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DYII > SEC Filings for DYII > Form 10-K on 22-Mar-2013All Recent SEC Filings

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Form 10-K for DYNACQ HEALTHCARE INC


22-Mar-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

Our Management's Discussion and Analysis includes forward-looking statements that are subject to risks and uncertainties. Actual results may differ substantially from the statements we make in this section due to a number of factors that are discussed in Item 1A - Risk Factors.

Our operating results for all periods presented reflect operations of our Garland facility in the U.S. and all of our subsidiaries in China and Hong Kong, except for Sino Bond, as discontinued operations.

RECENT DEVELOPMENTS

Internal Investigation

As previously disclosed in our Current Report on Form 8-K filed with the Securities and Exchange Commission (the "SEC") on August 9, 2012, we announced that, at the request of our Board of Directors (the "Board"), we commenced an internal investigation of our past business practices, potentially encompassing members of the Board, management and third persons, and related accounting matters (the "Investigation").

The Investigation, which was performed by outside legal counsel and other outside consultants at the direction of the Board, was substantially completed on December 27, 2012. The Investigation included a review of a substantial number of Company documents and emails, as well as interviews with employees, members of the Board and other persons who were familiar with the facts surrounding the Investigation. The results of the Investigation, which were reported directly to the Board, revealed that the former Chief Financial Officer of the Company did not perform a significant review or independent analysis of transactions initiated by the former Chief Executive Officer. As a result, we believe that, for the five fiscal years ending on August 31, 2012, we did not maintain effective control over financial reporting due to the existence of a material weakness related to a failure of internal controls designed to limit the ability of management to override our system of internal controls. The results of the Investigation also revealed that the former Chief Financial Officer misrepresented certain information to our independent auditor, which we have also determined to be a material weakness in our internal control over financial reporting. We also identified the existence of a significant deficiency related to a lack of objectivity by our former executive officers with respect to accounting decisions.

Based on the results of the Investigation and recommendations made by our independent auditor regarding the foregoing material weaknesses and significant deficiencies in internal control over financial reporting, we are reviewing our internal control and compliance policies and procedures. We believe that no additional remediation efforts with respect to the material weaknesses and the significant deficiency as they relate to the former Chief Executive Officer and the former Chief Financial Officer are necessary, as the executives who occupied these offices during the events in question are no longer employed by us.

We have determined that our previously reported consolidated balance sheets for periods up to and including August 31, 2012 do not require any material adjustments and/or restatements in respect of the results of the Investigation. Further, the Investigation did not result in any material change to our previously reported net income or loss or financial position for the same periods. However, the Investigation, along with subsequent analysis performed by us and our auditors, did reveal that Company expenditures in the amount of approximately $7.8 million were authorized by former officers of the Company and paid to various third parties, and the results of the Investigation and the subsequent analysis performed by us and our auditors provided no evidence of a discernible benefit to the Company resulting from these expenditures. We have determined that the questionable nature of these expenditures may result in their reclassification in our financial statements, from operating costs and expenses to other expenses, depending on determinations that the Board may make in the future. We do not expect these reclassifications, even if they are made, to result in a material restatement of our financial statements. Please see note 16 to our consolidated financial statements for additional information.


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Delisting of Common Stock from NASDAQ Global Markets

As discussed in our Current Report on Form 8-K filed with the SEC on October 11, 2012, and further discussed in our Current Reports on Form 8-K filed on each of September 28, 2012 and April 13, 2012, the NASDAQ Stock Market ("NASDAQ") announced on October 10, 2012 that the Company's common stock would be delisted from NASDAQ. Prior to being delisted, trading in the Company's stock was halted by NASDAQ on August 9, 2012, and NASDAQ suspended the Company's stock from trading on October 4, 2012. As discussed in the Company's Current Report on Form 8-K filed with the SEC on April 13, 2012, NASDAQ informed the Company that it would be subject to delisting upon a failure to regain compliance with (i) the $1.00 minimum bid price per share of its common stock pursuant to NASDAQ Listing Rule 5450(a)(1) for a period of at least ten consecutive business days ending on a date prior to October 9, 2012, and (ii) the minimum market value of its publicly held shares of at least $5 million pursuant to NASDAQ Listing Rule 5450(b)(1)(C) for at least ten consecutive business days prior to October 9, 2012. Further, on September 25, 2012, the Company received notification from NASDAQ stating that the Company's common stock will be delisted from NASDAQ effective at the opening of business on October 4, 2012. The delisting of the Company's common stock was a result of the Company's failure to make timely payment of certain listing fees, as required by NASDAQ Listing Rule 5250(f), in the amount of $5,000. In light of the prior NASDAQ notice described in further detail above, the Company concluded that no valid business purpose would be served by making payment of these fees. The Company did not request an appeal hearing regarding the delisting. As a result of the trading halt in effect at the time of the notice for the Company's common stock and the failure of the minimum bid price to reach $1.00 per share for 10 consecutive business days after receipt of the NASDAQ letter and prior to the commencement of the trading halt, and in light of the fact that there were fewer than ten business days remaining before October 9, 2012, the Company did not believe that it would be able to regain compliance with the NASDAQ Listing Rules discussed above prior to October 9, 2012. As a result, the Company believed that it would have become subject to delisting for failure to comply with Listing Rule 5450(a)(1) on October 9, 2012, even if it had paid the listing fees in compliance with NASDAQ Listing Rule 5250(f) on or before October 4, 2012. A Form 25 was filed with the SEC on October 11, 2012, and the Company's stock was effectively delisted ten days following this filing.

Changes in Officers and Directors

On May 17, 2012, Chiu M. Chan, the Chairman of our Board of Directors, passed away. His seat on the Board of Directors remains vacant while the Board considers whether to appoint a new director or permanently reduce the size of the Board to five members. As previously reported in the Company's Current Report on Form 8-K filed with the SEC on January 13, 2012, on January 10, 2012 the Board of Directors expanded the Board from five to six members and appointed Eric K. Chan, M.D. as a new member of the Board. Eric K. Chan is the son of Chiu M. Chan, who was incapacitated at the time by an unexpected illness. Eric K. Chan did not stand for election at the Annual Meeting of Shareholders held on February 15, 2012 and his term as director ended. At the conclusion of the Annual Meeting, the Board of Directors reappointed Eric K. Chan as a member of the Board. Eric K. Chan currently serves as our Chief Executive Officer and President. Dr. Chan is board certified in anesthesiology. He has been the sole owner of Redwood Health Corporation since March 2005, which furnishes physicians to provide in-house emergency medical coverage and recruits anesthesiologists and certified registered nurse anesthetists at hospitals, including the Company's Pasadena facility. Dr. Chan has also been the sole owner of Anesthesia Associates of Houston Metroplex since August 2007, which provides anesthesiology services to hospitals, including the Company's Pasadena facility. He was an Assistant Professor at Memorial Hermann Hospital, University of Texas at Houston from August 2007 to September 2008. Dr. Chan earned his M.B.A. in Health Organization Management and M.D. from Texas Tech University.

On August 8, 2012, the Board placed Mr. Philip Chan on paid administrative leave from his position as Chief Financial Officer of Dynacq. On November 28, 2012, Mr. Chan submitted to the Board his resignation from all positions at Dynacq and its affiliates, including his positions as Chief Financial Officer and Director of Dynacq. While Mr. Chan was on administrative leave, the Board appointed Hemant Khemka, the current Controller of Dynacq, to act as principal financial officer of Dynacq pending the results of the investigation. Mr. Khemka continues to act as principal financial officer of Dynacq.


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As discussed in the Definitive Information Statement filed pursuant to
Section 14(c) (the "Information Statement") of the Securities Exchange Act of 1934, as amended (the "Exchange Act"") on October 9, 2012, pursuant to an Action by Written Consent of Stockholders in lieu of a Special Meeting, stockholders of Dynacq holding more than two-thirds of the issued and outstanding shares of our common stock as of September 24, 2012 (the "Record Date") approved the removal of Ping S. Chu, James G. Gerace and Stephen L. Huber from their positions as members of our Board, to be effective on October 30, 2012. On October 24, 2012, James G. Gerace resigned. On October 30, 2012, the stockholder approval became effective, and Messrs. Chu and Huber were removed.

The sole remaining member of our Board is Dr. Eric K. Chan, who also serves as our Chief Executive Officer and President. As a result of the stockholder action and recent resignations, our Board has five vacancies, including the vacancy left by Mr. Chiu M. Chan's passing. We intend to seek qualified candidates to fill these Board vacancies, including some candidates that are deemed independent based on the independence standards of NASDAQ. There can be no assurance, however, that we will be able to fill any of these vacancies with new directors, independent or otherwise. In the interim, the sole remaining member of our Board will continue to fulfill the Board's responsibilities. The following holders of 9,966,482 shares of our common stock, constituting 68.5% of our outstanding common stock on the Record Date, consented to the stockholder action: Estate of Chiu M. Chan (represented by the widow of Mr. Chan, Ella Y.T.C. Chan, the sole executrix of the estate); Ella Y.T.C. Chan; Chan Chang Chin Ying (the aunt of Dr. Eric K. Chan); Philip S. Chan; Dr. Eric K. Chan; Edward K. Chiu (no relation to any other stockholder consenting to the action); and Bert Chan (brother of Eric K. Chan and son of Ella Y.T.C. Chan). Please see the Information Statement for additional information.

Restatement of Financial Statements for Fiscal Year 2011 Due to Change in Benefit for Income Tax Amount

We restated our financial statements for the fiscal year ended August 31, 2011, which produced adjustments to previously reported amounts. These adjustments are described in Note 15 to the consolidated financial statements included in this annual report on Form 10-K. The restatement did not change our previously reported net revenue or cash flow from operating activities. It reduced the benefit for income taxes and stockholders' equity. Due to the restatements, investors should not rely on the Company's previously issued financial statements for the fiscal year ended August 31, 2011.

Critical Accounting Policies and Estimates

The Consolidated Financial Statements and Notes to Consolidated Financial Statements contain information that is pertinent to the management's discussion and analysis. 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 any contingent assets and liabilities. Management believes these accounting policies involve judgment due to the significant assumptions and estimates necessary in determining the related asset and liability amounts. Management believes it has exercised proper judgment in determining these estimates based on the facts and circumstances available to it at the time the estimates were made. The significant accounting policies are described in the Company's financial statements (see Note 1 in Notes to the Consolidated Financial Statements). Of these policies, management believes the following ones may involve a comparatively higher degree of judgment and complexity. We have discussed the development and selection of the critical accounting policies and related disclosures with the Board of Directors.

Revenue Recognition

Background

The Company's revenue recognition policy is significant because net patient service revenue is a primary component of its results of operations. Revenue is recognized as services are delivered. The determination of the amount of revenue to be recognized in connection with the Company's services is subject to significant judgments and estimates, which are discussed below.


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Revenue Recognition Policy

The Company has established billing rates for its medical services which it bills as gross revenue as services are delivered. Gross billed revenues are then reduced by the Company's estimate of the discount (contractual allowance) to arrive at net patient service revenues. Net patient service revenues may not represent amounts ultimately collected. The Company adjusts current period revenue for actual differences in estimated revenue recorded in prior periods and actual cash collections.

The table below sets forth the percentage of our gross patient service revenue by financial class for our Pasadena facility for the fiscal years 2012 and 2011:

                                              2012       2011
                      Workers' Compensation      11 %       26 %
                      Commercial                 40 %       39 %
                      Medicare                   28 %       17 %
                      Medicaid                    1 %        1 %
                      Self-Pay                   16 %       13 %
                      Other                       4 %        4 %

Contractual Allowance

The Company computes its contractual allowance based on the estimated collections on its gross billed charges. The Company computes its estimate by taking into account collections received, up to 30 days after the end of the period, for the services performed and also estimating amounts collectible for the services performed within the last six months. The following table shows gross revenues and contractual allowances for our Pasadena facility for fiscal years 2012 and 2011:

                                                  2012              2011
        Gross billed charges                  $ 19,619,903      $ 22,138,821
        Contractual allowance(1)                14,088,670        24,116,028

        Net revenue                           $  5,531,233      $ (1,977,207 )

        Contractual allowance percentage(1)             72 %             109 %

(1) The contractual allowance percentage, excluding the stop-loss fee dispute amount booked in the quarter ended May 31, 2011, which is discussed below, would have been 63% for the year ended August 31, 2011.

A significant amount of our net revenue results from Texas workers' compensation claims, which are governed by the rules and regulations of the Texas Department of Workers' Compensation ("TDWC") and the workers' compensation healthcare networks. If our hospital chooses to participate in a network, the amount of revenue that will be generated from workers' compensation claims will be governed by the network contract.

For claims arising prior to the implementation of workers' compensation networks and out of network claims, inpatient and outpatient surgical services are either reimbursed pursuant to the Acute Care In-Patient Hospital Fee Guideline or at a "fair and reasonable" rate for services in which the fee guideline is not applicable. Starting March 1, 2008, the Texas Workers' Compensation 2008 Acute Care Hospital Outpatient and Inpatient Facility Fee Guidelines (the "Guidelines") became effective. Under these Guidelines, the reimbursement amounts are determined by applying the most recently adopted and effective Medicare reimbursement formula and factors; however, if the maximum allowable reimbursement for the procedure performed cannot be calculated using these Guidelines, then reimbursement is determined on a fair and reasonable basis.

Based on these Guidelines, the reimbursement due the Company for workers' compensation cases is lower than we previously experienced. The Company has continued accepting Texas workers' compensation cases, and has not made any substantial changes in its focus towards such cases. Our net patient service revenue for Texas workers' compensation cases as a percentage of gross billings has decreased primarily as a result of lower reimbursement rates for workers' compensation procedures still being performed.


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Should we disagree with the amount of reimbursement provided by a third-party payer, we are required to pursue the MDR process at the TDWC to request proper reimbursement for services. From January 2007 to November 2008, the Company had been successful in its pursuit of collections regarding the stop-loss cases pending before the State Office of Administrative Hearings ("SOAH"), receiving positive rulings in over 90% of its claims presented for administrative determination. The 2007 district court decision upholding our interpretation of the statute as applied to the stop-loss claims was appealed by certain insurance carriers, and on November 13, 2008 the Third Court of Appeals determined that in order for a hospital to be reimbursed at 75% of its usual and customary audited charges for an inpatient admission, the hospital must not only bill at least $40,000, but also show that the admission involved unusually costly and unusually extensive services. Procedurally, the decision means that each case where a carrier raised an issue regarding whether the services provided were unusually costly or unusually extensive would be remanded to either SOAH or MDR for a case-by-case determination of whether the services provided meet these standards, once the definitions of those standards are determined. As a result of the Third Court of Appeals opinion, any stop-loss cases pending at SOAH have been remanded to the TDWC since these cases have not been reviewed or decided by the two-prong standard decided by the Third Court of Appeals. The SOAH Administrative Law judges determined that the most appropriate location for these cases is the TDWC, pending a final, non-appealable decision.

A petition asking the Texas Supreme Court to review the Third Court of Appeals decision has been denied. Therefore, the Company is bound by the Third Court of Appeals decision. The Texas Supreme Court's decision has further delayed final adjudication in these pending stop-loss cases. The uncertain outcome in these cases will depend on a very lengthy process. We anticipate further, lengthy litigation at the Travis County District Courts and the Texas Courts of Appeals. Because of this lengthy process and the uncertainty of recovery in these cases, collection of a material amount of funds in these pending stop-loss cases is not anticipated during the 2013 fiscal year.

Through August 2012, insurance carriers have voluntarily paid the awards in the decisions and orders issued by SOAH, plus interest, in approximately 180 cases, involving approximately $11 million in claims. In most of these cases, the carriers have requested refunds of the payments made in the event that the SOAH decisions and orders are reversed on appeal. Our request that the TDWC Commissioner enforce the awards which were not voluntarily paid by the carriers was refused in approximately 130 cases. Motions filed seeking a refund in some cases in which the awards were voluntarily paid have been granted and the Company has been ordered to refund approximately $3.7 million, including prejudgment interest, pending remand for a case-by-case determination of whether the services provided were unusually costly and unusually extensive. In fiscal year 2011, the Company deposited these amounts as cash deposits into the registry of the court in order to stay execution of the judgments ordering refunds. Additionally, the Company has deposited $204,000 in September 2012 for another year's interest in order to continue to stay execution of the judgments ordering refunds. We anticipate that similar motions requesting remand and a refund for awards voluntarily paid will be filed and will likely be granted by the 345th Judicial District Court of Travis County, Texas. If and when these additional motions are granted, the Company will be ordered to refund an additional $7.7 million, not including prejudgment interest. The Company has appealed the judgments requiring a refund to the carriers. The briefs of the parties have been filed with the court of appeals and the Company is now waiting for the court of appeals to act on the appeals. While the appeals are pending, the adjudication of those cases remanded for determinations of whether the services provided were unusually costly and unusually extensive will continue. Voluntary payments made pursuant to the Decisions and Orders are premature payments by the carriers and may be ordered to be refunded. Once the Company is given the opportunity to present its evidence regarding whether the services provided were unusually costly and unusually extensive, the Company anticipates that it will prevail in the underlying stop-loss fee disputes and that payments refunded to the carriers will be recaptured.

Due to the uncertainties associated with these stop-loss fee dispute cases, in fiscal year 2011, the Company recognized an increase of $10,254,990 in the contractual allowance at our Pasadena facility (and an additional $779,583 in the contractual allowance at our Garland facility, which is classified as discontinued operations), and $1,751,478 in interest expense at our Pasadena facility (and an additional interest expense of $132,339 at our Garland facility). The increase in the contractual allowance resulted in the $1,977,207 negative revenue for the Pasadena facility for the year ended August 31, 2011.


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Claims regarding payment for ambulatory surgical center and hospital outpatient services remain pending at the TDWC. It is expected that these claims will be adjudicated at SOAH and possibly in the Texas district and appellate courts. The basis for reimbursement for these services made the subject of these pending cases is the determination of "fair and reasonable" charges. In 2007, we received unfavorable rulings from SOAH in all of our appeals of unfavorable decisions related to services provided in 2001 and 2002. The 179 cases, which have been appealed to the Travis County district courts, challenge the constitutionality of the relevant statutory language. The Company received an unfavorable ruling in its lead case in March 2009, which ruling was appealed to and was upheld by the Third Court of Appeals on August 26, 2010. The Texas Supreme Court denied a petition asking for review of the Third Court of Appeals decision. The unfavorable interpretation by the Texas Courts of Appeal in our lead case negatively affects the recovery of additional reimbursement, not only in the lead case, but in the remaining 178 pending cases. Consequently, the Company is bound by the Third Court of Appeals' ruling that interprets the applicable statute and fee guideline to require that the amount that will be paid to a provider must not only be at a "fair and reasonable rate" but also must "ensure the quality of medical care" and "achieve effective cost control" and be the same or less than that charged to others with an equivalent standard of living. This ruling will impact cases in which a fee guideline was not applicable, specifically all pending cases involving ambulatory surgical services provided from 2001 through 2004 as well as all pending cases involving hospital outpatient services provided prior to March 1, 2008, when the Guidelines took effect. Since the Third Court of Appeals' unfavorable ruling, collection, if any, in these cases depends on the Company's ability to establish the criteria in this ruling. The Company was given the opportunity to establish the criteria in approximately 80 cases, which were set for hearing on the merits from March through May 2012 and was unsuccessful. Additionally, the Company will have the opportunity to continue to establish the criteria in several thousand cases currently pending at SOAH during the 2013 fiscal year.

Due to the uncertainties regarding the accounts receivable in the MDR process, the 2008 and 2010 Third Court of Appeals' opinions and our legal counsel's advice that settlements with insurance carriers have virtually stopped, the Company had fully reserved all accounts receivable related to the MDR process as of August 31, 2008. Any monies collected for these MDR accounts receivable will be recorded as current period's net patient service revenues.

Accounts Receivable

Accounts receivable represent net receivables for services provided by the Company. At each balance sheet date management reviews the accounts receivable for collectibility.

The contractual allowance stated as a percentage of gross receivables at the balance sheet dates is larger than the contractual allowance percentage used to reduce gross billed charges due to the application of partial cash collections to the outstanding gross receivable balances, without any adjustment being made to the contractual allowance. The contractual allowance amounts netted against gross receivables are not adjusted until such time as the final collections on an individual receivable are recognized.

Sources of Revenue and Reimbursement

The focal point of our business is providing patient care services, including complex orthopedic and bariatric procedures. The Company pursues optimal reimbursement from third-party payers for these services. We do not normally participate in managed care or other contractual reimbursement agreements, principally because they limit reimbursement for the medical services provided. This business model often results in increased amounts of reimbursement for the same or similar procedure, as compared to other healthcare providers. However, there are no contractual or administrative requirements for "prompt payment" of claims by third-party payers within a specified time frame. As a result, the Company has tended to receive higher amounts of per-procedure reimbursement than that which may be received by other healthcare providers performing similar services. Conversely, despite the increased reimbursement, we may take . . .

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