HALSEY DRUG CO INC/NEW - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO .

COMMISSION FILE NUMBER 1-10113
HALSEY DRUG CO., INC.
(Exact name of registrant as specified in its charter)

NEW YORK 11-0853640
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

695 NORTH PERRYVILLE ROAD, 61107
CRIMSON BUILDING NO. 2 (Zip Code)
ROCKFORD, ILLINOIS
(Address of principal executive offices)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
(815) 399-2060

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

TITLE OF CLASS

NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

(TITLE OF CLASS)

COMMON STOCK, PAR VALUE $0.01

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 [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [ ] No [X]

As of March 31, 2003, the registrant had 21,035,323 shares of Common Stock,
par value $0.01, outstanding. Based on the average closing bid and asked prices
of the Common Stock on June 28, 2002 ($1.515)(the last business day of the
registrant's most recently completed second fiscal quarter), the aggregate
market value of the voting stock held by non-affiliates of the registrant was
approximately $21,002,667.
DOCUMENTS INCORPORATED BY REFERENCE
NONE
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CONTENTS

1

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain statements in this Report under the captions Item 7, "Management's
Discussion and Analysis of Financial Condition and Results of Operations," Item
1, "Business", Item 3, "Legal Proceedings" and elsewhere in this Report
constitute "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995 (the "Reform Act"). Such
forward-looking statements involve known and unknown risks, uncertainties and
other factors which may cause the actual results, performance or achievements of
Halsey Drug Co., Inc. ("Halsey" or the "Company"), or industry results, to be
materially different from any future results, performance, or achievements
expressed or implied by such forward-looking statements. Such factors include,
among others, the following: changes in general economic and business
conditions; loss of market share through competition; introduction of competing
products by other companies; the timing of regulatory approval and the
introduction of new products by the Company; changes in industry capacity;
pressure on prices from competition or from purchasers of the Company's
products; regulatory changes in the generic pharmaceutical manufacturing
industry; difficulties encountered in the development of novel product synthesis
and manufacturing techniques; regulatory obstacles to the introduction of new
technologies or products that are important to the Company's growth;
availability of qualified personnel; the loss of any significant customers; and
other factors both referenced and not referenced in this Report. When used in
this Report, the words "estimate," "project," "anticipate," "expect," "intend,"
"believe," and similar expressions are intended to identify forward-looking
statements.

2

PART I

ITEM 1. BUSINESS

GENERAL

The Company, a New York corporation established in 1935, and its
subsidiaries, are engaged in the development, manufacture, sale and distribution
of generic drugs and active pharmaceutical ingredients ("APIs"). A generic drug
is the chemical and therapeutic equivalent of a brand-name drug for which patent
protection has expired. A generic drug may only be manufactured and sold if
patents (and any additional government-granted exclusivity periods) relating to
the brand-name equivalent of the generic drug have expired. A generic drug is
usually marketed under its generic chemical name or under a brand name developed
by the generic manufacturer. Through its strategic alliance with Watson
Pharmaceuticals, Inc. ("Watson"), as described below, the Company sells its
generic drug products under the Watson name for distribution by Watson to
drugstore chains and drug wholesalers. In addition, the Company intends to
directly market and sell its generic drug products under its own name or that of
a wholly-owned subsidiary commencing in the second quarter of 2003. While
subject to the same governmental standards for safety and efficacy as its
brand-name equivalent, a generic drug is usually sold at a price substantially
below that of its brand-name equivalent.

APIs, also known as bulk chemical products, are used in the development and
manufacture of finished dosage pharmaceutical products. The development and sale
of APIs generally is not subject to the same level of regulation as is the
development and sale of finished dosage products. As a result, APIs may be
brought to market substantially sooner than finished dosage products.

The Company manufactures its products at facilities in New York and
Indiana. During the last several years, the Company has sought to diversify its
businesses through strategic acquisitions and alliances and through the
development of technologies for the synthesis and production of APIs intended
for sale to third parties as well as for use by the Company and others as raw
materials in the manufacture of finished drug forms. The Company's primary
emphasis in this regard, and for which the Company is committing the substantial
majority of the Company's resources and sources of available capital, is the
development of novel opiate synthesis technologies which the Company expects to
use in the manufacture of APIs and finished dosage products indicated for pain
management.

We file annual, quarterly and current reports, proxy statements and other
information with the Securities and Exchange Commission (the "SEC"). These
filings are available to the public over the Internet at the SEC's web site at
http://www.sec.gov. You may also read and copy any document we file at the SEC's
public reference room at 450 Fifth Street, N.W., Washington, D.C. 20549. Please
call the SEC at 1-800-SEC-0330 for further information on the public reference
room.

Our principal Internet address is www.HalseyDrug.com. We make available
free of charge on www.HalseyDrug.com our annual, quarterly and current reports
and amendments to those reports, as soon as reasonably practicable after we
electronically file such material with, or furnish it to, the SEC. In
additional, you may request a copy of these filings (excluding exhibits) at no
cost by writing or telephoning us at the following address or telephone number:

Halsey Drug Co., Inc.
695 No. Perryville Rd. Crimson Bldg. 2
Rockford, Illinois 61107
Attn: Investor Relations
(815) 399-2060

RECENT EVENTS

DEBENTURE OFFERING

On December 20, 2002, the Company consummated a private offering of
securities for an approximate aggregate purchase price of $26,394,000 (the
"Offering"). The securities issued in the Offering consisted of

3

5% convertible senior secured debentures (the "Debentures"). The Debentures were
issued by the Company pursuant to a certain Debenture Purchase Agreement dated
December 20, 2002 (the "Purchase Agreement") by and among the Company, Care
Capital Investments II, LP ("Care Capital"), Essex Woodlands Health Ventures V,
L.P. ("Essex"), Galen Partners III, L.P. and each of the purchasers listed on
the signature page thereto (collectively, the "2002 Debenture Investor Group").

Of the $26,394,000 in Debentures issued in the Offering, approximately
$15,894,000 of Debentures were issued in exchange for the surrender of a like
amount of principal and accrued interest outstanding under Company's 10%
convertible promissory notes issued pursuant to various working capital bridge
loan transactions with Galen Partners III, L.P., Galen International III, L.P.,
Galen Employee Fund III, L.P. (collectively, "Galen") and certain other lenders,
during the period from August 15, 2001 through and including December 20, 2002.

The Debentures, issued at par, will become due and payable as to principal
on March 31, 2006. Interest on the principal amount of the Debentures, at the
rate of 5% per annum, is payable on a quarterly basis. With the exception of the
Debentures issued to Care Capital, interest on the Debentures will be paid by
the Company's issuance of a debenture instrument substantially identical to the
Debentures issued in the Offering, in the principal amount equal to the accrued
interest for each quarterly period (the "Interest Debentures"). Debentures
issued to Care Capital provide that fifty percent (50%) of the interest payments
under such Debentures will be satisfied in cash with the balance satisfied by
Company's issuance of Interest Debentures.

The Debentures issued to each of Care Capital and Essex are convertible at
any time after issuance into shares of the Company's Common Stock, $.01 per
value per share (the "Common Stock"). The Debentures issued to Galen and the
other investors in the Offering (excluding Care Capital and Essex) are
convertible at any time after the approval of the Company's shareholders and
debentureholders of an amendment to the Company's Certificate of Incorporation
to increase its authorized shares of Common Stock from 80,000,000 shares to such
number of shares as shall provide sufficient authorized shares to permit the
conversion of such Debentures and Company's outstanding convertible securities,
as provided in the Purchase Agreement. Subject to the foregoing, the Debentures
are convertible into shares of Common Stock at a price per share (the
"Conversion Price") of $.34. Until such time as the Company completes a
Subsequent Material Offering (as defined below) the Conversion Price is subject
to adjustment, from time to time, to equal the consideration per share received
by the Company for its Common Stock, or the conversion/exercise price per share
of the Company's Common Stock issuable under rights or options for the purchase
of, or stock or other securities convertible into, Common Stock ("Convertible
Securities"), if lower than the then applicable Conversion Price. Following the
Company's completion of a Subsequent Material Offering, the Conversion Price is
subject to adjustment from time to time on a weighted-average dilution basis. A
"Subsequent Material Offering" is the grant or issuance of Common Stock or
Convertible Securities by the Company during any six month period for an
aggregate gross consideration of at least $10,000,000. The Conversion Price is
also subject to adjustment to give effect to additional Debentures, if any, that
may be issued under the Purchase Agreement and in the event of a subsequent
recapitalization of the Company's outstanding common stock purchase warrants
issued to Galen in prior debenture offerings and in consideration for various
bridge loans to the Company.

The Interest Debentures are convertible at any time after issuance into
shares of Common Stock at a price per share equal to the average of the closing
bid and asked prices of the Common Stock for the twenty (20) trading days
immediately preceding the applicable interest payment date under the Debentures,
as reported by the Over-the-Counter ("OTC") Bulletin Board.

Assuming the conversion of the Debentures at the initial Conversion Price
of $.34 per share, the Debentures are convertible into an aggregate of
approximately 77,629,000 shares of the Company's Common Stock.

The Purchase Agreement provides that the holders of the Debentures shall
have the right to vote as part of a single class with all holders of the
Company's Common Stock on all matters to be voted on by such stockholders. Each
Debenture holder shall have such number of votes as shall equal the number of
votes he would have had if such holder converted the entire outstanding
principal amount of his Debenture into shares
4

of Common Stock immediately prior to the record date relating to such vote;
provided, however, that any Debentures held by Care Capital shall, for so long
as they are held by Care Capital, have no voting rights. The Purchase Agreement
also provided for the execution of a Debentureholder Agreement providing the
holders of the Debentures with veto rights relating to certain material Company
transactions.

The Debentures are secured by a lien on all assets of the Company, tangible
and intangible. In addition, each of Houba, Inc. and Halsey Pharmaceuticals,
Inc., each a wholly-owned subsidiary of the Company, has executed in favor of
the 2002 Debenture Investor Group an Unconditional Agreement of Guaranty of the
Company's obligations under the Purchase Agreement. Each Guaranty is secured by
all assets of such subsidiary, and, in the case of Houba, Inc., by a mortgage
lien on its real estate. In addition, the Company has pledged the stock of each
such subsidiary to the 2002 Debenture Investor Group to further secure its
obligations under the Purchase Agreement.

In accordance with the terms of a Subordination Agreement dated December
20, 2002 between the Company, the holders of the Debentures, the holders of the
Company's 5% Convertible Senior Secured Debentures issued pursuant to that
certain Debenture and Warrant Purchase Agreement (the "1998 Purchase Agreement")
between the Company, Galen and other signatories thereto, dated March 10, 1998
(the "Galen Group Debentures"), the holders of the Company's 5% Convertible
Senior Secured Debentures issued pursuant to that certain Debenture and Warrant
Purchase Agreement (the "1999 Purchase Agreement") between the Company, Oracle
Strategic Partners, L.P. and other signatories thereto, dated May 26, 1999 (the
"Oracle Group Debentures" and together with the Galen Group Debentures, the
"Existing Debentures"), and Watson Pharmaceuticals, Inc. ("Watson"), the liens
on the Company's and its Subsidiaries' assets as well as the payment priority of
the Debentures are (i) subordinate to the Company's lien and payment obligations
in favor of Watson under the Company's Loan Agreement with Watson pursuant to
which Watson has made a term loan to the Company in the principal amount of
$21,401,331 (as amended, the "Watson Loan Agreement"), and (ii) senior to the
Company's lien and payment obligations in favor of the holders of the Existing
Debentures in the aggregate principal amount of approximately $50,723,938. In
addition to the subordination of the liens and the payment priority of the
Existing Debentures in favor of the Debentures issued in the Offering, as part
of the completion of the Offering, each of the holders of the Galen Group
Debentures and the Oracle Group Debentures agreed to extend the maturity date of
the Existing Debentures from March 15, 2003 to March 31, 2006.

As part of the closing of the Offering, the Watson Loan Agreement was
amended to (i) extend the maturity date of the Watson Loan Agreement from March
31, 2003 to March 31, 2006, (ii) increase the interest rate from prime plus two
and one-half percent (2.5%) to prime plus four and one-half percent (4.5%), and
(iii) increase the principal amount of the Watson Term Loan from $17,500,000 to
$21,401,331 to reflect the inclusion of approximately $3,901,331 owed by the
Company to Watson under a product supply agreement between the parties. In
consideration for the amendment to the Watson Loan Agreement, the Company issued
to Watson a Common Stock Purchase Warrant exercisable for 10,700,665 shares of
the Company's Common Stock (the "Watson Warrant"). The Watson Warrant has a term
expiring December 31, 2009 and an exercise price of $.34 per share.

As part of the completion of the transactions contemplated in the Purchase
Agreement, the Company consummated the terms of a Warrant Recapitalization
Agreement dated December 20, 2002 (the "Recapitalization Agreement") between the
Company and certain holders of an aggregate of 8,145,736 Common Stock Purchase
Warrants issued by the Company (i) pursuant to the 1998 Purchase Agreement (the
"1998 Warrants"), (ii) pursuant to the 1999 Purchase Agreement (the "1999
Warrants"), and (iii) pursuant to various bridge loan transactions during the
period from 1998 through 2002 (the "Bridge Loan Warrants" and collectively with
the 1998 Warrants and 1999 Warrants, the "Recapitalization Warrants"). As part
of the closing of the Recapitalization Agreement, the warrantholders a party
thereto surrendered to the Company for cancellation the Recapitalization
Warrants in exchange for the issuance of an aggregate of 5,970,083 shares of the
Company's Common Stock.

5

OPIATE SYNTHESIS TECHNOLOGIES

Halsey has developed internally both an opiate isolation synthesis process
which the Company believes provides an efficient and cost-effective alternative
to the extraction of morphine and codeine from raw opium (the "IMP Process"),
and an alternate development synthesis route for the manufacture of other pain
management products (the "New Synthesis Process", and together with the IMP
Process, collectively the "Opiate Synthesis Technologies"). To date, the Company
has successfully completed laboratory-scale proof of concept testing on each of
the IMP Process and the New Synthesis Process. The Company will continue the
development of the IMP Process and the New Synthesis Process, including the
construction of pilot and commercial scale manufacturing facilities within
existing Company manufacturing facilities, with the expectation of manufacturing
opiate-derived APIs and finished dosage pain management products in the future.

Each of the Opiate Synthesis Technologies are novel processes intended to
be more efficient and cost effective methods of deriving APIs to be used in the
manufacture of finished dosage pain management products by substantially
reducing the time and steps required to produce the desired API as well as the
waste product relating to such production. It is the Company's expectation to
prepare and file patent applications covering each of the IMP Process and the
New Synthesis Process. No assurance can be given, however, that a patent will be
issued on any of the Opiate Synthesis Technologies.

The development of the Opiate Synthesis Technologies demonstrates the
Company's continuing efforts to develop and manufacture APIs and finished dosage
products with an emphasis on pain management products. The Company estimates
that the market for pain management products in the United States is
approximately $2 billion and is growing at approximately 20% per year. In
addition to its development efforts relating to the Opiate Synthesis
Technologies, the Company is a party to agreements with Watson (see "Recent
Events -- Strategic Alliance" below) providing for Watson's right to negotiate
for a supply of select APIs currently in development and to be developed by the
Company. It is the Company's intention to continue its focus on pain management
products by developing APIs incorporating the Opiate Synthesis Technologies and
other technologies developed internally by the Company or licensed from third
parties. Such development efforts may be performed solely by the Company or in
partnership with third-party manufacturers. It is the Company's expectation to
use such APIs in the Company's own manufacture and sale of finished dosage
pharmaceutical products as well as to sell such APIs to third parties.

The development, marketing and sale of pain management products
incorporating the Opiate Synthesis Technologies is subject to extensive
regulation by the U.S. Drug Enforcement Administration ("DEA") and the U.S. Food
and Drug Administration ("FDA"). The Company's API manufacturing facility
located in Culver, Indiana is DEA approved to manufacture Schedule II to V
controlled substances (the "Manufacturing Registration"). In order to continue
the development and ultimate commercialization of the Opiate Synthesis
Technologies, the Company has filed for DEA approval to import raw poppy
directly from India and Turkey to be used in the Company's API development and
manufacturing efforts (the "Import Registration"). At present, the Company
believes that only three manufacturers in the United States possess such import
registrations.

The Company's application for an Import Registration was published in the
Federal Register on September 6, 2001. Within the 30 day period provided under
DEA guidelines, three parties, including the two companies that represent the
largest importers of narcotic raw materials used to manufacture controlled
substances, requested a hearing to formally object to the Company's request for
an Import Registration. In their hearing request, the objecting parties oppose
the DEA's issuance to the Company of an Import Registration on various grounds,
including that the Company's application be stayed pending the resolution of
three (3) pending import registration requests from other parties, that the
issuance of an Import Registration to the Company has the potential for
increasing the prices for narcotic raw materials from foreign sources as a
result of increased demand from U.S. manufacturers, that the Company lacks the
experience, technology, personnel and capital to process narcotic raw materials,
and that the competition in the marketplace for pain management products is
adequate.

6

The Company's hearing before the Office of Administrative Law Judge
("OALJ") relating to its Import Registration application is expected to be held
in the third quarter of 2003. The Company estimates that a ruling by the OALJ
will occur during the first quarter of 2004 . No assurance can be given that the
Company's Import Registration application will be approved by the DEA. As part
of the DEA's analysis as to whether the issuance of an Import Registration to
the Company is appropriate, the DEA will consider, among other things, whether
adequate security safeguards and controls exist at the Company's Culver, Indiana
facility and at all points in the chain of transfer of the raw poppy from
suppliers in India and Turkey to the Company's Culver facility, whether the
Opiate Synthesis Technologies are viable and efficient processes, whether market
demand for pain management products supports the approval of another import
source, and whether the Company has established itself as an eligible party to
source and obtain raw poppy supplies from foreign sources. The Company is
currently making the necessary upgrades to its Culver, Indiana facility and
establishing points of supply in foreign markets to meet these DEA requirements.

The development and commercialization of APIs and finished dosage products
incorporating the Opiate Synthesis Technologies are subject to various factors,
many of which are outside the Company's control. Specifically, the Opiate
Synthesis Technologies have been tested only in laboratory settings and will
need to be successfully "scaled up" in order to be commercially viable, of which
no assurance can be given. Additionally, the Company must satisfy, and continue
to maintain compliance with, the DEA's requirements for the maintenance of its
Manufacturing Registration and the issuance and maintenance of the Import
Registration. Even assuming the Company can satisfy the DEA's requirements in
this regard, no assurance can be given that the Company will prevail in any
hearings with the OALJ at which third-party manufacturers already possessing
import registrations will object to any proposed issuance by the DEA of the
Import Registration to the Company. The process of seeking the Import
Registration and contesting opposition proceedings, as well as the continuing
development of the Opiate Synthesis Technologies, will likely continue through
2004. The Company is currently unable to provide any assurance that the Opiate
Synthesis Technologies will be commercially viable or that the Company will
succeed in obtaining an Import Registration. The Company is committing the
substantial majority of its resources, available capital and cash flow from
operations to the development of the Opiate Synthesis Technologies and to the
receipt of the Import Registration. The failure of the Company to successfully
develop the Opiate Synthesis Technologies or to obtain the Import Registration
will have a material adverse effect on the Company's operations and financial
condition. The Company's cash flow and limited sources of available financing
make it uncertain that the Company will have sufficient capital to continue to
fund operations or to otherwise complete the development of the Opiate Synthesis
Technologies, to obtain required DEA approvals and to fund the capital
improvements necessary for the manufacture of APIs and finished dosage products
incorporating the Opiate Synthesis Technologies. See Item 7. "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources" for a discussion of the Company's need for
additional financing and estimated capital requirements for the development of
the Opiate Synthesis Technologies, for the receipt of DEA approvals and for
improvements to its manufacturing facilities.

STRATEGIC ALLIANCE WITH WATSON

On March 29, 2000, the Company completed various strategic alliance
transactions with Watson Pharmaceuticals, Inc. ("Watson"). The transactions with
Watson provided for Watson's purchase of the Company's then pending ANDA for
doxycycline capsules USP, 50 mg and 100 mg (the "doxycycline ANDA"), for
Watson's rights to negotiate for Halsey to manufacture and supply certain
identified future products to be developed by Halsey, for Watson's marketing and
sale of the Company's core products and for Watson's extension of a $17,500,000
term loan to the Company.

The product acquisition portion of the transactions with Watson provided
for the Company's sale of the pending doxycycline ANDA and related rights (the
"Product") to Watson for an aggregate consideration of $13,500,000 (the "Product
Acquisition Agreement"). The final installment of the purchase price for the
Product of $3.5 million was paid by Watson to the Company on July 10, 2001. As
part of the execution of the Product Acquisition Agreement, the Company and
Watson executed ten year supply agreements covering the API and finished dosage
form of the Product pursuant to which Halsey, at Watson's discretion, will

7

manufacture and supply Watson's requirements for the Product API and, where the
Product API is sourced from the Company, finished dosage forms of the Product.

The Company and Watson also executed a right of first negotiation agreement
providing Watson with a first right to negotiate the terms under which the
Company would manufacture and supply certain specified APIs and finished dosage
products to be developed by the Company. The right of first negotiation
agreement provides that upon Watson's exercise of its right to negotiate for the
supply of a particular product, the parties will negotiate the specific terms of
the manufacturing and supply arrangement, including price, exclusivity, minimum
purchase requirements, if any, territory and term. In the event Watson does not
exercise its right of first negotiation upon notice from the Company, or in the
event the parties are unable to reach agreement on the material terms of a
supply arrangement relating to such product within sixty (60) days of Watson's
exercise of its right to negotiate for such product, the Company may negotiate
with third parties for the supply, marketing and sale of the applicable product.
The right of first negotiation agreement has a term of ten years, subject to
extension in the absence of written notice from either party for two additional
periods of five years each. The right of first negotiation agreement applies
only to API and finished dosage products identified in the agreement and does
not otherwise prohibit the Company from developing APIs or finished dosage
products for itself or third parties.

The Company's strategic alliance with Watson also provides for Watson's
extension of the Watson Term Loan to the Company. The Watson Term Loan is
secured by a first lien on all of the Company's assets, senior to the lien
securing all other Company indebtedness and carries a floating rate of interest
equal to prime plus four and one-half percent (4.5%). On December 20, 2002, the
Watson Loan Agreement was amended to increase the principal amount of the loan
from $17,500,000 to $21,401,331 reflecting the inclusion of the Company's
payment obligations to Watson under the Core Products Supply Agreement between
the parties (see below). As of December 31, 2002, the entire principal amount
available under the Watson Term Loan had been advanced to the Company. The net
proceeds from the term loan have, in large part, been used to upgrade and equip
the API manufacturing facility of Houba, Inc. located in Culver, Indiana, the
Company's wholly-owned subsidiary, to upgrade and equip the Company's Congers,
New York leased facilities, to satisfy approximately $3,300,000 in bridge
financing provided by Galen Partners and for working capital to fund continued
operations.

The Company and Watson also executed a manufacturing and supply agreement
providing for Watson's marketing and sale of the Company's existing core
products portfolio (the "Core Products Supply Agreement"). Pursuant to the terms
of the Core Products Supply Agreement, Watson was required to purchase and pay
for on a quarterly basis a minimum of $3,060,000 for products supplied by the
Company under such Agreement. For the three quarters ending December 31, 2000,
Watson made an advance payment to the Company of approximately $4,402,000 as
required under the terms of the Core Products Supply Agreement to be applied
against future product purchases under such Agreement. The advance payments and
any additional advance payments made by Watson under the Core Products Supply
Agreement will require that the Company supply Watson with a like amount of
products without additional payments from Watson at such time. On August 8,
2001, the Company and Watson executed an amendment to the Core Products Supply
Agreement (the "Core Products Amendment") providing (i) for a reduction of
Watson's minimum purchase requirements from $3,060,000 to $1,500,000 per
quarter, (ii) for an extension of Watson's minimum purchase requirements from
the quarter ending September 30, 2001 to quarter ending September 30, 2002,
(iii) for Watson to recover previous advance payments made under the Core
Products Supply Agreement in the form of the Company's provision of products
having a purchase price of up to $750,000 per quarter (such credit amount to be
in excess of Watson's $1,500,000 minimum quarterly purchase obligation), and
(iv) for the Company's repayment to Watson of any remaining advance payments
made by Watson under the Core Products Supply Agreement (and which amount has
not been recovered by product deliveries by the Company to Watson as provided in
Subsection (iii) above) in two (2) equal monthly installments on October 1, 2002
and November 1, 2002. As part of the completion of the Company's Offering of
Debentures (as described above under the caption "Debenture Offering"), on
December 20, 2002, the Company and Watson further amended the Core Products
Supply Agreement to provide for the Company's satisfaction of its outstanding
payment obligations to Watson of approximately $3,901,331 under such Agreement
by the

8

transfer of such payment obligation to the principal amount of the Watson Loan
Agreement. As a consequence, the Watson Loan Agreement was amended to increase
the principal amount of the Watson Term Loan from $17,500,000 to $21,401,331. In
addition, the maturity date of the Watson Loan Agreement was extended from March
31,2003 to March 31, 2006.

ACQUISITION OF PRODUCT ANDAS

On April 16, 1999, the Company completed an acquisition agreement with Barr
Laboratories, Inc. ("Barr") providing for the Company's purchase of the rights
to 50 pharmaceutical products (the "Barr Products"). Under the terms of the
acquisition agreement with Barr, the Company acquired all of Barr's rights in
the Barr Products, including all related governmental approvals (including
ANDAs) and related technical data and information. In consideration for the
acquisition of the Barr Products, the Company issued to Barr a common stock
purchase warrant exercisable for 500,000 shares of the Company's common stock
having an exercise price of $1.0625 per share (the fair market value of the
Common Stock on the date of issuance) and having a term of five years. The
acquisition agreement with Barr also allows Barr to purchase any of the Barr
Products manufactured by the Company for a period of five years.

The Barr Products acquired by the Company were previously marketed by Barr,
prior to its decision to strategically refocus its generic product portfolio
several years ago. While the Barr Products cover a broad range of therapeutic
applications and are the subject of approved ANDAs, the Company will be required
to obtain approval from the FDA to permit manufacture and sale of any of the
Barr Products, including site specific approval. The Company initially has
identified 8 of the products for which it will devote substantial effort in
seeking approval from the FDA for manufacture and sale. The Company estimates
that certain of these Barr Products will be available for sale in the fourth
quarter of 2003, although no assurance can be given that any of the Barr
Products will receive FDA approval or that if approved, that the Company will be
successful in the manufacture and sale of such products. It is the Company's
intention to continue to evaluate the remaining Barr Products on an ongoing
basis to assess their prospects for commercialization and likelihood of
obtaining regulatory approval.

PRODUCTS AND PRODUCT DEVELOPMENT

GENERIC FINISHED DRUG PRODUCTS

The Company historically has manufactured and sold a broad range of
prescription and over-the-counter drug products. The Company's pharmaceutical
product list currently includes a total of approximately 26 products, consisting
of 20 dosage forms and strengths of prescription drugs and 6 dosage forms and
strengths of over-the-counter drugs. Each dosage form and strength of a
particular drug is considered in the industry to be a separate drug product. The
Company's drug products are sold in various forms, including liquid and powder
preparations, compressed tablets and two-piece, hard-shelled capsules.

Most of the generic drug products manufactured by the Company can be
classified within one of the following categories:

1. Antibiotics,

2. Narcotic analgesics,

3. Anti-infective and anti-tubercular drugs,

4. Antihistamines and antihistaminic decongestants,

5. Antitussives, or

6. Steroids

During fiscal 2002, sales of antibiotics and narcotic analgesics accounted
for approximately 75% of net product sales during such year. The Company
anticipates that sales of antibiotics and narcotic analgesics will continue to
represent a significant portion of the Company's revenue.

9

The Company's development strategy for new drug products has been to focus
on the development of a broad-range of generic form drugs, each of which (i) has
developed a solid market acceptance with a wide base of customers, (ii) can be
sold on a profitable basis notwithstanding intense competition from other drug
manufacturers, and (iii) is no longer under patent protection. The Company has
also diversified its current product line to include some less widely prescribed
drugs as to which limited competition might be expected.

During the fiscal year ended December 31, 2002, the Company received 21
ANDA amendments consisting of products transferred from other Company locations
and submitted 16 ANDA supplements or amendments to the FDA. During fiscal 2003,
the Company anticipates the submission of 10 ANDA supplements or amendments to
the FDA. The supplements and amendments relate to the transfer of existing ANDAs
from the Company's Brooklyn, New York facility (at which operations were
discontinued in March 2001) to its Congers facility as well as the transfer of
certain ANDAs obtained from Barr Laboratories. Although the Company has been
successful in receiving ANDA approvals since its release from the FDA's
Application Integrity Policy list in December 1996, there can be no assurance
that any newly submitted ANDAs, or supplements or amendments thereto or those
contemplated to be submitted, will be approved by the FDA. The Company will not
be permitted to market any new product unless and until the FDA approves the
ANDA relating to such product. Failure to obtain FDA approval for the Company's
pending ANDAs, or a significant delay in submitting for or obtaining such
approval, would adversely affect the Company's business operations and financial
condition.

Development activities for each new generic drug product begin several
years in advance of the patent expiration date of the brand-name drug
equivalent. This is because the profitability of a new generic drug usually
depends on the ability of the Company to obtain FDA approval to market that drug
product upon or immediately after the patent expiration date of the equivalent
brand-name drug. Being among the first to market a new generic drug product is
vital to the profitability of the product. As other off-patent drug
manufacturers receive FDA approvals on competing generic products, prices and
revenues typically decline. Accordingly, the Company's ability to attain
profitable operations will, in large part, depend on its ability to develop and
introduce new products, the timing of receipt of FDA approval of such products
and the number and timing of FDA approvals for competing products.

While the Company will continue the development of its finished goods
pharmaceutical business, including the rehabilitation of the product ANDAs
acquired from Barr, the Company will dedicate the substantial majority of its
resources to the expansion and enhancement of its operations devoted to the
development and manufacture of APIs and finished dosage products incorporating
the Opiate Synthesis Technologies. See "Recent Events -- Opiate Synthesis
Technologies".

ACTIVE PHARMACEUTICAL INGREDIENTS

As discussed above under the caption "Opiate Synthesis Technologies", in
the last few years, the Company has increased its efforts to develop and
manufacture APIs, also known as bulk chemical products. The development and sale
of APIs generally is not subject to the same level of regulation as is the
development and sale of drug products. Accordingly, APIs may be brought to
market substantially sooner than drug products. Although the Company did not
generate revenues from the sale of API's in fiscal 2002 it is the Company's
expectation that its strategic alliance with Watson and the continued
development of the Opiate Synthesis Technologies and other API development
efforts, in addition to assisting in the expansion of the Company's line of
finished dosage products, will generate revenues from the sale of products using
internally produced APIs starting in the fourth quarter of 2003 and such revenue
segment will likely increase thereafter as a percentage of total revenue.

RESEARCH AND DEVELOPMENT

The Company currently conducts research and development activities at each
of its Congers, New York and Culver, Indiana facilities. The Company's research
and development activities consist primarily of the development of the Opiate
Synthesis Technologies, including the development for sale of new chemical
products and the development of APIs, as well as new generic drug product
development efforts and

10

manufacturing process improvements. New drug product development activities are
primarily directed at conducting research studies to develop generic drug
formulations, reviewing and testing such formulations for therapeutic
equivalence to brand name products and additional testing in areas such as
bioavailability, bioequivalence and shelf-life. For fiscal years 2002, 2001 and
2000, total research and development expenditures were $1,517,000, $1,327,000
and $1,821,000, respectively. During 2003, the Company's research and
development efforts will cover finished dosage products and APIs in a variety of
therapeutic applications, with an emphasis on pain management products.

As of March 31, 2003, the Company maintained a full-time staff of 9 in its
Research and Development Department.

MARKETING AND CUSTOMERS

The application of the FDA Application Integrity Policy list to the
Company's operations until December 1996, combined with the Company's continuing
operating losses and lack of adequate working capital during fiscal 1997 and the
first quarter of 1998 resulted in the Company's inability to maintain sufficient
raw materials and finished goods inventories to permit the Company to actively
solicit customer orders, and when orders were received, to fill such orders
promptly. Following the completion in March 1998 of the offering with Galen
Partners (the "Galen Offering") pursuant to the 1998 Purchase Agreement, new
management adopted a marketing strategy focused on developing and maintaining
sufficient raw materials and finished goods inventories so as to permit a
targeted sales effort by the Company to a core customer group, with an emphasis
on quality, prompt product delivery and excellent customer service.

The strategic alliance with Watson entered into on March 29, 2000 provided
for the Company's core products portfolio to be sold by Watson's sales force
under Watson's label. Accordingly, following its alliance with Watson, the
Company discontinued its own sales efforts of these products. In an effort to
increase the sales of the Company's core products, the Company intends to begin
marketing such products under its own label or that of a wholly owned subsidiary
commencing in the second quarter of 2003. In addition to sales of the Company's
core products, the Company continues to perform limited contract manufacturing
of certain non-core products for other pharmaceutical companies.

During 2002, 85% of the Company's total product revenues were derived from
sales to Watson pursuant to the Core Products Supply Agreement between the
Company and Watson (See "Recent Events -- Strategic Alliance with Watson"). The
Company believes that the loss of this customer would have a material adverse
effect on the Company. During 2001 and 2000, 86% and 59%, respectively of the
Company's total product revenues were derived from sales to Watson
Pharmaceuticals.

The estimated dollar amount of the backlog of orders for future delivery as
of March 31, 2003 was approximately $1,233,000 as compared with approximately
$5,200,000 as of March 31, 2002. Although these orders are subject to
cancellation, management expects to fill substantially all orders by the second
and third quarter of 2003. The decrease in the Company's backlog as of March 31,
2003 compared to that for the comparable date in 2002 is largely a function of
increased manufacturing output at the Company's Congers, New York facility
allowing for the filling of open orders on a more timely basis.

GOVERNMENT REGULATION

GENERAL

All pharmaceutical manufacturers, including the Company, are subject to
extensive regulation by the Federal government, principally by the FDA, and, to
a lesser extent, by state and local governments. Additionally, the Company is
subject to extensive regulation by the U.S. Drug Enforcement Agency ("DEA") as a
manufacturer of controlled substances. The Company cannot predict the extent to
which it may be affected by legislative and other regulatory developments
concerning its products and the healthcare industry generally. The Federal Food,
Drug, and Cosmetic Act, the Generic Drug Enforcement Act of 1992, the Controlled
Substance Act and other Federal statutes and regulations govern or influence the
testing, manufacture, safe labeling, storage, record keeping, approval, pricing,
advertising, promotion, sale and

11

distribution of pharmaceutical products. Noncompliance with applicable
requirements can result in fines, recall or seizure of products, criminal
proceedings, total or partial suspension of production, and refusal of the
government to enter into supply contracts or to approve new drug applications.
The FDA also has the authority to revoke approvals of new drug applications. The
ANDA drug development and approval process now averages approximately eight
months to two years. The approval procedures are generally costly and time
consuming.

FDA approval is required before any "new drug," whether prescription or
over-the-counter, can be marketed. A "new drug" is one not generally recognized
by qualified experts as safe and effective for its intended use. Such general
recognition must be based on published adequate and well controlled clinical
investigations. No "new drug" may be introduced into commerce without FDA
approval. A drug which is the "generic" equivalent of a previously approved
prescription drug also will require FDA approval. Furthermore, each dosage form
of a specific generic drug product requires separate approval by the FDA. In
general, as discussed below, less costly and time consuming approval procedures
may be used for generic equivalents as compared to the innovative products.
Among the requirements for drug approval is that the prospective manufacturer's
methods must conform to the current Good Manufacturing Practice Regulations
("CGMPs"). CGMPs apply to the manufacture, receiving, holding and shipping of
all drugs, whether or not approved by the FDA. CGMPs must be followed at all
times during which the drug is manufactured. To ensure full compliance with
standards, some of which are set forth in regulations, the Company must continue
to expend time, money and effort in the areas of production and quality control.
Failure to so comply risks delays in approval of drugs, disqualification from
eligibility to sell to the government, and possible FDA enforcement actions,
such as an injunction against shipment of the Company's products, the seizure of
noncomplying drug products, and/or, in serious cases, criminal prosecution. The
Company's manufacturing facilities are subject to periodic inspection by the
FDA.

In addition to the regulatory approval process, the Company is subject to
regulation under Federal, state and local laws, including requirements regarding
occupational safety, laboratory practices, environmental protection and
hazardous substance control, and may be subject to other present and future
local, state, Federal and foreign regulations, including possible future
regulations of the pharmaceutical industry.

DRUG APPROVALS

There are currently three ways to obtain FDA approval of a new drug.

1. New Drug Applications ("NDA"). Unless one of the procedures
discussed in paragraph 2 or 3 below is available, a prospective
manufacturer must conduct and submit to the FDA complete clinical studies
to prove a drug's safety and efficacy, in addition to the bioavailability
and/or bioequivalence studies discussed below, and must also submit to the
FDA information about manufacturing practices, the chemical make-up of the
drug and labeling. Some of the products anticipated to be developed by the
Company which will incorporate the Opiate Synthesis Technologies may
require the filing of an NDA. The full clinical testing required for the
preparation and filing of an NDA requires the expenditure of substantial
resources. The Company will likely need to collaborate with a third-party
to fund the preparation and filing of an NDA. There can be no assurance
that any such collaboration will be available on terms acceptable to the
Company, if at all.

2. Abbreviated New Drug Applications ("ANDA"). The Drug Price
Competition and Patent Term Restoration Act of 1984 (the "1984 Act")
established the ANDA procedure for obtaining FDA approval for those drugs
that are off-patent or whose exclusivity has expired and that are
bioequivalent to brand-name drugs. An ANDA is similar to an NDA, except
that the FDA waives the requirement of conducting complete clinical studies
of safety and efficacy, although it may require expanded clinical
bioavailability and/or bioequivalence studies. "Bioavailability" means the
rate of absorption and levels of concentration of a drug in the blood
stream needed to produce a therapeutic effect. "Bioequivalence" means
equivalence in bioavailability between two drug products. In general, an
ANDA will be approved only upon a showing that the generic drug covered by
the ANDA is bioequivalent to the previously approved version of the drug,
i.e., that the rate of absorption and the levels of concentration of a
generic

12

drug in the body are substantially equivalent to those of a previously
approved equivalent drug. The principal advantage of this approval
mechanism is that an ANDA applicant is not required to conduct the same
preclinical and clinical studies to demonstrate that the product is safe
and effective for its intended use.

The 1984 Act, in addition to establishing the ANDA procedure, created
new statutory protections for approved brand-name drugs. In general, under
the 1984 Act, approval of an ANDA for a generic drug may not be made
effective until all product and use patents listed with the FDA for the
equivalent brand name drug have expired or have been determined to be
invalid or unenforceable. The only exceptions are situations in which the
ANDA applicant successfully challenges the validity or absence of
infringement of the patent and either the patent holder does not file suit
or litigation extends more than 30 months after notice of the challenge was
received by the patent holder. Prior to enactment of the 1984 Act, the FDA
gave no consideration to the patent status of a previously approved drug.
Additionally, under the 1984 Act, if specific criteria are met, the term of
a product or use patent covering a drug may be extended up to five years to
compensate the patent holder for the reduction of the effective market life
of that patent due to federal regulatory review. With respect to certain
drugs not covered by patents, the 1984 Act sets specified time periods of
two to ten years during which approvals of ANDAs for generic drugs cannot
become effective or, under certain circumstances, ANDAs cannot be filed if
the equivalent brand-name drug was approved after December 31, 1981.

3. "Paper" NDA. An alternative NDA procedure is provided by the 1984
Act whereby the applicant may rely on published literature and more limited
testing requirements. While that alternative sometimes provides advantages
over the ANDA procedure, it is not frequently used.

GENERIC DRUG ENFORCEMENT ACT

As a result of hearings and investigations concerning the activities of the
generic drug industry and the FDA's generic drug approval process, Congress
enacted the Generic Drug Enforcement Act of 1992 (the "Generic Drug Act"). The
Generic Drug Act confers significant new authority upon the FDA to impose
debarment and civil penalties for individuals and companies who commit certain
illegal acts relating to the generic drug approval process.

The Generic Drug Act requires the mandatory debarment of companies or
individuals convicted of a federal felony for conduct relating to the
development or approval of any ANDA, and gives the FDA discretion to debar
corporations or individuals for similar conduct resulting in a federal
misdemeanor or state felony conviction. The FDA may not accept or review during
the period of debarment (one to ten years in the case of mandatory, or up to
five years in the case of permissive, debarment of a corporation) any ANDA
submitted by or with the assistance of the debarred corporation or individual.
The Generic Drug Act also provides for temporary denial of approval of generic
drug applications during the investigation of crimes that could lead to
debarment. In addition, in more limited circumstances, the Generic Drug Act
provides for suspension of the marketing of drugs under approved generic drug
applications sponsored by affected companies. The Generic Drug Act also provides
for fines and confers authority on the FDA to withdraw, under certain
circumstances, approval of a previously granted ANDA if the FDA finds that the
ANDA was obtained through false or misleading statements. As all of the
Company's revenue is derived from the sale of FDA approved products, the taking
of any such action by the FDA would have a material adverse effect on the
Company.

HEALTHCARE REFORM

Several legislative proposals to address the rising costs of healthcare
have been introduced in Congress and several state legislatures. Many of such
proposals include various insurance market reforms, the requirement that
businesses provide health insurance coverage for all their employees,
significant reductions in the growth of future Medicare and Medicaid
expenditures, and stringent government cost controls that would directly control
insurance premiums and indirectly affect the fees of hospitals, physicians and
other healthcare providers. Such proposals could adversely affect the Company's
business by, among other things, reducing the

13

demand, and the prices paid, for pharmaceutical products such as those produced
and marketed by the Company. Additionally, other developments, such as (i) the
adoption of a nationalized health insurance system or a single payor system,
(ii) changes in needs-based medical assistance programs, or (iii) greater
prevalence of capitated reimbursement of healthcare providers, could adversely
affect the demand for the Company's products.

ENVIRONMENTAL COMPLIANCE

In addition to regulation by the FDA and DEA, the Company is subject to
regulation under Federal, state and local environmental laws. While the Company
believes it is in material compliance with applicable environmental laws,
continued compliance may require substantial capital expenditures. The Company
has budgeted approximately $300,000 in 2003 for the construction of a production
waste tank system at its Culver, Indiana facility in order to comply with
applicable waste discharge regulations.

COMPETITION

The Company competes in varying degrees with numerous companies in the
health care industry, including other manufacturers of generic drugs (among
which are divisions of several major pharmaceutical companies) and manufacturers
of brand-name drugs. Many of the Company's competitors have substantially
greater financial and other resources and are able to expend more money and
effort than the Company in areas such as marketing and product development.
Although a company with greater resources will not necessarily receive FDA
approval for a particular generic drug before its smaller competitors,
relatively large research and development expenditures enable a company to
support many FDA applications simultaneously, thereby improving the likelihood
of being among the first to obtain approval of at least some generic drugs.

One of the principal competitive factors in the generic pharmaceutical
market is the ability to introduce generic versions of brand-name drugs promptly
after a patent expires. Other competitive factors in the generic pharmaceutical
market are price, quality and customer service (including maintenance of
sufficient inventories for timely deliveries).

RAW MATERIALS

The raw materials essential to the Company's business are APIs purchased
from numerous sources. Raw materials are generally available from several
sources. The Federal drug application process requires specification of raw
material suppliers. If raw materials from a supplier specified in a drug
application were to become unavailable on commercially acceptable terms, FDA
supplemental approval of a new supplier would be required. During 2002, 2001 and
2000, the Company purchased approximately $1,264,000, $1,512,000 and $1,485,000,
respectively, of its raw materials (constituting 26%, 25% and 28% of each year's
aggregate purchases of raw materials) from one supplier. Although the Company is
now able to submit supplements to the FDA in order to allow the Company to
purchase raw materials from alternate sources, there can be no assurance that if
the Company were unable to continue to purchase raw materials from this
supplier, that the Company would be successful in receiving FDA approval to such
supplement or that it would not face difficulties in obtaining raw materials on
commercially acceptable terms. Failure to receive FDA approval for, and to
locate, acceptable alternative sources of raw materials would have a material
adverse effect on the Company. The Company experienced a shortage of two raw
materials in during 2002. These shortages are not expected to continue in 2003.

The DEA limits the quantity of the controlled substance inventories of
certain raw materials used by pharmaceutical manufacturers in the production of
controlled substances based on historical sales data. As part of the Company
commercialization of controlled substance products the Company is required to
file for and obtain quotas from the DEA for the purchase and use of controlled
substance raw materials. In view of the Company's recently depressed sales
volume, any DEA quotas obtained by the Company may have the effect of limiting
such materials and could increase the likelihood of raw material shortages and
of manufacturing delays in the event the Company experiences increased sales
volume or is required to find new suppliers of these raw materials.

14

As described under the caption "Recent Events -- Opiate Synthesis
Technologies", the Company is developing certain opiate technologies to be used
in the manufacture of controlled substances. The Company is also seeking to
obtain an import registration from the DEA to import raw poppy to be used in
such development and manufacturing efforts directly from third-party suppliers
in opiate producing countries. No assurance can be given that the Company will
be successful in identifying and contracting with third-party suppliers in
opiate producing countries on commercially acceptable terms for the Company's
requirements of raw materials to be used in its controlled substance development
and commercialization efforts.

SUBSIDIARIES

The Company's Culver, Indiana manufacturing operations are conducted by
Houba, Inc., an Indiana corporation and wholly-owned subsidiary of the Company.
Halsey Pharmaceuticals, Inc., a Delaware corporation, is a wholly-owned
subsidiary which is currently inactive.

EMPLOYEES

As of March 31, 2003, the Company had approximately 114 full-time
employees. Approximately 50 employees are administrative and professional
personnel and the balance are in production and shipping. Among the professional
personnel, 9 are engaged in research and product development. Management
believes that its relations with its employees are satisfactory.

ITEM 2. PROPERTIES

The Company leases, as sole tenant, a pharmaceutical manufacturing facility
of approximately 35,000 square feet located at 77 Brenner Drive, Congers, New
York. The Agreement of Lease, with an unaffiliated third party, contains a three
year term with a two year renewal option and provides for annual fixed rent of
$500,000 per year during the primary term of the Lease and $600,000 per year
during the renewal period. The term of the Lease expires on March 21, 2004. The
leased facility houses a portion of the Company's manufacturing operations and
includes office and warehouse space. The Lease also contains an option pursuant
to which the Company may purchase the leased premises and improvements
(including certain production and related equipment) for a purchase price of $5
million, exercisable at any time during the Lease term.

Halsey leases, as sole tenant, a facility located at 125 Wells Avenue,
Congers, New York. The Facility contains office, warehouse and manufacturing
space and is approximately 18,000 square feet. The Lease provides for a term of
four years with an option to renew for an additional three years and provides
for annual fixed rent of approximately $127,000 per year during the first two
years of the Lease and approximately $135,000 per year during the last two
years.

Halsey leases approximately 4,700 square feet of office space located at
695 North Perryville Road, Building No. 2, Rockford, Illinois. The lease is
between the Company and an unaffiliated lessor. The original lease term of two
years expired August 31, 2000. There are five one-year renewal options, which
the last renewal period will expire on August 31, 2005. The lease calls for
annual rental, including maintenance and common area expense, of approximately
$46,000 per year. This leased facility houses the Company's principal executive
offices, including its sales, administration and finance operations.

The Company's Houba, Inc. subsidiary owns approximately 45,000 square feet
of building space on approximately 30 acres of land in Culver, Indiana, which
includes a 15,000 square foot manufacturing facility. This manufacturing
facility houses separate plants for the production of certain raw materials as
well as finished dosage products in capsule and tablet form.

ITEM 3. LEGAL PROCEEDINGS

Beginning in 1992, actions were commenced against the Company and numerous
other pharmaceutical manufacturers in connection with the alleged exposure to
diethylstilbestrol ("DES"). The defense of all of such matters was assumed by
the Company's insurance carrier, and a substantial number have been settled by

15

the carrier. Currently, several actions remain pending with the Company as a
defendant, and the insurance carrier is defending each action. The Company does
not believe any of such actions will have a material impact on the Company's
financial condition.

The Company is named as a defendant in an action entitled Alfred Kohn v.
Halsey Drug Co. in the Supreme Court of New York, Bronx County. The plaintiff
seeks damages of $1 million for breach of an alleged oral contract to pay a
finder's fee for a business transaction involving the Company. Discovery in this
action has been completed. It is the Company's expectation to file for summary
judgment in this action. In the event the Company is unsuccessful in its motion
for summary judgment, a trial on this action will follow. The Company does not
believe this action will have a material impact on the Company's financial
condition.

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

No matters were submitted to a vote of security holders during the fourth
quarter of 2002.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER
MATTERS

MARKET AND MARKET PRICES OF COMMON STOCK

Set forth below for the periods indicated are the high and low bid price
for the Company's Common Stock for trading in the Common Stock on the OTC
Bulletin Board as reported by the OTC Bulletin Board.

- ---------------

* Such over-the-counter market quotations reflect inter-dealer prices, without
retail mark-up, mark-down or commission and may not necessarily represent
actual transactions.

HOLDERS

There were approximately 750 holders of record of the Company's common
stock on March 31, 2003. This number, however, does not reflect the ultimate
number of beneficial holders of the Company's common stock.

DIVIDEND POLICY

The payment of cash dividends from current earnings is subject to the
discretion of the Board of Directors and is dependent upon many factors,
including the Company's earnings, its capital needs and its general financial
condition. The terms of the Company's 5% convertible senior secured debentures
and the Loan Agreement with Watson prohibit the Company from paying cash
dividends. The Company does not intend to pay any cash dividends in the
foreseeable future.
16

RECENT SALES OF UNREGISTERED SECURITIES

During the quarter ended December 31, 2002, the Company issued the
following securities which were not registered under the Securities Act:

(i) 10% convertible promissory notes in the aggregate principal amount
$2,500,000 (the "Bridge Notes") issued to bridge lenders (the "Bridge
Lenders") on each of October 1, November 4, November 12, November 21,
and December 5, 2002.

(ii) Common Stock purchase warrants (the "Bridge Warrants") issued to the
Bridge Lenders on each of October 1, November 4, November 12,
November 21, and December 5, 2002 exercisable for an aggregate of
168,554 shares of the Company's Common Stock at exercise prices
ranging from $1.28 to $1.77 per share;

(iii) 5% Convertible Senior Secured Debentures in the aggregate principal
amount of $26,394,000 (the "Debentures") on December 20, 2002. The
Debentures were issued in consideration for cash proceeds of
$10,500,000 and the surrender and cancellation of Bridge Notes issued
during 2001 and 2002 in the aggregate principal amount of
$15,894,000. The Debentures are convertible into the Company's Common
Stock at a price of $.34 per share; and

(iv) 5,970,083 shares of the Company's Common Stock issued on December 20,
2002 in exchange for common stock purchase warrants exercisable for an
aggregate of 8,145,734 shares of the Company's Common Stock (the
"Warrant Recap Shares" and together with the Bridge Notes, the Bridge
Warrants and the Debentures, collectively, the "Securities").

Each of the holders of the Securities is an Accredited Investor as defined
in Rule 501(a) of Regulation D promulgated under the Securities Act. Each of the
Securities was issued without registration under the Securities Act in reliance
upon Section 4(2) of the Securities Act and Regulation D promulgated thereunder.

ITEM 6. SELECTED FINANCIAL DATA

The selected consolidated financial data presented on the following pages
for the years ended December 31, 2002, 2000, 1999 and 1998 are derived from the
Company's audited Consolidated Financial Statements. The Consolidated Financial
Statements as of December 31, 2002 and December 31, 2001, and for each of the
years in the three-year period ended December 31, 2002, and the report thereon,
are included elsewhere herein. The selected financial information as of and for
the years ended December 31, 1999 and 1998 are derived from the audited
Consolidated Financial Statements of the Company not presented herein.

The information set forth below is qualified by reference to, and should
be read in conjunction with, the Consolidated Financial Statements and related
notes thereto included elsewhere in this Report and "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations."

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Certain statements set forth under this caption constitute "forward-looking
statements" within the meaning of the Reform Act. See "Special Note Regarding
Forward-Looking Statements" on page 2 of this Report for additional factors
relating to such Statements.

OVERVIEW

The Company reported a net loss of $45,441,000 or $2.98 per share for the
year ended December 31, 2002 as compared to a net loss of $12,563,000 or $.84
per share for 2001. Included in net product revenues for 2001 was $8.5 million
of a total $13.5 million earned from Watson Pharmaceuticals representing the sum
of the second and the final payments for a product ANDA sold by the Company to
Watson in March, 2000. Excluding the payments made by Watson to the Company for
a product ANDA, net revenues for the year ended December 31, 2001 representing
product sales, were approximately $8,429,000.

The Company reduced its loss from operations by $1,502,000 to $12,937,000
in 2002 as compared to $14,439,000 for 2001 after adjusting for the $8,500,000
of product development revenues earned in 2001. This was achieved even after
increases in research and development expenses and selling, general and
administrative expenses during 2002 of $190,000 and $600,000, respectively.

The Company had the following significant achievements in 2002:

- Received approval from the DEA to manufacture Schedule II to V controlled
substances at the Company's Culver, Indiana facility.

- Completed a debenture offering in the principal amount of approximately
$26,394,000.

- Recapitalized common stock purchase warrants exercisable for
approximately 8,145,000 shares in exchange for approximately 5,970,000
shares of Common Stock.

18

- Extended the maturity date of the Company's term loan agreement with
Watson from March 31, 2003 to March 31, 2006.

- Extended the maturity date of the Company's outstanding 5% Convertible
Senior Secured Debentures in the aggregate principal amount of
approximately $50,723,000 from March 15, 2003 to March 31, 2006.

RESULTS OF OPERATIONS

NET REVENUES

Net product revenues for 2002 of $8,205,000 represents a decrease of
$224,000 in product sales as compared to $8,429,000 in 2001 and a decrease of
$8,500,000 in product development revenues in 2002 as compared to 2001. The
Company had earned $8,500,000 in product development revenues from Watson in
2001 relating to the Company's sale of a product ANDA to Watson.

Net product revenues for 2001 of $16,929,000 represents a decrease of
$3,294,000 as compared to net product revenues for 2000. Net product revenues
for 2001 are comprised of sales of products totaling $8,429,000 and revenues
from product development of $8,500,000. The Company had $5,000,000 of product
development revenue in 2000. The decrease in sales of products is attributable
primarily to raw material shortages required for the manufacture of two
products.

COST OF MANUFACTURING

The Company's cost of manufacturing for 2002 was 153% of net product sales
versus 176% of net product sales for 2001 after adjustment of $8,500,000 for
product development revenues in 2001. The improvement in 2002 is due primarily
to the transition of both outside packaging and laboratory services to internal
departments. During 2001, the Company utilized both third party packaging
operations and laboratory services.

The Company's cost of manufacturing for 2001 improved to 88% of net product
sales versus 93% of net product sales for 2000. The improvement in 2001 is due
primarily to the addition of the $8,500,000 of product development revenue. The
development costs associated with this revenue were substantially incurred in
years prior to 2000 and were expensed at that time. The cost of manufacturing
for 2001 on product sales alone was 176% due primarily to underutilized
productive capacity and the significant fixed costs associated with
pharmaceutical production regardless of sales volume.

RESEARCH & DEVELOPMENT EXPENSES

For 2002, research and development expenses amounted to $1,517,000 as
compared to $1,327,000 for 2001. The increase of $190,000 or 14% reflects
development expenses incurred on a number of projects including the development
of the Company's Opiate Synthesis Technologies.

For 2001, research and development expenses amounted to $1,327,000 as
compared to $1,821,000 for 2000. The decrease of $494,000 or 27% primarily
reflects the absence of $500,000 in costs associated with licensing a codeine
technology in 2000. Such codeine license agreement has since been terminated by
the Company.

The Company expects research and development expenses to increase in 2003
as compared to 2002 consistent with its plans to develop and manufacture APIs
and finished dosage products incorporating the Opiate Synthesis Technologies and
in the rehabilitation of certain product ANDAs acquired from Barr.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative costs were $7,216,000 (88% of net
product revenue) for 2002 compared to $6,616,000 (78% of net product revenue)
for 2001 after adjustment of $8,500,000 in product development revenues in 2001.
This increase is primarily due to added legal expenses incurred for patent
research and regulatory matters associated with the DEA manufacturing and import
license registrations on
19

the Opiate Synthesis Technologies, as well as increases in product marketing
expenses and corporate insurance premiums.

Selling, general and administrative costs were $6,616,000 (39% of net
product revenue) for 2001 compared to $6,208,000 (31% of net product sales) for
2000. This increase is primarily due to the added legal expenses associated with
the Opiate Synthesis Technologies.

INTEREST EXPENSE, NET OF INTEREST INCOME

Interest expense, net of interest income for 2002 increased by $869,000 or
22.6% over that of 2001 reflecting interest on Bridge Loan borrowings under the
Galen Bridge Loan Agreement. During 2002, the Company borrowed an aggregate
$12,500,000 under the Galen Bridge Loan Agreement.

Interest expense, net of interest income for 2001 increased by $807,000 or
26.6% over that of 2000 reflecting interest on borrowings under the Watson Term
Loan. During 2001, the Company borrowed an additional $5,500,000 under the
Watson Term Loan.

AMORTIZATION OF DEFERRED DEBT DISCOUNT, AND PRIVATE OFFERING COSTS

In 2002, 2001 and 2000 the Company issued warrants and incurred costs
associated with private placements and bridge financings. The value of warrants
issued in 2002, 2001, and 2000, as determined by use of the Black-Scholes
valuation model, was approximately $5,115,000, $310,000, and $125,000
respectively. The Company incurred private offering costs of approximately
$1,041,000 in 2002. The private placements and bridge financings included
beneficial conversion features with an estimated fair value of $78,364,000 in
2002. The value of the warrants, private offering costs, and beneficial
conversion features are being amortized over the life of the underlying
debentures and notes. In conjunction with the December 2002 private placement of
the remaining unamortized balance of private offering costs from 1999 was
written-off. Amortization expense of deferred debt discount and private offering
costs was $12,558,000, $2,591,000, and $2,448,000 in 2002, 2001, and 2000,
respectively. At December 31, 2002, the Company recorded debt discount of
$73,955,000 which will be amortized to expense over the remaining life of the
related debentures through March 31, 2006.

Loss on Extinguishment of Debt

In 2002, the Company recorded a loss on the extinguishment of debt of
$11,985,000 which represents the fair value of 10,700,665 warrants that the
Company issued to Watson in consideration of Watson's extension of the maturity
date of the Watson Term Loan.

Other Income (Expense)

In 2002, the Company recorded a charge to earnings of $2,282,000 in
connection with the issuance of 5,920,083 shares of common stock in exchange for
8,145,736 warrants. The Company also recorded a charge to earning of $863,000 as
a result of the modification of the terms of certain outstanding warrants to
purchase common stock.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 2002, the Company had cash and cash equivalents of
$9,211,000 as compared to $422,000 at December 31, 2001. The Company had working
capital of $5,933,000 at December 31, 2002.

In addition to the other strategic alliance transactions with Watson
completed on March 29, 2000, the Company and Watson executed a Loan Agreement
providing for Watson's extension of a $17,500,000 term loan to the Company (the
"Watson Term Loan"). On December 20, 2002, the Company and Watson amended the
Watson Term Loan to (i) increase the principal amount of the Watson Term Loan
from $17,500,000 to $21,401,331 to reflect the Company's then outstanding
payment obligation of $3,901,331 to Watson under the terms of the Company's Core
Products Supply Agreement with Watson, (ii) increase the interest rate under the
Watson Term Loan from prime plus 2.5% to prime plus 4.5%, and (iii) extend the
20

maturity date of the Watson Term Loan from March 31, 2003 to March 31, 2006. The
Watson Term Loan is secured by a first lien on all of the Company's assets,
senior to the liens securing all other Company indebtedness. The net proceeds of
the Watson Term Loan were used in part to satisfy certain bridge loans made by
Galen Partners III, L.P. ("Galen") to the Company during 2000, to satisfy
Company's payment obligations under the Settlement Agreement with the landlord
of its Brooklyn, New York facility, to fund capital improvements and to fund the
Company's working capital requirements.

As described under Item 1, Recent Events-Debenture Offering, on December
20, 2002, the Company completed a private offering of 5% convertible senior
secured debentures (the "2002 Debentures") in the principal amount $26,394,000
(the "Offering"). The 2002 Debentures were issued pursuant to a certain
Debenture Purchase Agreement dated December 20, 2002 (the "Purchase Agreement")
by and among the Company, Care Capital Investments II, LP ("Care Capital"),
Essex Woodlands Health Ventures V, L.P. ("Essex"), Galen and each of the
purchasers listed on the signature page thereto.

The 2002 Debentures, issued at par, will become due and payable as to
principal on March 31, 2006. Interest on the principal amount of the 2002
Debentures, at the rate of 5% per annum, is payable on a quarterly basis. With
the exception of the 2002 Debentures issued to Care Capital, interest will be
paid by the Company's issuance of a debenture instrument substantially identical
to the 2002 Debentures issued in the Offering, in the principal amount equal to
the accrued interest for each quarterly period (the "Interest Debentures"). The
2002 Debentures issued to Care Capital provide that fifty percent (50%) of the
interest payment under such 2002 Debentures will be satisfied in cash with the
balance satisfied by the Company's issuance of Interest Debentures.

The Debentures issued to each of Care Capital and Essex are convertible at
any time after issuance into shares of the Company's Common Stock. The 2002
Debentures issued to Galen and the other investors in the Offering (excluding
Care Capital and Essex) are convertible at any time after the approval of the
Company's shareholders and debentureholders of an amendment to the Company's
Certificate of Incorporation to increase its authorized shares of Common Stock
from 80,000,000 shares to such number of shares as shall provide sufficient
authorized shares to permit the conversion of the 2002 Debentures and the
Company's other outstanding convertible securities. Subject to the foregoing,
the 2002 Debentures are convertible into shares of Common Stock at a price per
share (the "Conversion Price") of $.34. Until such time as the Company completes
a Subsequent Material Offering (as defined below) the Conversion Price is
subject to adjustment, from time to time, to equal the consideration per share
received by the Company for its Common Stock, or the conversion/exercise price
per share of the Company's Common Stock issuable under rights or option for the
purchase of, or stock or other securities convertible into, Common Stock
("Convertible Securities"), if lower than the then applicable Conversion Price.
Following the Company's completion of a Subsequent Material Offering, the
Conversion Price is subject to adjustment from time to time on a
weighted-average dilution basis. A "Subsequent Material Offering" is the grant
or issuance of Common Stock or Convertible Securities by the Company during any
six (6) month period for an aggregate gross consideration of at least
$10,000,000. Assuming the conversion of the 2002 Debentures at the initial
Conversion Price of $.34 per share, the 2002 Debentures are convertible into an
aggregate of approximately 77,629,000 shares of Common Stock.

The Interest Debentures are convertible at anytime after issuance into
shares of Common Stock at a price per share equal to the average of the closing
bid and asked prices of the Common Stock for the twenty (20) trading days
immediately preceding the applicable interest payment date under the 2002
Debentures, as reported by the Over-the-Counter ("OTC") Bulletin Board.

The Purchase Agreement provides that the holders of the 2002 Debentures
shall have the right to vote as part of a single class with all holders of the
Company's Common Stock on all matters to be voted upon by such stockholders.
Each 2002 Debentureholder shall have such number of votes as shall equal the
number of votes he would have had if such holder converted the entire
outstanding principal amount of his 2002 Debenture into shares of Common Stock
immediately prior to the record date relating to such vote; provided, however,
that any Debentures initially held by Care Capital shall, for so long as they
are held by Care Capital, have no voting rights.

21

The 2002 Debentures are secured by a lien on all assets of the Company,
tangible and intangible. In addition, each of Houba, Inc. and Halsey
Pharmaceuticals, Inc., each a wholly-owned subsidiary of the Company, has
executed in favor of the holders of the 2002 Debentures an unconditional
agreement of guarantee of the Company's obligations under the Purchase
Agreement. Each guarantee is secured by all assets of such subsidiary, and, in
the case of Houba, Inc., by a mortgage lien on its Culver, Indiana real estate.
In addition, the Company has pledged the stock of each such subsidiary to the
holders of the 2002 Debentures to further secured its obligations under the
Purchase Agreement.

In accordance with the terms of a Subordination Agreement dated December
20, 2002 between the Company, the holders of the 2002 Debentures, the holders of
the Existing Debentures and Watson, the liens on the Company's and its
subsidiaries' assets as well as the payment priority of the 2002 Debenture are
(i) subordinate to the Company's lien and payment obligations in favor of Watson
under the Watson Term Loan, and (ii) senior to the Company's lien and payment
obligations in favor of holders of the Existing Debentures in the aggregate
principal amount of approximately $50,724,000.

Of the $26,394,000 in Debentures issued in the Offering, approximately
$15,894,000 Debentures were issued in exchange for the surrender of a like
amount of principal and accrued interest on the Company's outstanding 10%
convertible promissory notes issued pursuant to various working capital bridge
loan transactions with Galen and the certain other lenders during the period
from August 15, 2001 through and including December 20, 2002.

The development and commercialization of APIs and finished dosage products
incorporating the Opiate Synthesis Technologies are subject to various factors,
many of which are outside the Company's control. Specifically, the Opiate
Synthesis Technologies have been tested only in laboratory settings and will
need to be successfully "scaled up" in order to be commercially viable, of which
no assurance can be given. Additionally, the Company must satisfy, and continue
to maintain compliance with, the DEA's requirements for the maintenance of its
Manufacturing Registration and the issuance and maintenance of the Import
Registration. The process of seeking the Import Registration and contesting
opposition proceedings, as well as the continuing development of the Opiate
Synthesis Technologies, will likely continue through 2004. The Company is
currently unable to provide any assurance that the Opiate Synthesis Technologies
will be commercially viable or that the Company will succeed in obtaining the
Import Registration. The Company is committing the substantial majority of its
resources, available capital and cash flow from operations to the development of
the Opiate Synthesis Technologies and to the receipt of the Import Registration.
The failure of the Company to successfully develop the Opiate Synthesis
Technologies or to obtain the Import Registration will have a material adverse
effect on the Company's operations and financial condition. The Company's cash
flow and limited sources of available financing make it uncertain that the
Company will have sufficient capital to continue to fund operations or to
otherwise complete the development of the Opiate Synthesis Technologies, to
obtain required DEA approvals and to fund the capital improvements necessary for
the manufacture of APIs and finished dosage products incorporating the Opiate
Synthesis Technologies.

The Company has budgeted approximately $2,500,000 in 2003 for the continued
development and commercialization of the Opiate Synthesis Technologies. Of such
amount, approximately $2,000,000 relates to capital expenditures for facility
improvements and the purchase of equipment at the Company's Culver, Indiana
facility, approximately $300,000 relates to capital expenditures for
environmental compliance waste discharge storage tanks at the Culver facility,
and approximately $200,000 relates to the legal fees and related expenses for
the OALJ hearing and third party opposition proceedings in connection with the
Company's application for the Import Registration. Until such time as the
Company successfully develops and commercializes new finished dosage products
and APIs, of which there can be no assurance, the majority of the Company's
revenues are expected to be derived from the Core Products Supply Agreement with
Watson, with the balance of the Company's revenues derived from a combination of
the Company's own selling efforts for the Company's core products, which sales
efforts are anticipated to commence in the second quarter of 2003, and the
Company's manufacture of non-core products for third parties. The Company
estimates that during 2003 and 2004, the Company will continue to incur
operating losses and negative cash flow. The Company believes that the net
proceeds of the Debenture Offering completed on December 20, 2002 will provide
the working capital necessary to fund operating losses only through June 2003.
22

At the Company's request, on May 5, 2003, the Company received a letter
executed by each of Care Capital, Galen and Essex (the "Majority 2002
Debentureholders") advising that the Majority 2002 Debentureholders would
provide funding to meet the Company's 2003 capital requirements, up to an
aggregate amount not to exceed $8.6 million (the "Letter of Support"). The
Letter of Support provides that the amount of any funding provided by the
Majority 2002 Debentureholders would be reduced to the extent of any funding
obtained by the Company from third-party sources during 2003. The Letter of
Support further provides that the terms of any funding provided by the Majority
2002 Debentureholders will be subject to negotiation between the Company and the
Majority 2002 Debentureholders at the time of any such funding. The terms of any
such funding will be subject to approval by those directors of the Company that
are unaffiliated with the Majority 2002 Debentureholders. While the terms of any
funding to meet the Company's 2003 capital requirements are currently unknown,
it is likely that such terms will result in significant additional dilution to
holders of the Company's Common Stock. In consideration for the issuance of the
Letter of Support, the Company authorized the issuance of warrants to the
Majority 2002 Debentureholders exercisable for an aggregate of 645,000 shares of
the Company's Common Stock at an exercise price of $.34 per share (which is
equivalent to the conversion price of the 2002 Debentures), subject to downward
adjustment to equal the consideration per share received by the Company for its
Common Stock, or the conversion/exercise price per share of the Company's Common
Stock issuable under convertible securities, in a third party investment if
lower than the exercise price of the warrants.

The Company believes that the remaining net proceeds of the 2002 Debenture
Offering, along with the funding to be provided under the Letter of Support
combined with cash flow from operations, will be sufficient to satisfy the
Company's working capital requirements through January 1, 2004.

Failure to obtain a third party investment or to reach agreement with the
Majority 2002 Debentureholders on mutually acceptable terms to fund the
Company's capital requirements for 2003 will require the Company to (i)
significantly curtail product commercialization efforts, including the
development and commercialization of the Opiate Synthesis Technologies, (ii) if
available, obtain funding through arrangements with collaborative partners or
others on terms that may require the Company to relinquish certain rights in its
Opiate Synthesis Technologies, which the Company could otherwise pursue on its
own, or that would significantly dilute the Company's stockholders, (iii)
significantly scale back or terminate operations, and/or (iv) seek relief under
applicable bankruptcy laws. Any extended delay in obtaining necessary financing
will result in the cessation of the Company's continuing development efforts
relating to its Opiate Synthesis Technologies and will have a material adverse
effect on the Company's financial condition and results of operations.

23

The following table presents the Company's expected cash requirements for
contractual obligations outstanding as of December 31, 2002:

CRITICAL ACCOUNTING POLICIES

Financial Reporting Release No. 60, which was released by the Securities
and Exchange Commission ("SEC") in December 2001, requires all companies to
include a discussion of critical accounting policies or methods used in the
preparation of financial statements. Note A of the Notes to Consolidated
Financial Statements, as contained in this Annual Report on Form 10-K, includes
a summary of the Company's significant accounting policies and methods used in
the preparation of the financial statements. In preparing these financial
statements, the Company has made its best estimates and judgments of certain
amounts included in the financial statements, giving due consideration to
materiality. The application of these accounting policies involves the exercise
of judgment and use of assumptions as to future uncertainties and, as a result,
actual results could differ from these estimates. The Company does not believe
there is a great likelihood that materially different amounts would be reported
under different conditions or using different assumptions. The Company's
critical accounting policies are as follows:

REVENUE RECOGNITION

The Company recognizes revenue, net of sales discounts and allowances, when
title to the product passes to customers, which generally occurs upon shipment.
The Company established sales provisions for estimated chargebacks, discounts,
rebates, returns, pricing adjustments and other sales allowances concurrently
with the recognition of revenue. The sales provisions are established based upon
consideration of a variety of factors, including but not limited to, actual
return and historical experience by product type, the number and timing of
competitive products approved for sale, the expected market for the product,
estimated customer inventory levels by product, price declines and current and
projected economic conditions and levels of competition. Actual product return,
chargebacks and other sales allowances incurred are, however, dependent upon
future events.

Management continually monitors the factors that influence sales allowance
estimates and makes adjustments to these provisions when allowances may differ
from established allowances.

ACCOUNTS RECEIVABLE-TRADE AND ALLOWANCE ACCOUNTS

The Company's accounts receivable-trade are due from customers engaged in
the distribution of pharmaceutical products. Credit is extended based on
evaluation of a customers' financial condition and, generally, collateral is not
required. Accounts receivable are due within 30 days and are stated at amounts
due from customers net of allowances for doubtful accounts, returns, term
discounts, and other allowances. Accounts outstanding longer than the
contractual payment terms are considered past due. Estimates that are used in
determining these allowances are based on the Company's historical experience,
current trends, credit policy and a percentage of its accounts receivable by
aging category. In determining these percentages, the

24

Company looks at the credit quality of its customer base as well as changes in
its credit policies. The Company continuously monitors collections and payments
from its customers. The Company writes off accounts receivable when they become
uncollectible, and payments subsequently received on such receivables are
credited to bad debt expense.

INVENTORIES

Inventories are stated at the lower of cost or market, with cost determined
on the first-in, first-out basis. In evaluating whether inventory is stated at
the lower of cost or market, management considers such factors as the amount of
inventory on hand, remaining shelf life and current and expected market
conditions, including levels of competition. As appropriate, the Company records
provisions to reduce inventories to their net realizable value.

INCOME TAXES

The Company accounts for income taxes under the liability method in
accordance with Statement of Financial Accounting Standards No. 109 ("SFAS No.
109"), "Accounting for Income Taxes." Under this method, deferred tax assets and
liabilities are determined based on differences between financial reporting and
tax bases of assets and liabilities and are measured using the enacted tax rates
and laws that will be in effect when the differences are expected to reverse. A
valuation allowance is established if it is more likely than not that all, or
some portion, of deferred tax assets will not be realized. The Company has
recorded a full valuation allowance to reduce its deferred tax assets to the
amount that is more likely than not to be realized. While the Company has
considered future taxable income in assessing the need for the valuation
allowance, in the event the Company were to determine that it would be able to
realize its deferred tax assets in the future in excess of its net recorded
amount, an adjustment to the deferred tax asset would increase income in the
period such determination was made.

STOCK COMPENSATION

The Company accounts for stock-based compensation using the intrinsic value
method in accordance with Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" and related Interpretations ("APB No.
25") and has adopted the disclosure provisions of Statement of Financial
Accounting Standards No. 148, "Accounting for Stock-Based
Compensation -- Transition and Disclosure, an amendment of FASB Statement No.
123" ("SFAS No. 148"). Under APB No. 25, when the exercise price of the
Company's employee stock options equals the market price of the underlying stock
on the date of grant, no compensation expense is recognized. Accordingly, no
compensation expense has been recognized in the consolidated financial
statements in connection with employee stock option grants. If the Company were
to include the cost of stock-based employee compensation in the financial
statements, the Company's operating results would decline based on the fair
value of the stock-based employee compensation.

DEFERRED DEBT DISCOUNT

Debt discount resulting from the issuance of stock warrants in connection
with the issuance of subordinated debt and other notes payable as well as
beneficial conversion features contained in convertible debt instruments is
recorded as a reduction of the related obligations and is amortized over the
remaining life of the related obligations. Debt discount related to the stock
warrants issued is determined by a calculation which is based on the relative
fair values ascribed to such warrants determined by an independent valuation or
management's use of the Black-Scholes valuation model. Inherent in the
Black-Scholes valuation model are assumptions made by management regarding the
estimated life of the warrant, the estimated volatility of the Company's common
stock and the expected dividend yield.

NEW ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 142, "Goodwill and Other
Intangible Assets." ("SFAS No. 142"). SFAS No. 142

25

requires that goodwill and intangible assets with indefinite useful lives no
longer be amortized, but instead be tested for impairment at least annually in
accordance with the provisions of SFAS No. 142. SFAS No. 142 also requires that
intangible assets with definite useful lives be amortized over their respective
estimated useful lives to their estimated residual values, and reviewed for
impairment in accordance with Statement of Financial Accounting Standards No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of," as amended. The Company adopted the provisions of
SFAS No. 142 effective January 1, 2002. The adoption of SFAS No. 142 had no
effect on the financial position or results of operations of the Company.

In October 2001, the FASB issued SFAS No. 144 "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS No. 144"). SFAS No. 144
requires that long-lived assets be measured at the lower of carrying amount or
fair value less cost to sell, whether reported in continuing operations or in
discontinued operations, Therefore, discontinued operations will no longer be
measured at net realizable value or include amounts for operating losses that
have not yet occurred. SFAS No. 144 is effective for financial statements issued
for fiscal years beginning after December 15, 2001 and, generally, is to be
applied prospectively. The adoption of SFAS No. 144 had no effect on the
Company's financial position or results of operations.

In April 2002, the FASB issued SFAS No. 145 ("FSAS No. 145"), "Rescission
of FASB statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and
Technical Corrections." This statement eliminates the requirement to report
gains and losses from extinguishment of debt as extraordinary unless they meet
the criteria of APB Opinion 30. SFAS No. 145 also requires sale-leaseback
accounting for certain lease modifications that have economic effects that are
similar to sale-leaseback transactions. The changes related to lease accounting
are effective for transactions occurring after May 15, 2002 and the changes
related to debt extinguishment are effective for fiscal years beginning after
May 15, 2002. The impact of adopting the provisions related to debt
extinguishments during the year ended December 31, 2002. The adoption did not
have a material impact on the Company's financial position or results of
operations.

In January 2003, the FASB issued FASB Interpretation No. 46 ("FIN No. 46")
"Consolidation of Variable Interest Entities." In general, a variable interest
entity is a corporation, partnership, trust, or any other legal structure used
for business purposes that either (a) does not have equity investors with voting
rights or (b) has equity investors that do not provide sufficient financial
resources for the entity to support its activities. A variable interest entity
often holds financial assets, including loans or receivables, real estate or
other property. A variable interest entity may be essentially passive or it may
engage in activities on behalf of another company. Until now, a company general
has included another entity in its consolidated financial statements only if it
controlled the entity through voting interests. FIN No. 46 changes that by
requiring a variable interest entity to be consolidated by a company if that
company is subject to a majority of the risk of loss from the variable interest
entity's activities or entitled to receive a majority of the entity's residual
returns or both. FIN No. 46's consolidation requirements apply immediately to
variable interest entities created or acquired after January 31, 2003. The
consolidation requirements apply to older entities in the first fiscal year or
interim period beginning after June 15, 2003. Certain of the disclosure
requirements apply to all financial statements issued after January 31, 2003,
regardless of when the variable interest entity was established. The Company has
adopted FIN No. 46 effective January 31, 2003. The Company does not anticipate
that the adoption of FIN 46 will have a material impact on the Company's
consolidated financial condition or results of operations taken as a whole.

CAPITAL EXPENDITURES

The Company's capital expenditures during 2002, 2001 and 2000 were
$287,000, $1,544,000 and $2,962,000, respectively. The capital expenditures
during these periods is attributable to capital improvements to the Company's
Congers, NY and Culver, Indiana facilities. In order for the Company to receive
the Manufacturing Registration, specific improvements were made for security and
related items to the Culver, Indiana facility. Additionally, expenditures were
made to significantly improve and expand the manufacturing capabilities of both
Congers, NY locations. The Company has budgeted for capital expenditures
approximately $2,500,000 in fiscal 2003. A portion of such amounts will be
funded from the net proceeds of the Debenture Offering, with the balance from
third party financing to be sought by the Company during 2003.
26

IMPACT OF INFLATION

The Company believes that inflation did not have a material impact on its
operations for the periods reported. Significant increases in labor, employee
benefits and other expenses could have a material adverse effect on the
Company's performance.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The response to this item is submitted as a separate section of this Report
commencing on page F-1.

27

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

Not Applicable.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

THE DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY ARE AS FOLLOWS:

MICHAEL K. REICHER has been Chairman of the Board of Directors since June
29, 2000 and Chief Executive Officer and a Director of the Company since
February 19, 1998. In 1980, Mr. Reicher founded UDL Laboratories, Inc., a
manufacturer of human generic pharmaceuticals, and served as its President
through February 1998. In February 1996, UDL Laboratories, Inc. was purchased by
Mylan Laboratories, Inc., and Mr. Reicher remained in the office of President
until joining the Company in February 1998.

VIJAI KUMAR has been Chief Operations Officer of the Company since November
2002. From 1996 to 2002 Mr. Kumar was President & CEO of Pharmalogix Inc., a
pharmaceutical research and development company. From 1992 to 1996 Mr. Kumar was
Director, Research and Development for the Warner Chilcott Division of Warner
Lambert. In that capacity, he coordinated all technical aspects of the Division
responsible for cGMP compliance, formulation development, analytical development
and clinical and bioequivalence studies. Mr. Kumar holds B.Sc. in Chemistry from
the University of Lucknow, India, a D.Pharm. from the College of Pharmacy, New
Delhi, an M.B.A. from Fairleigh Dickinson University and an M.S. in Industrial
Pharmacy from Long Island University.

PETER A. CLEMENS has been the Vice President and Chief Financial Officer of
the Company since February 1998 and a Director of the Company since June 1998.
From February, 1988 until joining the Company, Mr. Clemens was employed by TC
Manufacturing Co., Inc. ("TC") which, through its various subsidiaries and
divisions, manufactures generic pharmaceuticals, industrial coatings and
flexible packaging. Mr. Clemens was TC's President from February, 1996 through
February, 1998. Prior to that time, he held the position of Vice President and
Chief Financial Officer.

BRUCE F. WESSON has been a Director of the Company since March 1998. Mr.
Wesson is President of Galen Associates, a health care venture firm, and a
General Partner of Galen Partners III, L.P. Prior to

28

January 1991, he was Senior Vice President and Managing Director of Smith
Barney, Harris Upham & Co. Inc., an investment banking firm. He currently serves
on the Boards of Witco Corporation, a publicly traded company, and several
privately held companies. Mr. Wesson earned a degree from Colgate University and
a Masters of Business Administration from Columbia University.

ALAN J. SMITH, PH.D. has been a Director of the Company since 1995. Since
1991, Dr. Smith has been a management consultant specializing in pharmaceutical
quality management, quality control, quality assurance and auditing, the Food
and Drug Administration's Current Good Manufacturing Practice regulations and
technology training, documentary systems and stability programming. From 1985 to
1991, he was Corporate Director of Quality affairs for Whitehall Laboratories, a
Division of American Home Products Corporation. Dr. Smith holds B.Sc. and Ph.D.
degrees from the University of London.

WILLIAM A. SUMNER has been a Director of the Company since August 1997.
From 1974 until his retirement in 1995, Mr. Sumner held various positions within
Hoechst-Roussel Pharmaceuticals, Inc., a manufacturer and distributor of
pharmaceutical products, including Vice-President and General Manager,
Dermatology Division from 1991 through 1995, Vice President, Strategic Business
Development, from 1989 to 1991 and Vice President, Marketing from 1985 to 1989.
Since his retirement from Hoechst-Roussel Pharmaceuticals, Inc. in 1995, Mr.
Sumner has acted as a consultant to various entities in the pharmaceutical
field.

WILLIAM SKELLY has been a Director of the Company since May 1996 and served
as Chairman of the Company from October 1996 through June 2000. Since 1990, Mr.
Skelly has served as Chairman, President and Chief Executive Officer of Central
Biomedia, Inc. and its subsidiary SERA, Inc., companies involved in the animal
health industry including veterinary biologicals and custom manufacturing of
animal sera products. From 1985 to 1990, Mr. Skelly served as President of
Martec Pharmaceutical, Inc., a distributor and manufacturer of human generic
prescription pharmaceuticals.

SRINI CONJEEVARAM has been a Director of the Company since March 1998. Mr.
Conjeevaram is Chief Financial Officer of Galen Associates, a health care
venture firm, and a General Partner of Galen Partners III, L.P. Prior to January
1991, he was an Associate in Corporate Finance at Smith Barney, Harris Upham &
Co. Inc. from 1989 to 1990 and a Senior Project Engineer for General Motors
Corporation from 1982 to 1987. Mr. Conjeevaram serves as a Director of Derma
Sciences, Inc., a publicly traded company. He earned a Bachelor of Science
degree in Mechanical Engineering from Madras University, a Masters of Science
degree in Mechanical Engineering from Stanford University, and a Masters of
Business Administration from Indiana University.

ZUBEEN SHROFF has been a Director of the Company since June 1998. Mr.
Shroff is a General Partner of Galen Partners III, L.P. He joined Galen
Associates, a health care venture firm, in January 1997 from The Wilkerson
Group, a leading provider of management consulting services to the health care
industry. Prior to The Wilkerson Group, he worked for Schering-Plough
International from 1989 to 1993 in a variety of staff and line management
positions and as head of Schering-Plough France's biotech franchise. Mr. Shroff
received a Bachelor of Science in Biological Sciences from Boston University in
1986 and a Masters of Business Administration from The Wharton School in 1988.
Mr. Shroff serves as a Director of AmericasDoctor.com and Encore Medical
Corporation.

JOEL D. LIFFMANN has been a Director of the Company since 1999. Mr.
Liffmann is a General Partner of Oracle Partners, L.P. Prior to joining Oracle
Partners in 1996, Mr. Liffmann was Senior Vice President of Business Development
at Merck-Medco, Inc. Prior to such time, Mr. Liffmann was Vice
President/Business Development at Medco Containment Services and Vice President
of Equity Research and later was Vice President of Corporate Finance at Drexel
Burnham Lambert. Mr. Liffmann holds a degree from Boston University.

JERRY KARABELAS has been a Director of the Company since December 2002. Mr.
Karabelas was Head of Healthcare and CEO of Worldwide Pharmaceuticals for
Novartis AG from 1998 until July 2000. Prior to joining Novartis, Mr. Karabelas
was Executive Vice President of SmithKline Beecham. From July 2000 until
December 2001, Mr. Karabelas was the Founder and Chairman of the Novartis Bio
Venture Fund. Since

29

November 2001 he has been a Partner with Care Capital LLC. Mr. Karabelas holds a
Ph.D. in pharmacokinetics from the Massachusetts College of Pharmacy and serves
as a Director of SkyePharma Plc., Human Genome Sciences, Nitromed, Anadys and
Renova.

IMMANUEL THANGARAJ has been a Director of the Company since December 2002.
Mr. Thangaraj has been a Managing Director of Essex Woodlands Health Ventures, a
venture capital firm specializing in the healthcare industry, since 1997. Prior
to joining Essex Woodlands Health Ventures, he helped form a telecommunication
services company, for which he served as its CEO. Mr. Thangaraj also worked as
an Associate for ARCH Venture Partners, LP and managing one of its portfolio
companies, a medical information technology company. Mr. Thangaraj holds a
Bachelor of Arts and a Masters in Business Administration from the University of
Chicago and serves as a Director of iKnowMed Systems, Sound ID and CBR Systems.

JAMES EMIGH has been Vice President of Sales and Marketing since November
2002. Mr. Emigh joined the Company in May, 1998, serving first as Executive
Director of Customer Relations and then as Vice President of Operations until
November 2002. From 1991 until joining the Company, Mr. Emigh was employed by
Organon, Inc., a pharmaceutical company, in various management positions and
most recently as its Director of Managed Care and Trade Relations. Mr. Emigh
holds a Bachelor of Pharmacy from Washington State University and a Masters of
Business Administration from George Mason University.

PHYLLIS A. LAMBRIDIS has been Vice President of Corporate Compliance since
March 19, 2001. From 1998 until joining the Company, Ms. Lambridis was employed
by Schein Pharmaceutical, Inc. (subsequently acquired by Watson Pharmaceuticals,
Inc. in 2000) as its Director, Corporate Quality Standards, Policies & Systems.
From 1987 to 1998 Ms. Lambridis was employed by Barr Laboratories, Inc. in a
number of quality and regulatory positions, most recently as Director of
Regulatory Compliance. Ms. Lambridis holds a Masters of Science in Bacteriology
from Wagner College and a Bachelor of Arts in Microbiology from Rutgers College.

CAROL WHITNEY has been Vice President of Administration since April 1998.
From 1992 until joining the Company, Ms. Whitney served as Director of Human
Resources for UDL Laboratories, Inc., a generic pharmaceutical manufacturer
located in Rockford, Illinois.

ROBERT SEISER has been Corporate Controller and Treasurer since March 1998.
From 1992 until joining the Company, Mr. Seiser served as Treasurer and
Corporate Controller of TC Manufacturing Co., Inc., a privately held company
based in Evanston, Illinois. Mr. Seiser is a Certified Public Accountant and
earned a B.B.A. degree from Loyola University of Chicago.

SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires
the Company's Directors and executive officers, and persons who own beneficially
more than ten percent (10%) of the Common Stock of the Company, to file reports
of ownership and changes of ownership with the Commission and, during the period
in which the Company's common stock was traded on the American Stock Exchange,
the AMEX. Copies of all filed reports are required to be furnished to the
Company pursuant to Section 16(a). Based solely on the reports received by the
Company and on written representations from reporting persons, the Company
believes that the Directors, executive officers and greater than ten percent
(10%) beneficial owners complied with all Section 16(a) filing requirements
during the year ended December 31, 2002, except that (i) a Form 3 filing
requirement for Mr. Vijai Kumar following his appointment as the Company's Chief
Operations Officer was filed late (ii) a Form 4 filing requirement by each of
Galen Partners III, L.P. and Galen Partners International III, L.P., each a
beneficial owner of in excess of 10% of the Company's Common Stock, were filed
late, and (iii) a Form 3 filing requirement by Mr. Dennis Adams, a beneficial
owner of in excess of 10% of the Company's Common Stock, has not been filed to
date.

30

ITEM 11. EXECUTIVE COMPENSATION

The following table sets forth a summary of the compensation paid by the
Company for services rendered in all capacities to the Company during the fiscal
years ended December 31, 2002, 2001 and 2000 to the Company's Chief Executive
Officer and the Company's next four most highly compensated executive officers
(collectively, the "named executive officers") whose total annual compensation
for 2002 exceeded $100,000:

SUMMARY COMPENSATION TABLE

- ---------------

(1) Mr. Price's services as President and Chief Operating Officer ceased
effective November 7, 2002

(2) Ms. Lambridis was appointed Vice President -- Corporate Compliance effective
March 19, 2001.

OTHER COMPENSATORY ARRANGEMENTS

Executive Officers and key employees participate in medical and disability
insurance plans provided to all non-union employees of the Company. The Company
also provided automobiles to certain of its executive Officers. Although the
Company is unable to assign a precise value to the possible personal benefit
derived from the use of the automobiles, the Company believes that, as to each
officer, such personal benefit amount is less than the lesser of $6,000 or 10%
of such officer's compensation reported above in the Summary Compensation Table.

EMPLOYMENT AGREEMENTS

Michael K. Reicher is employed pursuant to an Employment Agreement
effective as of March 10, 1998, which after giving effect to amendments dated
May 24, 2000 and May 4, 2001, provides that Mr. Reicher will serve as the
Company's Chief Executive Officer for a term expiring April 30, 2005. The
Agreement provides for an annual base salary of $200,000 plus the payment of an
annual bonus to be determined based on the satisfaction of such targets,
conditions or parameters as may be set from time to time by the Compensation
Committee of the Board of Directors. No bonus was paid for fiscal 2002 . The
Employment Agreement also provides for the grant of stock options on March 10,
1998 to purchase 1,000,000 shares of the Company's Common Stock at an exercise
price of $2.375 per share (representing the closing price for the Company's
common stock as reported by the American Stock Exchange ("AMEX") on the day
preceding the grant of the option), which options vest in equal increments of
62,500 option shares at the end of each quarterly period during the term of the
Agreement (as such vesting schedule may be amended by mutual agreement between

31

Mr. Reicher and the Board of Directors). The Employment Agreement also permits
the Company to repurchase the vested portion of Mr. Reicher's options upon his
termination for cause (as defined in the Agreement) or his resignation (other
than for "Good Reason" as defined therein), at a purchase price equal to the
positive difference, if any, between the average of the Closing Price of the
Company's common stock for the five trading days prior to the date of
termination or resignation, multiplied by the number of option shares which, as
of the date of termination, are vested under the option. The Employment
Agreement contains standard termination provisions, including upon death,
disability, for cause (as defined in the Agreement) and without cause. In the
event the Employment Agreement is terminated by the Company without cause or by
Mr. Reicher for Good Reason (as defined in the Agreement), the Company is
required to pay Mr. Reicher an amount equal to $350,000 or twice his then base
salary, whichever is greater, payable in 24 equal monthly installments and to
continue to provide Mr. Reicher coverage under the Company's then existing
benefit plans, including medical and life insurance, for a term of 24 months.
The Employment Agreement permits Mr. Reicher to terminate the Agreement in the
event of a change of control and for Good Reason (as defined in the Agreement).
The Agreement also restricts Mr. Reicher from disclosing, disseminating or using
for his personal benefit or for the benefit of others confidential or
proprietary information (as defined in the Employment Agreement) and, provided
the Company has not breached the terms of the Employment Agreement, from
competing with the Company at any time prior to two years after the earlier to
occur of the expiration of the term and the termination of his employment.

Peter A. Clemens is employed pursuant to an Employment Agreement effective
as of March 10, 1998, which after giving effect to amendments dated June 28,
2000 and May 4, 2001, provides that Mr. Clemens will serve as the Company's Vice
President and Chief Financial Officer for a term expiring April 30, 2005. The
Employment Agreement provides an annual base salary of $155,000 plus the payment
of an annual bonus to be determined based on the satisfaction of such targets,
conditions or parameters as may be determined from time to time by the
Compensation Committee of the Board of Directors. No bonus was paid for fiscal
2002. The Employment Agreement also provides for the grant of stock options on
March 10, 1998 to purchase 300,000 shares of the Company's common stock at an
exercise price of $2.375 per share, which options vest in equal increments of
25,000 option shares at the end of each quarterly period during the term of the
Employment Agreement (as such vesting schedule may be amended by mutual
agreement of Mr. Clemens and the Board of Directors). The remaining terms of Mr.
Clemens' Employment Agreement with the Company are substantially identical to
that of Mr. Reicher.

Vijai Kumar is employed pursuant to an Employment Agreement effective as of
November 18, 2002, which provides that Mr. Kumar will serve as the Company's
Chief Operations Officer for a term expiring November 18, 2004. The Employment
Agreement provides an annual base salary of $180,000 plus the payment of an
annual bonus to be determined based on the satisfaction of such targets,
conditions or parameters as may be determined from time to time by the
Compensation Committee of the Board of Directors. The Employment Agreement also
provides for the grant of stock options on November 18, 2002 to purchase 400,000
shares of the Company's common stock at an exercise price of $1.125 per share,
which options vest in equal increments of 100,000 annually. The Employment
Agreement permits the Company to repurchase the vested portion of Mr. Kumar's
options upon his termination for cause (as defined in the Agreement) or his
resignation, at a purchase price equal to the positive difference, if any,
between the average of the closing price of the Company's common stock for the
five trading days prior to the date of termination or resignation, multiplied by
the number of option shares which, as of the date of termination, are vested
under the option. The Employment Agreement contains standard termination
provisions, including upon death, disability, for cause (as defined in the
Agreement) and without cause. The Employment Agreement also provides that in the
event of a change of control (as defined in the Agreement), if Mr. Kumar's
employment with the Company is terminated without cause, he is entitled to his
base salary for the lesser of (i) the remaining term of the Agreement, and (ii)
one year. The Agreement also restricts Mr. Kumar from disclosing, disseminating
or using for his personal benefit or the benefit of others confidential or
proprietary information (as defined in the Agreement) and, provided the Company
has not breached the terms of the Employment Agreement, from competing with the
Company at any time prior to one year after the earlier to occur of the
expiration of the term and the termination of his employment.

32

COMPENSATION OF DIRECTORS

Directors who are employees of the Company receive no additional or special
remuneration for their services as Directors. Directors who are not employees of
the Company receive an annual grant of options to purchase 10,000 shares of the
Company's common stock (15,000 shares in the case of the Chairman of the Board)
and $500 for each meeting attended ($250 in the case of telephonic meetings).
The Company also reimburses Directors for travel and lodging expenses, if any,
incurred in connection with attendance at Board meetings. Directors who serve on
any of the Committees established by the Board of Directors receive $250 for
each Committee meeting attended unless held on the day of a full Board meeting.

STOCK OPTION PLANS

The Company currently maintains two stock option plans adopted in 1995 and
1998, respectively. The Company in the past has used, and will continue to use,
stock options to attract and retain key employees in the belief that employee
stock ownership and stock-related compensation devices encourage a community of
interest between employees and shareholders.

The 1995 Stock Option Plan. In September 1995, the Company established the
1995 Halsey Drug Co., Inc. Stock Option and Restricted Stock Purchase Plan (the
"1995 Stock Option Plan"). Under the 1995 Stock Option Plan, the Company may
grant options to purchase up to 1,000,000 shares of the Company's Common Stock.
Incentive Stock Options ("ISO's") may be granted to employees of the Company and
its subsidiaries and non-qualified options may be granted to employees,
directors and other persons employed by, or performing services for, the Company
and its subsidiaries. Subject to the 1995 Stock Option Plan, the Stock Option
Committee determines the persons to whom grants are made and the vesting,
timing, amounts and other terms of such grants. An employee may not receive
ISO's exercisable in any one calendar year for shares with a fair market value
on the date of grant in excess of $100,000. No quantity limitations apply to the
grant of non-qualified stock options.

As of March 31, 2003, ISO's to purchase 689,813 shares and non-qualified
options to purchase 257,780 shares have been granted under the 1995 Stock Option
Plan, leaving 52,407 shares available for grant under the Plan. The average per
share exercise price for all outstanding options under the 1995 Stock Option
Plan is approximately $1.44. No exercise price of an ISO was set at less than
100% of the fair market value of the underlying Common Stock, except for grants
made to any person who owned stock possessing more than 10% of the total voting
power of the Company, in which case the exercise price was set at not less than
110% of the fair market value of the underlying Common Stock.

The 1998 Stock Option Plan. The 1998 Stock Option Plan was adopted by the
Board of Directors in April 1998 and approved by the Company's shareholders in
June 1998. The 1998 Stock Option Plan was amended by the Board of Directors in
April 1999 to increase the number of shares available for the grant of options
under the Plan from 2,600,000 to 3,600,000 shares. The Company's shareholders
ratified the Plan amendment on August 19, 1999. The 1998 Stock Option Plan was
further amended by Board of Directors in April, 2001 to increase the number of
shares available for grant of options under the Plan from 3,600,000 to 8,100,000
shares. The Company's shareholders ratified the Plan amendment on June 14, 2001.
The 1998 Stock Option Plan permits the grant of incentive stock options
("ISO's") and non-qualified stock options to purchase shares of the Company's
Common Stock. As of March 31, 2003, ISO's to purchase 1,653,151 shares and
non-qualified options to purchase 1,562,466 shares have been granted under the
1998 Stock Option Plan, leaving 4,884,383 shares available for grant under the
Plan. The average per share exercise price for all outstanding options under the
1998 Stock Option Plan is approximately $1.97. No exercise price of an ISO was
set at less than 100% of the fair market value of the underlying Common Stock,
except for grants made to any person who owned stock possessing more than 10% of
the total voting power of the Company, in which case the exercise price was set
at not less than 110% of the fair market value of the underlying Common Stock.
Subject to the terms of the 1998 Stock Option Plan, the Stock Option Committee
determines the person's to whom grants are made and the vesting, timing,
amounts, and other terms of such grant. An employee may not receive ISO's
exercisable in any one calendar year for shares with a fair market value on the
date of grant in excess of $100,000. No quantity limitations applied to the
grant of non-qualified stock options.

33

SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS

The following table includes information as of December 31, 2002 relating
to the Company's 1995 Stock Option Plan and 1998 Stock Option Plan, which
comprise all of the equity compensation plans of the Company. The table provides
the number of securities to be issued upon the exercise of outstanding options
under such plans, the weighted-average exercise price of such outstanding
options and the number of securities remaining available for future issuance
under such equity compensation plans:

EQUITY COMPENSATION PLAN INFORMATION

AGGREGATE OPTION EXERCISES IN LAST FISCAL YEAR
AND FISCAL YEAR END OPTION VALUES

No stock options were granted to or exercised by the named executive
officers during 2002. The following table presents information regarding the
value of options outstanding at December 31, 2002 for each of the named
executive officers.

- ---------------

(1) Mr. Price's services as President and Chief Operating Officer ceased
effective November 7, 2002.

(2) Value is based upon the average of the closing bid and ask price of $.96 per
share at December 31, 2002.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

The Company's Compensation Committee consisted of Messrs. Wesson,
Conjeevaram, Skelly and Reicher during fiscal 2002. During 2002, except for Mr.
Reicher, the Company's Chairman and Chief Executive Officer, there were no
Compensation Committee interlocks or insider participation in compensation
decisions.

34

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS

The following table sets forth information regarding the beneficial
ownership of the Common Stock, as of April 1, 2003 for individuals or entities
in the following categories: (i) each of the Company's Directors and nominees
for Directors; (ii) the Chief Executive Officer and the next four highest paid
executive officers of the Company whose total annual compensation for 2002
exceeded $100,000 (the "named executive officers"); (iii) all Directors and
executive officers as a group; and (iv) each person known by the Company to be a
beneficial owner of more than 5% of the Common Stock. Unless indicated
otherwise, each of the shareholders has sole voting and investment power with
respect to the shares beneficially owned.

- ---------------

* Represents less than 1% of the outstanding shares of the Company's Common
Stock.

(1) The information with respect to Hemant K. Shah and Varsha H. Shah, Dennis
Adams, Bernard Selz and Michael and Susan Weisbrot and Watson
Pharmaceuticals, is based upon filings with the Commission and/or
information provided to the Company.

(2) Includes (i) 18,524,915 shares issuable upon conversion of 1998 Debentures
and 1999 Debentures, (ii) 5,483,034 shares issuable upon exercise of 1998
Warrants and 1999 Warrants, (iii) 5,851,500 shares issuable upon exercise
of common stock purchase warrants issued in connection with the 2001/2002
Galen Bridge Loans, (iv) 3,937,678 shares issuable upon conversion of
Debentures issued in lieu of quarterly cash interest payments, and (v)
150,000 shares subject to currently exercisable stock options.

(3) Includes (i) 1,966,652 shares issuable upon conversion of 1998 Debentures
and 1999 Debentures, (ii) 583,157 shares issuable upon exercise of 1998
Warrants and 1999 Warrants, (iii) 525,545 shares issuable upon exercise of
common stock purchase warrants issued in connection with the 2001/2002
Galen Bridge Loans, and (iv) 418,996 shares issuable upon conversion of
Debentures issued in lieu of quarterly cash interest payments.

(4) Includes (i) 7,122,508 shares issuable upon conversion of the 1999
Debentures, and (ii) 1,227,156 shares issuable upon conversion of
Debentures issued in lieu of quarterly cash interest payments, and (iii)
30,000 shares subject to currently exercisable stock options.

(5) Includes 14,705,882 shares issuable upon conversion of 2002 Debentures.

(6) Includes 14,705,882 shares issuable upon conversion of 2002 Debentures.

(7) Includes 10,700,665 shares issuable upon exercise of the Watson Warrant.

(8) Includes 1,296,698 shares issuable upon conversion of 1998 Debentures and
1999 Debentures.

(9) Includes 916,403 shares issuable upon conversion of 1998 Debentures and
1999 Debentures.

(10) Includes 512,714 shares issuable upon conversion of 1998 Debentures and
1999 Debentures

(11) Includes 679,726 shares issuable upon conversion of 1998 Debentures and
1999 Debentures.

(12) Includes (i) 266,502 shares issuable upon conversion of 1998 Debentures,
(ii) 62,213 shares issuable upon conversion of Debentures issued in lieu of
quarterly interest payments and (iii) 1,343,750 shares subject to currently
exercisable stock options.

(13) Includes 200,000 shares subject to currently exercisable stock options.

(14) Includes (i) 50,000 shares subject to currently exercisable Common Stock
Purchase Options and (ii) 42,952 shares issuable upon conversion of
Debentures.

(15) Includes 50,000 shares subject to currently exercisable stock options.

(16) Includes (i) 211,821 shares issuable upon conversion of 1998 Debentures,
(ii) 35,678 shares issuable upon conversion of Debentures issued in lieu of
quarterly interest payments, and (iii) 568,750 shares subject to currently
exercisable stock options.

(17) Includes 31,250 shares subject to currently exercisable stock options.

36

(18) Includes 109,750 shares subject to currently exercisable stock options.

(19) Includes 3,723,126 shares which Directors and executive officers have the
right to acquire within the next 60 days through the conversion of
Debentures and the exercise of outstanding stock options.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

On March 10, 1998, the Company completed a private offering of securities
(the "Galen Offering") to Galen Partners III, L.P., Galen Partners
International, L.P., Galen Employee Fund III, L.P., (collectively "Galen") and
each of the purchasers listed on the signature page to a certain Debenture and
Warrant Purchase Agreement (the "1998 Purchase Agreement") dated March 10, 1998
(inclusive of Galen, collectively the "Galen Investor Group"). The securities
issued in the Galen Offering consisted of 5% convertible senior secured
debentures (the "1998 Debentures") and common stock purchase warrants (the "1998
Warrants"). After giving effect to the Company's issuance of additional
debentures to Galen in satisfaction of interest payments under the 1998
Debentures and the 1999 Debentures described below, as well as the 2002
Debentures issued to Galen in the 2002 Debenture Offering (as further described
below), an aggregate of approximately 123,302,173 shares are issuable to Galen
upon conversion of outstanding convertible debentures and exercise of
outstanding common stock purchase warrants issued to Galen. See "Item
12 -- Security Ownership of Certain Beneficial Owners and Management."

Each of Messrs. Wesson, Conjeevaram and Shroff, members of the Board of
Directors, are designees of the Galen Investor Group pursuant to the terms of
the 1998 Purchase Agreement which provides, among other things, that the Company
must nominate and appoint to the Board of Directors, subject to shareholder
approval, three designees of the Galen Investor Group for 2003, and two
designees of the Galen Investor Group thereafter, for so long as the 1998
Debentures and 1998 Warrants remain outstanding. Each of Messrs. Wesson,
Conjeevaram and Shroff is a General Partner of Galen Associates, an affiliate of
each of the Galen entities included in the Galen Investor Group.

The Company secured bridge financing from Galen and certain other lenders
in the aggregate principal amount of approximately $15,277,761, funded through
numerous bridge loan transactions during the period from August 15, 2001 through
December 2002 (collectively, the "2001/2002 Galen Bridge Loans"). Approximately
$14,770,186 in aggregate principal amount of the 2001/2002 Galen Bridge Loans
was advanced by Galen with a balance of approximately $507,575 advanced by
certain members of the Galen Investor Group. As part of the closing of the 2002
Debenture Offering, as defined and provided below, the Company issued 2002
Debentures to Galen in the aggregate principal amount $15,483,731 in exchange
for the surrender of a like amount of principal and accrued interest then
outstanding under the 10% Convertible Promissory Notes ("Convertible Notes")
issued to Galen in the 2001/2002 Galen Bridge Loans. Prior to the surrender of
the Convertible Notes for 2002 Debentures issued in the 2002 Debenture Offering,
the 2001/2002 Galen Bridge Loans accrued interest at the rate of 10% per annum
and were secured by a lien on all the Company's assets. In consideration for the
extension of the 2001/2002 Galen Bridge Loans, the Company issued Common Stock
purchase warrants to Galen to purchase an aggregate of 6,401,029 shares of the
Company's Common Stock. The warrants issued pursuant to the 2001/2002 Galen
Bridge Loans have an exercise price equal to the fair market value of the
Company's Common Stock on the date of issuance of such warrants and are
substantially identical to those issued in the Galen Offering. The 2001/2002
Galen Bridge Loans were obtained by the Company in order to provide necessary
working capital.

Galen controls approximately 85.7% of the Company's voting securities (or
approximately 55.9% after giving effect to the conversion of other convertible
securities issued by the Company). Holders of the 1998 Debentures and the 1999
Debentures (as defined in the paragraph below) are permitted to vote on all
matters submitted to a vote of shareholders, voting together with holders of
common stock as one class and having such number of votes as equals the number
of votes represented by the Common Stock that would be acquired upon conversion
of such debentures into common stock. In addition, in accordance with the terms
of the 2002 Debenture Offering, the Company is obligated to seek shareholder
approval to amend its Certificate of Incorporation to grant voting rights to the
holders of the 2002 Debentures. Assuming the receipt of shareholder approval to
the Company's Certificate of Incorporation to grant such voting rights, holders
of the

37

2002 Debentures, including Galen, would be permitted to vote on all matters
submitted to a vote of shareholders of the Company, voting together with holders
of Common Stock as one class and having such number of votes as equal the
numbers of votes represented by the Common Stock that would be acquired upon
conversion of the 2002 Debenture into Common Stock. Assuming the receipt of
shareholder approval to the Company's Certificate of Incorporation to grant
voting rights to the holders of 2002 Debentures, Galen would control
approximately 85.7% of the Company's voting securities (or approximately 55.9%
after giving effect to the conversion of other convertible securities issued by
the Company). Accordingly, Galen possesses sufficient voting rights to control
the nomination and election of the board of directors of the Company without the
need to convert its debentures into common stock.

On May 26, 1999, the Company completed a private offering of securities for
an aggregate purchase price of up to approximately $22.8 million (the "Oracle
Offering"). The securities issued in the Oracle Offering consist of 5%
convertible senior secured debentures (the "1999 Debentures") and common stock
purchase warrants (the "1999 Warrants"). The 1999 Debentures and 1999 Warrants
were issued by the Company pursuant to a certain Debenture and Warrant Purchase
Agreement dated May 26, 1999 (the "1999 Purchase Agreement") by and among the
Company, Oracle Strategic Partners, L.P. ("Oracle") and such other investors in
the Galen Offering electing to participate in the Oracle Offering (inclusive of
Oracle, collectively, the "Oracle Investor Group"). On the closing date of the
Oracle Offering, the Company issued an aggregate of approximately $12,862,000 in
principal amount of 1999 Debentures. In accordance with the Oracle Purchase
Agreement, Oracle funded an additional $5 million investment installment on July
27, 1999. Pursuant to an agreement reached between the Company and Oracle on
March 20, 2000, the final $5 million investment to be made to Oracle under the
1999 Purchase Agreement has been waived.

The holders of the 1999 Debentures (including Oracle) are permitted to vote
on all matters submitted to a vote of shareholders of the Company, voting
together with holders of common stock as one class and having such number of
votes as equals the number of votes represented by the common stock that would
be acquired upon conversion of the 1999 Debentures into Common Stock.
Accordingly, Oracle controls approximately 34.8% of the Company's voting
securities without the need to convert the 1999 Debentures into Common Stock.
The Oracle Purchase Agreement also provides that the Company must nominate and
appoint to the Board of Directors, subject to shareholder approval, one designee
of the Oracle Investor Group for so long as the 1999 Debentures and 1999
Warrants remain outstanding. Mr. Joel D. Liffmann, a current member of the Board
of Directors, is a designee of the Oracle Investor Group and is a General
Partner of Oracle Partners, L.P.

On December 20, 2002, the Company completed a private offering of
securities for an approximate aggregate purchase price of $26,394,000 (the "2002
Debenture Offering"). The securities issued in the 2002 Debenture Offering
consisted of 5% convertible senior secured debentures (the "2002 Debentures").
The Debentures were issued by the Company pursuant to a certain Debenture
Purchase Agreement dated December 20, 2002 (the "2002 Purchase Agreement") by
and among the Company, Care Capital Investments II, LP ("Care Capital"), Essex
Woodlands Health Ventures V, L.P. ("Essex"), Galen and each of the purchasers
listed on the signature page thereto (collectively, the "2002 Debenture Investor
Group").

The 2002 Purchase Agreement provides that the holders of the 2002
Debentures shall have the right to vote as part of a single class with all
holders of the Company's Common Stock on all matters to be voted on by such
stockholders. Each 2002 Debenture holder shall have such number of votes as
shall equal the number of votes he would have had if such holder converted the
entire outstanding principal amount of his 2002 Debenture into shares of Common
Stock immediately prior to the record date relating to such vote; provided,
however, that any 2002 Debentures held by Care Capital shall, for so long as
they are held by Care Capital, have no voting rights. In accordance with the
terms of the 2002 Purchase Agreement, the Company will seek shareholder approval
at its 2003 Annual Meeting of Shareholders to amend its Certificate of
Incorporation to provide as-converted voting rights to the holders of the 2002
Debentures. Assuming the receipt of shareholder approval, Essex would control
approximately 41.2% of the Company's voting securities (without giving effect to
the conversion of other convertible securities issued by the Company).

38

The 2002 Purchase Agreement also provides that each of Care Capital and
Essex has the right to designate one person for nomination to be a member of the
Company's Board of Directors as of the closing date of the 2002 Debenture
Offering (collectively, the "Designees"). The Purchase Agreement further
provides that the Designees shall be, if so requested by such Designee in his
sole discretion, appointed to the Company's Executive Committee, Compensation
Committee and any other Committee of the Board of Directors. Accordingly,
effective as of the closing of the 2002 Purchase Agreement, the Board of
Directors appointed each of Jerry Karabelas and Immanuel Thangaraj to the
Company's Board of Directors. Mr. Karabelas is a General Partner of Care Capital
Investments II, LP an affiliate of Care Capital, LLC. Mr. Thangaraj is a
Managing Director of Essex Woodlands Health Ventures V, an affiliate of Essex.
The Company has agreed to nominate and appoint to the Board of Directors,
subject to shareholder approval, one designee of each of the Care Capital and
Essex for so long as each holds the 2002 Debentures.

As part of the closing of the 2002 Purchase Agreement, the Company and the
purchasers of the 2002 Debentures, including Care, Essex and Galen, executed a
certain Debentureholders Agreement providing, among other things, that the
approval of the holders of at least sixty six and two-thirds percent (66 2/3%)
of the aggregate principal amount of the 2002 Debentures is required to
authorize (a) any modification of the rights of the holders of the 2002
Debentures, (b) any issuance of securities of the Company which rank senior or
pari passu to the 2002 Debentures, (c) any dividends or distributions on, or
redemption of, any securities ranking junior in priority to the 2002 Debentures,
other than dividends or distributions payable in the Company's Common Stock or
cash interest paid to individual investors in the Company's 1998 Debentures and
1999 Debentures (collectively, the "Existing Debentures"), (d) the merger or
consolidation of the Company, the sale, transfer, lease or other disposition of
all or substantially all the Company's consolidated assets, or the liquidation,
recapitalization or reorganization of the Company, other than any such
transaction where the cash, securities and/or other liquid consideration
received for the voting stock of the Company in such transaction is at least
four (4) times the then applicable conversion price of the 2002 Debentures, (e)
any increase in the number of members comprising the Company's Board of
Directors above eleven (11) members, and (f) the consummation of a strategic
alliance, business combination, licensing arrangement or other corporate
partnering involving the issuance by the Company of in excess of $10,000,000 in
equity securities of the Company.

The Debentureholders Agreement further provides that the holders of at
least sixty six and two-thirds percent (66 2/3%) of the aggregate principal
amount of the 2002 Debentures and Existing Debentures is required in order to
authorize (a) any amendment to the Company's Certificate of Incorporation, (b)
dividends or distributions on, or redemptions of, any securities ranking junior
to the Existing Debentures, other than distributions or dividends payable in the
Company's capital stock or cash interest paid to individual investors in the
Existing Debentures, (c) any issuance of the Company's securities ranking senior
or pari passu to the Existing Debentures, and (d) the completion of any
transaction described in subsections (d), (e) and (f) in the preceding
paragraph.

As part of the closing of the 2002 Purchase Agreement, each of Galen,
Oracle, Michael Reicher, the Company's Chief Executive Officer, and Peter
Clemens, the Company's Chief Financial Officer (collectively, the "Voting
Agreement Parties") executed a Voting Agreement dated December 20, 2002 pursuant
to which each agreed to vote all of their respective voting securities of the
Company in favor of the amendments to the Company's Charter to increase the
Company's authorized shares in order to permit the conversion of the 2002
Debentures and the Company's other outstanding convertible securities, and to
provide voting rights to the holders of the 2002 Debentures. The voting
securities held by the Voting Agreement Parties represent an aggregate of
approximately 64.3% of the voting rights under the Company's outstanding voting
securities.

As part of the closing of the 2002 Debenture Offering, the Company's term
loan agreement (the "Watson Loan Agreement") with Watson Pharmaceuticals, Inc.
("Watson") was amended to (i) extend the maturity date of the Watson Loan
Agreement from March 31, 2003 to March 31, 2006, and (ii) increase the principal
amount of the Watson Loan Agreement from $17,500,000 to $21,401,331 (the "Watson
Term Loan") to reflect the inclusion of approximately $3,901,331 owed by the
Company to Watson under a product supply agreement between the parties. In
consideration for the amendment to the Watson Loan Agreement, the Company issued
to Watson a Common Stock Purchase Warrant exercisable for 10,700,665 shares of
the
39

Company's Common Stock (the "Watson Warrant"). The Watson Warrant has a term
expiring December 31, 2009 and has an exercise price of $.34 per share. After
giving effect to the terms of a Reserved Share Waiver (as defined and described
in the paragraph below) the Watson Warrant is immediately exercisable for
approximately 33.7% of the Company's Common Stock (without giving effect to the
conversion of other convertible securities issued by the Company, including
those issued to Galen).

In furtherance of the completion of the 2002 Debenture Offering, each of
the Company, Galen, Oracle, Care Capital, Essex and Watson executed a certain
Reserved Share Waiver Agreement dated December 20, 2002 (the "Reserved Share
Agreement"). Under the terms of the Reserved Share Agreement, each of Galen and
Oracle authorized the release of shares previously reserved by the Company for
issuance under the 1998 Debentures, 1999 Debentures, 1998 Warrants and 1999
Warrants previously issued to Galen and Oracle, in order to provide sufficient
authorized and unreserved shares to permit the conversion of the 2002 Debentures
issued to each of Care Capital and Essex as well as the exercise of the Watson
Warrant. As a consequence, even in the absence of the approval of the amendment
to the Company's Charter described in Proposal 2 to this Proxy Statement, an
aggregate of 40,112,429 shares of the Company's authorized Common Stock have
been reserved for issuance in the event of the conversion of the 2002 Debentures
issued to each of Care Capital and Essex and in the event Watson's exercise of
the Watson Warrant.

On December 20, 2002, as part of the completion of the 2002 Debenture
Offering, the Company consummated the terms of a Warrant Recapitalization
Agreement (the "Recapitalization Agreement") between the Company and certain
holders of an aggregate of 8,145,736 Common Stock Purchase Warrants issued by
the Company (i) pursuant to the 1998 Purchase Agreement (the "1998 Warrants"),
(ii) pursuant to the 1999 Purchase Agreement (the "1999 Warrants"), and (iii)
pursuant to various bridge loan transactions during the period from 1998 through
2002 (the "Bridge Loan Warrants" and collectively with the 1998 Warrants and
1999 Warrants, the "Recapitalization Warrants"). As part of the closing of the
Recapitalization Agreement, the warrantholders a party thereto surrendered to
the Company for cancellation the Recapitalization Warrants in exchange for the
issuance of an aggregate of 5,970,083 shares of Common Stock.

Each of Oracle, Michael and Susan Weisbrot, Dennis Adams, Bernard Selz and
Hemant and Varsha Shah beneficially own in excess of 5% of the Company's voting
securities. (See "Security Ownership of Certain Beneficial Owners and
Management"). Each of such security holders participated in the Recapitalization
Agreement. Oracle surrendered 4,786,956 Recapitalization Warrants in exchange
for 3,649,461 shares of Common Stock. Michael and Susan Weisbrot surrendered
557,319 Recapitalization Warrants in exchange for 405,727 shares of Common
Stock. Dennis Adams surrendered 913,034 Recapitalization Warrants in exchange
for 608,844 shares of Common Stock. Bernard Selz surrendered 489,765
Recapitalization Warrants in exchange for 360,243 shares of Common Stock. Hemant
and Varsha Shah surrendered 741,388 Recapitalization Warrants in exchange for
497,727 shares of Common Stock.

In addition to their participation in the Recapitalization Agreement,
Michael and Susan Weisbrot and Bernard Selz surrendered their 10% Convertible
Promissory Notes (issued by the Company pursuant to the 2001/2002 Galen Bridge
Loans), plus accrued and unpaid interest in the aggregate amount of $40,590 and
$342,454, respectively, in exchange for a 2002 Debenture in a like principal
amount. Hemant and Varsha Shah surrendered their 10% Convertible Notes to the
Company on December 20, 2002 for payment in full of $128,535.

ITEM 14. CONTROLS AND PROCEDURES

Within the 90 days prior to the date of this report, the Company carried
out an evaluation, under the supervision and with the participation of the
Company's management, including the Company's Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of the
Company's disclosure controls and procedures pursuant to Exchange Act Rule
13a-14. Based upon that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that the Company's disclosure controls and
procedures are effective in timely alerting them to material information
relating to the Company (including its consolidated subsidiaries) required to be
included in the Company's periodic Securities and

40

Exchange Commission filings. No significant changes were made in the Company's
internal controls or in other factors that could significantly affect these
controls subsequent to the date of their evaluation.

Disclosure controls and procedures are those controls and other procedures
that are designed to ensure that information required to be disclosed by the
Company in the reports that it files or submits under the Exchange Act is
recorded, processed, summarized and reported, within the time periods specified
in the Securities and Exchange Commission's rules and forms. Disclosure controls
and procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by the Company in the reports
that it files or submits under the Exchange Act is accumulated and communicated
to the Company's management, including the Company's principal executive officer
and principal financial officer, as appropriate, to allow timely decisions
regarding required disclosure.

PART IV

ITEM 15. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENTS, CONSOLIDATED FINANCIAL
STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a)(1) Consolidated Financial Statements -- See Index to Financial
Statements.

(a)(2) Consolidated Financial Statement Schedules -- See Index to Financial
Statements

(b) Reports on Form 8-K

On December 27, 2002, the Company filed a Current Report on Form 8-K. The
Form 8-K described the completion of private offering of securities for an
aggregate purchase price of $26,394,000 (the "Offering"). The securities issued
in the Offering consisted of 5% Convertible Senior Secured Debentures (the
"Debentures"). The Debentures were issued by the Company pursuant to a certain
Debenture Purchase Agreement dated December 20, 2002 (the "Purchase Agreement")
by and among the Company, Care Capital Investments II, Essex Woodlands Health
Ventures V, L.P., Galen Partners III, L.P. and each of the purchasers listed on
the signature page thereto.

The Form 8-K also described the amendment to the Company's term loan
agreement with Watson pursuant to which the principal amount of the Company's
term loan from Watson was increased from $17,500,000 to $21,401,331 to reflect
the inclusion of approximately $3,901,331 owed by the Company to Watson under a
product supply agreement between the parties. The term loan agreement with
Watson was also amended to extend the maturity date from March 31, 2003 to March
31, 2006.

Finally, the Form 8-K described the completion of a Warrant
Recapitalization Agreement dated December 20, 2002 pursuant to which common
stock purchase warrants exercisable for an aggregate of 8,145,736 shares were
recapitalized for an aggregate of 5,970,083 shares of common stock.

(c) Exhibits

The following exhibits are included as a part of this Annual Report on Form
10-K or incorporated herein by reference.

- ---------------

* Filed herewith.

+ A portion of this exhibit has been omitted pursuant to an application for
confidential treatment pursuant to Rule 24b-2 of the Securities Exchange Act
of 1934, as amended.

47

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

HALSEY DRUG CO., INC.

By: /s/ MICHAEL REICHER
--------------------------------------
Michael Reicher,
Chairman and Chief Executive Officer
(Principal Executive Officer)

Date: May 6, 2003

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.

/s/ WILLIAM G. SKELLY Director May 6, 2003
- -------------------------------------------
William G. Skelly

/s/ MICHAEL REICHER Chief Executive Officer and Director May 6, 2003
- ------------------------------------------- (Principal Executive Officer)
Michael Reicher

/s/ PETER CLEMENS Vice President, Chief Financial Officer May 6, 2003
- ------------------------------------------- (Principal Financial and Accounting
Peter Clemens Officer) and Director

/s/ ALAN J. SMITH Director May 6, 2003
- -------------------------------------------
Alan J. Smith

/s/ BRUCE F. WESSON Director May 6, 2003
- -------------------------------------------
Bruce F. Wesson

/s/ WILLIAM SUMNER Director May 6, 2003
- -------------------------------------------
William Sumner

/s/ SRINI CONJEEVARAM Director May 6, 2003
- -------------------------------------------
Srini Conjeevaram

/s/ ZUBEEN SHROFF Director May 6, 2003
- -------------------------------------------
Zubeen Shroff

/s/ JOEL LIFFMANN Director May 6, 2003
- -------------------------------------------
Joel Liffmann

/s/ JERRY KARABELAS Director May 6, 2003
- -------------------------------------------
Jerry Karabelas

/s/ IMMANUEL THANGARAJ Director May 6, 2003
- -------------------------------------------
Immanuel Thangaraj

48

INDEX TO FINANCIAL STATEMENTS

F-1

REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

Board of Directors and Stockholders
HALSEY DRUG CO., INC.

We have audited the accompanying consolidated balance sheets of Halsey Drug
Co., Inc. and Subsidiaries as of December 31, 2002 and 2001, and the related
consolidated statements of operations, stockholders' equity (deficit) and cash
flows for each of the three years in the period ended December 31, 2002. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Halsey Drug
Co., Inc. and Subsidiaries as of December 31, 2002 and 2001, and the
consolidated results of their operations and their consolidated cash flows for
each of the three years in the period ended December 31, 2002, in conformity
with accounting principles generally accepted in the United States of America.

We have also audited the consolidated financial statement schedule listed
in the Index at Item 15(a)(2). In our opinion, this schedule, when considered in
relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.

GRANT THORNTON LLP

New York, New York
February 26, 2003, except for Note B, as to
which the date is May 5, 2003

F-2

HALSEY DRUG CO., INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these statements.

F-3

HALSEY DRUG CO., INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (CONTINUED)

The accompanying notes are an integral part of these statements.

F-4

HALSEY DRUG CO., INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

The accompanying notes are an integral part of these statements.

F-5

HALSEY DRUG CO., INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)

The accompanying notes are an integral part of these statements.

F-6

HALSEY DRUG CO., INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of these statements.
F-7

HALSEY DRUG CO., INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS -- (CONTINUED)
YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(IN THOUSANDS, EXCEPT SHARE DATA)

Supplemental disclosures of noncash investing and financing activities:

Year ended December 31, 2002

1. The Company issued 5,970,083 shares of common stock as result of
recapitalization of warrants to purchase 8,145,736 shares of common stock
and recorded a charge to earnings of $2,282 in connection with this
transaction.

2. The Company issued 10,700,665 warrants with an estimated relative fair
value of $11,985 in connection with the extension of a note payable.

3. The Company issued $15,885 in debentures in exchange for like amounts of
notes payable and accrued interest.

4. The Company's convertible debentures contained beneficial conversion
features, which were valued at $74,619.

5. The Company issued $2,191 of debentures as payment of like amounts of
debenture accrued interest.

6. The Company has repaid $1,826 of indebtedness in the form of product
deliveries.

7. The Company issued approximately 2,120,000 warrants with an estimated
relative fair value of $2,412 in connection with the refinancing of
existing bridge loans in January and May 2002.

8. The Company issued 600,000 warrants with an estimated relative fair value
of $948 for the lending commitment of a bridge loan.

9. The Company issued approximately 1,535,000 warrants with an estimated
relative fair value of $1,755 in connection with the issuance of bridge
loans.

10. The Company's bridge loans contained beneficial conversion features, which
were valued at $3,745.

11. Equipment financed through capital leases aggregated approximately $35.

F-8

HALSEY DRUG CO., INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS -- (CONTINUED)
YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(IN THOUSANDS, EXCEPT SHARE DATA)

Year ended December 31, 2001

1. The Company issued 51,924 shares of common stock as payment for
approximately $70 in debenture accrued interest.

2. The Company issued 187,500 warrants with an estimated relative fair value of
$310 in connection with the issuance of bridge loans.

3. The Company issued $2,085 of debentures as payment of like amounts of
debenture accrued interest.

4. The Company has repaid $3,979 of indebtedness in the form of product
deliveries.

5. Equipment financed through capital leases aggregated approximately $79.

6. The Company issued $300 in notes payable in exchange for $300 in debentures
that matured.

Year ended December 31, 2000

1. The Company issued 89,638 and 32,000 shares of common stock as payment for
$252 in debenture accrued interest and $38 in trade payables and legal
expenses.

2. The Company issued warrants to purchase 125,000 shares of common stock for
the extension of the 2000 Galen Bridge Loan(s) maturity dates and recorded
$125 as deferred private issuance costs. The issuance costs were fully
expensed during 2000.

3. The Company issued $1,858 of debentures as payment for like amounts of
debenture accrued interest.

4. Debentures of $12 were converted into 8,834 shares of the Company's common
stock.

5. The Company has paid $1,003 of indebtedness in the form of product
deliveries.

F-9

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2002, 2001 AND 2000

NOTE A -- DESCRIPTION OF BUSINESS AND SUMMARY OF ACCOUNTING POLICIES

Halsey Drug Co., Inc. (the "Company" or "Halsey"), a New York corporation
established in 1935, and its subsidiaries, are engaged in the development,
manufacture, sale, and distribution of generic drugs and active pharmaceutical
ingredients ("APIs"). During the last several years, the Company has sought to
diversify its businesses through strategic acquisitions and alliances and
through the development of technologies for the synthesis and production of APIs
intended for sale to third parties as well as for use by the Company and others
as raw materials in the manufacture of finished drug forms.

A summary of the significant accounting policies consistently applied in
the preparation of the accompanying consolidated financial statements follows.

1. Principles of Consolidation and Basis of Presentation

The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries, Houba, Inc., and Halsey Pharmaceuticals, Inc.
All material intercompany accounts and transactions have been eliminated. During
2002, the Company dissolved all of its inactive subsidiaries with the exception
of Halsey Pharmaceuticals, Inc. The dissolution of the inactive subsidiaries had
no impact on the consolidated financial position, results of operations or cash
flows of the Company.

2. Statements of Cash Flows

For purposes of the statements of cash flows, the Company considers all
highly liquid debt instruments purchased with an original maturity of three
months or less to be cash equivalents. The Company paid no substantial income
taxes for the years ended December 31, 2002, 2001 and 2000. In addition, the
Company paid interest of approximately $136,000, $683,000 and $1,253,000 for the
years ended December 31, 2002, 2001 and 2000, respectively.

3. Accounts Receivable-Trade and Allowance Accounts

The Company's accounts receivable-trade are due from customers engaged in
the distribution of pharmaceutical products. Credit is extended based on
evaluation of a customer's financial condition and, generally, collateral is not
required. Accounts receivable are due within 30 days and are stated at amounts
due from customers net of allowances for doubtful accounts, returns, term
discounts, and other allowances. Accounts outstanding longer than the
contractual payment terms are considered past due. Estimates that are used in
determining these allowances are based on the Company's historical experience,
current trends, credit policy and a percentage of its accounts receivable by
aging category. In determining these percentages, the Company looks at the
credit quality of its customer base as well as changes in its credit policies.
The Company continuously monitors collections and payments from its customers.
The Company writes off accounts receivable when they become uncollectible, and
payments subsequently received on such receivables are credited to bad debt
expense.

Changes in the Company's allowance accounts are as follows:

F-10

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

4. Inventories

Inventories are stated at the lower of cost or market and include material,
labor and manufacturing overhead. The first-in, first-out method is used to
determine the cost of inventories. In evaluating whether inventory is stated at
the lower of cost or market, management considers such factors as the amount of
inventory on hand, remaining shelf life and current and expected market
conditions, including levels of competition.

5. Property, Plant and Equipment

Property, plant and equipment are stated at cost less accumulated
depreciation and amortization. Major improvements are capitalized and
maintenance and repairs are expensed as incurred. Depreciation and amortization
are provided for in amounts sufficient to relate the cost of depreciable assets
to operations over their estimated service lives, principally on a straight-line
basis. The estimated lives used in determining depreciation and amortization
are:

Building and building improvements....... 20-39 years
Machinery and equipment.................. 3-10 years
Leasehold improvements................... Shorter of the life of the lease or the
service life of the asset

6. Impairment of Long-Lived Assets

Long-lived assets are reviewed for impairment whenever events or changes in
circumstances indicate the carrying value may not be recoverable. Impairment is
measured by comparing the carrying value of the long-lived assets to the
estimated undiscounted future cash flows expected to result from use of the
assets and their ultimate disposition. To the extent impairment has occurred,
the carrying amount of the asset would be written down to an amount to reflect
the fair value of the asset. See Note K for the impairment charge related to the
write-off of leasehold improvements of the Company's Brooklyn, New York plant,
which closed in March 2001.

7. Deferred Private Offering Costs

Deferred private offering costs represent costs incurred by the Company in
conjunction with securing debt financing. The Company incurred approximately
$1,041,000 in deferred private offering costs during the year ended December 31,
2002 in conjunction with a private offering of securities. (See Notes B and H.)
Deferred private offering costs are amortized to interest expense over the life
of the related obligations.

8. Deferred Debt Discount

Debt discount resulting from the issuance of stock warrants in connection
with the issuance of subordinated debt and other notes payable as well as
beneficial conversion features contained in convertible debt instruments (Notes
H and I) is recorded as a reduction of the related obligations and is amortized
over the remaining life of the related obligations. Debt discount related to the
stock warrants issued is determined by a calculation which is based on the
relative fair values ascribed to such warrants determined by an independent
valuation or management's use of the Black-Scholes valuation model. Inherent in
the Black-Scholes valuation model are assumptions made by management regarding
the estimated life of the warrant, the estimated volatility of the Company's
common stock and the expected dividend yield.

9. Revenue Recognition

The Company recognizes revenue, net of sales discounts and allowances, when
title to the product passes to customers, which generally occurs upon shipment.
The Company established sales provisions for estimated chargebacks, discounts,
rebates, returns, pricing adjustments and other sales allowances concurrently
with the

F-11

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

recognition of revenue. The sales provisions are established based upon
consideration of a variety of factors, including, but not limited to, actual
return and historical experience by product type, the number and timing of
competitive products approved for sale, the expected market for the product,
estimated customer inventory levels by product, price declines and current and
projected economic conditions and levels of competition. Actual product return,
chargebacks and other sales allowances incurred are, however, dependent upon
future events.

10. Shipping and Handling Costs

The Company includes all shipping and handling expenses incurred as a
component of cost of manufacturing.

11. Research and Development Costs

All research and development costs, including payments related to licensing
agreements on products under development and research consulting agreements, are
expensed when incurred.

12. Advertising Costs

Advertising costs are expensed as incurred. Advertising costs charged to
operations for the years ended December 31, 2002, 2001 and 2000 were
approximately $288,000, $39,000 and $31,000, respectively.

13. Income Taxes

The Company accounts for income taxes under the liability method in
accordance with Statement of Financial Accounting Standards No. 109 ("SFAS No.
109"), "Accounting for Income Taxes." Under this method, deferred tax assets and
liabilities are determined based on differences between financial reporting and
tax bases of assets and liabilities and are measured using the enacted tax rates
and laws that will be in effect when the differences are expected to reverse. A
valuation allowance is established if it is more likely than not that all, or
some portion, of deferred tax assets will not be realized. The Company has
recorded a full valuation allowance to reduce its deferred tax assets to the
amount that is more likely than not to be realized. While the Company has
considered future taxable income in assessing the need for the valuation
allowance, in the event the Company were to determine that it would be able to
realize its deferred tax assets in the future in excess of its net recorded
amount, an adjustment to the deferred tax asset would increase income in the
period such determination was made.

14. Earnings (Loss) Per Share

The computation of basic earnings (loss) per share of common stock is based
upon the weighted average number of common shares outstanding during the period.
Diluted earnings per share is based on basic earnings per share adjusted for the
effect of other potentially dilutive securities. Excluded from the 2002, 2001
and 2000 computation are approximately 200,368,000, 52,976,000 and 50,636,000,
respectively, of outstanding warrants and options and the effect of convertible
debentures outstanding which would have been antidilutive.

15. Stock-Based Compensation

The Company has two stock-based employee compensation plans, which are
described more fully in Note N. The Company accounts for stock-based
compensation using the intrinsic value method in accordance with Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and
related Interpretations ("APB No. 25") and has adopted the disclosure provisions
of Statement of Financial Accounting Standards No. 148, "Accounting for
Stock-Based Compensation -- Transition and Disclosure, an amendment of FASB
Statement No. 123." Under APB No. 25, when the exercise price of the Company's
employee stock options equals the market price of the underlying stock on the
date of grant, no compensation

F-12

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

expense is recognized. Accordingly, no compensation expense has been recognized
in the consolidated financial statements in connection with employee stock
option grants.

The following table illustrates the effect on net income and earnings per
share had the Company applied the fair value recognition provisions of Statement
of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation," to stock-based employee compensation.

Pro forma compensation expense may not be indicative of future disclosures
because they do not take into effect pro forma compensation expense related to
grants before 1995. For purposes of estimating the fair value of each option on
the date of grant, the Company utilized the Black-Scholes option-pricing model.

The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options, which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those of traded options and because changes in the
subjective input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.

The weighted-average option fair values and the assumptions used to
estimate these values are as follows:

Equity instruments issued to nonemployees in exchange for goods, fees and
services are accounted for under the fair value-based method of SFAS No. 123.

16. Use of Estimates in Consolidated Financial Statements

In preparing consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America,
management makes estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the consolidated financial statements, as well as the reported
amounts of revenues and expenses during the reporting period. Actual results
could differ from those estimates.

F-13

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

17. New Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and
Other Intangible Assets." SFAS No. 142 requires that goodwill and intangible
assets with indefinite useful lives no longer be amortized, but instead be
tested for impairment at least annually in accordance with the provisions of
SFAS No. 142. SFAS No. 142 also requires that intangible assets with definite
useful lives be amortized over their respective estimated useful lives to their
estimated residual values, and reviewed for impairment in accordance with
Statement of Financial Accounting Standards No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," as
amended. The Company adopted the provisions of SFAS No. 142 effective January 1,
2002. The adoption of SFAS No. 142 had no effect on the financial position or
results of operations of the Company.

In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS No. 144 requires that
long-lived assets be measured at the lower of carrying amount or fair value less
cost to sell, whether reported in continuing operations or in discontinued
operations. Therefore, discontinued operations will no longer be measured at net
realizable value or include amounts for operating losses that have not yet
occurred. SFAS No. 144 is effective for financial statements issued for fiscal
years beginning after December 15, 2001 and, generally, is to be applied
prospectively. The adoption of SFAS No. 144 had no effect on the Company's
financial position or results of operations.

In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." This statement eliminates the requirement to report gains and
losses from extinguishment of debt as extraordinary unless they meet the
criteria of APB Opinion 30. SFAS No. 145 also requires sale-leaseback accounting
for certain lease modifications that have economic effects that are similar to
sale-leaseback transactions. The changes related to lease accounting are
effective for transactions occurring after May 15, 2002 and the changes related
to debt extinguishment are effective for fiscal years beginning after May 15,
2002. The impact of adopting the provisions related to lease accounting did not
have a material impact on the Company's financial position or results of
operations. The Company early adopted the provisions related to debt
extinguishments during the year ended December 31, 2002. The adoption did not
have a material impact on the Company's financial position or results of
operations.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 nullifies Emerging
Issues Task Force Issue No. 94-3 and requires that a liability for a cost
associated with an exit or disposal activity be recognized when the liability is
incurred. This statement also establishes that fair value is the objective for
initial measurement of the liability. SFAS No. 146 is effective for exit or
disposal activities that are initiated after December 31, 2002. The impact of
the adoption of SFAS No. 146 is not expected to have a material impact on the
Company's financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation -- Transition and Disclosure, an amendment of FASB Statement No.
123." SFAS No. 148 amends SFAS No. 123, "Accounting for Stock-Based
Compensation," to provide alternative methods of transition for an entity that
voluntarily changes to the fair value-based method of accounting for stock-based
employee compensation. It also amends the disclosure provisions of that
Statement to require prominent disclosure about the effects on reported net
income of an entity's accounting policy decisions with respect to stock-based
employee compensation. The Company has chosen to continue to account for
stock-based compensation using the intrinsic value method prescribed in APB
Opinion No. 25 and related interpretations as provided for under SFAS No. 148.
Accordingly, compensation expense is only recognized when the market value of
the Company's stock at the date of the grant exceeds the amount an employee must
pay to acquire the stock. The Company has adopted the annual disclosure
provisions of SFAS No. 148 in its financial reports for the year

F-14

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

ended December 31, 2002 and will adopt the interim disclosure provisions for its
financial reports for the quarter ended March 31, 2003. The adoption of SFAS No.
148 did not have a material impact on the Company's financial position or
results of operations.

In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others." FIN No. 45 requires that upon issuance of
a guarantee, a guarantor must recognize a liability for the fair value of an
obligation assumed under a guarantee. FIN No. 45 also requires additional
disclosures by a guarantor in its interim and annual financial statements about
the obligations associated with guarantees issued. The recognition provisions of
FIN No. 45 are effective for any guarantees issued or modified after December
31, 2002. The disclosure requirements are effective for financial statements of
interim or annual periods ending after December 15, 2002. The adoption of the
disclosure requirements of FIN No. 45 did not have a material impact on the
Company's financial position or results of operations. The Company is currently
evaluating the effects of the recognition provision of FIN No. 45, but does not
expect the adoption to have a material impact on the Company's financial
position or results of operations.

In January 2003, the FASB issued FASB Interpretation No. 46 "Consolidation
of Variable Interest Entities." In general, a variable interest entity is a
corporation, partnership, trust, or any other legal structure used for business
purposes that either (a) does not have equity investors with voting rights or
(b) has equity investors that do not provide sufficient financial resources for
the entity to support its activities. A variable interest entity often holds
financial assets, including loans or receivables, real estate or other property.
A variable interest entity may be essentially passive or it may engage in
activities on behalf of another company. Until now, a company generally has
included another entity in its consolidated financial statements only if it
controlled the entity through voting interests. FIN No. 46 changes that by
requiring a variable interest entity to be consolidated by a company if that
company is subject to a majority of the risk of loss from the variable interest
entity's activities or entitled to receive a majority of the entity's residual
returns or both. FIN No. 46's consolidation requirements apply immediately to
variable interest entities created or acquired after January 31, 2003. The
consolidation requirements apply to older entities in the first fiscal year or
interim period beginning after June 15, 2003. Certain of the disclosure
requirements apply to all financial statements issued after January 31, 2003,
regardless of when the variable interest entity was established. The Company has
adopted FIN No. 46 effective January 31, 2003. The Company does not anticipate
that the adoption of FIN No. 46 will have a material impact on the Company's
consolidated financial condition or results of operations taken as a whole.

18. Reclassifications

Certain reclassifications have been made to the prior years' amounts to
conform with the current year's presentation.

NOTE B -- BASIS OF PRESENTATION AND LIQUIDITY MATTERS

At December 31, 2002, the Company had cash and cash equivalents of
$9,211,000, working capital of approximately $5,933,000 and a stockholders'
deficit of approximately $12,268,000. The Company incurred a loss from
operations of approximately $12,937,000 and a net loss of $59,589,000 during the
year ended December 31, 2002.

On December 20, 2002, the Company consummated a private offering of
securities for an approximate aggregate purchase price of $26,394,000 (the "2002
Debenture Offering"). The securities issued in the Offering consisted of 5%
convertible senior secured debentures (the "2002 Debentures"). Of the
$26,394,000 in 2002 Debentures issued in the 2002 Debenture Offering,
approximately $15,894,000 of the 2002 Debentures were issued in exchange for the
surrender of a like amount of principal and accrued interest

F-15

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

outstanding under Company's 10% convertible promissory notes issued pursuant to
various working capital bridge loan transactions with Galen Partners III, L.P.,
Galen International III, L.P., Galen Employee Fund III, L.P. (collectively,
"Galen") and certain other lenders, during the period from August 15, 2001
through and including December 20, 2002. The 2002 Debentures, issued at par,
will become due and payable as to principal on March 31, 2006. Interest on the
principal amount of the 2002 Debentures, at the rate of 5% per annum, is payable
on a quarterly basis. Interest on the 2002 Debentures will be substantially paid
by the Company's issuance of a debenture instrument substantial identical to the
2002 Debentures issued in the 2002 Debenture Offering, in the principal amount
equal to the accrued interest for each quarterly period. (See Note H)

Until such time as the Company successfully develops and commercializes new
finished dosage products and active pharmaceutical ingredients, of which there
can be no assurance, the Company will continue to incur operating losses and
negative cash flow from operations. The Company believes that the proceeds
received in the 2002 Debenture Offering, will be sufficient to satisfy the
Company's working capital requirements only through June 2003. At the Company's
request, on May 5, 2003, the Company received a letter executed by each of Care
Capital Investments II, LP, Galen and Essex Woodlands Health Ventures V, L.P.
(the "Majority 2002 Debentureholders") advising that the Majority 2002
Debentureholders would provide funding to meet the Company's 2003 capital
requirements, up to an aggregate amount not to exceed $8.6 million (the "Letter
of Support"). The Letter of Support provides that the amount of any funding
provided by the Majority 2002 Debentureholders would be reduced to the extent of
any funding obtained by the Company from third-party sources during 2003. The
Letter of Support further provides that the terms of any funding provided by the
Majority 2002 Debentureholders will be subject to negotiation between the
Company and the Majority 2002 Debentureholders at the time of any such funding.
The terms of any such funding will be subject to approval by those directors of
the Company that are unaffiliated with the Majority 2002 Debentureholders. While
the terms of any funding to meet the Company's 2003 capital requirements are
currently unknown, it is likely that such terms will result in significant
additional dilution to holders of the Company's Common Stock. In consideration
for the issuance of the Letter of Support, the Company authorized the issuance
of warrants to the Majority 2002 Debentureholders exercisable for an aggregate
of 645,000 shares of the Company's Common Stock at an exercise price of $.34 per
share (which is equivalent to the conversion price of the 2002 Debentures),
subject to downward adjustment to equal the consideration per share received by
the Company for its Common Stock, or the conversion/exercise price per share of
the Company's Common Stock issuable under convertible securities, in a third
party investment if lower than the exercise price of the warrants.

The Company believes that the remaining net proceeds of the 2002 Debenture
Offering, along with the funding to be provided under the Letter of Support
combined with cash flow from operations, will be sufficient to satisfy the
Company's working capital requirements through January 1, 2004.

Failure to obtain a third party investment or to reach agreement with the
Majority 2002 Debentureholders on mutually acceptable terms to fund the
Company's capital requirements for 2003 will require the Company (i) to delay or
cease the continued development of its licensed technologies and the completion
of planned capital expenditures, (ii) to obtain funds through arrangements with
third parties on terms that may require the Company to relinquish rights to its
licensed technologies, which the Company would otherwise pursue on its own or
that would dilute the Company's stockholders, (iii) significantly scale back or
terminate operations and/or (iv) seek protection under applicable bankruptcy
laws. An extended delay or a cessation of the Company's continuing development
efforts related to its opiate synthesis technologies or delays in obtaining
required DEA approvals, will have a material adverse effect on the Company's
financial condition and results of operations.

F-16

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

NOTE C -- STRATEGIC ALLIANCE WITH WATSON PHARMACEUTICALS

On March 29, 2000, the Company completed various strategic alliance
transactions with Watson Pharmaceuticals, Inc. ("Watson"). The transactions
provided for Watson's purchase of a certain pending abbreviated new drug
application ("ANDA") from the Company, for Watson's rights to negotiate for
Halsey to manufacture and supply certain identified future products to be
developed by Halsey, for Watson's marketing and sale of the Company's core
products and for Watson's extension of a $17,500,000 term loan to the Company.
(See Note I(a).)

1. Product Acquisition Agreement

The product acquisition portion of the transactions with Watson provided
for Halsey's sale of a pending ANDA and related rights (the "Product") to Watson
for aggregate consideration of $13,500,000 (the "Product Acquisition
Agreement"). As part of the execution of the Product Acquisition Agreement, the
Company and Watson executed ten-year supply agreements covering the active
pharmaceutical ingredient ("API") and finished dosage form of the Product
pursuant to which Halsey, at Watson's discretion, will manufacture and supply
Watson's requirements for the Product API and, where the Product API is sourced
from the Company, finished dosage forms of the Product. The purchase price for
the Product was payable in three installments as certain milestones were
achieved. The first of such milestones was achieved in April of 2000, whereby
the Company received FDA approval and Watson paid the Company $5,000,000. In
April 2001, Watson remitted $5,000,000 to the Company representing the second
milestone achievement. The third and last of the milestones was achieved in July
2001, whereby $3,500,000 was received from Watson.

2. Right of First Negotiation Agreement

The Company and Watson also executed a right of first negotiation agreement
providing Watson with a first right to negotiate the terms under which the
Company would manufacture and supply certain specified APIs and finished dosage
products to be developed by the Company. The right of first negotiation
agreement provides that upon Watson's exercise of its right to negotiate for the
supply of a particular product, the parties will negotiate the specific terms of
the manufacturing and supply arrangement, including price, exclusivity, minimum
purchase requirements, if any, territory and term. In the event Watson does not
exercise its right of first negotiation upon receipt of written notice from the
Company as to its receipt of applicable governmental approval relating to a
covered product, or in the event the parties are unable to reach agreement on
the material terms of a supply arrangement relating to such product within sixty
days of Watson's exercise of its right to negotiate for such product, the
Company may negotiate with third parties for the supply, marketing and sale of
the applicable product. The right of first negotiation agreement has a term of
ten years, subject to extension in the absence of written notice from either
party for two additional periods of five years each. The right of first
negotiation agreement applies only to API and finished dosage products
identified in the agreement and does not otherwise prohibit the Company from
developing other APIs or finished dosage products for itself or third parties.

3. Core Products Supply Agreement

The Company and Watson also completed a manufacturing and supply agreement
providing for Watson's marketing and sale of the Company's existing core
products portfolio (the "Core Products Supply Agreement"). The Core Products
Supply Agreement obligated Watson to purchase a minimum amount of approximately
$3,060,000 per quarter (the "Minimum Purchase Amount") in core products from the
Company, through September 30, 2001 (the "Minimum Purchase Period"). At the
expiration of the initial Minimum Purchase Period, if Watson did not continue to
satisfy the Minimum Purchase Amount, the Company would then be able to market
and sell the core products on its own or through a third party. On August 8,
2001, the Company and Watson executed an amendment to the Core Products Supply
Agreement providing (i) for a reduction of the Minimum Purchase Amount from
$3,060,000 to $1,500,000 per quarter,

F-17

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

(ii) for an extension of the Minimum Purchase Period from the quarter ended
September 30, 2001 to the quarter ended September 30, 2002, (iii) for Watson to
recover previous advance payments made under the Core Products Supply Agreement
in the form of the Company's provision of products having a purchase price of up
to $750,000 per quarter (such credit amount to be in excess of Watson's
$1,500,000 minimum quarterly purchase obligation), and (iv) for the Company's
repayment to Watson of any remaining advance payments made by Watson under the
Core Products Supply Agreement (and which amount has not been recovered by
product deliveries by the Company to Watson as provided in Subsection (iii)
above) in two (2) equal monthly installments on October 1, 2002 and November 1,
2002. The Company's remaining advance payments from Watson were $3,901,331 at
September 30, 2002. (See Note C-4.) In March 2003, the Company notified Watson
that the Company intended to commence selling the core products independent of,
and in addition to, Watson's efforts as provided for under the Core Products
Agreement.

4. Term Loan Agreement

The final component of the Company's strategic alliance with Watson
provided for Watson's extension of a $17,500,000 term loan to the Company
("Watson Term Loan"). The loan was funded in installments upon the Company's
request for advances and the provision to Watson of a supporting use of proceeds
relating to each such advance. The loan is secured by a first lien on all of the
Company's assets, senior to the lien securing all other Company indebtedness,
carries a floating rate of interest equal to prime plus two percent and had an
initial maturity date of March 31, 2003. As part of the Company's 2002 Debenture
Offering (Note H), the Watson Term Loan was amended to (1) extend the maturity
date to March 31, 2006, (2) increase the interest rate to prime plus four and
one half percent and (3) increase the principal amount by $3,901,331 to reflect
the inclusion of the Core Products Supply Agreement advance payments owed by the
Company to Watson. In consideration of the amendment to the Watson Term Loan,
the Company issued to Watson a common stock purchase warrant ("Watson Warrant")
exercisable for 10,700,665 shares of the Company's common stock at an exercise
price of $.34 per share. The warrant has a term expiring December 31, 2009. The
fair value of the Watson Warrant on the date of grant, as calculated using the
Black-Scholes option-pricing model, of $11,985,745 was charged to earnings on
the date of grant as a loss on the extinguishment of debt. As of December 31,
2002, Watson has advanced $21,401,331 to the Company under the Watson Term Loan.
(See Note I(a).)

NOTE D -- CARRYING AMOUNT AND FAIR VALUE OF FINANCIAL INSTRUMENTS

The carrying amount of cash and cash equivalents and accounts receivable
approximates fair value due to the short-term maturities of the instruments. The
fair value of the Company's accounts payable, long-term and short-term debt
cannot be determined without incurring excessive costs.

F-18

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

NOTE E -- INVENTORIES

Inventories consist of the following:

NOTE F -- PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment are summarized as follows:

Included in machinery and equipment is equipment recorded under capitalized
leases at December 31, 2002 and 2001, of $114,000 and $79,000, respectively.
Depreciation and amortization expense for the years ended December 31, 2002,
2001 and 2000 was approximately $835,000, $861,000 and $644,000, respectively.

NOTE G -- ACCRUED EXPENSES

Accrued expenses are summarized as follows:

F-19

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

NOTE H -- CONVERTIBLE SUBORDINATED DEBENTURES AND STOCK WARRANTS

At December 31, 2002 and 2001, convertible subordinated debentures
outstanding and related debt discount related to the following issuances are as
follows:

In March and June 1998, the Company consummated a private offering of
securities for an aggregate purchase price of approximately $25,800,000 million
(the "Galen Offering"). The securities issued in the Galen Offering consisted of
5% Convertible Senior Secured Debentures (the "1998 Debentures") and Common
Stock Purchase Warrants (the "1998 Warrants"). The 1998 Debentures had an
initial conversion price of $1.404 per share, for an aggregate of up to
approximately 18,376,068 shares of the Company's Common Stock. The 1998 Warrants
were initially exercisable for an aggregate of approximately 5,500,084 shares of
the Company's Common Stock. Of such Warrants, 2,784,250 Warrants were
exercisable at $1.404 per share and the remaining 2,715,834 Warrants were
exercisable at $2.279 per share. In connection with the Galen Offering, the
Company incurred offering costs of $1,236,000 for legal and investment banker
fees. These related offering costs were amortized over the life of the related
debentures. Pursuant to certain provisions contained in the Watson Term Loan
(see Note I(a)), certain interest payments on the 1998 Debentures to investors,
as agreed, are to be made in the form of additional debentures. As of December
31, 2002 and 2001, the Company has issued additional debentures as payment of
accrued interest on the 1998 Debentures of $4,427,000 and $3,166,000,
respectively.

In May 1999, the Company consummated a private offering of securities for
an aggregate purchase price of approximately $17,862,000(the "Oracle Offering").
The securities issued in the Oracle Offering consisted of 5% Convertible Senior
Secured Debentures (the "1999 Debentures") and Common Stock Purchase Warrants
(the "1999 Warrants"). The 1999 Debentures had an initial conversion price of
$1.404 per share, for an aggregate of up to approximately 12,722,222 shares of
the Company's Common Stock. The 1999 Warrants were initially exercisable for an
aggregate of approximately 3,608,602 shares of the Company's Common Stock. Of
such Warrants, 1,804,301 Warrants were exercisable at $1.404 per share and the
remaining 1,804,301 Warrants were exercisable at $2.279 per share. Approximately
$7,037,000 of the 1999 Debentures were issued in exchange for the surrender of a
like amount of principal and accrued interest outstanding under the Company's
convertible promissory notes issued pursuant to various bridge loans received in
the aggregate amount of $10,533,000 during the period from August 1998 through
and including May 1999 (the "1999 Bridge Loans"). In exchange for the creditors
granting extensions on maturity dates of the Company's 1999 Bridge Loans, the
Company issued warrants to purchase 1,025,049 shares of the Company's common
stock at exercise prices ranging from $1.18 to $2.32. Pursuant to certain
provisions contained in the Watson Term Loan (see Note I(a)), certain interest
payments on the 1999 Debentures to investors, as agreed, are to be made in the
form of additional debentures. As of December 31, 2002 and 2001, the Company has
issued

F-20

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

additional debentures as payment of accrued interest on the 1999 Debentures of
$2,647,000 and $1,718,000, respectively.

Each of the 1998 Debentures, 1999 Debentures, 1998 Warrants and 1999
Warrants contain customary antidilution protection. Specifically, each of such
convertible securities provides that in the event the Company issues shares of
its Common Stock or securities convertible into Common Stock at a price less
than the fair market value of the Company's Common Stock on the date of issuance
(fair market value being equal to the average of the closing bid and asked price
for the Company's Common Stock as reported by the Over-the-Counter Bulletin
Board for the 20 trading days preceding the date of issuance), the conversion
and exercise prices of the 1998 Debentures, 1999 Debentures, 1998 Warrants and
1999 Warrants are adjusted downward on a weighted-average basis. In addition,
once having determined the new conversion/exercise price of such convertible
securities, the holder of such convertible securities is entitled to acquire
upon conversion or exercise of such instrument, the number of shares of Common
Stock obtained by multiplying the conversion/exercise price in effect
immediately prior to such adjustment by the number of shares of Common Stock
acquirable immediately prior to such adjustments, and dividing the product
thereof by the new conversion/exercise price.

On December 20, 2002, the Company consummated a private offering of
securities (the "2002 Debenture Offering") for an aggregate purchase price of
$26,394,000. The securities issued consisted of 5% convertible senior secured
debentures (the "2002 Debentures"). Of the 2002 Debentures, approximately
$15,894,000 of Debentures were issued in exchange for the surrender of like
amount of principal and accrued interest outstanding under various working
capital bridge loan transactions during the period from August 15, 2001 through
and including December 20, 2002. (See Note I(b).) The 2002 Debentures were
issued at par, will become due and payable as to principal on March 31, 2006 and
interest is accrued at the rate of 5% per annum and is payable on a quarterly
basis. Interest payments on certain of the 2002 Debentures are to be made in the
form of additional debentures.

2002 Debentures issued to certain investors in the aggregate face amount of
$10,000,000 are convertible at any time after issuance into shares of the
Company's Common Stock. The remainder of the 2002 Debentures are convertible at
any time after the approval of the Company's shareholders and debentureholders
to an amendment to the Company's Certificate of Incorporation to increase its
authorized shares of Common Stock from 80,000,000 shares to such number of
shares as shall provide sufficient authorized shares to permit the conversion of
the 2002 Debentures and the Company's other outstanding convertible securities.
Subject to the foregoing, the 2002 Debentures are convertible into shares of
Common Stock at a price per share (the "Conversion Price") of $.34. Until such
time as the Company completes a Subsequent Material Offering (as defined below)
the Conversion Price is subject to adjustment, from time to time, to equal the
consideration per share received by the Company for its Common Stock, or the
conversion/exercise price per share of the Company's Common Stock issuable under
rights or option for the purchase of, or stock or other securities convertible
into, Common Stock ("Convertible Securities"), if lower than the then applicable
Conversion Price. Following the Company's completion of a Subsequent Material
Offering, the Conversion Price is subject to adjustment from time to time on a
weighted-average dilution basis. A "Subsequent Material Offering" is the grant
or issuance of Common Stock or Convertible Securities by the Company during any
six (6) month period for an aggregate gross consideration of at least
$10,000,000. The 2002 Debentures are initially convertible into an aggregate of
approximately 77,629,000 shares of Common Stock. Debentures that are issued to
pay interest on the 2002 Debentures are convertible at anytime after issuance
into shares of Common Stock at a price per share equal to the average of the
closing bid and asked prices of the Common Stock for the twenty (20) trading
days immediately preceding the applicable interest payment date under the 2002
Debentures, as reported by the Over-the-Counter ("OTC") Bulletin Board. As a
condition of the 2002 Debenture Offering, the maturity of the 1998 Debentures
and 1999 Debentures was extended from March 15, 2003 to March 31, 2006.

F-21

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

The 2002 Purchase Agreement provides that the holders of the 2002
Debentures shall have the right to vote as part of a single class with all
holders of the Company's Common Stock on all matters to be voted on by such
stockholders. Each 2002 Debenture holder shall have such number of votes as
shall equal the number of votes he would have had if such holder converted the
entire outstanding principal amount of his 2002 Debenture into shares of Common
Stock immediately prior to the record date relating to such vote, provided,
however, that any Debentures held by a certain investor shall, for so long as
they are held by that investor, have no voting rights.

As part of the completion of the 2002 Debenture Offering, the Company also
amended its term loan agreement with Watson and issued to Watson a common stock
purchase warrant for 10,700,665 shares (the "Watson Warrant"). (See Note I(a)).
The exercise price of the Watson Warrant is $.34 per share. The fair market
value of the Company's Common Stock on December 20, 2002, the date of the
closing of the 2002 Purchase Agreement (as calculated in accordance with the
definition of fair market value contained in the 1998 Debentures, 1999
Debentures, 1998 Warrants and 1999 Warrants), was $.99 per share. As the
conversion price of the 2002 Debentures and exercise price of the Watson Warrant
were less than the fair market value of the Company's Common Stock on the date
of issuance of the 2002 Debentures, the dilution adjustment provisions contained
in each of the 1998 Debentures, 1999 Debentures, 1998 Warrants and 1999 Warrants
were triggered. As a result, the conversion price of the 1998 Debentures was
reduced from $1.34 per share to $.59 and the conversion price of the 1999
Debentures was reduced from $1.404 per share to $.61. Additionally, the exercise
price of the 1998 Warrants was reduced from $1.34 per share to $.59 per share
and from $2.16 per share to $.95 per share. The conversion price of the 1999
Warrants was reduced from $1.404 per share to $ .61 per share and from $2.285
per share to $1.00 per share. After giving effect to the Dilution Adjustments,
the number of shares issuable upon conversion of the 1998 Debentures and 1999
Debentures has been increased by 41,184,184 shares of Common Stock, from
31,967,120 to 73,151,304 shares. In addition, the number of shares issuable upon
exercise of the remaining 1998 Warrants and 1999 Warrants, after taking into
effect the Warrant recapitalization, as discussed below, has been increased by
8,023,928 shares, from 5,867,013 to 13,890,941 shares. As a condition of the
2002 Debenture Offering, the maturity date of the 1998 Debentures and 1999
Debentures was extended from March 15, 2003 to March 31, 2006. The Company
recorded a charge to earnings of $14,148,757 related to an increase in the fair
value of the warrants, as calculated using the Black-Scholes option-pricing
model, as a result of the modification of terms of the 1998 Warrants and 1999
Warrants.

The conversion features contained in the Company's 2002 Debentures are
considered to be beneficial to the holder as they allow the holder to convert
the 2002 Debentures to the Company's common stock at conversion prices that were
below the fair market value of the Company's common stock on the date of
issuance. The conversion features, as adjusted, contained in certain of the
Company's 1998 Debentures and 1999 Debentures are also considered to beneficial
to the holder as they allow the holder to convert the 1998 Debentures and 1999
Debentures to the Company's common stock at conversion prices that were below
the fair market value of the Company's common stock on the date of issuance. The
estimated value of the beneficial conversion features contained in each of the
1998 Debentures, 1999 Debentures and 2002 Debentures of $74,618,817 has been
recorded as debt discounts and is being amortized to expense over the life of
the debt.

The 2002 Debentures are secured by a lien on all assets of the Company,
tangible and intangible. In addition, each of Houba, Inc. and Halsey
Pharmaceuticals, Inc. has executed in favor of the holders of the 2002
Debentures an unconditional agreement of guarantee of the Company's obligations
under the Purchase Agreement. Each guarantee is secured by all assets of such
subsidiary, and, in the case of Houba, Inc., by a mortgage lien on its Culver,
Indiana real estate. In addition, the Company has pledged the stock of each such
subsidiary to the holders of the 2002 Debentures to further secure its
obligations under the Purchase Agreement.

F-22

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

In accordance with the terms of a Subordination Agreement dated December
20, 2002 between the Company, the holders of the 2002 Debentures, the holders of
the 1998 and 1999 Debentures and Watson, the liens on the Company's and its
subsidiaries' assets as well as the payment priority of the 2002 Debenture are
(i) subordinate to the Company's lien and payment obligations in favor of Watson
under the Watson Term Loan, and (ii) senior to the Company's lien and payment
obligations in favor of holders of the 1998 and 1999 Debentures.

WARRANT RECAPITALIZATION

As part of the completion of the transactions contemplated in the 2002
Purchase Agreement, the Company consummated the terms of a Warrant
Recapitalization Agreement dated December 20, 2002 (the "Recapitalization
Agreement") between the Company and certain holders of an aggregate of 8,145,736
Common Stock Purchase Warrants issued by the Company (i) pursuant to the 1998
Purchase Agreement (the "1998 Warrants"), (ii) pursuant to the 1999 Purchase
Agreement (the "1999 Warrants"), and (iii) pursuant to various bridge loan
transactions during the period from 1998 through 2002 (the "Bridge Loan
Warrants" and collectively with the 1998 Warrants and 1999 Warrants, the
"Recapitalization Warrants"). As part of the closing of the Recapitalization
Agreement, the warrant holders surrendered to the Company for cancellation the
Recapitalization Warrants in exchange for the issuance of an aggregate of
5,970,083 shares of Common Stock. The Company recorded a charge to earnings of
$2,282,000, representing the fair value of excess shares of Common Stock
granted, related to the warrant recapitalization.

Certain other outstanding warrant agreements were modified as a result of
dilution adjustment provisions contained therein. The Company recorded a charge
to earnings of $863,000 related to an increase in the fair value of the
warrants, as calculated using the Black-Scholes option-pricing model, as a
result of the modification of terms.

RELATED-PARTY TRANSACTIONS

Certain of the 1998 Debentures and 1999 Debentures are held by members of
the Company's management and Board of Directors. The aggregate principal amount
of such debentures was approximately $364,000 and $348,000 at December 31, 2002
and 2001, respectively. Interest expense on these debentures was approximately
$17,000, $17,000 and $16,000, for the years ended December 31, 2002, 2001 and
2000, respectively, of which approximately $16,000, $15,000 and $10,000 was paid
through the issuance of like debentures.

NOTE I -- NOTES PAYABLE AND STOCK WARRANTS

At December 31, 2002 and 2001, notes payable consisted of the following:

F-23

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

- ---------------

(a) In connection with various strategic alliance transactions, Watson advanced
$17,500,000 to the Company under a term loan. The loan is secured by a first
lien on all of the Company's assets, senior to the lien securing all other
Company indebtedness, and carries a floating rate of interest equal to prime
plus two percent and had an original maturity date of March 31, 2003. As
part of the Company's 2002 Debenture Offering, the Watson Term Loan was
amended to (1) extend the maturity date to March 31, 2006, (2) increase the
interest rate to prime plus four and one half percent and (3) increase the
principal amount to $21,401,331 to reflect the inclusion of the Core
Products Supply Agreement advance payments. The interest rate at December
31, 2002 was 8.75%. In consideration for the extension of the maturity date
of the Watson Term Loan, the Company granted the Watson Warrant described in
Notes C and H. The fair value of the warrant on the date of grant, as
calculated using the Black-Scholes option-pricing model, of $11,985,745 was
charged to operations on the date of grant as loss on the extinguishment of
debt.

(b) On August 15, 2001, the Company executed a Bridge Loan Agreement pursuant to
which the Company received $2,500,000 (the "2001 Bridge Loan"). The proceeds
of the 2001 Bridge Loan were used by the Company to satisfy in full the
Company's 10% convertible subordinated debentures in the principal amount of
$2,500,000 issued in August 1996 and which matured on August 6, 2001. The
2001 Bridge Loan bore interest at the rate of 10% per annum. The 2001 Bridge
Loan was convertible into common stock at a conversion price of $3.012 per
share, which conversion price equals the average trading price of the
Company's common stock for the 20 days preceding the closing date. In
consideration for the extension of the 2001 Bridge Loan, the Company issued
warrants expiring August 15, 2008, to purchase an aggregate of 187,500
shares of the Company's common stock at an exercise price of $3.012 per
share. The relative estimated fair value of the warrants, $310,000, was
recorded as additional debt discount and was amortized over the life of the
bridge loan.

During the period January 9, 2002 through December 5, 2002, the Company
secured various bridge loans in the total principal amount of $12,500,000 to
fund the Company's working capital requirements. These loans bear interest at
10.0% per annum and were convertible at prices ranging from $2.16 to $1.28 into
a total of 7,389,940 shares of the Company's common stock. The conversion
features contained in certain of these bridge loans were considered to be
beneficial to the holder as they allowed the holder to convert the bridge loans
to the Company's common stock at conversion prices that were below the fair
market value of the Company's common stock on the date of issuance. As
additional consideration for these bridge loans, the Company issued warrants to
purchase 4,255,143 shares of the Company's common stock with exercise prices
ranging from $2.16 to $1.28. The relative estimated fair value of the warrants
of $5,115,000 and the estimated value of the conversion feature of $3,745,000
were recorded as additional debt discount and amortized over the life of the
bridge loans.

At December 20, 2002, total bridge loans and accrued interest outstanding
equaled approximately $16,022,000, of which approximately $15,894,000 was
surrendered in exchange for the 2002 Debentures and approximately $128,000 was
repaid. The total number of warrants issued in connection with these bridge
loans was 4,442,643. Under the terms of the warrant agreements the conversion
price of each of these warrants was adjusted to $.34.

F-24

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

The following table summarizes information concerning outstanding and
exercisable stock purchase warrants:

NOTE J -- INCOME TAXES

Reconciliations between the Federal income tax rate and the Company's
effective income tax rate were as follows:

The Company has net operating loss carryforwards aggregating approximately
$147,800,000, expiring during the years 2011 through 2022.

The tax loss carryforwards of the Company and its subsidiaries may be
subject to limitation by Section 382 of the Internal Revenue Code with respect
to the amount utilizable each year. This limitation reduces the Company's
ability to utilize net operating loss carryforwards included above each year.
The amount of the limitation has not been quantified by the Company.

F-25

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

The components of the Company's deferred tax assets (liabilities), pursuant
to SFAS No. 109, are summarized as follows:

SFAS No. 109 requires a valuation allowance against deferred tax assets if,
based on the weight of available evidence, it is more likely than not that some
or all of the deferred tax assets may not be realized. The valuation allowance
at December 31, 2002 primarily pertains to uncertainties with respect to future
utilization of net operating loss carryforwards.

NOTE K -- CESSATION AND RELOCATION OF BROOKLYN, NEW YORK PLANT OPERATIONS

The Company's formal decision to discontinue its Brooklyn, New York plant
operations was initiated in the fourth quarter of 1999 with notification to its
union. The Brooklyn operations ceased in March 2001. The total charge of
approximately $3,220,000 resulting from eliminating the Brooklyn operation taken
in 1999 includes the lease termination payment of $1,150,000, a provision of
$200,000 for plant repairs, the write-off of leasehold improvements of
$1,778,000, severance and other costs for terminated employees of $730,000, less
deferred rent previously expensed of $638,000.

During the year ended December 31, 2000, the Company recorded a charge of
approximately $53,000 representing additional severance costs. During the year
ended December 31, 2001, the Company recorded a charge of approximately $68,000
representing loss on disposal of idle fixed assets. During the year ended
December 31, 2002, the Company recorded a benefit of approximately $126,000
representing a recovery from the landlord related to the Company's provision of
plant repair costs that were not utilized by the landlord.

NOTE L -- INVESTMENT IN JOINT VENTURE AND IMPAIRMENT CHARGE

The Company entered into a 50% joint venture in February 2000 for the
purpose of engaging in the development, manufacture and marketing of various
products. The joint venture was accounted for under the equity method. During
the fourth quarter of 2001, the Company recorded an impairment charge of
$151,000, as it was determined that the fair value of such investment was zero,
due to the uncertainty of the joint

F-26

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

venture's ability to raise additional capital or to generate income from
operations. During 2002, the partners in the joint venture began proceedings to
dissolve the entity.

NOTE M -- PRODUCT AGREEMENTS

1. Acquisition of Barr Laboratories, Inc. ANDA

On April 16, 1999, the Company completed an acquisition agreement with Barr
Laboratories, Inc. ("Barr") providing for the Company's purchase of the rights
to 50 pharmaceutical products (the "Barr Products"). Under the terms of the
acquisition agreement with Barr, the Company acquired all of Barr's rights in
the Barr Products, including all related governmental approvals (including
ANDAs) and related technical data and information. In consideration for the
acquisition of the Barr Products, the Company issued to Barr a common stock
purchase warrant exercisable for 500,000 shares of the Company's common stock
having an exercise price of $1.0625 per share (the fair value of the Common
Stock on the date of issuance) and having a term of five years. The Company
valued the warrants at $350,000 using the Black-Scholes option-pricing model.
Accordingly, the Company recorded a deferred charge to be amortized as an
expense to the Company's operations over a ten-year period, which is the
estimated life of the related ANDAs. The acquisition agreement with Barr also
allows Barr to purchase any of the Barr Products manufactured by the Company for
a period of five years.

2. Commercialization and License Agreement

Effective September 27, 2000, the Company entered into an exclusive license
for certain patented technology owned by Bio-Fine Pharmaceuticals, Inc.
("Bio-Fine") for the synthesis of codeine from morphine. The agreement provided
for a fixed amount of $3,175,000 to be paid out as certain milestones are
achieved with a total of $500,000 paid during 2000. The agreement also provided
for the grant of 50,000 warrants and an employment agreement, both contingent
upon FDA approval and the first commercial sale, which has not yet occurred.

In November 2001, the Company notified Bio-Fine of its election to
immediately terminate the commercialization and license agreement. Upon
termination of this agreement, the contingent warrant and employment agreement
expired.

NOTE N -- EMPLOYEE BENEFIT PLANS

1. Employees' Pension Plan

The Company contributed approximately $19,000 and $56,000, in 2001 and
2000, respectively, to a multiemployer pension plan for employees covered by
collective bargaining agreements. The Company has not made any contributions to
this plan subsequent to April 1, 2001, since the Company ceased operations at
its Brooklyn, New York plant in March 2001, whose employees were covered by this
plan. (See Note K). This plan was not administered by the Company and
contributions were determined in accordance with provisions of negotiated labor
contracts. Information with respect to the Company's proportionate share of the
excess, if any, of the actuarially computed value of vested benefits over the
total of the pension plan's net assets is not available from the plan's
administrator.

The Multiemployer Pension Plan Amendments Act of 1980 (the "Act")
significantly increased the pension responsibilities of participating employers.
Under the provision of the Act, if the plans terminate or the Company withdraws,
the Company could be subject to a "withdrawal liability." As of December 31,
2002, the Company has not been notified of any withdrawal liability.

F-27

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

2. 401(k) and Profit-sharing Plan

Effective October 1, 1998, the Company established a 401(k) and
profit-sharing plan for all employees other than those covered under collective
bargaining agreements. Eligible employees may elect to make a basic contribution
of up to 1.5% of their annual earnings. The plan provides that the Company can
make discretionary matching contributions equal to 25% of the first 6% of
employee contributions for an aggregate employee contribution of 1.5%, along
with a discretionary profit-sharing contribution. The Company incurred no
expense under the plan in 2002, 2001 and 2000, respectively.

3. Stock Option Plans

In September 1995, the stockholders of the Company approved the adoption of
a stock option and restricted stock purchase plan (the "1995 Option Plan"). The
1995 Option Plan provides for the granting of (i) nonqualified options to
purchase the Company's common stock at not less than the fair market value on
the date of the option grant, (ii) incentive stock options to purchase the
Company's common stock at not less than the fair market value on the date of the
option grant and (iii) rights to purchase the Company's common stock on a
"Restricted Stock" basis, as defined, at not less than the fair market value on
the date the right is granted. The total number of shares which may be sold
pursuant to options and rights granted under the 1995 Option Plan is 1,000,000.
No option can be granted under the 1995 Option Plan after May 2005 and no option
can be outstanding for more than ten years after its grant. At December 31,
2002, 8,207 shares are available for grant under the 1995 Option Plan.

In June 1998, the stockholders of the Company approved the adoption of a
stock option and restricted stock purchase plan (the "1998 Option Plan"). The
1998 Option Plan provides for the granting of (i) nonqualified options to
purchase the Company's common stock at a price determined by the Stock Option
Committee, and (ii) incentive stock options to purchase the Company's common
stock at not less than the fair market value on the date of the option grant.
All grants of stock options have been at the fair market value on the date of
grant. In June 2001, the shareholders of the Company approved a resolution to
increase the total number of shares which may be sold pursuant to options and
rights granted under the 1998 Option Plan to 8,100,000. No option can be granted
under the 1998 Option Plan after April 2008 and no option can be outstanding for
more than ten years after its grant. At December 31, 2002, 3,920,383 options are
available for grant under the 1998 Option Plan.

Transactions involving stock options under all plans are summarized as
follows:

F-28

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

The following table summarizes information concerning currently outstanding
and exercisable stock options:

NOTE O -- COMMITMENTS AND CONTINGENCIES

The Company occupies plant and office facilities under noncancellable
operating leases, which expire at various dates through June 2004. These
operating leases provide for scheduled base rent increases over the term of the
lease. The leases provide for payment of real estate taxes based upon a
percentage of the annual increase. In addition, the Company rents certain
equipment under operating leases, generally for terms of two years or less.
Total rent expense for the years ended December 31, 2002, 2001 and 2000 was
approximately $993,000, $986,000 and $1,517,000, respectively.

LEASE OF CONGERS, NEW YORK FACILITY (BRENNER DRIVE LOCATION)

Effective March 22, 1999, the Company leased, as sole tenant, a
pharmaceutical manufacturing facility located in Congers, New York (the "Brenner
Drive Facility") from Par Pharmaceuticals, Inc. ("Par") pursuant to an Agreement
to Lease (the "Lease"). The Brenner Drive Facility contains office, warehouse
and manufacturing space and is approximately 35,000 square feet. The Lease
provides for a term of three years, with a two-year renewal option, and provides
for annual fixed rent of $500,000 per year during the primary term of the Lease
and $600,000 per year during the option period. The Lease also covers certain
manufacturing and related equipment previously used by Par in its operations at
the Brenner Drive Facility (the "Leased Equipment"). In connection with the
execution of the Lease, the Company and Par entered into a certain Option
Agreement pursuant to which the Company may purchase the Brenner Drive Facility
and the Leased Equipment at any time during the lease term for $5,000,000. The
Company paid $100,000 for the right to exercise the Option Agreement any time
during the primary term of three years. In March 2002, the Company paid Par
$150,000 to secure the right to exercise the Option Agreement through March 31,
2004.

As part of the execution of the Lease, the Company and Par entered into a
certain Manufacturing and Supply Agreement (the "M&S Agreement") having a
minimum term of twenty-seven months. The M&S Agreement provided for the
Company's contract manufacture of certain designated products manufactured by

F-29

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

Par at the Brenner Drive Facility prior to the effective date of the Lease. The
M&S Agreement also provided that Par will purchase a minimum of $1,150,000 in
product during the initial eighteen months of the Agreement. The M&S Agreement
ended in July 2001 and was not renewed; however, the Company continues to
provide contract manufacturing services to Par. The M&S Agreement further
provides that the Company will not manufacture, supply, develop or distribute
the designated products to be supplied by the Company to Par under the M&S
Agreement to or for any other person for a period of three years. Effective
April 2002, the restriction on the designated products to be supplied by the
Company to Par was removed.

LEASE OF CONGERS, NEW YORK FACILITY (WELLS AVENUE LOCATION)

Effective July 1, 2000, the Company leased, as sole tenant, a facility
located at 125 Wells Avenue, Congers, New York (the "Wells Avenue Facility").
The Wells Avenue Facility contains office, warehouse and manufacturing space and
is approximately 18,000 square feet. The lease provides for a term of four years
with an option to renew for an additional three years and provides for annual
fixed rent of approximately $127,000 per year during the first two years of the
lease and approximately $135,000 per year during the last two years.

As of December 31, 2002, the approximate minimum rental commitments under
these operating leases are as follows:

EMPLOYMENT CONTRACTS

During March 1998, the Company entered into employment contracts with each
of two new officers/ employees of the Company, which cover a five-year and a
three-year period, respectively. The contracts provide for, among other things:
(i) annual salaries of $175,000 and $140,000 to be paid over the five-year and
three-year periods, respectively, and (ii) an aggregate of 1,300,000 options to
purchase the Company's stock at an exercise price of $2.38 per common share that
vest evenly over a three-to-five-year service period and expire in ten years. In
April 2000, these contracts were extended to April 30, 2005. In 2001, the annual
salaries under these contracts were increased to $200,000 and $155,000,
respectively.

During November 2002, the Company entered into an employment contract with
a new officer/employee of the Company which covers a two-year period. The
contract calls for, among other things: (1) annual salary of $180,000 to be paid
over the two-year period, and (2) an aggregate of 400,000 options to purchase
the Company's stock at an exercise price of $1.15 per common share that vest
evenly over a four-year period. The employment agreement automatically renews
for successive one-year periods unless the Company provides 90 days' notice of
nonrenewal.

U.S. DEPARTMENT OF JUSTICE SETTLEMENT

On June 21, 1993, the Company entered into a Plea Agreement with the U.S.
Department of Justice (the "DOJ") to resolve the DOJ's investigation into the
manufacturing and record keeping practices of the Company's Brooklyn, New York
plant. The Plea Agreement required the Company to pay a fine of $2,500,000 over
five years in quarterly installments of $125,000, commencing on or about
September 15, 1993.

F-30

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

As of February 28, 1998, the Company was in default of the payment terms of
the Plea Agreement and had made payments aggregating $350,000. On May 8, 1998,
the Company and the DOJ signed the Letter Agreement serving to amend the Plea
Agreement relating to the terms of the Company's satisfaction of the fine
assessed under the Plea Agreement. Specifically, the Letter Agreement provided
that the Company will satisfy the remaining $2,150,000 of the fine through the
monthly payments of $25,000 commencing June 1, 1998, plus interest on such
outstanding balance (at the rate calculated pursuant to 28 U.S.C. Section 1961
(5.319%). Such payment schedule will result in the full satisfaction of the DOJ
fine in July 2005. The Letter Agreement also provides certain restrictions on
the payment of salary or compensation to any individual in excess of certain
amounts without the written consent of the DOJ. In addition, the Letter
Agreement requires the repayment of the outstanding fine to the extent of 25% of
the Company's after-tax profit or 25% of the net proceeds received by the
Company on any sale of a capital asset for a sum in excess of $10,000, if not
invested in another capital asset. At December 31, 2002, the Company is current
in its payment obligations, with a remaining obligation of $761,000.

OTHER LEGAL PROCEEDINGS

Beginning in 1992, actions were commenced against the Company and numerous
other pharmaceutical manufacturers, in connection with the alleged exposure to
diethylstilbestrol ("DES"). The defense of all of such matters was assumed by
the Company's insurance carrier, and a substantial number have been settled by
the carrier. Currently, several actions remain pending with the Company as a
defendant in the Pennsylvania Court of Common Pleas, Philadelphia Division, and
the insurance carrier is defending each action. The Company and its legal
counsel do not believe any of such actions will have a material impact on the
Company's financial condition. The ultimate outcome of these lawsuits cannot be
determined at this time, and accordingly, no adjustment has been made to the
consolidated financial statements.

The Company is named as a defendant in an action entitled Alfred Kohn v.
Halsey Drug Co. in the Supreme Court of New York, Bronx County. The Plaintiff
seeks damages of $1 million for breach of an alleged oral contract to pay a
finder's fee for a business transaction involving the Company. Discovery in this
action has been completed. It is the Company's expectation to file for summary
judgment in this action. In the event the Company is unsuccessful in its motion
for summary judgment, a trial on this action will follow. The Company does not
believe this action will have a material impact on the Company's financial
condition. The ultimate outcome of this lawsuit cannot be determined at this
time, and accordingly, no adjustment has been made to the consolidated financial
statements.

In addition, the Company is a party to legal matters arising in the general
conduct of business. The ultimate outcome of such matters is not expected to
have a material adverse effect on the Company's results of operations or
financial position.

INDEMNIFICATIONS

Each of the purchase agreements for the Company's 1998 Debentures, 1999
Debentures and 2002 Debentures contains provisions by which the Company is
obligated to indemnify the purchasers of the debentures for any losses, claims,
damages, liabilities, obligations, penalties, awards, judgments, expenses or
disbursements arising out of or resulting from the breach of any representation,
warranty or agreement of the Company related to the purchase of the debentures.
These indemnification obligations do not include a limit

F-31

HALSEY DRUG CO., INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DECEMBER 31, 2002, 2001 AND 2000

on maximum potential future payments, nor are there any recourse provisions or
collateral that may offset the cost. As of December 31, 2002, the Company has
not recorded a liability for any obligations arising as a result of these
indemnification obligations.

NOTE P -- SIGNIFICANT CUSTOMERS AND SUPPLIERS

Through its strategic alliance with Watson, as discussed in Note C, the
Company sells its portfolio of core products under the Watson label for
distribution by Watson to drugstore chains and drug wholesalers. The Company
continues to perform limited contract manufacturing of certain non-core products
for other customers. During 2002, the Company had net product revenues from two
customers in excess of 10% of total product revenues, accounting for 85% and
13%, respectively, of total product revenues, and 82% and 1%, respectively, of
gross accounts receivable at December 31, 2002. During 2001 and 2000, the
Company had net product revenues to one customer in excess of 10% of total
product revenues aggregating to 86% and 59%, respectively, of total product
revenues. At December 31, 2001, accounts receivable from this customer
aggregated 61% of gross accounts receivable. The loss of these customers would
have a material adverse impact on the Company.

During 2002, 2001 and 2000, the Company purchased approximately $1,264,000,
$1,512,000 and $1,485,000 respectively, of its raw materials, representing
approximately 26%, 25%, and 28% in each year, of total raw material purchases
from one supplier.

NOTE Q -- QUARTERLY FINANCIAL DATA (UNAUDITED)

QUARTERLY FINANCIAL DATA

F-32

HALSEY DRUG CO., INC. AND SUBSIDIARIES

SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS

F-33