million and No/100 Dollars ($11,000,000.00) (the "PURCHASE PRICE"). The Purchase Price shall be payable at Closing by wire transfer to an account designated by Sellers of immediately available, same day federal funds. At Closing, the Escrow Amounts (as defined herein), together with any interest earned thereon, shall be applied to the Purchase Price and Buyer shall also receive a credit for vacation and sick leave as assumed by Buyer, or Buyer's agent, pursuant to Section 1.3(1) above. The amount of the credit for the assumed vacation and sick leave shall be equal to the amount accrued by Sellers for such obligations, determined in accordance with generally accepted accounting principles, applied consistently with Sellers' past practices. At Closing, this amount shall be estimated based on Sellers' most currently available financial reports and if there is any change in the amount accrued by Sellers between the date of said financial report and the Closing Date, the parties agree to settle on the appropriate adjustment in accordance with Section 2.2 below.       2.2 Apportionable Income and Expenses. All income and expense attributable to the operation of the Facilities (measured on an accrual basis) through 11:59 p.m. on the date of Closing shall be for the account of Sellers. Thereafter, such income and expense shall be for the account of Buyer. All apportionable items of operating income and expense applicable to any periods commencing before Closing and continuing after Closing shall be prorated between Sellers and, to the extent they are included within the Assumed Liabilities, Buyer. Apportionable operating income and expenses shall include, but shall not be limited to, such items as prepaid income, power and utility charges, personal property taxes, real estate taxes and rents.        If final prorations cannot be made at Closing for any item being prorated under this Section 2.2, Buyer and Sellers agree to allocate such items on a fair and equitable basis as soon as invoices or bills are available and applicable reconciliation have been completed, with final adjustment to be made as soon as reasonably possible after the Closing (but in no event later than ninety (90) days after the Closing, except that adjustments arising from any tax protest shall not be subject to such ninety (90) day limitation, but shall be made as soon as reasonably possible), to the effect that income and expenses are received and paid by the parties on an accrual basis with respect to their period of ownership. Payments in connection with the final adjustment shall be due no later than ninety (90) days after the Closing, except that adjustments arising from any tax protest shall not be subject to such 90-day limitation, but shall be made as soon as reasonably possible. Sellers shall have reasonable access to, and the right to inspect and audit, Buyer's books to confirm the final prorations for a period of one (1) year after the Closing. To the extent invoices or bills for the current real estate tax year are not yet issued, the parties shall prorate such taxes on the basis of the most recent tax year and will adjust such proration within five (5) business days after Sellers or Buyer receive the real estate tax invoice for the current tax year.                                          4        2.3 Allocation of Purchase Price. The Purchase Price shall be allocated among the Assets in the manner set forth in Exhibit 2.3 attached hereto (the "ALLOCATION"). The parties to this Agreement agree that the Allocation shall be used by them for all purposes including tax, reimbursement and other purposes. Each party to this Agreement agrees that it will report the transaction completed pursuant to this Agreement in accordance with the Allocation, including any report made under Section 1060 of the Internal Revenue Code of 1986, as amended (the "CODE"), and that no party will take a position inconsistent with the Allocation except with the prior written consent of the other parties hereto.       2.4 Escrow Deposit. Buyer has previously deposited with Chicago Title ("ESCROW AGENT") the sum of One Hundred Thousand and No/100 Dollars ($100,000.00) (together with all interest thereon, the "ESCROWED AMOUNT"). The Escrowed Amount shall be held by Escrow Agent and paid, disbursed or applied as a credit against the Purchase Price as provided in this Agreement. The Escrowed Amount shall be held or placed by Escrow Agent in an interest bearing account and the term "Escrowed Amount" shall include any interest thereon. If the Closing occurs, the Escrowed Amount will be credited against the Purchase Price. If the Closing does not occur or the Agreement is otherwise terminated (i) by reason of Buyer's default, Escrow Agent shall be irrevocably authorized and directed to release the Escrowed Amount to Sellers and such amounts shall be retained by Sellers as liquidated damages; or (ii) for any other reason, Escrow Agent shall be irrevocably authorized and directed to release the Escrowed Amount to the Buyer. This Agreement shall constitute both an agreement among Sellers and Buyer and escrow instructions for Escrow Agent. If Escrow Agent requires a separate or additional escrow agreement to hold the Escrowed Amount, Buyer and Sellers hereby agree upon request by Escrow Agent to promptly execute and deliver such agreement; provided, that such agreement shall not modify or amend the provisions of this Agreement unless otherwise consented and agreed to in writing by Sellers and Buyer.       2.5 Accounts Receivable.           (1) Sellers are not selling, and shall retain all right, title and interest in and to all unpaid accounts receivable with respect to the Facilities which relate to the period prior to the Closing Date, including, but not limited to, any accounts receivable arising from rate adjustments which relate to the period prior to the Closing Date even if such adjustments occur after the Closing Date ("SELLERS' A/R"). Buyer (i) shall do nothing to interfere with any and all of Sellers' rights with respect to the Sellers' A/R, including but not limited to, the right to collect the same and to enforce any and all of Sellers' rights with respect to Sellers' A/R; provided the Sellers shall not initiate any litigation for collections against parties who continue to be residents of the Facilities after Closing without Buyer's consent, and (ii) agrees that if it receives any proceeds with respect to the Sellers' A/R, Buyer will hold such proceeds in trust for Sellers and shall promptly turn over those proceeds to Sellers without demand, in the form received. Sellers agree that if Sellers receive any amounts with respect to accounts receivable for services provided after the Closing of the Facilities, such amounts shall promptly (and in no event more than five (5) business days after receipt by Sellers) be forwarded to Buyer.           (2) Within ten (10) business days following the Closing Date, Sellers shall provide Buyer with a schedule setting forth by patient its outstanding accounts receivable with respect to the Facilities as of the Closing Date.                                          5            (3) In furtherance and not in limitation of the requirements set forth in Section 2.5, payments received by Buyer from and after the Closing Date from third party payors, including but not limited to Medicare, Medicaid, managed care and health insurance, shall be handled as follows:               (a) If such payments specifically indicate on the accompanying remittance advice, or the parties otherwise agree, that they relate to the period prior to the Closing Date, the payments shall be forwarded to Sellers by Buyer, along with the applicable remittance advice, promptly, but in no event more than five (5) business days, after receipt thereof;               (b) If such payments indicate on the accompanying remittance advice, or the parties otherwise agree, that they relate to the period on or after the Closing Date, they shall be retained by Buyer; and               (c) If the period(s) for which such payments are made is not indicated on the accompanying remittance advice, and the parties are unable to agree as to the periods for which such payments relate, the parties shall assume that each payment received within ninety (90) days after the Closing Date relates to the oldest outstanding unpaid receivables for reimbursement and, based on such assumption, the portion thereof which relates to the period on and after the Closing Date shall be retained by Buyer and the balance shall be remitted to Sellers promptly, but in no event more than five (5) business days, after receipt thereof. After said ninety (90) day period, such payments which fail to designate the period to which they relate shall be first applied to current balances with any excess applied to reduce pre-Closing balances.               (d) Any payments received by Buyer within ninety (90) days after the Closing Date from or on behalf of private pay patients with outstanding balances as of the Closing Date which fail to designate the period to which they relate, will first be applied by Buyer to reduce the patients' pre-Closing Date balances, with any excess applied to reduce any balances due for services rendered by Buyer after the Closing Date.               (e) In the event the parties mutually determine that they misapplied any payment hereunder, the party that erroneously received the payment shall remit it to the other party promptly, but in no event more than five (5) business days, after the determination of misapplication is made.               (f) For the six (6) month period following the Closing Date or until Sellers receive payment of all accounts receivable attributed to the operation of the Facilities prior to the Closing Date, whichever is sooner, Buyer shall provide Sellers with an accounting by the 20th day of each month setting forth all amounts received by Buyer during the preceding month with respect to Sellers' A/R which are set forth in the schedule provided by Sellers pursuant to Section 2.5. Sellers shall have the right to inspect all cash receipts of Buyer during weekday business hours in order to confirm Buyer's compliance with the obligations imposed on it under this Section.           (4) The obligations of the parties to forward the accounts receivable payments pursuant to this Section 2.5 are absolute and unconditional and irrespective of                                          6   any circumstances whatsoever which might constitute a legal or equitable discharge, offset, counterclaim or defense of the parties, the right to assert any of which is hereby waived.       2.6 Transfer on Resident Trust Funds.           (1) Upon execution of this Agreement, Sellers shall prepare and deliver to Buyer a current true, correct, and complete accounting and inventory (properly reconciled) of any resident trust funds and residents' property held by Sellers in trust for residents at the Facility (collectively the "RESIDENT TRUST FUNDS"). Not less than fourteen (14) days prior to Closing, Sellers shall prepare and deliver to Buyer an updated true, correct and complete accounting and inventory (properly reconciled) of the Resident Trust Funds.           (2) As of the Closing Date, Sellers hereby agree to transfer to Buyer the Resident Trust Funds and Buyer hereby agrees that it will accept such Resident Trust Funds in trust for the residents/responsible parties and be solely accountable to the residents/responsible parties for such Resident Trust Funds in accordance with the terms of this Agreement and applicable statutory and regulatory requirements.           (3) Within five (5) days after the Closing Date, Sellers shall prepare a final reconciliation comparing the actual Resident Trust Fund balance on the Closing Date to the amount of the Resident Trust Funds transferred to Buyer at the Closing and to the extent the former exceeds the latter, Sellers shall remit such excess to Buyer or to the extent the latter exceeds the former, Buyer shall remit such excess to Sellers.           (4) Sellers shall have no responsibility to the applicable resident/ responsible party and regulatory authorities with respect to any Resident Trust Funds delivered to Buyer.                ARTICLE 3. REPRESENTATIONS AND WARRANTIES OF SELLERS           As a material inducement to Buyer to enter into this Agreement and to consummate the transactions contemplated herein, Sellers hereby represent and warrant to Buyer, which representations and warranties shall be true and correct on the date hereof and as of the date of Closing, as follows:       3.1 Organization, Qualification and Authority. Each Seller is a limited liability company organized, validly existing and in good standing in the State of Delaware, and is in good standing and qualified to do business as a foreign corporation in the State of North Carolina. Each Seller has full power and authority to own, lease and operate its facilities and assets as presently owned, leased and operated and to carry on its business as it is now being conducted. Each Seller has the full right, power and authority to execute, deliver and carry out the terms of this Agreement and all documents and agreements necessary to give effect to the provisions of this Agreement and to consummate the transactions contemplated on the part of such Seller hereby. The execution, delivery and consummation of this Agreement, and all other agreements and documents executed in connection herewith by each Seller, have been duly authorized by all necessary action on the part of such Seller and Sellers have provided Buyer certified copies of resolutions or consents of each Seller evidencing such authorizations. No other action, consent or approval on the part of Sellers or any other person or entity is necessary to authorize Sellers' due and valid                                         7   execution, delivery and consummation of this Agreement and all other agreements and documents executed in connection herewith. This Agreement and all other agreements and documents executed in connection herewith by Sellers, upon execution and delivery thereof, constitute the valid and binding obligations of each Seller, enforceable in accordance with their respective terms.       3.2 Absence of Default. The execution, delivery and consummation of this Agreement and all other agreements and documents executed in connection herewith by Sellers will not constitute a violation of, or be in conflict with, and will not, with or without the giving of notice or the passage of time, or both, result in a breach of, constitute a default under, or create or cause the acceleration of the maturity of any debt, indenture, obligation or liability affecting the Assets or the Facilities pursuant to, or result in the creation or imposition of any security interest, lien, charge or other encumbrance upon any of the Assets under: (1) any term or provision of the governing documents of each Seller; (2) any contract, lease, purchase order, agreement, document, instrument, indenture, mortgage, pledge, assignment, permit, license, approval or other commitment to which either Seller is a party or by which either Seller and/or the Assets are bound; (3) any judgment, decree, order, regulation or rule of any court or regulatory authority; or (4) any law, statute, rule, regulation, order, writ, injunction, judgment or decree of any court or governmental authority or arbitration tribunal to which either Seller and/or the Assets are subject or that would have an adverse effect on Buyer, the Facilities or the Assets.       3.3 Financial Statements. Attached hereto as Exhibit 3.3 are true and correct copies of the unaudited balance sheets for each Facility as of December 31, 2003 and 2004, and unaudited income statements for the years then ending, and the interim unaudited balance sheet and income statement of each Facility for the eight (8) month period ended August 31, 2005 (collectively, the "FINANCIAL STATEMENTS"). The Financial Statements are based on the books and records of Sellers and present fairly and accurately the financial position of the Facilities as of the periods specified, the results of its operation, and all costs and expenses for the periods specified. The Financial Statements are true, complete and correct and contain no untrue or misleading statements and do not omit anything which would cause them to be misleading or inaccurate in any respect. The Financial Statements have been prepared in compliance with generally accepted accounting principles on an accrual basis, except that they do not include footnotes and they are subject to normal year-end adjustments.       3.4 Operations Since August 31, 2005. Except as set forth on Exhibit 3.4, since August 31, 2005, there has been no:           (1) Material change in the condition, financial or otherwise, of Sellers, the Facilities or the Assets that has, or could reasonably be expected to have, an adverse effect on any of the Assets, the Facilities or future prospects of the Facilities, or the results of the operations of Sellers;           (2) Uninsured loss, damage or destruction in excess of $10,000.00 of or to any of the Assets;                                          8            (3) Sale, lease, transfer or other disposition by Sellers of, or mortgages or pledges of or the imposition of any lien or encumbrance on, any portion of the Assets, except as set forth on Exhibit 3.4(3) attached hereto;           (4) Increase in the compensation payable by Sellers to any of their employees other than those made in the ordinary course of business, or any increase in, or institution of, any bonus, insurance, pension, profit-sharing or other employee benefit plan or arrangements;           (5) Strike, work stoppage or other labor dispute at any Facility;           (6) Amendment to or change in the terms of any of the Leases and Contracts or termination, waiver or cancellation of any rights or claims of Sellers thereunder;           (7) Assumption or creation of any liability outside of Sellers' ordinary course of business in excess of $10,000.00, except as set forth on Exhibit 3.4(7) attached hereto; or           (8) Institution or settlement of any litigation, action or proceeding before any court or governmental body relating to Sellers, the Facilities or the Assets, except as set forth on Exhibit 3.4(8) attached hereto.       3.5 Employment Discrimination. Except as disclosed in Exhibit 3.5 attached hereto, no person or party (including, without limitation, any governmental agency) has asserted, or to the best knowledge of Sellers, has threatened to assert, any claim for any action or proceeding against either Seller (or any officer, director, employee, agent or member of such Seller) arising out of any statute, ordinance or regulation relating to wages, collective bargaining, discrimination in employment or employment practices or occupational safety and health standards including, without limitation, the Fair Labor Standards Act, Title VII of the Civil Rights Act of 1964, as amended, the Occupational Safety and Health Act, the Age Discrimination in Employment Act of 1967, the Americans With Disabilities Act and the Family and Medical Leave Act.       3.6 Licenses and Permits. The Facilities have all licenses, permits, registrations, certificates and accreditations (collectively, the "LICENSES AND PERMITS") necessary for Sellers to own, occupy and operate the Facilities as adult care home facilities. To the knowledge of Sellers, there is no default under any of the Licenses and Permits, nor do Sellers know of any ground for revocation, suspension or limitation of any of the Licenses or Permits. No written or, to Sellers' knowledge, verbal notices have been received by Sellers with respect to any threatened or pending revocation, termination, suspension or limitation of any of the Licenses and Permits.       3.7 Compliance with Zoning, Land Use and Other Laws. Except as set forth on Exhibit 3.7, none of the Real Estate is in material violation of any zoning, public health, building code or other similar law applicable thereto or to the ownership, occupancy and/or operation thereof, or there exist applicable variances, conditional use permits, waivers or exemptions relating to the Real Estate with respect to any non-conforming use or other zoning or building codes matters.                                          9        3.8 Title to Assets.           (1) Except as set forth on Exhibit 3.8(1), Sellers are the sole legal and beneficial owners of, or have the exclusive, unrestricted right and authority to use and transfer to Buyer, the personal property included in the Assets, free and clear of all mortgages, security interests, liens, leases, covenants, assessments, easements, options, rights of refusal, restrictions, reservations, defects in the title, encroachments and other encumbrances.           (2) The descriptions of the Real Estate contained in Exhibit 1.1(1) hereto are complete and sufficient for their intended purposes and such descriptions include all real property owned by Sellers in connection with the Facilities. At Closing, Sellers will be the sole and exclusive record, legal and equitable owners of all right, title and interest in and at Closing will have, good, marketable and insurable title in fee simple to, and will be in possession of all of the Real Estate used in connection with the Facilities; provided, however, that at the Heritage Care of Seven Lakes Facility, a residence for the Facility's manager located at Lot 129, McDougal Street, West End, North Carolina 27376 (the "SEVEN LAKES MANAGER'S RESIDENCE") is owned by Sellers' parent, Diversicare Assisted Living Services NC, LLC, a Tennessee limited liability company ("DALS"). At Closing, Sellers shall cause DALS to convey the Seven Lakes Manager's Residence to Buyer on the same terms that the Real Estate is being transferred by Sellers. At Closing, the Real Estate and the Seven Lakes Manager's Residence shall be free and clear of all mortgages, liens, leases, assessments, easements, covenants, options, rights of refusal, restrictions, reservations, defects in title, encroachments and other encumbrances or claims of any other person or party, except for (i) any lien to secure the payment of real estate taxes, including special assessments, not delinquent, (ii) all applicable laws, ordinances, rules and governmental regulations affecting the use and occupancy of the Real Estate, (iii) easements, restrictions and other matters applicable to the Real Estate that do not hinder, interfere with or prohibit the use and occupancy of the Real Estate as adult care home facilities, and (iv) those matters described on Exhibit 3.8(2) (the "PERMITTED EXCEPTIONS"). Sellers have, and will at Closing have, the full right and authority to transfer and convey the Real Estate to Buyer as contemplated by the terms of this Agreement, and to vest in Buyer good, marketable and insurable fee simple title and the lawful right to possess and use the Real Estate. Title shall be transferred in all cases by General Warranty Deed.           (3) No other person or entity owns any interest in any of the Assets, except as set forth on Exhibit 3.8(3) attached hereto       3.9 Leases and Contracts.           (1) Exhibit 3.9 attached hereto sets forth a complete and accurate list of all material contracts, agreements, purchase orders, leases, subleases, options and commitments, oral or written, and all assignments, amendments, schedules, exhibits and appendices thereof, affecting or relating to the Facilities or any Asset to which either Seller is a party or by which either Seller, the Assets or the Facilities is bound or affected, including, without limitation, service contracts, management agreements, equipment leases and leases pertaining to any part of the Real Estate (collectively, the "LEASES AND CONTRACTS"); provided, however, that for purposes of this Agreement, "Leases and                                          10   Contracts" shall expressly exclude Sellers' "National Contracts" (herein so called), which are also identified on Exhibit 3.9. Buyer acknowledges that the National Contracts are excluded from the Leases and Contracts being assigned to Buyer under this Agreement.           (2) None of the Leases and Contracts have been modified, amended, assigned, transferred or subordinated except as described on Exhibit 3.9 and each is in full force and effect and is valid, binding and enforceable in accordance with its respective terms.           (3) No event or condition has happened or presently exists that constitutes a default or breach or, after notice or lapse of time or both, would constitute a default or breach by any party under any of the Leases and Contracts. There are no counterclaims or offsets under any of the Leases and Contracts.           (4) None of the Leases and Contracts shall be amended between the date hereof and Closing without the prior written consent of Buyer.       3.10 Environmental Matters.           (1) Hazardous Substances. As used in this Section, the term "HAZARDOUS SUBSTANCES" means any hazardous or toxic substance, medical or biologic material or waste or other material or waste including, but not limited to, those substances, materials, and wastes defined in Section 101 of the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"), listed in the United States Department of Transportation Table (49 CFR 172.101) or by the Environmental Protection Agency as hazardous substances pursuant to 40 CFR Part 302, or which are regulated under any other Environmental Law (as defined herein), or any hydrocarbons, petroleum, petroleum products, asbestos, polychlorinated biphenyls, formaldehyde, radioactive substances, flammables or explosives.           (2) Compliance with Laws and Regulations. Except as set forth on Exhibit 3.10, all operations, use or occupancy of the Real Estate, or any portion thereof, by Sellers and any agent, contractor or employee of any agent or contractor of Sellers (collectively, "AGENTS"), or any tenant or subtenant of Sellers of any part of the Real Estate, have been in material compliance with any and all laws, regulations, orders, codes, judicial decisions, decrees, licenses, permits and other applicable requirements of governmental authorities with respect to Hazardous Substances, pollution or protection of human health and safety (collectively, "ENVIRONMENTAL Law") including, but not limited to, the release, emission, discharge, storage and removal of Hazardous Substances. Sellers, Affiliates and Agents have kept the Real Estate free of any lien imposed pursuant to Environmental Law.           (3) Except as set forth on Exhibit 3.10, neither Seller: (i) has either received or been issued a notice, demand, request for information, citation, summons or complaint regarding an alleged failure to comply with Environmental Law; or (ii) is subject to any existing, pending, or threatened investigation or inquiry by any governmental authority for failure to comply with, or any remedial obligations under, Environmental Law, and there are no circumstances known to Sellers which could serve as a basis therefor. Sellers have not assumed any liability of any third party for clean up under, or noncompliance with, Environmental Law.                                          11            (4) Neither Seller nor, to the knowledge of Sellers, the Agents have transported or arranged for the transportation of any Hazardous Substances to any location which is listed or, to Sellers' knowledge, proposed for listing under Environmental Law, or is the subject of any enforcement action, investigation or other inquiry under Environmental Law.           Sellers shall promptly notify Buyer in writing of any order of which either is aware, receipt of any notice of violation or noncompliance with any Environmental Law, any threatened or pending action of which either is aware by any regulatory agency or governmental authority, or any claims made by any third party of which it is aware relating to Hazardous Substances on, emanations on or from, releases on or from, any of the Real Estate which relate to the period prior to Closing; and shall promptly furnish Buyer with copies of any written correspondence, notices or legal pleadings and written summaries of any oral communications or notices in connection therewith.           (5) Other Environmental Matters. Sellers have furnished to Buyer a copy of any environmental audit, study, report or other analysis on the Real Estate in Sellers' possession, custody or control.       3.11 Condemnation. No part of the Real Estate is currently subject to condemnation proceedings and, to Sellers' knowledge, no condemnation or taking is threatened or contemplated.       3.12 Litigation. Except as set forth on Exhibit 3.12, neither Seller has received notice of any violation of any law, rule, regulation, ordinance or order of any court or federal, state, municipal or other governmental department, commission, board, bureau, agency or instrumentality. Except as set forth in Exhibit 3.12 attached hereto, there are no lawsuits, proceedings, actions, arbitrations, governmental investigations, claims, inquiries or proceedings pending or, to Sellers' knowledge, threatened involving Sellers, any of the Assets or the Facilities and Sellers know of no basis therefor. A list of each lawsuit, administrative proceeding, governmental investigation, arbitration or other action commenced against Sellers or involving the Real Estate or Assets during the past three (3) years is set forth on Exhibit 3.12 attached hereto, along with identifying information such as docket numbers and forum where any such matter was pending.       3.13 Sellers' Employees. Exhibit 3.13 attached hereto sets forth: (1) a complete list of all of Sellers' employees at the Facilities and all employees of DALS at the Regional Office (collectively, the "EMPLOYEES") and rates of pay; (2) categorization of each such person as a full-time or part-time employee of Sellers; (3) the employment dates and job titles of each such person; and (4) true and complete copies of any and all fringe benefits and personnel policies. For purposes of this Section, "PART-TIME employee" means an employee who is employed for an average of fewer than twenty (20) hours per week or who has been employed for fewer than six (6) of the twelve (12) months preceding the date on which notice is required pursuant to the Worker Adjustment and Retraining Notification Act ("WARN"), 29 U.S.C. Section 2102 et seq. Except as provided in Exhibit 3.13, Sellers have no employment agreements with the Employees and all such Employees are employed on an "at will" basis. Sellers and DALS will terminate all of their employees at Closing. The parties expressly agree that Sellers shall retain responsibility for and timely pay all salaries and wages, paid time off benefits, related payroll taxes and all retention bonuses, retirement                                          12   and other fringe benefits that have accrued to the Employees through Closing; provided that Buyer, or Buyer's agent, shall assume accrued vacation and sick leave obligations pursuant to Section 1.3(1) above. Sellers shall use their best efforts to retain the Employees in their current positions up to Closing.       3.14 Labor Relations. Except as set forth on Exhibit 3.14, neither Seller is a party to any labor contract, collective bargaining agreement, contract, Letter of Understanding, or any other arrangement, with any labor union or organization which obligates such Seller to compensate its employees at prevailing rates or union scale nor are any of its employees represented by any labor union or organization. There is no pending or threatened labor dispute, work stoppage, unfair labor practice complaint, strike, administrative or court proceeding or order between Sellers and any present or former employee(s) of Sellers.       3.15 Insurance. A complete and accurate list of all insurance policies held by Sellers with respect to the Facilities is set forth on Exhibit 3.15 attached hereto. True and complete copies of such policies have previously been provided to Buyer. Exhibit 3.15 also sets forth a summary of Sellers' current insurance coverage (listing type, carrier and limits), and includes a list of any pending insurance claims relating to Sellers. Neither Seller is in default or breach with respect to any provision of any such insurance policies nor has such Seller failed to give any notice or to present any claim thereunder in due and timely fashion.       3.16 Broker's or Finder's Fee. Except for Marcus & Millichap, whose fees shall be the responsibility of Sellers, neither Seller has employed or is liable for the payment of any fee to any finder, broker, consultant or similar person in connection with the transactions contemplated by this Agreement. Sellers shall indemnify and hold Buyer harmless from any breach of this representation.       3.17 Intellectual Property. All trademarks, service marks, trade names, patents, inventions, processes, copyrights and applications therefor, whether registered or at common law (collectively, the "INTELLECTUAL PROPERTY"), used in or related to the Facilities are listed and described on Exhibit 3.17 attached hereto. No proceedings have been instituted or are pending or threatened which challenge the validity of the ownership by Sellers of any such Intellectual Property. Sellers have not licensed anyone to use any such Intellectual Property and neither Seller has any knowledge of the use or the infringement of any of such Intellectual Property by any other person. No present or former employee of either Seller and no other person owns or has any proprietary, financial or other interest, direct or indirect, in whole or in part, in any of the Intellectual Property.       3.18 Motor Vehicles. Any motor vehicles used at any Facility, whether owned or leased, are listed in Exhibit 3.18 attached hereto. All such vehicles are properly licensed and registered in accordance with applicable law.       3.19 Employee Benefit Plans.           (1) Welfare Benefit Plans. Exhibit 3.19(1) attached hereto contains a true, accurate and complete list of each "EMPLOYEE WELFARE BENEFIT PLAN" (as defined in Section 3(1) of the Employee Retirement Income Security Act of 1974 as amended ("ERISA")) maintained by Sellers or to which Sellers contribute or are required to contribute (such employee welfare benefit plans being hereinafter collectively referred to as the "WELFARE                                          13   BENEFIT PLANS"). Complete and accurate copies of all Welfare Benefit Plans have previously been provided to Buyer.           (2) Pension Benefit Plans. Exhibit 3.19(2) attached hereto contains a true and complete list of each "EMPLOYEE PENSION BENEFIT PLAN" (as defined in Section 3(2) of ERISA) maintained by Sellers, to which Sellers contribute or are required to contribute, or which covered any employee of Sellers during the period of their employment with any predecessor of Sellers, including any multi-employer pension plan as defined under Section 414(f) of the Code (such employee pension benefit plans being hereinafter collectively referred to as the "PENSION BENEFIT PLANS"). Complete and accurate copies of all Pension Benefit Plans have previously been provided to Buyer.           (3) Liabilities. Unfunded liabilities under any Welfare Benefit Plans or Pension Benefit Plans are described on Exhibit 3.19(3) attached hereto. Buyer shall not be liable or responsible for any debt, obligation, responsibility or liability of Sellers under any such plans. Sellers shall be liable under their Welfare Benefit Plans and Pension Benefit Plans for all claims due and unpaid at Closing and for all claims incurred before Closing, whether or not paid or presented before Closing.           (4) COBRA Coverage. Sellers have provided or caused to be provided notice of the availability of continuation coverage within the meaning of Section 4980B of the Code ("COBRA COVERAGE") for all of either present and former employees and their dependents entitled to such notice because of a qualifying event occurring before Closing, and for providing COBRA coverage as required by law for all such employees, or their dependents, who elect or have elected such coverage.       3.20 Compliance with Laws. Sellers have received no written or, to Sellers' knowledge, verbal notices of non-compliance with any laws, rules and regulations applicable to the Assets or Facilities except as set forth on Exhibit 3.20 attached hereto. Sellers are in material compliance with all federal, state and local laws, rules and regulations which relate to the operations of the Facilities.       3.21 Condition of Assets. Except as otherwise specifically set forth in this Agreement, the Assets will be conveyed subject only to the representations and warranties set forth herein and will be conveyed by Sellers (and Buyer hereby agrees to accept the Assets) "AS IS", AND "WHERE IS", WITH NO WARRANTY OR REPRESENTATION (EXPRESS OR IMPLIED) OF CONDITION, HABITABILITY, USE OR FITNESS FOR HABITATION OR FOR ANY PARTICULAR PURPOSE WITH RESPECT TO THE REAL ESTATE AND WITH NO WARRANTIES OR REPRESENTATIONS (EXPRESS OR IMPLIED), INCLUDING THE WARRANTY OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE, WITH RESPECT TO ALL OF THE OTHER ASSETS, and all of which warranties (both express and implied) Sellers hereby disclaim (OTHER THAN THOSE EXPRESSLY SET FORTH IN THIS AGREEMENT, and further subject to normal wear and tear on the Assets.       3.22 WARN Act. Within the period ninety (90) days prior to Closing, Sellers have not temporarily or permanently closed or shut down any single site of employment or any facility or any operating unit, department or service within a single site of employment, as such terms are used in WARN.                                          14        3.23 Tax Returns; Taxes. Sellers have filed all federal, state and local tax returns and tax reports required by such authorities to be filed. Sellers have paid all taxes, assessments, governmental charges, penalties, interest and fines due or claimed to be due (including, without limitation, taxes on properties, income, franchises, licenses, sales and payrolls) by any federal, state or local authority. Except as set forth on Exhibit 3.23, there is no pending tax examination or audit of, nor any action, suit, investigation or claim asserted or, to the best knowledge of Sellers, threatened against Sellers by any federal, state or local authority. All tax returns are (and with respect to the final returns will be) at the time of filing complete and accurate and in accordance with the tax laws applicable thereto and disclose all taxes required to be paid for the periods covered thereby. Sellers have not committed any violation of any federal, state or local tax laws. Proper amounts have been collected or withheld by Sellers for all income, franchise, property, sales, employment or other taxes payable or anticipated to be payable and for the payment of all other taxes (including without limitation all employment, sales or use taxes). Proper amounts have been withheld or collected from each payment made or to be made to each employee of Sellers for all taxes required to be withheld therefrom.       3.24 Deposits. The Deposits currently held by Sellers are listed on Exhibit 3.24 attached hereto. All funds held with respect to such Deposits are in balance and will be in balance at Closing. Exhibit 3.24 will be updated to Closing by Sellers for purposes of crediting any additional Deposits to Buyer's account.       3.25 Medicaid. In connection with the Facilities, Sellers participates in the Medicaid Program (the "Program") under valid Medicaid contracts and reimbursement agreements (collectively, the "Program Agreements"). To the best of Sellers' knowledge, Sellers are in compliance with rules and policies respecting the Program, including all certification, billing, reimbursement and documentation requirements, and there is no threatened or pending revocation, suspension, termination, probation, restriction, limitation or non-renewal affecting any of Sellers' Program Agreements or third-party payor contracts.                 ARTICLE 4. REPRESENTATIONS AND WARRANTIES OF BUYER       As an inducement to Sellers to enter into this Agreement and to consummate the transactions contemplated herein, Buyer hereby represents and warrants to Sellers, which representations and warranties shall be true and correct on the date hereof and on the date of Closing, as follows:       4.1 Organization, Qualification and Authority. Buyer is a limited liability company duly organized under the laws of the State of North Carolina, validly existing and in good standing under the laws of the State of North Carolina. Buyer has the full corporate power and authority to own, lease and operate its properties and assets as presently owned, leased and operated and to carry on its business as it is now being conducted. Buyer has the full right, power and authority to execute, deliver and carry out the terms of this Agreement and all documents and agreements necessary to give effect to the provisions of this Agreement and to consummate the transactions contemplated on the part of Buyer hereby. The execution, delivery and consummation of this Agreement and all other agreements and documents executed in connection herewith by Buyer has been duly authorized by all necessary corporate action on the part of Buyer. No other action on the part of Buyer or any other person or entity is necessary to authorize the execution, delivery                                          15   and consummation of this Agreement and all other agreements and documents executed in connection herewith. This Agreement, and all other agreements and documents executed in connection herewith by Buyer, upon due execution and delivery thereof, shall constitute the valid binding obligations of Buyer, enforceable in accordance with their respective terms, except as enforcement may be limited by bankruptcy, insolvency, reorganization or similar laws affecting creditors' rights generally and by general principles of equity.       4.2 Absence of Default. The execution, delivery and consummation of this Agreement and all other agreements and documents executed in connection herewith by Buyer will not constitute a violation of, be in conflict with, or, with or without the giving of notice or the passage of time, or both, result in a breach of, constitute a default under, or create (or cause the acceleration of the maturity of) any debt, indenture, obligation or liability or result in the creation or imposition of any security interest, lien, charge or other encumbrance upon any of the Assets (except in the ordinary course pursuant to Buyer's existing credit agreements) under: (1) any term or provision of the Certificate of Incorporation or Bylaws of Buyer; (2) any contract, lease, agreement, indenture, mortgage, pledge, assignment, permit, license, approval or other commitment to which Buyer is a party or by which Buyer is bound; (3) any judgment, decree, order, regulation or rule of any court or regulatory authority; or (4) any law, statute, rule, regulation, order, writ, injunction, judgment or decree of any court or governmental authority or arbitration tribunal to which Buyer is subject.       4.3 Broker's or Finder's Fee. Buyer has not employed and is not liable for the payment of any fee to any finder, broker, government official, consultant or similar person in connection with the transactions contemplated by this Agreement.                          ARTICLE 5. COVENANTS OF PARTIES       5.1 Preservation of Facilities and Assets. From the date hereof through Closing, each Seller shall use its best efforts and shall do or cause to be done all such acts and things as may be necessary to preserve, protect and maintain intact the operation of the Facilities and Assets as a going concern consistent with prior practice and not other than in the ordinary course of business and to preserve, protect and maintain for Buyer the goodwill of the clinical staff, suppliers, employees, clientele, patients and others having business relations with the Facilities. Each Seller shall use its best efforts to obtain all documents called for by this Agreement. Buyer and Sellers shall use their best efforts to facilitate the consummation of the transactions contemplated under this Agreement. Until termination of this Agreement, Sellers agree that they will not sell or transfer, or negotiate the sale or transfer of, the Assets or any of the Facilities. From the date hereof until Closing, Sellers will not sell, discard or dispose of any of the Assets other than in the ordinary course of business. None of the Leases and Contracts shall be amended between the date hereof and Closing without the prior written consent of Buyer. From the date hereof through Closing, Sellers and any party in possession of all or any part of the Real Estate will not perform any material grading or excavation, construction or removal of any improvement, or make any other material change or improvement upon or about the Real Estate without the prior written consent of Buyer. From the date hereof through Closing, Sellers and any party in possession of all or any part of the Assets will maintain and keep the Assets in a sanitary, well-maintained condition and in good order and repair.                                         16          5.2 Absence of Material Change. From the date hereof through Closing, neither Seller shall make any material change in the operations of the Facility or and in the utilization of the Assets and shall not enter into any other material contract or commitment or any other transaction with respect to the Facilities or the Assets without the prior written consent of Buyer.       5.3 Access to Books and Records.           (1) From the date hereof through Closing, Sellers shall give Buyer and Buyer's counsel, accountants and other representatives full access to all of Sellers' offices, properties, books, contracts, commitments, records and affairs relating to the Assets or the Facilities so that Buyer may inspect and audit them and shall furnish to Buyer a copy of all documents and information concerning the properties and affairs of Sellers, the Facilities or the Assets as Buyer may request. If any such books, records and materials are in the custody of third parties, Sellers shall direct such third parties to promptly provide them to Buyer. Copies of documents furnished to Buyer by Sellers will be returned by Buyer upon request if the transaction is not consummated. Sellers shall provide Buyer promptly with interim financial statements of Sellers and any other management reports, as and when they are available.           (2) Following Closing, Buyer shall permit Sellers' representatives (including, without limitation, its counsel and auditors), during normal business hours, to have reasonable access to, and examine and make copies of, all books and records of the Facilities which relate to transactions or events occurring through Closing. Buyer's reasonable out-of-pocket costs associated with the delivery of the requested documents shall be paid by Sellers.           (3) Following Closing, Sellers shall permit Buyer and its representatives (including, without limitation, its counsel and auditors), to have access to, and examine and make copies of, all books and records relating to the Facilities or Assets, which books and records are retained by Sellers and which relate to transactions or events occurring prior to Closing. For a period of five (5) years after Closing or such longer period as may be mandated by law, Sellers agree that, prior to the destruction or disposition of any such books or records, Sellers shall provide not less than forty-five (45) days, nor more than ninety (90) days, prior written notice to Buyer of such proposed destruction or disposal. If Buyer desires to obtain any such documents or records, it may do so by notifying Sellers in writing at any time prior to the date scheduled for such destruction or disposal. In such event, Sellers shall not destroy such documents or records and the parties shall then promptly arrange for the delivery of such documents or records to Buyer, its successors or assigns. Sellers' reasonable out-of-pocket costs associated with the delivery of the requested documents or records shall be paid by Buyer.       5.4 Risk of Loss. In the event there is any damage to or loss of any of the Assets (whether by fire, theft, vandalism, terrorism, act of God or other cause or casualty, damage or loss) between the date hereof and Closing, the Purchase Price shall be reduced by the amount necessary to repair the damage, which reduction shall be offset by any amounts paid by Sellers' insurance company and assigned to Buyer; provided, however, that in the event of a material casualty that affects a Facility and renders it unusable for its intended purposes, either party may elect to terminate this Agreement with respect to the damaged                                          17   Facility only, and proceed to close the transaction contemplate hereby on the remainder of the Facilities with a reduction in the Purchase Price determined in accordance with Exhibit 5.4.; provided, however, that if the Facility damaged is one of the "Core Facilities", as defined in Exhibit 5.4, Buyer may, at Buyer's option, either (i) terminate this Agreement with respect to such damaged Facility and close on the remainder with an adjustment to the Purchase Price pursuant to said Exhibit 5.4, or (ii) terminate this Agreement in its entirety without penalty or obligation.       5.5 Condemnation. From the date hereof through Closing, in the event that any Facility becomes subject to or is threatened with any condemnation or eminent domain proceedings that threatens to render a Facility unusable for its intended purposes then Buyer, in its sole discretion, may elect to terminate this Agreement with respect only to that Facility that is condemned or threatened to be condemned and close on the remainder of the Facilities with a reduction in the Purchase Price determined as provided in Section 5.4. In the event such proceedings pertain to a Core Facility, Buyer may terminate this Agreement in its entirety without obligation or penalty. In the event that any Facility becomes subject to or is threatened with any condemnation or eminent domain proceedings which do not threaten to render a Facility unusable for its intended purposes, then the parties shall proceed to Closing and Buyer shall be entitled to any condemnation award or damages paid with respect to such proceeding.       5.6 Preserve Accuracy of Representations and Warranties. Each Seller shall refrain from taking any action which would render any representation and warranty contained in Article 3 hereof untrue, inaccurate or misleading as of Closing. Sellers will promptly notify Buyer of any lawsuit, claim, administrative action or other proceeding asserted or commenced against Sellers that may involve or relate in any way to Sellers, the Assets or the operation of the Facilities. Sellers each shall promptly notify Buyer of any facts or circumstances that come to either's attention and that cause, or through the passage of time or the giving of notice or either, may cause any of Sellers' representations and warranties to be untrue or misleading at any time from the date hereof through Closing.       5.7 Maintain Books and Accounting Practices. From the date hereof through Closing, Sellers shall maintain their books of account in the usual, regular and ordinary manner on a basis consistent with prior years and shall make no change in its accounting methods or practices.       5.8 Indebtedness; Liens. Other than in the ordinary course of Sellers' business consistent with past practice, from the date hereof through Closing, Sellers shall not create, incur, assume, guarantee or otherwise become liable or obligated with respect to any indebtedness for borrowed money, nor make any loan or advance to, or any investment in, any person or entity, nor create any lien, security interest, mortgage, right or other encumbrance in any of the Assets, without Buyer's prior written approval.       5.9 Compliance with Laws and Regulatory Consents. From the date hereof through Closing: (1) Sellers shall comply with all applicable statutes, laws, ordinances and regulations; (2) Sellers shall keep, hold and maintain all certificates, accreditations, participations, licenses, and other permits necessary for operation of the Facilities; (3) Sellers shall use their best efforts and shall cooperate with Buyer to obtain all consents, approvals, exemptions and authorizations of third parties, whether governmental or private,                                          18   necessary to consummate the transactions contemplated by this Agreement; and (4) Sellers shall make and cause to be made all filings and give and cause to be given all notices which may be necessary or desirable under all applicable laws and under applicable contracts, agreements and commitments in order to consummate the transactions contemplated by this Agreement.       5.10 Maintain Insurance Coverage. From the date hereof through Closing, Sellers shall maintain and cause to be maintained the existing insurance on the Assets and the operations of the Facilities.       5.11 Licensure and Certification. Buyer shall within three (3) business days of the date of this Agreement file all initial applications and other documents required by the State of North Carolina (the "STATE") for the issuance of the licenses, certifications and approvals required by the State for the operation of the Facilities by Buyer (the "LICENSURE APPROVALS") and Buyer shall diligently proceed with securing the Licensure Approvals, including providing the State with any supplemental or additional information required for the State to deem any such applications to be complete and shall (A) from time to time, upon request of Sellers, advise Sellers of the status of Buyer's efforts to secure the Licensure Approvals and (B) promptly advise Sellers once the anticipated date of such Licensure Approvals is known to Buyer. Buyer shall be solely responsible for any and all costs associated with the change of ownership process. Sellers shall cooperate with Buyer in the licensure application process by providing Buyer with such information concerning Sellers or the Facilities as Buyer may advise Sellers, from time to time, is required for Buyer to file and/or complete its licensure application. Buyer shall not use or bill under any Medicaid provider numbers used by Sellers, and Buyer shall be responsible for obtaining all such new Medicaid provider agreements and numbers and/or Medicaid certification as may be necessary for the continued operations of the Facilities ("NEW PROVIDER NUMBER"). Sellers' provider account numbers for the Facilities shall remain the sole and exclusive property of Sellers. Buyer shall be responsible for obtaining all other payor or provider agreements (commercial, governmental or otherwise) which may be necessary for the operation of the Facilities after the Effective Date.       5.12 Performance. Sellers and Buyer shall take all appropriate steps to satisfy their respective obligations, and the conditions to Closing, including without limitation the application for necessary licenses and permits.       5.13 WARN Act; Hiring of Employees. Prior to Closing, Sellers will not temporarily or permanently close or shut down any "single" site of "employment" or any "facility" or any "operating unit," department or service within a single site of employment, as such terms are used in WARN. In addition, at Closing, Buyer shall offer employment to a sufficient number of the Employees, and on such terms, and for such periods, as may be necessary to avoid triggering any obligations on behalf of either Seller under WARN or any similar state law or regulation. Without limiting the foregoing, at Closing, Buyer shall offer employment to all of the Employees except as may be listed on Exhibit 5.13.       5.14 Consents. Sellers shall use their reasonable best efforts to obtain all consents required in form and substance reasonably acceptable to Buyer for the assignment of the Leases and Contracts and Buyer shall assist Sellers in such efforts; provided that Sellers shall not be obligated to incur any unreimbursed cost or expense to                                          19   obtain such consents. Anything contained herein to the contrary notwithstanding, this Agreement shall not constitute an agreement to assign any of the Leases and Contracts if an attempted assignment thereof without the consent of another party thereto would constitute a breach thereof, unless such consent is obtained. If such consent is not obtained, or if an attempted assignment would be ineffective or would materially affect Sellers' rights thereunder so that Buyer would not in fact receive all such rights, Sellers shall cooperate in any reasonable arrangement designed to provide Buyer the benefit under any such Leases and Contracts, including without limitation enforcement, at no out-of-pocket cost to Sellers, of any and all rights of Sellers against the other party or parties thereto arising out of the breach or cancellation by such other party or otherwise.       5.15 Cost Reports. Sellers shall timely prepare and file with the appropriate Medicaid agencies any final cost reports with respect to its operation of the Facilities which are required to be filed by law under the terms of the Medicare and Medicaid Programs. Sellers shall provide Buyer with copies of such cost reports, together with copies of any amendments.       5.16 Prohibited Actions Pending Closing. Unless otherwise expressly provided for herein or approved by Buyer in writing, from the date of this Agreement until the Closing Date, neither Seller nor any manager of any Facility shall:           (1) Accept any advance payment for more than thirty (30) days of any rent or residents' occupancy fees under any Lease or occupancy agreement; or waive, reduce or forgive any rent or occupancy fees required to be paid under any occupancy agreement, or grant any lease or other concessions or free rent periods under any occupancy agreement;           (2) Make any capital improvements to the Property in excess of $10,000 or incur any other obligations in excess of $10,000;           (3) Make any commitments or representations to any applicable Governmental Authority, any adjoining or surrounding property owners, any civic association, any utility or any other person or entity that would in any manner be binding upon Buyer;           (4) Sell or otherwise dispose of, or agree to sell or dispose of any of the Assets, except in the ordinary course of business as permitted by this Agreement; and           (5) Take any action prior to the Closing Date which would breach any of the representations and warranties contained in this Agreement or otherwise take any action outside of the ordinary course of business of Seller.                                 ARTICLE 6. CLOSING       6.1 Closing. If all of the conditions to Closing set forth in Articles 7 and 8 hereof are satisfied, then the closing of the transaction contemplated by this Agreement (the "CLOSING") shall occur on the first business day of the month following the month in which Buyer, or Buyer's Agent, obtains all necessary licenses, permits and accreditations to own and operate the Facilities (the "CLOSING DATE"). Closing shall take place at the offices of                                          20   Harwell Howard Hyne Gabbert & Manner, P.C., Nashville, Tennessee, or at such other time or place as the parties may mutually agree. Upon consummation, the Closing shall be deemed to be effective, and the transfer of the Assets shall be deemed to have occurred, as of 12:01 a.m. local time on the first day of such month. On the day of Closing, Buyer shall pay to Sellers or their designee (pursuant to wire instructions given to Buyer by Sellers) funds in an amount equal to the Purchase Price.       6.2 Termination. Notwithstanding anything in this Agreement to the contrary, this Agreement and the obligations of the parties hereunder may be terminated at or prior to Closing as follows:           (1) By Sellers: (a) in the event the transactions contemplated by this Agreement have been prohibited or enjoined by reason of any final judgment, decree or order entered or issued by a court of competent jurisdiction in litigation or proceedings involving either Buyer or Sellers; or (b) in the event Buyer breaches or violates any material provision of this Agreement or fails to perform any material covenant or agreement to be performed by Buyer under the terms of this Agreement and such breach, violation or failure is not cured prior to Closing or waived by Sellers at or prior to Closing.           (2) By Buyer: (a) in the event the transactions contemplated by this Agreement have been prohibited or enjoined by reason of any final judgment, decree or order entered or issued by a court of competent jurisdiction in litigation or proceedings involving either Buyer or Sellers; (b) pursuant to Section 5.4 or 5.5; or (3) in the event Sellers breach or violate any material provision of this Agreement or fails to perform any material covenant or agreement to be performed by either under the terms of this Agreement and such breach, violation or failure is not cured prior to Closing or waived by Buyer at or prior to Closing. Buyer shall be entitled to the Escrowed Amount if it shall terminate this Agreement pursuant to this Section 6.2(2).           (3) By Buyer or Sellers if Closing hereunder shall not have taken place by April 1, 2006, or by such later date as shall be agreed upon by an appropriate amendment to this Agreement if the parties agree in writing to an extension, provided that a party shall not have the right to terminate under this Section 6.2(3) if the conditions precedent to such party's obligation to close have been fully satisfied and such party has failed or refused to close after being requested in writing to close by the other party.                      ARTICLE 7. SELLERS' CONDITIONS TO CLOSE       The obligations of Sellers under this Agreement are subject to the satisfaction on or prior to Closing, of the following conditions (which may be waived in writing by Sellers in whole or in part):       7.1 Representations and Warranties True at Closing; Compliance with Agreement. The representations and warranties of Buyer contained in this Agreement (including the Exhibits hereto) or in any certificate or document delivered by Buyer to Sellers pursuant hereto shall be deemed to have been made again at Closing and shall then be true in all material respects; and Buyer shall have performed and complied with all material covenants, agreements and conditions required by this Agreement to be performed or complied with by it prior to or at Closing.                                          21        7.2 No Action/Proceeding. No action or proceeding before a court or any other governmental agency or body shall have been instituted to restrain or prohibit the transaction herein contemplated, and no governmental agency or body or other entity shall have taken any other action as a result of which to proceed with the transactions hereunder will constitute a violation of law. The waiting periods specified under the Antitrust Improvements Act with respect to the transactions contemplated by this Agreement will have lapsed or been terminated.       7.3 Order Prohibiting Transaction. No order shall have been entered in any action or proceeding before any court or governmental agency, and no preliminary or permanent injunction by any court shall have been issued which would have the effect of: (1) making the transactions contemplated by this Agreement illegal; or (2) otherwise preventing consummation of such transactions. There shall have been no United States federal or state statute, rule or regulations enacted or promulgated after the date of this Agreement that results in any of the consequences referred to in this Section.       7.4 Consent of Lender. Sellers shall provide Buyer with evidence of consent to the transaction contemplated hereby by the lenders, GMAC and AmSouth.                       ARTICLE 8. BUYER'S CONDITIONS TO CLOSE       The obligations of Buyer under this Agreement are subject to the satisfaction, on or prior to Closing, of the following conditions (which may be waived in writing by Buyer in whole or in part):       8.1 Representations and Warranties True at Closing; Compliance with Agreement. The representations and warranties of Sellers contained in this Agreement (including the Exhibits hereto) or in any certificate or document delivered to Buyer in connection herewith, shall be deemed to have been made again at Closing and shall then be true in all material respects; and Sellers shall have performed and complied with all material covenants, agreements and conditions required by this Agreement to be performed or complied with by them prior to or at Closing.       8.2 No Loss, Damage of Destruction. In the event there is any damage to or loss of any of the Assets (whether by fire, theft, vandalism or other cause or casualty), the terms of Sections 5.4 and 5.5 shall have been complied with.       8.3 Regulatory Approvals. Buyer shall have obtained or have reasonable assurance that it will obtain (at its own cost) (a) certification for participation in the Medicaid Programs of the State of North Carolina under a new provider agreement and provider number, (b) certification from the appropriate agency of the federal government for participation in the federal Medicare Program under a new provider agreement and provider number, and (c) all other licenses, permits, approvals or certificates necessary for the ownership and operation of the Facilities; provided that Buyer has promptly made application for such certifications, consents, licenses, etc. Buyer acknowledges and agrees that it shall not be entitled to use Sellers' Medicaid provider account numbers for the Facilities, which shall remain the sole and exclusive property of the Sellers.                                          22        8.4 No Action/Proceeding. No action or proceeding before a court or any other governmental agency or body shall have been instituted to restrain or prohibit the transaction herein contemplated, and no governmental agency or body or other entity shall have taken any other action as a result of which to proceed with the transactions hereunder constitute a violation of law. The waiting periods specified under the Antitrust Improvements Act with respect to the transactions contemplated by this Agreement shall have lapsed or been terminated.       8.5 Material Adverse Change. There shall not have occurred a material adverse change with respect to the assets, financial condition or operations of the Facilities, taken as a whole. Expressly excluded from the definition of "material adverse change" hereunder are changes (a) generally affecting the adult care and assisted living industries, including changes due to actual or proposed changes in law or regulations, (b) that result from political or economic turmoil, or (c) that result from the announcement or pendency of the transaction contemplated by this Agreement.                    ARTICLE 9. OBLIGATIONS OF SELLERS AT CLOSING       At Closing, Sellers shall deliver or cause to be delivered to Buyer the following in form and substance reasonably satisfactory to Buyer:       9.1 Documents Relating to Title. Sellers shall execute, acknowledge, deliver and cause to be executed, acknowledged and delivered to Buyer:           (1) General warranty deeds from Sellers, in form reasonably satisfactory to Buyer and the title insurer, with all recording, stamp tax, deed tax or other transfer fees paid by Sellers, and conveying to Buyer good, valid and marketable title in fee simple to the owned Real Estate free and clear of all liens, mortgages, pledges, encumbrances, security interests, covenants, easements, rights of way, equities, options, rights of first refusal, restrictions, special tax or governmental assessments, defects in title, encroachments and other burdens, except for Permitted Exceptions.           (2) General warranty deeds from DALS, in form reasonably satisfactory to Buyer and the title insurer, with all recording, stamp tax, deed tax or other transfer fees paid by Sellers or DALS, and conveying to Buyer good, valid and marketable title in fee simple to the owned Seven Lakes Manager's Residence free and clear of all liens, mortgages, pledges, encumbrances, security interests, covenants, easements, rights of way, equities, options, rights of first refusal, restrictions, special tax or governmental assessments, defects in title, encroachments and other burdens, except for Permitted Exceptions.           (3) A Bill of Sale and Assignment Agreement, in form and substance satisfactory to Buyer, warranting and conveying to Buyer good, valid and marketable title to all Assets, free and clear of all liens, mortgages, pledges, encumbrances, security interests, covenants, easements, rights of way, equities, options, rights of first refusal restrictions, special tax or governmental assessments, defects in title, encroachments and other burdens, except for those expressly acceptable to Buyer.                                          23            (4) Certificates of title to all vehicles that constitute Assets endorsed by Sellers together with completed originals of any forms required by all applicable states to transfer the same, free and clear of all liens, except for those acceptable to Buyer.           (5) An effective and enforceable assignment to Buyer of each Lease and Contract.       9.2 Possession. Sellers shall deliver to Buyer full possession and control of the Facilities and Assets, free and clear of all liens, mortgages, pledges, security interests, restrictions, encumbrances and burdens of any kind whatsoever, including, without limitation, limitations on use and rights of reclamation by donees.       9.3 Corporate Good Standing and Resolutions. Sellers shall deliver to Buyer certificates of good standing from the Secretary of State of its state of organization, and from the State of North Carolina, certified copies of the Certificates of Formation and other governing documentation of Sellers (all dated the most recent practical date prior to Closing), certified copies of the resolutions of the sole member of Sellers authorizing the execution, delivery and consummation of this Agreement and the execution, delivery and consummation of all other agreements and documents executed in connection herewith.       9.4 Closing Certificate. Sellers shall deliver to Buyer certificates of officers of Sellers, dated as of Closing, certifying that: (1) each covenant and obligation of Sellers has been complied with by Sellers; and (2) each representation and warranty of Sellers is true and correct at Closing as if made on and as of Closing.       9.5 Taxes and Other Payments. Sellers shall deliver to Buyer:           (1) Proof of cash payment directly to the tax authorities or cash payment (or credit on the Purchase Price) to Buyer in the amount of all real estate taxes and assessments which are due and payable on the date of Closing, general and special.           (2) A certificate of non-foreign status signed by the appropriate party and sufficient in form and substance to relieve Buyer of all withholding obligations under Section 1445 of the Code. In the event that Sellers cannot furnish such a certificate or Buyer is not entitled to rely upon such a certificate under the provisions of Section 1445 and the regulations thereunder, Sellers shall take and/or permit Buyer or Buyer's nominee to take any and all steps necessary to allow Buyer or Buyer's nominee to satisfy the requirements of Section 1445.           (3) Executed releases of all mortgages, security interests, liens, pledges, restrictions or other encumbrances on or applicable to the Assets, other than the Permitted Exceptions.       9.6 Additionally Requested Documents; Post Closing Assistance. At the request of Buyer at Closing and/or from time to time thereafter, Sellers shall cooperate with Buyer to put Buyer in actual possession and operating control of the Assets and Facilities, execute and deliver such further instruments of sale, conveyance, transfer and assignment, as Buyer may request in order to effectively sell, convey, transfer and assign the Assets and Facilities to Buyer, to execute and deliver such further instruments and to take such other                                          24   actions as Buyer may request to release Buyer from all obligation and liability with regard to any obligation or liability retained by Sellers and to execute and deliver such further instruments and to cooperate with Buyer as Buyer may request or to enable Buyer to obtain all necessary health care or regulatory certifications, approvals, consents and licenses, accreditations or permits.                    ARTICLE 10. OBLIGATIONS OF BUYER AT CLOSING       At Closing, Buyer shall deliver or cause to be delivered to Sellers the following in a form and substance reasonably satisfactory to Sellers:       10.1 Purchase Price. Buyer shall pay to Sellers the Purchase Price upon the terms specified in Section 2.1 hereof.       10.2 Good Standing and Resolutions. Buyer shall deliver to Sellers a certificate of good standing from the Secretary of State of North Carolina, dated the most recent practical date prior to Closing, together with a certified copy of the resolutions of Buyer approving this Agreement and the consummation of the transactions intended hereby.       10.3 Closing Certificate. Buyer shall deliver to Sellers a certificate of officers of Buyer, dated as of Closing, certifying that: (1) each covenant and obligation of Buyer has been complied with by Buyer; and (2) each representation and warranty of Buyer is true and correct at Closing as if made on and as of Closing.       10.4 Assumption of Liabilities. Buyer shall covenant to perform and comply with all of the Assumed Liabilities, subject to the provisions of this Agreement, from and after Closing.       10.5 Use of Name. From and after Closing, Buyer shall discontinue all use of the names "Diversicare" and "Advocat" and any related marks or derivatives thereof in connection with the operation of the Facilities; provided, however, that Buyer will be permitted to use such names and marks on existing signage and office supplies at the Facilities for a period not to exceed ninety (90) days.               ARTICLE 11. SURVIVAL OF PROVISIONS AND INDEMNIFICATION       11.1 Survival. The covenants, obligations, representations and warranties of Buyer and Sellers contained in this Agreement, or in any certificate or document delivered pursuant to this Agreement, shall be deemed to be material and to have been relied upon by the parties hereto notwithstanding any investigation prior to Closing, and shall survive Closing for a period of one (1) year (except as provided in Section 5.3(3) above) and shall not be merged into any documents delivered in connection with Closing.       11.2 Indemnification by Sellers. Subject to Section 11.4, Sellers shall promptly indemnify, defend, and hold harmless Buyer, the directors, officers, shareholders, employees and agents of Buyer, and the Assets against any and all losses, costs, and expenses (including reasonable costs of investigation, court costs and legal fees) and other damages resulting from: (1) any breach by either Seller of any of the covenants, obligations, representations or warranties or breach or untruth of any representation, warranty, fact or                                          25   conclusion contained in this Agreement or any certificate or document of Sellers delivered pursuant to this Agreement; (2) any liability of Sellers not expressly assumed by Buyer pursuant to Section 1.3 hereof; and (3) any claim (whether or not disclosed herein) that is brought or asserted by any third party(s) against Buyer arising out of the ownership, licensing, operation or conduct of the Facilities or Assets or the conduct of any of Sellers' employees, agents or independent contractors, relating to all periods of time through Closing. Any indemnification payment made pursuant to this Article shall include interest at a floating rate equal to two points over the prime rate published from time to time in The Wall Street Journal (the "RATE"), payable for the period measured from the date that the loss, cost, expense or damage was incurred until the date of payment.       11.3 Indemnification by Buyer. Subject to Section 11.4, Buyer shall promptly indemnify, defend, and hold Sellers harmless against any and all losses, costs, and expenses (including reasonable cost of investigation, court costs and legal fees) and other damages resulting from: (1) any breach by Buyer of any of its covenants, obligations, representations or warranties or breach or untruth of any representation, warranty, fact or conclusion contained in this Agreement or any certificate or document of Buyer delivered pursuant to this Agreement; (2) any claim which is brought or asserted by any third party(s) against Sellers for failure to pay or perform any of the Assumed Liabilities; and (3) subject to the other provisions of this Agreement, any claim that is brought or asserted by any third party(s) against Sellers arising out of the ownership, licensing, operation or conduct of the Facilities or Assets or the conduct of any of Buyer's employees, agents or independent contractors, relating to all periods of time subsequent to Closing. Any indemnification payment pursuant to the foregoing shall include interest at the Rate from the date that the loss, cost, expense or damage was incurred until the date of payment.       11.4 Rules Regarding Indemnification. The obligations and liabilities of each party which may be subject to indemnification liability hereunder (the "INDEMNIFYING PARTY") to the other party (the "INDEMNIFIED PARTY") shall be subject to the following terms and conditions:           (1) Claims by Non-parties. The indemnified party shall give written notice within a reasonably prompt period of time to the indemnifying party of any written claim by a third party which is likely to give rise to a claim by the indemnified party against the indemnifying party based on the indemnity agreements contained in this Article, stating the nature of said claim and the amount thereof, to the extent known. The indemnified party shall give notice to the indemnifying party that pursuant to the indemnity, the indemnified party is asserting against the indemnifying party a claim with respect to a potential loss from the third party claim, and such notice shall constitute the assertion of a claim for indemnity by the indemnified party. If, within thirty (30) days after receiving such notice, the indemnifying party advises the indemnified party that it will provide indemnification and assume the defense at its expense, then so long as such defense is being conducted, the indemnified party shall not settle or admit liability with respect to the claim and shall afford to the indemnifying party and defending counsel all reasonable assistance in defending against the claim, but the indemnified party shall remain entitled to notice and an opportunity to participate in any proceedings relating to the claim. If the indemnifying party assumes the defense, counsel shall be selected by such party and if the indemnified party then retains its own counsel, it shall do so at its own expense. If the indemnified party does not receive a written objection to the notice from the indemnifying party within thirty (30)                                           26   days after the indemnifying party's receipt of such notice, the claim for indemnity shall be conclusively presumed to have been assented to and approved, and in such case the indemnified party may control the defense of the matter or case and, at its sole discretion, settle or admit liability. If within the aforesaid thirty (30) day period the indemnified party shall have received written objection to a claim (which written objection shall briefly describe the basis of the objection to the claim or the amount thereof, all in good faith), then for a period of ten (10) days after receipt of such objection the parties shall attempt to settle the dispute as between the indemnified and indemnifying parties. If they are unable to settle the dispute, the unresolved issue or issues may be resolved in conjunction with the underlying action that gave rise to the claim for indemnification.           (2) Claims by a Party. The determination of a claim asserted by a party hereunder (other than as set forth in subsection (1) above) pursuant to this Article shall be made as follows: The indemnified party shall give written notice within a ten (10) days to the indemnifying party of any claim by the indemnified party which has not been made pursuant to subsection (1) above, stating the nature and basis of such claim and the amount thereof, to the extent known. The claim shall be deemed to have resulted in a determination in favor of the indemnified party and to have resulted in a liability of the indemnifying party in an amount equal to the amount of such claim estimated pursuant to this Section if within forty-five (45) days after the indemnifying party's receipt of the claim the indemnified party shall not have received written objection to the claim. In such event, the claim shall be conclusively presumed to have been assented to and approved. If within the aforesaid forty-five (45) day period the indemnified party shall have received written objection to a claim (which written objection shall briefly describe the basis of the objection to the claim or the amount thereof, all in good faith), then for a period of sixty (60) days after receipt of such objection the parties shall attempt to settle the disputed claim as between the indemnified and indemnifying parties. If they are unable to settle the disputed claim, the unresolved issue or issues be resolved in conjunction with the underlying action that gave rise to the claim for indemnification.           (3) Indemnification Maximum. The maximum aggregate liability of Sellers for indemnification under this Agreement with respect to claims made or arising under Section 11.2 shall be equal to the Purchase Price.           (4) Indemnification Threshold. Buyer agrees not to seek recourse against, and shall not recover from Sellers under Section 11.2 on account of any Loss arising out of a breach of Sellers' representations and warranties in Article 3 hereof, unless and until the aggregate amount thereof with respect to Losses exceeds One Hundred Thousand and No/100 Dollars ($100,000.00) (the "INDEMNIFICATION THRESHOLD"); provided that once the Indemnification Threshold has been reached, Buyer shall be entitled to recovery of all amounts with respect to claims, including the first One Hundred Thousand and No/100 Dollars ($100,000.00). Notwithstanding the foregoing, the Indemnification Threshold shall not be applicable if the indemnification claim relates to an Excluded Liability, or any proration of real estate taxes.                             ARTICLE 12. MISCELLANEOUS       12.1 Assignment. Except as otherwise provided below, neither Sellers nor Buyer may assign any rights or delegate any obligations under this Agreement without the prior                                          27   written consent of the other party, and any prohibited assignment or delegation will be null and void. Notwithstanding the foregoing, Buyer may assign its rights to purchase one or more Facilities to a designee so long as Buyer remains obligated hereunder. This Agreement shall be binding upon and shall inure to the exclusive benefit of the parties hereto and their respective permitted heirs, legal representatives, successors and assigns.       12.2 Other Expenses. Except as otherwise provided in this Agreement, Sellers shall pay all of their expenses in connection with the negotiation, execution, and implementation of the transactions contemplated by this Agreement and Buyer shall pay all of its expenses in connection with the negotiation, execution, and implementation of the transactions contemplated by this Agreement. All state and local sales and use taxes, recording fees and transfer taxes incurred in connection with the transactions contemplated within this Agreement shall be borne by Sellers and paid by Closing. All ad valorem taxes incurred in connection with the transactions contemplated within this Agreement shall be prorated at Closing. The Purchase Price shall be reduced, on a dollar-per-dollar basis, to the extent and in an amount equal to any taxes or other obligations that are accrued but unpaid by Sellers as of the date of Closing.       12.3 Notices. All notices, requests, demands, waivers and other communications required or permitted to be given under this Agreement shall be in writing and shall be deemed to have been duly given: (1) if delivered personally or sent by facsimile, on the date received; (2) if delivered by overnight courier, on the day after mailing; and (3) if mailed, five (5) days after mailing with postage prepaid. Any such notice shall be sent as follows:                    To Seller:                    Advocat Inc.                   1621 Galleria Boulevard                   Brentwood, Tennessee 37027                   Attn: William R. Council III, Chief Executive Officer                   (615) 771-7575                   (615) 771-7409 (fax)                    with a copy to:                    Harwell Howard Hyne Gabbert & Manner, P.C.                   315 Deaderick Street, Suite 1800                   Nashville, Tennessee 37238-1800                   Attn: Michael R. Hill                   (615) 256-0500                   (615) 251-1059 (fax)                                              28                      To Buyer:                    Agemark Acquisition LLC                   56 Third Street, Northwest                   Hickory, North Carolina  28601                   Attn: Charles E. Trefzger, Jr.                   (828) 322-5535                   (828) 322-3897 (fax)                    with a copy to:                    Bell, David & Pitt, P.A.                   100 North Cherry Street, Suite 600                   Winston-Salem, North Carolina  27101                   Attn: John A. Cocklereece, Jr.                   (336) 714-4123                   (336) 722-6558 (fax)       12.4 Confidentiality. All parties agree to maintain the confidentiality of the existence of this Agreement and the transactions contemplated hereunder, unless disclosure is required by law, except that Buyer shall be entitled to disclose the terms of this Agreement to its attorneys, accountants, financing sources, third party agents, investors, and other advisors, provided, such persons agree to keep the terms of this Agreement confidential.       12.5 Controlling Law. This Agreement shall be construed, interpreted and enforced in accordance with the laws of the State of North Carolina without regard to its choice or conflicts of law provisions. Sellers and Buyer hereby consent to the jurisdiction of courts located in Winston-Salem, North Carolina, for the resolution of any disputes arising under this Agreement for which a dispute resolution mechanism has not been specified herein.       12.6 Headings. Table of contents and Section headings in this Agreement are for convenience of reference only and shall not be considered or referred to in resolving questions of interpretation.       12.7 Partial Invalidity. The invalidity or unenforceability of any particular provision of this Agreement shall not affect the other provisions hereof, and this Agreement shall be construed in all respects as if such invalid or unenforceable provisions were omitted.       12.8 Waiver. Neither the failure nor any delay on the part of any party hereto in exercising any rights, power or remedy hereunder shall operate as a waiver thereof, or of any other right, power or remedy; nor shall any single or partial exercise of any right, power or remedy preclude any further or other exercise thereof, or the exercise of any other right, power or remedy. No waiver of any of the provisions of this Agreement shall be valid unless it is in writing and signed by the party against which it is sought to be enforced.       12.9 Counterparts. This Agreement may be executed simultaneously in two or more counterparts each of which shall be deemed an original and all of which together shall constitute but one and the same instrument.                                          29        12.10 Interpretation; Knowledge. All pronouns and any variation thereof shall be deemed to refer to the masculine, feminine, neuter, singular or plural as the identity of the person or entity, or the context, may require. Further, it is acknowledged by the parties that this Agreement has undergone several drafts with the negotiated suggestions of both; and, therefore, no presumptions shall arise favoring either party by virtue of the authorship of any of its provisions or the changes made through revisions. Whenever in this Agreement the term "to the knowledge of Sellers" or the like is used, Sellers shall each be deemed to have the knowledge of Sellers' executive officers, managers and directors.       12.11 Entire Agreement. This Agreement, including the Exhibits hereto, constitutes the entire agreement between the parties hereto with regard to the matters contained herein and it is understood and agreed that all previous undertakings, negotiations, letters of intent and agreements between the parties are merged herein. This Agreement may not be modified orally, but only by an agreement in writing signed by Buyer and Sellers.       12.12 Legal Fees and Costs. In the event any party incurs legal expenses to enforce or interpret any provision of this Agreement, the prevailing party will be entitled to recover such legal expenses, including, without limitation, attorney's fees, costs and necessary disbursements, in addition to any other relief to which such party shall be entitled.       12.13 No Third Party Beneficiaries. The provisions of this Agreement are solely for the benefit of the parties hereto. It shall create no rights in any persons other than as set forth in the immediately preceding sentence.       12.14 North Carolina Business Purposes Notice. BUYER HEREBY ACKNOWLEDGES THAT THE REAL ESTATE IS PROPERTY USED FOR BUSINESS PURPOSES AND IS NOT RESIDENTIAL REAL PROPERTY AND AGREES THAT THE REAL ESTATE IS EXEMPT FROM, AND THAT SELLERS ARE NOT REQUIRED TO PROVIDE, ANY RESIDENTIAL PROPERTY DISCLOSURES WITH RESPECT TO THE REAL ESTATE.       12.15 Exclusivity. Until and unless this Agreement is terminated by Buyer, Sellers will not solicit any offers or proposals, or enter into letters of intent, negotiations or contracts with any third-party with respect to a transaction relating to the sale, transfer, conveyance, merger or any other transaction of similar import with respect to Sellers or any of the Assets.       12.16 Business Days. To the extent that the expiration of any time period hereunder falls on a day that is not a Business Day, the expiration of such time period shall be extended to 5:00 pm E.S.T. on the following Business Day.       12.17 Joint and Several. Any and all of the covenants, representations, obligations, and liabilities of any Sellers hereunder shall be joint and several as to all Sellers.                                               30              The parties hereto have executed this Agreement as of the date first above written.                                       SELLERS:                                       DIVERSICARE ASSISTED LIVING                                      SERVICES NC I, LLC                                       By:  Diversicare Assisted Living                                           Services NC, LLC, the sole member                                             By: /s/ William R. Council III                                               ----------------------------------                                            Title: President                                                  -------------------------------                                         DIVERSICARE ASSISTED LIVING                                      SERVICES NC II, LLC                                       By:  Diversicare Assisted Living                                           Services NC, LLC, the sole member                                             By: /s/ William R. Council III                                               ----------------------------------                                            Title: President                                                  -------------------------------                                         BUYER:                                       AGEMARK ACQUISITION, LLC                                        By: /s/ Charles E. Trefzer, Jr.                                          ---------------------------------------                                       Title: Manager                                             ------------------------------------                                              31                                          EXHIBIT A                     NORTH CAROLINA ASSISTED LIVING FACILITIES     - -----------------------------------------------------------------------------------              FACILITY NAME/ADDRESS                                      OWNER - -----------------------------------------------------------------------------------   BROMAN REST HOME                                                     DALS NC I(1) 453 Howard Blvd. Newport, Carteret County, NC  28570-9244 - -----------------------------------------------------------------------------------  CLAYTON RESTFUL MANOR                                                DALS NC I 145 Dairy Road Clayton, Johnston County, NC 27520-4965 - -----------------------------------------------------------------------------------  HERITAGE CARE OF CLINTON                                             DALS NC I 205 Martha Lane Clinton, Sampson County, NC 28328-9639 - -----------------------------------------------------------------------------------  HERITAGE CARE OF SEVEN LAKES                                         DALS NC I 292 McDougal Street West End, Moore County, NC  27376-9330 - -----------------------------------------------------------------------------------  HERITAGE RETIREMENT OF WILSON                                        DALS NC I 1800 Martin Luther King Jr. Pkwy SE Wilson, Wilson County, NC 27893-6527 - -----------------------------------------------------------------------------------  BRANCHWOOD REST HOME                                                 DALS NC II(2) 305 S. Branch Street Reidsville, Rockingham County, NC  27320-3917 - -----------------------------------------------------------------------------------  CHATHAM CREEK                                                       DALS NC II 809 W. Chatham Street Cary, Wake County, NC 27511-3136 - -----------------------------------------------------------------------------------  CHRISTIAN CARE OF WINSTON-SALEM                                     DALS NC II 2900 Reynolds Park Rd. Winston-Salem, Forsyth County, NC 27107-1653 - -----------------------------------------------------------------------------------  CHRISTIAN CARE OF SMITHFIELD - #1                                   DALS NC II 303 Hospital Road. Smithfield, Johnston County, NC 27577-4101 - -----------------------------------------------------------------------------------  CHRISTIAN CARE OF SMITHFIELD - #2                                   DALS NC II 303 Hospital Road Smithfield, Johnston County, NC   27577-4101 - -----------------------------------------------------------------------------------  KANNAPOLIS VILLAGE                                                  DALS NC II 1516 Pine St. Kannapolis, Cabarrus County, NC 28081-4142 - -----------------------------------------------------------------------------------  SENTERS REST HOME                                                   DALS NC II 40 Rawls Club Road Fuquay Varina, Harnett County, NC 27526-8031 - -----------------------------------------------------------------------------------   - ----------------------------- (1) DALS NC I means Diversicare Assisted Living Services NC I, LLC, a Delaware limited liability company  (2) DALS NC II means Diversicare Assisted Living Services NC II, LLC, a Delaware limited liability company     EX-10.147 3 g00369exv10w147.txt EX-10.147  AMENDMENT TO MASTER LEASE AGREEMENT  12/31/05                                                                      EXHIBIT 10.147                FIRST AMENDMENT TO AMENDED AND RESTATED MASTER LEASE                                     AGREEMENT           THIS FIRST AMENDMENT TO AMENDED AND RESTATED MASTER LEASE AGREEMENT ("Amendment") is made and entered into as of the 31 day of December, 2005, by and between FLORIDA LESSOR-EMERALD, INC., a Maryland corporation, (the "Lessor") and SENIOR CARE FLORIDA LEASING, LLC, a Delaware limited liability company (herein called the "Lessee").                                      RECITALS           WHEREAS, Lessee entered into a Master Lease dated April 1, 2003 with Emerald-Cedar Hills, Inc., a Florida corporation, Emerald-Golfview, Inc., a Florida corporation, Emerald-Golfcrest, Inc., a Florida corporation, and Emerald-Southern Pines, Inc., a Florida corporation (the "Emerald Lessors"), covering certain real property located in the State of Florida as more particularly described on EXHIBITS A-1 THROUGH A-4 attached hereto on which there are located four (4) existing fully licensed nursing home facilities (collectively, the "Leased Properties") (said Master Lease being referred to from time to time as the "Original Master Lease");           WHEREAS, the Original Master Lease was amended by that certain First Amendment to Master Lease Agreement dated December 31, 2005 ("First Amendment");           WHEREAS, at the time of the Original Master Lease and the First Amendment were entered into, the Emerald Lessors were the owners and mortgagors of the Leased Properties and Omega Healthcare Investors, Inc., a Maryland corporation ("Omega") was the mortgagee of the Leased Properties;           WHEREAS, as a material condition and inducement to Omega's consent, as mortgagee, to the Original Master Lease and the First Amendment, Senior Care Florida Leasing, LLC, a Delaware limited liability company ("Lessee") and Emerald, Inc., a Maryland corporation ("Lessor") entered into a Subordination, Nondisturbance and Attornment Agreement ("SNDA"), whereby, if and in the event Lessor were to foreclose upon, or accept a deed in lieu of foreclosure to, the Leased Properties or any of them, the Original Master Lease would automatically and without further action by either Lessor or Lessee be and become amended and restated in its entirety pursuant to the SNDA and that certain Amended and Restated Master Lease Agreement ("Amended & Restated Lease");           WHEREAS, the parties acknowledge and consent that the SNDA remains in full force and effect with respect to the Original Master Lease and First Amendment and that the Lessor and Lessee shall continue the requirement to amend and restate the Original Master Lease (as amended) in the event Lessor were to foreclose upon, or accept a deed in lieu of foreclosure to the Leased Properties, or any of them;              WHEREAS, Lessor and Lessee desire to amend the terms of the Amended & Restated Lease upon the terms, covenants and conditions hereinafter set forth.           NOW THEREFORE, in consideration of the mutual covenants and agreements contained herein, and other good and valuable consideration, the receipt and sufficiency of which is acknowledged, the parties to this Amended & Restated Amendment hereby covenant and agree as follows:           1. Amendment Definitions. Any capitalized term used but not defined in this Amendment will have the meaning assigned to such term in the Lease.           2. Modification of CPI or Consumer Price Index. The definition of "CPI or Consumer Price Index" as defined in Section 2.1 of the Amended & Restated Lease is hereby deleted and the following inserted in lieu thereof:                    "CPI" or "Consumer Price Index": As of any date, the United          States Department of Labor, Bureau of Labor Statistics Revised Consumer          Price Index for All Urban Consumers (1982=84=100), U.S. City Average,          All Items, or, if that index is not available at the time in question,          the index designated by such Department as the successor to such index,          and if there is no index so designated, an index for an area in the          United States that most closely corresponds to the entire United          States, published by such Department, or if none, by any other          instrumentality of the United States, calculated in this Lease as the          CPI attributable to the month three months prior to the applicable date          herein (e.g., the CPI used to calculate the adjustment in Base Rent as          of January 1, 2006, shall be the CPI for the month of October, 2005,          compared to the CPI for the month of October, 2004)."           3. Extension of Term. The definition of "Term Expiration Date" as defined in Section 1.3 of the Lease is hereby deleted and the following inserted in lieu thereof:                    "Term Expiration Date: February 28, 2010, or such earlier date          as Lessor sells and conveys title to the Leased Properties to a third          party other than in connection with the sale or other disposition of          the properties which are the subject of the 2000 Master Lease, or of          the interest of Lessor's Affiliate in the 2000 Master Lease."           4. Modification of Base Rent. The definition of "Base Rent" as defined in Section 2.1 of the Amended & Restated Lease is hereby deleted and the following inserted in lieu thereof:                    "Base Rent: (i) From the Commencement Date through December          31, 2005, the base rent shall be calculated on the basis of One Million          Four Hundred Ninety-Eight Thousand and No/100 Dollars ($1,498,000.00)          per annum, payable in equal monthly installments of One Hundred                                           2            Twenty-Four Thousand Eight Hundred Thirty-Three and 34/100 Dollars          ($124,833.34) each. Base Rent for any partial Lease Year shall be          pro-rated based on the number of days elapsed in such Lease Year.                    (ii) For each year Lease Year commencing January 1, 2006 and          continuing through February 28, 2010, Base Rent shall be the lesser of          (A) $1,498,000.00 increased by a percentage equal to two (2) times the          percentage increase in the CPI (if positive) from January 1, 2005 to          January 1, 2006 and the first day of each succeeding Lease Year, as          applicable and (B) the following amounts for each calendar year:                      Lease Year                                  Base Rent                   ----------                                  ---------                     2006                                        $1,542,940                    2007                                        $1,589,228                    2008                                        $1,636,905                    2009                                        $1,686,012                    2010                                        $1,736,592            Under no circumstances will the Base Rent decrease. Base Rent for any          partial Lease Year shall be pro-rated based on the number of days          elapsed in such Lease Year. Base Rent shall continue to be paid in          equal monthly installments."           5. Lease Year. The definition of "Lease Year" as defined in Section 2.1 of the Lease is hereby deleted and the following inserted in lieu thereof:                    "Lease Year: A period of twelve (12) successive calendar          months commencing on the Commencement Date (as defined in Article 2          hereof) and on the same date in each successive calendar year through          December 31, 2005. As of January 1, 2006, a new Lease Year shall          commence and continue for a period of twelve (12) successive calendar          months and on January 1st of each successive calendar year until the          Term Expiration Date or date of earlier termination of this Lease as          provided herein."           6. Section 13.11 of the Amended & Restated Lease is hereby deleted and the following inserted in lieu thereof:                    "13.11. Lessor acknowledges that the liability insurance          coverage and the malpractice insurance coverage required pursuant to          Sections 13.2.4 and 13.2.5 of the Lease, are currently unavailable          generally in the nursing home industry at commercially affordable rates          and that Lessee currently maintains and has in place general liability          and malpractice                                          3            insurance with single limit coverage of Two Hundred Fifty Thousand          Dollars ($250,000.00) per occurrence and Five Hundred Thousand Dollars          ($500,000.00) cumulative, with a deductible of Twenty Five Thousand          Dollars ($25,000.00). Lessor hereby agrees that, the provisions of          Sections 13.2.4 and 13.2.5 of the Lease to the contrary          notwithstanding, until such item as the insurance coverage required          therein is generally available in the nursing home industry at          commercially affordable rates, Lessee shall not be required to obtain          the coverage required in this Article and Lessor agrees to accept          Lessee's current coverage in lieu thereof for the remainder of the          Initial Term of the Lease. Lessee shall not be deemed to be in default          of the provisions of Section 13 of the Leases as a result thereof.          Lessee shall provide Lessor, on an annual basis, information from its          insurance carrier and from comparable insurance carriers of the costs          of insurance premiums to meet Lessor's insurance requirements. At such          time as the premium amounts quoted are commercially affordable, Lessee          shall immediately purchase any and all insurance policies necessary to          meet the requirements of Sections 13.2.4 and 13.2.5 of the Lease. This          provision does not relieve Lessee from its agreement of indemnity under          Article 21 of the Lease nor does it modify the provisions thereof.          Notwithstanding the foregoing, Lessee acknowledges and agrees that the          provisions of this Section 13.11 shall (i) be applicable only during          the Initial Term of the Lease and not any Renewal Term and (ii) not be          applicable in the event of any Transfer. Lessee acknowledges and agrees          that Lessor shall have the right to (i) require that the Lessee provide          the insurance coverages required by the provisions of Sections 13.2.4          and 13.2.5 during any Renewal Term of the Lease and (ii) withhold its          consent to any proposed Transfer unless the Transferee agrees to          provide the insurance coverage required by the provisions of Sections          13.2.4 and 13.2.5 of the Lease."           7. Arbitration. Section 35.1 of the Amended & Restated Lease is hereby deleted and the following inserted in lieu thereof:                    "35.1 Arbitration. Except with respect to payment of Rent          under this Lease and any proceedings to recover possession of one or          more of the Leased Properties, in case any controversy arises between          the parties hereto as to any one of the provisions of this Lease or the          performance thereof, and the parties are unable to settle the          controversy by agreement or as otherwise provided herein, the          controversy shall be decided by arbitration. The arbitration shall be          conducted by three arbitrators selected in accordance with the rules          and procedures of the American Arbitration Association. The decision of          the arbitrators shall be final and binding, and judgment may be entered          thereon in any court of competent jurisdiction. The decision shall set          forth in writing the basis for the decision. In rendering the decision          and award, the arbitrators shall not add to, subtract from, or          otherwise modify the provisions of this Lease.                                          4            The expenses of arbitration shall be divided between Lessors and Lessee          unless otherwise specified in the award. Each party in interest shall          pay the fees and expenses of its own counsel. The arbitration shall be          conducted in Baltimore, Maryland. In any arbitration, the parties shall          be entitled to conduct discovery in the same manner as permitted under          the Federal Rules of Civil Procedure 26 through 37, as amended. No          provision of this Article shall limit the right of any party to this          Agreement to obtain provisional or ancillary remedies from a court of          competent jurisdiction before, after, or during the pendency of any          arbitration, and the exercise of such remedies does not constitute a          waiver of the right of either party to arbitration."           8. Execution and Counterparts. This Amendment may be executed in any number of counterparts, each of which, when so executed and delivered, shall be deemed to be an original, but when taken together shall constitute one and the same Amendment.           9. Headings. Section headings used in this Amendment are for convenience of reference only and shall not affect the construction of the Amendment.           10. Enforceability of Lease. Except as expressly and specifically set forth herein, the Lease remains unmodified and in full force and effect. In the event of any discrepancy between Lease and this Amendment, the terms and conditions of this Amendment will control and the Lease is deemed amended to conform hereto.           IN WITNESS WHEREOF, the parties have executed this Amendment by their duly authorized officers as of the date first above written.  LESSOR:                                  LESSEE: - ------                                   ------  Florida Lessor-Emerald, Inc.,            Senior Care Florida Leasing, LLC a Maryland corporation                   a Delaware limited liability company   By: /s/ Daniel J. Booth                  By: /s/ William R. Council III     -------------------------                ----------------------------------- Name: Daniel J. Booth                    Name: William R. Council III       -----------------------                  --------------------------------- Its: Chief Operating Officer             Its: President      ------------------------                 ----------------------------------                                                 5                                     ACKNOWLEDGMENT           The undersigned consents to the transactions contemplated by this Amendment, ratifies and affirms its Guaranty dated as of April 1, 2003, on the same terms and conditions in effect prior to this Amendment.                                         GUARANTORS:                                        ----------                                         Advocat, Inc.,                                        a Delaware corporation                                          By: /s/ William R. Council III                                            -----------------------------------                                        Name: William R. Council III                                              ---------------------------------                                        Its: President & CEO                                             ----------------------------------                                         Diversicare Management Services, Co.,                                        a Tennessee corporation                                          By: /s/ William R. Council III                                            -----------------------------------                                        Name: William R. Council III                                              ---------------------------------                                        Its: President & CEO                                             ----------------------------------                                          Advocat Finance, Inc.,                                        a Delaware corporation                                          By: /s/ William R. Council III                                            -----------------------------------                                        Name: William R. Council III                                              ---------------------------------                                        Its: President & CEO                                             ----------------------------------                                              6    EX-10.148 4 g00369exv10w148.txt EX-10.148  AMENDMENT TO MASTER LEASE AGREEMENT 12/31/05                                                                     EXHIBIT 10.148                      FIRST AMENDMENT TO MASTER LEASE AGREEMENT           THIS FIRST AMENDMENT TO MASTER LEASE AGREEMENT ("Amendment") is made and entered into as of the 31st day of December, 2005, by and between EMERALD-CEDAR HILLS, INC. a Florida corporation, EMERALD-GOLFVIEW, INC. a Florida corporation, EMERALD-SOUTHERN PINES, INC. a Florida corporation and EMERALD-GOLFCREST, INC., a Florida corporation (herein collectively called the "Lessor") and SENIOR CARE FLORIDA LEASING, LLC, a Delaware limited liability company (herein called the "Lessee").                                      RECITALS           WHEREAS, Lessor owns certain real property located in the State of Florida as more particularly described on EXHIBITS A-1 THROUGH A-4 attached hereto on which there are located four (4) existing fully licensed nursing home facilities owned and operated by Lessor (collectively, the "Leased Properties");           WHEREAS, Lessor and Lessee have entered into a Master Lease Agreement dated as of April 1, 2003 (the "Lease"), whereby Lessor has leased the Leased Properties to Lessee;           WHEREAS, the Lease is scheduled to expire at midnight on December 31, 2005; and           WHEREAS, Lessor and Lessee desire to extend the terms of the Lease upon the terms, covenants and conditions hereinafter set forth.           NOW, THEREFORE, in consideration of the mutual covenants and agreements contained herein, and other good and valuable consideration, the receipt and sufficiency of which is acknowledged, the parties to this Amendment hereby covenant and agree as follows:       1.  Amendment Definitions. Any capitalized term used but not defined in this Amendment will have the meaning assigned to such term in the Lease. Section 1.3 of the Lease is amended to add the following additional definitions:                    "CPI" or "Consumer Price Index": As of any date, the United          States Department of Labor, Bureau of Labor Statistics Revised Consumer          Price Index for All Urban Consumers (1982=84=100), U.S. City Average,          All Items, or, if that index is not available at the time in question,          the index designated by such Department as the successor to such index,          and if there is no index so designated, an index for an area in the          United States that most closely corresponds to the entire United          States, published by such Department, or if none, by any other          instrumentality of the United States, calculated in this Lease as the          CPI attributable to the month three months prior to the applicable date          herein (e.g., the CPI used to calculate   1            the adjustment in Base Rent as of January 1, 2006, shall be the CPI for          the month of October, 2005, compared to the CPI for the month of          October, 2004."                    "Qualified Capital Expenditures: Expenditures capitalized on          the books of Lessee for alterations, renovations, repairs and          replacements to the Facilities including without limitation any of the          following:              Replacement of furniture, fixtures and equipment, including             refrigerators, ranges, major appliances, bathroom fixtures, doors             (exterior and interior), central air conditioning and heating             systems (including cooling towers, water chilling units, furnaces,             boilers and fuel storage tanks) and major replacement of siding;             major roof replacements, including major replacements of gutters,             down spouts, eaves and soffits; major repairs and replacements of             plumbing and sanitary systems; overhaul of elevator systems; major             repaving, resurfacing and sealcoating of sidewalks, parking lots and             driveways; repainting of entire building exterior; but excluding             additions, normal maintenance and repairs. For purposes of this             definition, "additions" shall mean any expansion of a Facility,             including the construction of a new wing or a new story on an             existing Facility."           2. Extension of Term. The definition of "Term Expiration Date" as defined in Section 1.3 of the Lease is hereby deleted and the following inserted in lieu thereof:           "Term Expiration Date: February 28, 2010."           3. Modification of Base Rent. The definition of "Base Rent" as defined in Section 1.3 of the Lease is hereby deleted and the following inserted in lieu thereof:                    "Base Rent: (i) From the Commencement Date through December          31, 2005, the base rent shall be calculated on the basis of One Million          Four Hundred Ninety-Eight Thousand and No/100 Dollars ($1,498,000.00)          per annum, payable in equal monthly installments of One Hundred          Twenty-Four Thousand Eight Hundred Thirty-Three and 34/100 Dollars          ($124,833.34) each. Base Rent for any partial Lease Year shall be          pro-rated based on the number of days elapsed in such Lease Year.                    (ii) For each year Lease Year commencing January 1, 2006 and          continuing through February 28, 2010, Base Rent shall be the lesser of          (A) $1,498,000.00 increased by a percentage equal to two (2) times the          percentage increase in the CPI (if positive) from January 1, 2005 to          January 1, 2006 and the first day of each succeeding Lease Year, as          applicable and (B) the following amounts for each calendar year:    2                      Lease Year                                  Base Rent                   ----------                                  ---------                     2006                                        $1,542,940                    2007                                        $1,589,228                    2008                                        $1,636,905                    2009                                        $1,686,012                    2010                                        $1,736,592            Under no circumstances will the Base Rent decrease. Base Rent for any          partial Lease Year shall be pro-rated based on the number of days          elapsed in such Lease Year. Base Rent shall continue to be paid in          equal monthly installments."           4. Lease Year. The definition of "Lease Year" as defined in Section 1.3 of the Lease is hereby deleted and the following inserted in lieu thereof:                    "Lease Year: A period of twelve (12) successive calendar          months commencing on the Commencement Date (as defined in Article 2          hereof) and on the same date in each successive calendar year through          December 31, 2005. As of January 1, 2006, a new Lease Year shall          commence and continue for a period of twelve (12) successive calendar          months and on January 1st of each successive calendar year until the          Term Expiration Date or date of earlier termination of this Lease as          provided herein."           5. Payments in the event of a Rent Adjustment. Section 4.2 of the Lease is hereby deleted and the following inserted in lieu thereof:                    "4.2 Payments in the event of Rent Adjustment. Base Rent shall          be adjusted on January 1, 2006, and each January 1 thereafter          throughout the Term of this Lease. In the event this Lease provides for          adjustment of the Base Rent on any basis that requires a determination          of Base Rent which cannot be made on or before the due date of the          first installment of Base Rent following the Adjustment Date, Lessee          shall continue to pay the Base Rent at the rate previously in effect          until Lessor gives Lessee Notice of its determination of the adjusted          Base Rent. Upon such determination, the Base Rent shall be          retroactively adjusted as of the Adjustment Date. On or before the          second (2nd) Payment Date for Base Rent following receipt by Lessee of          Lessors' Notice of the adjustment, Lessee shall make an additional          payment of Base Rent in such amount as will bring the Base Rent, as          adjusted, current on or before such (2nd) Payment Date, plus interest          on the amount of such additional payment (i.e. the difference between          the monthly installment of Base Rent before and after the increase as          of the Adjustment Date, divided by thirty (30) and   3            multiplied by the number of days between the Adjustment Date and the          date of payment by Lessee) at the Prime Rate from the Adjustment Date          through the date of such additional payment, and thereafter Lessee          shall pay the adjusted Base Rent in correspondingly adjusted monthly          installments until the Base Rent is next adjusted as required herein.          This Section 4.2 shall survive the expiration or termination of this          Lease with respect to any adjustment which is not known or fully paid          as of the date of the expiration or termination.                    The reference to "Additional Rent" in the definition of "Rent"          under Section 1.3 and in Section 4.3, or elsewhere in this Lease are          hereby deleted, and Exhibit C is hereby deleted and no longer a part of          this Lease."           6. General Insurance Requirements. Article 11 of the Lease is hereby deleted and the following inserted in lieu thereof:                     "11.1 General Insurance Requirements. Lessee shall keep the          Leased Properties, and all property located in or on the Leased          Properties, including any personal property of Lessors and Lessee's          Personal Property, insured with insurance meeting the following          requirements: (a) all insurance shall be written by companies          authorized to do insurance business in the applicable States and having          a rating classification of not less than A- and a financial size          category of "Class VII" or larger, according to the then most recent          issue of Best's Key Rating Guide; (b) all policies must name Lessors as          an additional insured, and name as an additional insured any Facility          Mortgagee by way of a standard form of mortgagee's loss payable          endorsement in use in the applicable States and in accordance with any          such other requirements as may be established by such Facility          Mortgagee; (c) casualty losses must be payable to Lessors or Lessee as          provided in Article 12, and loss adjustments shall require the written          consent of Lessors, any Facility Mortgagee, and, provided no Event of          Default has occurred and is continuing at the time, Lessee, which          consent shall not be unreasonably withheld by either Lessors or Lessee;          (d) each insurer must agree that it will give Lessors and any Facility          Mortgagee at least thirty (30) days written notice before its policy          shall be altered, allowed to expire or canceled; (e) the amount of any          deductible or retention must be approved by Lessors prior to the          issuance of any policy, which approval will not be unreasonably          withheld, conditioned or delayed; and (f) the form of all policies          shall be approved by Lessors and any existing Facility Mortgagee, whose          approval shall not unreasonably be withheld, conditioned or delayed,          provided that such policies conform to the requirements of this Article          11. Notwithstanding the foregoing, Lessee may obtain so-called          "umbrella" policies, comprehensive liability policies and professional   4            liability policies of insurance from non-admitted surplus line carriers          acceptable to Lessors.                     11.2 Risks to be Insured. The policies covering the Leased          Properties and Lessee's Personal Property shall insure against the          following risks:                             11.2.1 Loss or damage by fire, vandalism and          malicious mischief, earthquake, extended coverage perils commonly known          as "Special Risk," and all physical loss perils normally included in          such Special Risk insurance, including but not limited to sprinkler          leakage, in an amount not less than one hundred percent (100%) of          Replacement Cost (provided that earthquake coverage may have a sublimit          coverage of $5,000,000.00);                             11.2.2 Loss or damage by explosion of steam boilers,          pressure vessels or similar apparatus in such amounts as may be          required by Lessors from time to time;                             11.2.3 Business interruption insurance or a blanket          earnings and expense coverage endorsement covering risk of loss during          reconstruction necessitated by the occurrence of any of the hazards          described in Sections 11.2.1 or 11.2.2 (but in no event for a period          less than twelve (12) months) in an amount sufficient to prevent          Lessors and Lessee from becoming a co-insurer;                             11.2.4 Claims for personal injury or property damage          under a policy of commercial general public liability insurance with a          combined single limit per occurrence in respect of bodily injury and          death and property damage of One Million Dollars ($1,000,000.00), and          an aggregate limitation of Three Million Dollars ($3,000,000.00), with          a minimum One Million Dollar ($1,000,000.00) excess policy, which          insurance shall insure Lessee's contractual liability to Lessors under          the indemnity provisions of Article 18 of this Lease, and if written on          a "claims-made" basis, Lessee shall also provide continuous liability          coverage for claims arising during the Term either by obtaining an          endorsement providing for an extended reporting period reasonably          acceptable to Lessors in the event such policy is canceled or not          renewed for any reason whatsoever, or by obtaining "tail" insurance          coverage providing coverage for a period of at least three (3) years          beyond the expiration of the Term;                             11.2.5 Claims arising out of malpractice in an amount          of not less than Two Million Dollars ($2,000,000.00) for each person          and for each occurrence and, if written on a "claims-made" basis,          Lessee shall also provide continuous liability coverage for claims          during the Term either   5            by obtaining an endorsement providing for an extended reporting period          reasonably acceptable to Lessors in the event such policy is canceled          or not renewed for any reason whatsoever, or by obtaining "tail"          insurance coverage providing coverage for a period of at least three          (3) years beyond the expiration of the Term;                             11.2.6 Flood (with respect to any portions of the          Leased Properties located in whole or in party within a designated          flood plain area) and such other hazards and in such amounts as may be          customary for comparable properties in the area up to the maximum limit          that can be obtained under the Federal Flood Insurance Program;                             11.2.7 During such time as Lessee is constructing any          improvements, (i) workers compensation insurance and employers'          liability insurance covering all persons employed in connection with          the improvements in statutory limits, (ii) builder's risk insurance,          completed value form, covering all physical loss, in an amount          satisfactory to Lessors, and (iii) such other insurance, in such          amounts, as Lessors deem necessary to protect Lessors' interest in the          Leased Properties from any act or omission of Lessee's contractors or          subcontractors, and certificates of insurance evidencing such coverage,          in form satisfactory to Lessors, shall be presented to Lessors prior to          the commencement of construction of such improvements;                             11.2.8 Primary automobile liability insurance with          limits of One Million Dollars ($1,000,000.00) per occurrence each for          owned and non-owned hired vehicles.                    11.3 Payment of Premiums; Copies of Policies; Certificates.          Lessee shall pay when due all of the premiums for the insurance          required by this Lease, and shall deliver to Lessors and to any          Facility Mortgagee requesting such evidence, certificates of insurance          in form satisfactory to Lessors and such Facility Mortgagee.          Satisfactory evidence of insurance required by this Lease or          certificates thereof shall be delivered to Lessors prior to their          effective date (and, with respect to any renewal policy, Lessee will          use commercially reasonable efforts to provide the same within twenty          (20) days but in all events not less than five (5) Business Days prior          to the expiration of the existing policy) with copies of such policies          to be provided as available, and in the event of the failure of Lessee          either to carry the required insurance or pay the premiums therefor, or          to deliver copies of policies or certificates to Lessors as required,          Lessors shall be entitled, but shall have no obligation, to obtain such          insurance an pay the premiums therefor when due, which premiums shall          be repayable to Lessors upon written demand therefor as Additional          Charges which Lessee shall be deemed to and does hereby agree to pay.    6                     11.4 Premiums Deposits. If any provision of a Facility          Mortgage requires deposits of premiums for insurance to be made with          the Facility Mortgagee, Lessee shall pay to Lessors monthly the amounts          required and Lessors shall transfer such amounts to the Facility          Mortgagee, unless, pursuant to written direction by Lessors, Lessee          makes such deposits directly with the Facility Mortgagee.                    11.5 Umbrella Policies. If Lessee chooses to carry umbrella          liability coverage to obtain the limits of liability required under          this Lease, the umbrella policies must provide coverage in the same          manner as the primary commercial general liability policy and must          contain no exclusions in addition to, or limitations materially          different than, those of the primary policy.                    11.6 Additional Insurance. In addition to the insurance          described above, Lessee shall maintain such insurance as may be          required from time to time by any Facility Mortgagee, and shall at all          times comply with all laws with respect to worker's compensation          insurance coverage.                    11.7 No Liability; Waiver of Subrogation. Lessors shall have          no liability to Lessee, and, provided Lessee provides the insurance          required of it by this Lease, Lessee shall have no liability to          Lessors, regardless of the cause, for any loss or expense resulting          from or in connection with damages to or the destruction or other loss          of any Leased Property or Lessee's Personal Property, and neither party          will have any right or claim against the other for any such loss or          expense by way of subrogation. Each insurance policy carried by either          party covering any of the Leased Properties and Lessee's Personal          Property, including without limitation, contents, fire and casualty          insurance, shall contain an express waiver of any right of subrogation          on the party of the insurer against the other party. Lessee shall pay          any additional costs or charges for obtaining such waiver.                    11.8 Increase in Limits. From time to time, but not more often          than once every two (2) years, in the event that Lessors shall          reasonably determine that the limits of the commercial general          liability insurance then carried are insufficient, Lessors shall give          Lessee Notice of acceptable increased limits for such insurance to be          carried; and Lessee shall then obtain and maintain such insurance with          such increased limits unless and until further increase as permitted          under the provisions of this Section. Lessors' determination of          increased limits shall be accompanied by a description of the basis for          such determination.                    11.9 Blanket Policy. Any insurance required by this Lease may          be provided by so-called blanket policies of insurance carried by          Lessee, provided, however, that the coverage afforded Lessors thereby          may not   7            thereby be less than or materially different from that which would be          provided by a separate policies meeting the requirements of this Lease,          and provided further that such policies meet the requirements of all          Facility Mortgages.                    11.10    No Separate Insurance.                             11.10.1 Lessee shall not on its own initiative or          pursuant to the request or requirement of any third party, take out          separate insurance concurrent in form or contributing in the event of          loss with that required by this Lease, to be furnished by, or which may          be reasonably be required to be furnished by, Lessee, or increase the          amount of any then existing insurance by securing an additional policy          or additional policies, unless all parties having an insurable interest          in the subject matter of the insurance, including in all cases Lessors          and all Facility Mortgagees, are named therein as additional insureds,          and losses are payable thereunder in the same manner as losses are          payable under this Lease.                             11.10.2 Nothing herein shall prohibit Lessee, upon          Notice to Lessors, from (i) securing insurance required to be carried          hereby with higher limits of liability than required in this Lease, or          (ii) securing insurance against risks not required to be insured          pursuant to this Lease, and as to such insurance, Lessors and any          Facility Mortgagee need not be included therein as additional insureds,          nor must losses thereunder be payable in the same manner as losses are          payable under this Lease, except to the extent required to avoid a          default under a Facility Mortgage or any other encumbrance.                             11.10.3 Lessor acknowledges that the liability          insurance coverage and the malpractice insurance coverage required          pursuant to Sections 11.2.4 and 11.2.5 of the Lease, are currently          unavailable generally in the nursing home industry at commercially          affordable rates and that Lessee currently maintains and has in place          general liability and malpractice insurance with single limit coverage          of Two Hundred Fifty Thousand Dollars ($250,000.00) per occurrence and          Five Hundred Thousand Dollars ($500,000.00) cumulative, with a          deductible of Twenty Five Thousand Dollars ($25,000.00). Lessor hereby          agrees that, the provisions of Sections 11.2.4 and 11.2.5 of the Lease          to the contrary notwithstanding, until such time as the insurance          coverage required therein is generally available in the nursing home          industry at commercially affordable rates, Lessee shall not be required          to obtain the coverages required therein. Lessee shall not be deemed to          be in default of the provisions of Section 11 of the Leases as a result          thereof. Lessee shall provide Lessor, on an annual basis, information          from its insurance carrier and from comparable insurance carriers of          the costs of insurance   8            premiums to meet Lessor's insurance requirements. At such time as the          premium amounts for required coverage quoted in this Article are          commercially affordable, Lessee shall immediately purchase any and all          insurance policies necessary to meet the requirements of Sections          11.2.4 and 11.2.5 of the Lease. This provision does not relieve Lessee          from its agreement of indemnity under Article 18 of the Lease (or          elsewhere in this Lease) nor does it modify the provisions thereof.          Notwithstanding the foregoing, Lessee acknowledges and agrees that          Lessor shall have the right to withhold its consent to any proposed          Permitted Assignment unless the permitted assignee agrees to provide          the insurance coverage required by the provisions of Sections 11.2.4          and 11.2.5 of the Lease."           7. Article 23. An Article 23 shall be inserted into the Lease and provide as follows:                    "23.1 Minimum Qualified Capital Expenditures. Each Lease Year,          Lessee shall expend with respect to each Leased Facility at least Three          Hundred Fifty Dollars ($350.00) and NO/100 per licensed bed for          Qualified Capital Expenditures to improve the applicable Facility,          which amount shall be increased each Lease Year, beginning the January          1, 2007 Lease Year, in proportion to increases in the CPI from the          Commencement Date to the commencement of each such Lease Year ("Minimum          Qualified Capital Expenditures"). If Lessee expends with respect to any          Facility more than the Minimum Qualified Capital Expenditures in any          Lease Year, the excess Minimum Qualified Capital Expenditures shall be          credited against Lessee's Minimum Qualified Capital Expenditures          required with respect to such Facility for the next Lease Year, and if          the amount of the credit exceeds Lessee's Minimum Qualified Capital          Expenditures required with respect to such Facility for the next Lease          Year, such excess shall be credited against Lessee's Minimum Qualified          Capital Expenditures required with respect to such Facility for the          following Lease Years. At least annually, at the request of Lessors,          Lessors and Lessee shall review the capital expenditures budgets and          reasonably agree on modifications, if any, required by changed          circumstances and the changed conditions of the Leased Properties."           8. Execution and Counterparts. This Amendment may be executed in any number of counterparts, each of which, when so executed and delivered, shall be deemed to be an original, but when taken together shall constitute one and the same Amendment.           9. Headings. Section headings used in this Amendment are for convenience of reference only and shall not affect the construction of the Amendment.           10. Enforceability of Lease. Except as expressly and specifically set forth herein, the Lease remains unmodified and in full force and effect. In the event of any   9   discrepancy between Lease and this Amendment, the terms and conditions of this Amendment will control and the Lease is deemed amended to conform hereto.                         10             IN WITNESS WHEREOF, the parties have executed this Amendment by their duly authorized officers as of the date first above written.  LESSOR:                                   LESSEE: - ------                                    ------  Emerald-Cedar Hills, Inc.,                Senior Care Florida Leasing, LLC a Florida corporation                     a Delaware limited liability company   By: /s/ R. Brent Maggio                   By: /s/ William R. Council III     --------------------------                -------------------------------- Name: R. Brent Maggio                     Name: William R. Council III       ------------------------                  ------------------------------ Its:  President                           Its: President       ------------------------                 -------------------------------  Emerald-Golfview, Inc., a Florida corporation   By: /s/ R. Brent Maggio     -------------------------- Name: R. Brent Maggio       ------------------------ Its:  President       ------------------------  Emerald-Southern Pines, Inc., a Florida corporation   By: /s/ R. Brent Maggio     -------------------------- Name: R. Brent Maggio       ------------------------ Its:  President       ------------------------  Emerald-Golfcrest, Inc., a Florida corporation   By: /s/ R. Brent Maggio     -------------------------- Name: R. Brent Maggio       ------------------------ Its:  President       ------------------------  OMEGA HEALTHCARE INVESTORS, INC., ACKNOWLEDGES AND CONSENTS TO THE TERMS OF THIS AMENDMENT.  Omega Healthcare Investors, Inc., a Maryland corporation   By: /s/ Daniel J. Booth     -------------------------- Name: Daniel J. Booth       ------------------------ Its:  Chief Operating Officer       -----------------------    11                                    ACKNOWLEDGMENT           The undersigned consents to the transactions contemplated by this Amendment, ratifies and affirms its Guaranty dated as of April 1, 2003, on the same terms and conditions in effect prior to this Amendment.                                        GUARANTORS:                                       ----------                                        Advocat, Inc.,                                       a Delaware corporation                                        By: /s/ William R. Council III                                           --------------------------------                                       Name: William R. Council III                                             ------------------------------                                       Its: President                                            -------------------------------                                          Diversicare Management Services, Co.,                                       a Tennessee corporation                                        By: /s/ William R. Council III                                           --------------------------------                                       Name: William R. Council III                                             ------------------------------                                       Its: President                                            -------------------------------                                         Advocat Finance, Inc.                                       a Delaware corporation                                        By: /s/ William R. Council III                                           --------------------------------                                       Name: William R. Council III                                             ------------------------------                                       Its: President                                            -------------------------------   12    EX-21 5 g00369exv21.txt EX-21  SUBSIDIARIES OF THE REGISTRANT                                                                                  .                                                                                .                                                                                .                                    EXHIBIT 21                                   SUBSIDIARIES     NAME OF CORPORATION                                       STATE OF INCORPORATION   Advocat Ancillary Services, Inc.                                   Tennessee Advocat Distribution Services, Inc.                                Tennessee Advocat Finance, Inc.                                              Delaware Diversicare Afton Oaks, LLC                                        Delaware Diversicare Assisted Living Services, Inc.                         Tennessee Diversicare Assisted Living Services NC, LLC                       Tennessee Diversicare Assisted Living Services NC I, LLC                     Delaware Diversicare Assisted Living Services NC II, LLC                    Delaware Diversicare Briarcliff, LLC                                        Delaware Diversicare General Partner, Inc.                                  Texas Diversicare Good Samaritan, LLC                                    Delaware Diversicare Hartford, LLC                                          Delaware Diversicare Leasing Corp.                                          Tennessee Diversicare Leasing Corp. of Alabama                               Alabama Diversicare Management Services Co.                                Tennessee Diversicare Pinedale, LLC                                          Delaware Diversicare Windsor House, LLC                                     Delaware First American Health Care, Inc.                                   Alabama Senior Care Florida Leasing, LLC                                   Delaware Senior Care Cedar Hills, LLC                                       Delaware Senior Care Golfcrest, LLC                                         Delaware Senior Care Golfview, LLC                                          Delaware Senior Care Southern Pines, LLC                                    Delaware Sterling Health Care Management, Inc.                              Kentucky     EX-23.1 6 g00369exv23w1.txt EX-23.1  CONSENT OF BDO SEIDMAN, LLP                                                                       Exhibit 23.1                CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM    Advocat Inc. Brentwood, Tennessee  We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (File Numbers 33-93940 and 33-93950) of Advocat Inc. of our report dated March 17, 2006, relating to the consolidated financial statements and financial statement schedules, which appear in this Form 10-K. Our report contains an explanatory paragraph regarding the Company's ability to continue as a going concern.  Memphis, Tennessee March 29, 2006                                                 /s/ BDO Seidman, LLP                                                ---------------------------------                                                BDO Seidman, LLP      EX-31.1 7 g00369exv31w1.txt EX-31.1  SECTION 302 CERTIFICATION OF THE CEO                                                                        Exhibit 31.1                      CERTIFICATIONS PURSUANT TO SECTION 302 OF                          THE SARBANES-OXLEY ACT OF 2002  (i)   CERTIFICATION        I, William R. Council, III, certify that:        1.    I have reviewed this annual report on Form 10-K of Advocat Inc.;        2.    Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;        3.    Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;        4.    The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15e and 15d-15e) for the registrant and we have:              (a)   Designed such disclosure controls and procedures, or caused       such disclosure controls and procedures to be designed under our       supervision, to ensure that material information relating to the       registrant, including its consolidated subsidiaries, is made known to us       by others within those entities, particularly during the period in which       this annual report is being prepared;              (b)   Evaluated the effectiveness of the registrant's disclosure       controls and procedures and presented in this annual report our       conclusions about the effectiveness of the disclosure controls and       procedures as of the end of the period covered by this report based on       such evaluation; and              (c)   Disclosed in this report any change in the registrant's       internal control over financial reporting that occurred during the       registrant's fourth fiscal quarter that has materially affected, or is       reasonably likely to materially affect, the registrant's internal control       over financial reporting; and        5.    The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):              (a)   All significant deficiencies and material weaknesses in the       design or operation of internal control over financial reporting which are       reasonably likely to          adversely affect the registrant's ability to record, process, summarize       and report financial information; and              (b)   Any fraud, whether or not material, that involves management       or other employees who have a significant role in the registrant's       internal control over financial reporting.  Date: March 29, 2006  /s/ William R. Council, III - ----------------------------------- William R. Council, III Chief Executive Officer     EX-31.2 8 g00369exv31w2.txt EX-31.2  SECTION 302 CERTIFICATION OF THE CFO                                                                        Exhibit 31.2                             CERTIFICATIONS PURSUANT TO                                  SECTION 302 OF                          THE SARBANES-OXLEY ACT OF 2002  (ii)  CERTIFICATION        I, L. Glynn Riddle, Jr., certify that:        1.    I have reviewed this annual report on Form 10-K of Advocat Inc.;        2.    Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;        3.    Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;        4.    The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15e and 15d-15e) for the registrant and we have:              (a)   Designed such disclosure controls and procedures, or caused       such disclosure controls and procedures to be designed under our       supervision, to ensure that material information relating to the       registrant, including its consolidated subsidiaries, is made known to us       by others within those entities, particularly during the period in which       this annual report is being prepared;              (b)   Evaluated the effectiveness of the registrant's disclosure       controls and procedures and presented in this annual report our       conclusions about the effectiveness of the disclosure controls and       procedures as of the end of the period covered by this report based on       such evaluation; and              (c)   Disclosed in this report any change in the registrant's       internal control over financial reporting that occurred during the       registrant's fourth fiscal quarter that has materially affected, or is       reasonably likely to materially affect, the registrant's internal control       over financial reporting; and  5.    The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function):          (a)   All significant deficiencies and material weaknesses in the design       or operation of internal control over financial reporting which are       reasonably likely to adversely affect the registrant's ability to record,       process, summarize and report financial information; and        (b)   Any fraud, whether or not material, that involves management or       other employees who have a significant role in the registrant's internal       control over financial reporting.  Date: March 29, 2006  /s/ L. Glynn Riddle, Jr. - ---------------------------- L. Glynn Riddle, Jr. Chief Financial Officer     EX-32 9 g00369exv32.txt EX-32  SECTION 906 CERTIFICATIONS OF THE CEO AND CFO                                                                          EXHIBIT 32                      CERTIFICATION OF ANNUAL REPORT ON FORM 10-K                                  OF ADVOCAT INC.                       FOR THE YEAR ENDED DECEMBER 31, 2005  The undersigned hereby certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the undersigned's best knowledge and belief, the Annual Report on Form 10-K for Advocat Inc. (the "Company") for the period ending December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the "Report"):       (a)  fully complies with the requirements of section 13(a) or 15(d) of the           Securities Exchange Act of 1934; and       (b)  the information contained in the Report fairly presents, in all           material respects, the financial condition and results of operations           of the Company.  This Certification is executed as of March 29, 2006.                                           /s/ William R. Council, III                                          ---------------------------------                                          William R. Council, III                                          Chief Executive Officer                                           /s/ L. Glynn Riddle, Jr.                                          ---------------------------------                                          L. Glynn Riddle, Jr.                                          Chief Financial Officer  A signed original of this written statement required by Section 906 of the Sarbanes-Oxley Act of 2002 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.                                                1    -----END PRIVACY-ENHANCED MESSAGE-----