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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
--------------------------
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004
OR
[ ] TRANSACTION 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 Identification No.)
incorporation or organization)
616 N. NORTH COURT, SUITE 120
PALATINE, ILLINOIS 60067
(Address of Principal Executive Offices) (Zip Code)
(847) 705-7709
(Registrant's telephone number, including area code)
(Former name, former address and former fiscal year, if changed since
last report.)
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 whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
As of August 6, 2004 the registrant had 21,927,943 shares of Common Stock,
$.01 par value, outstanding.
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HALSEY DRUG CO., INC. & SUBSIDIARIES
INDEX
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets-
June 30, 2004 (Unaudited) and December 31, 2003 ..................................... 1
Condensed Consolidated Statements of
Operations (Unaudited) - Three months and six months ended June 30, 2004
and June 30, 2003 ................................................................... 3
Condensed Consolidated Statements of Cash
Flows (Unaudited) - Six months ended June 30, 2004
and June 30, 2003 ................................................................... 4
Consolidated Statement of Stockholders'
Equity (Deficit) (Unaudited) - Six months ended June 30, 2004 ....................... 7
Notes to Condensed Consolidated Financial Statements ................................ 8
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ................................................. 27
Item 4. Controls and Procedures.............................................................. 47
PART II. OTHER INFORMATION
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities..... 48
Item 6. Exhibits and Reports on Form 8-K..................................................... 48
SIGNATURES ..................................................................................... 49
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
HALSEY DRUG CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
UNAUDITED
JUNE 30, DECEMBER 31,
2004 2003
--------- -----------
(IN THOUSANDS)
ASSETS
CURRENT ASSETS
Cash ........................................................ $ 6,583 $ 942
Accounts Receivable - net of allowance for
doubtful accounts of $428 at December 31, 2003 ............ - 467
Inventories ................................................. - 312
Prepaid expenses and other current assets ................... 216 401
------- -------
Total current assets ...................................... 6,799 2,122
PROPERTY, PLANT & EQUIPMENT, NET .................................. 3,171 3,394
DEFERRED PRIVATE OFFERING COSTS,
net of accumulated amortization of $561 and $318
at June 30, 2004 and December 31, 2003, respectively ...... 795 714
OTHER ASSETS AND DEPOSITS ......................................... 40 392
------- -------
TOTAL ASSETS ...................................................... $10,805 $ 6,622
======= =======
The accompanying notes are an integral part of these unaudited condensed
consolidated financial statements
1
HALSEY DRUG CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
UNAUDITED
JUNE 30, DECEMBER 31,
2004 2003
--------- ---------
(IN THOUSANDS,EXCEPT PER SHARE DATA)
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES
Convertible subordinated debentures ................. $ 14,000 $ -
Less: debt discount ................................ (2,793) -
--------- ---------
............................................ 11,207 -
Current maturities of notes payable and capital lease
obligations ....................................... 27 45
Accounts payable .................................... - 1,895
Accrued interest .................................... 3,478 1,544
Accrued expenses .................................... 1,065 2,108
Deferred asset proceeds ............................. 2,000 -
Department of Justice Settlement .................... - 300
--------- ---------
Total current liabilities ........................ 17,777 5,892
SENIOR SECURED TERM NOTE PAYABLE ....................... 5,000 21,401
BRIDGE LOANS ........................................... - 2,000
Less: debt discount ................................. - (568)
--------- ---------
- 1,432
CONVERTIBLE SUBORDINATED DEBENTURES .................... 86,632 86,632
Less: debt discount .................................. (44,247) (56,893)
--------- ---------
42,385 29,739
CAPITAL LEASE OBLIGATIONS .............................. 79 92
DEPARTMENT OF JUSTICE SETTLEMENT ....................... - 133
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY (DEFICIT)
Common stock - $.01 par value; authorized
80,000,000 shares; issued and outstanding,
21,716,025 and 21,601,704 shares at June 30, 2004
and December 31, 2003, respectively .............. 217 216
Additional paid-in capital .......................... 171,324 157,262
Accumulated deficit ................................. (225,977) (209,545)
--------- ---------
STOCKHOLDERS' DEFICIT ................................. (54,436) (52,067)
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) $ 10,805 $ 6,622
========= =========
The accompanying notes are an integral part of these unaudited condensed
consolidated financial statements
2
HALSEY DRUG CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE DATA)
JUNE 30,
------------------------------------------------------------------
FOR THE SIX MONTHS ENDED FOR THE THREE MONTHS ENDED
------------------------------ ------------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Net product revenues $ 838 $ 2,732 $ 210 $ 1,206
Cost of manufacturing 1,437 5,138 184 2,265
Research and development 1,242 616 1,004 287
Selling, general and administrative expenses 2,363 3,917 1,142 2,206
------------ ------------ ------------ ------------
Loss from operations (4,204) (6,939) (2,120) (3,552)
Other income (expense)
Interest expense (2,152) (2,904) (1,194) (1,471)
Interest income 22 21 15 4
Amortization of deferred debt discount and
private offering costs (24,655) (11,683) (13,812) (5,916)
Gain (loss) on asset disposals 1,755 -- 1 --
Gain on debt restructure 12,401 -- -- --
Other 401 (97) (2) (92)
------------ ------------ ------------ ------------
NET LOSS $ (16,432) $ (21,602) $ (17,112) $ (11,027)
============ ============ ============ ============
Basic and diluted loss per share $ (0.76) $ (1.03) $ (0.79) $ (0.52)
============ ============ ============ ============
Weighted average number of outstanding 21,612,382 21,065,373 21,623,061 21,095,092
shares ============ ============ ============ ============
The accompanying notes are an integral part of these unaudited condensed
consolidated financial statements
3
HALSEY DRUG CO., INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30
------------------
2004 2003
---- ----
(IN THOUSANDS)
Cash flows from operating activities
Net loss ................................................. $(16,432) $(21,602)
-------- --------
Adjustments to reconcile net loss to net cash
used in operating activities
Depreciation and amortization ......................... 251 402
Amortization of deferred debt discount and private
offering costs ........................................ 24,655 11,683
Amortization of deferred product acquisition costs .... 205 23
Debentures and stock issued for interest .............. 63 1,459
Loss on disposal of assets ............................ 71 5
Increase in fair value of warrants .................... - 92
Gain on restructure of debt ........................... (12,401) -
Changes in assets and liabilities
Accounts receivable ................................ 315 (1,295)
Inventories ........................................ 312 (252)
Prepaid expenses and other current assets .......... 182 (292)
Other assets and deposits .......................... 149 48
Accounts payable ................................... (1,895) (310)
Accrued expenses ................................... 2,776 1,279
-------- --------
Total adjustments ............................... 14,683 12,842
-------- --------
Net cash used in operating activities ................. (1,749) (8,760)
-------- --------
Cash flows from investing activities
Capital expenditures .................................. (99) (719)
Proceeds from disposal of assets ...................... 2 -
-------- --------
Net cash used in investing activities .............. (97) (719)
-------- --------
Cash flows from financing activities
Payments on notes payable and capital lease obligations (4,030) (20)
Proceeds from issuance of debentures .................. 11,951 500
Payments to Department of Justice ..................... (434) (162)
-------- --------
Net cash provided by financing activities ............. 7,487 318
-------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ..... 5,641 (9,161)
Cash and cash equivalents at beginning of period ......... 942 9,211
-------- --------
Cash and cash equivalents at end of period ............... $ 6,583 $ 50
======== ========
Cash paid for interest was $47 during the six months ended June 30, 2004.
The accompanying notes are an integral part of these unaudited condensed
consolidated financial statements
4
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES FOR THE
SIX MONTHS ENDED JUNE 30, 2004:
1. The Company's Convertible Subordinated Debentures contained
beneficial conversation features, which were valued at $14,000,000.
2. The Company has repaid $166,000 of indebtedness in the form of
product deliveries.
3. Bridge Loans of $2,000,000 and accrued interest of $49,000 were
converted into like amounts of Convertible Subordinated Debentures.
4. The Company has issued 114,322 shares of common stock as payment of
$63,000 of Senior Secured Term Note Payable accrued interest.
The accompanying notes are an integral part of these unaudited condensed
consolidated financial statements
5
HALSEY DRUG CO., INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
SIX MONTHS ENDED JUNE 30, 2004
(IN THOUSANDS, EXCEPT SHARE DATA)
(UNAUDITED)
COMMON STOCK
$.01 PAR VALUE ADDITIONAL
---------------------- PAID-IN ACCUMULATED
SHARES AMOUNT CAPITAL DEFICIT TOTAL
------ ------ ------- ------- -----
Balance at January 1, 2004 ...................... 21,601,704 $ 216 $ 157,262 $(209,545) $ (52,067)
Net loss for the six
months ended June 30, 2004 ................... (16,432) (16,432)
Issuance of common shares for payment of interest 114,321 1 62 63
Beneficial conversion features in connection with
issuance of debentures ....................... 14,000 14,000
---------- --------- --------- --------- ---------
Balance at June 30, 2004 ........................ 21,716,025 $ 217 $ 171,324 $(225,977) $ (54,436)
========== ========= ========= ========= =========
The accompanying notes are an integral part of these unaudited condensed
consolidated financial statements
6
HALSEY DRUG CO., INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1 - BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial
statements of Halsey Drug Co., Inc. and subsidiaries (the "Company") have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Rule 10-01 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles in the United
States for complete financial statements. In the opinion of management, all
adjustments, consisting of normal recurring accrual adjustments, considered
necessary to present fairly the financial position, results of operations and
changes in cash flows for the six months ended June 30, 2004, assuming that the
Company will continue as a going concern, have been made. The results of
operations for the six month' period ended June 30, 2004 are not necessarily
indicative of the results that may be expected for the full year ended December
31, 2004. The unaudited condensed consolidated financial statements should be
read in conjunction with the consolidated financial statements and footnotes
thereto for the year ended December 31, 2003 included in the Company's Annual
Report on Form 10-K filed with the Securities and Exchange Commission.
At June 30, 2004 the Company had cash and cash equivalents of $6,583,000
as compared to $942,000 at December 31, 2003. The Company had working capital
deficit at June 30, 2004 of $10,978,000 and an accumulated deficit of
$225,977,000. The Company had an operating loss of $4,204,000 during the six
months ended June 30, 2004.
In the fourth quarter of 2003 and first quarter of 2004, the Company
restructured its operations, as more fully described in Note 2, and ceased the
manufacturing, sale and distribution of the Company's generic finished dosage
pharmaceutical products by the Company's subsidiary, Axiom Pharmaceutical
Corporation ("Axiom"). Axiom's manufacturing operations ceased on January 30,
2004, packaging and labeling operations ceased approximately February 12, 2004
and quality assurance and related support activities ceased on approximately
February 27, 2004.
As restructured, the Company is engaged in the development of proprietary
opioid abuse deterrent formulation technology (the "ADF Technology"), the
manufacture, packaging and stability testing of clinical trial supplies of
finished product candidates utilizing the ADF Technology, the evaluation of such
product candidates in appropriate clinical trials, the development and scale up
of novel active pharmaceutical ingredient ("API") opioid synthesis technologies
(the "Opioid Synthesis Technologies"), and the prosecution of the Company's
application to the Drug Enforcement Administration ("DEA") for a registration to
import narcotic raw materials ("NRMs"). The Company proposes to enter into
license agreements with strategic partners providing that such licensees will
further develop abuse deterrent formulation finished dosage product candidates,
file for regulatory approval with the U.S. Food and Drug Administration ("FDA")
and other regulatory authorities and commercialize such products. The Company
intends to manufacture commercial supplies of such products for sale by the
Company's licensees.
NOTE 2 - LIQUIDITY MATTERS
General
The accompanying financial statements have been prepared assuming the
Company will continue as a going concern. At December 31, 2003, the Company had
cash and cash equivalents of $942,000, working capital deficit of $3,770,000 and
a stockholders' deficit of $52,067,000. The Company incurred a loss from
operations of $17,244,000 and a net loss of $48,455,000 during the year ended
December 31, 2003. At June 30, 2004, the Company had cash and cash equivalents
of $6,583,000, a working capital deficit of $10,978,000 and an accumulated
7
deficit of $225,977,000. The Company incurred operating losses of $4,204,000
during the six months ended June 30, 2004. Historically, the Company has
incurred significant losses from operations and until such time as its research
and development efforts are commercialized, for which no assurance can be given,
the Company will continue to incur operating losses. These factors, among
others, raise substantial doubt about the Company's ability to continue as a
going concern. Management's plans with respect to these matters follow.
Company Restructuring
On November 6, 2003, the Company publicly announced a restructuring plan
to focus its efforts on research and development related to certain proprietary
finished dosage products and opioid APIs. In making its determination the Board
of Directors considered, among other factors, the Company's ability and time
required to generate positive cash flow and income from the operation of the
Company's finished dosage manufacturing, packaging, labeling and distribution
facilities located in Congers, New York (collectively, the "Congers Facilities")
in the manufacture and distribution of finished dosage generic products pursuant
to abbreviated new drug applications ("ANDAs").
The Company incurred losses of $48.5 million in 2003, $59.6 million in
2002 and $12.6 million in 2001. The Board determined that near term sales of the
Company's finished dosage generic products would likely result in continued
financial losses in view of the highly competitive market environment, low
market pricing, declining market size for its existing generic products and the
lack of timely new generic product launches. Based on this analysis and other
factors, the Board concluded that the Company restructure its operations by
closing or divesting the Congers Facilities and reducing certain activities at
its Culver, Indiana facility (the "Culver Facility"). The plan targeted a
reduction in workforce of approximately 70 employees at the Congers Facilities,
25 employees at the Culver Facility and 5 employees at the Rockford, Illinois
office facility (the "Rockford Office").
In implementing the restructuring plan at the Culver Facility, the
reduction in work force involved approximately 25 employees engaged primarily in
or supporting the manufacture of doxycycline hyclate and doxycycline monohydrate
APIs, which were converted to finished dosage products at the Congers
Facilities. With the closure of the Congers Facilities, the doxycycline APIs
manufactured at the Culver Facility were not required. The Culver Facility work
force reduction was completed by December 31, 2003.
In implementing the restructuring plan at the Rockford Office, the Company
terminated its Rockford office lease agreement and relocated the administrative
functions to Palatine, Illinois. This process was completed on February 29, 2004
resulting in a reduction in work force of 5 employees.
In implementing the restructuring of operations at the Congers Facilities,
the reduction in work force involved essentially all of the employees at the
site. Finished generic product manufacturing operations ceased on January 30,
2004. Packaging and labeling operations ceased approximately February 12, 2004
and quality assurance and related support activities ceased on February 27,
2004. Such dates also mark the substantial completion of the reduction in work
force of approximately 70 employees engaged in these activities at the Congers
Facilities. From approximately March 1, 2004 to March 19, 2004 a small
logistics, maintenance and warehouse staff prepared the Congers Facilities for
sale to IVAX Pharmaceuticals as discussed below under the caption "Sale of
Certain Company Assets to IVAX".
In implementing the restructuring adopted by the Board, the Company has
transitioned to a single vertically integrated operations facility located in
Culver, Indiana. The Company's strategy and key activities to be conducted at
the Culver Facility are as follows:
- Development of the Company's ADF Technology for use in orally
administered opioid finished dosage product candidates.
- Manufacture and quality assurance release of clinical trial
supplies of certain finished dosage form product candidates utilizing the
ADF Technology.
8
- Evaluation of certain finished dosage product candidates
utilizing the ADF Technology in clinical trials.
- Scale-up and manufacture of commercial quantities of certain
product candidates utilizing the ADF Technology for sale by the Company's
licensees.
- Research, development and scale up of the Company's novel
Opioid Synthesis Technologies.
- Prosecution of the Company's application to the DEA to for
registration to import NRMs for use in the production of opioid API's
utilizing the Company's Opioid Synthesis Technologies.
- Negotiating and executing license and development agreements
with strategic pharmaceutical company partners providing that such
licensees will further develop certain finished dosage product candidates
utilizing the ADF Technology, file for regulatory approval with the FDA
and other regulatory authorities and commercialize such products.
As of December 31, 2003, the Company has recorded aggregate restructuring
expenses of approximately $3,280,000 consisting of an impairment charge of
$1,673,000 against property, plant and equipment, an impairment charge of
$1,354,000 against inventory (charged against cost of sales), and $253,000 of
other costs.At December 31, 2003, $100,000 of other costs were included in
accrued expenses. During the six months ended June 30, 2004, $41,000 of such
costs were paid and there remains $59,000 accrued at June 30, 2004.
2004 Debenture Offering
On February 6, 2004, the Company consummated a private offering of
convertible senior secured debentures (the "2004 Debentures") in the aggregate
principal amount of approximately $12.3 million (the "2004 Debenture Offering").
The 2004 Debentures were issued by the Company pursuant to a certain Debenture
and Share Purchase Agreement dated as of February 6, 2004 (the "2004 Purchase
Agreement") by and among the Company, Care Capital Investments II, L.P. ("Care
Capital"), Essex Woodlands Health Ventures V, L.P. ("Essex"), Galen Partners
III, L.P. and certain of its affiliates (collectively, "Galen") and each of the
purchasers listed on the signature page thereto (the "2004 Debenture Investor
Group"). Of the approximate $12.3 million in debentures issued on February 10,
2004 under the 2004 Debenture Offering, approximately $2.0 million of 2004
Debentures were issued in exchange for the surrender of a like amount of
principal plus accrued and unpaid interest under the Company's 2002 Debentures
issued to Care Capital, Essex and Galen during November and December, 2003
pursuant to the Letter of Support. As the conversion price of such debentures
was less than the fair market value of the Company's common stock on the date of
issue, beneficial conversion features were determined to exist. The Company
recorded approximately $12.3 million of debt discount limited to the face amount
of the new debt, which is being amortized over the life of the debt, which
matures July 31, 2004, subject to automatic extension up to October 31, 2004 to
allow for the completion of the Company's 2004 Annual Meeting of Shareholders.
During the six months ended June 30, 2004, the Company recognized approximately
$3.8 million of amortization expense from this transaction.
Additional Funding under 2004 Debenture Offering
On April 14, 2004, the Company completed an additional closing under the
2004 Purchase Agreement pursuant to which the Company issued additional 2004
Debentures in the aggregate principal amount of approximately $0.6 million,
bringing the aggregate principal amount of 2004 Debentures issued by the Company
under the 2004 Purchase Agreement to $12.9 million. As the conversion price of
such debentures was less than the fair market value of the Company's common
stock on the date of issue, beneficial conversion features were determined to
exist. The Company recorded approximately $0.6 million of debt discount limited
to the face amount of the new debt, which will be amortized over the life of the
debt, which matures July 31, 2004, subject to automatic extension up to October
31, 2004 to allow for the completion of the Company's 2004 Annual Meeting of
Shareholders.
9
On May 26, 2004, the Company completed an additional closing under the
2004 Purchase Agreement pursuant to which the Company issued additional 2004
Debentures in the aggregate principal amount of approximately $1.1 million,
bringing the aggregate principal amount of 2004 Debentures issued by the Company
under the 2004 Purchase Agreement to $14.0 million. As the conversion of such
debentures was less than the fair market value of the Company's common stock on
the date of issue, beneficial conversion features were determined to exist. The
Company recorded approximately $1.1 million of debt discount limited to the face
amount of the new debt, which will be amortized over the life of the debt, which
matures July 31, 2004, subject to automatic extension up to October 31, 2004 to
allow for the completion of the Company's 2004 Annual Meeting of Shareholders.
Amendment to 2004 Purchase Agreement
The 2004 Purchase Agreement provided for the issuance by the Company of
convertible senior secured debentures in the aggregate principal amount of $14.0
million to be completed no later than June 5, 2004. On June 1, 2004, an
Amendment to the 2004 Purchase Agreement was executed providing for (i) an
increase the principal amount of debentures issuable by the Company under the
2004 Purchase Agreement from $14.0 million to $17.5 million, and (ii) an
extension of the time to complete this additional financing from June 5, 2004 to
June 30, 2004 (the "2004 Purchase Agreement Amendment"). No additional 2004
Debentures were issued following the 2004 Purchase Agreement Amendment.
Terms of 2004 Debentures
The 2004 Debentures, issued at par, bear interest at the rate of 1.62% per
annum, the short-term Applicable Federal Rate on February 6, 2004. The 2004
Debentures are secured by a lien on all assets of the Company. In addition, each
of Houba, Inc. and Axiom Pharmaceutical Corporation, each a wholly-owned
subsidiary of the Company, has executed in favor of the 2004 Debenture holders,
an unconditional agreement of guaranty of the Company's obligations under the
2004 Purchase Agreement. Each guaranty is secured by all assets of such
subsidiaries. In addition, the Company has pledged the stock of each such
subsidiary to the holders of the 2004 Debentures to further secure its
obligations under the 2004 Purchase Agreement.
Subordination of Lien of Holders of 2004 Debentures to the Lien Under the Watson
Term Loan Agreement
In accordance with the terms of an Amended and Restated Subordination
Agreement dated as of February 6, 2004 between the Company, the holders of the
2004 Debentures and the holders of the Company's other outstanding debentures,
the liens on the Company's and its subsidiary's assets as well as the payment
priority of the 2004 Debentures are (i) subordinate to the Company's lien and
payment obligations in favor of Watson Pharmaceuticals under the Watson Term
Loan Agreement, and (ii) senior to the Company's lien and payment obligations in
favor of the holders of the Company's other outstanding debentures in the
aggregate principal amount of approximately $86.6 million.
Conversion of 2004 Debentures into Series A Preferred Stock
The 2004 Debentures (including the principal amount plus interest accrued
at the date of conversion) will convert automatically into the Company's Series
A convertible preferred stock (the "Series A Preferred") immediately following
the Company's receipt of shareholder approval at its next shareholders' meeting
to restate the Company's Certificate of Incorporation (the "Charter Amendment")
to authorize the Series A Preferred and the Junior Preferred Shares (as
described below) and the filing of the Charter Amendment with the Office of the
New York Department of State (the date of such filing, the "Charter Amendment
Filing Date"), as provided in the 2004 Purchase Agreement. The 2004 Debentures
will convert into Series A Preferred at a price per share (the "Series A
Conversion Price") of $0.6425, representing the average of the closing bid and
asked prices of the Company's Common Stock for the twenty (20) trading days
ending February 4, 2004, as reported by the Over-the-Counter ("OTC") Bulletin
Board. The Series A 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
10
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 Series A Conversion Price.
Based on the $0.6425 Series A Conversion Price of the Series A Shares and
estimating the interest accrual under the 2004 Debentures prior to the Charter
Amendment Filing Date, the 2004 Debentures with an aggregate principal amount of
$14.0 million will be convertible into an aggregate of approximately 22 million
Series A Preferred shares.
Series A Preferred Stock Liquidation Preference, Conversion Right and
Participation Right
In general, the Series A Preferred shares have a liquidation preference
equal to five (5) times the initial $0.6425 Series A Conversion Price (the
"Series A Liquidation Preference"). In addition, the Series A Preferred shares
are convertible into the Company's Common Stock, with each Series A Preferred
share convertible into the number of shares of Common Stock obtained by dividing
(i) the Series A Liquidation Preference, by (ii) the $0.6425 Series A Conversion
Price, as such conversion price may be adjusted, from time to time, pursuant to
the dilution protections of such shares. Without limiting the Series A
Liquidation Preference, the holders of Series A Preferred shares also have the
right to participate with the holders of the Company's Common Stock upon the
occurrence of a liquidation event, including the Company's merger, sale of all
or substantially all of its assets or a change of control transaction, on an
as-converted basis (but for these purposes only, assuming the Series A Preferred
shares to be convertible into only thirty percent (30%) of the shares of Common
Stock into which they are otherwise then convertible). The holders of Series A
Preferred shares also have the right to vote as part of a single class with all
holders of the Company's voting securities on all matters to be voted on by such
security holders. Each holder of Series A Preferred shares will have such number
of votes as shall equal the number of votes he would have had if such holder
converted all Series A Preferred shares held by such holder into shares of
Common Stock immediately prior to the record date relating to such vote.
Nomination of Directors to the Company's Board of Directors by the Lead 2004
Investors
The 2004 Purchase Agreement provides that each of Care Capital, Essex and
Galen (collectively, the "Lead 2004 Investors") has the right to designate for
nomination one member of the Company's Board of Directors, and that the Lead
Investors collectively may designate one additional member of the Board
(collectively, the Designees"). The Purchase Agreement further provides that the
Designees, if so requested by such Designee in his sole discretion, shall be
appointed to any Committee of the Board of Directors. The Designees of Care
Capital, Essex and Galen are Messrs. Karabelas, Thangaraj and Wesson,
respectively, each of whom are current Board members. Effective as of the
closing of the 2004 Purchase Agreement, the Lead 2004 Investors may collectively
nominate one additional Designee to the Board. The Company has agreed to
nominate and appoint to the Board of Directors, subject to shareholder approval,
one designee of each of Care Capital, Essex and Galen, and one collective
designee of the Lead 2004 Investors, for so long as each holds a minimum of 50%
of the Series A Preferred shares initially issued to such party (or at least 50%
of the shares of Common Stock issuable upon conversion of the Series A Preferred
shares).
Impact of Conversion of the Company's Outstanding Debentures
As of February 6, 2004, the date of the initial closing of the 2004
Purchase Agreement, the Company had issued and outstanding and aggregate of
approximately $86.6 million in principal amount of 5% convertible senior secured
debentures maturing March 31, 2006 issued pursuant to three separate Debenture
Purchase Agreements dated March 10, 1998, as amended (the "1998 Debentures"),
May 26, 1999, as amended (the "1999 Debentures") and December 20, 2002 (the
"2002 Debentures"), respectively. The 1998 Debentures, 1999 Debentures and 2002
Debentures are referred to collectively as the "1998-2002 Debentures". After
giving effect to the Company's issuance of additional 5% convertible senior
secured debentures in satisfaction of interest payments on the 1998-2002
Debentures, as of February 10, 2004, the 1998-2002 Debentures were convertible
into an aggregate of approximately
11
190.4 million shares of the Company's Common Stock.
Conversion Agreement of Holders of 1998-2002 Debentures
Simultaneous with the execution of the 2004 Purchase Agreement, and as a
condition to the initial closing of the 2004 Purchase Agreement, the Company,
the 2004 Debenture Investor Group and each of the holders of the 1998-2002
Debentures executed a certain Debenture Conversion Agreement, dated as of
February 6, 2004 (the "Conversion Agreement"). In accordance with the terms of
the Conversion Agreement, each holder of the 2004 Debentures agreed to convert
the 2004 Debentures held by such holder into the Company's Series A Preferred
shares and each holder of 1998-2002 Debentures agreed to convert the 1998-2002
Debentures held by such holder into the Company's Series B convertible preferred
stock (the "Series B Preferred") and/or Series C-1, C-2 and/or C-3 convertible
preferred stock (collectively, the "Series C Preferred"). The Series C Preferred
shares together with the Series B Preferred shares are herein referred to as,
the "Junior Preferred Shares", and the Junior Preferred Shares together with the
Series A Preferred, are collectively referred to as the "Preferred Stock". The
Conversion Agreement provides, among other things, for the automatic conversion
of the 2004 Debentures and the 1998-2002 Debentures (collectively, the
"Outstanding Debentures") into the appropriate class of Preferred Stock
immediately following the Company's receipt of shareholder approval to the
Charter Amendment authorizing the creation of the Preferred Stock and the filing
of the Charter Amendment with the Office of the New York Department of State.
Shares of Junior Preferred Stock Resulting from Conversion of 1998-2002
Debentures
Under the Conversion Agreement, the holders of approximately $6.6 million
in principal amount of 2002 Debentures issued during 2003 will convert such 2002
Debentures (plus accrued and unpaid interest) into Series B Preferred Shares. Of
the remaining approximate $80.0 million in principal amount of the 1998-2002
Debentures, approximately $31.2 million is comprised of 1998 Debentures,
approximately $21.5 million is comprised of 1999 Debentures and approximately
$27.3 million is comprised of 2002 Debentures. The 1998 Debentures will be
converted into Series C-1 Preferred shares. The 1999 Debentures will be
converted into Series C-2 Preferred shares. The remaining balance of the 2002
Debentures shall be converted into Series C-3 Preferred shares.
Shares of Common Stock Resulting from Conversion of Junior Preferred Shares
The number of Junior Preferred Shares to be received by each holder of
1998-2002 Debentures is based on the respective prices at which the 1998-2002
Debentures were convertible into Common Stock. The 2002 Debentures issued in
2003 have a conversion price of $0.3420 per share. The 1998 Debentures, 1999
Debentures and the remaining balance of the 2002 Debentures have conversion
prices of $0.5776, $0.5993 and $0.3481 per share, respectively. Based on the
respective conversion prices of the 1998-2002 Debentures, and estimating the
interest accrual on the 1998-2002 Debentures prior to the Charter Amendment
Filing Date, the 1998-2002 Debentures are convertible into an aggregate of
approximately 20.0 million Series B Preferred shares, 56.5 million Series C-1
Preferred shares, 37.5 million Series C-2 Preferred shares and 80.9 million
Series C-3 Preferred shares.
Liquidation Preference of Junior Preferred Shares
In general, the Junior Preferred Shares have a liquidation preference
equal to one (1) time the principal amount plus accrued and unpaid interest of
the 1998-2002 Debentures converted into Junior Preferred Shares. The liquidation
preference of the Series B Preferred has priority over, and will be satisfied
prior to, the liquidation preference of the Series C Preferred. The liquidation
preference for each class of the Junior Preferred Shares is equal to the
conversion prices of such shares. The Junior Preferred Shares are convertible
into the Company's Common Stock, with each Junior Preferred Share convertible
into one share of Common Stock. The holders of the Junior Preferred Shares have
the right to vote as part of the single class with all holders of the Company's
Common Stock and the holders of the Series A Preferred on all matters to be
voted on by such stockholders, with each holder of Junior Preferred Shares
having such number of votes as shall equal the number of votes he would have had
if such holder had converted all Junior Preferred Shares held by such holder
into Common Stock immediately prior to the
12
record date relating to such vote.
Amendment to Watson Term Loan Agreement
The Company was a party to a certain loan agreement with Watson
Pharmaceuticals ("Watson") pursuant to which Watson made term loans to the
Company (the "Watson Term Loan Agreement") in the aggregate principal amount of
approximately $21.4 million as evidenced by two promissory notes (the "Watson
Notes"). It was a condition to the completion of the 2004 Debenture Offering
that simultaneous with the closing of the 2004 Purchase Agreement, the Company
shall have paid Watson the sum of approximately $4.3 million (which amount was
funded from the proceeds of the 2004 Debenture Offering) and conveyed to Watson
certain Company assets in consideration for Watson's forgiveness of
approximately $16.4 million of indebtedness under the Watson Notes. As part of
such transaction, the Watson Notes were amended to extend the maturity date of
such notes from March 31, 2006 to June 30, 2007, to provide for satisfaction of
future interest payments under the Watson Notes in the form of the Company's
Common Stock, to reduce the principal amount of the Watson Notes from $21.4
million to $5.0 million, and to provide for the forbearance from the exercise of
rights and remedies upon the occurrence of certain events of default under the
Watson Notes (the Watson Notes as so amended, the "New Watson Note").
Simultaneous with the issuance of the New Watson Note, each of the Lead 2004
Investors and the other investors in the 2004 Debentures as of February 10, 2004
(collectively, the "Watson Note Purchasers") purchased the New Watson Note from
Watson in consideration for a payment to Watson of $1.0 million.
In addition to Watson's forgiveness of approximately $16.4 million under
the Watson Notes, as additional consideration for the Company's payment to
Watson of approximately $4.3 million and the Company's conveyance of certain
Company assets, all supply agreements between the Company and Watson were
terminated and Watson waived the dilution protections contained in the Common
Stock purchase warrant dated December 20, 2002 exercisable for approximately
10.7 million shares of the Company's Common Stock previously issued by the
Company to Watson, to the extent such dilution protections were triggered by the
transactions provided in the 2004 Debenture Offering.
Terms of the New Watson Note
The New Watson Note in the principal amount of $5.0 million as purchased
by the Watson Note Purchasers is secured by a first lien on all of the Company's
and its subsidiaries' assets, senior to the lien securing the Outstanding
Debentures and all other Company indebtedness, carries a floating rate of
interest equal to the prime rate plus 4.5% and matures on June 30, 2007.
Net Proceeds from the 2004 Debenture Offering
After giving effect to the payment to Watson of approximately $4.3 million
to restructure the Watson Term Loan and the payment of legal and other
professional fees relating to the 2004 Debenture Offering, the Company realized
net proceeds from the 2004 Debenture Offering of approximately $7.3 million (the
"2004 Debenture Offering Proceeds").
Sale of Certain Company Assets to Mutual
On February 18, 2004, the Company and Mutual Pharmaceutical Company, Inc.
("Mutual") entered into a certain Asset Purchase Agreement (the "Mutual Asset
Purchase Agreement"). Pursuant to the terms of the Mutual Asset Purchase
Agreement, the Company sold certain inactive, non-revenue generating ANDAs to
Mutual in consideration of $2.0 million. The ANDAs sold to Mutual are set forth
below.
13
THERAPEUTIC CATEGORY APPROXIMATE NUMBER OF ANDAS
-------------------- ---------------------------
Analgesic 29
Anti-Infective 14
Antihypertensive/Cardiac 32
Antihistamine 6
Steroid 12
Cough & Cold 7
Central Nervous System 42
Other 10
The Company's decision to divest the above generic product ANDAs was based
on (i) the Company's revised business strategy which focuses on research and
development of novel and proprietary abuse deterrent formulation technology and
opioid active pharmaceutical ingredient synthesis technologies, (ii) the Company
had ceased operations at its finished dosage generic product manufacturing and
packaging facilities and was in the process of negotiating for the sale of such
facilities and (iii) these ANDAs were inactive, non revenue producing generic
product ANDAs which had never been qualified for manufacturing or commercial
distribution in the Company's Congers, NY generic product manufacturing
facilities. These ANDAs were therefore not deemed to be operating assets of the
Company.
Sale of Certain Company Assets to IVAX
On March 19, 2004, the Company and its wholly-owned subsidiary, Axiom
Pharmaceutical Corporation, entered into an Asset Purchase Agreement with IVAX
Pharmaceuticals New York LLC ("IVAX"). Pursuant to the Purchase Agreement, the
Company and Axiom agreed to sell to IVAX substantially all of the Company's
assets used in the operation of the Company's former generic manufacturing and
packaging operations located in Congers, New York in consideration of an
immediate payment of $2.0 million and an additional payment $0.5 million upon
receipt of shareholder approval of the transaction to be sought at the Company's
annual meeting of shareholders to be held on August 12, 2004. Pending
Shareholder approval, the Company has recorded the initial payment of $2.0
million as a short term liability.
After giving effect to the payment of legal and other professional fees
relating to the divestment of the ANDAs to Mutual and the proposed divestment of
certain assets to IVAX, the Company estimates that it will realize aggregate net
proceeds from such transactions of approximately $4.3 million. (the "Asset
Divestment Proceeds").
ADF Technology Research and Development
The Company's primary business focus is the research and development of
proprietary abuse deterrent formulation technologies (the "ADF Technology")
intended to deter the abuse of opioid containing orally administered
prescription products. The ADF technology has been tested in a variety of
non-clinical settings and a patent application was filed with the United States
Patent and Trademarks Office in the fourth quarter of 2003 (see discussion below
under the caption "Patent Applications"). The Company's first product candidate
("ADF Product Candidate #1") resulting from the ADF Technology is a tablet
formulation intended for oral administration. ADF Product Candidate #1 is
currently undergoing required drug product stability testing prior to regulatory
submission. To date the Company can provide no assurances that the stability of
ADF Product Candidate #1 will result in a commercially acceptable drug product.
In addition, ADF Product Candidate #1 is also currently under evaluation in a
clinical study to assess the bio-availability of such product candidate in
comparison to a frequently prescribed commercially marketed drug product with
the same opioid active ingredient but without abuse deterrent properties. The
final results from such clinical study are expected to be available in the
second half of 2004. There can be no assurances that ADF Product Candidate #1
will be bio-available or bioequivalent to the extent required to justify
continued clinical testing. To receive marketing authorization for commercial
distribution in the United States, all drug products formulated with the ADF
Technology will require the development, submission and filing of a new
14
drug application ("NDA") and approval of such application by the U.S. Food and
Drug Administration (the "FDA"). In the event that ADF Product Candidate #1 is
stable and demonstrates acceptable bio-availability, then substantial additional
clinical and non-clinical testing will be required prior to the submission of an
NDA. There can be no assurances that ADF Product Candidate #1 will lead to an
NDA submission or that if an NDA is filed, that the FDA will approve such
regulatory application for commercial distribution.
Opioid Synthesis Technology Research and Development
The Company is also engaged in the research, development and scale-up of a
variety of proprietary manufacturing processes for opioid active pharmaceutical
ingredients (the "Opioid Synthesis Technologies") as generally described in the
table below.
APPLICABLE DEA
OPIOID SYNTHESIS STARTING ESTIMATED REGISTRATIONS STATUS OF PATENT
TECHNOLOGY MATERIAL YIELD REQUIRED APPLICATION
Codeine
Oxycodone HCl Phosphate 40 - 50% a) Research One (1) Notice of Allowance issued
- ----------------------------------------------------------------------------------------------------------------------
One (1) other Patent Pending before
Process #1 b) Manufacturing the PTO
- ----------------------------------------------------------------------------------------------------------------------
Codeine Patent Application filed in the
Hydrocodone Bitartrate Phosphate 85% a) Manufacturing second quarter of 2004
- ----------------------------------------------------------------------------------------------------------------------
Process #1
- ----------------------------------------------------------------------------------------------------------------------
Oxycodone HCl NRMs 68 - 72% a) Research Patent Application filed in July 2004
- ----------------------------------------------------------------------------------------------------------------------
Process #2 b) Manufacturing
- ----------------------------------------------------------------------------------------------------------------------
c) Import
- ----------------------------------------------------------------------------------------------------------------------
Patent Application filed in the
Codeine Phosphate NRMs 90 - 100% a) Research second quarter of 2004
- ----------------------------------------------------------------------------------------------------------------------
Process #1 b) Manufacturing
- ----------------------------------------------------------------------------------------------------------------------
c) Import
- ----------------------------------------------------------------------------------------------------------------------
Patent Application filed in the
Codeine Phosphate NRMs 80-90% a) Research second quarter of 2004
- ----------------------------------------------------------------------------------------------------------------------
Process #2 b) Manufacturing
- ----------------------------------------------------------------------------------------------------------------------
c) Import
- ----------------------------------------------------------------------------------------------------------------------
Patent Application filed in the
Codeine Phosphate NRMs 65-85% a) Research fourth quarter of 2003
- ----------------------------------------------------------------------------------------------------------------------
Process #3 b) Manufacturing
- ----------------------------------------------------------------------------------------------------------------------
c) Import
- ----------------------------------------------------------------------------------------------------------------------
Patent Application filed
Hydrocodone Bitartrate Codeine Base 85 - 95% a) Research in the second quarter of 2004
- ----------------------------------------------------------------------------------------------------------------------
Process #2 b) Manufacturing
- ----------------------------------------------------------------------------------------------------------------------
Patent Application expected to be
Morphine Sulfate NRMs 96% a) Research filed by the second quarter of 2005
- ----------------------------------------------------------------------------------------------------------------------
b) Manufacturing
- ----------------------------------------------------------------------------------------------------------------------
c) Import
- ----------------------------------------------------------------------------------------------------------------------
Dihydrocodeine Patent Application filed in the
Bitartrate Codeine Base >90% a) Research second quarter of 2004
- ----------------------------------------------------------------------------------------------------------------------
b) Manufacturing
15
The Company believes at this stage of development that, except for
oxycodone hydrochloride process #1, the Opioid Synthesis Technologies are
efficient and cost-effective methods of manufacturing opioid APIs. The Company
believes that the primary advantages of these processes include a substantial
reduction in the time and number of processing steps required to produce the
desired opioid APIs and reduction of the quantity and/or toxicity of the waste
products relating to such production. The Company believes that at the current
manufacturing scale Hydrocodone Bitartrate Process #1 meets all USP release
testing specifications, provides high yields and high levels of purity compared
to competitive manufacturing processes used for this active ingredient. The
development and documentation of Hydrocodone Process #1 has been completed and
the Company believes such process is ready to be tested at full commercial
scale. Until such time, if any, as the Company secures third-party financing
dedicated to scale-up expenses (as defined below under the caption "Hydrocodone
Bitartrate Option Agreement") the Company will be unable to complete the
commercial scale-up of the Hydrocodone Bitartrate Process #1 or the other Opioid
Synthesis Technologies in the above table. No assurance can be given that the
Company will obtain the third-party financing necessary to scale-up the Opioid
Synthesis Technologies or that if such financing is obtained, that any one or
more of the Opioid Synthesis Technologies will be capable of commercial
scale-up.
Patent Applications
To date, the Company has filed seven (7) patents applications with the
United States Patent and Trademark Office ("PTO") and one (1) foreign
application relating to the Opioid Synthesis Technologies including two (2) in
June 2003, one (1) in October 2003 and four (4) in May 2004 and one (1) patent
application relating to the ADF Technology in the fourth quarter of 2003. The
typical review time of a U.S. patent application varies. The initial review
generally occurs approximately 12 to 18 months from date of patent filing. At
the completion of the initial review, the patent examiner will issue an Office
Action letter, which will detail any necessary amendments, supplements or
reasons for the rejection. Subsequent processing of the patent application will
depend on the number of Office Action letters issued and the speed of review of
the Company's responses thereto. If an application is granted, a Notice of
Allowance will be issued, requiring a payment of the issue fee within three (3)
months from the date of the notice. Upon the payment of the fee, the patent
would be issued.
In March 2004 the Company received a notice of allowance from the PTO
relating to one of the patent applications filed in June of 2003. The Company
has paid the issue fee and expects a U.S. patent will be granted from that
application. No assurance can be given, however, that any other currently
pending patent applications or future patent applications relating to the Opioid
Synthesis Technologies will be granted. In addition, the Company is currently
unable to provide any assurance that the U.S. patent application associated with
the ADF Technology will issue, or if such patent issues, that the claims granted
will be sufficiently broad to provide economic value.
Import License Registration
To provide for an economical source of raw materials for the commercial
manufacture of opioids utilizing certain of the Opioid Synthesis Technologies,
the Company filed with the U.S. Drug Enforcement Agency (the "DEA") an
application for registration to import certain narcotic raw materials ("NRMs").
The Company filed its application for registration to import NRMs on January 31,
2001 (the "Import Registration"). Notice of the Company's application was
published in the Federal Register on September 6, 2001. Within the 30 day period
provided under DEA guidelines, three parties, including two companies that the
Company believes are the largest U.S. importers of NRMs requested a hearing to
formally object to the Company's request for an Import Registration. Pursuant to
established procedures, an evidentiary hearing relating to the Company's Import
Registration application was held before a DEA Administrative Law Judge ("ALJ")
in August 2003. The ALJ later re-opened the administrative record, at the
request of opposing parties, to consider the Company's November and December
2003 announcements concerning the Company restructuring and financing
activities. After submission of additional testimony by the Company and certain
of the opposing parties, the ALJ closed the evidentiary record effective May 25,
2004. Additionally, as of August 3, 2004, the Company and the opposing parties
prepared and submitted
16
briefing documents to the ALJ based on the evidentiary record. With the
evidentiary record now closed, the ALJ will make findings of fact, draw legal
conclusions and recommend a specific decision on the Company's Import
Registration application to the DEA and issue a final order relating to the
Company's application. Following the decision of the ALJ, the DEA will judge
whether the issuance of an Import Registration is appropriate. Assuming DEA
grants the Company's application, of which no assurance can be given, the
Company would be permitted to import NRMs upon appropriate notice in the Federal
Register. The opposing parties may challenge the DEA decision to grant the
Company's application in an appropriate Court of Appeals. In such a case,
assuming the Company opposes an appellate challenge, the Company would likely
incur additional time delays and legal expenses prior to the issuance of a final
decision by the U.S. Court of Appeals. Provided the Company continues to seek
the Import Registration, the proceedings will continue through 2004 and beyond.
No assurance can be given that the Company's Import Registration
application will be approved by the DEA or that if granted by DEA, the Import
Registration would be upheld following an appellate challenge. Furthermore, 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 the
development of the Opioid 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 Opioid Synthesis
Technologies.
Hydrocodone Bitartrate Option Agreement
The Company estimates that to scale up its Hydrocodone Bitartrate Process
#1 Opioid Synthesis Technology to desirable commercial scale at its Culver
Facility, additional funding of approximately $7.0 million will be required for
facility improvements, the purchase, installation and validation of new API
manufacturing equipment, environmental waste management compliance, the
preparation of the drug master files for the API to be produced at the facility,
and related direct labor expense (collectively, the "API Scale Up Expenses").
The Company is a party to a certain Hydrocodone Option Agreement dated February
6, 2004 with Watson Pharmaceuticals ("Watson") pursuant to which the Company has
granted Watson a six (6) month exclusive option (the "Hydrocodone Option") to
enter into a supply agreement with the Company for supply of hydrocodone
bitartrate API (the "Hydrocodone API"). If such option is exercised by Watson,
at Watson's sole discretion, of which there can be no assurance, Watson will
fund 50% of the API Scale Up Expenses, up to a maximum of $3.5 million and the
Company has agreed to use commercially reasonable efforts to obtain financing
dedicated to fund its portion of the API Scale Up Expenses. In the event the
Company is unable to secure financing dedicated to fund its portion of the API
Scale Up Expenses, the Hydrocodone Option provides that the parties will discuss
alternatives relating to the scale up of the its Opioid Synthesis Technology for
Hydrocodone API. On August 4, 2004 the Hydrocodone Option Agreement with Watson
expired unexercised.
As described in this Report, no portion of the 2004 Debenture Offering
Proceeds or the Asset Divestment Proceeds is budgeted for the API Scale Up
Expenses. Until such time, if any, as the Company secures third-party financing
dedicated to the API Scale Up Expenses, the Company will be unable to complete
the commercial scale up of its Opioid Synthesis Technologies.
Commercial Focus and Funding Requirements
The Company is committing substantially all of its resources and available
capital to the development of the ADF Technology, Opioid Synthesis Technologies
and to the prosecution of its Patent applications and the Import Registration.
The failure of the Company to successfully develop the ADF Technology or to
successfully obtain an issued U.S. patent relating to such technology 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 Opioid Synthesis and
ADF Technologies, to obtain required DEA and FDA approvals, and to successfully
prosecute its patent applications. The Company currently does not have the funds
necessary to make the capital improvements required for the commercial scale
manufacture of APIs and finished dosage products incorporating such
17
technologies.
In view of the matters described above, recoverability of a major portion
of the recorded asset amounts shown in the accompanying consolidated balance
sheets is dependent upon continued operations of the Company, which in turn are
dependent upon the Company's ability to meet its financing requirements on a
continuing basis, to maintain present financing, and to succeed in its future
operations. The financial statements do not include any adjustments relating to
the recoverability and classification of recorded asset amounts or amounts and
classification of liabilities that might be necessary should the Company be
unable to continue in existence.
NOTE 3 - NEW ACCOUNTING PRONOUNCEMENTS
In January 2003, the FASB issued Financial Interpretation No. 46,
"Consolidation of Variable Interest Entities" ("FIN No. 46"), which addresses
consolidation by business enterprises of variable interest entities (VIEs). 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. The accounting provisions and
disclosure requirements of FIN No. 46 are effective immediately for VIEs created
or acquired after January 31, 2003, and are effective for the Company's interim
period ending March 31, 2004, for VIEs created prior to February 1, 2003. In
December 2003, the FASB published a revision to FIN No. 46 ("FIN No. 46R") to
clarify some of the provisions of the interpretation and to defer the effective
date of implementation for certain entities. Under the guidance of FIN No. 46R,
public companies that have interests in VIE's that are commonly referred to as
special purpose entities are required to apply the provisions of FIN No. 46R for
periods ending after December 15, 2003. A public company that does not have any
interests in special purpose entities but does have a variable interest in a VIE
created before February 1, 2003, must apply the provisions of FIN No. 46R by the
end of the first interim or annual reporting period ending after March 14, 2004.
During the quarter ended March 31, 2004 the Company adopted the provisions of
FIN No. 46R. Adoption of FIN No. 46R did not have a material effect on the
Company's financial statements. .
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133
on Derivative Instruments and Hedging Activities," ("SFAS No. 149"), which
amends and clarifies financial accounting and reporting for derivative
instruments, including certain derivative instruments embedded in other
contracts and for hedging activities under SFAS No. 133. SFAS No. 149 is
effective for contracts entered into or modified after June 30, 2003 except for
the provisions that were cleared by the FASB in prior pronouncements. The
adoption of SFAS No. 149 did not have a material impact on the Company's
financial position or results of operations.
In May 2003, the FASB issued "SFAS No. 150", "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity"
("SFAS No. 150"). This statement establishes standards for how an issuer
classifies and measures in its statement of financial position certain financial
instruments with characteristics of both liabilities and equity. In accordance
with the standard, financial instruments that embody obligations for the issuer
are required to be classified as liabilities. This Statement shall be effective
for financial instruments entered into or modified after May 31, 2003, and
otherwise is effective at the beginning of the first interim period beginning
after June 15, 2003. The adoption of SFAS No. 150 did not have a material impact
on the Company's financial position or results of operations.
Stock Based Compensation
18
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
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.
SIX MONTHS ENDED JUNE 30,
-------------------------
2004 2003
---- ----
(IN THOUSANDS, EXCEPT PER SHARE DATA)
-------------------------------------
Net loss, as reported ............................ $ (16,432) $ (21,602)
Deduct: Total stock-based employee compensation
expense determined under fair value-based method
for all awards ................................... (111) (382)
---------- ----------
Pro forma net income (loss) ...................... $ (16,543) $ (21,984)
========== ==========
Basic EPS -- as reported ........................ $ (0.76) $ (1.03)
---------- ----------
Basic EPS -- pro forma .......................... $ (0.77) $ (1.05)
========== ==========
Diluted EPS -- as reported ....................... $ (0.76) $ (1.03)
---------- ----------
Diluted EPS -- pro forma ......................... $ (0.77) $ (1.05)
========== ==========
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.
NOTE 4 - RECLASSIFICATIONS
Certain reclassifications have been made to prior years' amounts to
conform to current year's presentation.
NOTE 5 - EARNINGS (LOSS) PER SHARE
Basic earnings (loss) per share are computed by dividing net income (loss)
by the weighted average common shares outstanding during the period. Diluted
earnings per share is based on the treasury stock method and is computed by
dividing net income by the weighted average common shares and common share
equivalents outstanding during the
19
periods presented assuming the exercise of all in-the-money stock options.
Common share equivalents have been excluded where their inclusion would be
anti-dilutive. A reconciliation of the numerator and denominators of basic and
diluted earnings per share for the six months ended June 30, 2004 and June 30,
2003 consisted of the following (in thousands except per share amount):
Six Months ended June 30, 2004 2003
- --------------------------------------------------------------------------------
Numerator:
Net loss $(16,432) $(21,602)
-------- --------
Denominator:
Basic weighted average shares outstanding 21,612 21,065
Convertible debentures - -
Warrants - -
Stock options - -
-------- --------
Diluted weighted average shares outstanding ..... 21,612 21,065
-------- --------
Basic loss per share $ (0.76) $ (1.03)
-------- --------
Diluted loss per share $ (0.76) $ (1.03)
-------- --------
For the six months ended June 30, 2004 and June 30, 2003, approximately
340,547,000 and 224,500,000, respectively of outstanding warrants, options, and
the effect of convertible debentures and convertible bridge loans outstanding,
have been excluded from the computation of diluted earnings per share as they
would be antidilutive to the reported net loss.
NOTE 6 - INVENTORIES
Inventories consist of the following:
JUNE 30, 2004 DECEMBER 31, 2003
------------- -----------------
(IN THOUSANDS)
Finished Goods ............................. $ 422 $ 357
Work in Process ............................ 188 953
Raw Materials .............................. 150 356
------- -------
760 1,666
Less impairment reserve .................... (760) (1,354)
------- -------
$ - $ 312
======= =======
20
NOTE 7 - ACCRUED EXPENSES
Accrued expenses are summarized as follows:
JUNE 30, 2004 DECEMBER 31, 2003
------------- -----------------
(IN THOUSANDS)
Payroll, Payroll Taxes and Benefits................... $ 345 $ 468
Legal and Audit Fees.................................. 195 519
Property and Sales Taxes.............................. 147 142
Medicaid Rebates and Other Customer Allowances........ 82 50
Benefit Plan Taxes.................................... 200 200
Restructure Costs..................................... 59 100
Investment Fees....................................... - 201
Director Fees......................................... - 45
Other ............................................. 37 383
---------------- ----------------
$ 1,065 $ 2,108
================ ================
NOTE 8 - CONVERTIBLE SUBORDINATED DEBENTURES
Convertible Subordinated Debentures consist of the following:
JUNE 30, 2004 DECEMBER 31, 2003
------------- -----------------
(IN THOUSANDS)
1998 Debentures....................................... $ 31,212 $ 31,212
1999 Debentures....................................... 21,485 21,485
2002 Debentures....................................... 27,303 27,303
2003 Debentures....................................... 6,632 6,632
2004 Debentures....................................... 14,000 --
---------------- ----------------
100,632 86,632
Less: Debt discount.................................... (47,040) (56,893)
----------------- -----------------
53,592 29,739
Less: Current maturities, net.......................... (11,207) --
----------------- ----------------
$ 42,385 $ 29,739
================ ================
Related-Party Transactions
A Company officer and Director of the Company holds certain of the 1998
Debentures and 1999 Debentures. The aggregate principal amount of such
debentures was approximately $173,000 at June 30, 2004 and December 31, 2003.
Interest expense on these debentures was approximately $4,400 and $9,200 for the
six months ended June 30, 2004 and 2003, respectively, of which approximately
$8,000 for the six-month period ended June 30, 2003 was paid through the
issuance of like debentures. Interest expense on these debentures was
approximately $2,200 and $4,600, for the three months ended June 30, 2004 and
2003, respectively, of which approximately $4,000 for the three month period
ended June 30, 2003 was paid through the issuance of like debentures.
Indemnifications
Each of the purchase agreements for the Company's 1998 Debentures, 1999
Debentures, 2002 Debentures,
21
2003 Debentures and Bridge Loans, and 2004 Debentures contain 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 and bridge loans. These indemnification obligations
do not include a limit on maximum potential future payments, nor are there any
recourse provisions or collateral that may offset the cost. As of June 30, 2004,
the Company does not believe that any liability has been incurred as a result of
these indemnification obligations.
NOTE 9 - TERM NOTE PAYABLE
Terms of Watson Term Loan
In connection with various transactions between the Company and Watson
completed in 2001, Watson advanced $17.5 million to the Company under the terms
of a certain loan agreement by and between the Company and Watson ("Watson Term
Loan"), dated as of March 29, 2000, as subsequently amended on each of March 31,
2000, December 20, 2002 and February 6, 2004. The Watson Term Loan was evidenced
by a note in the principal amount of $17.5 million (the "Original Watson Note").
The Watson Term Loan was secured by a first lien on all of the Company's assets,
senior to the lien securing all other Company indebtedness, and carried a
floating rate of interest equal to prime plus two percent and had an original
maturity date of June 30, 2004.
2002 Amendment to Watson Term Loan and Issuance of the Watson Warrant
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 approximately $21.4 million to reflect the inclusion of the
Company's payment obligations under the Core Products Supply Agreement between
Watson and the Company. As amended, the Watson Term Loan was evidenced by the
Original Watson Note and an additional note in the principal amount of
approximately $ 3.9 million (collectively, the "Watson Notes"). 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 $0.34 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, 2003, Watson had advanced
approximately $21.4 million to the Company under the Watson Term Loan and the
interest rate was 8.50%.
2004 Amendment to Watson Term Loan
In satisfaction of a condition to the completion of the 2004 Debenture
Offering, simultaneous with the closing of the 2004 Purchase Agreement, the
Watson Term Loan was further amended, as a result of which (1) the Company paid
Watson the sum of approximately $4.3 million (which amount was funded from the
proceeds of the 2004 Debenture Offering), (2) the Company conveyed to Watson
certain Company assets in consideration for Watson's forgiveness of
approximately $16.4 million of indebtedness under the Watson Notes, (3) all
then-current supply agreements between the Company and Watson were terminated ,
(4) Watson waived the dilution protections contained in the Watson Warrant, to
the extent such dilution protections were triggered by the transactions provided
in the 2004 Debenture Offering and (5) the Watson Notes were consolidated into a
single note in the principal amount of $5.0 million (the "New Watson Note"),
which (i) bears interest at the rate equal to the prime rate plus four and one
half percent (4.5%) per annum, (ii) has a maturity date of June 30, 2007
(extended from March 31, 2006), (iii) provides for satisfaction of future
quarterly interest payments thereunder in the form of the Company's Common
Stock, (iv) provides for the forbearance from the exercise of rights and
remedies upon the occurrence of certain events of default thereunder and (v) is
secured by a first lien on all assets of the Company. Further, the Company's
obligations under the New Watson Note are guaranteed by Houba, Inc. and Axiom
Pharmaceutical Corporation, each a wholly-
22
owned subsidiary of the Company, which guarantees are secured by all assets of
such subsidiary, and, in the case of Houba, Inc., by a mortgage lien on its real
property located in Culver, Indiana.
Purchase of the New Watson Note
Simultaneous with the issuance of the New Watson Note, each of the Lead
2004 Investors and the other investors in the 2004 Debentures at the initial
closing of the 2004 Purchase Agreement on February 10, 2004 (collectively, the
"Watson Note Purchasers") purchased the New Watson Note from Watson in
consideration for a payment to Watson of $1.0 million. The New Watson Note is
secured by a first lien on all of the Company's and its subsidiaries' assets,
senior to the lien securing the Outstanding Debentures and all other Company
indebtedness, carries a floating rate of interest equal to the prime rate plus
4.5% and matures on June 30, 2007. The rate of interest at June 30, 2004 was
8.50%. Effective July 1, 2004, the interest rate became 8.75% as a result of the
increase in the prime rate of interest.
NOTE 10 - INCOME TAXES
The Company has not provided for any tax expense during the six months
ended June 30, 2004, as a result of utilizing net operating loss carry forwards
not previously provided for. Historically, the Company has incurred significant
losses from operations and until such time as the research and development
efforts are commercialized, for which no assurance can be given, the Company
will continue to incur operating losses.
NOTE 11 - COMMITMENTS AND CONTINGENCIES
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.
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 (the "Letter 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 provides for 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, 2003, the
Company was current in its payment obligations, with a remaining obligation of
$433,000. In February 2004, the Company fully satisfied its obligation to the
DOJ under the Letter Agreement.
Employment Contracts
During April 2004, the Company entered into an employment agreement
with a new officer/employee of the Company. The agreement provides for, among
other things: (i) an annual base salary of $260,000, and (ii) an aggregate of
3,000,000 options to purchase the Company's stock at an exercise price of $0.13
per common share that vest 1,000,000 option shares on October 1, 2004 and the
balance thereafter at a rate of 333,333 per calendar quarter,
23
beginning January 1, 2005 with an exercise term expiring in ten years. The stock
option is subject to the shareholders approval to modify the Company's 1998
Stock Option Plan to (i) increase the number of shares reserved for issuance and
(ii) authorize issuance of stock options having an exercise price less than fair
market value of the common stock of the Company on the date of issuance. The
employment agreement term is for a two year period, which automatically renews
for successive one-year periods unless either the Company or the employee
provides 90 days' notice of non-renewal.
During August 2003, the Company entered into an employment agreement with
a new officer/employee of the Company. The agreement provides for, among other
things: (i) an annual base salary of $300,000, and (ii) the commitment to issue
an aggregate of 5,500,000 options to purchase the Company's stock at an exercise
price of $0.34 per common share that vest 1,000,000 option shares on March 31,
2004 and the balance thereafter at a rate of 500,000 per calendar quarter,
beginning June 30, 2004 which an exercise term expiring in ten years. The stock
option is subject to the shareholders approval to modify the Company's 1998
Stock Option Plan to (i) increase the number of shares reserved for issuance and
(ii) authorize issuance of stock options having an exercise price less than fair
market value of the common stock of the Company on the date of issuance. The
employment agreement term is for a two year period, which automatically renews
for successive one-year periods unless either the Company or the employee
provides 90 days' notice of non-renewal. In May 2004, such employment agreement
was amended, among other things, to adjust the Company's commitment to issue
stock options from 5,500,000 shares to 8,750,000 shares and to provide for an
exercise price of $0.13 per share. Upon grant, the option will have a ten-year
term and will provide for vesting in the amount of 2,750,000 shares on June 30,
2004 and the balance thereafter at a rate of 250,000 shares per calendar month,
beginning July 31, 2004.
During April 2004, the Company committed to issue to current employees
stock options that upon grant, will be exercisable for an aggregate of 1,425,000
shares of the Company's common stock at an exercise price of $0.13 per common
share and will vest 25% annually over four years and provide for immediate
vesting upon change of control. The grant of these stock options is subject to
the shareholders approval to modify the Company's 1998 Stock Option Plan to (i)
increase the number of shares reserved for issuance and (ii) authorize issuance
of stock options having an exercise price less than fair market value of the
common stock of the Company on the date of issuance.
Stock Option Grants to Board Members
On June 26, 2004, the Company committed to issue to the members of its
board of directors, including the Independent Committee of the Board, stock
options that upon grant or complete vesting, will be exercisable for an
aggregate of 1,100,000 shares of the Company's common stock at an exercise price
equal to the fair market value of the Company's Common Stock on the date of
grant. With the exception of stock options to purchase an aggregate of 200,000
shares of the Company's Common Stock, all options are fully vested at the time
of grant. Options to purchase an aggregate of 200,000 shares of the Company's
Common Stock will vest 25% quarterly over one year. The grant of all stock
options is subject to the shareholders approval to modify the Company's 1998
Stock Option Plan.
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 and the insurance carrier is defending each action. Plaintiffs in the
pending litigations seek unspecified damages. The Company does 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.
24
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 $1.0 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 is complete. The Company's motion for summary judgment was due to be
heard by the Court on August 8, 2003. Plaintiff Kohn deceased shortly prior to
such hearing date, and the motion for summary judgment and any trial of this
matter have been stayed pending the substitution of Mr. Kohn's estate as the
plaintiff. 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.
On June 13, 2002, the Company was named an additional defendant in an
Amended Complaint filed in the matter entitled Vintage Pharmaceuticals, Inc., v.
Watson Pharmaceuticals, Inc., and Halsey Drug Company, Inc., pending in the
United States District Court for the Northern District of Alabama, Civil Action
No. CV 01-B-1847-NE. Vintage seeks unspecified damages from the Company for
allegedly interfering with Vintage's contract to produce Monodox(R), the brand
name of doxycycline monohydrate, for Watson. During the first quarter of 2004,
Watson's motion for summary judgment was approved by the Court and the case was
dismissed against Watson. On May 4, 2004, the Court issued an order in favor of
the Company dismissing the case with prejudice. On May 14, 2004, Vintage filed
for appeal of each of these rulings. The Company does not believe such 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.
25
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003
NET PRODUCT REVENUES
The Company's net product revenues for the six months ended June 30, 2004
and June 30, 2003 were as follows (in thousands):
6/30/04 6/30/03 6/30/04-6/30/03 6/30/04-6/30/03
NET PRODUCT NET PRODUCT NET PRODUCT NET PRODUCT
REVENUES REVENUES REVENUE CHANGE REVENUE CHANGE
($) (%)
- -----------------------------------------------------------------------------
$ 838 $ 2,732 ($ 1,894) (69%)
The decrease in net product revenues was primarily a result of the
Company's decision to restructure operations and cease the manufacture of
finished dosage generic pharmaceutical products. The net product revenues in the
second quarter of 2004 reflect the sale of all remaining inventories of saleable
finished dosage generic pharmaceutical products.
COST OF MANUFACTURING
The Company's cost of manufacturing for the six months ended June 30, 2004
and June 30, 2003 were as follows (in thousands):
6/30/04 6/30/03 6/30/04-6/30/03 COST OF 6/30/04-6/30/03 COST OF
COST OF COST OF MANUFACTURING MANUFACTURING
MANUFACTURING MANUFACTURING CHANGE CHANGE
($) (%)
- --------------------------------------------------------------------------------------------------
$ 1,437 $ 5,138 ($ 3,701) (72%)
For the six months ending 6/30/04 cost of manufacturing includes fixed
costs of the Company's generic finished dosage manufacturing operations in the
first quarter of 2004. The generic finished dosage manufacturing operations were
discontinued in March, 2004.
RESEARCH AND DEVELOPMENT EXPENSES
The Company's research and development expenses for the six months ended
June 30, 2004 and June 30, 2003 were as follows (in thousands):
26
6/30/04 6/30/03 6/30/04-6/30/03 6/30/04-6/30/03
R&D EXPENSES R&D EXPENSES R&D EXPENSES CHANGE R&D EXPENSES CHANGE
($) (%)
- --------------------------------------------------------------------------------------------------------------
$ 1,242 $ 616 $ 626 102%
The increase in R&D expenses is primarily related to the Company's
strategic decision to devote a major portion of its resources in 2004 to
research and development activities relating to its ADF Technologies and to a
lessor extent to its Opioid Synthesis Technologies.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the six months ended June
30, 2004 and 2003 were as follows (in thousands):
6/30/04 6/30/03 6/30/04-6/30/03 6/30/04-6/30/03
S, G&A EXPENSES S, G&A EXPENSES S, G&A EXPENSES CHANGE S, G&A EXPENSES CHANGE
($) (%)
- ----------------------------------------------------------------------------------------------------------------
$ 2,363 $ 3,917 ($ 1,554) (40%)
The decrease is due primarily to a reduction in sales and marketing expenses of
$33, reduced general and administrative expenses of $477, and reduced payroll
and payroll related expenses of $852 resulting from the Company's decision to
discontinue the marketing and sale of generic finished dosage products and
reduce administrative staff, as well as a $192 benefit for settlement of trade
payables at a discount.
ENVIRONMENTAL COMPLIANCE EXPENSES
During the six months ended June 30, 2004 and June 30, 2003, the Company
incurred the following expenses in connection with environmental compliance (in
thousands):
6/30/04 6/30/03 6/30/04-6/30/03 6/30/04-6/30/03
ENVIRONMENTAL COMPLIANCE ENVIRONMENTAL ENVIRONMENTAL COMPLIANCE ENVIRONMENTAL COMPLIANCE
EXPENSES COMPLIANCE EXPENSES EXPENSES CHANGE EXPENSES CHANGE
($) (%)
- ------------------------------------------------------------------------------------------------------------------
$ 180 $ 121 $ 59 49%
The environmental compliance expenses relate primarily to disposal of
hazardous and controlled substances waste and related personnel costs for
environmental compliance.
27
INTEREST EXPENSE, NET OF INTEREST INCOME
The Company's interest expense, net of interest income for the six months
ended June 30, 2004 and June 30, 2003 was as follows (in thousands):
6/30/04 6/30/03 6/30/04-6/30/03 6/30/04-6/30/03
INTEREST EXPENSE, NET OF INTEREST EXPENSE, NET OF INTEREST EXPENSE, NET OF INTEREST EXPENSE, NET OF
INTEREST INCOME INTEREST INCOME INTEREST INCOME CHANGE INTEREST INCOME CHANGE
($) (%)
- -----------------------------------------------------------------------------------------------------------------
$ 2,130 $ 2,883 ($ 753) (26%)
The change in the interest expense, net of interest income reflects the
interest savings from the restructuring of the Company's term note indebtedness
to Watson Pharmaceuticals.
AMORTIZATION OF DEFERRED DEBT DISCOUNT AND PRIVATE OFFERING COSTS
The Company's deferred debt discount and private offering costs for the
six months ended June 30, 2004 and June 30, 2003 were as follows (in thousands):
6/30/04 6/30/03 6/30/04-6/30/03 6/30/04-6/30/03
DEFERRED DEBT DISCOUNT AND DEFERRED DEBT DISCOUNT AND DEFERRED DEBT DISCOUNT DEFERRED DEBT DISCOUNT AND
PRIVATE OFFERING COSTS PRIVATE OFFERING COSTS AND PRIVATE OFFERING PRIVATE OFFERING COSTS
COSTS CHANGE CHANGE
($) (%)
- ------------------------------------------------------------------------------------------------------------------
$ 24,655, consisting of $ 11,683, consisting of $ 12,972 111%
- $ 234 private - $ 306 private
offering costs offering costs
- $ 24,421 deferred - $ 11,377 deferred
debt discount debt discount
The change in the deferred debt discount and private offering costs of the
Company reflects the additional amortization of the debt discount incurred from
the Company's 2004 financings.
NET LOSS
The Company's net loss for the six months ended June 30, 2004 and June 30,
2003 was as follows (in thousands):
6/30/04 6/30/03 6/30/04-6/30/03 6/30/04-6/30/03
NET LOSS NET LOSS NET LOSS NET LOSS
CHANGE CHANGE
($) (%)
- ----------------------------------------------------------------------------------------------------------
($ 16,432) ($ 21,602) ($ 5,170) (24%)
28
Included in the net loss for the six months ending 6/30/04 are gains on
debt restructuring of $12,401 and asset sales of $1,755 and other income of $401
relating to settlement of a liability at a discount.
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2004 AND 2003
NET PRODUCT REVENUES
The Company's net product revenues for the three months ended June 30,
2004 and June 30, 2003 were as follows (in thousands):
3 MONTHS ENDED 3 MONTHS ENDED 3 MONTHS ENDED 3 MONTHS ENDED
6/30/04 6/30/03 6/30/04- 6/30/03 6/30/04-6/30/03
NET PRODUCT REVENUES NET PRODUCT NET PRODUCT NET PRODUCT
REVENUES REVENUE CHANGE REVENUE CHANGE
($) (%)
- ------------------------------------------------------------------------------------------------------------------
$ 210 $ 1,206 ($ 996) (83%)
The decrease in net product revenues was primarily a result of the
Company's decision to restructure operations and cease the manufacture of
finished dosage generic pharmaceutical products. The net product revenues in the
second quarter of 2004 reflect the sale of all remaining inventories of saleable
finished dosage products.
COST OF MANUFACTURING
The Company's cost of manufacturing for the three months ended June 30,
2004 and June 30, 2003 were as follows (in thousands):
3 MONTHS ENDED 6/30/04 3 MONTHS ENDED 6/30/03 3 MONTHS ENDED 3 MONTHS ENDED
COST OF MANUFACTURING COST OF MANUFACTURING 6/30/04-6/30/03 COST OF 6/30/04-6/30/03 COST OF
MANUFACTURING MANUFACTURING
CHANGE CHANGE
($) (%)
- -----------------------------------------------------------------------------------------------------------------
$ 184 $ 2,265 ($ 2,081) (92%)
For the three months ending 6/30/04 cost of manufacturing includes
residual fixed costs of associated with the Company's generic finished dosage
manufacturing operations in the first quarter of 2004. The generic finished
dosage manufacturing operations were discontinued in March, 2004.
RESEARCH AND DEVELOPMENT EXPENSES
The Company's research and development expenses for the three months ended
June 30, 2004 and June 30, 2003 were as follows (in thousands):
29
3 MONTHS ENDED 3 MONTHS ENDED 3 MONTHS ENDED 3 MONTHS ENDED
6/30/04 6/30/03 6/30/04-6/30/03 6/30/04-6/30/03
R&D EXPENSES R&D EXPENSES R&D EXPENSES CHANGE R&D EXPENSES CHANGE
($) (%)
- ---------------------------------------------------------------------------------------------------------------
$ 1,004 $ 287 $ 717 250%
The increase in R&D expenses is primarily related to the Company'
strategic decision to devote a large portion of its resources in 2004 to
research and development activities relating to its ADF Technologies and to a
lessor extent to its Opioid Synthesis Technologies.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the three months ended
June 30, 2004 and 2003 were as follows (in thousands):
3 MONTHS ENDED 6/30/04 3 MONTHS ENDED 6/30/03 3 MONTHS ENDED 3 MONTHS ENDED
S, G&A EXPENSES S, G&A EXPENSES 6/30/04-6/30/03 6/30/04-6/30/03
S, G&A EXPENSES CHANGE S, G&A EXPENSES CHANGE
($) (%)
- ------------------------------------------------------------------------------------------------------------------
$ 1,142 $ 2,206 ($ 1,064) (48%)
The decrease is due primarily to a reduction in sales and marketing
expenses of $42, reduced general and administrative expenses of $239, and
reduced payroll and payroll related expenses of $783 resulting from the
Company's decision in the fourth quarter of 2003 to eliminate the sale of
generic finished dosage products and reduce administrative staff.
ENVIRONMENTAL COMPLIANCE EXPENSES
During the three months ended June 30, 2004 and June 30, 2003, the Company
incurred the following expenses in connection with environmental compliance (in
thousands):
3 MONTHS ENDED 6/30/04 3 MONTHS ENDED 6/30/03 3 MONTHS ENDED 3 MONTHS ENDED
ENVIRONMENTAL COMPLIANCE ENVIRONMENTAL 6/30/04-6/30/03 6/30/04-6/30/03
EXPENSES COMPLIANCE EXPENSES ENVIRONMENTAL COMPLIANCE ENVIRONMENTAL COMPLIANCE
EXPENSES CHANGE EXPENSES CHANGE
($) (%)
- ------------------------------------------------------------------------------------------------------------------
$ 83 $ 36 $ 47 131%
The environmental compliance expenses relate to disposal of hazardous and
controlled substances waste and related personnel costs for environmental
compliance...
30
INTEREST EXPENSE, NET OF INTEREST INCOME
The Company's interest expense, net of interest income for the three
months ended June 30, 2004 and June 30, 2003 was as follows (in thousands):
3 MONTHS ENDED 6/30/04 3 MONTHS ENDED 6/30/03 3 MONTHS ENDED 3 MONTHS ENDED
INTEREST EXPENSE, NET OF INTEREST EXPENSE, NET OF 6/30/04-6/30/03 6/30/04-6/30/03
INTEREST INCOME INTEREST INCOME INTEREST EXPENSE, NET OF INTEREST EXPENSE, NET OF
INTEREST INCOME CHANGE INTEREST INCOME CHANGE
($) (%)
- ------------------------------------------------------------------------------------------------------------------
$ 1,179 $ 1,467 ($ 288) (20%)
The change in the interest expense, net of interest income reflects the
interest savings from the restructuring of the Company's term note indebtedness
to Watson Pharmaceuticals.
AMORTIZATION OF DEFERRED DEBT DISCOUNT AND PRIVATE OFFERING COSTS
The Company's deferred debt discount and private offering costs or the
three months ended June 30, 2004 and June 30, 2003 were as follows (in
thousands):
3 MONTHS ENDED 6/30/04 3 MONTHS ENDED 6/30/03 3 MONTHS ENDED 3 MONTHS ENDED
DEFERRED DEBT DISCOUNT AND DEFERRED DEBT DISCOUNT AND 6/30/04-6/30/03 6/30/04-6/30/03
PRIVATE OFFERING COSTS PRIVATE OFFERING COSTS DEFERRED DEBT DISCOUNT DEFERRED DEBT DISCOUNT AND
AND PRIVATE OFFERING PRIVATE OFFERING COSTS
COSTS CHANGE CHANGE
($) (%)
- -------------------------------------------------------------------------------------------------------------------
$ 13,812, consisting of $ 5,916, consisting of $ 7,896 134%
- $ 136 private - $ 228 private
offering costs offering costs
- $ 13,676 deferred - $ 5,688 deferred
debt discount debt discount
The change in the deferred debt discount and private offering costs of the
Company reflects the amortization of the debt discount incurred from the
Company's 2004 financings.
31
NET LOSS
The Company's net loss for the three months ended June 30, 2004 and June
30, 2003 was as follows (in thousands):
3 MONTHS ENDED 6/30/04 3 MONTHS ENDED 6/30/03 3 MONTHS ENDED 3 MONTHS ENDED
NET LOSS NET LOSS 6/30/04-6/30/03 6/30/04-6/30/03
NET LOSS CHANGE NET ILOSS CHANGE
($) (%)
- ------------------------------------------------------------------------------------------------------------------
($ 17,112) ($ 11,027) $ 6,085 55%
Included in the net loss for the 3 months ending 6/30/04 is a gain on asset
sales of $1 and other expenses of $2.
LIQUIDITY AND CAPITAL RESOURCES
Overview
In November 2003, the Company commenced the restructuring of its
operations to focus its efforts on research and development relating to certain
proprietary technologies and to provide for the cessation of operations, and the
sale of assets, relating to the manufacture and distribution of finished dosage
generic products conducted at the Company's Congers, New York facilities (the
"Congers Facilities").
In order to fund continuing operations and the research and development of
the Company's proprietary technologies, on February 6, 2004, the Company
completed a private offering of debentures in the aggregate principal amount of
approximately $12.3 million (the "2004 Debenture Offering"). As part of the
completion of the 2004 Debenture Offering, the Company retired approximately
$16.4 million in indebtedness under the Company's $21.4 million term loan with
Watson Pharmaceuticals.
On April 14, 2004 and May 26, 2004 the Company completed additional
funding under the 2004 Debenture Offering in the principal amount of
approximately $1.7 million resulting in the aggregate principal amount of
convertible secured debentures issued as part of the 2004 Debenture Offering of
$14.0 million.
Additionally, on February 18, 2004 and March 19, 2004, the Company
contracted for the sale of certain of its assets. Specifically, on February 18,
2004, the Company sold certain of its inactive, non-revenue generating ANDAs to
Mutual Pharmaceutical Company, Inc. in consideration of $2.0 million. On March
19, 2004, the Company and its wholly-owned subsidiary, Axiom Pharmaceutical
Corporation, entered into an Asset Purchase Agreement with IVAX Pharmaceuticals
New York LLC ("IVAX") pursuant to which the Company and Axiom agreed to sell to
IVAX substantially all of the Company's assets used in the operation of the
Congers Facilities in consideration of $2.5 million.
Company's Present Financial Condition and Commercial Focus
At June 30, 2004 the Company had cash and cash equivalents of $6,583,000
as compared to $942,000 at December 31, 2003. The Company had a working capital
deficit of $10,978,000 at June 30, 2004 and a working capital deficit of
$3,770,000 at December 31, 2003. The Company had an accumulated deficit of
$225,977,000 and $209,545,000 as June 30, 2004 and December 31, 2003,
respectively. The Company had an operating loss of $4,204,000 for the six months
ended June 30, 2004.
In implementing the restructuring adopted by the Board, the Company has
transitioned to a single vertically integrated operations facility located in
Culver, Indiana. The Company's strategy and key activities to be conducted at
the Culver Facility are as follows:
- Development of the Company's ADF Technology for use in orally
administered opioid finished dosage product candidates.
- Manufacture and quality assurance release of clinical trial
supplies of certain finished dosage form product candidates utilizing the
ADF Technology.
- Evaluation of certain finished dosage product candidates utilizing
the ADF Technology in
32
clinical trials.
- Scale-up and manufacture of commercial quantities of certain
product candidates utilizing the ADF Technology for sale by the Company's
licensees.
- Research, development and scale up of the Company's Opioid
Synthesis Technologies.
- Prosecution of the Company's application to the DEA to for
registration to import NRMs for use in the production of opioid API's
utilizing the Company's Opioid Synthesis Technologies.
- Negotiating and executing license and development agreements with
strategic pharmaceutical company partners providing that such licensees
will further develop certain finished dosage product candidates utilizing
the ADF Technology, file for regulatory approval with the FDA and other
regulatory authorities and commercialize such products.
2004 Debenture Offering
On February 10, 2004, the Company consummated a private offering of
convertible senior secured debentures (the "2004 Debentures") in the aggregate
principal amount of approximately $12.3 million (the "2004 Debenture Offering").
The 2004 Debentures were issued by the Company pursuant to a certain Debenture
and Share Purchase Agreement dated as of February 6, 2004 (the "2004 Purchase
Agreement") by and among the Company, Care Capital, Essex, Galen and each of the
purchasers listed on the signature page thereto. As the conversion price of such
debentures was less than the fair market value of the Company's common stock on
the date of issue, beneficial conversion features were determined to exist. The
Company recorded approximately $12.3 million of debt discount limited to the
face amount of the new debt, which is being amortized over the life of the debt,
which matures July 31, 2004, subject to automatic extension up to October 31,
2004 to allow for the completion of the Company's 2004 Annual Meeting of
Shareholders. During the six months ended June 30, 2004, the Company recognized
approximately $3.8 million of amortization expense from this transaction.
Additional Funding under 2004 Debenture Offering
On April 14, 2004, the Company completed an additional closing under the
2004 Purchase Agreement pursuant to which the Company issued additional 2004
Debentures in the aggregate principal amount of approximately $0.6 million,
bringing the aggregate principal amount of 2004 Debentures issued by the Company
under the 2004 Purchase Agreement to $12.9 million. As the conversion price of
such debentures was less than the fair market value of the Company's common
stock on the date of issue, beneficial conversion features were determined to
exist. The Company recorded approximately $0.6 million of debt discount limited
to the face amount of the new debt, which will be amortized over the life of the
debt, which matures July 31, 2004, subject to automatic extension up to October
31, 2004 to allow for the completion of the Company's 2004 Annual Meeting of
Shareholders.
On May 26, 2004, the Company completed an additional closing under the
2004 Purchase Agreement pursuant to which the Company issued additional 2004
Debentures in the aggregate principal amount of approximately $1.1 million,
bringing the aggregate principal amount of 2004 Debentures issued by the Company
under the 2004 Purchase Agreement to $14.0 million. As the conversion of such
debentures was less than the fair market value of the Company's common stock on
the date of issue, beneficial conversion features were determined to exist. The
Company recorded approximately $1.1 million of debt discount limited to the face
amount of the new debt, which will be amortized over the life of the debt, which
matures July 31, 2004, subject to automatic extension up to October 31, 2004 to
allow for the completion of the Company's 2004 Annual Meeting of Shareholders.
Source and Amount of Funding under 2004 Purchase Agreement
Of the $14.0 million in 2004 Debentures issued in the 2004 Debenture
Offering, approximately $2.0 million
33
of 2004 Debentures were issued in exchange for the surrender of like amount of
principal plus accrued interest outstanding under Company's 5% convertible
senior secured debentures issued pursuant to working capital bridge loan
transactions with Care Capital, Essex and Galen during November and December,
2003.
Amendment to 2004 Purchase Agreement
The 2004 Purchase Agreement provided for the issuance by the Company of
convertible senior secured debentures in the aggregate principal amount of $14.0
million to be completed no later than June 5, 2004. On June 1, 2004, an
Amendment to the 2004 Purchase Agreement was executed providing for (i) an
increase the principal amount of debentures issuable by the Company under the
2004 Purchase Agreement from $14.0 million to $17.5 million, and (ii) an
extension of the time to complete this additional financing from June 5, 2004 to
June 30, 2004 (the "2004 Purchase Agreement Amendment"). No additional 2004
Debentures were issued following the 2004 Purchase Agreement Amendment.
Terms of 2004 Debentures
The 2004 Debentures, issued at par, bear interest at the rate of 1.62% per
annum, the short-term Applicable Federal Rate on February 6, 2004. The 2004
Debentures are secured by a lien on all assets of the Company. In addition, each
of Houba, Inc. and Axiom Pharmaceutical Corporation, each a wholly-owned
subsidiary of the Company, has executed in favor of the 2004 Debenture holders,
an unconditional agreement of guaranty of the Company's obligations under the
2004 Purchase Agreement. Each guaranty is secured by all assets of such
subsidiaries. In addition, the Company has pledged the stock of each such
subsidiary to the holders of the 2004 Debentures to further secure its
obligations under the 2004 Purchase Agreement.
Subordination of Lien of Holders of 2004 Debentures to the Lien Under the Watson
Term Loan Agreement
In accordance with the terms of an Amended and Restated Subordination
Agreement dated as of February 6, 2004 between the Company, the holders of the
2004 Debentures and the holders of the Company's other outstanding debentures,
the liens on the Company's and its subsidiary's assets as well as the payment
priority of the 2004 Debentures are (i) subordinate to the Company's lien and
payment obligations in favor of Watson Pharmaceuticals under the Watson Term
Loan Agreement, and (ii) senior to the Company's lien and payment obligations in
favor of the holders of the Company's other outstanding debentures in the
aggregate principal amount of approximately $86.6 million.
Conversion of 2004 Debentures into Series A Preferred Stock
The 2004 Debentures (including the principal amount plus interest accrued
at the date of conversion) will convert automatically into the Company's Series
A convertible preferred stock (the "Series A Preferred") immediately following
the Company's receipt of shareholder approval at its next shareholders' meeting
to restate the Company's Certificate of Incorporation (the "Charter Amendment")
to authorize the Series A Preferred and the Junior Preferred Shares (as
described below) and the filing of the Charter Amendment with the Office of the
New York Department of State (the date of such filing, the "Charter Amendment
Filing Date"), as provided in the 2004 Purchase Agreement. The 2004 Debentures
will convert into Series A Preferred at a price per share (the "Series A
Conversion Price") of $0.6425, representing the average of the closing bid and
asked prices of the Company's Common Stock for the twenty (20) trading days
ending February 4, 2004, as reported by the Over-the-Counter ("OTC") Bulletin
Board. The Series A 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 Series A Conversion Price.
Based on the $0.6425 Series A Conversion Price of the Series A Shares and
estimating the interest accrual
34
under the 2004 Debentures prior to the Charter Amendment Filing Date, the 2004
Debentures with an aggregate principal amount of $14 million would be
convertible into an aggregate of approximately 22 million Series A Preferred
shares.
Series A Preferred Stock Liquidation Preference, Conversion Right and
Participation Right
In general, the Series A Preferred shares have a liquidation preference
equal to five (5) times the initial $0.6425 Series A Conversion Price (the
"Series A Liquidation Preference"). In addition, the Series A Preferred shares
are convertible into the Company's Common Stock, with each Series A Preferred
share convertible into the number of shares of Common Stock obtained by dividing
(i) the Series A Liquidation Preference, by (ii) the $0.6425 Series A Conversion
Price, as such conversion price may be adjusted, from time to time, pursuant to
the dilution protections of such shares. Without limiting the Series A
Liquidation Preference, the holders of Series A Preferred shares also have the
right to participate with the holders of the Company's Common Stock upon the
occurrence of a liquidation event, including the Company's merger, sale of all
or substantially all of its assets or a change of control transaction, on an
as-converted basis (but for these purposes only, assuming the Series A Preferred
shares to be convertible into only thirty percent (30%) of the shares of Common
Stock into which they are otherwise then convertible). The holders of Series A
Preferred shares also have the right to vote as part of a single class with all
holders of the Company's voting securities on all matters to be voted on by such
security holders. Each holder of Series A Preferred shares will have such number
of votes as shall equal the number of votes he would have had if such holder
converted all Series A Preferred shares held by such holder into shares of
Common Stock immediately prior to the record date relating to such vote.
Nomination of Directors to the Company's Board of Directors by the Lead 2004
Investors
The 2004 Purchase Agreement provides that each of Care Capital, Essex and
Galen (collectively, the "Lead 2004 Investors") has the right to designate for
nomination one member of the Company's Board of Directors, and that the Lead
Investors collectively may designate one additional member of the Board
(collectively, the Designees"). The Purchase Agreement further provides that the
Designees, if so requested by such Designee in his sole discretion, shall be
appointed to the Company's Executive Committee, Compensation Committee and any
other Committee of the Board of Directors. The Designees of Care Capital, Essex
and Galen are Messrs. Karabelas, Thangaraj and Wesson, respectively, each of
whom are current Board members. Effective as of the closing of the 2004 Purchase
Agreement, the Lead 2004 Investors may collectively nominate one additional
Designee to the Board. The Company has agreed to nominate and appoint to the
Board of Directors, subject to shareholder approval, one designee of each of
Care Capital, Essex and Galen, and one collective designee of the Lead 2004
Investors, for so long as each holds a minimum of 50% of the Series A Preferred
shares initially issued to such party (or at least 50% of the shares of Common
Stock issuable upon conversion of the Series A Preferred shares).
Impact of Conversion of the Company's Outstanding Debentures
As of February 6, 2004, the date of the initial closing of the 2004
Purchase Agreement, the Company had issued and outstanding and aggregate of
approximately $86.6 million in principal amount of 5% convertible senior secured
debentures maturing March 31, 2006 issued pursuant to three separate Debenture
Purchase Agreements dated March 10, 1998, as amended (the "1998 Debentures"),
May 26, 1999, as amended (the "1999 Debentures") and December 20, 2002 (the
"2002 Debentures"), respectively. The 1998 Debentures, 1999 Debentures and 2002
Debentures are referred to collectively as the "1998-2002 Debentures". After
giving effect to the Company's issuance of additional 5% convertible senior
secured debentures in satisfaction of interest payments on the 1998-2002
Debentures, as of February 10, 2004, the 1998-2002 Debentures were convertible
into an aggregate of approximately 190.4 million shares of the Company's Common
Stock.
Conversion Agreement of Holders of 1998-2002 Debentures
Simultaneous with the execution of the 2004 Purchase Agreement, and as a
condition to the initial closing
35
of the 2004 Purchase Agreement, the Company, the 2004 Debenture Investor Group
and each of the holders of the 1998-2002 Debentures executed a certain Debenture
Conversion Agreement, dated as of February 6, 2004 (the "Conversion Agreement").
In accordance with the terms of the Conversion Agreement, each holder of the
2004 Debentures agreed to convert the 2004 Debentures held by such holder into
the Company's Series A Preferred shares and each holder of 1998-2002 Debentures
agreed to convert the 1998-2002 Debentures held by such holder into the
Company's Series B convertible preferred stock (the "Series B Preferred") and/or
Series C-1, C-2 and/or C-3 convertible preferred stock (collectively, the
"Series C Preferred"). The Series C Preferred shares together with the Series B
Preferred shares are herein referred to as, the "Junior Preferred Shares", and
the Junior Preferred Shares together with the Series A Preferred, are
collectively referred to as the "Preferred Stock". The Conversion Agreement
provides, among other things, for the automatic conversion of the 2004
Debentures and the 1998-2002 Debentures (collectively, the "Outstanding
Debentures") into the appropriate class of Preferred Stock immediately following
the Company's receipt of shareholder approval to the Charter Amendment
authorizing the creation of the Preferred Stock and the filing of the Charter
Amendment with the Office of the New York Department of State.
Shares of Junior Preferred Stock Resulting from Conversion of 1998-2002
Debentures
Under the Conversion Agreement, the holders of approximately $6.6 million
in principal amount of 2002 Debentures issued during 2003 will convert such 2002
Debentures (plus accrued and unpaid interest) into Series B Preferred Shares. Of
the remaining approximate $80 million in principal amount of the 1998-2002
Debentures, approximately $31.2 million is comprised of 1998 Debentures,
approximately $21.5 million is comprised of 1999 Debentures and approximately
$27.3 million is comprised of 2002 Debentures. The 1998 Debentures will be
converted into Series C-1 Preferred shares. The 1999 Debentures will be
converted into Series C-2 Preferred shares. The remaining balance of the 2002
Debentures shall be converted into Series C-3 Preferred shares.
Shares of Common Stock Resulting from Conversion of Junior Preferred Shares
The number of Junior Preferred Shares to be received by each holder of
1998-2002 Debentures is based on the respective prices at which the 1998-2002
Debentures were convertible into Common Stock. The 2002 Debentures issued in
2003 have a conversion price of $0.3420 per share. The 1998 Debentures, 1999
Debentures and the remaining balance of the 2002 Debentures have conversion
prices of $0.5776, $0.5993 and $0.3481 per share, respectively. Based on the
respective conversion prices of the 1998-2002 Debentures, and estimating the
interest accrual on the 1998-2002 Debentures prior to the Charter Amendment
Filing Date, the 1998-2002 Debentures are convertible into an aggregate of
approximately 20.0 million Series B Preferred shares, 56.5 million Series C-1
Preferred shares, 37.5 million Series C-2 Preferred shares and 80.9 million
Series C-3 Preferred shares.
Liquidation Preference of Junior Preferred Shares
In general, the Junior Preferred Shares have a liquidation preference
equal to one (1) time the principal amount plus accrued and unpaid interest of
the 1998-2002 Debentures converted into Junior Preferred Shares The liquidation
preference of the Series B Preferred has priority over, and will be satisfied
prior to, the liquidation preference of the Series C Preferred. The liquidation
preference for each class of the Junior Preferred Shares is equal to the
conversion prices of such shares. The Junior Preferred Shares are convertible
into the Company's Common Stock, with each Junior Preferred Share convertible
into one share of Common Stock. The holders of the Junior Preferred Shares have
the right to vote as part of the single class with all holders of the Company's
Common Stock and the holders of the Series A Preferred on all matters to be
voted on by such stockholders, with each holder of Junior Preferred Shares
having such number of votes as shall equal the number of votes he would have had
if such holder had converted all Junior Preferred Shares held by such holder
into Common Stock immediately prior to the record date relating to such vote.
Amendment to Watson Term Loan Agreement
The Company was a party to a certain loan agreement with Watson
Pharmaceuticals ("Watson") pursuant to
36
which Watson made term loans to the Company (the "Watson Term Loan Agreement")
in the aggregate principal amount of $21.4 million as evidenced by two
promissory notes (the "Watson Notes"). It was a condition to the completion of
the 2004 Debenture Offering that simultaneous with the closing of the 2004
Purchase Agreement, the Company shall have paid Watson the sum of approximately
$4.3 million (which amount was funded from the proceeds of the 2004 Debenture
Offering) and conveyed to Watson certain Company assets in consideration for
Watson's forgiveness of approximately $16.4 million of indebtedness under the
Watson Notes. A part of such transaction, the Watson Notes were amended to
extend the maturity date of such notes from March 31, 2006 to June 30, 2007, to
provide for satisfaction of future interest payments under the Watson Notes in
the form of the Company's Common Stock, to reduce the principal amount of the
Watson Notes from $21.4 million to $5.0 million, and to provide for the
forbearance from the exercise of rights and remedies upon the occurrence of
certain events of default under the Watson Notes (the Watson Notes as so
amended, the "New Watson Note"). Simultaneous with the issuance of the New
Watson Note, each of the Lead 2004 Investors and the other investors in the 2004
Debentures as of February 10, 2004 (collectively, the "Watson Note Purchasers")
purchased the New Watson Note from Watson in consideration for a payment to
Watson of $1.0 million.
In addition to Watson's forgiveness of approximately $16.4 million under
the Watson Notes, as additional consideration for the Company's payment to
Watson of approximately $4.3 million and the Company's conveyance of certain
Company assets, all supply agreements between the Company and Watson were
terminated and Watson waived the dilution protections contained in the Common
Stock purchase warrant dated December 20, 2002 exercisable for approximately
10.7 million shares of the Company's Common Stock previously issued by the
Company to Watson, to the extent such dilution protections were triggered by the
transactions provided in the 2004 Debenture Offering.
Terms of the New Watson Note
The New Watson Note in the principal amount of $5.0 million as purchased
by the Watson Note Purchasers is secured by a first lien on all of the Company's
and its subsidiaries' assets, senior to the lien securing the Outstanding
Debentures and all other Company indebtedness, carries a floating rate of
interest equal to the prime rate plus 4.5% and matures on June 30, 2007.
Net Proceeds from the 2004 Debenture Offering
After giving effect to the payment to Watson of approximately $4.3 million
to restructure the Watson Term Loan and the payment of legal and other
professional fees relating to the 2004 Debenture Offering, the Company realized
net proceeds from the 2004 Debenture Offering of approximately $7.3 million (the
"2004 Debenture Offering Proceeds").
Sale of Certain Company Assets to Mutual
On February 18, 2004, the Company and Mutual Pharmaceutical Company, Inc.
("Mutual") entered into a certain Asset Purchase Agreement (the "Mutual Asset
Purchase Agreement"). Pursuant to the terms of the Mutual Asset Purchase
Agreement, the Company sold certain inactive, non-revenue generating ANDAs to
Mutual in consideration of $2.0 million. The ANDAs sold to Mutual are set forth
below.
THERAPEUTIC CATEGORY APPROXIMATE NUMBER OF ANDAS
- ------------------------------------------------------------------
Analgesic 29
- ------------------------------------------------------------------
Anti-Infective 14
- ------------------------------------------------------------------
Antihypertensive/Cardiac 32
- ------------------------------------------------------------------
Antihistamine 6
- ------------------------------------------------------------------
Steroid 12
- ------------------------------------------------------------------
Cough & Cold 7
- ------------------------------------------------------------------
Central Nervous System 42
- ------------------------------------------------------------------
Other 10
- ------------------------------------------------------------------
37
The Company's decision to divest the above generic product ANDAs was based
on (i) the Company's revised business strategy which focuses on research and
development of novel and proprietary abuse deterrent formulation technology and
opioid active pharmaceutical ingredient synthesis technologies, (ii) the Company
had ceased operations at its finished dosage generic product manufacturing and
packaging facilities and was in the process of negotiating for the sale of such
facilities and (iii) these ANDAs were inactive, non revenue producing generic
product ANDAs which had never been qualified for manufacturing or commercial
distribution in the Company's Congers, NY generic product manufacturing
facilities. These ANDAs were therefore not deemed to be operating assets of the
Company.
Sale of Certain Company Assets to IVAX
On March 19, 2004, the Company and its wholly-owned subsidiary, Axiom
Pharmaceutical Corporation, entered into an Asset Purchase Agreement with IVAX
Pharmaceuticals New York LLC ("IVAX"). Pursuant to the Purchase Agreement, the
Company and Axiom agreed to sell to IVAX substantially all of the Company's
assets used in the operation of the Company's former generic manufacturing and
packaging operations located in Congers, New York in consideration of an
immediate payment of $2.0 million and an additional payment $0.5 million upon
receipt of shareholder approval of the transaction to be sought at the Company's
annual meeting of shareholders to be held on August 12, 2004. Pending
Shareholder approval, the Company has recorded the initial payment of $2.0
million as a short term liability.
After giving effect to the payment of legal and other professional fees
relating to the divestment of the ANDAs to Mutual and the proposed divestment of
certain assets to IVAX, the Company estimates that it will realize aggregate net
proceeds from such transactions of approximately $4.3 million. (the "Asset
Divestment Proceeds")
ADF Technology Research and Development
The Company's primary business focus is the research and development of
proprietary abuse deterrent formulation technologies (the "ADF Technology")
intended to deter the abuse of opioid containing orally administered
prescription products. The ADF technology has been tested in a variety of
non-clinical settings and a patent application was filed with the United States
Patent and Trademarks Office in the fourth quarter of 2003 (see discussion below
under the caption "Patent Applications"). The Company's first product candidate
("ADF Product Candidate #1") resulting from the ADF Technology is a tablet
formulation intended for oral administration. ADF Product Candidate #1 is
currently undergoing required drug stability testing prior to regulatory
submission. To date the Company can provide no assurances that the stability of
ADF Product Candidate #1 will result in a commercially acceptable drug product.
In addition, ADF Product Candidate #1 is also currently under evaluation in a
clinical study to assess the bio-availability of such product candidate in
comparison to a frequently prescribed commercially marketed drug product with
the same opioid active ingredient but without abuse deterrent properties. The
final results from such clinical study are expected to be available in the
second half of 2004. There can be no assurances that ADF Product Candidate #1
will be bio-available or bioequivalent to the extent required to justify
continued clinical testing. To receive marketing authorization for commercial
distribution in the United States, all drug products formulated with the ADF
Technology will require the development, submission and filing of a new drug
application ("NDA") and approval of such application by the U.S. Food and Drug
Administration (the "FDA"). In the event that ADF Product Candidate #1 is stable
and demonstrates acceptable bio-availability, then substantial additional
clinical and non-clinical testing will be required prior to the submission of an
NDA. There can be no assurances that ADF Product Candidate #1 will lead to an
NDA submission or that if an NDA is filed, that the FDA will approve such
regulatory application for commercial distribution.
38
Opioid Synthesis Technology Research and Development
The Company is also engaged in the research, development and scale-up of a
variety of proprietary manufacturing processes for opioid active pharmaceutical
ingredients (the "Opioid Synthesis Technologies") as generally described in the
table below.
APPLICABLE DEA
OPIOID SYNTHESIS STARTING ESTIMATED REGISTRATIONS STATUS OF PATENT
TECHNOLOGY MATERIAL YIELD REQUIRED APPLICATION
- ----------------- ------------ ---------- ----------------- -------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------
Codeine
Oxycodone HCl Phosphate 40 - 50% a) Research One (1) Notice of Allowance issued
- ---------------------------------------------------------------------------------------------------------------------
Process #1 b) Manufacturing One (1) other Patent Pending before the PTO
- ---------------------------------------------------------------------------------------------------------------------
Hydrocodone Codeine Patent Application filed in the second
Bitartrate Phosphate 85% a) Manufacturing quarter of 2004
- ---------------------------------------------------------------------------------------------------------------------
Process #1
- ---------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------
Oxycodone HCl NRMs 68 - 72% a) Research Patent Application filed in July 2004
- ---------------------------------------------------------------------------------------------------------------------
Process #2 b) Manufacturing
- ---------------------------------------------------------------------------------------------------------------------
c) Import
- ---------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------
Patent Application filed in the second
Codeine Phosphate NRMs 90 - 100% a) Research quarter of 2004
- ---------------------------------------------------------------------------------------------------------------------
Process #1 b) Manufacturing
- ---------------------------------------------------------------------------------------------------------------------
c) Import
- ---------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------
Patent Application filed in the second
Codeine Phosphate NRMs 80-90% a) Research quarter of 2004
- ---------------------------------------------------------------------------------------------------------------------
Process #2 b) Manufacturing
- ---------------------------------------------------------------------------------------------------------------------
c) Import
- ---------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------
Patent Application filed in the fourth
Codeine Phosphate NRMs 65-85% a) Research quarter of 2003
- ---------------------------------------------------------------------------------------------------------------------
Process #3 b) Manufacturing
- ---------------------------------------------------------------------------------------------------------------------
c) Import
- ---------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------
Patent Application filed
Hydrocodone Bitartrate Codeine Base 85 - 95% a) Research in the second quarter of 2004
- ---------------------------------------------------------------------------------------------------------------------
Process #2 b) Manufacturing
- ---------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------
Patent Application expected to be
Morphine Sulfate NRMs 96% a) Research filed by the second quarter of 2005
- ---------------------------------------------------------------------------------------------------------------------
b) Manufacturing
- ---------------------------------------------------------------------------------------------------------------------
c) Import
- ---------------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------------
Dihydrocodeine Patent Application filed in the second
Bitartrate Codeine Base >90% a) Research quarter of 2004
- ---------------------------------------------------------------------------------------------------------------------
b) Manufacturing
- ---------------------------------------------------------------------------------------------------------------------
The Company believes at this stage of development that, except for
oxycodone hydrochloride process #1, the Opioid Synthesis Technologies are
efficient and cost-effective methods of manufacturing opioid APIs. The Company
believes that the primary advantages of these processes include a substantial
reduction in the time and
39
number of processing steps required to produce the desired opioid APIs and
reduction of the quantity and/or toxicity of the waste products relating to such
production. The Company believes that at the current manufacturing scale
Hydrocodone Bitartrate Process #1 meets all USP release testing specifications,
provides high yields and high levels of purity compared to competitive
manufacturing processes used for this active ingredient. The development and
documentation of Hydrocodone Process #1 has been completed and the Company
believes such process is ready to be tested at full commercial scale. Until such
time, if any, as the Company secures third-party financing dedicated to scale up
expenses (as defined below under the caption "Hydrocodone Bitartrate Option
Agreement") the Company will be unable to complete the commercial scale up of
the Hydrocodone Bitartrate Process #1 or the other Opioid Synthesis Technologies
in the above table. No assurance can be given that the Company will obtain the
third-party financing necessary to scale-up the Opioid Synthesis Technologies or
that if such financing is obtained, that any one or more of the Opioid Synthesis
Technologies will be capable of commercial scale up.
Patent Applications
To date, the Company has filed seven (7) patents applications with the
United States Patent and Trademark Office ("PTO") and one (1) foreign
application relating to the Opioid Synthesis Technologies including two (2) in
June 2003, one (1) in October 2003 and four (4) in May 2004 and one (1) patent
application relating to the ADF Technology in the fourth quarter of 2003. The
typical review time of a U.S. patent application varies. The initial review
generally occurs approximately 12 to 18 months from date of patent filing. At
the completion of the initial review, the patent examiner will issue an Office
Action letter, which will detail any necessary amendments, supplements or
reasons for the rejection. Subsequent processing of the patent application will
depend on the number of Office Action letters issued and the speed of review of
the Company's responses thereto. If an application is granted, a Notice of
Allowance will be issued, requiring a payment of the issue fee within three (3)
months from the date of the notice. Upon the payment of the fee, the patent
would be issued.
In March 2004 the Company received a notice of allowance from the PTO
relating to one of the patent applications filed in June of 2003. The Company
has paid the issue fee and expects a U.S. patent will be granted from that
application. No assurance can be given, however, that any other currently
pending patent applications or future patent applications relating to the Opioid
Synthesis Technologies will be granted. In addition, the Company is currently
unable to provide any assurance that the U.S. patent application associated with
the ADF Technology will issue, or if such patent issues, that the claims granted
will be sufficiently broad to provide economic value.
Import License Registration
To provide for an economical source of raw materials for the commercial
manufacture of opioids utilizing certain of the Opioid Synthesis Technologies,
the Company filed with the U.S. Drug Enforcement Agency (the "DEA") an
application for registration to import certain narcotic raw materials ("NRMs").
The Company filed its application for registration to import NRMs on January 31,
2001 (the "Import Registration"). Notice of the Company's application was
published in the Federal Register on September 6, 2001. Within the 30 day period
provided under DEA guidelines, three parties, including two companies that the
Company believes are the largest U.S. importers of NRMs requested a hearing to
formally object to the Company's request for an Import Registration. Pursuant to
established procedures, an evidentiary hearing relating to the Company's Import
Registration application was held before a DEA Administrative Law Judge ("ALJ")
in August 2003. The ALJ later re-opened the administrative record, at the
request of opposing parties, to consider the Company's November and December
2003 announcements concerning the Company restructuring and financing
activities. After submission of additional testimony by the Company and certain
of the opposing parties, the ALJ closed the evidentiary record effective May 25,
2004. Additionally, as of August 3, 2004, the Company and the opposing parties
prepared and submitted briefing documents to the ALJ based on the evidentiary
record. With the evidentiary record now closed, the ALJ will make findings of
fact, draw legal conclusions and recommend a specific decision on the Company's
Import Registration application to the DEA and issue a final order relating to
the Company's application. Following the decision of the ALJ, the DEA will judge
whether the issuance of an Import Registration is appropriate. Assuming DEA
grants the Company's application, of which no assurance can be given, the
Company would be permitted to
40
import NRMs upon appropriate notice in the Federal Register. The opposing
parties may challenge the DEA decision to grant the Company's application in an
appropriate Court of Appeals. In such a case, assuming the Company opposes an
appellate challenge, the Company would likely incur additional time delays and
legal expenses prior to the issuance of a final decision by the U.S. Court of
Appeals. Provided the Company continues to seek the Import Registration, the
proceedings will continue through 2004 and beyond.
No assurance can be given that the Company's Import Registration
application will be approved by the DEA or that if granted by DEA, the Import
Registration would be upheld following an appellate challenge. Furthermore, 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 the
development of the Opioid 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 Opioid Synthesis
Technologies.
Hydrocodone Bitartrate Option Agreement
The Company estimates that to scale up its Hydrocodone Bitartrate Process
#1 Opioid Synthesis Technology to desirable commercial scale at its Culver
Facility, additional funding of approximately $7.0 million will be required for
facility improvements, the purchase, installation and validation of new API
manufacturing equipment, environmental waste management compliance, the
preparation of the drug master files for the API to be produced at the facility,
and related direct labor expense (collectively, the "API Scale Up Expenses").
The Company is a party to a certain Hydrocodone Option Agreement dated February
6, 2004 with Watson Pharmaceuticals ("Watson") pursuant to which the Company has
granted Watson a six (6) month exclusive option (the "Hydrocodone Option") to
enter into a supply agreement with the Company for supply of hydrocodone
bitartrate API (the "Hydrocodone API"). If such option is exercised by Watson,
at Watson's sole discretion, of which there can be no assurance, Watson will
fund 50% of the API Scale Up Expenses, up to a maximum of $3.5 million and the
Company has agreed to use commercially reasonable efforts to obtain financing
dedicated to fund its portion of the API Scale Up Expenses. In the event the
Company is unable to secure financing dedicated to fund its portion of the API
Scale Up Expenses, the Hydrocodone Option provides that the parties will discuss
alternatives relating to the scale up of the its Opioid Synthesis Technology for
Hydrocodone API. On August 4, 2004 the Hydrocodone Option Agreement with Watson
expired unexercised.
As described in this Report, no portion of the 2004 Debenture Offering
Proceeds or the Asset Divestment Proceeds is budgeted for the API Scale Up
Expenses. Until such time, if any, as the Company secures third-party financing
dedicated to the API Scale Up Expenses, the Company will be unable to complete
the commercial scale up of its Opioid Synthesis Technologies.
Commercial Focus, Cash Reserves and Funding Requirements of the Restructured
Company
The 2004 Debenture Offering Proceeds, the Asset Divestment Proceeds and
the Company's other cash balances (as reduced by operating expenses through July
31, 2004) provided the Company with approximately $5,750,000 million in cash
reserves at August 1, 2004. Except for the professional fees related to the
prosecution of the Import Registration, all of such cash reserves will be
dedicated to the development of the Company's ADF Technology, the Opioid
Synthesis Technologies and for administrative and related operating expenses.
Subsequent to the completed restructuring of its operations, the Company
is no longer engaged in the manufacture and sale of finished dosage generic
pharmaceutical products. As a result, the Company has no ability presently to
generate revenue from product sales. Accordingly, the Company must rely on its
current cash reserves to fund the development of its ADF Technology, the Opioid
Synthesis Technologies and related ongoing administrative and operating
expenses. The Company's future sources of revenue, if any, will be derived from
the sale of API manufactured using its Opioid Synthesis Technologies and from
contract signing fees, milestone payments and royalties and/or profit sharing
payments from licensees for the Company's ADF Technology or Opioid Synthesis
41
Technologies. The Company estimates that its current cash reserves will be
sufficient to fund the development of the ADF Technology, the Opioid Synthesis
Technologies and related operating expenses through January 2005. To fund
operations through December, 2005, the Company estimates that it must raise
additional financing, or enter into alliances or collaboration agreements with
third parties providing for net proceeds to the Company of at least $5 million.
No assurance can be given that the Company will be successful in obtaining any
such financing or in securing collaborative agreements with third parties on
acceptable terms, if at all, or if secured, that such financing or collaborative
agreements will provide for payments to the Company sufficient to continue to
fund operations. In the absence of such financing or third-party collaborative
agreements, the Company will be required to scale back or terminate operations
and/or seek protection under applicable bankruptcy laws.
Even assuming the Company is successful in securing additional sources of
financing to fund the continued development of the ADF Technology or the Opioid
Synthesis Technologies, or otherwise enters into alliances or collaborative
agreements relating to such technologies, there can be no assurance that the
Company's development efforts will result in commercial scale technologies, or
that if such technologies are capable of being scaled up, that they will result
in commercially viable products. The Company is also unable to provide any
assurance that it will succeed in its application to the DEA for the Import
Registration. The Company's failure to successfully develop the ADF Technology
in a timely manner will have a material adverse impact on its financial
condition and results of operations.
Additional Considerations Relating to the Company
The Company's financial success will depend on its ability to successfully
implement its new business strategy.
In accordance with the restructuring of the Company's operations, the
Company has transitioned to a single operations facility located in Culver,
Indiana. At such site, the Company will seek to develop and commercialize its
proprietary ADF Technology and Opioid Synthesis Technologies. With respect to
the ADF Technology, the first product candidate ("ADF Product Candidate #1")
resulting from the ADF Technology is a tablet formulation intended for oral
administration. Such product candidate is currently undergoing stability testing
and the Company can provide no assurance that the stability of ADF Product
Candidate #1 will result in a commercially acceptable drug product. In addition,
ADF Product Candidate No. 1 is currently under evaluation in a clinical study to
assess the bio-availability of such product candidate in comparison to a
frequently prescribed commercially marketed drug product with the same opioid
active ingredient but without abuse deterrent properties. There can be no
assurance that ADF Product Candidate #1 will be bio-available or bioequivalent
to the extent required to justify continued clinical testing. Moreover, even if
ADF Product Candidate #1 is stable and demonstrates acceptable bio-availability,
substantial additional clinical and non-clinical testing will required to
continue development and for the preparation and submission of an NDA filing
with the FDA. There can be no assurance that ADF Product Candidate #1 or any
other product developed using the ADF Technology will lead to an NDA submission
to the FDA and that if an NDA is filed, that the FDA will approve such
regulatory application to allow for commercial distribution of the product.
With respect to the Opioid Synthesis Technologies, while the Company
believes that the such technologies are effect and cost-effective methods of
manufacturing opioid APIs, such technologies will need to be scaled up to
commercial scale in order to have economic value, of which assurance can be
given. Additionally, until such time as the Company secures third-party
financing dedicated to the scale up expenses relating to the Opioid Synthesis
Technologies (estimated by the Company to be approximately $7.0 million), the
Company will be unable to complete the commercial scale up of the Opioid
Synthesis Technologies. No assurance can be given that the Company will obtain
the third-party financing necessary to scale up the Opioid Synthesis
Technologies or that if such financing is obtained, that any one or more of the
Opioid Synthesis Technologies will be capable of commercial scale up.
The Company is committing substantially all of its resources and available
capital to the development of the ADF Technology, the Opioid Synthesis
Technologies and the prosecution of its patent applications and the Import
42
Registration. The failure of the Company to successfully development the ADF
Technology or to successfully obtain an issued patent from the PTO 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 Opioid Synthesis and ADF
Technologies, to obtain required DEA and FDA approvals, and to successfully
prosecute its patent applications. The Company currently does not have the funds
necessary to make the capital improvements required for the commercial scale
manufacture of API's and finished dosage products incorporating such
technologies.
The Company has no near term sources of revenue and must rely on current
capital resources and third party financing to fund operations.
Pending the completion of the development and commercial scale up of the
Company proprietary technologies, and the receipt of regulatory approval of
products incorporating such technologies, of which no assurance can be given,
the Company must rely on its current capital resources and available third-party
financing to fund the Company's operations. As a consequence of the Company's
restructuring of operations, including the cessation of its finished dosage
manufacturing and packaging operations at the Congers Facilities and the
proposed sale of the related assets to IVAX, the Company will have no ability to
generate revenues from the sale of generic products. As a result, the Company
must rely on its current cash resources or available third-party financing to
fund operations. As of August 1, 2004, the Company had cash and cash equivalents
of approximately $5,750,000 million, plus an anticipated additional $500,000 to
be paid by IVAX on the closing of the asset sale transaction following the
receipt of shareholder approval. No assurance can be given that such cash
resources will be sufficient to fund the continued development and
commercialization of the Company's proprietary technologies until such time as
the Company generates revenue from the license of products incorporating such
technologies to third parties. Moreover, in the event of a cash shortfall, no
assurance can be given that the Company will succeed in raising additional
financing to fund operations or that if funding is obtained, that such funding
will be sufficient to fund operations until the Company's proprietary
technologies, or products incorporating such proprietary technologies, may be
commercialized.
The Company received a "going concern" opinion from its independent
auditors, has a history of operating losses and may not achieve profitability
sufficient to generate a positive return on shareholders' investment.
The Company has incurred net losses since 1992. The Company's consolidated
financial statements for the year ended December 31, 2003 and the quarter ended
June 30, 2004 have been prepared on a going-concern basis, expressing
substantial doubt about the Company's ability to continue as a going-concern as
a result of recurring losses and negative cash flows. The Company's loss from
operations for the year ended December 31, 2003 and the six months ended June
30, 2004 was approximately $17.2 million and $4.2 million, respectively. The
Company's accumulated deficit as of June 30, 2004 was $225.9 million. The
Company expects to incur net operating losses at least through 2004. There can
be no assurance that the Company will ever generate revenues or achieve
profitability at a level sufficient to generate a positive return on
shareholders' investment. If the Company is unable to successfully develop and
commercialize its proprietary technologies with its currently available cash
resources or available sources of third-party financing, the Company's ability
to execute its business plan and remain a going-concern will be significantly
impaired.
There can be no assurance that even if the Company is successful in
developing and commercializing its proprietary technologies, that products
incorporating such technologies will be accepted in the market.
The commercial success of products incorporating the Company's
technologies that are approved for marketing by the FDA and other regulatory
authorities will depend upon their acceptance by the medical community and third
party payors as clinically useful, cost effective and safe. There can be no
assurance that, even if the Company succeeds in the development of products
incorporating its technologies and receives FDA approval for such products, that
the Company's products will be accepted by the medical community and others.
Factors that the
43
Company believes could materially affect market acceptance of its products
include:
- - The relative advantages and disadvantages of the Company's technologies
and timing to commercial launch of products utilizing such technologies
compared to products incorporating competitive technologies;
- - The timing of the receipt of market approvals and the countries in which
such approvals are obtained;
- - The safety and efficacy of products incorporating the Company's
technologies as compared to competitive products; and
- - The cost-effectiveness of the products incorporating the Company's
technologies and the ability to receive third party reimbursement.
The Company must obtain required regulatory approvals from the FDA
and DEA.
The Company's business strategy focuses on the development of opioid
containing products incorporating the Company's proprietary technologies. The
development, marketing and sale of products incorporating the Company's
technologies is subject to extensive regulation by the DEA and FDA. At present,
the Company's facility located in Culver, Indiana is approved to manufacture
Schedule II to V controlled substance APIs and finished dosage products. To
continue the development and commercialization of the Company's API
Technologies, the Company is seeking to obtain a registration from the DEA to
import narcotic raw materials ("NRMs") and has begun the application process
seeking approval to import NMRs directly from foreign countries for use in the
Company's opioid API manufacturing efforts.
The Company filed its application for registration to import NRMs on
January 31, 2001 (the "Import Registration"). Notice of the Company's
application was published in the Federal Register on September 6, 2001. Within
the 30 day period provided under DEA guidelines, three parties, including two
companies that the Company believes are the largest U.S. importers of NRMs
requested a hearing to formally object to the Company's request for an Import
Registration. Pursuant to established procedures, an evidentiary hearing
relating to the Company's Import Registration application was held before a DEA
Administrative Law Judge ("ALJ") in August 2003. The ALJ later re-opened the
administrative record, at the request of opposing parties, to consider the
Company's November and December 2003 announcements concerning the Company
restructuring and financing activities. After submission of additional testimony
by the Company and certain of the opposing parties, the ALJ closed the
evidentiary record effective May 25, 2004. The Company and the opposing parties
have a deadline in August 2004 to prepare and submit briefing documents to the
ALJ based on the evidentiary record. Thereafter the ALJ will make findings of
fact, draw legal conclusions and recommend a specific decision on the Company's
Import Registration application to the DEA and issue a final order relating to
the Company's application. Following the decision of the ALJ, the DEA will judge
whether the issuance of an Import Registration is appropriate. Assuming DEA
grants the Company's application, of which no assurance can be given, then the
Company would be permitted to import NRMs upon appropriate notice in the Federal
Register. The opposing parties may challenge the DEA decision to grant the
Company's application in an appropriate Court of Appeals. In such a case,
assuming the Company opposes an appellate challenge, the Company would likely
incur additional time delays and legal expenses prior to the issuance of a final
decision by the U.S. Court of Appeals. Provided the Company continues to seek
the Import Registration, the proceedings will continue through 2004 and beyond.
No assurance can be given that the Company's Import Registration
application will be approved by the DEA or that if granted by DEA, the Import
Registration would be upheld following an appellate challenge. Furthermore, 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 the
development of the Opioid 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 Opioid Synthesis
Technologies.
44
The marketing and sale of products incorporating the Company's
technologies requires FDA approval, which can be time-consuming and expensive.
The development, testing, manufacture, marketing and sale of
pharmaceutical products are subject to extensive federal, state and local
regulation in the United States and other countries. The regulatory approval
process and the Company's ongoing compliance with FDA regulations, is
time-consuming and often expensive. Substantially all of the Company's
activities are subject to compliance with FDA regulations. Failure to adhere to
applicable FDA regulations would have a material adverse effect on the Company's
financial condition. In addition, in the event the Company is successful in
developing products for sale in other countries, the Company would be subject to
regulation in such countries.
The Company may encounter delays or rejections during any stage of the
regulatory approval process based upon the failure of clinical or laboratory
data to demonstrate compliance with, or upon the failure of the product to meet,
the FDA's requirements for safety, efficacy and quality. After the Company's
submission to the FDA of a marketing application, in the form of a new drug
application and/or a 505(b)(2) application the FDA may deny the application, may
require additional testing or data and/or may require post-marketing testing and
surveillance to monitor the safety or efficacy of a product. The FDA commonly
takes one to two years to grant final approval to a marketing application.
Further, the terms of approval of any marketing application, including the
labeling content, may be more restrictive than the Company desires and could
affect the marketability of products incorporating the Company's technologies.
The FDA also has the authority to revoke or suspend approvals of
previously approved products for cause, to debar companies and individuals from
participating in the drug-approval process, to request recalls of allegedly
violative products, to seize allegedly violative products, to obtain injunctions
to close manufacturing plants allegedly not operating in conformity with current
Good Manufacturing Practice regulations and to stop shipments of allegedly
violative products. Any future source of Company revenue will be derived from
the sale of FDA approved products, and the taking of any such action by the FDA
would have a material adverse effect on the Company.
The Company may become involved in patent litigation or other intellectual
property proceedings relating to is products or technologies, which could result
in liability for damages or stop the Company's development and commercialization
efforts.
The pharmaceutical industry has been characterized by significant
litigation and other proceedings regarding patents and other intellectual
property rights. The situations in which the Company may become a party to such
litigation or proceedings include:
- - The Company may initiate litigation or other proceedings against third
parties to enforce the Company's patent rights;
- - The Company may initiate litigation or other proceedings against third
parties to seek to invalidate the patents held by such third parties or to
obtain a judgment that the Company's products or processes due not
infringe such third parties' patents;
- - If the Company's competitors file patent applications claiming technology
also claimed by the Company, the Company may participate in interference
or opposition proceedings to determine the priority of inventions;
- - If third parties initiate litigation claiming that the Company's processes
or products infringe such third parties' patent or intellectual property
rights, the Company will need to defend against such proceedings; and
- - An adverse outcome in any litigation or other proceeding could subject the
Company to significant liabilities to third parties and require that the
Company cease using the technology that is at issue or to license the
technology from third parties. The Company may not be able to obtain any
required license on commercially acceptable
45
terms or at all.
The cost of any patent litigation or other proceeding, even if resolved in
the Company's favor, could be substantial. Uncertainties resulting from the
initiation and continuation of patent litigation or other proceedings could have
a material adverse effect on the Company's ability to compete in the
marketplace. Patent litigation and other proceedings may also consume
significant management time.
The Company faces significant competition, which may result in others
discovering, developing or commercializing products before or more successfully
than the Company.
The pharmaceutical industry is highly competitive and is affected by new
technologies, government regulations, health care legislation, availability of
financing, litigation and other factors. Most of the Company's competitors have
longer operating histories and greater financial and other resources than the
Company.
The Company will be concentrating essentially all of its efforts and
resources on the development of its proprietary technologies. The success of
products incorporating such technologies, if any, will depend, in large part, on
the intensity of competition from branded and generic opioid containing
products, abuse deterrent and opioid synthesis technologies developed by other
companies that compete with the Company's technologies and the relative timing
of product approval by the FDA of the Company's products compared to competitive
products.
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 the Company's 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 at the time a product is shipped to
customers. 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 make adjustments to these provisions
when allowances may differ from established allowances.
Allowance For Doubtful Accounts
Estimates are used in determining the allowance for doubtful accounts
based on the Company's historical collections experience, current trends, credit
policy and a percentage of its accounts receivable by aging category. In
determining these percentages, the Company looks at historical write-offs of its
receivables. The Company also looks at the credit quality of its customer base
as well as changes in its credit policies. The Company continuously
46
monitors collections and payments from its customers. While credit losses have
historically been within expectations and the provisions established, the
Company cannot guarantee that it will continue to experience the same credit
loss rates that it has in the past .
Inventories
The Company's 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
Deferred income taxes are recognized for temporary differences between
financial statement and income tax bases of assets and liabilities and loss
carry-forwards for which income tax benefits are expected to be realized in
future years. A valuation allowance is established, when necessary, to reduce
deferred tax assets to the amount expected to be realized. In estimating future
tax consequences, the Company generally considers all expected future events
other than an enactment of changes in the tax laws or rates. 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 employee compensation arrangements in
accordance with provisions of APB Opinion No. 25, "Accounting for Stock Issued
to Employees" ("APB No. 25") and complies with the disclosure provision of SFAS
No. 148, "Accounting for Stock-based Compensation - Transition and Disclosure,
an amendment of FASB Statement No. 123" ("SFAS No. 148"). 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
Deferred debt discount results from the issuance of stock warrants and
beneficial conversion features in connection with the issuance of subordinated
debt and other notes payable. The amount of the discount is recorded as a
reduction of the related obligation and is amortized over the remaining life of
the related obligations. Management determines the amount of the discount,
based, in part, by the relative fair values ascribed to the warrants determined
by an independent valuation or through the 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.
ITEM 4. CONTROLS AND PROCEDURES
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 as of the end of the period covered by this
Report. 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
47
them to material information relating to the Company (including its consolidated
subsidiaries) required to be included in the Company's periodic Securities and
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 II
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEED AND ISSUER PURCHASES OF EQUITY
SECURITIES
During the quarter ended June 30, 2004, the Company issued Convertible
Subordinated Debentures in the aggregate principal amount of approximately
$1,687,000 (the "Convertible Debentures") and issued 114,321 shares of the
Company's common stock as payment of $63,000 accrued interest due April 1, 2004
on the Senior Secured Term Note Payable.
Each of the holders of the Convertible Debentures and the Senior Secured
Term Note Payable and shares of common stock issued during the quarter ended
June 30, 2004 are accredited investors as defined in Rule 501(a) of Regulation D
promulgated under the Securities Act of 1933, as amended (the "Act"). The
Convertible Debentures were issued without registration under the Act in
reliance upon Section 4(2) of the Act and Regulation D promulgated thereunder.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) The exhibits required to be filed as part of this Report on form
10-Q are listed in the attached Exhibit Index.
(b) Reports on Form 8-K.
The Company filed a Current Report on Form 8-K dated April 22, 2004
relating to it financial results for the fourth quarter ended
December 31, 2003 and the twelve months ended December 31, 2003.
The Company filed a Current Report on Form 8-K dated May 26, 2004
relating to the filing by the Company of four non-provisional patent
applications with the US Patent and Trademark Office relating to the
Company's opioid synthesis technologies.
The Company filed a Current Report on Form 8-K dated June 10, 2004
relating to (a) the completion of a $14.0 million offering of the
Company's convertible debentures pursuant to the Debenture and Share
Purchase Agreement executed by the Company in February 2004, and (b)
an amendment to the Debenture and Share Purchase Agreement to (i)
increase the principal amount of debentures issuable thereunder from
$14.0 million to $17.5 million and (ii) extend the time to complete
such additional financing from June 5, 2004 to June 30, 2004.
48
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: August 6, 2004 HALSEY DRUG CO., INC.
By:/s/ Andrew D. Reddick
------------------------------------
Andrew D. Reddick
President & Chief Executive Officer
By:/s/Peter A. Clemens
------------------------------------
Peter A. Clemens
Senior Vice President & Chief
Financial Officer
49
EXHIBIT INDEX
Exhibit Document
- --------- ------------------
10.1 Executive Employment Agreement of Vijai Kumar, dated as of November 18, 2002.
10.2 Executive Employment Agreement of Andrew D. Reddick, dated as of August 26, 2003.
10.3 Executive Employment Agreement of Ron Spivey, dated as of April 5, 2004.
10.4 Amendment to Executive Employment Agreement of Andrew D. Reddick, dated as of May 27,
2004.
10.5 Separation Agreement and General Release by and between Michael K. Reicher and Halsey Drug Co., Inc., dated
Co., Inc., dated September 18, 2003.
10.6 First Amendment to Separation Agreement and General Release by and between Michael K.
Reicher and Halsey Drug Co., Inc., dated as of December 4, 2003.
10.7 Asset Purchase Agreement by and between Mutual Pharmaceutical Company, Inc. and Halsey Drug Co., Inc., dated
February 18, 2004.
10.8 First Amendment to Debenture Purchase Agreement by and among Halsey Drug Co., Inc., Galen
Partners III, L.P.,Care Capital Investments II, LP, Essex Woodlands Health Ventures V, L.P. and
other signatories thereto, dated June 1, 2004.
10.9 Amendment to Debenture and Share Purchase Agreement by and among Halsey Drug Co., Inc.,
Galen Partners III, L.P., Care Capital Investments II, LP, Essex Woodlands Health Ventures V,
L.P. and other signatories thereto, dated August 11, 2003.
10.10 Letter of Support in favor of Halsey Drug Co., Inc. by and among Care Capital Investment II, L.P., Galen
Partners III, L.P. and Essex Woodlands Health Ventures V, L.P., dated May 5, 2003.
31.1 Certification of Periodic Report by Chief Executive Officer pursuant to Rule 13a-14 and 15d-14 of
the Securities Exchange Act of 1934.
31.2 Certification of Periodic Report by Chief Financial Officer pursuant to Rule 13a-14 and 15d-14 of
the Securities Exchange Act of 1934.
32.1 Certification of Periodic Report by Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Periodic Report by Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
50