UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x     Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2009

or

o     Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 1-12040

SUN HEALTHCARE GROUP, INC.

(Exact name of Registrant as specified in its charter)

Delaware	85-0410612
(State of Incorporation)	(I.R.S. Employer Identification No.)

18831 Von Karman, Suite 400

Irvine, CA  92612

(949) 255-7100

(Address, zip code and telephone number of Registrant)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  Noo

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

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

Large accelerated filer  o	Accelerated filer  x
Non-accelerated filer  o (Do not check if a smaller reporting company)	Smaller reporting company  o

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

As of August 4, 2009, there were 43,724,879 shares of the Registrant’s $.01 par value Common Stock outstanding.

1

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Index

		Page Numbers
PART I.  FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Consolidated Balance Sheets (unaudited)	3-4
	As of June 30, 2009
	As of December 31, 2008
	Consolidated Income Statements (unaudited)	5-6
	For the three months ended June 30, 2009 and 2008
	For the six months ended June 30, 2009 and 2008
	Consolidated Statements of Cash Flows (unaudited)	7
	For the three months ended June 30, 2009 and 2008
	For the six months ended June 30, 2009 and 2008
	Notes to Consolidated Financial Statements (unaudited)	8-32
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	33-51
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	51
Item 4.	Controls and Procedures	51
PART II.  OTHER INFORMATION
Item 1.	Legal Proceedings	52
Item 4.	Submission of Matters to a Vote of Security Holders	52
Item 6.	Exhibits	53
Signature		53

References throughout this document to the Company, “we,” “our,” “ours” and “us” refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Information provided in this Quarterly Report on Form 10-Q (this “10-Q”) contains “forward-looking” information as that term is defined by the Private Securities Litigation Reform Act of 1995 (the “Act”).  All statements regarding our expected future financial position, results of operations, cash flows, liquidity, financing plans, business strategy, budgets, the impact of reductions in reimbursement and other changes in government reimbursement programs, projected costs and capital expenditures, growth opportunities, ability to refinance our indebtedness on favorable terms, plans and objectives of management for future operations and words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” "intend,” ”should,” “may” and other similar expressions are forward-looking statements.  The forward-looking statements are qualified in their entirety by these cautionary statements, which are being made pursuant to the provisions of the Act and with the intention of obtaining the benefits of the “safe harbor” provisions of the Act.  We caution investors that any forward-looking statements made by us are not guarantees of future performance and that actual results may differ materially from those in the forward-looking statements as a result of various factors, including, but not limited to, those referred to below and included herein.  We do not intend, and undertake no obligation, to update our forward-looking statements to reflect future events or circumstances.

Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from those projected or contemplated in the forward-looking statements as a result of, but not limited to, the factors set forth below. You should also carefully consider the risks described in our 2008 Annual Report on Form 10-K (see Item 1A – “Risk Factors”).  There may be additional risks of which we are presently unaware or that we currently deem immaterial.

_______________________

2

PART I.     FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited)

ASSETS

(in thousands)

		June 30, 2009		December 31, 2008
				(Note 1)
Current assets:
Cash and cash equivalents	$	95,672	$	92,153
Restricted cash		25,150		34,676
Accounts receivable, net of allowance for doubtful accounts
of $48,386 and $44,830 at June 30, 2009 and
December 31, 2008, respectively		216,795		205,620
Prepaid expenses and other assets		23,141		21,456
Assets held for sale		959		3,654
Deferred tax assets		58,534		57,261
Total current assets		420,251		414,820
Property and equipment, net		611,403		603,645
Intangible assets, net		50,723		54,388
Goodwill		327,020		326,808
Restricted cash, non-current		3,308		3,303
Deferred tax assets		121,015		134,807
Other assets		5,068		5,563
Total assets	$	1,538,788	$	1,543,334

See accompanying notes.

3

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited) (CONTINUED)

LIABILITIES AND STOCKHOLDERS’ EQUITY

(in thousands, except share data)

		June 30, 2009			December 31, 2008
					(Note 1)
Current liabilities:
Accounts payable	$	56,821		$	62,000
Accrued compensation and benefits		61,031			60,660
Accrued self-insurance obligations, current		48,619			45,293
Other accrued liabilities		55,831			56,857
Current portion of long-term debt and capital lease obligations		8,260			17,865
Total current liabilities		230,562			242,675
Accrued self-insurance obligations, net of current portion		112,482			114,557
Long-term debt and capital lease obligations, net of current portion		696,022			707,976
Unfavorable lease obligations, net		14,092			15,514
Other long-term liabilities		59,045			58,903
Total liabilities		1,112,203			1,139,625
Commitments and contingencies (Note 5)
Stockholders’ equity:
Preferred stock of $.01 par value, authorized 10,000,000
shares, no shares were issued or outstanding as of
June 30, 2009 and December 31, 2008		-			-
Common stock of $.01 par value, authorized 125,000,000
shares; 43,720,116 and 43,544,765 shares issued and
outstanding as of June 30, 2009 and December 31, 2008,
respectively		437			435
Additional paid-in capital		652,773			650,543
Accumulated deficit		(222,344	)		(242,683	)
Accumulated other comprehensive loss, net		(4,281	)		(4,586	)
Total stockholders’ equity		426,585			403,709
Total liabilities and stockholders’ equity	$	1,538,788		$	1,543,334

See accompanying notes.

4

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED INCOME STATEMENTS (unaudited)

(in thousands, except per share data)

		For the
		Three Months Ended
		June 30, 2009			June 30, 2008
Total net revenues	$	468,884		$	450,933
Costs and expenses:
Operating salaries and benefits		262,039			252,088
Self-insurance for workers’ compensation and general and
professional liability insurance		16,815			11,697
Operating administrative expenses		13,192			12,944
Other operating costs		94,563			92,179
Center rent expense		18,268			18,534
General and administrative expenses		15,721			16,111
Depreciation and amortization		11,153			9,782
Provision for losses on accounts receivable		6,294			2,877
Interest, net of interest income of $96 and $569, respectively		12,465			13,643
Loss on sale of assets		40			-
Total costs and expenses		450,550			429,855
Income before income taxes and discontinued operations		18,334			21,078
Income tax expense		7,517			8,445
Income from continuing operations		10,817			12,633
Discontinued operations:
Loss from discontinued operations, net of related taxes		(714	)		(1,141	)
Loss on disposal of discontinued operations, net of
related taxes		(7	)		(1,807	)
Loss from discontinued operations, net		(721	)		(2,948	)
Net income	$	10,096		$	9,685
Basic earnings per common and common equivalent share:
Income from continuing operations	$	0.25		$	0.29
Loss from discontinued operations, net		(0.02	)		(0.07	)
Net income	$	0.23		$	0.22
Diluted earnings per common and common equivalent share:
Income from continuing operations	$	0.25		$	0.29
Loss from discontinued operations, net		(0.02	)		(0.07	)
Net income	$	0.23		$	0.22
Weighted average number of common and common
equivalent shares outstanding:
Basic		43,851			43,188
Diluted		43,960			43,928

See accompanying notes.

5

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED INCOME STATEMENTS (unaudited)

(in thousands, except per share data)

		For the
		Six Months Ended
		June 30, 2009			June 30, 2008
Total net revenues	$	937,180		$	901,302
Costs and expenses:
Operating salaries and benefits		525,023			507,019
Self-insurance for workers’ compensation and general and
professional liability insurance		31,474			26,471
Operating administrative expenses		25,769			24,880
Other operating costs		190,382			185,121
Center rent expense		36,683			36,975
General and administrative expenses		32,471			32,697
Depreciation and amortization		21,876			19,389
Provision for losses on accounts receivable		10,281			6,184
Interest, net of interest income of $203 and $1,114, respectively		25,191			28,074
Loss (gain) on sale of assets		41			(76	)
Total costs and expenses		899,191			866,734
Income before income taxes and discontinued operations		37,989			34,568
Income tax expense		15,575			13,833
Income from continuing operations		22,414			20,735
Discontinued operations:
Loss from discontinued operations, net of related taxes		(1,760	)		(604	)
Loss on disposal of discontinued operations, net of
related taxes		(315	)		(1,869	)
Loss from discontinued operations, net		(2,075	)		(2,473	)
Net income	$	20,339		$	18,262
Basic earnings per common and common equivalent share:
Income from continuing operations	$	0.51		$	0.48
Loss from discontinued operations, net		(0.05	)		(0.06	)
Net income	$	0.46		$	0.42
Diluted earnings per common and common equivalent share:
Income from continuing operations	$	0.51		$	0.47
Loss from discontinued operations, net		(0.05	)		(0.06	)
Net income	$	0.46		$	0.41
Weighted average number of common and common
equivalent shares outstanding:
Basic		43,748			43,122
Diluted		43,891			44,034

See accompanying notes.

6

 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

(in thousands)

		For the						For the
		Three Months Ended						Six Months Ended
		June 30, 2009			June 30, 2008			June 30, 2009			June 30, 2008
		(Unaudited)						(Unaudited)
Cash flows from operating activities:
Net income	$	10,096		$	9,685		$	20,339		$	18,262
Adjustments to reconcile net income to net cash provided by
operating activities, including discontinued operations:
Depreciation and amortization		11,153			9,883			21,876			19,600
Amortization of favorable and unfavorable lease intangibles		(474	)		(488	)		(876	)		(991	)
Provision for losses on accounts receivable		6,294			3,210			10,281			6,511
Loss on sale of assets, including discontinued
operations, net		53			1,732			575			1,716
Impairment charge for discontinued operation		-			1,800			-			1,800
Stock-based compensation expense		1,641			1,368			2,909			2,333
Deferred taxes		6,345			6,442			12,519			8,271
Other		-			79			-			79
Changes in operating assets and liabilities, net of acquisitions:
Accounts receivable		(11,599	)		(3,512	)		(21,667	)		(19,552	)
Restricted cash		1,415			3,058			9,521			3,063
Prepaid expenses and other assets		(392	)		(1,905	)		(238	)		(5,321	)
Accounts payable		(1,527	)		(1,727	)		(5,063	)		(3,130	)
Accrued compensation and benefits		(3,907	)		(4,713	)		366			(3,651	)
Accrued self-insurance obligations		344			(2,268	)		1,251			(235	)
Income taxes payable		-			1,121			-			1,591
Other accrued liabilities		(5,571	)		(10,049	)		(825	)		(3,617	)
Other long-term liabilities		885			4,266			1,181			6,052
Net cash provided by operating activities		14,756			17,982			52,149			32,781
Cash flows from investing activities:
Capital expenditures		(13,137	)		(10,223	)		(25,002	)		(16,139	)
Purchase of leased real estate		(3,275	)		(727	)		(3,275	)		(727	)
Proceeds from sale of assets held for sale		-			180			2,174			3,957
Acquisitions, net of cash acquired		-			(6	)		-			(313	)
Insurance proceeds received		-			75			-			75
Net cash used for investing activities		(16,412	)		(10,701	)		(26,103	)		(13,147	)
Cash flows from financing activities:
Borrowings of long-term debt		-			20,290			-			20,290
Principal repayments of long-term debt and capital lease
obligations		(2,075	)		(22,115	)		(21,687	)		(25,199	)
Payment to non-controlling interest		-			-			-			(2,035	)
Distribution to non-controlling interest		(549	)		-			(860	)		(223	)
Proceeds from issuance of common stock		7			31			20			70
Net cash used for financing activities		(2,617	)		(1,794	)		(22,527	)		(7,097	)
Net (decrease) increase in cash and cash equivalents		(4,273	)		5,487			3,519			12,537
Cash and cash equivalents at beginning of period		99,945			62,882			92,153			55,832
Cash and cash equivalents at end of period	$	95,672		$	68,369		$	95,672		$	68,369

See accompanying notes.

7

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

(1)  Nature of Business

References throughout this document to the Company include Sun Healthcare Group, Inc. and our consolidated subsidiaries. In accordance with the Securities and Exchange Commission’s “Plain English” guidelines, this report has been written in the first person. In this document, the words “we,” “our,” “ours,” and “us” refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

Business

Our subsidiaries provide long-term, post-acute and related specialty healthcare in the United States.  We operate through three principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, and (iii) medical staffing services.  Inpatient services represent the most significant portion of our business.  We operated 207 healthcare centers in 25 states as of June 30, 2009.

Other Information

The accompanying unaudited consolidated financial statements have been prepared in accordance with our customary accounting practices and accounting principles generally accepted in the United States for interim financial statements.  In our opinion, the accompanying interim consolidated financial statements are a fair statement of our financial position at June 30, 2009, and our consolidated results of operations and cash flows for the three-month and six-month periods ended June 30, 2009 and 2008, respectively.  These statements are unaudited, and certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted, as permitted under the applicable rules and regulations of the Securities and Exchange Commission.  The accompanying unaudited consolidated financial statements reflect all adjustments, consisting of only normal recurring items.  Readers of these statements should refer to our audited consolidated financial statements and notes thereto for the year ended December 31, 2008, which are included in our Annual Report on Form 10-K for the year ended December 31, 2008 (the “2008 Form 10-K”).

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, the disclosure of significant contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include determination of third-party payor settlements, allowances for doubtful accounts, self-insurance obligations, loss accruals, and income taxes. Actual results could differ from those estimates.

Recent Accounting Pronouncements

In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial Statements (“SFAS No. 160”).  SFAS No. 160 requires that a noncontrolling interest in a subsidiary be reported as equity in the consolidated financial statements; that net income attributable to the parent and the noncontrolling interest be clearly identifiable; that changes in a parent’s ownership interest, while the parent retains its controlling financial interest in its subsidiary, be accounted for as equity transactions and that disclosures be expanded to clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners.  SFAS No. 160 was effective beginning January 1, 2009, and did not have a material impact on our financial position, cash flows or results of operations.

In February 2008, the FASB issued Staff Position FAS 157-2, Effective Date of FASB Statement No. 157 (“FSP FAS 157-2”), which delayed the effective date of the FASB Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”), for certain nonfinancial assets and nonfinancial liabilities until interim periods for fiscal years beginning after November 15, 2008.  SFAS No. 157 changed the underlying methodology of determining fair value when fair value measurements are required in accounting principles generally accepted in the United States.  SFAS No. 157 also expanded the disclosure requirements about fair value measurements.  The adoption of FSP FAS 157-2 did not have a material impact on our financial position, cash flows or results of operations.

8

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, Disclosures About Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133 (“SFAS No. 161”), which expands quarterly disclosure requirements in SFAS No. 133, Accounting for Derivative Instruments and Hedging Activity (“SFAS No. 133”), about an entity’s derivative instruments and hedging activities. SFAS No. 161 was effective for fiscal years beginning January 1, 2009, and we have included the required disclosures in Note 2 – “Long-Term Debt and Capital Lease Obligations” below.

In April 2008, the FASB issued Staff Position FAS No. 142-3, Determination of the Useful Life of Intangible Assets (“FSP FAS 142-3”). This pronouncement amends Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”), regarding the factors that should be considered in developing the useful lives for intangible assets with renewal or extension provisions. FSP FAS 142-3 requires an entity to consider its own historical experience in renewing or extending similar arrangements, regardless of whether those arrangements have explicit renewal or extension provisions, when determining the useful life of an intangible asset. In the absence of such experience, an entity shall consider the assumptions that market participants would use concerning renewal or extension, adjusted for entity-specific factors. FSP FAS 142-3 also requires an entity to disclose information regarding the extent to which the expected future cash flows associated with an intangible asset are affected by the entity’s intent and/or ability to renew or extend the arrangement. FSP FAS 142-3 is effective for qualifying intangible assets acquired on or after January 1, 2009. The application of FSP FAS 142-3 did not have a material impact on our financial position, cash flows or results of operations; however, it could impact future transactions.  

In April 2009, the FASB issued Staff Position No. FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, which amends FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments (“SFAS No. 107”), and Accounting Principles Board Opinion No. 28, Interim Financial Reporting (“APB No. 28”).  This pronouncement was effective for our reporting periods beginning with our June 30, 2009 interim financial statements.  The amendments expand the disclosure requirements of SFAS No. 107 and APB No. 28 about how an entity reports on fair value to be included in the summarized, interim financial statements.  The adoption of SFAS No. 107 and APB No. 28 did not have a material impact on our financial position, cash flows or results of operations.  All required disclosures have been included in our June 30, 2009 interim financial statements.

In April 2009, the FASB issued Staff Position No. FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (“FSP FAS Nos. 115-2 and 124-2”), which provides guidance for measuring and expands the presentation and disclosure requirements of other-than-temporary impairments on debt and equity securities in interim and annual financial statements.  As we currently do not own any debt or equity securities, this Staff Position is not expected to impact our financial position, cash flows or results of operations.  Should we own any such securities in the future, the provisions of this Staff Position will be applied.

In April 2009, the FASB issued Staff Position No. 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (“FSP FAS No. 157-4”), which expands quarterly disclosure requirements in SFAS No. 157 about how an entity determines fair value when the volume and level of activity for an asset or liability have significantly decreased and transactions related to such assets and liabilities are not orderly.  This pronouncement was effective beginning with our June 30, 2009 interim financial statements.  The adoption of FSP FAS 157-4 did not have a material impact on our financial position, cash flows or results of operations.

In May 2009, the FASB issued Statement of Financial Accounting Standards No. 165, Subsequent Events (“SFAS No. 165”), which provides guidance on accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued.  SFAS No. 165 requires companies to evaluate events or transactions taking place after the balance sheet date for recognition in the financial statements prior to issuance.  Additionally, SFAS No. 165 requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date; that is, whether that date represents the date the financial statements were issued or were available to be issued.  SFAS No. 165 became effective for our interim and annual reporting periods on April 1, 2009.  The adoption of SFAS No. 165 did not impact our financial position, cash flows or results of operations.  For the purposes of this reporting

9

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

period, we have evaluated the subsequent events occurring after June 30, 2009 through August 6, 2009, which we consider to be the date that the financial statements were “issued” and “available to be issued”.

In June 2009, the FASB issued Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140 (“SFAS No. 166”), which provides guidance on accounting for and disclosure of  the transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.  Additionally, SFAS No. 166 eliminates the concept of the “qualified special purpose entity” (as established in Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities-a replacement of FASB Statement No. 125) and replaces it with the the concept of a “participating interest”, which is defined as an entity having a proportionate ownership interest in the asset(s) being transferred.  SFAS No. 166 is effective for annual reporting periods beginning after November 15, 2009.  We do not expect SFAS No. 166 to have any impact on our financial position, cash flows or results of operations.

In June 2009, the FASB issued Statement of Financial Accounting Standards No. 167, Amendments for FASB Interpretation No. 46(R) (“SFAS No. 167”), which provides guidance on determining whether the enterprise’s variable interest or interests give it a controlling financial interest in a variable interest entity (“VIE”) based on the power to direct the activities of the VIE and the obligation to absorb losses of the VIE.  SFAS No. 167 requires an entity to assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining whether it has the power to direct the activities of the VIE that most significantly impact the entity’s economic performance.  Additionally, SFAS No. 167 requires an entity to assess, on an ongoing basis, whether or not it continues to be the primary beneficiary of a VIE.  SFAS No. 167 is effective for annual reporting periods beginning after November 15, 2009.  We do not expect SFAS No. 167 to have any impact on our financial position, cash flows or results of operations.

In June 2009, the FASB issued Statement of Financial Accounting Standards No. 168, The FASB Accounting Standards CodificationTM (“Codification”) and the Hierarchy of Generally Accepted Accounting Principles, a replacement of FASB Statement No. 162 (“SFAS No. 168”), which established the Codification as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP.  SFAS No. 168 is effective for interim and annual periods ending after September 15, 2009.  The impact of SFAS No. 168 will only impact references for accounting guidance.

Reclassifications and Adjustments

Certain reclassifications have been made to the prior period financial statements to conform to the 2009 financial statement presentation.  Primarily, we have reclassified the results of operations of four divested centers (see Note 4 – “Discontinued Operations and Assets Held for Sale”) for all periods presented to discontinued operations within the income statement, in accordance with accounting principles generally accepted in the United States.  As discussed in “Recent Accounting Pronouncements” above, the adoption of SFAS No. 160 did not have a material impact on our financial position, cash flows or results of operations, although we did reclassify $1.5 million previously reported as minority interest payable on our December 31, 2008 consolidated balance sheet in our 2008 Form 10-K to other long-term liabilities to conform to the 2009 financial statement presentation.

10

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(2)  Long-Term Debt and Capital Lease Obligations

Long-term debt and capital lease obligations consisted of the following as of the periods indicated (in thousands):

		June 30, 2009			December 31, 2008
Revolving credit facility	$	-		$	-
Mortgage notes payable due at various dates through 2037, interest at
rates from 3.7% to 11.1%, collateralized by the carrying values of
various centers totaling approximately $200,000 (1)		172,430			178,142
Term loan agreement		330,786			346,359
Senior subordinated notes		200,000			200,000
Capital leases		1,066			1,340
Total long-term obligations		704,282			725,841
Less amounts due within one year		(8,260	)		(17,865	)
Long-term obligations, net of current portion	$	696,022		$	707,976

(1) The mortgage notes payable balance includes fair value premiums of $0.7 million related to acquisitions.

The scheduled or expected maturities of long-term obligations, excluding premiums, as of June 30, 2009, were as follows (in thousands):

For the twelve months ending June 30:
2010	$	8,260
2011		62,227
2012		6,664
2013		6,789
2014		351,568
Thereafter		268,087
	$	703,595

We manage interest expense using a mix of fixed and variable rate debt, and to help manage borrowing costs, we may enter into interest rate swap agreements. Under these arrangements, we agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed-upon notional principal amount. We use interest rate swaps to manage interest rate risk related to borrowings.  Our intent is to only enter such arrangements that qualify for hedge accounting treatment in accordance with SFAS No. 133.  Accordingly, we designate all such arrangements as cash-flow hedges and perform initial and quarterly effectiveness testing using the hypothetical derivative method.  To the extent that such arrangements are effective hedges, changes in fair value are recognized through other comprehensive loss.  Ineffectiveness, if any, would be recognized in earnings.

We entered into interest rate swap agreements in July 2008 and July 2007 for interest rate risk management purposes.  The interest rate swap agreements effectively modify our exposure to interest rate risk by converting a portion of our floating rate debt to a fixed rate.  These agreements involve the receipt of floating rate amounts in exchange for fixed rate interest payments over the life of the agreement without an exchange of the underlying principal amount.  The July 2008 agreement is based on a notional amount of $50.0 million and has a term of two years.  Settlement occurs on a quarterly basis, which is based upon a floating rate of LIBOR and an annual fixed rate of 3.65%.  The July 2007 agreement is based on a notional amount of $100.0 million and has a term of three years.  Settlement occurs on a quarterly basis, which is based upon a floating rate of LIBOR and an annual fixed rate of 5.388%.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

The interest rate swap agreements qualify for hedge accounting treatment under SFAS No. 133 and have been designated as cash flow hedges.  Hedge effectiveness testing for the three and six months ended June 30, 2009 and 2008 indicates that the swaps are highly effective hedges and as such, there is no amount related to hedging ineffectiveness to expense.  We do not anticipate our 2009 other comprehensive loss to be reclassified into earnings within the next year.

The fair values of our interest rate swap agreements as presented in the consolidated balance sheets are as follows (in thousands):

	Liability Derivatives
	June 30, 2009			December 31, 2008
	Balance Sheet			Balance Sheet
	Location		Fair Value	Location		Fair Value
Derivatives designated as
hedging instruments:
Interest rate swap	Other Long Term			Other Long Term
agreements	Liabilities	$	7,135	Liabilities	$	7,644

The effect of the interest rate swap agreements on our consolidated comprehensive income, net of related taxes, for the three months ended June 30, is as follows (in thousands):

						Gain/(Loss) Reclassified from
		Amount of Gain/(Loss) Recognized in				Accumulated Other Comprehensive
		Other Comprehensive Income/(Loss)				Loss to Income (effective portion)
		2009		2008		2009		2008
Derivatives designated as cash
flow hedges:
Interest rate swap agreements	$	374	$	1,580	$	-	$	-

The effect of the interest rate swap agreements on our consolidated comprehensive income, net of related taxes, for the six months ended June 30, is as follows (in thousands):

						Gain/(Loss) Reclassified from
		Amount of Gain/(Loss) Recognized in				Accumulated Other Comprehensive
		Other Comprehensive Income/(Loss)				Loss to Income (effective portion)
		2009		2008		2009		2008
Derivatives designated as cash
flow hedges:
Interest rate swap agreements	$	305	$	(141)	$	-	$	-

12

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(3)  Fair Value of Financial Instruments

The estimated fair values of our financial instruments were as follows (in thousands):

		June 30, 2009				December 31, 2008
		Carrying				Carrying
		Amount		Fair Value		Amount		Fair Value
Cash and cash equivalents	$	95,672	$	95,672	$	92,153	$	92,153
Restricted cash	$	28,458	$	28,458	$	37,979	$	37,979
Long-term debt and capital lease obligations,
including current portion	$	704,282	$	667,715	$	725,841	$	645,434
Interest rate swap agreements	$	7,135	$	7,135	$	7,644	$	7,644

The cash and cash equivalents and restricted cash carrying amounts approximate fair value because of the short maturity of these instruments. At June 30, 2009 and December 31, 2008, the fair value of our long-term debt, including current maturities, and our interest rate swap agreements was based on estimates using present value techniques that are significantly affected by the assumptions used concerning the amount and timing of estimated future cash flows and discount rates that reflect varying degrees of risk.

SFAS No. 157 establishes a common definition for fair value to be applied to U.S. generally accepted accounting principles requiring use of fair value, establishes a framework for measuring fair value, and expands disclosures about such fair value measurements.  Issued in February 2008, FASB Staff Position No. 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13, removed leasing transactions accounted for under Statement No. 13 and related guidance from the scope of SFAS No. 157.  FASB Staff Position No. 157-2, Partial Deferral of the Effective Date of Statement 157, deferred the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008.

SFAS No. 157 establishes a hierarchy for ranking the quality and reliability of the information used to determine fair values.  The statement requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:

Level 1:	Unadjusted quoted market prices in active markets for identical assets or liabilities.
Level 2:	Unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.
Level 3:	Unobservable inputs for the asset or liability.

13

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

We endeavor to utilize the best available information in measuring fair value.  The following tables summarize the valuation of our financial instruments by the above SFAS No. 157 pricing levels as of June 30, 2009 and December 31, 2008, respectively (in thousands):

		June 30, 2009
		Total		Unadjusted Quoted Market Prices (Level 1)		Significant Other Observable Inputs (Level 2)
Cash equivalents – money market
funds/certificate of deposit	$	51,905	$	20,496	$	31,409
Restricted cash – money market funds	$	1,695	$	1,695	$	-
Interest rate swap agreements – liability	$	7,135	$	-	$	7,135

		December 31, 2008
		Total		Unadjusted Quoted Market Prices (Level 1)		Significant Other Observable Inputs (Level 2)
Cash equivalents – money market
funds/certificate of deposit	$	10,098	$	5,053	$	5,045
Restricted cash – money market funds	$	1,272	$	1,272	$	-
Interest rate swap agreements – liability	$	7,644	$	-	$	7,644

We currently have no other financial instruments subject to fair value measurement on a recurring basis.

(4) Discontinued Operations and Assets Held for Sale

(a) Discontinued Operations

In accordance with the provisions of Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”), the results of operations of assets to be disposed of, disposed assets and the gains (losses) related to these divestitures have been classified as discontinued operations for all periods presented in the accompanying consolidated income statements as their operations and cash flows have been (or will be) eliminated from our ongoing operations and we will not have any significant continuing involvement in their operations after their disposal.

As a result of June 2008 flooding in the Midwest, our center in Terre Haute, Indiana was severely damaged and the operation permanently discontinued, at which time we recorded a $1.8 million fixed assets impairment charge for the three months ended June 30, 2008 due to the damage to the building and contents.  This center was sold during March 2009 for cash proceeds of $2.2 million.  We recorded a $0.5 million loss on disposal during the three months ended March 31, 2009.

During 2008, we reclassified six skilled nursing centers into discontinued operations because they were divested, sold or otherwise qualified as assets held for sale. In the second quarter of 2008, we sold two hospitals that were classified as held for sale since 2007 for $10.1 million and recorded a net loss of $2.7 million. In the third quarter of 2008, we exercised an option to purchase a skilled nursing center in Indiana that was classified as held for sale since 2007 and simultaneously sold the asset for a net $0.4 million and recorded a net loss of $0.2 million.  In the third quarter of 2008, we exercised options to purchase two skilled nursing centers in Oklahoma that were classified as held for sale.  We sold these two centers and one other Oklahoma skilled nursing center for $7.6 million and recorded a net loss of $0.9 million.  We also transferred operations of a leased skilled nursing center in Tennessee to an outside party. In the fourth quarter of 2008, we transferred operations of a leased skilled nursing center in Utah to an outside party.  We also sold a subsidiary that provided adolescent rehabilitation and special education services.

14

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

A summary of the discontinued operations for the periods presented is as follows (in thousands):

		For the Three Months Ended
		June 30, 2009
		Inpatient
		Services			Other			Total
Net operating revenues	$	10		$	-		$	10
Loss from discontinued operations, net (1)	$	(705	)	$	(9	)	$	(714	)
(Loss) gain on disposal of discontinued operations, net (2)		(20	)		13			(7	)
(Loss) income from discontinued operations, net	$	(725	)	$	4		$	(721	)

(1)  Net of related tax benefit of $496

(2)  Net of related tax benefit of $5

		For the Three Months Ended
		June 30, 2008
		Inpatient
		Services			Other		Total
Net operating revenues	$	17,518		$	5,271	$	22,789
(Loss) income from discontinued operations, net (1)	$	(1,356	)	$	215	$	(1,141	)
Loss on disposal of discontinued operations, net (2)		(1,807	)		-		(1,807	)
(Loss) income from discontinued operations, net	$	(3,163	)	$	215	$	(2,948	)

(1)  Net of related tax benefit of $784

(2)  Net of related tax benefit of $1,204

		For the Six Months Ended
		June 30, 2009
		Inpatient
		Services			Other			Total
Net operating revenues	$	53		$	-		$	53
Loss from discontinued operations, net (1)	$	(1,744	)	$	(16	)	$	(1,760	)
Loss on disposal of discontinued operations, net (2)		(299	)		(16	)		(315	)
Loss from discontinued operations, net	$	(2,043	)	$	(32	)	$	(2,075	)

(1)  Net of related tax benefit of $1,223

(2)  Net of related tax benefit of $219

15

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

		For the Six Months Ended
		June 30, 2008
		Inpatient
		Services			Other			Total
Net operating revenues	$	37,527		$	9,590		$	47,117
Loss from discontinued operations, net (1)	$	(441	)	$	(163	)	$	(604	)
Loss on disposal of discontinued operations, net (2)		(1,823	)		(46	)		(1,869	)
Loss from discontinued operations, net	$	(2,264	)	$	(209	)	$	(2,473	)

(1)  Net of related tax benefit of $389

(2)  Net of related tax benefit of $1,195

(b) Assets Held for Sale

As of June 30, 2009, assets held for sale consisted of an undeveloped parcel of land valued at $1.0 million, which is classified in our Corporate segment in our consolidated financial statements.

(5)  Commitments and Contingencies

Insurance

We self-insure for certain insurable risks, including general and professional liabilities, workers' compensation liabilities and employee health insurance liabilities through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There is a risk that amounts funded to our self-insurance programs may not be sufficient to respond to all claims asserted under those programs. Insurance reserves represent estimates of future claims payments.  This liability includes an estimate of the development of reported losses and losses incurred but not reported.  Provisions for changes in insurance reserves are made in the period of the related coverage.  An independent actuarial analysis is prepared twice a year to assist management in determining the adequacy of the self-insurance obligations booked as liabilities in our financial statements.  The methods of making such estimates and establishing the resulting reserves are reviewed periodically and are based on historical paid claims information and nationwide nursing home trends. Any adjustments resulting from such reviews are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves.

We evaluate the adequacy of our self-insurance reserves on a quarterly basis and perform detailed actuarial analyses semi-annually in the second and fourth quarters. The analyses use generally accepted actuarial methods in evaluating the workers’ compensation reserves and general and professional liability reserves.  For both the workers’ compensation reserves and the general and professional liability reserves, those methods include reported and paid loss development methods, expected loss method and the reported and paid Bornhuetter-Ferguson methods.  Reported loss methods focus on development of case reserves for incurred losses through claims closure.  Paid loss methods focus on development of claims actually paid to date.  Expected loss methods are based upon an anticipated loss per unit of measure.  The Bornhuetter-Ferguson method is a combination of loss development methods and expected methods.

The foundation for most of these methods is our actual historical reported and/or paid loss data, over which we have effective internal controls.  We utilize third-party administrators (“TPAs”) to process claims and to provide us with the data utilized in our semi-annual actuarial analyses.  The TPAs are under the oversight of our in-house risk management and legal functions.  These functions ensure that the claims are properly administered so that the historical data is reliable for estimation purposes.  Case reserves, which are approved by our legal and risk management departments, are determined based on our estimate of the ultimate settlement of individual claims.  In cases where our historical data are not statistically credible, stable, or mature, we supplement our experience with skilled nursing industry benchmark reporting and payment patterns.

16

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

The use of multiple methods tends to eliminate any biases that one particular method might have.  Management’s judgment based upon each method’s inherent limitation is applied when weighting the results of each method.  The results of each of the methods are estimates of ultimate losses which include the case reserves plus an estimate for future development of these reserves based on past trends, and an estimate for losses incurred but not reported.   These results are compared by accident year, and an estimated unpaid loss and allocated loss adjustment expense is determined for the open accident years based on judgment reflecting the range of estimates produced by the methods.

During the three and six months ended June 30, 2009, we determined that the previous estimates for general and professional liabilities reserves for accident years prior to 2009 were understated, based on currently available information, by $4.9 million or 5.5%.  Of that amount, $4.3 million related to continuing operations and $0.6 million related to discontinued operations.  There were no large or unusual settlements or significant new claims during the period. Professional liability claims have a reporting tail that exceeds one year.  A significant component of our reserves is estimates for incidents that have been incurred but not reported. The increase in prior period reserves is driven in part by an increase in our estimate of incurred but not reported claims.

Activity in our insurance reserves as of and for the three and six months ended June 30, 2009 and 2008 is as follows (in thousands):

		Professional			Workers’
		Liability			Compensation			Total
Balance as of January 1, 2008	$	86,291		$	61,439		$	147,730
Current year provision, continuing operations		8,321			6,453			14,774
Current year provision, discontinued operations		465			272			737
Claims paid, continuing operations		(4,125	)		(4,349	)		(8,474	)
Claims paid, discontinued operations		(1,249	)		(1,016	)		(2,265	)
Amounts paid for administrative services and other		(1,052	)		(2,025	)		(3,077	)
Balance as of March 31, 2008		88,651			60,774			149,425
Current year provision, continuing operations		6,576			7,771			14,347
Current year provision, discontinued operations		128			475			603
Prior year reserve adjustments, continuing operations		(5,250	)		2,600			(2,650	)
Prior year reserve adjustments, discontinued operations		(770	)		400			(370	)
Claims paid, continuing operations		(4,234	)		(5,420	)		(9,654	)
Claims paid, discontinued operations		(932	)		(669	)		(1,601	)
Amounts paid for administrative services and other		(1,044	)		(1,157	)		(2,201	)
Balance as of June 30, 2008	$	83,125		$	64,774		$	147,899

17

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

		Professional			Workers’
		Liability			Compensation			Total
Balance as of January 1, 2009	$	87,282		$	66,588		$	153,870
Current year provision, continuing operations		7,240			7,419			14,659
Current year provision, discontinued operations		306			155			461
Claims paid, continuing operations		(4,234	)		(5,217	)		(9,451	)
Claims paid, discontinued operations		(936	)		(835	)		(1,771	)
Amounts paid for administrative services and other		(1,362	)		(1,900	)		(3,262	)
Balance as of March 31, 2009		88,296			66,210			154,506
Current year provision, continuing operations		6,040			6,475			12,515
Current year provision, discontinued operations		331			155			486
Prior year reserve adjustments, continuing operations		4,300			-			4,300
Prior year reserve adjustments, discontinued operations		590			-			590
Claims paid, continuing operations		(6,858	)		(5,538	)		(12,396	)
Claims paid, discontinued operations		(1,487	)		(539	)		(2,026	)
Amounts paid for administrative services and other		(1,115	)		(1,757	)		(2,872	)
Balance as of June 30, 2009	$	90,097		$	65,006		$	155,103

A summary of the assets and liabilities related to insurance risks at June 30, 2009 and December 31, 2008 is as indicated (in thousands):

		June 30, 2009							December 31, 2008
		Professional		Workers’			|		Professional		Workers’
		Liability		Compensation		Total	|		Liability		Compensation		Total
Assets (1):							|
Restricted cash							|
Current	$	3,589	$	13,062	$	16,651	|	$	3,439	$	22,131	$	25,570
Non-current		-		-		-	|		-		-		-
Total	$	3,589	$	13,062	$	16,651	|	$	3,439	$	22,131	$	25,570
							|
Liabilities (2)(3):							|
Self-insurance							|
Liabilities							|
Current	$	22,544	$	20,077	$	42,621	|	$	20,739	$	18,574	$	39,313
Non-current		67,553		44,929		112,482	|		66,543		48,014		114,557
Total	$	90,097	$	65,006	$	155,103	|	$	87,282	$	66,588	$	153,870

(1)	Total restricted cash includes cash collateral deposits posted and other cash deposits held by third parties.  Total restricted cash above excludes $11,807 and $12,409 at June 30, 2009and December 31, 2008, respectively, held for bank collateral, various mortgages, bond payments and capital expenditures on HUD insured buildings.
(2)	Total self-insurance liabilities above excludes $5,998 and $5,980 at June 30, 2009 and December 31, 2008, respectively, related to our employee health insurance liabilities.
(3)	Total self-insurance liabilities are collateralized, in addition to the restricted cash, by letters of credit of $750 and $56,472 for general and professional liability insurance and workers’ compensation, respectively, as of June 30, 2009 and $750 and $48,172 for general and professional liability insurance and workers’ compensation, respectively, as of December 31, 2008.

18

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(6)  Income Taxes

The provision for income taxes of $7.5 million and $15.6 million for the three and six months, respectively, ended June 30, 2009 is based on a combined federal and state income tax rate of approximately 41%.  The provision for income taxes of $8.4 million and $13.8 million for the three and six months, respectively, ended June 30, 2008 was based on a combined income tax rate of approximately 40%.

During the three months ended June 30, 2009, the Internal Revenue Service commenced an examination of the tax returns for 2006 and the short-period ended April 19, 2007 of Harborside Healthcare Corporation (“Harborside”), a business we acquired in 2007.  At this time, we are unable to determine what impact, if any, this examination will have on our financial statements.

The realization of our deferred tax assets is dependent upon generation of taxable income during periods in which deductions and/or credits can be utilized.  As a result, we consider the level of historical taxable income, historical non-recurring credits and charges, the scheduled reversal of deferred tax liabilities, tax-planning strategies and projected future taxable income in determining the amount of the valuation allowance.  Based on these considerations, we significantly reduced our valuation allowance in 2007 and 2008.  The remaining valuation allowance of $34.3 million relates primarily to state net operating loss (“NOL”) carryforwards and other deferred tax assets for which realization is uncertain.

The Internal Revenue Code (“IRC”) Section 382 annual base limitation to be applied to our tax attribute carryforwards is approximately $24.9 million, which includes approximately $14.6 million due to a significant acquisition in 2007. Accordingly, our net operating loss (“NOL”), capital loss, and tax credit carryforwards have been reduced to take into account this limitation and the respective carryforward periods for these tax attributes.  As a result of unused IRC Section 382 limitations from prior years and post-ownership change NOLs, there is approximately $134.9 million of NOLs which can be used to offset U.S. taxable income in 2009.Considering annual Section 382 limitations and built-in gains, we have a total of $285.5 million of utilizable NOL carryforwards to offset taxable income in 2009 and future years.

(7)  Other Events

(a)  Litigation

We are a party to various legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of our business, including claims that our services have resulted in injury or death to the residents of our centers and claims relating to employment and commercial matters. Although we intend to vigorously defend ourselves in these matters, there can be no assurance that the outcomes of these matters will not have a material adverse effect on our results of operations, financial condition and cash flows.

We operate in industries that are extensively regulated. As such, in the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which are non-routine. In addition to being subject to direct regulatory oversight of state and federal regulatory agencies, these industries are frequently subject to the regulatory supervision of fiscal intermediaries. If a provider is found to have engaged in improper practices, it could be subject to civil, administrative or criminal fines, penalties or restitutionary relief; and reimbursement authorities could also seek the suspension or exclusion of the provider or individual from participation in their program. We believe that there has been, and will continue to be, an increase in governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations and cash flows.

        In December 2006, Harborside was notified by the United States Department of Justice (“DOJ”) that one of its subsidiaries is one of a significant number of unrelated defendants in a qui tam lawsuit filed under the Federal False Claims Act. It is our understanding that Harborside’s involvement relates to its Medicare billings for durable medical equipment. Although the complaint remains under seal pending completion of the DOJ’s investigation, it is our understanding that

19

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

neither Sun Healthcare Group, Inc. nor any of its other subsidiaries is a defendant in this litigation.  We have met with a representative of the DOJ to discuss the litigation and intend to continue to cooperate with the investigation and respond to the litigation in a timely fashion.  Based on our understanding of the allegations as described by the DOJ, we do not believe that the litigation will have a material impact on our operations, financial condition and cash flows.

The Kentucky Attorney General’s office commenced an investigation in 2008 that relates to potentially all of our 20 centers in Kentucky, which we acquired in April 2007.  The investigation appears to be focused on resident care provided at certain centers, although we have not been informed of the complete scope of the investigation.  We continue to cooperate with the Attorney General’s office, although we have not been aware of any activity for several months.  At this time we are unable to predict the outcome of the investigation.

(b)  Other Inquiries

From time to time, fiscal intermediaries and Medicaid agencies examine cost reports filed by predecessor operators of our skilled nursing centers. If, as a result of any such examination, it is concluded that overpayments to a predecessor operator were made, we, as the current operator of such centers, may be held financially responsible for such overpayments. At this time, we are unable to predict the outcome of any existing or future examinations.

(8)  Segment Information

We operate predominantly in the long-term care segment of the healthcare industry. We are a provider of long-term, sub-acute and related ancillary care services to nursing home patients.

The following summarizes the services provided by our reportable segments:

Inpatient Services:  This segment provides, among other services, inpatient skilled nursing and custodial services as well as rehabilitative, restorative and transitional medical services. We provide 24-hour nursing care in these centers by registered nurses, licensed practical nurses and certified nursing aids.  At June 30, 2009, we operated 207 healthcare centers (consisting of 184 skilled nursing centers, 15 assisted living and independent living centers and eight mental health centers) in 25 states with 23,345 licensed beds as compared with 211 healthcare centers (consisting of 188 skilled nursing centers, 15 assisted living and independent living centers, and eight mental health centers) with 23,678 licensed beds at June 30, 2008.

Rehabilitation Therapy Services:  This segment provides primarily physical, occupational and speech and respiratory therapy supplies and services to affiliated and nonaffiliated skilled nursing centers.  At June 30, 2009, this segment provided services in 32 states to 447 centers, of which 326 were nonaffiliated and 121 were affiliated, as compared to 425 centers, of which 317 were nonaffiliated and 108 were affiliated at June 30, 2008.

Medical Staffing Services: As of June 30, 2009, this segment provided services in 36 states and derived 56.5% of its revenues from hospitals and other providers,24.2% from skilled nursing centers, 15.8% from schools and3.5% from prisons. We provide (i) licensed therapists skilled in the areas of physical, occupational and speech therapy, (ii) nurses, (iii) pharmacists, pharmacist technicians and medical imaging technicians, (iv) physicians, and (v) related medical personnel. As of June 30, 2009, this segment had 28 branch offices, which provided temporary therapy, nursing, and pharmacy staffing services in major metropolitan areas and one division office, which specializes in the placement of temporary traveling therapists, and one office servicing locum tenens.

Corporate assets primarily consist of cash and cash equivalents, receivables from subsidiary segments, notes receivable, property and equipment and unallocated intangible assets. Although corporate assets include unallocated intangible assets, the amortization, if applicable, is reflected in the results of operations of the associated segment.

The accounting policies of the segments are the same as those described in Note 2 – “Summary of Significant Accounting Policies” of our 2008 Form 10-K.  We primarily evaluate segment performance based on profit or loss from operations before reorganization and restructuring items, income taxes and extraordinary items (net segment income). Gains or losses on sales of assets and certain items including impairment of assets recorded in connection with SFAS No. 144 and

20

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

SFAS No. 142, and restructuring costs are not considered in the evaluation of segment performance.  Interest expense is recorded in the segment carrying the obligation to which the interest relates.

Our reportable segments are strategic business units that provide different products and services. They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.

21

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

The following tables summarize, for the periods indicated, operating results and other financial information, by business segment (in thousands):

As of and for the
Three Months Ended
June 30, 2009
				Rehabilitation		Medical
		Inpatient		Therapy		Staffing						Intersegment
		Services		Services		Services			Corporate			Eliminations			Consolidated
Revenues from external customers	$	416,622	$	26,155	$	26,097		$	10		$	-		$	468,884
Intersegment revenues		-		18,360		563			-			(18,923	)		-
Total revenues		416,622		44,515		26,660			10			(18,923	)		468,884
Operating salaries and benefits		206,603		36,801		18,635			-			-			262,039
Self-insurance for workers’
compensation and general and
professional liability insurance		15,850		542		320			103			-			16,815
Other operating costs		107,416		1,930		4,140			-			(18,923	)		94,563
General and administrative expenses		10,691		1,777		723			15,722			-			28,913
Provision for losses on accounts
receivable		6,096		109		89			-			-			6,294
Segment operating income (loss)	$	69,966	$	3,356	$	2,753		$	(15,815	)	$	-		$	60,260
Center rent expense		17,921		114		233			-			-			18,268
Depreciation and amortization		10,118		131		232			672			-			11,153
Interest, net		3,111		-		(1	)		9,355			-			12,465
Net segment income (loss)	$	38,816	$	3,111	$	2,289		$	(25,842	)	$	-		$	18,374
Identifiable segment assets	$	1,164,361	$	14,612	$	26,651		$	861,749		$	(528,446	)	$	1,538,927
Goodwill	$	322,412	$	75	$	4,533		$	-		$	-		$	327,020
Segment capital expenditures	$	12,146	$	123	$	10		$	858		$	-		$	13,137

______________________________________

General and administrative expenses include operating administrative expenses.

The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net gain (loss) on sale of assets, income tax expense and discontinued operations.

The term “net segment income (loss)” is defined as earnings before gain (loss) on sale of assets, net, income tax expense and discontinued operations.

22

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

As of and for the
Three Months Ended
June 30, 2008
				Rehabilitation		Medical
		Inpatient		Therapy		Staffing						Intersegment
		Services		Services		Services			Corporate			Eliminations			Consolidated
Revenues from external customers	$	399,686	$	21,142	$	30,096		$	9		$	-		$	450,933
Intersegment revenues		-		14,462		794			-			(15,256	)		-
Total revenues		399,686		35,604		30,890			9			(15,256	)		450,933
Operating salaries and benefits		201,010		28,847		22,231			-			-			252,088
Self-insurance for workers’
compensation and general and
professional liability insurance		10,654		527		401			115			-			11,697
Other operating costs		101,415		1,758		4,262			-			(15,256	)		92,179
General and administrative expenses		10,382		1,515		1,047			16,111			-			29,055
Provision for losses on accounts
receivable		2,652		164		61			-			-			2,877
Segment operating income (loss)	$	73,573	$	2,793	$	2,888		$	(16,217	)	$	-		$	63,037
Center rent expense		18,195		99		240			-			-			18,534
Depreciation and amortization		8,733		132		200			717			-			9,782
Interest, net		3,263		-		(8	)		10,388			-			13,643
Net segment income (loss)	$	43,382	$	2,562	$	2,456		$	(27,322	)	$	-		$	21,078
Identifiable segment assets	$	1,114,877	$	13,462	$	37,133		$	725,825		$	(521,050	)	$	1,370,247
Goodwill	$	319,744	$	-	$	4,533		$	-		$	-		$	324,277
Segment capital expenditures	$	9,178	$	46	$	76		$	893		$	-		$	10,193

______________________________________

General and administrative expenses include operating administrative expenses.

The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net gain (loss) on sale of assets, income tax expense and discontinued operations.

The term “net segment income (loss)” is defined as earnings before gain (loss) on sale of assets, net, income tax expense and discontinued operations.

23

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

As of and for the
Six Months Ended
June 30, 2009
				Rehabilitation			Medical
		Inpatient		Therapy			Staffing						Intersegment
		Services		Services			Services			Corporate			Eliminations			Consolidated
Revenues from external customers	$	832,025	$	51,670		$	53,471		$	14		$	-		$	937,180
Intersegment revenues		-		36,576			1,123			-			(37,699	)		-
Total revenues		832,025		88,246			54,594			14			(37,699	)		937,180
Operating salaries and benefits		413,703		72,991			38,329			-			-			525,023
Self-insurance for workers’
compensation and general and
professional liability insurance		29,500		1,077			692			205			-			31,474
Other operating costs		215,764		3,720			8,596			1			(37,699	)		190,382
General and administrative expenses		20,556		3,693			1,520			32,471			-			58,240
Provision for losses on accounts
receivable		9,753		279			249			-			-			10,281
Segment operating income (loss)	$	142,749	$	6,486		$	5,208		$	(32,663	)	$	-		$	121,780
Center rent expense		35,977		229			477			-			-			36,683
Depreciation and amortization		19,846		259			422			1,349			-			21,876
Interest, net		6,322		(2	)		(1	)		18,872			-			25,191
Net segment income (loss)	$	80,604	$	6,000		$	4,310		$	(52,884	)	$	-		$	38,030
Identifiable segment assets	$	1,164,361	$	14,612		$	26,651		$	861,749		$	(528,446	)	$	1,538,927
Goodwill	$	322,412	$	75		$	4,533		$	-		$	-		$	327,020
Segment capital expenditures	$	23,573	$	259		$	50		$	1,120		$	-		$	25,002

______________________________________

General and administrative expenses include operating administrative expenses.

The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net gain (loss) on sale of assets, income tax expense and discontinued operations.

The term “net segment income (loss)” is defined as earnings before gain (loss) on sale of assets, net, income tax expense and discontinued operations.

24

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

As of and for the
Six Months Ended
June 30, 2008
				Rehabilitation			Medical
		Inpatient		Therapy			Staffing						Intersegment
		Services		Services			Services			Corporate			Eliminations			Consolidated
Revenues from external customers	$	798,666	$	42,851		$	59,764		$	21		$	-		$	901,302
Intersegment revenues		-		28,752			1,328			-			(30,080	)		-
Total revenues		798,666		71,603			61,092			21			(30,080	)		901,302
Operating salaries and benefits		403,542		58,772			44,705			-			-			507,019
Self-insurance for workers’
compensation and general and
professional liability insurance		24,444		1,054			743			230			-			26,471
Other operating costs		203,810		3,260			8,131			-			(30,080	)		185,121
General and administrative expenses		19,889		3,132			1,858			32,698			-			57,577
Provision for losses on accounts
receivable		5,538		253			393			-			-			6,184
Segment operating income (loss)	$	141,443	$	5,132		$	5,262		$	(32,907	)	$	-		$	118,930
Center rent expense		36,302		185			488			-			-			36,975
Depreciation and amortization		17,332		258			395			1,404			-			19,389
Interest, net		6,582		(1	)		(9	)		21,502			-			28,074
Net segment income (loss)	$	81,227	$	4,690		$	4,388		$	(55,813	)	$	-		$	34,492
Identifiable segment assets	$	1,114,877	$	13,462		$	37,133		$	725,825		$	(521,050	)	$	1,370,247
Goodwill	$	319,744	$	-		$	4,533		$	-		$	-		$	324,277
Segment capital expenditures	$	14,446	$	101		$	110		$	1,375		$	-		$	16,032

______________________________________

General and administrative expenses include operating administrative expenses.

The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, net gain (loss) on sale of assets, income tax expense and discontinued operations.

The term “net segment income (loss)” is defined as earnings before gain (loss) on sale of assets, net, income tax expense and discontinued operations.

25

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

Measurement of Segment Income

We evaluate financial performance and allocate resources primarily based on income or loss from operations before income taxes, excluding any unusual items. The following table reconciles net segment income to consolidated income before income taxes and discontinued operations (in thousands):

		For the Three Months Ended
		June 30,
		2009			2008
Net segment income	$	18,374		$	21,078
Loss on sale of assets		(40	)		-
Consolidated income before income taxes and
discontinued operations	$	18,334		$	21,078

		For the Six Months Ended
		June 30,
		2009			2008
Net segment income	$	38,030		$	34,492
(Loss) gain on sale of assets		(41	)		76
Consolidated income before income taxes and
discontinued operations	$	37,989		$	34,568

(9) Summarized Consolidating Information

In connection with the Company's offering of 9-1/8% Senior Subordinated Notes due 2015 (the “Notes”) in April 2007, certain 100% owned subsidiaries of the Company (the “Guarantors”) have, jointly and severally, unconditionally guaranteed the Notes. These guarantees are subordinated to all existing and future senior debt and senior guarantees of the Guarantors and are unsecured.

The Company conducts all of its business through and derives virtually all of its income from its subsidiaries. Therefore, the Company's ability to make required payments with respect to its indebtedness (including the Notes) and other obligations depends on the financial results and condition of its subsidiaries and its ability to receive funds from its subsidiaries.

Pursuant to Rule 3-10 of Regulation S-X, the following summarized consolidating information is provided for the Company (the “Parent”), the Guarantors, and the Company's non-Guarantor subsidiaries with respect to the Notes. This summarized financial information has been prepared from the books and records maintained by the Company, the Guarantors and the non-Guarantor subsidiaries. The summarized financial information may not necessarily be indicative of the results of operations or financial position had the Guarantors or non-Guarantor subsidiaries operated as independent entities. The separate financial statements of the Guarantors are not presented because management has determined they would not be material to investors. In addition, intercompany activities between subsidiaries and the Parent are presented within operating activities on the condensed consolidating statement of cash flows.

Condensed consolidating financial statements for the Company and its subsidiaries, including the Parent only, the combined Guarantor Subsidiaries and the combined Non-Guarantor Subsidiaries are as follows:

26

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING BALANCE SHEETS

As of June 30, 2009

(in thousands)

					Combined		Combined
		Parent			Guarantor		Non-Guarantor
		Company			Subsidiaries		Subsidiaries		Elimination			Consolidated
Current assets:
Cash and cash equivalents	$	77,693		$	16,295	$	1,684	$	-		$	95,672
Restricted cash		16,651			4,946		3,553		-			25,150
Accounts receivable, net		-			213,940		2,873		(18	)		216,795
Prepaid expenses and other assets		8,968			15,023		649		(1,499	)		23,141
Assets held for sale		959			-		-		-			959
Deferred tax assets		-			65,816		1,234		(8,516	)		58,534
Total current assets		104,271			316,020		9,993		(10,033	)		420,251
Property and equipment, net		7,647			536,361		67,395		-			611,403
Intangible assets, net		34,952			11,348		1,428		2,995			50,723
Goodwill		-			323,062		3,958		-			327,020
Restricted cash, non-current		2,966			342		-		-			3,308
Deferred tax assets		14,888			118,516		-		(12,389	)		121,015
Other assets		412			4,725		-		(69	)		5,068
Intercompany balances		318,698			-		12,228		(330,926	)		-
Investment in subsidiaries		591,201			-		-		(591,201	)		-
Total assets	$	1,075,035		$	1,310,374	$	95,002	$	(941,623	)	$	1,538,788
Current liabilities:
Accounts payable	$	8,369		$	47,510	$	960	$	(18	)	$	56,821
Accrued compensation and benefits		5,058			54,929		1,044		-			61,031
Accrued self-insurance obligations, current		4,295			44,324		-		-			48,619
Other accrued liabilities		16,018			37,264		4,048		(1,499	)		55,831
Deferred tax liability		8,516			-		-		(8,516	)		-
Current portion of long-term debt and capital lease
obligations		3,358			3,653		1,249		-			8,260
Total current liabilities		45,614			187,680		7,301		(10,033	)		230,562
Accrued self-insurance obligations, net of current		43,184			68,869		429		-			112,482
Deferred tax liability		-			-		12,389		(12,389	)		-
Long-term debt and capital lease obligations, net of current portion		527,967			104,289		63,766		-			696,022
Unfavorable lease obligations, net		-			17,087		-		(2,995	)		14,092
Other long-term liabilities		31,685			24,145		3,215		-			59,045
Intercompany balances		-			325,005		-		(325,005	)		-
Total liabilities		648,450			727,075		87,100		(350,422	)		1,112,203
Stockholders’ equity:
Common stock		437			-		-		-			437
Additional paid-in capital		652,773			-		-		-			652,773
Accumulated deficit		(222,344	)		583,299		7,902		(591,201	)		(222,344	)
Accumulated other comprehensive loss, net		(4,281	)		-		-		-			(4,281	)
Total stockholders' equity		426,585			583,299		7,902		(591,201	)		426,585
Total liabilities and stockholders' equity	$	1,075,035		$	1,310,374	$	95,002	$	(941,623	)	$	1,538,788

27

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING BALANCE SHEETS

As of December 31, 2008

(in thousands)

					Combined		Combined
		Parent			Guarantor		Non-Guarantor
		Company			Subsidiaries		Subsidiaries		Elimination			Consolidated
Current assets:
Cash and cash equivalents	$	72,529		$	17,952	$	1,672	$	-		$	92,153
Restricted cash		25,570			5,135		3,971		-			34,676
Accounts receivable, net		-			201,390		4,251		(21	)		205,620
Prepaid expenses and other assets		8,909			13,229		496		(1,178	)		21,456
Assets held for sale		951			2,693		10		-			3,654
Deferred tax assets		-			64,445		1,261		(8,445	)		57,261
Total current assets		107,959			304,844		11,661		(9,644	)		414,820
Property and equipment, net		7,877			527,413		68,355		-			603,645
Intangible assets, net		37,202			12,681		4,505		-			54,388
Goodwill		-			323,062		3,746		-			326,808
Restricted cash, non-current		2,963			340		-		-			3,303
Deferred tax assets		15,140			132,718		-		(13,051	)		134,807
Other assets		912			4,643		16		(8	)		5,563
Intercompany balances		372,179			-		3,730		(375,909	)		-
Investment in subsidiaries		539,385			-		-		(539,385	)		-
Total assets	$	1,083,617		$	1,305,701	$	92,013	$	(937,997	)	$	1,543,334
Current liabilities:
Accounts payable	$	14,630		$	46,107	$	1,284	$	(21	)	$	62,000
Accrued compensation and benefits		9,271			50,433		956		-			60,660
Accrued self-insurance obligations, current		4,001			40,735		557		-			45,293
Other accrued liabilities		14,741			42,585		709		(1,178	)		56,857
Deferred tax liability		8,445			-		-		(8,445	)		-
Current portion of long-term debt and capital lease
obligations		10,255			6,394		1,216		-			17,865
Total current liabilities		61,343			186,254		4,722		(9,644	)		242,675
Accrued self-insurance obligations, net of current		43,159			70,969		429		-			114,557
Deferred tax liability		-			-		13,051		(13,051	)		-
Long-term debt and capital lease obligations, net of current
portion		543,214			100,360		64,402		-			707,976
Unfavorable lease obligations, net		-			15,514		-		-			15,514
Other long-term liabilities		32,192			26,711		-		-			58,903
Intercompany balances		-			375,917		-		(375,917	)		-
Total liabilities		679,908			775,725		82,604		(398,612	)		1,139,625
Stockholders’ equity:
Common stock		435			-		-		-			435
Additional paid-in capital		650,543			-		-		-			650,543
Accumulated deficit		(242,683	)		529,976		9,409		(539,385	)		(242,683	)
Accumulated other comprehensive loss, net		(4,586	)		-		-		-			(4,586	)
Total stockholders' equity		403,709			529,976		9,409		(539,385	)		403,709
Total liabilities and stockholders' equity	$	1,083,617		$	1,305,701	$	92,013	$	(937,997	)	$	1,543,334

28

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Three Months Ended June 30, 2009

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries			Elimination			Consolidated
Total net revenues	$	10		$	480,519		$	7,278		$	(18,923	)	$	468,884
Costs and expenses:
Operating salaries and benefits		-			257,942			4,097			-			262,039
Self-insurance for workers’ compensation and
general and professional liability insurance		103			16,553			159			-			16,815
General and administrative expenses (1)		16,093			12,820			-			-			28,913
Other operating costs		-			111,676			1,810			(18,923	)		94,563
Center rent expense		-			18,083			185			-			18,268
Depreciation and amortization		672			9,900			581			-			11,153
Provision for losses on accounts receivable		-			6,152			142			-			6,294
Interest, net		9,219			2,127			1,119			-			12,465
Loss on sale of assets, net		-			47			(7	)		-			40
Income from investment in subsidiaries		(25,481	)		-			-			25,481			-
Total costs and expenses		606			435,300			8,086			6,558			450,550
(Loss) income before income taxes and
discontinued operations		(596	)		45,219			(808	)		(25,481	)		18,334
Income tax (benefit) expense		(10,692	)		18,540			(331	)		-			7,517
Income (loss) from continuing operations		10,096			26,679			(477	)		(25,481	)		10,817
Discontinued operations:
Loss from discontinued operations, net		-			(135	)		(579	)		-			(714	)
(Loss) gain on disposal of discontinued
operations, net		-			(12	)		5			-			(7	)
Loss on discontinued operations, net		-			(147	)		(574	)		-			(721	)
Net income (loss)	$	10,096		$	26,532		$	(1,051	)	$	(25,481	)	$	10,096

(1) Includes operating administrative expenses

29

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Three Months Ended June 30, 2008

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries		Elimination			Consolidated
Total net revenues	$	8		$	459,319		$	6,862	$	(15,256	)	$	450,933
Costs and expenses:
Operating salaries and benefits		-			249,176			2,912		-			252,088
Self-insurance for workers’ compensation and
general and professional liability insurance		114			11,421			162		-			11,697
General and administrative expenses (1)		16,112			12,943			-		-			29,055
Other operating costs		-			105,916			1,519		(15,256	)		92,179
Center rent expense		-			18,366			168		-			18,534
Depreciation and amortization		716			8,503			563		-			9,782
Provision for losses on accounts receivable		-			2,832			45		-			2,877
Interest, net		10,389			2,108			1,146		-			13,643
Gain on sale of assets		-			-			-		-			-
Income from investment in subsidiaries		(26,079	)		-			-		26,079			-
Total costs and expenses		1,252			411,265			6,515		10,823			429,855
(Loss) income before income taxes and
discontinued operations		(1,244	)		48,054			347		(26,079	)		21,078
Income tax (benefit) expense		(10,929	)		19,235			139		-			8,445
Income (loss) from continuing operations		9,685			28,819			208		(26,079	)		12,633
Discontinued operations:
(Loss) income from discontinued operations, net		-			(2,457	)		1,316		-			(1,141	)
(Loss) gain on disposal of discontinued
operations, net		-			(3,011	)		1,204		-			(1,807	)
(Loss) income on discontinued operations, net		-			(5,468	)		2,520		-			(2,948	)
Net income (loss)	$	9,685		$	23,351		$	2,728	$	(26,079	)	$	9,685

(1)   Includes operating administrative expenses

30

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Six Months Ended June 30, 2009

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries			Elimination			Consolidated
Total net revenues	$	14		$	960,400		$	14,465		$	(37,699	)	$	937,180
Costs and expenses:
Operating salaries and benefits		-			516,919			8,104			-			525,023
Self-insurance for workers’ compensation and
general and professional liability insurance		205			30,950			319			-			31,474
General and administrative expenses (1)		33,214			25,026			-			-			58,240
Other operating costs		-			224,484			3,597			(37,699	)		190,382
Center rent expense		-			36,313			370			-			36,683
Depreciation and amortization		1,349			19,367			1,160			-			21,876
Provision for losses on accounts receivable		-			10,031			250			-			10,281
Interest, net		18,597			4,357			2,237			-			25,191
Loss on sale of assets, net		-			48			(7	)		-			41
Income from investment in subsidiaries		(51,816	)		-			-			51,816			-
Total costs and expenses		1,549			867,495			16,030			14,117			899,191
(Loss) income before income taxes and
discontinued operations		(1,535	)		92,905			(1,565	)		(51,816	)		37,989
Income tax (benefit) expense		(21,874	)		38,091			(642	)		-			15,575
Income (loss) from continuing operations		20,339			54,814			(923	)		(51,816	)		22,414
Discontinued operations:
Loss from discontinued operations, net		-			(957	)		(803	)		-			(1,760	)
(Loss) gain on disposal of discontinued
operations, net		-			(534	)		219			-			(315	)
Loss on discontinued operations, net		-			(1,491	)		(584	)		-			(2,075	)
Net income (loss)	$	20,339		$	53,323		$	(1,507	)	$	(51,816	)	$	20,339

(1) Includes operating administrative expenses

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Six Months Ended June 30, 2008

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries		Elimination			Consolidated
Total net revenues	$	21		$	917,363		$	13,998	$	(30,080	)	$	901,302
Costs and expenses:
Operating salaries and benefits		-			501,049			5,970		-			507,019
Self-insurance for workers’ compensation and
general and professional liability insurance		229			25,921			321		-			26,471
General and administrative expenses (1)		32,697			24,880			-		-			57,577
Other operating costs		-			212,218			2,983		(30,080	)		185,121
Center rent expense		-			36,645			330		-			36,975
Depreciation and amortization		1,405			16,861			1,123		-			19,389
Provision for losses on accounts receivable		-			6,020			164		-			6,184
Interest, net		21,502			4,262			2,310		-			28,074
Gain on sale of assets		(76	)		-			-		-			(76	)
Income from investment in subsidiaries		(51,703	)		-			-		51,703			-
Total costs and expenses		4,054			827,856			13,201		21,623			866,734
(Loss) income before income taxes and
discontinued operations		(4,033	)		89,507			797		(51,703	)		34,568
Income tax (benefit) expense		(22,295	)		35,809			319		-			13,833
Income (loss) from continuing operations		18,262			53,698			478		(51,703	)		20,735
Discontinued operations:
(Loss) income from discontinued operations, net		-			(1,689	)		1,085		-			(604	)
(Loss) gain on disposal of discontinued
operations, net		-			(3,015	)		1,146		-			(1,869	)
(Loss) income on discontinued operations, net		-			(4,704	)		2,231		-			(2,473	)
Net income (loss)	$	18,262		$	48,994		$	2,709	$	(51,703	)	$	18,262

(1)   Includes operating administrative expenses

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

For the Six Months Ended June 30, 2009

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries			Elimination	Consolidated
Net cash provided by operating activities	$	21,916		$	25,134		$	5,099		$	-	52,149
Cash flows from investing activities:
Capital expenditures		(1,118	)		(23,802	)		(82	)		-	(25,002	)
Purchase of lease real estate		-			(3,275	)		-			-	(3,275	)
Proceeds from sale of assets held for sale		-			2,174			-			-	2,174
Net cash used for investing activities		(1,118	)		(24,903	)		(82	)		-	(26,103	)
Cash flows from financing activities:
Principal repayments of long-term debt and capital
lease obligations .		(15,654	)		(1,888	)		(4,145	)		-	(21,687	)
Distribution to non-controlling interest		-			-			(860	)		-	(860	)
Proceeds from issuance of common stock		20			-			-			-	20
Net cash used for financing activities		(15,634	)		(1,888	)		(5,005	)		-	(22,527	)
Net increase (decrease) in cash and cash equivalents		5,164			(1,657	)		12			-	3,519
Cash and cash equivalents at beginning of period		72,529			17,952			1,672			-	92,153
Cash and cash equivalents at end of period	$	77,693		$	16,295		$	1,684		$	-	95,672

For the Six Months Ended June 30, 2008

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries			Elimination		Consolidated
Net cash provided by operating activities	$	12,609		$	17,824		$	2,348		$	-	$	32,781
Cash flows from investing activities:
Capital expenditures		(1,375	)		(14,719	)		(45	)		-		(16,139	)
Purchase of lease real estate		-			(727	)		-			-		(727	)
Proceeds from sale of assets held for sale		3,777			180			-			-		3,957
Acquisitions		-			(313	)		-			-		(313	)
Insurance proceeds received		75			-			-			-		75
Net cash provided by (used for) investing
activities		2,477			(15,579	)		(45	)		-		(13,147	)
Cash flows from financing activities:
Borrowings of long-term debt		-			20,290			-			-		20,290
Principal repayments of long-term debt and
capital lease obligations		(1,854	)		(22,778	)		(567	)		-		(25,199	)
Payment to non-controlling interest		-			-			(2,035	)		-		(2,035	)
Distribution to non-controlling interest		-			-			(223	)		-		(223	)
Proceeds from issuance of common stock		70			-			-			-		70
Net cash used for financing activities		(1,784	)		(2,488	)		(2,825	)		-		(7,097	)
Net increase (decrease) in cash and cash equivalents		13,302			(243	)		(522	)		-		12,537
Cash and cash equivalents at beginning of period		30,221			23,547			2,064			-		55,832
Cash and cash equivalents at end of period	$	43,523		$	23,304		$	1,542		$	-	$	68,369

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

Sun Healthcare Group, Inc.’s subsidiaries are providers of nursing, rehabilitative and related specialty healthcare services primarily to the senior population in the United States. Our core business is providing inpatient services, primarily through 184 skilled nursing centers, 15 assisted and independent living centers and eight mental health centers with 23,345 licensed beds located in 25 states as of June 30, 2009. Our subsidiaries also provide hospice services, rehabilitation therapy services and temporary medical staffing services to skilled nursing centers.

Revenues from Medicare, Medicaid and Other Sources

We receive revenues from Medicare, Medicaid, commercial insurance, self-pay residents, other third party payors and healthcare centers that utilize our specialty medical services. The sources and amounts of our inpatient services revenues are determined by a number of factors, including the number of licensed beds and occupancy rates of our centers, the acuity level of patients and the rates of reimbursement among payors. Federal and state governments continue to focus on methods to curb spending on health care programs such as Medicare and Medicaid, and pressures on state budgets resulting from the current economic conditions in the United States may intensify these efforts. This focus has not been limited to skilled nursing centers, but includes specialty services provided by us, such as skilled therapy services, to third parties. We cannot at this time predict the extent to which proposals limiting federal or state expenditures will be adopted or, if adopted and implemented, what effect, if any, such proposals will have on us. Efforts to impose reduced coverage, greater discounts and more stringent cost controls by government and other payors are expected to continue.

In addition, we have experienced, and may continue to experience, due to current economic conditions, reduced demand for the specialty services that we provide to third parties.  We are unable to predict the future impact or extent of such reduced demand.

The following table sets forth the revenues and percentage of revenues by payor source for our continuing operations, on a consolidated and on an inpatient operations only basis, for the periods indicated (data is in thousands and includes revenues for acquired centers following the date of acquisition only):

		For the								For the
		Three Months Ended								Six Months Ended
Sources of Revenues		June 30, 2009				June 30, 2008				June 30, 2009				June 30, 2008
Consolidated:
Medicaid	$	188,030	40.1	%	$	179,166	39.7	%	$	369,480	39.4	%	$	358,083	39.7	%
Medicare		137,863	29.4			129,151	28.6			279,739	29.8			258,308	28.7
Private pay and other		117,202	25.0			118,896	26.4			235,763	25.2			239,168	26.5
Managed care and
commercial insurance		25,789	5.5			23,720	5.3			52,198	5.6			45,743	5.1
Total	$	468,884	100.00	%	$	450,933	100.0	%	$	937,180	100.0	%	$	901,302	100.0	%
Inpatient Only:
Medicaid	$	187,990	45.1	%	$	179,123	44.8	%	$	369,400	44.4	%	$	358,021	44.8	%
Medicare		133,766	32.1			126,372	31.6			271,630	32.6			252,785	31.7
Private pay and other		69,244	16.7			70,613	17.7			139,106	16.8			142,415	17.8
Managed care and
commercial insurance		25,622	6.1			23,578	5.9			51,889	6.2			45,445	5.7
Total	$	416,622	100.0	%	$	399,686	100.0	%	$	832,025	100.0	%	$	798,666	100.0	%

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Medicare

Medicare is available to nearly every United States citizen 65 years of age and older. It is a broad program of health insurance designed to help the nation’s elderly meet hospital, hospice, home health and other health care costs. Health insurance coverage extends to certain persons under age 65 who qualify as disabled or those having end-stage renal disease. Medicare is comprised of four related health insurance programs.  Medicare Part A provides for inpatient services including hospital, skilled long-term care, and home healthcare.  Medicare Part B provides for outpatient services including physicians’ services, diagnostic service, durable medical equipment, skilled therapy services and medical supplies.  Medicare Part C is a managed care option (“Medicare Advantage”) for beneficiaries who are entitled to Part A and enrolled in Part B.  Medicare Part D is a benefit that provides prescription drug benefits for both Medicare and Medicare/Medicaid dually eligible patients.

Medicare reimburses our skilled nursing centers for Medicare Part A services under the Prospective Payment System (“PPS”) as defined by the Balanced Budget Act of 1997 and subsequently refined in 1999, 2000 and 2005.  PPS regulations predetermine a payment amount per patient, per day, based on the 1995 costs of treating patients indexed forward. The amount to be paid is determined by classifying each patient into one of 53 Resource Utilization Group (“RUG”) categories that are based upon each patient’s acuity level.

The following table sets forth the average amounts of inpatient Medicare Part A revenues per patient, per day, recorded by our healthcare centers for the periods indicated:

	For the				For the
	Three Months Ended				Six Months Ended
	June 30, 2009		June 30, 2008		June 30, 2009		June 30, 2008
$	454.42	$	415.73	$	452.39	$	414.31

On July 31, 2008, the Centers for Medicare and Medicaid Services (“CMS”) issued a final rule to implement a 3.4% market basket increase for the 2009 federal fiscal year, which commenced on October 1, 2008.  The rule also contained an update of the wage indices.   The net impact of these changes was approximately a 3.3% increase in our reimbursement rates, which resulted in increased revenues of approximately $3.8 million per quarter. 

On July 31, 2009, CMS issued its final rule for skilled nursing facilities for the 2010 federal fiscal year, which will commence on October 1, 2009.  This rule provides for a market basket increase of 2.2% in our reimbursement rates and a 3.3% reduction for a forecast error/parity adjustment.  We estimate that the net result of the two adjustments, based on Sun’s current acuity mix, is a decrease of 0.85% in our reimbursement rates.

On July 31, 2009, CMS also issued its final rule for hospice services for the 2010 federal fiscal year.  The rule includes a market basket increase of 2.1% and a 0.7% decrease resulting from a phase out of the wage index budget neutrality factor.  We estimate that the net impact on our hospice service operations of these two adjustments is an increase of 1.52% in our reimbursement rates.

In addition to the changes that affect the upcoming 2010 federal fiscal year, the rule also contains provisions for the 2011 federal fiscal year which commences on October 1, 2010.  We are not able to predict whether these changes will occur but are able to confirm that CMS has determined that the changes will be budget neutral.

The Balanced Budget Act of 1997 established limits on reimbursement provided under Medicare Part B for therapy services.  An automatic exception is currently in place for patients residing in skilled nursing centers until at least December 31, 2009.

Medicaid

Medicaid is a state-administered program financed by state funds and federal matching funds. The program provides for medical assistance to the indigent and certain other eligible persons. Although administered under broad federal regulations, states are given flexibility to construct programs and payment methods. Each state in which we operate nursing and rehabilitation centers has its own unique Medicaid reimbursement system.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

        The following table sets forth the average amounts of inpatient Medicaid revenues per patient, per day (excluding any impact of individually identifiable state-imposed provider taxes), recorded by our healthcare centers for the periods indicated:

	For the				For the
	Three Months Ended				Six Months Ended
	June 30, 2009		June 30, 2008		June 30, 2009		June 30, 2008
$	171.77	$	165.45	$	170.25	$	165.25

For comparison purposes, the inclusion of the impact from individually identifiable state-imposed provider taxes on the average amounts of inpatient Medicaid revenues per patient, per day recorded by our healthcare centers for the periods indicated results in the following:

	For the				For the
	Three Months Ended				Six Months Ended
	June 30, 2009		June 30, 2008		June 30, 2009		June 30, 2008
$	160.12	$	155.66	$	159.36	$	155.37

Medicaid outlays are a significant component of state budgets, and there have been cost containment pressures on Medicaid outlays for nursing homes.  The current economic downturn has caused many states to institute freezes on or reductions in Medicaid spending to address state budget concerns.

Twenty-one of the states in which we operate impose a provider tax on nursing homes as a method of increasing federal matching funds paid to those states for Medicaid.  Those states that have imposed the provider tax have used some or all of the matching funds to fund Medicaid reimbursement to nursing homes.

Managed Care and Insurance

During the three months ended June 30, 2009, we received 5.5% of our revenues from managed care and insurance, of which the Medicare Advantage program is the primary component.  As discussed above, Medicare Advantage is the Medicare Part C managed care option for beneficiaries entitled to Part A and enrolled in Part B.  Medicare Advantage is administered by contracted third party payors.  The managed care and insurance payors are continuing their efforts to control healthcare costs through direct contracts with healthcare providers and increased utilization review.  These payors are increasingly demanding discounted fee structures and the assumption by healthcare providers of all or a portion of the financial risk.

The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the periods indicated:

	For the				For the
	Three Months Ended				Six Months Ended
	June 30, 2009		June 30, 2008		June 30, 2009		June 30, 2008
$	376.44	$	348.64	$	375.17	$	345.87

Private Payors, Veterans and Other

During the three months ended June 30, 2009, we received 25.0% of our revenues from private payors, veterans’ coverage, healthcare centers that utilize our specialty medical services, self-pay center residents and other third party payors. These private and other payors are continuing their efforts to control healthcare costs.  Private payor rates are set at a price point that enables continued competition; they are driven by the markets in which our healthcare centers operate.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

The following table sets forth the average amounts of inpatient revenues per patient, per day, recorded by our healthcare centers from these revenue sources for the periods indicated:

	For the				For the
	Three Months Ended				Six Months Ended
	June 30, 2009		June 30, 2008		June 30, 2009		June 30, 2008
$	177.50	$	171.96	$	177.90	$	171.57

Other Reimbursement Matters

Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment by payors during the settlement process. Under cost-based reimbursement plans, payors may disallow, in whole or in part, requests for reimbursement based on determinations that certain costs are not reimbursable or reasonable or because additional supporting documentation is necessary. We recognize revenues from third-party payors and accrue estimated settlement amounts in the period in which the related services are provided. We estimate these settlement balances by making determinations based on our prior settlement experience and our understanding of the applicable reimbursement rules and regulations.

Recent Accounting Pronouncements

In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial Statements (“SFAS No. 160”).  SFAS No. 160 requires that a noncontrolling interest in a subsidiary be reported as equity in the consolidated financial statements; that net income attributable to the parent and the noncontrolling interest be clearly identifiable; that changes in a parent’s ownership interest, while the parent retains its controlling financial interest in its subsidiary, be accounted for as equity transactions and that disclosures be expanded to clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners.  SFAS No. 160 was effective beginning January 1, 2009, and did not have a material impact on our financial position, cash flows or results of operations.

In February 2008, the FASB issued Staff Position FAS 157-2, Effective Date of FASB Statement No. 157 (“FSP FAS 157-2”), which delayed the effective date of the FASB Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”), for certain nonfinancial assets and nonfinancial liabilities until interim periods for fiscal years beginning after November 15, 2008.  SFAS No. 157 changed the underlying methodology of determining fair value when fair value measurements are required in accounting principles generally accepted in the United States.  SFAS No. 157 also expanded the disclosure requirements about fair value measurements.  The adoption of FSP FAS 157-2 did not have a material impact on our financial position, cash flows or results of operations.

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, Disclosures About Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133 (“SFAS No. 161”), which expands quarterly disclosure requirements in SFAS No. 133, Accounting for Derivative Instruments and Hedging Activity, about an entity’s derivative instruments and hedging activities. SFAS No. 161 was effective for fiscal years beginning January 1, 2009, and we have included the required disclosures in Note 2 – “Long-Term Debt and Capital Lease Obligations” of our consolidated financial statements.

In April 2008, the FASB issued Staff Position FAS No. 142-3, Determination of the Useful Life of Intangible Assets (“FSP FAS 142-3”). This pronouncement amends Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, regarding the factors that should be considered in developing the useful lives for intangible assets with renewal or extension provisions. FSP FAS 142-3 requires an entity to consider its own historical experience in renewing or extending similar arrangements, regardless of whether those arrangements have explicit renewal or extension provisions, when determining the useful life of an intangible asset. In the absence of such experience, an entity shall consider the assumptions that market participants would use concerning renewal or extension, adjusted for entity-specific factors. FSP FAS 142-3 also requires an entity to disclose information regarding the extent to which the expected future cash flows associated with an intangible asset are affected by the entity’s intent and/or ability to renew or extend the arrangement. FSP FAS 142-3 is effective for qualifying intangible assets acquired on or after January 1, 2009. The application of FSP FAS

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

142-3 did not have a material impact on our financial position, cash flows or results of operations; however, it could impact future transactions.  

In April 2009, the FASB issued Staff Position No. FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, which amends FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments (“SFAS No. 107”), and Accounting Principles Board Opinion No. 28, Interim Financial Reporting (“APB No. 28”).  This pronouncement was effective for our reporting periods beginning with our June 30, 2009 interim financial statements.  The amendments expand the disclosure requirements of SFAS No. 107 and APB No. 28 about how an entity reports on fair value to be included in the summarized, interim financial statements.  The adoption of SFAS No. 107 and APB No. 28 did not have a material impact on our financial position, cash flows or results of operations.  All required disclosures have been included in our June 30, 2009 interim financial statements.

In April 2009, the FASB issued Staff Position No. FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (“FSP FAS 115-2 and 124-2”), which provides guidance for measuring and expands the presentation and disclosure requirements of other-than-temporary impairments on debt and equity securities in interim and annual financial statements.  As we currently do not own any debt or equity securities, this Staff Position is not expected to impact our financial position, cash flows or results of operations.  Should we own any such securities in the future, the provisions of this Staff Position will be applied.

In April 2009, the FASB issued Staff Position No. 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (“FSP FAS No. 157-4”), which expands quarterly disclosure requirements in SFAS No. 157 about how an entity determines fair value when the volume and level of activity for an asset or liability have significantly decreased and transactions related to such assets and liabilities are not orderly.  This pronouncement was effective for our reporting periods beginning with our June 30, 2009 interim financial statements.  The adoption of FSP FAS 157-4 did not have a material impact on our financial position, cash flows or results of operations.

In May 2009, the FASB issued Statement of Financial Accounting Standards No. 165, Subsequent Events (“SFAS No. 165”), which provides guidance on accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued.  SFAS No. 165 requires companies to evaluate events or transactions taking place after the balance sheet date for recognition in the financial statements prior to issuance.  Additionally, SFAS No. 165 requires the disclosure of the date through which an entity has evaluated subsequent events and the basis for that date; that is, whether that date represents the date the financial statements were issued or were available to be issued.  SFAS No. 165 became effective for our interim and annual reporting periods on April 1, 2009.  The adoption of SFAS No. 165 did not impact our financial position, cash flows or results of operations.  For the purposes of this reporting period, we have evaluated the subsequent events occurring after June 30, 2009 through August 6, 2009, which we consider to be the date that the financial statements were “issued” and “available to be issued”.

In June 2009, the FASB issued Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140 (“SFAS No. 166”), which provides guidance on accounting for and disclosure of  the transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.  Additionally, SFAS No. 166 eliminates the concept of the “qualified special purpose entity” (as established in Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities-a replacement of FASB Statement No. 125) and replaces it with the the concept of a “participating interest”, which is defined as an entity having a proportionate ownership interest in the asset(s) being transferred.  SFAS No. 166 is effective for annual reporting periods beginning after November 15, 2009.  We do not expect SFAS No. 166 to have any impact on our financial position, cash flows or results of operations.

In June 2009, the FASB issued Statement of Financial Accounting Standards No. 167, Amendments for FASB Interpretation No. 46(R) (“SFAS No. 167”), which provides guidance on determining whether the enterprise’s variable interest or interests give it a controlling financial interest in a variable interest entity (“VIE”) based on the power to direct the activities of the VIE and the obligation to absorb losses of the VIE.  SFAS No. 167 requires an entity to assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining whether it has the power to direct the activities of the VIE that most significantly impact the entity’s economic performance.  Additionally, SFAS No.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

167 requires an entity to assess, on an ongoing basis, whether or not it continues to be the primary beneficiary of a VIE.  SFAS No. 167 is effective for annual reporting periods beginning after November 15, 2009.  We do not expect SFAS No. 167 to have any impact on our financial position, cash flows or results of operations.

In June 2009, the FASB issued Statement of Financial Accounting Standards No. 168, The FASB Accounting Standards CodificationTM (“Codification”) and the Hierarchy of Generally Accepted Accounting Principles, a replacement of FASB Statement No. 162 (“SFAS No. 168”), which established the Codification as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP.  SFAS No. 168 is effective for interim and annual periods ending after September 15, 2009.  The adoption of SFAS No. 168 will only impact references for accounting guidance.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Results of Operations

The following table sets forth our unaudited historical consolidated income statements and certain percentage relationships for the periods presented (dollars in thousands):

		For the Three			For the Three		As a Percentage of Net Revenues
		Months Ended			Months Ended
		June 30, 2009			June 30, 2008		June 30, 2009		June 30, 2008
Total net revenues	$	468,884		$	450,933		100.0	%	100.0	%
Costs and expenses:
Operating salaries and benefits		262,039			252,088		55.8		55.9
Self-insurance for workers’ compensation and
general and professional liabilities		16,815			11,697		3.6		2.6
Other operating costs (1)		107,755			105,123		23.0		23.3
Center rent expense		18,268			18,534		3.9		4.1
General and administrative expenses		15,721			16,111		3.4		3.6
Depreciation and amortization		11,153			9,782		2.4		2.2
Provision for losses on accounts receivable		6,294			2,877		1.3		0.6
Interest, net		12,465			13,643		2.7		3.0
Other loss		40			-		-		-
Income before income taxes and discontinued
operations		18,334			21,078		3.9		4.7
Income tax expense		7,517			8,445		1.6		1.9
Income from continuing operations		10,817			12,633		2.3		2.8
Loss from discontinued operations, net		(721	)		(2,948	)	(0.1	)	(0.7	)
Net income	$	10,096		$	9,685		2.2	%	2.1	%

(1)   Operating administrative expenses are included in “other operating costs” above.

		For the Six			For the Six		As a Percentage of Net Revenues
		Months Ended			Months Ended
		June 30, 2009			June 30, 2008		June 30, 2009		June 30, 2008
Total net revenues	$	937,180		$	901,302		100.0	%	100.0	%
Costs and expenses:
Operating salaries and benefits		525,023			507,019		55.9		56.3
Self-insurance for workers’ compensation and
general and professional liabilities		31,474			26,471		3.4		2.9
Other operating costs (1)		216,151			210,001		23.0		23.3
Center rent expense		36,683			36,975		3.9		4.1
General and administrative expenses		32,471			32,697		3.5		3.6
Depreciation and amortization		21,876			19,389		2.4		2.2
Provision for losses on accounts receivable		10,281			6,184		1.1		0.7
Interest, net		25,191			28,074		2.7		3.1
Other loss (income)		41			(76	)	-		-
Income before income taxes and discontinued
operations		37,989			34,568		4.1		3.8
Income tax expense		15,575			13,833		1.7		1.5
Income from continuing operations		22,414			20,735		2.4		2.3
Loss from discontinued operations, net		(2,075	)		(2,473	)	(0.2	)	(0.3	)
Net income	$	20,339		$	18,262		2.2	%	2.0	%

(1)   Operating administrative expenses are included in “other operating costs” above.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

The following discussion of the “Three Months Ended June 30, 2009 Compared to Three Months Ended June 30, 2008” is based, in part, on the financial information presented in Note 8 – “Segment Information” in our interim consolidated financial statements.

Three Months Ended June 30, 2009 Compared to Three Months Ended June 30, 2008

The following summarizes our results of operations on a consolidated basis.  A more detailed discussion and analysis of the results of operations of each of our segments (Inpatient Services, Rehabilitation Therapy Services, Medical Staffing Services and Corporate) is provided below under “Segment Information.”

Net revenues increased $18.0 million, or 4.0%, to $468.9 million for the three months ended June 30, 2009 from $450.9 million for the three months ended June 30, 2008. We reported net income for the three months ended June 30, 2009 of $10.1 million compared to net income of $9.7 million for the three months ended June 30, 2008.

The increase in net revenues for the 2009 period included $16.9 million of additional revenue in our Inpatient Services segment primarily due to increases in Medicare Part A and Part B rates, higher customer base and rates in managed care and commercial insurance revenues, and improved Medicaid rates.  The remainder of the increase primarily resulted from a $8.9 million increase in revenue from our Rehabilitation Therapy segment due primarily to increases in billable minutes and billing rates, partially offset by a $4.2 million decrease in revenue from our Medical Staffing segment mainly due to a decrease in billable nursing hours.

Operating salaries and benefits, excluding workers’ compensation insurance costs, increased $9.9 million, or 3.9%, to $262.0 million (55.8% of net revenues) for the three months ended June 30, 2009 from $252.1 million (55.9% of net revenues) for the three months ended June 30, 2008.  The increase resulted primarily from $5.6 million in our Inpatient Services segment driven by wage increases and an $8.0 million increase from our Rehabilitation Therapy segment attributable to wage rate increases and business growth.  These increases were offset by a $3.6 million decrease in our Medical Staffing segment due to a decline in staffing levels resulting from a decrease in the nurse staffing and pharmacy business.

Self-insurance for workers’ compensation and general and professional liability insurance increased $5.1 million, or 43.6%, to $16.8 million (3.6% of net revenues) for the three months ended June 30, 2009 from $11.7 million (2.6% of net revenues) for the three months ended June 30, 2008 primarily due to increased medical, legal and administrative costs associated with prior period claims.

Other operating costs increased $2.7 million, or 2.6%, to $107.8 million (23.0% of net revenues) for the three months ended June 30, 2009 from $105.1 million (23.3% of net revenues) for the three months ended June 30, 2008.  The increase was primarily due to an increase in our Inpatient Services segment primarily driven by increased therapy costs due to an increase in higher acuity patients requiring more rehabilitation therapy and an increase in purchased services.

Center rent expense decreased $0.2 million, or 1.1%, to $18.3 million (3.9% of net revenues) for the three months ended June 30, 2009 from $18.5 million (4.1% of net revenues) for the three months ended June 30, 2008.

General and administrative expenses decreased $0.4 million, or 2.5%, to $15.7 million (3.3% of net revenues) for the three months ended June 30, 2009 from $16.1 million (3.6% of net revenues) for the three months ended June 30, 2008.  The decrease was primarily due to cost reductions in professional and consultant fees, utilities and benefits expenses.

Depreciation and amortization increased $1.4 million, or 14.3%, to $11.2 million (2.4% of net revenues) for the three months ended June 30, 2009 from $9.8 million (2.2% of net revenues) for the three months ended June 30, 2008.  The increase was attributable to additional depreciation expense due to the purchase of previously leased centers and for property and equipment acquired during the period.

The provision for losses on accounts receivable increased $3.4 million, or 117.2%, to $6.3 million (1.3% of net revenues) for the three months ended June 30, 2009 from $2.9 million (0.6% of net revenues) for the three months ended June 30, 2008.  The increase resulted from slower cash collections.

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Net interest expense decreased $1.1 million, or 8.1%, to $12.5 million (2.7% of net revenues) for the three months ended June 30, 2009 from $13.6 million (3.0% of net revenues) for the three months ended June 30, 2008 due to lower interest rates on variable rate indebtedness in the current quarter coupled with reduced debt balances.

Segment Information

The following table sets forth the amount and percentage of certain elements of total net revenues for the three months ended June 30 (dollars in thousands):

		2009					2008
Inpatient Services	$	416,622		88.8	%	$	399,686		88.6	%
Rehabilitation Therapy Services		44,515		9.5			35,604		7.9
Medical Staffing Services		26,660		5.7			30,890		6.9
Corporate		10		-			9		-
Intersegment Eliminations		(18,923	)	(4.0	)		(15,256	)	(3.4	)
Total net revenues	$	468,884		100.0	%	$	450,933		100.0	%

Inpatient Services revenues include revenues billed to patients for therapy and medical staffing provided by our affiliated operations.  The following table sets forth a summary of the intersegment revenues for the three months ended June 30 (in thousands):

		2009		2008
Rehabilitation Therapy Services	$	18,360	$	14,462
Medical Staffing Services		563		794
Total intersegment revenue	$	18,923	$	15,256

The following table sets forth the amount of net segment income for the three months ended June 30 (in thousands):

		2009			2008
Inpatient Services	$	38,816		$	43,382
Rehabilitation Therapy Services		3,111			2,562
Medical Staffing Services		2,289			2,456
Net segment income before Corporate		44,216			48,400
Corporate		(25,842	)		(27,322	)
Net segment income	$	18,374		$	21,078

Our reportable segments are strategic business units that provide different products and services.  They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.  We evaluate the operational strengths and performance of each segment based on financial measures, including net segment income.  Net segment income is defined as earnings before loss on sale of assets, income tax expense and discontinued operations. Net segment income for the three months ended June 30, 2009 for (1) our Inpatient Services segment decreased $4.6 million, or 10.6%, to $38.8 million, (2) our Rehabilitation Therapy Services segment increased $0.5 million, or 19.2%, to $3.1 million and (3) our Medical Staffing Services segment decreased $0.2 million, or 8.0%, to $2.3 million in comparison to the three months ended June 30, 2008, due to the factors discussed below for each segment.  We use the measure of net segment income to help identify opportunities for improvement and assist in allocating resources to each segment. 

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Inpatient Services

Net revenues increased $16.9 million, or 4.2%, to $416.6 million for the three months ended June 30, 2009 from $399.7 million for the three months ended June 30, 2008.  The increase was primarily the result of:

-	an increase of $4.4 million in Medicare revenues as result of a $10.0 million increase from higher Medicare Part A rates, a $2.1 million increase in Medicare Part B revenues and a $7.7 million decrease in revenues due to a lower customer base;
-	a $2.0 million increase in managed care and commercial insurance revenues driven by higher rates, which contributed $1.9 million of the increase, and higher customer base, which drove the remaining $0.1 million of the increase;
-	an increase of $8.8 million in Medicaid revenues consisting of $6.8 million related to improved rates and $2.0 million from an increase in customer base; and
-	a $3.3 million increase in hospice Medicare revenues, resulting in part from an acquisition of a hospice company in September 2008;
	Offset in part by:
-	a $1.6 million decrease in private pay revenues due to a decline in revenues of $3.3 million as a result of a lower customer base, offset in part by a $1.7 million increase attributable to higher rates.

Operating salaries and benefits expenses increased $5.6 million, or 2.8%, to $206.6 million for the three months ended June 30, 2009 from $201.0 million for the three months ended June 30, 2008.  The increase was attributable to the following:

-	wage increases and related benefits and taxes of $7.4 million; and
-	an increase of $0.9 million in health insurance expense;
	Offset in part by:
-	a decrease of $2.1 million in overtime pay; and
-	a decrease of $0.6 million in bonus expense.

Self-insurance for workers’ compensation and general and professional liability insurance increased $5.2 million, or 48.6%, to $15.9 million for the three months ended June 30, 2009 as compared to $10.7 million for the three months ended June 30, 2008.  General and professional liability insurance increased $9.1 million due to increased legal and administrative costs associated with claims, $4.3 million of which related to prior periods’ claims.  Workers’ compensation insurance decreased $3.9 million due to decreased exposures.

Other operating costs increased $6.0 million, or 5.9%, to $107.4 million for the three months ended June 30, 2009 from $101.4 million for the three months ended June 30, 2008.  The increase was attributable to the following:

- a $3.3 million increase in therapy costs due to an increase in higher acuity patients requiring more rehabilitation therapy;

- a $2.3 million increase in taxes primarily related to provider and real estate taxes;

- a $1.9 million increase in supplies, due to higher costs for medical, incontinency and Medicare Part A drugs; and

- a $1.2 million increase in purchased services related to medical, software maintenance and service contracts;

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

	Offset in part by:
-	a $1.1 million decrease in nursing contract labor due to lower volume and more in-house availability of staff;
-	a $0.7 million decrease in education and training;
-	a $0.3 million decrease in utilities primarily related to a decrease in gas and oil offset by an increase in water and sewer;
-	a $0.3 million decrease in recruiting expenses; and
-	a $0.3 million increase in rebates and discounts.

General and administrative expenses increased $0.3 million, or 2.9%, to $10.7 million for the three months ended June 30, 2009 from $10.4 million for the three months ended June 30, 2008. The increase is primarily due to the increase in salaries and benefits (net of decrease in contract labor) and travel partially offset by a decrease in utilities.

The provision for losses on accounts receivable increased $3.4 million, or 125.9%, to $6.1 million for the three months ended June 30, 2009 from $2.7 million for the three months ended June 30, 2008.  The increase resulted from slower cash collections.

Center rent expense decreased $0.3 million, or 1.6%, to $17.9 million for the three months ended June 30, 2009 from $18.2 million for the three months ended June 30, 2008.  The decrease is attributable to the purchase of previously leased centers.

Depreciation and amortization increased $1.4 million, or 16.1%, to $10.1 million for the three months ended June 30, 2009 from $8.7 million for the three months ended June 30, 2008.  The increase was attributable to additional depreciation expense on property and equipment acquired during the period.

Net interest expense decreased $0.2 million, or 6.1%, to $3.1 million for the three months ended June 30, 2009 from $3.3 million for the three months ended June 30, 2008.  The decrease is a result of lower borrowing costs and lower aggregate borrowings.

Rehabilitation Therapy Services

Total revenues from the Rehabilitation Therapy Services segment increased $8.9 million, or 25.0%, to $44.5 million for the three months ended June 30, 2009 from $35.6 million for the three months ended June 30, 2008. The revenue increase was the result of:

- an increase of $7.4 million attributable to increased billable minutes, of which 22 new contracts, net of lost contracts, accounted for $0.4 million, or 5%, and 425 existing contracts accounted for $7.0 million, or 95%;

- an increase of $1.2 million attributable to a higher revenue per minute rate due to our renegotiation of certain customer contract rates and a shift in payor mix; and

- an increase of $0.3 million in revenue earned for contract management fees.

Operating salaries and benefits expenses increased $8.0 million, or 27.8%, to $36.8 million for the three months ended June 30, 2009 from $28.8 million for the three months ended June 30, 2008. The increase was primarily driven by wage rate increases coupled with the increase in service volume mentioned above.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Medical Staffing Services

Total revenues from the Medical Staffing Services segment decreased $4.2 million, or 13.6%, to $26.7 million for the three months ended June 30, 2009 from $30.9 million for the three months ended June 30, 2008.  The decrease was primarily the result of:

-	a decrease of $2.1 million attributable to a decline in demand for our nurse staffing business;
-	a decrease of $1.4 million due to a decline in hours for therapy and pharmacy;
-	a decrease of $1.1 million related to closed offices; and
-	a decrease of $0.2 million in school business revenue;
	Offset in part by:
-	an increase of $0.6 million due to higher fees earned from the temporary placement of physicians.

Operating salaries and benefits expenses were $18.6 million for the three months ended June 30, 2009 as compared to $22.2 million for the three months ended June 30, 2008, a decrease of $3.6 million, or 16.2%. The decrease in operating salaries and benefits is a direct result of the decline in staffing levels from nurse staffing, therapy staffing and pharmacy businesses.

Other operating costs decreased $0.2 million, or 4.7%, to $4.1 million for the three months ended June 30, 2009 from $4.3 million for the three months ended June 30, 2008. The decrease was primarily attributable to costs paid for travel and lodging for travel nurses and therapists.

Corporate

General and administrative expenses not directly attributed to segments decreased $0.4 million, or 2.5%, to $15.7 million for the three months ended June 30, 2009 from $16.1 million for the three months ended June 30, 2008. The decrease was primarily due to cost reductions in professional and consultant fees, utilities and benefits expense.

Interest expense

Interest expense not directly attributed to operating segments decreased $1.0 million, or 9.6%, to $9.4 million for the three months ended June 30, 2009 from $10.4 million for the three months ended June 30, 2008 due to lower interest rates on variable rate indebtedness in the current quarter coupled with a decrease in aggregate indebtedness since June 30, 2008.

Six Months Ended June 30, 2009 Compared to Six Months Ended June 30, 2008

The following summarizes our results of operations on a consolidated basis.  A more detailed discussion and analysis of the results of operations of each of our segments (Inpatient Services, Rehabilitation Therapy Services, Medical Staffing Services and Corporate) is provided below under “Segment Information.”

Net revenues increased $35.9 million, or 4.0%, to $937.2 million for the six months ended June 30, 2009 from $901.3 million for the six months ended June 30, 2008. We reported net income for the six months ended June 30, 2009 of $20.3 million compared to net income of $18.3 million for the six months ended June 30, 2008.

The increase in net revenues for the 2009 period included $33.4 million of additional revenue in our Inpatient Services segment primarily due to increases in Medicare Part A and Part B rates, higher customer base and rates in managed care and commercial insurance revenues, and improved Medicaid rates.  The remainder of the increase primarily resulted from a $16.6 million increase in revenue from our Rehabilitation Therapy segment due primarily to increases in billable minutes and billing rates, partially offset by a $6.5 million decrease in revenue from our Medical Staffing segment mainly due to a decrease in billable nursing hours.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Operating salaries and benefits, excluding workers’ compensation insurance costs, increased $18.0 million, or 3.6%, to $525.0 million (55.9% of net revenues) for the six months ended June 30, 2009 from $507.0 million (56.3% of net revenues) for the six months ended June 30, 2008.  The increase resulted primarily from $10.2 million of wage increases in our Inpatient Services segment and a $14.2 million increase from our Rehabilitation Therapy segment attributable to wage rate increases and business growth.  These increases were offset by a $6.4 million decrease in our Medical Staffing segment due to a decline in staffing levels resulting from a decrease in the nurse staffing and pharmacy business.

Self-insurance for workers’ compensation and general and professional liability insurance increased $5.0 million, or 18.9%, to $31.5 million (3.4% of net revenues) for the six months ended June 30, 2009 from $26.5 million (2.9% of net revenues) for the six months ended June 30, 2008 primarily due to increased medical, legal and administrative costs associated with prior period claims.

Other operating costs increased $6.1 million, or 2.9%, to $216.1 million (23.0% of net revenues) for the six months ended June 30, 2009 from $210.0 million (23.3% of net revenues) for the six months ended June 30, 2008.  The increase was primarily due to an increase in our Inpatient Services segment primarily driven by increased therapy costs due to an increase in higher acuity patients requiring more rehabilitation therapy and an increase in purchased services.

Center rent expense decreased  $0.3 million, or 0.8%, to $36.7 million (3.9% of net revenues) for the six months ended June 30, 2009 from $37.0 million (4.1% of net revenues) for the six months ended June 30, 2008.

General and administrative expenses decreased $0.2 million, or 0.6%, to $32.5 million (3.5% of net revenues) for the six months ended June 30, 2009 from $32.7 million (3.6% of net revenues) for the six months ended June 30, 2008.  The decrease was due to lower costs in our Corporate segment, primarily from reductions in professional and consultant fees, utilities and benefits expenses.

Depreciation and amortization increased $2.5 million, or 12.9%, to $21.9 million (2.4% of net revenues) for the six months ended June 30, 2009 from $19.4 million (2.2% of net revenues) for the six months ended June 30, 2008.  The increase was attributable to additional depreciation expense due to the purchase of previously leased centers and for property and equipment acquired during the period.

The provision for losses on accounts receivable increased $4.1 million, or 66.1%, to $10.3 million (1.1% of net revenues) for the six months ended June 30, 2009 from $6.2 million (0.7% of net revenues) for the six months ended June 30, 2008.  The increase resulted from slower cash collections.

Net interest expense decreased $2.9 million, or 10.3%, to $25.2 million (2.7% of net revenues) for the six months ended June 30, 2009 from $28.1 million (3.1% of net revenues) for the six months ended June 30, 2008 due to lower interest rates on variable rate indebtedness in the current quarter coupled with reduced debt balances.

Segment Information

The following table sets forth the amount and percentage of certain elements of total net revenues for the six months ended June 30 (dollars in thousands):

		2009					2008
Inpatient Services	$	832,025		88.8	%	$	798,666		88.6	%
Rehabilitation Therapy Services		88,246		9.4			71,603		7.9
Medical Staffing Services		54,594		5.8			61,092		6.8
Corporate		14		-			21		-
Intersegment Eliminations		(37,699	)	(4.0	)		(30,080	)	(3.3	)
Total net revenues	$	937,180		100.0	%	$	901,302		100.0	%

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Inpatient services revenues include revenues billed to patients for therapy and medical staffing provided by our affiliated operations.  The following table sets forth a summary of the intersegment revenues for the six months ended June 30 (in thousands):

		2009		2008
Rehabilitation Therapy Services	$	36,576	$	28,752
Medical Staffing Services		1,123		1,328
Total intersegment revenue	$	37,699	$	30,080

The following table sets forth the amount of net segment income for the six months ended June 30 (in thousands):

		2009			2008
Inpatient Services	$	80,604		$	81,227
Rehabilitation Therapy Services		6,000			4,690
Medical Staffing Services		4,310			4,388
Net segment income before Corporate		90,914			90,305
Corporate		(52,884	)		(55,813	)
Net segment income	$	38,030		$	34,492

Inpatient Services

Net revenues increased $33.3 million, or 4.2%, to $832.0 million for the six months ended June 30, 2009 from $798.7 million for the six months ended June 30, 2008.  The increase was primarily the result of:

-	an increase of $13.1 million in Medicare revenues as a result of a $20.2 million increase  in Medicare Part A rates, a $3.6 million increase in Medicare Part B revenues and a $10.7 million decrease due to a lower customer base;
-	a $6.4 million increase in managed care and commercial insurance revenues driven by higher rates, which contributed $4.0 million of the increase, and higher customer base, which drove the remaining $2.4 million of the increase;
-	an increase of $11.2 million in Medicaid revenues consisting of $10.7 million related to improved rates and $0.5 million from an increase in customer base;
-	a $6.2 million increase in hospice Medicare revenues, resulting in part from an acquisition of a hospice company in September 2008; and
-	an increase of $1.0 million in other revenues;
	Offset in part by:
-	a $4.1 million decrease in private pay revenues due to a decline in revenues of $8.2 million as a result of a lower customer base, offset in part by a $4.1 million increase in revenues resulting from higher rates; and
-	a $0.5 million decrease in revenues related to our Medicare Part B billing company.

Operating salaries and benefits expenses increased $10.2 million, or 2.5%, to $413.7 million for the six months ended June 30, 2009 from $403.5 million for the six months ended June 30, 2008.  The increase was attributable to the following:

- wage increases and related benefits and taxes of $13.0 million; and

- an increase of $1.6 million in health insurance expense;

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

	Offset in part by:
-	a decrease of  $4.2 million in overtime pay; and
-	a decrease of $0.2 million in bonus expense.

Self-insurance for workers’ compensation and general and professional liability insurance increased $5.1 million, or 20.9%, to $29.5 million for the six months ended June 30, 2009 as compared to $24.4 million for the six months ended June 30, 2008. General and professional liability insurance increased $8.1 million due to increased legal and administrative costs associated with claims, $4.3 million of which related to prior periods’ claims.  Workers’ compensation insurance decreased $3.0 million due to decreased exposures.

Other operating costs increased $12.0 million, or 5.9%, to $215.8 million for the six months ended June 30, 2009 from $203.8 million for the six months ended June 30, 2008.  The increase was attributable to the following:

-	a $6.7 million increase in therapy costs due to an increase in higher acuity patients requiring more rehabilitation therapy;
-	a $3.2 million increase in taxes primarily related to real estate, provider and gross receipts;
-	a $2.7 million increase in purchased services including software maintenance and service contracts;
-	a $2.1 million increase in supplies, due to higher costs for medical, IV, oxygen and office supplies; and
-	a $0.7 million increase in legal fees;
	Offset in part by:
-	a $1.2 million decrease in nursing contract labor due to lower volume and improved labor management;
-	a $1.0 million decrease in education training;
-	a $0.6 million decrease in civil monetary penalties; and
-	a $0.6 million decrease in recruiting expenses.

General and administrative expenses increased $0.7 million, or 3.5%, to $20.6 million for the six months ended June 30, 2009 from $19.9 million for the six months ended June 30, 2008. The increase is primarily due to the increase in salaries and benefits (net of decrease in contract labor) and travel.

The provision for losses on accounts receivable increased $4.3 million, or 78.2%, to approximately $9.8 million for the six months ended June 30, 2009 from $5.5 million for the six months ended June 30, 2008.  The increase resulted from slower cash collections.

Center rent expense decreased $0.3 million, or 0.8%, to $36.0 million for the six months ended June 30, 2009 from $36.3 million for the six months ended June 30, 2008.  The decrease is attributable to the purchase of previously leased centers.

Depreciation and amortization increased $2.5 million, or 14.5%, to $19.8 million for the six months ended June 30, 2009 from $17.3 million for the six months ended June 30, 2008. The increase was attributable to additional depreciation expense due to the purchase of previously leased centers and for property and equipment acquired during the period.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Net interest expense decreased $0.3 million, or 4.5%, to $6.3 million for the six months ended June 30, 2009 from $6.6 million for the six months ended June 30, 2008.  The decrease is a result of lower borrowing costs and lower aggregate borrowings.

Rehabilitation Therapy Services

Total revenues from the Rehabilitation Therapy Services segment increased $16.6 million, or 23.2%, to $88.2 million for the six months ended June 30, 2009 from $71.6 million for the six months ended June 30, 2008. The revenue increase was the result of:

- an increase of $14.2 million attributable to increased billable minutes, of which 22 new contracts, net of lost contracts, accounted for $.7 million, or 5%, and 425 existing contracts accounted for $13.6 million, or 95%;

- an increase of $1.8 million attributable to a higher revenue per minute rate due to our renegotiation of certain customer contract rates and a shift in payor mix; and

- an increase of $0.6 million in revenue earned for contract management fees.

Operating salaries and benefits expenses increased $14.2 million, or 24.1%, to $73.0 million for the six months ended June 30, 2009 from $58.8 million for the six months ended June 30, 2008. The increase was primarily driven by wage rate increases coupled with the increase in service volume mentioned above.

Medical Staffing Services

Total revenues from the Medical Staffing Services segment decreased $6.5 million, or 10.6%, to $54.6 million for the six months ended June 30, 2009 from $61.1 million for the six months ended June 30, 2008.  The decrease was primarily the result of:

-	a decrease of $5.0 million attributable to a decline in demand for our nurse staffing business;
-	a decrease of $1.1 million due to a decline in hours for therapy and pharmacy;
-	a decrease of $2.1 million related to closed offices; and
-	a decrease of $0.2 million in school business revenue;
	Offset in part by:
-	an increase of $1.9 million due to higher fees earned from the temporary placement of physicians.

Operating salaries and benefits expenses were $38.3 million for the six months ended June 30, 2009 as compared to $44.7 million for the six months ended June 30, 2008, a decrease of $6.4 million, or 14.3%. The decrease in operating salaries and benefits resulted from a decline in staffing levels due to a decrease in the nurse staffing, therapy staffing and pharmacy businesses.

Other operating costs increased $0.5 million, or 6.2%, to $8.6 million for the six months ended June 30, 2009 from $8.1 million for the six months ended June 30, 2008. The increase was primarily attributable to costs paid for temporary independent contractors that are physicians.

Corporate

General and administrative expenses not directly attributed to segments decreased $0.2 million, or 0.6%, to $32.5 million for the six months ended June 30, 2009 from $32.7 million for the three months ended June 30, 2008.  The decrease was primarily due to cost reductions in professional and consultant fees and benefits expense.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Interest expense

Interest expense not directly attributed to operating segments decreased $2.6 million, or 12.1%, to $18.9 million for the six months ended June 30, 2009 from $21.5 million for the six months ended June 30, 2008 due to lower interest rates on variable rate indebtedness in the current quarter coupled with a decrease in aggregate indebtedness since June 30, 2008.

Liquidity and Capital Resources

There have been no material changes to our liquidity and capital resources since December 31, 2008.  For the three and six months ended June 30, 2009, our net income was $10.1 million and $20.3 million, respectively.  As of June 30, 2009, our working capital was $189.7 million. As of June 30, 2009, we had cash and cash equivalents of $95.7 million, $704.3 million in borrowings and $50.0 million available under our revolving credit facility.  As of June 30, 2009, we were in compliance with the covenants contained in the credit agreement governing the revolving credit facility and our term loan indebtedness, and the indenture governing our 9-1/8% Senior Subordinated Notes due 2015.

Based on current levels of operations, we believe that our operating cash flows (which were $87.8 million for the year ended December 31, 2008 and $52.1 million for the six months ended June 30, 2009), existing cash reserves and availability for borrowing under our revolving credit facility will provide sufficient funds for our operations, capital expenditures (both discretionary and nondiscretionary) as discussed under “Capital Expenditures”, scheduled debt service payments and our other commitments described in the table under “Obligations and Commitments” at least through the next twelve months.  We believe our long term liquidity needs will be satisfied by these same sources, as well as borrowings as required to refinance indebtedness.  Although our credit agreement, which is described under “Loan Agreements”, contains restrictions on our ability to incur indebtedness, we currently believe that we will be able to refinance existing indebtedness or incur additional indebtedness, if needed.  However, there can be no assurance that we will be able to refinance our indebtedness, incur additional indebtedness or access additional sources of capital, such as by issuing debt or equity securities, on terms that are acceptable to us or at all.

We have not drawn on our revolving credit facility since April 2007, and have since that time relied on our cash flows to provide for operational needs and capital expenditures.  However, there can be no assurance that our operations will continue to provide sufficient cash flow or that refinancing sources will be available in the future, particularly given current economic conditions.  We anticipate that we will be able to utilize our revolving credit facility if needed, as we expect to remain in compliance with the covenants contained in our credit agreement for at least the next twelve months.  However, recent issues involving the stability of financial institutions generally have called into question credit availability, and under the terms of our revolving credit facility, if one lender defaults on a borrowing request, then the other lenders are not required to fund that lender’s share.  While we do not anticipate that any of our lenders will be unable to lend under the revolving credit facility if we determine to borrow funds, no assurance can be given that one or more of our lenders will be able to fulfill their commitments.  We do not depend on cash flows from discontinued operations or sales of assets to provide for future liquidity.

In April 2009, we purchased a leased center in Oklahoma that we operate but did not own.  The purchase price of $3.3 million was funded through available cash.

Cash Flows

During the three months ended June 30, 2009, net cash provided by operating activities decreased by $3.2 million as compared to the same period last year. This decrease was the result of (i) our quarter-over-quarter increase in net income of $0.4 million, (ii) our quarter-over-quarter decrease in working capital changes of $4.6 million, driven by changes in accounts receivable, restricted cash, prepaid expenses and other assets, income taxes payable, accrued compensation and benefits and other accrued liabilities and (iii) a $1.0 million increase in non-cash adjustments to net income, principally related to deferred taxes.

Net cash used for investing activities of $16.4 million for the three months ended June 30, 2009 is comprised of (i) $13.1 million used for capital expenditures and (ii) $3.3 million used to purchase leased real estate.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Net cash used for financing activities of $2.6 million for the three months ended June 30, 2009 is comprised of (i) $2.1 million used to repay long-term debt and capital lease obligations and (ii) $0.5 million used for distributions to non-controlling interests.

Capital Expenditures

We incurred capital expenditures, related primarily to improvements in continuing operations, as reflected in our consolidated statements of cash flows, of $13.1 million and $10.2 million for the three months ended June 30, 2009 and 2008, respectively, and $25.0 million and $16.1 million for the six months ended June 30, 2009 and 2008, respectively.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk because we have issued debt that is sensitive to changes in interest rates. We manage our interest rate risk exposure by maintaining a mix of fixed and variable rates of interest on our debt. The following table provides information regarding our market sensitive financial instruments and constitutes a forward-looking statement.

																							Fair Value		Fair Value
		Expected Maturity Dates																					June 30,		December 31,
		2010			2011				2012			2013			2014			Thereafter			Total		2009 (1)		2008 (1)
							(Dollars in thousands)
Long-term debt:
Fixed rate debt (2)	$	6,230		$	35,829			$	5,054		$	5,179		$	199,435		$	268,087		$	519,814	$	489,828	$	442,992
Rate		8.1	%		9.1	%			7.4	%		7.4	%		6.8	%		8.6	%
Variable rate debt	$	2,030		$	26,398			$	1,610		$	1,610		$	152,133		$	-		$	183,781	$	177,887	$	202,442
Rate		3.3	%		3.6	%			3.3	%		3.3	%		3.3	%		-	%
Interest rate swaps:
Variable to fixed	$	150,000		$	-			$	-		$	-		$	-		$	-				$	7,135	$	7,644
Average pay rate		4.8	%		-				-			-			-			-
Average receive rate		1.1	%		-				-			-			-			-

(1)	The fair value of fixed and variable rate debt was determined based on the current rates offered for debt with similar risks and maturities.
(2)	Excludes fair value premiums of $0.7 million related to acquisitions.

ITEM 4.  CONTROLS AND PROCEDURES

As of the end of the period covered by this report, our management, including our principal executive officer (Richard Matros) and our principal financial officer (L. Bryan Shaul), conducted an evaluation of the effectiveness of our disclosure controls and procedures.  Disclosure controls and procedures are defined as controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits 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, and include, without limitation, controls and procedures designed to ensure that information is accumulated  and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding  required disclosure.  Based on that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of June 30, 2009.  No change in our internal control over financial reporting occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In 2004, we commenced a declaratory relief action in the Orange County, California Superior Court in which two subsidiaries of American International Group (“AIG”) are parties. The action sought, among other things, a determination that the AIG subsidiary that was the carrier providing coverage under our excess/umbrella insurance policy for the 2000 through 2002 policy years is obligated to provide first dollar insurance coverage for those three policy years pursuant to the terms of the excess/umbrella policy.   Trial of this matter commenced in January 2009.  In June 2009, after conclusion of the liability phase of the trial, the judge ruled in favor of AIG and dismissed our claims.  We are currently evaluating whether to appeal.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

(a)  The annual meeting of our stockholders was held on June 10, 2009.

(b)  Gregory S. Anderson, Tony M. Astorga, Christian K. Bement, Michael J. Foster, Barbara B. Kennelly, Steven M. Looney, Richard K. Matros, and Milton J. Walters were each elected to a one-year term on the Board of Directors that will expire at the Annual Meeting of Stockholders in June 2010. The following table sets forth the number of votes cast for, the number of votes cast against and the number of abstentions with respect to each director nominee:

	For	Against	Abstain
Anderson	39,837,345	435,404	5,238
Astorga	39,627,983	644,684	5,320
Bement	35,449,563	4,823,107	5,317
Foster	39,786,843	485,829	5,315
Kennelly	39,554,805	717,870	5,312
Looney	39,093,508	1,179,155	5,324
Matros	39,529,595	743,076	5,315
Walters	39,037,695	1,234,969	5,323

(c)  The 2009 Performance Incentive Plan was approved and the results were as follows:

For	Against	Abstain	Broker Non-Votes
27,300,948	10,923,295	8,926	2,044,818

(d)  The other matter voted on at the meeting was the ratification of the appointment of PricewaterhouseCoopers LLP as our independent public accountants for the fiscal year ending December 31, 2009 and the results were as follows:

For	Against	Abstain
40,264,530	11,579	1,698

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

ITEM 6. EXHIBITS

3.1	Amended and Restated Certificate of Incorporation of Sun Healthcare Group, Inc., as amended (incorporated by reference from exhibits to our Form 10-K filed on March 7, 2008).
3.2	Amended and Restated Bylaws of Sun Healthcare Group, Inc. (incorporated by reference from exhibits to our Form 8-K filed on December 27, 2007).
10.1	Amended and Restated Severance Benefits Agreement dated as of December 17, 2008 by and between Richard L. Peranton and CareerStaff Unlimited, Inc.
10.2	2009 Incentive Bonus Plan for President of CareerStaff Unlimited, Inc.
31.1	Section 302 Sarbanes-Oxley Certification by Chief Executive Officer
31.2	Section 302 Sarbanes-Oxley Certification by Chief Financial Officer
32.1	Section 906 Sarbanes-Oxley Certification by Chief Executive Officer
32.2	Section 906 Sarbanes-Oxley Certification by Chief Financial Officer

SIGNATURE

Pursuant to the requirements 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.

SUN HEALTHCARE GROUP, INC.

By:  /s/ L. Bryan Shaul                                        

L. Bryan Shaul

Executive Vice President and Chief Financial Officer

(Principal Financial and Accounting Officer)

August 6, 2009

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