10-Q

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 September 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  No o

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See 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	Smaller reporting company  o
(Do not check if a smaller reporting company)

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 October 26, 2009, there were 43,749,001 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 September 30, 2009
	As of December 31, 2008
	Consolidated Income Statements (unaudited)	5-6
	For the three months ended September 30, 2009 and 2008
	For the nine months ended September 30, 2009 and 2008
	Consolidated Statements of Cash Flows (unaudited)	7
	For the three months ended September 30, 2009 and 2008
	For the nine months ended September 30, 2009 and 2008
	Notes to Consolidated Financial Statements (unaudited)	8-28
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	29-45
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	46
Item 4.	Controls and Procedures	46
PART II.  OTHER INFORMATION
Item 1.	Legal Proceedings	46
Item 6.	Exhibits	47
Signature		47

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)

		September 30, 2009		December 31, 2008
				(Note 1)
Current assets:
Cash and cash equivalents	$	117,405	$	92,153
Restricted cash		25,855		34,676
Accounts receivable, net of allowance for doubtful accounts
of $51,202 and $44,830 at September 30, 2009 and
December 31, 2008, respectively		210,394		205,620
Prepaid expenses and other assets		23,385		21,456
Assets held for sale		-		3,654
Deferred tax assets		58,995		57,261
Total current assets		436,034		414,820
Property and equipment, net		615,825		603,645
Intangible assets, net		49,299		54,388
Goodwill		327,020		326,808
Restricted cash, non-current		3,313		3,303
Deferred tax assets		115,054		134,807
Other assets		5,042		5,563
Total assets	$	1,551,587	$	1,543,334

See accompanying notes.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited) (CONTINUED)

LIABILITIES AND STOCKHOLDERS’ EQUITY

(in thousands, except share data)

		September 30, 2009			December 31, 2008
					(Note 1)
Current liabilities:
Accounts payable	$	48,005		$	62,000
Accrued compensation and benefits		65,592			60,660
Accrued self-insurance obligations, current		46,847			45,293
Other accrued liabilities		65,141			56,857
Current portion of long-term debt and capital lease obligations		27,781			17,865
Total current liabilities		253,366			242,675
Accrued self-insurance obligations, net of current portion		114,258			114,557
Long-term debt and capital lease obligations, net of current portion		674,795			707,976
Unfavorable lease obligations, net		13,377			15,514
Other long-term liabilities		57,651			58,903
Total liabilities		1,113,447			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
September 30, 2009 and December 31, 2008		-			-
Common stock of $.01 par value, authorized 125,000,000
shares; 43,738,565 and 43,544,765 shares issued and
outstanding as of September 30, 2009 and December 31, 2008,
respectively		437			435
Additional paid-in capital		654,280			650,543
Accumulated deficit		(212,686	)		(242,683	)
Accumulated other comprehensive loss, net		(3,891	)		(4,586	)
Total stockholders’ equity		438,140			403,709
Total liabilities and stockholders’ equity	$	1,551,587		$	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
		September 30, 2009			September 30, 2008
Total net revenues	$	470,893		$	455,757
Costs and expenses:
Operating salaries and benefits		265,929			259,349
Self-insurance for workers’ compensation and general and
professional liability insurance		14,165			14,527
Operating administrative expenses		12,462			12,792
Other operating costs		97,067			94,599
Center rent expense		18,194			18,409
General and administrative expenses		15,586			13,832
Depreciation and amortization		11,460			10,165
Provision for losses on accounts receivable		5,318			3,307
Interest, net of interest income of $106 and $340, respectively		12,231			13,070
Restructuring costs		872			-
Total costs and expenses		453,284			440,050
Income before income taxes and discontinued operations		17,609			15,707
Income tax expense		7,220			6,286
Income from continuing operations		10,389			9,421
Discontinued operations:
Loss from discontinued operations, net of related taxes		(712	)		(163	)
Loss on disposal of discontinued operations, net of
related taxes		(19	)		(654	)
Loss from discontinued operations, net		(731	)		(817	)
Net income	$	9,658		$	8,604
Basic earnings per common and common equivalent share:
Income from continuing operations	$	0.24		$	0.22
Loss from discontinued operations, net		(0.02	)		(0.02	)
Net income	$	0.22		$	0.20
Diluted earnings per common and common equivalent share:
Income from continuing operations	$	0.24		$	0.21
Loss from discontinued operations, net		(0.02	)		(0.02	)
Net income	$	0.22		$	0.19
Weighted average number of common and common
equivalent shares outstanding:
Basic		43,923			43,468
Diluted		44,015			44,478

See accompanying notes.

5

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED INCOME STATEMENTS (unaudited)

(in thousands, except per share data)

		For the
		Nine Months Ended
		September 30, 2009			September 30, 2008
Total net revenues	$	1,407,735		$	1,356,706
Costs and expenses:
Operating salaries and benefits		790,804			766,223
Self-insurance for workers’ compensation and general and
professional liability insurance		45,626			40,985
Operating administrative expenses		38,231			37,671
Other operating costs		287,376			279,644
Center rent expense		54,773			55,325
General and administrative expenses		48,057			46,529
Depreciation and amortization		33,336			29,553
Provision for losses on accounts receivable		15,599			9,491
Interest, net of interest income of $310 and $1,454, respectively		37,422			41,144
Loss (gain) on sale of assets		42			(77	)
Restructuring costs		872			-
Total costs and expenses		1,352,138			1,306,488
Income before income taxes and discontinued operations		55,597			50,218
Income tax expense		22,795			20,119
Income from continuing operations		32,802			30,099
Discontinued operations:
Loss from discontinued operations, net of related taxes		(2,472	)		(710	)
Loss on disposal of discontinued operations, net of
related taxes		(334	)		(2,523	)
Loss from discontinued operations, net		(2,806	)		(3,233	)
Net income	$	29,996		$	26,866
Basic earnings per common and common equivalent share:
Income from continuing operations	$	0.75		$	0.70
Loss from discontinued operations, net		(0.07	)		(0.08	)
Net income	$	0.68		$	0.62
Diluted earnings per common and common equivalent share:
Income from continuing operations	$	0.75		$	0.68
Loss from discontinued operations, net		(0.07	)		(0.07	)
Net income	$	0.68		$	0.61
Weighted average number of common and common
equivalent shares outstanding:
Basic		43,807			43,240
Diluted		43,926			44,086

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						Nine Months Ended
		September 30, 2009			September 30, 2008			September 30, 2009			September 30, 2008
		(Unaudited)						(Unaudited)
Cash flows from operating activities:
Net income	$	9,658		$	8,604		$	29,996		$	26,866
Adjustments to reconcile net income to net cash provided by
operating activities, including discontinued operations:
Depreciation and amortization		11,460			10,202			33,336			29,802
Amortization of favorable and unfavorable lease      intangibles		(474	)		(452	)		(1,350	)		(1,443	)
Provision for losses on accounts receivable		5,318			3,460			15,599			9,971
Loss on sale of assets, including discontinued
operations, net		31			539			607			2,255
Impairment charge for discontinued operation		-			-			-			1,800
Stock-based compensation expense		1,476			1,405			4,385			3,738
Deferred taxes		5,500			5,276			18,019			13,547
Other		-			(68	)		-			11
Changes in operating assets and liabilities, net of acquisitions:
Accounts receivable		1,079			1,751			(20,588	)		(17,801	)
Restricted cash		(710	)		1,379			8,811			4,442
Prepaid expenses and other assets		382			(379	)		144			(5,700	)
Accounts payable		(6,762	)		(3,983	)		(11,825	)		(7,113	)
Accrued compensation and benefits		4,561			2,522			4,927			(1,129	)
Accrued self-insurance obligations		4			(3,171	)		1,255			(3,406	)
Income taxes payable		-			(615	)		-			976
Other accrued liabilities		9,355			4,296			8,530			679
Other long-term liabilities		(1,004	)		(1,404	)		177			4,648
Net cash provided by operating activities		39,874			29,362			92,023			62,143
Cash flows from investing activities:
Capital expenditures		(16,456	)		(12,393	)		(41,458	)		(28,532	)
Purchase of leased real estate		-			(8,229	)		(3,275	)		(8,956	)
Proceeds from sale of assets held for sale		-			9,840			2,174			13,797
Acquisitions, net of cash acquired		-			(7,060	)		-			(7,373	)
Insurance proceeds received		-			553			-			628
Net cash used for investing activities		(16,456	)		(17,289	)		(42,559	)		(30,436	)
Cash flows from financing activities:
Borrowings of long-term debt		20,822			-			20,822			20,290
Principal repayments of long-term debt and capital lease
obligations		(22,562	)		(2,221	)		(44,249	)		(27,420	)
Payment to non-controlling interest		-			-			(311	)		(2,035	)
Distribution to non-controlling interest		-			(130	)		(549	)		(353	)
Proceeds from issuance of common stock		55			2,342			75			2,412
Net cash used for financing activities		(1,685	)		(9	)		(24,212	)		(7,106	)
Net increase in cash and cash equivalents		21,733			12,064			25,252			24,601
Cash and cash equivalents at beginning of period		95,672			68,369			92,153			55,832
Cash and cash equivalents at end of period	$	117,405		$	80,433		$	117,405		$	80,433

See accompanying notes.

7

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(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 206 healthcare centers in 25 states as of September 30, 2009.

Restructuring Costs

As we continue to focus on reducing costs and maximizing occupancy, we have evaluated and will continue to evaluate certain restructuring activities in our operations and administrative functions.  During the three and nine months ended September 30, 2009, we incurred $0.9 million of restructuring costs.  The costs consisted primarily of severance benefits resulting from reductions of administrative staff.

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 (“GAAP”) for interim financial statements.  In our opinion, the accompanying interim consolidated financial statements are a fair statement of our financial position at September 30, 2009, and our consolidated results of operations and cash flows for the three-month and nine-month periods ended September 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, as amended by a Form 10-K/A (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 revised guidance for accounting for noncontrolling interests.  The guidance 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.  The guidance was effective beginning January 1, 2009, and 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 rules that expanded quarterly disclosure requirements about an entity’s derivative instruments and hedging activities. The expanded disclosures were required 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 2009, the FASB issued guidance requiring disclosures of fair value be included in the summarized, interim financial statements.  This pronouncement was effective for our reporting periods beginning with our June 30, 2009 interim financial statements.  All required disclosures have been included in our September 30, 2009 interim financial statements.

In May 2009, the FASB issued 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.  Companies are required to evaluate events or transactions taking place after the balance sheet date for recognition in the financial statements prior to issuance.  Additionally, we are required to disclose the date through which we have 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.  These requirements became effective for our interim and annual reporting periods on April 1, 2009 and their adoption did not have a material impact on our financial position, cash flows or results of operations.  For the purposes of this reporting period, we have evaluated the subsequent events occurring through October 28, 2009, which we consider to be the date that the financial statements were “issued”.

In June 2009, the FASB established the FASB Accounting Standards CodificationTM (“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.  Recognition of the Codification in financial statements is effective for interim and annual periods ending after September 15, 2009.  The impact in our financial statements was only to 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 two divested centers (see Note 4 – “Discontinued Operations”) for all periods presented to discontinued operations within the income statement, in accordance with GAAP.  As discussed in “Recent Accounting Pronouncements” above, the adoption of the new guidance for accounting for noncontrolling interests did not have a material impact on our financial position, cash flows or results of operations.  We have, however, reclassified $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 on our consolidated balance sheet in this Form 10-Q to conform to the 2009 financial statement presentation.

9

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):

		September 30, 2009			December 31, 2008
Revolving credit facility	$	-		$	-
Mortgage notes payable due at various dates through 2047, interest at
rates from 3.4% to 11.6%, collateralized by the carrying values of
various centers totaling approximately $200,000 (1)		171,700			178,142
Term loan agreement		329,946			346,359
Senior subordinated notes		200,000			200,000
Capital leases		930			1,340
Total long-term obligations		702,576			725,841
Less amounts due within one year		(27,781	)		(17,865	)
Long-term obligations, net of current portion	$	674,795		$	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 September 30, 2009, were as follows (in thousands):

For the twelve months ending September 30:
2010	$	27,781
2011		42,130
2012		6,600
2013		6,715
2014		350,151
Thereafter		268,517
	$	701,894

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 GAAP.  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 and have been designated as cash flow hedges.  Hedge effectiveness testing for the three and nine months ended September 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
	September 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	$	6,485	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 September 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 (ineffective portion)
		2009		2008		2009		2008
Derivatives designated as cash
flow hedges:
Interest rate swap agreements	$	390	$	190	$	-	$	-

The effect of the interest rate swap agreements on our consolidated comprehensive income, net of related taxes, for the nine months ended September 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 (ineffective portion)
		2009		2008		2009		2008
Derivatives designated as cash
flow hedges:
Interest rate swap agreements	$	695	$	331	$	-	$	-

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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):

		September 30, 2009				December 31, 2008
		Carrying				Carrying
		Amount		Fair Value		Amount		Fair Value
Cash and cash equivalents	$	117,405	$	117,405	$	92,153	$	92,153
Restricted cash	$	29,168	$	29,168	$	37,979	$	37,979
Long-term debt and capital lease obligations,
including current portion	$	702,576	$	673,057	$	725,841	$	645,434
Interest rate swap agreements	$	6,485	$	6,485	$	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 September 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.

The FASB Codification 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.

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 pricing levels as of September 30, 2009 and December 31, 2008, respectively (in thousands):

		September 30, 2009
				Unadjusted Quoted		Significant Other
				Market Prices		Observable Inputs
		Total		(Level 1)		(Level 2)
Cash equivalents – money market
funds/certificate of deposit	$	48,066	$	43,016	$	5,050
Restricted cash – money market funds	$	1,274	$	1,274	$	-
Interest rate swap agreements – liability	$	6,485	$	-	$	6,485

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

		December 31, 2008
				Unadjusted Quoted		Significant Other
				Market Prices		Observable Inputs
		Total		(Level 1)		(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

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.

In October 2009, we transferred operations of a leased assisted living center in Utah to an outside party, which was reclassified to discontinued operations for the three and nine months ended September 30, 2009 and 2008.

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.

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

		For the Three Months Ended
		September 30, 2009
		Inpatient
		Services			Other		Total
Net operating revenues	$	132		$	-	$	132
Loss from discontinued operations, net (1)	$	(712	)	$	-	$	(712	)
Loss on disposal of discontinued operations, net (2)		(19	)		-		(19	)
Loss from discontinued operations, net	$	(731	)	$	-	$	(731	)

(1)  Net of related tax benefit of $495

(2)  Net of related tax benefit of $13

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

		For the Three Months Ended
		September 30, 2008
		Inpatient
		Services			Other		Total
Net operating revenues	$	3,691		$	4,525	$	8,216
(Loss) income from discontinued operations, net (1)	$	(188	)	$	25	$	(163	)
Loss on disposal of discontinued operations, net (2)		(654	)		-		(654	)
(Loss) income from discontinued operations, net	$	(842	)	$	25	$	(817	)

(1)  Net of related tax benefit of $114

(2)  Net of related tax benefit of $436

		For the Nine Months Ended
		September 30, 2009
		Inpatient
		Services			Other			Total
Net operating revenues	$	523		$	-		$	523
Loss from discontinued operations, net (1)	$	(2,454	)	$	(18	)	$	(2,472	)
Loss on disposal of discontinued operations, net (2)		(318	)		(16	)		(334	)
Loss from discontinued operations, net	$	(2,772	)	$	(34	)	$	(2,806	)

(1)  Net of related tax benefit of $1,718
(2)  Net of related tax benefit of $232
		For the Nine Months Ended
		September 30, 2008
		Inpatient
		Services			Other			Total
Net operating revenues	$	41,570		$	14,115		$	55,685
Loss from discontinued operations, net (1)	$	(571	)	$	(139	)	$	(710	)
Loss on disposal of discontinued operations, net (2)		(2,477	)		(46	)		(2,523	)
Loss from discontinued operations, net	$	(3,048	)	$	(185	)	$	(3,233	)

               (1)  Net of related tax benefit of $503

               (2)  Net of related tax benefit of $1,631

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(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.

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.

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

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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			6,462			12,502
Current year provision, discontinued operations		331			168			499
Prior year reserve adjustments, continuing operations		4,300			-			4,300
Prior year reserve adjustments, discontinued operations		590			-			590
Claims paid, continuing operations		(6,858	)		(5,535	)		(12,393	)
Claims paid, discontinued operations		(1,487	)		(542	)		(2,029	)
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
Current year provision, continuing operations		6,937			7,228			14,165
Current year provision, discontinued operations		434			158			592
Claims paid, continuing operations		(5,278	)		(4,511	)		(9,789	)
Claims paid, discontinued operations		(621	)		(474	)		(1,095	)
Amounts paid for administrative services and other		(1,562	)		(1,853	)		(3,415	)
Balance as of September 30, 2009	$	90,007		$	65,554		$	155,561
Balance as of January 1, 2008	$	86,291		$	61,439		$	147,730
Current year provision, continuing operations		8,321			6,452			14,773
Current year provision, discontinued operations		465			274			739
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	)		(2,026	)		(3,078	)
Balance as of March 31, 2008		88,651			60,774			149,425
Current year provision, continuing operations		6,576			7,759			14,335
Current year provision, discontinued operations		128			487			615
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
Current year provision, continuing operations		6,957			7,570			14,527
Current year provision, discontinued operations		143			78			221
Claims paid, continuing operations		(5,537	)		(5,517	)		(11,054	)
Claims paid, discontinued operations		(1,544	)		(1,056	)		(2,600	)
Amounts paid for administrative services and other		(1,164	)		(2,086	)		(3,250	)
Balance as of September 30, 2008	$	81,980		$	63,763		$	145,743

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

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

		September 30, 2009							December 31, 2008
		Professional		Workers’			|		Professional		Workers’
		Liability		Compensation		Total	|		Liability		Compensation		Total
Assets (1):							|
Restricted cash							|
Current	$	5,880	$	10,438	$	16,318	|	$	3,439	$	22,131	$	25,570
Non-current		-		-		-	|		-		-		-
Total	$	5,880	$	10,438	$	16,318	|	$	3,439	$	22,131	$	25,570
							|
Liabilities (2)(3):							|
Self-insurance							|
liabilities							|
Current	$	21,101	$	20,202	$	41,303	|	$	20,739	$	18,574	$	39,313
Non-current		68,906		45,352		114,258	|		66,543		48,014		114,557
Total	$	90,007	$	65,554	$	155,561	|	$	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 $12,850 and $12,409 at September 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 exclude $5,544 and $5,980 at September 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 $363 and $56,355 for general and professional liability insurance and workers’ compensation, respectively, as of September 30, 2009 and $750 and $48,172 for general and professional liability insurance and workers’ compensation, respectively, as of December 31, 2008.

(6)  Income Taxes

The provision for income taxes of $7.2 million and $22.8 million for the three and nine months, respectively, ended September 30, 2009 is based on a combined federal and state income tax rate of approximately 41%.  The provision for income taxes of $6.3 million and $20.1 million for the three and nine months, respectively, ended September 30, 2008 was based on a combined income tax rate of approximately 40%.

During the second quarter of 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 $25.1 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 $147.5 million of NOLs which

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

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 $298.7 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.  We have cooperated with the DOJ since we became aware of the lawsuit and have consistently denied the allegations in the lawsuit, which relate to Medicare billings for durable medical equipment.  In October 2009, we agreed to settle this lawsuit to avoid the protracted costs of litigation.  The settlement agreement provides that the settlement is not an admission of liability by us or the defendants, releases Harborside and its subsidiary from all liability arising from allegations in the lawsuit, and requires the defendants to pay $1.4 million.  We have fully accrued these amounts at September 30, 2009.

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.  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.  More complete

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

descriptions and accounting policies of the segments are described in Note 14 – “Segment Information” and  Note 2 – “Summary of Significant Accounting Policies” of our 2008 Form 10-K.

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
September 30, 2009
				Rehabilitation		Medical
		Inpatient		Therapy		Staffing					Intersegment
		Services		Services		Services		Corporate			Eliminations			Consolidated
Revenues from external customers	$	420,623	$	26,394	$	23,864	$	12		$	-		$	470,893
Intersegment revenues		-		18,592		545		-			(19,137	)		-
Total revenues	$	420,623	$	44,986	$	24,409	$	12		$	(19,137	)	$	470,893
Net segment income (loss)	$	39,330	$	2,606	$	2,091	$	(25,546	)	$	-		$	18,481
Identifiable segment assets	$	1,163,806	$	15,499	$	24,793	$	880,219		$	(528,443	)	$	1,555,874
Goodwill	$	322,412	$	75	$	4,533	$	-		$	-		$	327,020
Segment capital expenditures	$	15,384	$	167	$	8	$	897		$	-		$	16,456

As of and for the
Three Months Ended
September 30, 2008
				Rehabilitation		Medical
		Inpatient		Therapy		Staffing					Intersegment
		Services		Services		Services		Corporate			Eliminations			Consolidated
Revenues from external customers	$	403,736	$	22,756	$	29,256	$	9		$	-		$	455,757
Intersegment revenues		-		15,562		827		-			(16,389	)		-
Total revenues	$	403,736	$	38,318	$	30,083	$	9		$	(16,389	)	$	455,757
Net segment income (loss)	$	35,821	$	1,793	$	2,479	$	(24,386	)	$	-		$	15,707
Identifiable segment assets	$	1,130,615	$	12,952	$	29,237	$	748,739		$	(528,457	)	$	1,393,086
Goodwill	$	326,579	$	-	$	4,533	$	-		$	-		$	331,112
Segment capital expenditures	$	11,875	$	72	$	51	$	381		$	-		$	12,379

_____________________________________

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

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

As of and for the
Nine Months Ended
September 30, 2009
				Rehabilitation		Medical
		Inpatient		Therapy		Staffing					Intersegment
		Services		Services		Services		Corporate			Eliminations			Consolidated
Revenues from external customers	$	1,252,310	$	78,063	$	77,335	$	27		$	-		$	1,407,735
Intersegment revenues		-		55,168		1,668		-			(56,836	)		-
Total revenues	$	1,252,310	$	133,231	$	79,003	$	27		$	(56,836	)	$	1,407,735
Net segment income (loss)	$	119,934	$	8,606	$	6,401	$	(78,430	)	$	-		$	56,511
Identifiable segment assets	$	1,163,806	$	15,499	$	24,793	$	880,219		$	(528,443	)	$	1,555,874
Goodwill	$	322,412	$	75	$	4,533	$	-		$	-		$	327,020
Segment capital expenditures	$	38,957	$	425	$	59	$	2,017		$	-		$	41,458

As of and for the
Nine Months Ended
September 30, 2008
				Rehabilitation		Medical
		Inpatient		Therapy		Staffing					Intersegment
		Services		Services		Services		Corporate			Eliminations			Consolidated
Revenues from external customers	$	1,202,050	$	65,607	$	89,020	$	29		$	-		$	1,356,706
Intersegment revenues		-		44,314		2,155		-			(46,469	)		-
Total revenues	$	1,202,050	$	109,921	$	91,175	$	29		$	(46,469	)	$	1,356,706
Net segment income (loss)	$	116,991	$	6,483	$	6,866	$	(80,199	)	$	-		$	50,141
Identifiable segment assets	$	1,130,615	$	12,952	$	29,237	$	748,739		$	(528,457	)	$	1,393,086
Goodwill	$	326,579	$	-	$	4,533	$	-		$	-		$	331,112
Segment capital expenditures	$	26,323	$	171	$	161	$	1,756		$	-		$	28,411

______________________________________

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

20

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
		September 30,
		2009			2008
Net segment income	$	18,481		$	15,707
Restructuring costs		(872	)		-
Income before income taxes and
discontinued operations	$	17,609		$	15,707

		For the Nine Months Ended
		September 30,
		2009			2008
Net segment income	$	56,511		$	50,141
(Loss) gain on sale of assets		(42	)		77
Restructuring costs		(872	)		-
Income before income taxes and
discontinued operations	$	55,597		$	50,218

(9) Subsequent Event

On October 1, 2009 we acquired all the capital stock of Allegiance Hospice Group, Inc., a privately-held, Medicare-certified hospice company that provides services to patients in Maine, Massachusetts and New Hampshire, for $15.5 million in cash, excluding transaction costs.  The purchase price excludes $0.5 million of transaction costs, primarily investment banker success fees, that we will expense during the fourth quarter of 2009 in accordance with GAAP. 

(10) 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.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

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:

CONDENSED CONSOLIDATING BALANCE SHEETS

As of September 30, 2009

(in thousands)

					Combined		Combined
		Parent			Guarantor		Non-Guarantor
		Company			Subsidiaries		Subsidiaries		Elimination			Consolidated
Current assets:
Cash and cash equivalents	$	98,323		$	17,484	$	1,598	$	-		$	117,405
Restricted cash		16,318			5,399		4,138		-			25,855
Accounts receivable, net		-			207,784		2,625		(15	)		210,394
Prepaid expenses and other assets		9,653			14,703		615		(1,586	)		23,385
Deferred tax assets		-			67,359		1,205		(9,569	)		58,995
Total current assets		124,294			312,729		10,181		(11,170	)		436,034
Property and equipment, net		8,844			539,798		67,183		-			615,825
Intangible assets, net		33,827			11,089		1,887		2,496			49,299
Goodwill		-			323,062		3,958		-			327,020
Restricted cash, non-current		2,969			344		-		-			3,313
Deferred tax assets		15,112			111,910		-		(11,968	)		115,054
Other assets		281			4,828		2		(69	)		5,042
Intercompany balances		299,012			-		10,040		(309,052	)		-
Investment in subsidiaries		616,244			-		-		(616,244	)		-
Total assets	$	1,100,583		$	1,303,760	$	93,251	$	(946,007	)	$	1,551,587
Current liabilities:
Accounts payable	$	14,470		$	33,013	$	537	$	(15	)	$	48,005
Accrued compensation and benefits		6,890			57,606		1,096		-			65,592
Accrued self-insurance obligations, current		4,138			42,709		-		-			46,847
Other accrued liabilities		20,899			40,837		3,405		-			65,141
Deferred tax liability		9,569			-		-		(9,569	)		-
Current portion of long-term debt and capital lease
obligations		3,358			18,805		5,618		-			27,781
Total current liabilities		59,324			192,970		10,656		(9,584	)		253,366
Accrued self-insurance obligations, net of current		44,960			68,869		429		-			114,258
Deferred tax liability		-			-		12,389		(12,389	)		-
Long-term debt and capital lease obligations, net of current portion		527,124			88,575		59,096		-			674,795
Unfavorable lease obligations, net		-			15,873		-		(2,496	)		13,377
Other long-term liabilities		31,035			23,401		3,215		-			57,651
Intercompany balances		-			305,294		-		(305,294	)		-
Total liabilities		662,443			694,982		85,785		(329,763	)		1,113,447
Stockholders’ equity:
Common stock		437			-		-		-			437
Additional paid-in capital		654,280			-		-		-			654,280
Accumulated deficit		(212,686	)		608,778		7,466		(616,244	)		(212,686	)
Accumulated other comprehensive loss, net		(3,891	)		-		-		-			(3,891	)
Total stockholders' equity		438,140			608,778		7,466		(616,244	)		438,140
Total liabilities and stockholders' equity	$	1,100,583		$	1,303,760	$	93,251	$	(946,007	)	$	1,551,587

22

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

23

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Three Months Ended September 30, 2009

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries			Elimination			Consolidated
Total net revenues	$	12		$	482,059		$	7,959		$	(19,137	)	$	470,893
Costs and expenses:
Operating salaries and benefits		-			261,722			4,207			-			265,929
Self-insurance for workers’ compensation and
general and professional liability insurance		108			13,898			159			-			14,165
General and administrative expenses (1)		16,034			12,014			-			-			28,048
Other operating costs		-			114,387			1,817			(19,137	)		97,067
Center rent expense		-			18,009			185			-			18,194
Depreciation and amortization		658			10,216			586			-			11,460
Provision for losses on accounts receivable		-			5,249			69			-			5,318
Interest, net		9,076			2,032			1,123			-			12,231
Restructuring costs		-			872			-			-			872
Income from investment in subsidiaries		(24,918	)		-			-			24,918			-
Total costs and expenses		958			438,399			8,146			5,781			453,284
(Loss) income before income taxes and
discontinued operations		(946	)		43,660			(187	)		(24,918	)		17,609
Income tax (benefit) expense		(10,604	)		17,901			(77	)		-			7,220
Income (loss) from continuing operations		9,658			25,759			(110	)		(24,918	)		10,389
Discontinued operations:
Loss from discontinued operations, net		-			(374	)		(338	)		-			(712	)
(Loss) gain on disposal of discontinued
operations, net		-			(32	)		13			-			(19	)
Loss on discontinued operations, net		-			(406	)		(325	)		-			(731	)
Net income (loss)	$	9,658		$	25,353		$	(435	)	$	(24,918	)	$	9,658

 (1) Includes operating administrative expenses

24

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Three Months Ended September 30, 2008

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries		Elimination			Consolidated
Total net revenues	$	9		$	464,657		$	7,480	$	(16,389	)	$	455,757
Costs and expenses:
Operating salaries and benefits		-			256,003			3,346		-			259,349
Self-insurance for workers’ compensation and
general and professional liability insurance		208			14,146			173		-			14,527
General and administrative expenses (1)		13,832			12,792			-		-			26,624
Other operating costs		2			109,437			1,549		(16,389	)		94,599
Center rent expense		-			18,234			175		-			18,409
Depreciation and amortization		831			8,769			565		-			10,165
Provision for losses on accounts receivable		-			3,147			160		-			3,307
Interest, net		9,527			2,315			1,228		-			13,070
Gain on sale of assets		-			-			-		-			-
Income from investment in subsidiaries		(23,238	)		-			-		23,238			-
Total costs and expenses		1,162			424,843			7,196		6,849			440,050
(Loss) income before income taxes and
discontinued operations		(1,153	)		39,814			284		(23,238	)		15,707
Income tax (benefit) expense		(9,757	)		15,929			114		-			6,286
Income from continuing operations		8,604			23,885			170		(23,238	)		9,421
Discontinued operations:
(Loss) income from discontinued operations, net		-			(265	)		102		-			(163	)
(Loss) gain on disposal of discontinued
operations, net		-			(1,085	)		431		-			(654	)
(Loss) income on discontinued operations, net		-			(1,350	)		533		-			(817	)
Net income	$	8,604		$	22,535		$	703	$	(23,238	)	$	8,604

(1)   Includes operating administrative expenses

25

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Nine Months Ended September 30, 2009

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries			Elimination			Consolidated
Total net revenues	$	27		$	1,442,120		$	22,424		$	(56,836	)	$	1,407,735
Costs and expenses:
Operating salaries and benefits		-			778,491			12,313			-			790,804
Self-insurance for workers’ compensation and
general and professional liability insurance		315			44,833			478			-			45,626
General and administrative expenses (1)		49,462			36,826			-			-			86,288
Other operating costs		-			338,798			5,414			(56,836	)		287,376
Center rent expense		-			54,218			555			-			54,773
Depreciation and amortization		2,006			29,585			1,745			-			33,336
Provision for losses on accounts receivable		-			15,280			319			-			15,599
Interest, net		27,673			6,388			3,361			-			37,422
Loss on sale of assets, net		-			49			(7	)		-			42
Restructuring costs		-			872			-			-			872
Income from investment in subsidiaries		(76,859	)		-			-			76,859			-
Total costs and expenses		2,597			1,305,340			24,178			20,023			1,352,138
(Loss) income before income taxes and
discontinued operations		(2,570	)		136,780			(1,754	)		(76,859	)		55,597
Income tax (benefit) expense		(32,566	)		56,080			(719	)		-			22,795
Income (loss) from continuing operations		29,996			80,700			(1,035	)		(76,859	)		32,802
Discontinued operations:
Loss from discontinued operations, net		-			(1,332	)		(1,140	)		-			(2,472	)
(Loss) gain on disposal of discontinued
operations, net		-			(566	)		232			-			(334	)
Loss on discontinued operations, net		-			(1,898	)		(908	)		-			(2,806	)
Net income (loss)	$	29,996		$	78,802		$	(1,943	)	$	(76,859	)	$	29,996

 (1) Includes operating administrative expenses

26

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING INCOME STATEMENTS

For the Nine Months Ended September 30, 2008

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries		Elimination			Consolidated
Total net revenues	$	29		$	1,381,667		$	21,479	$	(46,469	)	$	1,356,706
Costs and expenses:
Operating salaries and benefits		-			756,906			9,317		-			766,223
Self-insurance for workers’ compensation and
general and professional liability insurance		437			40,054			494		-			40,985
General and administrative expenses (1)		46,006			38,194			-		-			84,200
Other operating costs		2			321,579			4,532		(46,469	)		279,644
Center rent expense		-			54,821			504		-			55,325
Depreciation and amortization		2,235			25,630			1,688		-			29,553
Provision for losses on accounts receivable		-			9,167			324		-			9,491
Interest, net		31,029			6,576			3,539		-			41,144
Gain on sale of assets		(77	)					-		-			(77	)
Income from investment in subsidiaries		(74,628	)		-			-		74,628			-
Total costs and expenses		5,004			1,252,927			20,398		28,159			1,306,488
(Loss) income before income taxes and
discontinued operations		(4,975	)		128,740			1,081		(74,628	)		50,218
Income tax (benefit) expense		(31,842	)		51,529			432		-			20,119
Income from continuing operations		26,867			77,211			649		(74,628	)		30,099
Discontinued operations:
(Loss) income from discontinued operations, net		(1	)		(1,823	)		1,114		-			(710	)
(Loss) gain on disposal of discontinued
operations, net		-			(4,100	)		1,577		-			(2,523	)
(Loss) income on discontinued operations, net		(1	)		(5,923	)		2,691		-			(3,233	)
Net income	$	26,866		$	71,288		$	3,340	$	(74,628	)	$	26,866

(1)   Includes operating administrative expenses

27

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

For the Nine Months Ended September 30, 2009

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries			Elimination		Consolidated
Net cash provided by operating activities	$	44,227		$	42,223		$	5,573		$	-	$	92,023
Cash flows from investing activities:
Capital expenditures		(2,014	)		(39,102	)		(342	)		-		(41,458	)
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		(2,014	)		(40,203	)		(342	)		-		(42,559	)
Cash flows from financing activities:
Borrowings of long-term debt		-			20,822			-			-		20,822
Principal repayments of long-term debt and capital
lease obligations		(16,494	)		(23,310	)		(4,445	)		-		(44,249	)
Payment to non-controlling interest		-			-			(311	)		-		(311	)
Distribution to non-controlling interest		-			-			(549	)		-		(549	)
Proceeds from issuance of common stock		75			-			-			-		75
Net cash used for financing activities		(16,419	)		(2,488	)		(5,305	)		-		(24,212	)
Net increase (decrease) in cash and cash equivalents		25,794			(468	)		(74	)		-		25,252
Cash and cash equivalents at beginning of period		72,529			17,952			1,672			-		92,153
Cash and cash equivalents at end of period	$	98,323		$	17,484		$	1,598		$	-	$	117,405

For the Nine Months Ended September 30, 2008

(in thousands)

					Combined			Combined
		Parent			Guarantor			Non-Guarantor
		Company			Subsidiaries			Subsidiaries			Elimination		Consolidated
Net cash provided by operating activities	$	16,317		$	42,166		$	3,660		$	-	$	62,143
Cash flows from investing activities:
Capital expenditures		(1,755	)		(26,624	)		(153	)		-		(28,532	)
Purchase of lease real estate		-			(8,956	)		-			-		(8,956	)
Proceeds from sale of assets held for sale		13,617			180			-			-		13,797
Acquisitions		-			(7,373	)		-			-		(7,373	)
Insurance proceeds received		628			-			-			-		628
Net cash provided by (used for) investing              activities		12,490			(42,773	)		(153	)		-		(30,436	)
Cash flows from financing activities:
Borrowings of long-term debt		-			20,290			-			-		20,290
Principal repayments of long-term debt and capital lease obligations		(2,911	)		(23,656	)		(853	)		-		(27,420	)
Payment to non-controlling interest		-			-			(2,035	)		-		(2,035	)
Distribution to non-controlling interest		-			-			(353	)		-		(353	)
Proceeds from issuance of common stock		2,412			-			-			-		2,412
Net cash used for financing activities		(499	)		(3,366	)		(3,241	)		-		(7,106	)
Net increase (decrease) in cash and cash equivalents		28,308			(3,973	)		266			-		24,601
Cash and cash equivalents at beginning of period		30,221			23,547			2,064			-		55,832
Cash and cash equivalents at end of period	$	58,529		$	19,574		$	2,330		$	-	$	80,433

28

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, 14 assisted and independent living centers and eight mental health centers with 23,289 licensed beds located in 25 states as of September 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								Nine Months Ended
Sources of Revenues		September 30, 2009				September 30, 2008				September 30, 2009				September 30, 2008
Consolidated:
Medicaid	$	189,878	40.3	%	$	184,453	40.5	%	$	559,358	39.8	%	$	542,536	40.0	%
Medicare		138,105	29.3			127,942	28.1			417,844	29.7			386,250	28.5
Private pay and other		118,517	25.2			121,213	26.6			353,942	25.1			360,028	26.5
Managed care and
commercial insurance		24,393	5.2			22,149	4.8			76,591	5.4			67,892	5.0
Total	$	470,893	100.0	%	$	455,757	100.0	%	$	1,407,735	100.0	%	$	1,356,706	100.0	%
Inpatient Only:
Medicaid	$	189,856	45.1	%	$	184,398	45.7	%	$	559,256	44.7	%	$	542,419	45.1	%
Medicare		134,148	31.9			124,763	30.9			405,778	32.4			377,548	31.4
Private pay and other		72,395	17.2			72,554	18.0			211,163	16.9			214,618	17.9
Managed care and
commercial insurance		24,224	5.8			22,021	5.4			76,113	6.0			67,465	5.6
Total	$	420,623	100.0	%	$	403,736	100.0	%	$	1,252,310	100.0	%	$	1,202,050	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.

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 commenced 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 our current acuity mix, will be a decrease of 0.85% in our reimbursement rates, which we estimate will decrease our net revenues by approximately $1.0 million per quarter.

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 will be an increase of 1.52% in our reimbursement rates, which we estimate will result in increased revenues of approximately $0.1 million per quarter.

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.

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				Nine Months Ended
	September 30, 2009		September 30, 2008		September 30, 2009		September 30, 2008
$	457.79	$	423.38	$	454.15	$	417.23

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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.

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.

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				Nine Months Ended
	September 30, 2009		September 30, 2008		September 30, 2009		September 30, 2008
$	172.06	$	167.12	$	170.86	$	165.88

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				Nine Months Ended
	September 30, 2009		September 30, 2008		September 30, 2009		September 30, 2008
$	159.38	$	157.35	$	159.37	$	156.04

Managed Care and Insurance

During the three months ended September 30, 2009, we received 5.2% 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 managed care option for Medicare beneficiaries.  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				Nine Months Ended
	September 30, 2009		September 30, 2008		September 30, 2009		September 30, 2008
$	371.09	$	352.17	$	373.86	$	347.90

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Private Payors, Veterans and Other

During the three months ended September 30, 2009, we received 25.2% 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.

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				Nine Months Ended
	September 30, 2009		September 30, 2008		September 30, 2009		September 30, 2008
$	178.09	$	172.95	$	178.38	$	172.45

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

Discussion of recent accounting pronouncements can be found in the “Recent Accounting Pronouncements” portion of Note 1 – “Nature of Business” to our consolidated financial statements.

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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
		September 30, 2009			September 30, 2008		September 30, 2009		September 30, 2008
Total net revenues	$	470,893		$	455,757		100.0	%	100.0	%
Costs and expenses:
Operating salaries and benefits		265,929			259,349		56.5		56.9
Self-insurance for workers’ compensation and
general and professional liabilities		14,165			14,527		3.0		3.2
Other operating costs (1)		109,529			107,391		23.3		23.6
Center rent expense		18,194			18,409		3.9		4.0
General and administrative expenses		15,586			13,832		3.3		3.0
Depreciation and amortization		11,460			10,165		2.4		2.2
Provision for losses on accounts receivable		5,318			3,307		1.1		0.7
Interest, net		12,231			13,070		2.6		2.9
Other costs		872			-		0.2		-
Income before income taxes and discontinued
operations		17,609			15,707		3.7		3.5
Income tax expense		7,220			6,286		1.5		1.4
Income from continuing operations		10,389			9,421		2.2		2.1
Loss from discontinued operations, net		(731	)		(817	)	(0.1	)	(0.2	)
Net income	$	9,658		$	8,604		2.1	%	1.9	%

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

		For the Nine			For the Nine		As a Percentage of Net Revenues
		Months Ended			Months Ended
		September 30, 2009			September 30, 2008		September 30, 2009		September 30, 2008
Total net revenues	$	1,407,735		$	1,356,706		100.0	%	100.0	%
Costs and expenses:
Operating salaries and benefits		790,804			766,223		56.2		56.5
Self-insurance for workers’ compensation and
general and professional liabilities		45,626			40,985		3.2		3.0
Other operating costs (1)		325,607			317,315		23.1		23.4
Center rent expense		54,773			55,325		3.9		4.1
General and administrative expenses		48,057			46,529		3.4		3.4
Depreciation and amortization		33,336			29,553		2.4		2.2
Provision for losses on accounts receivable		15,599			9,491		1.1		0.7
Interest, net		37,422			41,144		2.7		3.0
Other costs (income)		914			(77	)	0.1		-
Income before income taxes and discontinued
operations		55,597			50,218		3.9		3.7
Income tax expense		22,795			20,119		1.6		1.5
Income from continuing operations		32,802			30,099		2.3		2.2
Loss from discontinued operations, net		(2,806	)		(3,233	)	(0.2	)	(0.2	)
Net income	$	29,996		$	26,866		2.1	%	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 September 30, 2009 Compared to Three Months Ended September 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 September 30, 2009 Compared to Three Months Ended September 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 $15.1 million, or 3.3%, to $470.9 million for the three months ended September 30, 2009 from $455.8 million for the three months ended September 30, 2008. We reported net income for the three months ended September 30, 2009 of $9.7 million compared to net income of $8.6 million for the three months ended September 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 rates from many of our payor sources:  Medicare Part A and Part B, managed care, commercial insurance and Medicaid, although the Medicaid rate increases were significantly offset by increased provider taxes.  Higher customer bases under our managed care, commercial insurance and Medicare hospice programs, the September 2008 acquisition of a hospice company and a $6.7 million increase in revenue from our Rehabilitation Therapy segment, due primarily to increases in billable minutes and billing rates, also contributed to the increase in net revenues.  This increase was partially offset by a $5.7 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 $6.6 million, or 2.5%, to $265.9 million (56.5% of net revenues) for the three months ended September 30, 2009 from $259.3 million (56.9% of net revenues) for the three months ended September 30, 2008.  The increase resulted primarily from $4.6 million in our Inpatient Services segment driven by wage increases and a $6.0 million increase from our Rehabilitation Therapy segment attributable to wage rate increases and business growth.  These increases were offset by a $4.0 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 decreased $0.3 million, or 2.1%, to $14.2 million (3.0% of net revenues) for the three months ended September 30, 2009 from $14.5 million (3.2% of net revenues) for the three months ended September 30, 2008 primarily due to decreased exposures in our workers’ compensation programs.

Other operating costs increased $2.1 million, or 2.0%, to $109.5 million (23.3% of net revenues) for the three months ended September 30, 2009 from $107.4 million (23.6% of net revenues) for the three months ended September 30, 2008.  The increase was primarily due to increased therapy costs in our Inpatient Services segment resulting from 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 $18.2 million (3.9% of net revenues) for the three months ended September 30, 2009 from $18.4 million (4.0% of net revenues) for the three months ended September 30, 2008.  The decrease was due to reduced rent for a previously leased center that was purchased in the first quarter of 2009.

General and administrative expenses increased $1.8 million, or 13.0%, to $15.6 million (3.3% of net revenues) for the three months ended September 30, 2009 from $13.8 million (3.0% of net revenues) for the three months ended September 30, 2008.  The increase was primarily due to bonus and lobbying expenses.

Depreciation and amortization increased $1.3 million, or 12.7%, to $11.5 million (2.4% of net revenues) for the three months ended September 30, 2009 from $10.2 million (2.2% of net revenues) for the three months ended September 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

The provision for losses on accounts receivable increased $2.0 million, or 60.6%, to $5.3 million (1.1% of net revenues) for the three months ended September 30, 2009 from $3.3 million (0.7% of net revenues) for the three months ended September 30, 2008.  The increase resulted from increased credit risk associated with slower cash collections.

Net interest expense decreased $0.9 million, or 6.9%, to $12.2 million (2.6% of net revenues) for the three months ended September 30, 2009 from $13.1 million (2.9% of net revenues) for the three months ended September 30, 2008 due to lower interest rates on variable rate indebtedness in the current quarter coupled with reduced debt balances.

As we continue to focus on reducing costs and maximizing occupancy, we have evaluated and will continue to evaluate certain restructuring activities in our operations and administrative functions.  During the three months ended September 30, 2009, we incurred $0.9 million of restructuring costs.  The costs consisted primarily of severance benefits resulting from reductions of administrative staff.

Segment Information

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

		2009					2008
Inpatient Services	$	420,623		89.3	%	$	403,736		88.6	%
Rehabilitation Therapy Services		44,986		9.6			38,318		8.4
Medical Staffing Services		24,409		5.2			30,083		6.6
Corporate		12		-			9		-
Intersegment Eliminations		(19,137	)	(4.1	)		(16,389	)	(3.6	)
Total net revenues	$	470,893		100.0	%	$	455,757		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 September 30 (in thousands):

		2009		2008
Rehabilitation Therapy Services	$	18,592	$	15,562
Medical Staffing Services		545		827
Total intersegment revenue	$	19,137	$	16,389

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

		2009			2008
Inpatient Services	$	39,330		$	35,821
Rehabilitation Therapy Services		2,606			1,793
Medical Staffing Services		2,091			2,479
Net segment income before Corporate		44,027			40,093
Corporate		(25,546	)		(24,386	)
Net segment income	$	18,481		$	15,707

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

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

measures, including net segment income.  Net segment income is defined as earnings before loss on sale of assets, restructuring costs, income tax expense and discontinued operations. Net segment income for the three months ended September 30, 2009 for (1) our Inpatient Services segment increased $3.5 million, or 9.8%, to $39.3 million, (2) our Rehabilitation Therapy Services segment increased $0.8 million, or 44.4%, to $2.6 million and (3) our Medical Staffing Services segment decreased $0.4 million, or 16.0%, to $2.1 million in comparison to the three months ended September 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. 

Inpatient Services

Net revenues increased $16.9 million, or 4.2%, to $420.6 million for the three months ended September 30, 2009 from $403.7 million for the three months ended September 30, 2008.  The increase was primarily the result of:

-	an increase of $6.5 million in Medicare revenues as a result of an $8.7 million increase from higher Medicare Part A rates and a $1.0 million increase in Medicare Part B revenues, partially offset by a $3.2 million decrease in revenues due to a lower customer base;
-	an increase of $5.4 million in Medicaid revenues consisting of $5.2 million related to improved rates, which were significantly offset by increased provider tax expense (as discussed below), and $0.2 million from an increase in customer base;
-	a $3.1 million increase in hospice revenues resulting from a September 2008 acquisition of a hospice company and a higher customer base; and
-	a $2.1 million increase in managed care and commercial insurance revenues driven by higher rates, which contributed $1.2 million of the increase, and higher customer base, which drove the remaining $0.9 million of the increase;
	Offset in part by:
-	a $0.2 million decrease in private pay and other revenues, primarily resulting from lower customer base.

Operating salaries and benefits expenses increased $4.6 million, or 2.2%, to $210.9 million for the three months ended September 30, 2009 from $206.3 million for the three months ended September 30, 2008.  The increase was attributable to the following:

-	wage increases and related benefits and taxes of $5.1 million; and
-	an increase of $1.3 million in health insurance expense;
	Offset in part by:
-	a decrease of $1.8 million in overtime pay.

Self-insurance for workers’ compensation and general and professional liability insurance decreased $0.2 million, or 1.5%, to $13.2 million for the three months ended September 30, 2009 as compared to $13.4 million for the three months ended September 30, 2008, which was driven by decreased exposures in our workers’ compensation programs.

Other operating costs increased $6.3 million, or 6.1%, to $110.4 million for the three months ended September 30, 2009 from $104.1 million for the three months ended September 30, 2008.  The increase was attributable to the following:

- a $3.2 million increase in taxes primarily due to provider taxes;

- a $2.8 million increase in therapy costs due to an increase in higher acuity patients requiring more rehabilitation therapy;

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

-	a $0.8 million increase in purchased services primarily related to service and medical contracts;
-	a $0.7 million increase in supplies, due to higher costs for medical, incontinency and drugs;
-	a $0.5 million increase in education and training expense; and
-	a $0.1 million increase in legal fees;
	Offset in part by:
-	a $0.7 million decrease in nursing contract labor due to lower volume and more in-house availability of staff;
-	a $0.7 million decrease in utilities primarily related to a decreases in electricity, gas and oil;
-	a $0.2 million decrease in recruiting expenses; and
-	a $0.2 million decrease in civil monetary penalties.

General and administrative expenses increased $0.1 million, or 1.0%, to $10.3 million for the three months ended September 30, 2009 from $10.2 million for the three months ended September 30, 2008, primarily due to increases in salaries and benefits.

The provision for losses on accounts receivable increased $1.9 million, or 57.6%, to $5.2 million for the three months ended September 30, 2009 from $3.3 million for the three months ended September 30, 2008.  The increase resulted from increased credit risk associated with slower cash collections.

Center rent expense decreased $0.2 million, or 1.1%, to $17.9 million for the three months ended September 30, 2009 from $18.1 million for the three months ended September 30, 2008.  The decrease is attributable to the purchase of previously leased centers.

Depreciation and amortization increased $1.5 million, or 16.7%, to $10.5 million for the three months ended September 30, 2009 from $9.0 million for the three months ended September 30, 2008.  The increase was attributable to additional depreciation expense on property and equipment acquired during the period.

Net interest expense decreased $0.5 million, or 14.3%, to $3.0 million for the three months ended September 30, 2009 from $3.5 million for the three months ended September 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 $6.7 million, or 17.5%, to $45.0 million for the three months ended September 30, 2009 from $38.3 million for the three months ended September 30, 2008. The revenue increase was the result of:

- an increase of $5.5 million attributable to increased billable minutes, of which eight new contracts, net of lost contracts, accounted for $0.1 million, or 2%, and existing contracts accounted for $5.4 million, or 98%;

- an increase of $0.8 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 $0.4 million in revenue earned for contract management fees.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Operating salaries and benefits expenses increased $6.0 million, or 18.8%, to $38.0 million for the three months ended September 30, 2009 from $32.0 million for the three months ended September 30, 2008.  The increase was primarily driven by the increase in service volume mentioned above coupled with wage rate increases.

Medical Staffing Services

Total revenues from the Medical Staffing Services segment decreased $5.7 million, or 18.9%, to $24.4 million for the three months ended September 30, 2009 from $30.1 million for the three months ended September 30, 2008.  The decrease was primarily the result of:

- a decrease of $3.2 million attributable to a decline in demand for our nurse staffing business;

- a decrease of $1.6 million due to a decline in hours for therapy and pharmacy;

- a decrease of $0.7 million related to closed offices; and

- a decrease of $0.2 million due to lower fees earned from the temporary placement of physicians.

Operating salaries and benefits expenses were $17.1 million for the three months ended September 30, 2009 as compared to $21.1 million for the three months ended September 30, 2008, a decrease of $4.0 million, or 19.0%.  The decrease in operating salaries and benefits is a direct result of the decline in staffing levels for our nurse staffing, therapy staffing and pharmacy businesses.

Other operating costs decreased $1.0 million, or 20.4%, to $3.9 million for the three months ended September 30, 2009 from $4.9 million for the three months ended September 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 increased $1.8 million, or 13.0%, to $15.6 million for the three months ended September 30, 2009 from $13.8 million for the three months ended September 30, 2008. The increase was primarily due to bonus and lobbying expenses.

As we continue to focus on reducing costs and maximizing occupancy, we have evaluated and will continue to evaluate certain restructuring activities in our operations and administrative functions.  During the three months ended September 30, 2009, we incurred $0.9 million of restructuring costs.  The costs consisted primarily of severance benefits resulting from reductions of administrative staff.

Interest expense

Interest expense not directly attributed to operating segments decreased $0.3 million, or 3.2%, to $9.2 million for the three months ended September 30, 2009 from $9.5 million for the three months ended September 30, 2008 due to lower interest rates on variable rate indebtedness in the current quarter coupled with a decrease in aggregate indebtedness since September 30, 2008.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 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 $51.1 million, or 3.8%, to $1,407.8 million for the nine months ended September 30, 2009 from $1,356.7 million for the nine months ended September 30, 2008. We reported net income for the nine months ended September 30, 2009 of $30.0 million compared to net income of $26.9 million for the nine months ended September 30, 2008.

The increase in net revenues for the 2009 period included $50.3 million of additional revenue in our Inpatient Services segment primarily due to increases in rates from many of our payor sources:  Medicare Part A and Part B, managed care, commercial insurance and Medicaid, although the Medicaid rate increases were significantly offset by increased provider taxes.  Higher customer bases under our managed care, commercial insurance and Medicare hospice programs, the September 2008 acquisition of a hospice company and a $23.3 million increase in revenue from our Rehabilitation Therapy segment, due primarily to increases in billable minutes and billing rates, also contributed to the increase in net revenues.  This increase was partially offset by a $12.2 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 $24.6 million, or 3.2%, to $790.8 million (56.2% of net revenues) for the nine months ended September 30, 2009 from $766.2 million (56.5% of net revenues) for the nine months ended September 30, 2008.  The increase resulted primarily from $14.7 million of wage increases in our Inpatient Services segment and a $20.2 million increase from our Rehabilitation Therapy segment attributable to wage rate increases and business growth.  These increases were offset by a $10.4 million decrease in our Medical Staffing segment due to a decline in staffing levels resulting from a decrease in the nurse staffing and pharmacy businesses.

Self-insurance for workers’ compensation and general and professional liability insurance increased $4.6 million, or 11.2%, to $45.6 million (3.2% of net revenues) for the nine months ended September 30, 2009 from $41.0 million (3.0% of net revenues) for the nine months ended September 30, 2008 primarily due to increased medical, legal and administrative costs associated with prior period claims.

Other operating costs increased $8.3 million, or 2.6%, to $325.6 million (23.1% of net revenues) for the nine months ended September 30, 2009 from $317.3 million (23.4% of net revenues) for the nine months ended September 30, 2008.  The increase was primarily due to increased therapy costs in our Inpatient Services segment resulting from an increase in higher acuity patients requiring more rehabilitation therapy and an increase in purchased services.

Center rent expense decreased $0.5 million, or 0.9%, to $54.8 million (3.9% of net revenues) for the nine months ended September 30, 2009 from $55.3 million (4.1% of net revenues) for the nine months ended September 30, 2008.  The decrease was due to reduced rent for a previously leased center that was purchased in the first quarter of 2009.

General and administrative expenses increased $1.6 million, or 3.4%, to $48.1 million (3.4% of net revenues) for the nine months ended September 30, 2009 from $46.5 million (3.4% of net revenues) for the nine months ended September 30, 2008.  The increase was primarily due to bonus and lobbying expenses.

Depreciation and amortization increased $3.7 million, or 12.5%, to $33.3 million (2.4% of net revenues) for the nine months ended September 30, 2009 from $29.6 million (2.2% of net revenues) for the nine months ended September 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 $6.5 million, or 68.4%, to $16.0 million (1.1% of net revenues) for the nine months ended September 30, 2009 from $9.5 million (0.7% of net revenues) for the nine months ended September 30, 2008.  The increase resulted from increased credit risk associated with slower cash collections.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Net interest expense decreased $3.7 million, or 9.0%, to $37.4 million (2.7% of net revenues) for the nine months ended September 30, 2009 from $41.1 million (3.0% of net revenues) for the nine months ended September 30, 2008 due to lower interest rates on variable rate indebtedness in the current quarter coupled with reduced debt balances.

As we continue to focus on reducing costs and maximizing occupancy, we have evaluated and will continue to evaluate certain restructuring activities in our operations and administrative functions.  During the nine months ended September 30, 2009, we incurred $0.9 million of restructuring costs.  The costs consisted primarily of severance benefits resulting from reductions of administrative staff.

Segment Information

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

		2009					2008
Inpatient Services	$	1,252,310		88.9	%	$	1,202,050		88.6	%
Rehabilitation Therapy Services		133,231		9.5			109,921		8.1
Medical Staffing Services		79,003		5.6			91,175		6.7
Corporate		27		-			29		-
Intersegment Eliminations		(56,836	)	(4.0	)		(46,469	)	(3.4	)
Total net revenues	$	1,407,735		100.0	%	$	1,356,706		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 nine months ended September 30 (in thousands):

		2009		2008
Rehabilitation Therapy Services	$	55,168	$	44,314
Medical Staffing Services		1,668		2,155
Total intersegment revenue	$	56,836	$	46,469

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

		2009			2008
Inpatient Services	$	119,934		$	116,991
Rehabilitation Therapy Services		8,606			6,483
Medical Staffing Services		6,401			6,866
Net segment income before Corporate		134,941			130,340
Corporate		(78,430	)		(80,199	)
Net segment income	$	56,511		$	50,141

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Inpatient Services

Net revenues increased $50.3 million, or 4.2%, to $1,252.3 million for the nine months ended September 30, 2009 from $1,202.1 million for the nine months ended September 30, 2008.  The increase was primarily the result of:

-	an increase of $19.6 million in Medicare revenues as a result of a $28.8 million increase in Medicare Part A rates, a $4.7 million increase in Medicare Part B revenues and a $13.9 million decrease due to a lower customer base;
-	an increase of $16.6 million in Medicaid revenues consisting of $16.0 million related to improved rates, which were significantly offset by increased provider tax expense (as discussed below), and $0.6 million from an increase in customer base;
-	a $9.3 million increase in hospice revenues, resulting from an acquisition of a hospice company in September 2008 and a higher customer base;
-	an $8.5 million increase in managed care and commercial insurance revenues driven by higher rates, which contributed $5.1 million of the increase, and higher customer base, which drove the remaining $3.4 million of the increase; and
-	an increase of $1.6 million in other revenues;
	Offset in part by:
-	a $4.8 million decrease in private pay revenues due to a decline in revenues of $10.5 million as a result of a lower customer base, offset in part by a $5.7 million increase in revenues resulting from higher rates; and
-	a $0.6 million decrease in revenues related to our Medicare Part B billing company.

Operating salaries and benefits expenses increased $14.7 million, or 2.4%, to $624.4 million for the nine months ended September 30, 2009 from $609.7 million for the nine months ended September 30, 2008.  The increase was attributable to the following:

-	wage increases and related benefits and taxes of $18.2 million; and
-	an increase of $2.9 million in health insurance expense;
	Offset in part by:
-	a decrease of $6.1 million in overtime pay; and
-	a decrease of $0.3 million in bonus expense.

Self-insurance for workers’ compensation and general and professional liability insurance increased $4.9 million, or 13.0%, to $42.7 million for the nine months ended September 30, 2009 as compared to $37.8 million for the nine months ended September 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 $3.2 million due to decreased exposures.

Other operating costs increased $18.3 million, or 5.9%, to $326.1 million for the nine months ended September 30, 2009 from $307.8 million for the nine months ended September 30, 2008.  The increase was attributable to the following:

- a $9.4 million increase in therapy costs due to an increase in higher acuity patients requiring more rehabilitation therapy;

- a $6.4 million increase in taxes primarily related to provider taxes;

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

-	a $3.5 million increase in purchased services including software maintenance, medical and service contracts;
-	a $3.4 million increase in supplies, due to higher costs for medical, incontinency, office supplies and drugs; and
-	a $0.8 million increase in legal costs;
	Offset in part by:
-	a $2.0 million decrease in nursing contract labor due to lower volume and improved labor management;
-	a $0.9 million increase in rebates and discounts;
-	a $0.9 million decrease in civil monetary penalties;
-	an $0.8 million decrease in utilities primarily related to decreases in electricity, gas and oil costs; and
-	a $0.6 million decrease in recruiting expenses.

General and administrative expenses increased $0.7 million, or 2.3%, to $30.8 million for the nine months ended September 30, 2009 from $30.1 million for the nine months ended September 30, 2008. The increase is primarily due to the increase in salaries and benefits.

The provision for losses on accounts receivable increased $6.1 million, or 68.5%, to $15.0 million for the nine months ended September 30, 2009 from $8.9 million for the nine months ended September 30, 2008.  The increase resulted from increased credit risk associated with slower cash collections.

Center rent expense decreased $0.6 million, or 1.1%, to $53.7 million for the nine months ended September 30, 2009 from $54.3 million for the nine months ended September 30, 2008.  The decrease is attributable to the purchase of previously leased centers.

Depreciation and amortization increased $4.0 million, or 15.2%, to $30.3 million for the nine months ended September 30, 2009 from $26.3 million for the nine months ended September 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.

Net interest expense decreased $0.8 million, or 7.9%, to $9.3 million for the nine months ended September 30, 2009 from $10.1 million for the nine months ended September 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 $23.3 million, or 21.2%, to $133.2 million for the nine months ended September 30, 2009 from $109.9 million for the nine months ended September 30, 2008. The revenue increase was the result of:

- an increase of $19.7 million attributable to increased billable minutes, of which eight new contracts, net of lost contracts, accounted for $0.3 million, or 2%, and existing contracts accounted for $19.4 million, or 98%;

- an increase of $2.6 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

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

- an increase of $1.0 million in revenue earned for contract management fees.

Operating salaries and benefits expenses increased $20.2 million, or 22.3%, to $110.9 million for the nine months ended September 30, 2009 from $90.7 million for the nine months ended September 30, 2008.  The increase was primarily driven by the increase in service volume mentioned above coupled with wage rate increases.

Medical Staffing Services

Total revenues from the Medical Staffing Services segment decreased $12.2 million, or 13.4%, to $79.0 million for the nine months ended September 30, 2009 from $91.2 million for the nine months ended September 30, 2008.  The decrease was primarily the result of:

-	a decrease of $9.0 million attributable to a decline in demand for our nurse staffing business;
-	a decrease of $2.7 million due to a decline in hours for therapy and pharmacy;
-	a decrease of $2.0 million related to closed offices; and
-	a decrease of $0.3 million in school business revenue;
	Offset in part by:
-	an increase of $1.8 million due to higher fees earned from the temporary placement of physicians.

Operating salaries and benefits expenses were $55.4 million for the nine months ended September 30, 2009 as compared to $65.8 million for the nine months ended September 30, 2008, a decrease of $10.4 million, or 15.8%. 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 decreased $0.5 million, or 3.8%, to $12.5 million for the nine months ended September 30, 2009 from $13.0 million for the nine months ended September 30, 2008.  The decrease was primarily attributable to costs paid for travel and lodging for travel nurses and therapists, partially offset by costs paid for temporary independent contractors that are physicians.

Corporate

General and administrative expenses not directly attributed to segments increased $1.6 million, or 3.4%, to $48.1 million for the nine months ended September 30, 2009 from $46.5 million for the nine months ended September 30, 2008.  The increase was primarily due to bonus and lobbying expenses.

As we continue to focus on reducing costs and maximizing occupancy, we have evaluated and will continue to evaluate certain restructuring activities in our operations and administrative functions.  During the nine months ended September 30, 2009, we incurred $0.9 million of restructuring costs.  The costs consisted primarily of severance benefits resulting from reductions of administrative staff.

Interest expense

Interest expense not directly attributed to operating segments decreased $2.9 million, or 9.4%, to $28.1 million for the nine months ended September 30, 2009 from $31.0 million for the nine months ended September 30, 2008 due to lower interest rates on variable rate indebtedness in the current quarter coupled with a decrease in aggregate indebtedness since September 30, 2008.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Liquidity and Capital Resources

There have been no material changes to our liquidity and capital resources since December 31, 2008.  For the three and nine months ended September 30, 2009, our net income was $9.7 million and $30.0 million, respectively.  As of September 30, 2009, our working capital was $182.7 million. As of September 30, 2009, we had cash and cash equivalents of $117.4 million, $702.6 million in borrowings and $50.0 million available under our revolving credit facility.  As of September 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 $92.0 million for the nine months ended September 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 our 2008 Form 10-K 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.  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.  In October 2009, we acquired all the capital stock of Allegiance Hospice Group, Inc. for approximately $15.5 million, which was funded with available cash.

Cash Flows

During the three months ended September 30, 2009, net cash provided by operating activities increased by $10.5 million as compared to the same period last year. This increase was the result of (i) our quarter-over-quarter increase in net income of $1.1 million, (ii) our quarter-over-quarter increase in working capital changes of $6.5 million, driven by changes in prepaid expenses and other assets, income taxes payable, accrued compensation and benefits and other accrued liabilities and (iii) a $2.9 million increase in non-cash adjustments to net income, principally related to the provision for losses on accounts receivable.

Net cash used for investing activities of $16.5 million for the three months ended September 30, 2009 is principally related to capital expenditures.

Net cash used for financing activities of $1.7 million for the three months ended September 30, 2009 is comprised of (i) $22.5 million used to repay long-term debt and capital lease obligations and (ii) $20.8 million of borrowing under long-term debt obligations.

Capital Expenditures

We incurred capital expenditures, related primarily to improvements in continuing operations, as reflected in our consolidated statements of cash flows, of $16.5 million and $12.4 million for the three months ended September 30, 2009 and 2008, respectively, and $41.5 million and $28.5 million for the nine months ended September 30, 2009 and 2008, respectively.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Loan Agreements

In April 2007 we issued $200.0 million aggregate principal amount of 9-1/8% Senior Subordinated Notes due 2015 (the “Notes”), which mature on April 15, 2015.  We are entitled to redeem some or all of the Notes at any time on or after April 15, 2011 at certain pre-specified redemption prices.  In addition, prior to April 15, 2011, we may redeem some or all of the Notes at a price equal to 100% of the principal amount thereof, plus accrued and unpaid interest, if any, plus a “make whole” premium.  We are entitled to redeem up to 35% of the aggregate principal amount of the Notes until April 15, 2010 with the net proceeds from certain equity offerings at certain pre-specified redemption prices.  The Notes accrue interest at an annual rate of 9-1/8% and pay interest semi-annually on April 15th and October 15th of each year through the April 15, 2015 maturity date.  The Notes are unconditionally guaranteed on a senior subordinated basis by certain of our subsidiaries but are not secured by any of our assets or those of our subsidiaries.  (See Note 10 – “Summarized Consolidating Information.”)

In April 2007, we entered into a $485.0 million senior secured credit facility with a syndicate of financial institutions led by Credit Suisse, as administrative agent and collateral agent (the “Credit Agreement”) in connection with our acquisition of Harborside Healthcare Corporation (“Harborside”).  The Credit Agreement provides for $365.0 million in term loans (of which $329.9 million was outstanding at September 30, 2009), a $50.0 million revolving credit facility (undrawn at September 30, 2009) and a $70.0 million letter of credit facility ($66.0 million outstanding at September 30, 2009).  The final maturity date of the term loans is April 19, 2014, and the revolving credit facility and letter of credit facility terminate on April 19, 2013.   Availability of amounts under the revolving credit facility is subject to compliance with financial covenants, including an interest coverage test, a total leverage covenant and a senior leverage covenant. We were in compliance with these covenants as of September 30, 2009.  The Credit Agreement contains customary events of default, such as our failure to make payment of amounts due, defaults under other agreements evidencing indebtedness, certain bankruptcy events and a change of control (as defined in the Credit Agreement). The Credit Agreement also contains customary covenants restricting, among other things, incurrence of indebtedness, liens, payment of dividends, repurchase of stock, acquisitions and dispositions, mergers and investments.  The Credit Agreement is collateralized by our assets and the assets of most of our subsidiaries.

Amounts borrowed under the term loan facility are due in quarterly installments of 0.25% of the aggregate principal amount of the term loans under the term loan facility outstanding as of January 15, 2008, with the remaining principal amount due on the maturity date of the term loans.  Accrued interest is payable at the end of an interest period, but no less frequently than every three months.  The loans under the Credit Agreement bear interest on the outstanding unpaid principal amount at a rate equal to an applicable percentage plus, at our option, either (a) an alternative base rate determined by reference to the higher of (i) the prime rate announced by Credit Suisse and (ii) the federal funds rate plus one-half of 1.0%, or (b) the London Interbank Offered Rate (“LIBOR”), adjusted for statutory reserves.  The applicable percentage for term loans is 1.0% for alternative base rate loans and 2.0% for LIBOR loans; and the applicable percentage for revolving loans is up to 1.0% for alternative base rate revolving loans and up to 2.0% for LIBOR rate revolving loans based on our total leverage ratio.  Each year, commencing in 2009, within 90 days of the prior fiscal year end, we are required to prepay a portion of the term loans in an amount based on the prior year’s excess cash flows, if any, as defined in the Credit Agreement.  We paid $8.5 million pursuant to this requirement in 2009.

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SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

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																				September 30,			December 31,
		2010			2011				2012			2013			2014			Thereafter			Total		2009 (1)		2008 (1)
							(Dollars in thousands)
Long-term debt:
Fixed rate debt (2)	$	25,744		$	15,845			$	4,990		$	5,105		$	198,421		$	268,516		$	518,621	$	494,950	$	442,992
Rate		9.8	%		7.8	%			7.3	%		7.2	%		6.8	%		8.4	%
Variable rate debt	$	2,037		$	26,286			$	1,610		$	1,610		$	151,730		$	-		$	183,273	$	178,107	$	202,442
Rate		2.9	%		3.3	%			2.8	%		2.8	%		2.8	%		-	%
Interest rate swaps:
Variable to fixed	$	150,000		$	-			$	-		$	-		$	-		$	-				$	6,485	$	7,644
Average pay rate		4.8	%		-				-			-			-			-
Average receive rate		0.5	%		-				-			-			-			-

(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 September 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.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In December 2006, Harborside, which we acquired in 2007, 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.  We have cooperated with the DOJ since we became aware of the lawsuit and have consistently denied the allegations in the lawsuit, which relate to Medicare billings for durable medical equipment.  In October 2009, we agreed to settle this lawsuit to avoid the protracted costs of litigation.  The settlement agreement provides that the settlement is not an admission of liability by us or the defendants, releases Harborside and its subsidiary from all liability arising from allegations in the lawsuit, and requires the defendants to pay $1.4 million.  We have fully accrued these amounts at September 30, 2009.

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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 Exhibit 3.1 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 Exhibit 3.2 to our Form 8-K filed on December 27, 2007).
10.1	Employment Agreement dated as of October 26, 2009 by and between Richard K. Matros and Sun Healthcare Group, Inc.
10.2	Sun Healthcare Group, Inc. Supplemental Bonus Plan
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)

October 28, 2009

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EX-10.1

EXHIBIT 10.1

EMPLOYMENT AGREEMENT

THIS EMPLOYMENT AGREEMENT (“Agreement”) is entered into this 26th day of October, 2009 (the “Effective Date”), by and between Richard K. Matros (“Mr. Matros”) and Sun Healthcare Group, Inc., a Delaware corporation (“Sun” or “Company”).

WHEREAS, Mr. Matros has served as the Chairman of the Board of Directors and Chief Executive Officer (“CEO”) of Sun since November 2001;

WHEREAS, Sun and Mr. Matros are parties to that certain Amended and Restated Employment Agreement dated December  17, 2008 (the “Existing  Agreement”); and

WHEREAS, this Agreement replaces and supersedes the Existing Agreement in its entirety.

NOW, THEREFORE, in consideration of the above recitals and the mutual covenants and agreements contained herein, Mr. Matros and Sun agree as follows:

Section 1:    Term of Employment.  Sun agrees to employ Mr. Matros and Mr. Matros agrees to accept employment with Sun, subject to the terms and conditions of this Agreement. Unless earlier terminated pursuant to the provisions of Sections 4 and 5 hereof, the initial term of employment of Mr. Matros under this Agreement is for a period of three (3) years, commencing on the Effective Date, and terminating on the third anniversary of the Effective Date.  On the first anniversary of the Effective Date, and on each anniversary of the Effective Date thereafter, this Agreement shall be renewed for a one (1) year period (the period from and after the Effective Date until the termination of this Agreement  is referred to as the “Term”) unless (i) earlier terminated pursuant to the provisions of Sections 4 and 5 hereof, or (ii) written notice of non-renewal is given by either party to the other at least 60 days prior to the anniversary of the Effective Date occurring in any given year, in which case this Agreement shall be terminated on anniversary of the Effective Date occurring in the second year following the year in which such notice of non-renewal was provided.  Notwithstanding the foregoing, the Term shall terminate, at the latest, on the tenth anniversary of the Effective Date.

Section 2:   Duties and Responsibilities.  Mr. Matros is employed as CEO and is engaged as Chairman of the Board of Directors of Sun (“Board of Directors”).  During the Term, Mr. Matros shall devote his full employment time, efforts, skills and attention exclusively to advancing and rendering profitable the business interests of Sun, its direct and indirect subsidiaries and their lines of business; provided, however, that to the extent the following activities do not materially interfere or conflict with his duties and responsibilities hereunder and as imposed by applicable laws, rules and regulations, Mr. Matros may (i) continue to serve as a member of the boards of directors of the companies previously disclosed in writing to the Board of Directors, (ii) engage in charitable, civic and religious affairs and (iii) with the prior written consent of the Board of Directors, serve as a member of the board of directors of other companies, subject to the provisions of Sun’s Governance Guidelines, as in effect from time to time.  Mr. Matros agrees to report to and render such services, commensurate with his positions as Chairman or CEO, as the Board of Directors may from time to time reasonably direct.  In the event that Mr. Matros serves

as director or senior executive officer of one or more direct or indirect subsidiaries of Sun, he shall do so without additional compensation.

Section 3:    Compensation, Benefits and Related Matters.

a. Annual Base Salary.  Sun shall pay during the Term to Mr. Matros a base salary at an annual rate of $875,000 (“Base Salary”), such salary to be payable in accordance with Sun’s customary payroll practices (but not less frequently than monthly).  Annually during the Term, on or prior to each anniversary of the Effective Date, the Board of Directors or the Compensation Committee of the Board of Directors (the “Compensation Committee”) shall review Mr. Matros’ annual base salary for possible merit increases in its sole discretion, and any increase in Mr. Matros’ annual base salary rate shall thereafter constitute “Base Salary” for purposes of this Agreement.

b. Cash Bonus/Incentive Compensation. In addition to the Base Salary provided for in Section 3(a) above, Mr. Matros shall be entitled to receive an annual bonus (“Bonus”) in accordance with the Sun Healthcare Group, Inc. Executive Bonus Plan (the “Plan”), as it may be amended from time to time by the Compensation Committee; provided, however, that no amendment shall be effective if it reduces the percentage of Base Salary that would constitute the target amount of the Bonus as compared to the prior year, unless such amendment has been agreed to in writing by Mr. Matros. The Bonus shall be payable at the same time as other annual bonuses are paid to senior management personnelwith respect to that fiscal year.  Notwithstanding the foregoing, but subject to the provisions of Section 5, in order to have earned and to be paid any such Bonus, Mr. Matros must be employed by Sun on the date of such payment.

c. Restricted Stock and Options.  Mr. Matros shall participate in such restricted stock and option plans of the Company as are made available generally to senior executive officers of the Company.  Any grants under such plans shall be made by the Board of Directors (or appropriate committee thereof) in its sole discretion and such plans are subject to change during the Term at the sole discretion of the Company.

d. Retirement and Benefit Plans.  During the Term, Mr. Matros shall be entitled to participate in all retirement plans, health benefit programs, insurance programs and other similar employee welfare benefit arrangements available generally to senior executive officers of Sun from time to time.  Such plans, programs and arrangements are subject to change during the Term at the sole discretion of the Company.

e. Paid Time Off.  During the Term, Mr. Matros shall be entitled to paid time off in accordance with Sun’s policy for senior executive officers.

f. Indemnification Liability/Insurance.  Mr. Matros shall be entitled to indemnification by Sun to the fullest extent permitted by applicable law and the

2

charter and bylaws of Sun.  In addition, Sun shall maintain during Mr. Matros’ employment customary director’s and officers’ liability insurance and Mr. Matros shall be covered by such insurance.

g. Taxes.  All compensation payable to Mr. Matros shall be subject to withholding for all applicable federal, state and local income taxes, occupational taxes, Social Security and similar mandatory withholdings.

h. Expenses.  Mr. Matros shall be entitled to reimbursement for expenses incurred by him in connection with the discharge of his duties hereunder.  All such expense reimbursement shall be subject to and shall be submitted, documented and paid in accordance with the expense reimbursement policies of the Company, as such policies may change from time to time.  Mr. Matros agrees that he will provide such documentation to the Company promptly after expenses are incurred.

Section 4:  Termination.  Sun may, at any time, in its sole discretion, terminate Mr. Matros as Chairman and CEO and from all other positions with Sun and its direct and indirect subsidiaries; provided, however, that Sun shall provide Mr. Matros with at least five (5) business days prior written notice of such termination and shall make the payments associated with such termination in accordance with Section 5.  Notwithstanding any provision in Section 1 hereof, the Term shall end on the date of Mr. Matros’ termination of employment in accordance with this Agreement.

a. Termination by Sun for “Good Cause.”  Sun may at any time, by written notice to Mr. Matros at least five (5) business days prior to the date of termination specified in such notice and specifying the acts or omissions believed to constitute Good Cause (as defined below), terminate Mr. Matros as Chairman and CEO and from all other positions with Sun and its direct and indirect subsidiaries for Good Cause.  Sun may relieve Mr. Matros of his duties and responsibilities pending a final determination of whether Good Cause exists, and such action shall not constitute Good Reason (as defined below) for purposes of this Agreement.  Payment to Mr. Matros upon a termination for Good Cause is set forth in Section 5(a).  “Good Cause” for termination shall mean any one of the following:

1. Any felony criminal conviction (including conviction pursuant to a nolo contendere plea) under the laws of the United States or any state or other political subdivision thereof which, in the sole discretion of the Board of Directors, renders Mr. Matros unsuitable for the position of either Chairman or CEO;

2. Any act of financial malfeasance or financial impropriety, as determined by the Board of Directors in good faith;

3. Mr. Matros’ continued willful failure to perform the duties reasonably requested by the Board of Directors and commensurate with his positions as Chairman and CEO (other than any such failure resulting from his incapacity due to his physical or mental condition) after a written demand

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for substantial performance is delivered to him by the Board of Directors, which demand specifically identifies the manner in which the Board of Directors believes that he has not substantially performed his duties, and which performance is not substantially corrected by him within ten (10) days of receipt of such demand;

4. Any material workplace misconduct or willful failure to comply with Sun’s general policies and procedures as they may exist from time to time by Mr. Matros which, in the good faith determination of the Board of Directors, renders Mr. Matros unsuitable for the position of either Chairman or CEO;

5. Any material breach by Mr. Matros of the provisions of this Agreement which has not been cured by Mr. Matros thirty (30) days following delivery of notice to Mr. Matros specifying such material breach, or the repetition of any such material breach after it has been cured; or

6. Any act of moral turpitude, as determined by the Board of Directors in good faith.

b. Termination by Sun without Good Cause.  Sun may at any time, by written notice to Mr. Matros at least five (5) business days prior to the date of termination specified in such notice, terminate Mr. Matros as Chairman and CEO and from all other positions with Sun and its direct and indirect subsidiaries.  If such termination is made by Sun other than by reason of Mr. Matros’ death, Disability (as defined in Section 4(e)) or expiration of the Term, and Good Cause does not exist, such termination shall be treated as a termination without Good Cause and Mr. Matros shall be entitled to payment in accordance with Section 5(b).

c. Termination by Mr. Matros for Good Reason.  Mr. Matros may, at any time at his option within sixty (60) days following the initial existence of the particular  event or condition that constitutes Good Reason (as defined below), resign for Good Reason as Chairman and CEO and from all other positions with Sun and its direct and indirect subsidiaries by written notice to Sun at least thirty (30) days prior to the date of termination specified in such notice; provided, however, that Sun has not substantially corrected the event or condition that would constitute Good Reason prior to the date of termination.  Payment to Mr. Matros upon a termination for Good Reason is set forth in Section 5(b).  Mr. Matros’ continued employment shall not, by itself, constitute consent to or a waiver of rights with respect to any circumstances constituting Good Reason hereunder.

“Good Reason” shall mean the occurrence of any one of the following events or conditions without Mr. Matros’ written consent:

(i)           A meaningful and detrimental reduction in Mr. Matros’ authority, duties or responsibilities or a meaningful and detrimental change in his reporting responsibilities;(ii)A material failure of Sun to comply with the

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compensation provisions set forth in Sections 3(a) and 3(b) or benefits provisions set forth in Sections 3(d) - 3(f) (collectively, the “Benefits”) (other than a reduction of Benefits uniformly applicable to other members of senior management); or (iii) A material relocation of Mr. Matros’ principal work location from its current location in Orange County, California;

provided that Sun is provided with notice and opportunity to cure such breach and Mr. Matros terminates his employment with Sun, in each case within the time periods prescribed under this Section 4(c).

d.          Voluntary Resignation.  Mr. Matros may, at any time at his option with thirty (30) calendar days written notice to Sun, voluntarily resign without Good Reason as Chairman and CEO and from all other positions with Sun and its direct and indirect subsidiaries.  Payment to Mr. Matros upon his voluntary resignation without Good Reason is set forth in Section 5(a).  Resignation from Sun shall automatically constitute resignation from all positions of any subsidiary.

e.          Death or Disability.  Mr. Matros’ employment under this Agreement and the Term shall terminate automatically as of the date of Mr. Matros’ death.  Sun may, at any time by written notice to Mr. Matros at least five (5) business days prior to the date of termination specified in such notice, terminate Mr. Matros as Chairman and CEO and from all other positions with Sun and its direct or indirect subsidiaries by reason of his Disability.  “Disability” shall mean any physical or mental condition or illness that prevents Mr. Matros’ from performing his duties hereunder in any material respect for a period of 120 substantially consecutive calendar days, as determined by a physician selected by Sun or, if Mr. Matros is incapacitated, reasonably acceptable to the Director of Medicine or equivalent senior physician at Hoag Hospital.  Payment to Mr. Matros upon his termination by reason of his death or Disability is set forth in Section 5(a).

Section 5:   Payments Upon Termination.

a. Payment Upon Termination for Good Cause, Resignation without Good Reason, Death or Disability.  In the event of termination of employment during the Term pursuant to Sections 4(a), 4(d) or 4(e), Mr. Matros, or his estate where applicable, shall be paid any earned but unpaid Base Salary through the date of Mr. Matros’ separation from service with Sun (the “Severance Date”)  and any accrued and unused paid time off through the Severance Date, which shall be paid to Mr. Matros or his estate or beneficiary, as applicable, in a lump sum in cash upon or promptly following (and in all events within 30 days after) the Severance Date (collectively, the “Accrued Obligations”).  In addition, in the case of a termination of employment pursuant to Sections 4(e), but not Sections 4(a) or 4(d), Mr. Matros or his estate shall be paid (i) any accrued and unpaid Bonus for any prior fiscal year, which shall be paid to Mr. Matros or his estate or beneficiary, as applicable, in a lump sum in cash at the time that annual bonuses are paid to senior management personnel with respect to that fiscal year, but in

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any event within seventy-five (75) days after the Severance Date, and (ii) a pro rata portion (based on the number of days of employment in the fiscal year of termination divided by 365 or 366, as applicable) of the Bonus, if any, for the fiscal year in which the termination occurs, which shall be paid at the time that annual bonuses are paid to senior management personnel with respect to that fiscal year, but in any event within seventy-five (75) days after the conclusion of the fiscal year to which such Bonus relates. Mr. Matros shall also receive his vested benefits in accordance with the terms of Sun’s compensation and benefit plans, and his participation in such plans and all other perquisites shall cease as of the Severance Date, except to the extent Mr. Matros may elect to continue coverage under any welfare benefit plans as required by Part 6, Title I of the Employee Retirement Income Security Act of 1974, as amended. Upon a termination under Section 4(a), 4(d) or 4(e), Mr. Matros shall not be entitled to any compensation or benefits under this Agreement except as set forth in this Section 5(a).

b. Payment Upon Termination by Sun without Good Cause or by Mr. Matros for Good Reason.  In the event of a termination of Mr. Matros’ employment during the Term pursuant to Sections 4(b) or 4(c), subject to the provisions of Section 7(f):

1. Mr. Matros shall be entitled to a severance benefit in an amount equal to (i) Mr. Matros’ then current annual Base Salary multiplied by 2.25, plus (ii) any accrued and unpaid Bonus for any prior fiscal year, plus (iii) a pro rata portion of the Bonus for the fiscal year in which the termination occurs (determined by multiplying the Bonus Mr. Matros would have received based upon actual performance had his employment continued through the end of the fiscal year by a fraction, the numerator of which is the number of days during the year of termination that Mr. Matros is employed by the Company and the denominator of which is 365 or 366, as applicable).  The amount payable pursuant to clause (i) above shall be paid to Mr. Matros in a lump sum cash payment in the month immediately following the month in which the Severance Date occurs.  The amount payable pursuant to clause (ii) above shall be paid to Mr. Matros at the time that annual bonuses are paid to senior management personnel with respect to the applicable fiscal year, but in any event within seventy-five (75) days after the Severance Date.  The amount payable pursuant to clause (iii) shall be paid to Mr. Matros at the time that annual bonuses are paid to senior management personnel with respect to the applicable fiscal year in which the Severance Date occurs, but in any event within seventy-five (75) days after the conclusion of such fiscal year.

2. In the event such termination occurs on or within two years following the date of a Change in Control, Mr. Matros shall not be entitled to the amount described in Section 5(b)(1) above but shall instead be entitled to an amount equal to (i) the sum of his then current annual Base Salary and his target Bonus for the then current fiscal year multiplied by 2, plus (ii) any

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accrued and unpaid Bonus for any prior fiscal year, plus (iii) a pro rata portion of the target Bonus for the fiscal year in which the termination occurs (assuming the Company achieves 100% of the financial performance target or targets for such fiscal year that are utilized in determining the amount of the Bonus and determined by multiplying the amount Mr. Matros would have received had his employment continued through the end of the fiscal year by a fraction, the numerator of which is the number of days during the performance year of termination that Mr. Matros is employed by the Company and the denominator of which is 365 or 366, as applicable). The amounts payable pursuant to clauses (i) and (iii) above shall be paid to Mr. Matros in a lump sum in the month immediately following the month in which the Severance Date occurs. The amount payable pursuant to clause (ii) above shall be paid to Mr. Matros at the time that annual bonuses are paid to senior management personnel with respect to the applicable fiscal year, but in any event within seventy-five (75) days after the Severance Date.

3. Mr. Matros’ participation in any other retirement and benefit plans and perquisites shall cease as of the Severance Date, except Sun shall pay premiums pursuant to COBRA for continuing coverage under Sun’s health plans for Mr. Matros and his eligible dependents (as determined under Sun’s health plans), or, at Mr. Matros’ option (which shall be communicated by written notice to Sun prior to the month such election is to take effect), provide a separate cash payment monthly equal to the amount of the COBRA premium until the earlier of (i) the eighteen-month anniversary (or, in the case of a Change in Control termination referred to in Section 5(b)(2) above, the twenty-four-month anniversary) of the last day of the month in which the Severance Date occurs or (ii) the date of Mr. Matros becomes eligible to participate in a plan of another employer or (iii), as to any of his eligible dependents, the date on which the eligible dependent becomes eligible to participate in a plan of another employer.  Any cash payment due to Mr. Matros pursuant to this Section 5(b)(3) shall be paid by Sun not later than the end of the month to which such payment relates.

4. Upon any such termination, Mr. Matros shall be entitled to receive any Accrued Obligations payable to Mr. Matros as set forth in Section 5(a).

5. Notwithstanding the foregoing, Mr. Matros’ right to receive the severance payments described in this Section 5(b) shall be and is conditioned upon his execution and delivery of (and not revoking) a general release in favor of Sun, which shall not be inconsistent with the terms of this Agreement, and such other documents and instruments as are reasonably required by Sun, each of which Mr. Matros shall deliver to Sun within twenty-one (21) days following the Severance Date.

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A termination of Mr. Matros’ employment during the Term without Good Cause (other than by reason of his death or Disability) within six (6) months preceding a Change in Control shall be treated as if such termination occurred on the date of such Change in Control if it is reasonably demonstrated that the termination was at the request of the third party who has taken steps reasonably calculated to effect such Change in Control or otherwise arose in connection with or in anticipation of such Change in Control.  In such case, Mr. Matros shall be entitled (in addition to the benefits described in Section 5(b)(1) which were triggered in connection with the original Severance Date) to the difference between the non-discounted present value of the benefits described in Section 5(b)(2) above less the non-discounted present value of the benefits described in Section 5(b)(1) above (each determined as of the Severance Date), which difference shall be paid to Mr. Matros upon or within thirty (30) days following the occurrence of such Change in Control.

c. “Change in Control.”  For purposes of this Section 5, a “Change in Control” shall be deemed to have occurred if any of the following events occurs:

1. Any “person” or “group” (within the meaning of Sections 13(d) and 14(d)(2) of the Securities Exchange Act of 1934, as amended (the “1934 Act”)), other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company (an “Acquiring Person”), is or becomes the “beneficial owner” (as defined in Rule 13d-3 under the 1934 Act), directly or indirectly, of more than 33 1/3% of the then outstanding voting stock of the Company;

2. A merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least 51% of the combined voting power of the voting securities of the Company or surviving entity outstanding immediately after such merger or consolidation;

3. A sale or other disposition by the Company of all or substantially all of the Company’s assets;

4. During any period of not more than one (1) year (beginning on or after the Effective Date), individuals who at the beginning of such period constitute the Board of Directors and any new director (other than a director who is a representative or nominee of an Acquiring Person) whose election by the Board of Directors or nomination for election by the Company’s shareholders was approved by a vote of at least a majority of the directors then still in office who either were directors at the beginning of the period or whose election or nomination was previously so approved, no longer constitute a majority of the Board of Directors;

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provided, however, in no event shall any acquisition of securities, a change in the composition of the Board of Directors or a merger or other consolidation pursuant to a plan of reorganization under chapter 11 of the Bankruptcy Code with respect to the Company (“Chapter 11 Plan”), or a liquidation under the Bankruptcy Code constitute a Change in Control and provided further that in no event shall any transaction be considered a Change in Control if it does not constitute a change in the ownership or effective control of Sun or a change in the ownership of a substantial portion of Sun’s assets, each within the meaning of Section 409A of the United States Internal Revenue Code of 1986, as amended (the “Code”) and the Treasury Regulations promulgated thereunder (“Section 409A”).  In addition, notwithstanding Sections 5(c)(1), 5(c)(2), 5(c)(3) and 5(c)(4), a Change in Control shall not be deemed to have occurred in the event of a sale or conveyance in which the Company continues as a holding company of an entity or entities that conduct the business or businesses formerly conducted by the Company, or any transaction undertaken for the purpose of reincorporating the Company under the laws of another jurisdiction, if such transaction does not materially affect the beneficial ownership of the Company’s capital stock.  A Change in Control shall not, by itself, constitute Good Reason hereunder.

d. Cooperation.  Following the expiration or a termination of this Agreement for any reason, Mr. Matros shall provide such cooperation as is reasonably required by the Company, including, without limitation, consulting with the Company with respect to litigation and/or matters that relate to facts and circumstances that occurred during the term of his employment by the Company, and executing such documents and instruments relating to such term of employment as are reasonably requested by Sun.

Section 6:   Reduction in Compensation to Avoid Excise Tax.  Notwithstanding anything herein to the contrary, if the excise tax imposed by Section 4999 of the Code or any similar or successor tax (the “Excise Tax”) applies to any payments, benefits and/or amounts received (or otherwise to be received) by Mr. Matros pursuant to Section 5(b) or otherwise, including, without limitation, amounts received or deemed received, within the meaning of any provision of the Code, by Mr. Matros as a result of (and not by way of limitation) any automatic vesting, lapse of restrictions and/or accelerated target or performance achievement provisions, or otherwise, applicable to outstanding grants or awards to Mr. Matros under any of Sun’s incentive plans (collectively, the “Total Payments”), then the Total Payments shall be reduced (but not below zero) so that the maximum amount of the Total Payments (after reduction) shall be one dollar ($1.00) less than the amount which would cause the Total Payments to be subject to the Excise Tax; provided that such reduction to the Total Payments shall be made only if the total after-tax benefit to Mr. Matros is greater after giving effect to such reduction than if no such reduction had been made.  If such a reduction is required, the Company shall reduce or eliminate the Total Payments by first reducing or eliminating any accelerated vesting of stock options that then have a term of one year or less and are then under-water, then by reducing or eliminating any cash severance benefits, then by reducing or eliminating any accelerated vesting of any other stock options, then by reducing or eliminating any accelerated vesting of other equity awards, and then by reducing or eliminating any other remaining Total Payments, in each case in reverse order beginning with the payments which are to be paid the farthest in time from the date of the

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related change in control event. The preceding provisions of this Section 6 shall take precedence over the provisions of any other plan, arrangement or agreement governing Mr. Matros’ rights and entitlements to any benefits or compensation. The Company agrees that, prior to and in connection with any Change in Control, the Company will reasonably consider alternatives (if any) Mr. Matros may have to eliminate or mitigate the impact of any Excise Tax on his Total Payments.

a. Determination of Reduction.  The amount of the reduction in compensation shall be determined by an accounting firm retained by Sun (the “Accounting Firm”) using such formulas as the Accounting Firm deems appropriate.  No compensation to Mr. Matros shall be reduced pursuant to the provisions of this Section 6 if the Accounting Firm determines that the payments to Mr. Matros are not subject to an Excise Tax.

b. Payment of Excise Tax.   If a reduction in compensation that results in no Excise Tax being payable does not result in Mr. Matros having a more positive after-tax financial position than he would have enjoyed without the reduction but with the resulting application of the Excise Tax, then, at the option of Mr. Matros, he can choose to pay the amount of the Excise Tax and avoid the reduction in compensation.  The amount of the Excise Tax shall be determined by the Accounting Firm using such formulas as the Accounting Firm deems appropriate.  In the event the Mr. Matros chooses to pay the Excise Tax, he will have no right of reimbursement or payment of additional compensation from the Company.

Section 7:  Protection of Sun’s Interests.

a. Ownership of Property.  Mr. Matros acknowledges and agrees that any and all property developed, discovered or created by him during the pendency of his employment by the Company, including, without limitation, any and all copyrights, trademarks, trade secrets or other intellectual property is and shall remain the sole and exclusive property of the Company and Mr. Matros hereby sells, assigns and otherwise transfers all of his right, title and interest in and to such property, if any, to the Company.

b. Confidentiality.  Mr. Matros agrees that he will not at any time, during or after the term of this Agreement, except in performance of his obligations to Sun hereunder or with the prior written consent of the Board of Directors, directly or indirectly disclose to any person or organization any secret or “Confidential Information” that Mr. Matros may learn or has learned by reason of his association with Sun and its direct and indirect subsidiaries.  For purposes of all of this Section 7 only, “Sun” shall also include Sun’s direct and indirect subsidiaries.  The term “Confidential Information” means any information not previously disclosed to the public or to the trade by Sun’s management with respect to Sun’s products, services, business practices, facilities and methods, salary and benefit information, trade secrets and other intellectual property, systems, procedures, manuals, confidential reports, product price lists, pricing information, customer lists, financial information (including revenues, costs or

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profits associated with any of Sun’s products or lines of business), business plans, prospects or opportunities.

c. Exclusive Property.  Mr. Matros confirms that all Confidential Information is and shall remain the exclusive property of Sun.  All business records, papers and documents kept or made by Mr. Matros relating to the business of Sun shall be and remain the property of Sun.  Upon the expiration or termination of Mr. Matros’ employment with Sun for any reason or upon the request of Sun at any time, Mr. Matros shall promptly deliver to Sun, and shall not without the consent of the Board of Directors, retain copies of, Confidential Information, or any written materials not previously made available to the public, or records and documents made by Mr. Matros or coming into Mr. Matros’ possession concerning the business or affairs of Sun.

d. Nonsolicitation.  Mr. Matros shall not, during his employment under this Agreement, and for two (2) years following the termination of this Agreement, for whatever reason or cause, in any manner induce, attempt to induce, or assist others to induce, or attempt to induce, any employee, agent, representative or other person associated with Sun or any customer, patient or client of Sun to terminate his or her association or contract with Sun, nor in any manner, directly or indirectly, interfere with the relationship between Sun and any of such persons or entities.

e. Non-Disparagement.  Mr. Matros shall not during his employment under this Agreement and for two (2) years following termination of the Agreement, for whatever reason, make any statements that are intended to or that would reasonably be expected to harm Sun or any of its subsidiaries or affiliates, their respective predecessors, successors, assigns and employees and their respective past, present or future officers, directors, shareholders, employees, trustees, fiduciaries, administrators, agents or representatives.  Sun and its officers and directors will not make any statements that are intended to or that would reasonably be expected to harm Mr. Matros or his reputation or that reflect negatively on Matros’ performance, skills or ability.

f. Violation of Covenants.

1. Without intending to limit the remedies available to Sun, Mr. Matros acknowledges that a breach of any of the covenants in this Section 7 may result in material irreparable injury to Sun for which there is no adequate remedy at law, that it will not be possible to measure damages for such injuries precisely and that, in the event of such a breach or threat thereof, Sun shall be entitled to obtain a temporary restraining order and/or a preliminary or permanent injunction restraining Mr. Matros from engaging in activities prohibited by this Section 7 or such other relief as may be required to specifically enforce any of the covenants in this Section 7.

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2. In the event that Mr. Matros breaches any of the covenants in this Section 7, Sun shall be entitled to cease payment of any further compensation or benefits pursuant to Section 5(b) or otherwise (other than compensation payable pursuant to Section 5(b)(1)(ii)) and recover from Mr. Matros any amounts paid to him pursuant to the provisions of Section 5(b)(1)(i), Section 5(b)(2)(i) or Section 5(b)(2)(iii).

Section 8:    Miscellaneous Provisions.

a. Amendments, Waivers, Etc.  No provision of this Agreement may be modified, waived or discharged unless such waiver, modification or discharge is agreed to in writing signed by both parties.  No waiver by either party hereto at any time of any breach by the other party hereto of, or compliance with, any condition or provision of this Agreement to be performed by such other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the same or at any prior or subsequent time.

b. Validity.  The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement, which shall remain in full force and effect.

c. Entire Agreement.  This Agreement sets forth the entire agreement and understanding of the parties hereto with respect to the matters covered hereby.  No agreements or representations, oral or otherwise, express or implied, with respect to the subject matter hereof have been made by either party which are not expressly set forth in this Agreement and this Agreement shall supersede all prior agreements, including the Existing Agreement, negotiations, correspondence, undertakings and communications of the parties, oral or written, with respect to the subject matter hereof.

d. Resolution of Disputes.  Any disputes arising under or in connection with this Agreement may, at the election of Mr. Matros or Sun, be resolved by binding arbitration, to be held in Orange County, California in accordance with the rules and procedures of the American Arbitration Association.  If arbitration is elected, Mr. Matros and Sun shall mutually select the arbitrator. If Mr. Matros and Sun cannot agree on the selection of an arbitrator, each party shall select an arbitrator and the two arbitrators shall select a third arbitrator who shall resolve the dispute.  Judgment upon the award rendered by the arbitrator may be entered in any court having jurisdiction thereof.  Nothing herein shall limit the ability of Sun to obtain the injunctive relief described in Section 7(f) pending final resolution of matters that are sent to arbitration.

e. Attorneys’ Fees.  Sun shall pay or reimburse Mr. Matros on an after-tax basis for all costs and expenses (including, without limitation, court costs, costs of arbitration and reasonable legal fees and expenses which reflect common practice with respect to the matters involved) incurred by Mr. Matros if Mr. Matros prevails on the merits of any claim, action or proceeding (i) contesting or

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otherwise relating to the existence of Good Cause in the event of Mr. Matros’ termination of employment during the Term for Good Cause; (ii) enforcing any right, benefit or obligation under this Agreement, or otherwise enforcing the terms of this Agreement or any provision thereof; or (iii) asserting or otherwise relating to the existence of Good Reason in the event of Mr. Matros’ termination of employment during the Term for Good Reason.

f. Governing Law.  The validity, interpretation, construction and performance of this Agreement shall be governed by the laws of the State of California.

g. Notice.  For the purpose of this Agreement, notice, demands and all other communication provided for in this Agreement shall be in writing and shall be deemed to have been duly given when delivered by hand delivery or overnight courier or mailed by United States certified or registered mail, return receipt requested, postage prepaid, addressed as follows or to other addresses as each party may have furnished to the other:

To Sun:

Sun Healthcare Group, Inc.

Attention:  General Counsel

18831 Von Karman, Suite 400

Irvine, California 92612-1537

To Mr. Matros:

Mr. Richard Matros

14 Scenic Bluff

Newport Coast, California 92657

h. Section 409A.

1. If Mr. Matros is a “specified employee” within the meaning of Treasury Regulation Section 1.409A-1(i) as of the date of Mr. Matros’ separation from service (within the meaning of Treasury Regulation Section 1.409A-1(h)(1), without regard to the optional alternative definitions available thereunder) and any payment or benefit provided in Section 5 hereof constitutes a “deferral of compensation” within the meaning of Section 409A, Mr. Matros shall not be entitled to any such payment or benefit until the earlier of: (i) the date which is six (6) months after his separation from service for any reason other than death, or (ii) the date of his death.  The provisions of this paragraph shall only apply if, and to the extent, required to avoid the imputation of any tax, penalty or interest pursuant to Section 409A.  Any amounts otherwise payable to Mr. Matros upon or in the six (6) month period following his separation from service that are not so paid by reason of this Section 8(h)(1) shall be paid (without interest) as soon as practicable (and in all events within thirty (30) days) after the date that is six (6) months after Mr. Matros’ separation from service (or, if

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earlier, as soon as practicable, and in all events within thirty (30) days, after the date of his death).

2. To the extent that any reimbursements pursuant to Sections 3(h), 5(b)(3)  and 8(e) are taxable to Mr. Matros, any reimbursement payment due to Mr. Matros pursuant to such provision shall be paid to Mr. Matros on or before the last day of Mr. Matros’ taxable year following the taxable year in which the related expense was incurred.  The benefits and reimbursements pursuant to Sections 3(h), 5(b)(3)and 8(e) are not subject to liquidation or exchange for another benefit and the amount of such benefits and reimbursements that Mr. Matros receives in one taxable year shall not affect the amount of such benefits and reimbursements  that Mr. Matros receives in any other taxable year.

3. It is intended that any amounts payable under this Agreement and Sun’s and Mr. Matros’ exercise of authority or discretion hereunder shall comply with and avoid the imputation of any tax, penalty or interest under Section 409A.  This Agreement shall be construed and interpreted consistent with that intent.

The parties hereto have executed this Agreement as of the date first above written.

RICHARD K. MATROS

/s/ Richard K. Matros

SUN HEALTHCARE
GROUP, INC.

/s/ Michael Newman

Its Executive Vice
President

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EX-10.2

EXHIBIT 10.2

Sun Healthcare Group, Inc. Supplemental Bonus Plan

Effective July 1, 2009, supplemental incentive bonuses of Executives of Sun and of SunBridge shall be determined pursuant to this plan.  This plan is intended to provide bonuses that qualify for the performance-based compensation exemption of Section 162(m) (“Section 162(m)”) of the Internal Revenue Code of 1986, as amended.  This plan is adopted under Section 5.2.2 of Sun’s 2009 Performance Incentive Plan (the “Plan”), and bonuses awarded under this plan shall be awards under the Plan that are subject to all of the terms and conditions of the Plan.

The supplemental incentive bonus (the “Supplemental Bonus”) of an Executive for the six-month period ending December 31, 2009 (the “Applicable Period”) shall be based on the criteria set forth below.   Supplemental Bonuses will be paid in addition to compensation payable under other compensation agreements and plans.  The Supplemental Bonus will be based upon achievement of the targets described below.

1.           EPS.  The Committee has established a target of $.53 for Sun’s consolidated earnings per share (“EPS”) for the Applicable Period (the EPS target is referred to as the “Target”).  EPS shall be measured using the normalized actual EPS of Sun as published by Sun in its press releases announcing financial results for the quarter ending September 30, 2009 and the quarter ending December 31, 2009, which normalizing adjustments consist of actuarial adjustments for self insurance for general and professional liability, EPS attributable to discontinued operations, and nonrecurring costs related to acquisitions and other similar events.When determining whether the Target has been achieved, the Committee shall make adjustments to the Target to eliminate the effect of discontinued operations or any change in accounting policies or practices.

The amount of the Supplemental Bonus shall be based upon normalized actual EPS attained as a percentage of the Target.  The Supplemental Bonuses will be determined as follows (percentages in the tables are percentages of base salary as of the last day of the Applicable Period):

Name	Position	60% of target	100% of target	115% of target
R. Matros	Chairman & CEO	11%	17%	28%
W. Mathies	COO SunBridge	9%	14%	23%
B. Shaul	CFO	9%	13%	23%
C. Hunker	Ch. Comp. & Ch. Risk Off.	9%	13%	23%
M. Newman	GC	9%	13%	23%
C. Chrispell	SVP, HR	6%	9%	16%

If normalized actual EPS is less than 60% of the Target, no Supplemental Bonus will be paid to any Executive.  If normalized actual EPS exceeds 115% of the Target, each Supplemental Bonus will equal the percentage of base salary set forth in the last column of the table above.  If normalized actual EPS is greater than 60% of the Target but less than 100% of the Target, or

greater than 100% but less than 115%, the amount of the Supplemental Bonus will be prorated on a straight-line basis between the amounts shown in the applicable columns of the table.

In no case, however, shall the amount of any Supplemental Bonus exceed (i) the amount that has been accrued for such Supplemental Bonus in the calculation of EPS and (ii) the applicable limit set forth in Section 5.2.3 of the Plan.  Notwithstanding the foregoing, no Supplemental Bonus shall be paid to any Executive if normalized EPS for the three months ending December 31, 2009 is less than $.20 per share.

2.           Committee Certification and Timing of Payment.  As soon as practicable after the end of the Applicable Period, the Committee shall determine the amount of Sun’s normalized actual EPS for the Applicable Period and normalized actual EPS for the quarter ending December 31, 2009.  No Supplemental Bonus shall be paid to an Executive unless and until the Committee has certified, by resolution or other appropriate action in writing, the normalized actual EPS earned by Sun for the Applicable Period, the normalized actual EPS earned by Sun for the quarter ending December 31, 2009, the normalized actual EPS earned by Sun for the Applicable Period as a percentage of the Target and the amount of the Supplemental Bonus earned by each Executive.  Any Supplemental Bonus shall be paid to each Executive as soon as practicable after completion of the 2009 year-end audit and following the Committee’s certification described above (but in no event later than March 15, 2010).

3.           Recoupment of Bonus Payments.  A Supplemental Bonus paid to an Executive is subject to recoupment, to the extent determined to be appropriate by the Committee, if each of the following circumstances occur: (1) the amount of the Supplemental Bonus was calculated based on the achievement of EPS, the calculation of which was based on financial statements that are subsequently the subject of an accounting restatement due to noncompliance with any financial reporting requirement under the securities laws; (2) fraud or intentional misconduct by any Executive, or any officer or employee that reports to an Executive was a significant contributing factor to such noncompliance; and (3) the restated financial statements are issued and completed prior to the issuance and completion of the financial statements for the 2012 fiscal year.  In such circumstances, a Supplemental Bonus will be subject to recoupment only to the extent a lesser Supplemental Bonus would have been paid to an Executive based upon EPS, as restated, and only as to the net amount of such portion of the Supplemental Bonus after reduction for the Executive’s tax liability on that portion of the Supplemental Bonus.  By accepting a Supplemental Bonus, each Executive agrees to promptly make any Supplemental Bonus reimbursement required by the Committee in accordance with this section, and that Sun, SunBridge and their respective affiliates may deduct from any amounts owed to the executive from time to time (such as wages or other compensation) any amounts the Executive is required to reimburse Sun and/or SunBridge pursuant to this section.  This section does not limit any other remedies Sun, SunBridge or their respective affiliates may have available in the circumstances, which may include, without limitation, dismissing the Executive or initiating other disciplinary procedures.  The provisions of this section are in addition to (and not in lieu of) any rights to repayment Sun, SunBridge or their respective affiliates may have under Section 304 of the Sarbanes-Oxley Act of 2002 and other applicable laws.

4.           Administration.  This plan shall be administered by the Committee, which shall consist solely of two or more members of the Board of Directors of Sun who are “outside directors”

2

within the meaning of Treasury Regulation Section 1.162-27(e)(3) under Section 162(m).  The Committee shall have the same administrative authority with respect to this plan as provided for under the Plan.

5.           Section 162(m).  This plan is intended to provide bonuses that qualify for the performance-based compensation exemption of Section 162(m).  Any provision, application or interpretation of this plan inconsistent with this intent to satisfy the standards in Section 162(m) shall be disregarded.

3

EX-31.1

EXHIBIT 31.1

CERTIFICATION PURSUANT TO

SECTION 302 OF

THE SARBANES-OXLEY ACT OF 2002

I, Richard K. Matros, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Sun Healthcare Group, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in the Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting;

5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: October 28, 2009	/s/ Richard K. Matros
	Richard K. Matros Chief Executive Officer (Principal Executive Officer)

EX-31.2

EXHIBIT 31.2

CERTIFICATION PURSUANT TO

SECTION 302 OF

THE SARBANES-OXLEY ACT OF 2002

I, L. Bryan Shaul, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Sun Healthcare Group, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in the Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting;

5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: October 28, 2009	/s/ L. Bryan Shaul
	L. Bryan Shaul Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)

EX-32.1

EXHIBIT 32.1

WRITTEN STATEMENT

 PURSUANT TO

18 U.S.C. SECTION 1350

   The undersigned, Richard K. Matros, the Chief Executive Officer (Principal Executive Officer), of Sun Healthcare Group, Inc. (the "Company"), pursuant to 18 U.S.C. Section 1350, hereby certifies that:

(i)   the Quarterly Report on Form 10-Q for the quarter ended September 30, 2009 of the Company (the "Report") fully complies with the requirements of section 13(a) and 15(d) of the Securities Exchange Act of 1934; and

(ii)   the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: October 28, 2009	/s/ Richard K. Matros
	Richard K. Matros

EX-32.2

EXHIBIT 32.2

WRITTEN STATEMENT

 PURSUANT TO

18 U.S.C. SECTION 1350

   The undersigned, L. Bryan Shaul, the Chief Financial Officer (Principal Financial Officer), of Sun Healthcare Group, Inc. (the "Company"), pursuant to 18 U.S.C. Section 1350, hereby certifies that:

(i)   the Quarterly Report on Form 10-Q for the quarter ended September 30, 2009 of the Company (the "Report") fully complies with the requirements of section 13(a) and 15(d) of the Securities Exchange Act of 1934; and

(ii)   the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: October 28, 2009	/s/ L. Bryan Shaul
	L. Bryan Shaul