UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2005

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period _______ to _______

Commission File Number 0-21185

AAIPHARMA INC.

2320 SCIENTIFIC PARK DRIVE, WILMINGTON, NC 28405
(Address of principal executive office)                       (Zip code)

(910) 254-7000
(Registrant’s telephone number, including area code)

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 þ      No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)      Yes þ      No o

The number of shares of the registrant’s common stock outstanding as of April 1, 2005 was 28,585,582 shares.

The terms “we”, “us” or “our” in this Form 10-Q include aaiPharma Inc., its corporate predecessors and its subsidiaries, except where the context may indicate otherwise. Our corporation was incorporated in 1986, although its corporate predecessor was founded in 1979. Our Internet address is www.aaipharma.com. We make available through our Internet website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

At March 31, 2005, we owned the following registered and unregistered trademarks referenced herein: Darvocet®, Darvon®, Darvon-N®, Darvocet-N®, Darvocet A500™, Brethine®, ProSorb-D™, Lynxorb™, Oramorph® SR, Roxicodone®, AzaSan®, aaiPharma® and AAI®. AzaSan® is a registered trademark owned by us and licensed to Salix Pharmaceuticals. Unless the context otherwise requires, references in this document to Darvon are to Darvon® and Darvon-N®, collectively, and references to Darvocet are to Darvocet-N® and Darvocet A500™, collectively. We also reference trademarks owned by other companies. M.V.I.®, M.V.I.-12®, M.V.I. Pediatric®, M.V.I. Adult™, Aquasol®, Aquasol A® and Aquasol E® are registered and unregistered trademarks owned by Mayne Pharma (USA) Inc. Prilosec® is a registered trademark owned by AstraZeneca. Unless the context otherwise requires, references to M.V.I. are to M.V.I.-12®, M.V.I. Pediatric® and M.V.I. Adult™, collectively, and references to Aquasol are to Aquasol A® and Aquasol E®, collectively. Duraclon® is a registered trademark owned by Fujisawa Healthcare, Inc. and licensed to us. All references in this document to any of these terms lacking the “®” or “^TM” symbols are defined terms that reference the products, technologies or businesses bearing the trademarks with these symbols.

aaiPharma Inc.
Table of Contents

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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.

aaiPharma Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

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The accompanying notes are an integral part of these financial statements.

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aaiPharma Inc.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)

The accompanying notes are an integral part of these financial statements.

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aaiPharma Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

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The accompanying notes are an integral part of these financial statements.

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aaiPharma Inc.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands)
(Unaudited)

The accompanying notes are an integral part of these financial statements.

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aaiPharma Inc.
Notes to Consolidated Financial Statements
(Unaudited)

1. Basis of presentation and other matters

aaiPharma Inc. (“aaiPharma” or the “Company”) is a science-based company with corporate headquarters in Wilmington, North Carolina with over 25 years experience in drug development. The Company sells branded pharmaceutical products, including the Darvon and Darvocet product lines, primarily in the area of pain management. The Company also offers comprehensive drug development services to the pharmaceutical, biotechnology, generic and device industries through its development services division. The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and applicable Securities and Exchange Commission (the “SEC”) regulations for interim financial information. These financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for annual financial statements. The consolidated financial information as of December 31, 2004 has been derived from audited financial statements; certain amounts from the three months ended March 31, 2004 have been reclassified for consistent presentation with current year financial statements. It is presumed that users of this interim financial information have read or have access to the audited financial statements for the preceding fiscal year, which were included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 (the “2004
Form 10-K”). In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation have been included in these interim financial statements. Operating results for the interim periods presented are not necessarily indicative of the results that may be expected for the full year.

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from such estimates and changes in such estimates may affect amounts reported in future periods.

The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations in accounting for its stock option plans; therefore, compensation expense has not been recognized for options granted at fair value. Under APB 25, if the exercise price of the Company’s stock options is not less than the estimated fair market value of the underlying stock on the date of grant, no compensation expense is recognized. If compensation cost for the Company’s plans had been determined based on the fair value at the grant dates for awards under those plans consistent with the fair value method of Statement of Financial Accounting Standards No. 123 “Accounting for Stock Based Compensation” (“SFAS 123"), the Company’s net income (loss) and income (loss) per share would have been changed to the pro forma amounts indicated below:

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Going Concern

The Company incurred a substantial net loss and loss from operations for 2004 and a substantial net loss for the quarter ended March 31, 2005. The Company’s results of operations have continued to deteriorate as customer concerns regarding its financial condition have affected sales of the Company’s pharmaceutical products as well as the Company’s ability to obtain and maintain development services engagements.

As a result of the Company’s substantial and recurring net losses, the Company believes that it does not have adequate sources of liquidity to fund operations in the near term unless the Company obtains additional sources of liquidity. Because the Company did not make the $10.5 million scheduled interest payment due on April 1, 2005 on its senior subordinated notes within 30 days after April 1, holders of 25% of the notes or the trustee under the indenture governing the notes may accelerate the notes. The ability of the holders of the notes or the trustee to accelerate the notes is an event of default under the Company’s senior credit facilities, entitling the lenders to accelerate the debt thereunder. In addition, the Company was in default of certain covenants under the senior credit facilities on March 31, 2005.

In light of its current financial condition, the Company believes that its operations can no longer support its existing debt and that the Company must restructure its debt to levels that are more in line with its operations. Thus, it is highly likely that the Company and its U.S. subsidiaries will seek relief under chapter 11 of Title 11 of the U.S. Code (the “Bankruptcy Code”) which would substantially dilute and may eliminate the interests of the holders of the Company’s common stock. On April 29, 2005, the Company accepted a commitment letter from Silver Point Finance, LLC to provide debtor-in-possession financing if the Company and its U.S. subsidiaries commence bankruptcy proceedings under the Bankruptcy Code. This debtor-in-possession financing would be subject to a number of conditions, including approval by the bankruptcy court. See Note 10 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources.”

These conditions raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classifications of liabilities that may result from the outcome of this uncertainty.

Because of the defaults under the Company’s senior credit facilities and the senior subordinated notes at March 31, 2005, all $350.5 million of debt under the Company’s senior credit facilities and the notes was classified as current liabilities on the Company’s consolidated balance sheet at March 31, 2005.

Impact of Recently Issued Accounting Standards

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which amends SFAS 123, and supersedes APB 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) requires compensation expense to be recognized for all share-based payments made to employees based on the fair value of the award at the date of grant, eliminating the intrinsic value alternative allowed by SFAS 123. SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in

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the financial statements based on their fair values (i.e., pro forma disclosure is no longer an alternative to financial statement recognition). SFAS 123(R) must be adopted in the first annual period beginning after June 15, 2005.

The Company currently plans to adopt SFAS 123(R) on January 1, 2006. This change in accounting is not expected to materially impact the Company’s financial position. However, because the Company currently accounts for share-based payments to its employees under APB No. 25, the results of operations have not included the recognition of compensation expense for the issuance of stock option awards. Had the Company applied the fair-value criteria established by SFAS 123(R) to previous stock option grants, the impact to its results of operations would have approximated the impact of applying SFAS 123, which was a reduction to net income of approximately $1.1 million and $3.1 million in the three months ended March 31, 2005 and 2004, respectively.

No other recently issued, but not yet effective, accounting standards are believed to have a material impact on the Company.

2. M.V.I. and Aquasol Product Line Sale and Contingent Payment

On April 26, 2004, the Company sold its M.V.I. and Aquasol product lines to Mayne Pharma (USA) Inc. for $105 million, subject to certain adjustments based on inventory levels at closing and other post-closing obligations (the “M.V.I. and Aquasol Sale”). A portion of the closing payment was held in escrow to satisfy post-closing obligations under the agreement. The Company received approximately $1.6 million from this escrow in September 2004 and does not anticipate receiving any additional payments out of this escrow. The M.V.I. and Aquasol Sale resulted in a preliminary gain of $37.5 million that the Company recorded in the second quarter of 2004. The gain on the sale was based on the net cash received from the sale less the book value of the intangible assets, inventories and other items related to the product lines sold.

The Company’s M.V.I. and Aquasol product line acquisition agreement with AstraZeneca AB, as amended, provided for a future contingent payment of $43.5 million potentially due in August 2004, depending on the status of certain reformulation activities being carried out by the seller and regulatory approval of the reformulations by the U.S. Food and Drug Administration. The amount of the $43.5 million contingent payment was to be reduced by $1 million per month if the conditions for the contingent payment had not occurred by December 31, 2002. The amount of the contingent payment had decreased by $12.0 million by December 31, 2003. Such conditions were satisfied in January and February 2004, fixing the previously contingent liability under the amendment at $31.5 million. The Company recorded this expense in the first quarter of 2004. As a result of an amendment to the original acquisition agreement, the Company was precluded from recognizing this obligation (the “M.V.I. Contingent Payment”) as additional purchase price for the M.V.I. and Aquasol product lines; therefore, this adjustment was expensed in the first quarter of 2004. As discussed above, the Company sold its M.V.I. and Aquasol product lines on April 26, 2004. Concurrently with the closing of the M.V.I. and Aquasol Sale on April 26, 2004, the Company paid to AstraZeneca AB the M.V.I. Contingent Payment, which was discounted to approximately $31.0 million as a result of the early payment.

3. Income taxes

The Company recorded no net federal income tax benefit or expense in the first quarter of 2005, primarily as a result of current period net loss before taxes. Any tax benefit would be offset by a valuation allowance for the entire amount because it is more likely than not that the deferred tax asset resulting from this benefit will not be realized.

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4. Loss per share

Basic loss per share is based on the weighted average number of common shares outstanding during the year. Diluted loss per share is computed assuming that the actual weighted average number of common shares outstanding was increased by the exercise of stock options issued to employees and members of the Company’s Board of Directors under the treasury stock method. The diluted per share amounts reflect a change in the number of shares outstanding (the “denominator”) to include the options as if they were exercised and converted to shares and issued, unless their inclusion would be anti-dilutive. During the three months ended March 31, 2004, approximately 360,000 options were exercised for aggregate proceeds to the Company of $3.6 million. No options were exercised in the three months ended March 31, 2005. In the three months ended March 31, 2005 and 2004, 5.9 million and 2.0 million options, respectively, which were all of the outstanding options, were excluded as they were anti-dilutive. In each period presented, each of the net loss (the “numerator”) and the weighted average number of common shares (the denominator) is the same for both basic and diluted per share computations.

5. Financial information by business segment and geographic area

In 2004 and the first quarter of 2005, the Company operated in three business segments consisting of a product sales business, primarily comprised of the pharmaceuticals division, a product development business, primarily the research and development business unit, and a development services business, primarily the AAI Development Services business unit. The product sales business provides for the sales of the Company’s pharmaceutical product lines. In the product development segment, the Company internally develops drugs and technologies for future sales by the product sales business or with the objective of licensing marketing rights to third parties in exchange for license fees and royalties. The core services provided by the development services business on a fee-for-service basis to pharmaceutical and biotechnology industries worldwide include comprehensive formulation, testing and manufacturing expertise, in addition to the ability to take investigational products into and through human clinical trials.

In late March 2005, the Company reorganized its operating structure to reflect the Company’s decision to curtail its research and development activities in light of its financial condition. At that time, the Company’s Research and Development Division was no longer actively engaged in any shared-risk development projects. Personnel involved in the development of proprietary products were assigned to the Company’s Pharmaceuticals Division, while personnel who had focused on independent research or shared-risk development projects were assigned to fee-for-service development projects in the Company’s AAI Development Services Division. As a result of this reorganization of the operating structure, the Company began operating in only two business segments in April 2005 – proprietary pharmaceutical product development and sales through the Pharmaceuticals Division and development services offered to third parties through the AAI Development Services Division. The majority of the Company’s non-U.S. operations are located in Germany.

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Corporate income (loss) from operations includes general corporate overhead costs which are not directly attributable to a business segment. Financial data by segment and geographic region are as follows (in thousands):

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6. Accounts receivable, net

The following table presents the components of accounts receivable (in thousands):

Accounts receivable are presented net of an allowance for uncollectible accounts and net of an allowance for customer credits, including discounts, rebates, chargebacks, product returns and other allowances. The decrease in the allowance for customer credits is due to decreases in product returns reserves primarily related to decreases in wholesaler inventory levels due to wholesaler shipments, product returns and related decreases in chargeback reserves.

7. Inventories, net

The following table presents the components of inventories (in thousands):

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8. Debt

The following table presents the components of long-term debt:

In March 2002, the Company issued $175 million of senior subordinated notes due April 1, 2010. The proceeds from the issuance of these notes were $173.9 million, which was net of the original issue discount. This discount is being charged to interest expense over the term of the notes. These notes initially had a fixed interest rate of 11% per annum and are guaranteed on a subordinated basis by all existing domestic subsidiaries and all future domestic subsidiaries that are owned 80% or more by the Company. When issued, the notes were not secured. Prior to the third anniversary of the date of issuance of the notes, up to 35% of the notes were redeemable with the proceeds of qualified sales of equity at 111% of par value. On or after the fourth anniversary of the date of issuance of the notes, all or any portion of the notes are redeemable at declining premiums to par value, beginning at 105.5%.

Concurrently with the issuance of the senior subordinated notes, the Company entered into an interest rate hedging agreement to effectively convert interest expense on a portion of the senior subordinated notes for the term of the notes from an 11% fixed annual rate to a floating annual rate equal to 6-month LIBOR plus a base rate. In 2003, the Company sold the then outstanding interest rate hedging agreement and replaced it with a similar interest rate hedging agreement. In April 2004, the Company paid $9.4 million to terminate this second interest rate hedging agreement. The amounts received, less the termination payment and the interest benefits earned through the dates of sale, have been recorded as premiums to the carrying amount of the notes and are being amortized into interest income over their remaining life.

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In April 2004, the Company, following the completion of a solicitation seeking the consent of holders of its senior subordinated notes, entered into a supplemental indenture to, among other things, grant a lien to secure the Company’s obligations under the senior subordinated notes, which lien is junior to the liens securing the Company’s current senior credit facilities but covers the same collateral, and to increase the interest rate of the senior subordinated notes from 11% per annum to 11.5% per annum effective April 1, 2004.

On October 29, 2004, the Company, following the completion of a solicitation seeking the consent of holders of its senior subordinated notes, entered into an additional supplemental indenture to, among other things:

•	permit the Company to incur up to $30 million of additional indebtedness under credit facilities;
•	permit the Company to incur additional senior debt in order to maintain $40 million (subject to an increase up to $50 million in order to allow the Company to make interest payments on the senior subordinated notes) in senior debt under credit facilities in the event the Company is required to pay down senior debt with the proceeds of asset sales;
•	require proceeds of asset sales to be used to reduce senior debt under credit facilities to $40 million;
•	provide that the liens on assets that secure obligations under the senior subordinated notes will continue if all senior debt is repaid, but will resume as junior liens if the Company thereafter incurs any new senior debt; and
•	temporarily increase the interest rate on the senior subordinated notes by 0.5% per annum (to 12% per annum), commencing to accrue on October 1, 2004 and ending on March 31, 2005.

In connection with the October 2004 consent solicitation, the Company paid a consent fee to the holders of senior subordinated notes who had submitted valid and unrevoked consents by the expiration date of the consent solicitation of $20 for each $1,000 in principal amount of senior subordinated notes for which a consent was submitted. Following discussions with representatives of an ad hoc committee of holders of the senior subordinated notes, the Company offered to pay the same consent fee with respect to senior subordinated notes for which a valid and unrevoked consent had not been properly submitted by the expiration of the consent solicitation, if the holder of such senior subordinated notes completed a consent and release for payment by February 7, 2005 that consented to the proposed amendments and waivers described above and waived all claims the holder may have against the Company, the trustee under the indenture governing the senior subordinated notes, Global Bondholder Services Corporation, and their respective directors, officers, employees, agents, attorneys, affiliates and advisors with respect to matters related to the consent solicitation.

In 2004, the Company paid approximately $4.2 million in consent fees in connection with the consent solicitations discussed above. On February 9, 2005, the Company paid approximately $1.0 million in additional consent fees.

At March 31, 2005, the Company was in default under the covenants under the senior subordinated notes as a result of its failure to timely file its 2004 Form 10-K and to deliver to the trustee of the indenture governing the senior subordinated notes certain certificates of its officers and its registered independent public accountants. These events of default would entitle the trustee under the indenture for the notes or the holders of 25% of the principal amount of the notes to accelerate the notes if such events of default were not cured within 60 days of notice provided by such person. The Company has since filed its 2004 Form 10-K. In addition, the Company failed to pay the $10.5 million of scheduled interest due on April 1, 2005 within 30 days after April 1. This event of default entitles the trustee under the indenture for the notes or the holders of 25% of the principal amount of the notes to accelerate the notes immediately. Any event of default entitling the trustee or the holders of the notes to accelerate the notes also constitutes an event of default under our senior credit facilities entitling the Company’s senior lenders to accelerate the debt thereunder.

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On April 23, 2004, aaiPharma entered into $140 million of senior credit facilities with a syndicate of lenders, Silver Point Finance LLC (“Silver Point”) as collateral agent, and Bank of America, N.A., as administrative agent. These senior credit facilities consisted of a two-year, $125 million senior secured term loan facility, which was fully drawn at closing, and a two-year, $15 million senior secured revolving credit facility, of which the entire amount was available for borrowing at closing. The Company’s senior credit facilities are secured by a security interest on substantially all domestic assets, all of the stock of domestic subsidiaries and 65% of the stock of material foreign subsidiaries.

On August 9, 2004 and August 13, 2004, the Company entered into amendments to its senior secured credit facilities to, among other things, increase the amount of the term loans by up to $10 million, extend the maturity date of the facilities by one year to April 21, 2007, increase the interest rate on the loans by an additional 1.5% subject to potential incremental reduction based on the Company’s financial performance, adjust certain covenants under the facilities and waive certain defaults and events of default. Under the amended credit facility, the Company borrowed an additional $10 million in term loans on August 13, 2004.

Effective as of October 8, 2004, the Company amended its senior secured credit facilities to, among other things, adjust financial covenants. On October 22, 2004, the Company entered into another amendment to its senior secured credit facilities that increased the existing term loan facility under the senior secured credit facilities by $30 million (the “Supplemental Term Loan”), subject to certain specified conditions which were satisfied on October 29, 2004. The Supplemental Term Loan was made available in up to three draws to be made on or prior to January 15, 2005, and the Company borrowed $20 million of such term loans on October 29, 2004. The remaining $10 million of such term loans was borrowed in increments by the Company on November 5, 2004, November 12, 2004, November 24, 2004 and December 9, 2004. Following effectiveness of the amendment and these borrowings, the senior secured credit facilities consisted of a term loan of $165 million and a revolving credit facility of up to $15 million.

The amendment also modified the interest rate on the entire senior secured credit facility, including the Supplemental Term Loan, to equal a defined LIBOR rate (with a floor of 2%) plus 8.25% per annum or a defined reference rate (with a floor of 4%) plus 7.25% per annum. The amendment also provided for a commitment fee equal to 0.75% per annum on any undrawn portion of the Supplemental Term Loan, payable monthly in arrears.

In addition, the amendment retained a covenant requiring certain levels of cash or revolver availability and increased the level of cash or revolver availability required for the period from March 31, 2005 through May 15, 2005 to $15.0 million. The amendment added a covenant requiring the Company to retain Rothschild Inc. or another financial advisor to assist with its exploration of the potential sale of some or all of the assets of the Company’s Pharmaceuticals Division. The amendment also added an event of default if the Company fails to pursue in good faith the exploration of the potential sale of some or all of the assets comprising its Pharmaceuticals Division or other non-core assets.

As of March 31, 2005, events of default existed under the Company’s senior credit facilities that prohibited borrowings thereunder absent a waiver from its senior lenders. These events of default included the violation of the cash/revolver availability covenant described above and the failure to timely file the Company’s 2004 Form 10-K, which was subsequently filed on April 27, 2005. On March 31, 2005, the Company entered into a waiver agreement pursuant to which its senior lenders agreed to forbear in exercising remedies with respect to the defaults and events of default existing on that date until the earlier of April 30, 2005 or the occurrence of another default under the waiver agreement or the Company’s senior credit facilities. The forbearance period under the waiver agreement terminated on April 30, 2005, and the Company’s senior lenders accordingly have the right to accelerate the debt outstanding under the Company’s senior credit facilities.

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The waiver agreement also permitted the Company to immediately use approximately $5.7 million of its $11.3 million tax refund received in March 2005 to meet budgeted liquidity needs and required the Company to temporarily pay down revolving loans under the senior credit facilities with the remaining $5.6 million of the tax refund. Despite the existing events of default, the waiver permitted the Company to reborrow this $5.6 million, in weekly draws, to meet budgeted liquidity needs, and the Company has fully borrowed this amount. Pursuant to an additional waiver agreement entered into by the Company and the lenders on April 29, 2005, the senior lenders permitted the Company to borrow approximately $1.0 million, provided that $750,000 of the borrowing was applied to pay commitment fees and expense deposits in connection with a specified debtor-in-possession financing facility for which the Company accepted a commitment letter on April 29, 2005. The Company has borrowed this additional amount and applied $750,000 of the proceeds of this borrowing as required under the waiver. On May 3 and May 4, 2005, as permitted by the terms of the senior credit facilities and as authorized by the Company, the lenders advanced approximately $1.8 million in aggregate revolving loans under the senior credit facilities to pay interest then due under the senior credit facilities. No other borrowings are permitted under the Company’s senior credit facilities absent a consent of the Company’s senior lenders.

Because of the defaults under the Company’s senior credit facilities and the notes at March 31, 2005, all $350.5 million of debt under the Company’s senior credit facilities and the senior subordinated notes was classified as a current liability on the Company’s consolidated balance sheet at March 31, 2005.

9. Other Accrued Liabilities and Restructuring Charges

The following table represents the components of other accrued liabilities:

The following table represents the components of the restructuring reserve (in thousands):

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10. Commitments and Contingencies

The Company may have to make contingent payments of $4.7 million over three years in connection with the purchase of its Charleston, South Carolina manufacturing facility, based on the level of manufacturing revenues at this facility. At March 31, 2005, these contingent payment obligations are not liabilities and have not been recorded on the Company’s consolidated balance sheet.

In April 2004, in connection with an investigation conducted by the United States Attorney’s Office for the Western District of North Carolina (the “U.S. Attorney’s Office”), the Company received five federal grand jury subpoenas for document production and potential testimony related to, among other things, certain transactions regarding its 2002 and 2003 financial information, the terms, conditions of employment and compensation arrangements of certain of its senior management personnel, compensation and incentive arrangements for employees responsible for the sale of its Brethine, Darvocet, calcitriol, azathioprine and Darvon Compound products, quantities of the foregoing products in distribution channels, financial benefits with respect to specified corporate transactions to its senior management and others, certain loans obtained by the Company, extensions of credit, if any, by aaiPharma to officers or directors, accounting for sales and returns of the Company’s foregoing products, its analysts’ conference calls on financial results, internal and external investigations of pharmaceutical product sales activities, and related matters. The SEC has also commenced an investigation and the Company has received a subpoena from the SEC covering similar matters. In addition, both the U.S. Attorney’s Office and the SEC have made informal requests for documents and other information related to these matters. Certain of the Company’s current and former officers, directors and employees have received subpoenas to appear before the federal grand jury or requests to provide information to the U.S. Attorney’s Office. A former officer of the Company, David M. Hurley, has been advised by the U.S. Attorney’s Office that he is a target of its investigation. The Company and a special committee of its Board of Directors established in February 2004 (the “Special Committee”) have agreed to cooperate fully with the government investigations, and the Special Committee has shared information regarding its investigation with the SEC and the U.S. Attorney’s Office. The U.S. Attorney’s Office, SEC and other government agencies that are investigating or might commence an investigation of the Company could impose, based on a claim of fraud, material misstatements, violation of false claims law or otherwise, civil and/or criminal sanctions, including fines, penalties, and/or administrative remedies. If any government sanctions are imposed, which the Company cannot predict or reasonably estimate at this time, aaiPharma’s business and financial condition, results of operations or cash flows could be materially adversely affected. These matters have resulted, and are expected to continue to result, in a significant diversion of management’s attention and resources and in significant professional fees. The Company has agreed to advance expenses reasonably incurred by certain of its current directors and current and former officers in connection with these investigations. This advancement of expenses was conditioned upon the execution by such persons of undertakings to assist and cooperate with the Company in connection with the investigations and to repay to the Company any advanced funds in the event that (i) aaiPharma determines that certain representations made by such directors and officers are inaccurate, (ii) aaiPharma is prohibited from providing indemnification to such directors or officers pursuant to Delaware law or its organizational documents, or (iii) such directors or officers stop cooperating with aaiPharma on the investigations.

The Company, certain of its current and former officers and directors, and its independent registered public accountants have been named as defendants in purported stockholder class action lawsuits alleging violations of federal securities laws and a stockholder derivative action alleging violations of state law fiduciary responsibilities. The securities lawsuits were filed beginning in February 2004 and are pending in the U.S. District Court for the Eastern District of North Carolina. By order dated April 16, 2004, the district court consolidated the securities lawsuits into one consolidated action, and on February 11, 2005 the plaintiffs filed a

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consolidated amended complaint. The amended securities complaint asserts claims arising under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 there under on behalf of a class of purchasers of the Company’s common stock during the period from April 24, 2002 through and including June 15, 2004. The securities complaints allege generally that the defendants knowingly or recklessly made false or misleading statements during the Class Period concerning the Company’s financial condition and that the Company’s financial statements did not present its true financial condition and were not prepared in accordance with generally accepted accounting principles. The amended securities complaint seeks certification as a class action, unspecified compensatory damages, attorneys’ fees and costs, and other relief. A stockholder derivative suit was filed in the United States District Court for the Eastern District of North Carolina on August 26, 2004 by two putative shareholders against current and former members of the Company’s Board of Directors and senior management. aaiPharma is named as a “nominal defendant.” The complaint alleges that the individual director and officer defendants breached fiduciary and contractual obligations to the Company by implementing an inadequate system of internal controls, and causing the Company to issue false and misleading statements exposing it to securities fraud liability, and that certain defendants engaged in insider trading. The complaint seeks unspecified compensatory damages, attorneys’ fees and costs, and other relief.

In addition, the Company and certain of its current and former directors, officers and employees have been named in a purported class action brought by an aaiPharma pension plan participant and beneficiary asserting claims under ERISA on behalf of a class of all persons who are or were participants or beneficiaries of the aaiPharma Inc. Retirement and Savings Plan during the period from April 24, 2002 to June 15, 2004. An amended complaint was filed on March 14, 2005 which alleges generally that the defendants breached fiduciary duties owed under ERISA with respect to the prudence and lack of diversification of investment of Plan assets in the Company’s common stock, by misleading participants and beneficiaries of the Plan regarding the Company’s earnings, prospects, and business condition, by failing to act in the sole interest of Plan participants, and by failing to monitor the actions of other Plan fiduciaries. The complaint seeks certification as a class action, unspecified compensatory damages, attorneys’ fees and costs, and other equitable relief. This ERISA lawsuit is pending in U.S. District Court for the Eastern District of North Carolina. The proceedings in this matter will be coordinated with the securities lawsuits described above.

These lawsuits are at an early stage. The Company’s response to the amended securities complaint is not due until May 26, 2005, and its response to the amended ERISA complaint is not due until June 30, 2005 at the earliest. By agreement, no response to the derivative suit is due until 60 days after the court's decision on the Company's motion to dismiss the amended complaint, and no discovery has yet occurred in either the securities or derivative litigation. Only limited discovery has occurred in the ERISA litigation.

By, and subject to, the terms of the Company’s bylaws, the Company has certain obligations to indemnify its current and former officers, directors and employees who have been named as defendants in these lawsuits. The Company has purchased directors and officers liability insurance (“D&O insurance”) that may provide coverage for some or all of these lawsuits and governmental investigations. The Company has given notice to its D&O insurance carriers of the securities and derivative suits described above, and the insurers have responded by requesting additional information and by reserving their rights under the policies, including the rights to deny coverage under various policy exclusions or to rescind the policies. There is a risk, however, that the D&O insurance carriers will rescind the policies or that some or all of the claims or expenses will not be covered by such policies; or that, even if covered, the Company’s ultimate liability will exceed the available insurance. The Company’s fiduciary liability insurance carrier has denied coverage of claims made in connection with the ERISA litigation complaint. Although the Company intends to vigorously pursue all defenses available in these lawsuits, an adverse determination in these lawsuits or an inability to obtain payment under the Company’s insurance policies for litigation and indemnification costs and any damages ultimately

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borne by us as a result of these lawsuits and investigations could have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows.

The Company is a party to a number of legal actions with generic drug companies. The Company is involved in two lawsuits centered on its omeprazole-related patents, including one lawsuit brought by it against an alleged infringer of its patents and another lawsuit which was brought by a third party against the Company and is currently essentially inactive. Omeprazole is the active ingredient found in Prilosec, a drug sold by AstraZeneca PLC. An additional lawsuit brought against the Company by Andrx Pharmaceuticals, Inc. involving omeprazole was dismissed without prejudice in December 2004.

An omeprazole-related case has been filed against the Company by Dr. Reddy’s Laboratories Ltd. and Reddy-Cheminor Inc. in the U.S. District Court for the Southern District of New York in November 2001. The plaintiffs in this case have challenged the validity of five patents that aaiPharma has obtained relating to omeprazole and are seeking a declaratory judgment that their generic form of Prilosec does not infringe these patents. Additionally, they have alleged misappropriation of trade secrets, tortious interference, unfair competition and violations of the North Carolina Unfair Trade Practice Act. The Company has denied the substantive allegations made in these cases. A second lawsuit brought by the plaintiffs involving omeprazole was filed in July 2001 and was dismissed without prejudice in March 2005.

The case is in the early stages of litigation. However, while these plaintiffs have sought approval from the FDA to market a generic form of Prilosec, to the best of the Company’s knowledge as of May 5, 2005, no such FDA approval has been granted to them. In addition, these plaintiffs’ omeprazole product has been found in separate litigation to infringe certain patents of AstraZeneca and the infringement findings have been upheld on appeal. The lawsuit is essentially inactive at this time. Only limited discovery has occurred in this lawsuit and no additional discovery is currently being sought. No date has been set for the trial. In the event that the lawsuit again becomes active, the Company intends to vigorously defend the patents’ validity and to determine whether or not the plaintiffs’ product infringes any of its relevant patents.

The other lawsuit involving the Company’s omeprazole patents was brought in December 2002 by it against Kremers Urban Development Co., Schwarz Pharma Inc. and Schwarz Pharma AG (collectively, together with the other named defendants, “KUDCO”) in the U.S. District Court for the Southern District of New York. KUDCO has a generic omeprazole product with final FDA marketing approval, was found not to infringe the AstraZeneca patents in the separate AstraZeneca patent litigation, and is currently selling its generic substitute for Prilosec in the U.S. marketplace.

The Company initially brought the lawsuit alleging infringement of the Company’s U.S. Patent No. 6,268,385. Following the collection of additional information concerning KUDCO’s commercially marketed product, the Company sought leave of the court to file an amended complaint, adding additional claims of infringement and contributory infringement under the Company’s U.S. Patent No. 6,326,384 and joining as defendants Schwarz Pharma Manufacturing Inc. and Schwarz Pharma USA Holdings Inc. These two patents include, among other claims, claims directed to compositions and methods wherein certain characteristics of solid state omeprazole are essentially the same in formulated drug product as in its active ingredient.

In September 2003, the judge granted aaiPharma leave to file the first amended complaint adding the Company’s second patent and the additional KUDCO affiliates to the lawsuit. Following initial discovery, the Company sought leave of the court to file a second amended complaint, adding Kremers Urban Inc., another KUDCO affiliate, to the lawsuit. On February 26, 2004, the judge granted the Company leave to file the second amended complaint, adding Kremers Urban Inc. to the lawsuit.

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KUDCO has filed its answer to aaiPharma’s complaint, denying its claims, asserting various affirmative defenses to its claims (including patent invalidity and product non-infringement), and asserting counterclaims and antitrust violations under federal and state antitrust laws. KUDCO is also contesting the personal jurisdiction of the court over all of the defendants in this lawsuit other than Kremers Urban Development Co., Kremers Urban Inc. and Schwarz Pharma Inc. Motions on the jurisdictional issues are pending before the court. The Company has denied the substantive allegations made by KUDCO in its counterclaims, and the court has granted aaiPharma’s motion to stay antitrust discovery.

Substantial discovery of both sides’ documents and of defendants’ product samples has occurred in the lawsuit, although both sides asserted numerous discovery deficiencies against the other. On February 26, 2004, the judge assigned the discovery disputes to a federal magistrate for resolution. Discovery is continuing at this time. No trial date has been set.

The Company has previously indicated to KUDCO a willingness to grant a license under its omeprazole patents for an appropriate royalty. In the absence of KUDCO taking a royalty-bearing license, aaiPharma is seeking damages equal to a reasonable royalty on all infringing sales by the KUDCO defendants since commercial launch of their generic substitute for Prilosec on December 9, 2002 through the date of a judicial decision in the litigation, and a permanent injunction on subsequent sales thereafter (unless KUDCO takes a license), among other remedies, in the event that the Company ultimately prevails in the litigation. The KUDCO defendants have publicly confirmed sales of their generic omeprazole product during the first twenty-two months after launch of their product of approximately $1.3 billion. In the absence of a license or settlement, the Company intends to vigorously prosecute the case, defend its patent rights and defend against the foregoing defenses and counterclaims asserted by KUDCO. It is possible that the omeprazole-related patents subject to the foregoing four lawsuits will be found invalid, unenforceable or not infringed and, while currently stayed by the court, it is possible that the defendants’ antitrust counterclaims in the KUDCO litigation will ultimately be allowed to proceed and be litigated. If adverse findings were to occur, they could have a material adverse effect on aaiPharma’s consolidated financial statements, results of operations and cash flow.

In cases where the Company has initiated an action, it intends to prosecute its claims to the full extent of its rights under the law. In cases where the Company is a named defendant, the Company intends to vigorously pursue all defenses available.

On April 15, 2004, the Company filed a lawsuit against Athlon Pharmaceuticals, Inc. in the U.S. District Court for the Northern District of Georgia seeking a declaratory judgment that it was entitled to terminate the Service Agreement (the “Athlon Service Agreement”) dated July 16, 2003, as amended, between the Company and Athlon as well as damages and injunctive relief for material breaches of the Athlon Service Agreement by Athlon. The Athlon Service Agreement incorporated the terms and conditions pursuant to which representatives of Athlon would promote the sale of the Company’s Darvocet A500 product to physicians. The Company initially paid Athlon $3,350,000 to build its sales force to promote the sale of the Company’s Darvocet A500, and the terms of the Athlon Service Agreement would require the Company to pay Athlon an additional $1,200,000 each month for such services for the contract period of 36 months, commencing in October 2003, subject to Athlon’s compliance with certain representations, warranties and covenants, some of which are described below.

The lawsuit asserts that Athlon has materially breached the Athlon Service Agreement in several ways, including failure to: (i) provide the required number of sales representatives during the Company’s launch of Darvocet A500 commencing in October 2003, (ii) use its best efforts to promote Darvocet A500 at the targeted levels of first and second pharmaceutical details to physicians, (iii) perform the services to the best of its ability, as contractually required, and (iv) require its sales representatives to perform the contracted services, as

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required, in a professional manner consistent with industry standards and in conformance with that level of care and skill ordinarily exercised by professional contract sales organizations in similar circumstances. The lawsuit also asserts that Athlon breached its representation and warranty that it would perform, and would require its sales representatives to perform, the contracted services in substantially the same manner that it would promote Athlon’s own products.

Athlon has asserted several counterclaims, including breach of an implied covenant of good faith in fair dealing and anticipatory breach of the contract. The Company has filed a reply denying these allegations.

In May 2004, the Company ceased making payments under the Athlon Service Agreement, and on June 4, 2004, it sent a notice of termination of the agreement to Athlon. On July 7, 2004, the Company amended the lawsuit to assert claims of fraud and breaches of contract and implied covenants, seeking to recover compensatory and punitive damages and attorneys’ fees. Athlon has amended its counterclaim to assert fraud claims and to seek punitive damages.

On August 11, 2004, Athlon filed a lawsuit against the Company, also in the U.S. District Court for the Northern District of Georgia, alleging that the Company breached the Asset Purchase Agreement (the “Purchase Agreement”) dated July 16, 2003 pursuant to which the Company acquired Darvocet A500 from Athlon. Athlon is seeking royalties it alleges the Company failed properly to calculate and pay under the Purchase Agreement, as well as attorneys’ fees. The Company has denied the substantive allegations in this case and filed counterclaims seeking to recover an overpayment in the royalties owed to Athlon.

The two cases have been consolidated and are currently in discovery. No trial date has been set. The Company intends to prosecute its claims and counterclaims, and defend against the claims and counterclaims made by Athlon, in these lawsuits to the full extent permitted by law.

CIMA Labs, Inc. (“CIMA”) commenced an action against the Company in the Fourth Judicial District, State of Minnesota, Hennepin County, on August 11, 2004. In its complaint, CIMA alleges that the Company is liable for fraudulent inducement, negligent fraudulent misrepresentation, fraudulent concealment, breach of contract, and attorneys fees and interest, all arising out of an Agreement and Plan of Merger dated as of August 5, 2003, between CIMA and aaiPharma (“Merger Agreement”). CIMA alleges that in the negotiations leading up to the Merger Agreement, the Company engaged in misrepresentations and concealments relating to its financial condition, and that in the Merger Agreement, the Company made false representations and warranties concerning its financial statements, regulatory filings, and absence of material adverse effects, among other things. Much of CIMA’s claims are based on disclosures made by the Company in its Amended Form 10-Q, filed with the SEC on June 24, 2004, for the period ended June 30, 2003. CIMA seeks to recover the amount of $11.5 million, which it paid to aaiPharma as a termination fee under the Merger Agreement, plus additional sums it spent for professional fees and due diligence activities (which it claims are in excess of $5 million), attorneys’ fees, litigation expenses, and interest. The Company answered CIMA’s complaint on September 17, 2004, denying all liability and raising a number of affirmative defenses. Among other things, the Company asserted that CIMA’s termination of the Merger Agreement barred any claims except those based on the Company’s willful breach of its representations, warranties, covenants, or other agreements as set forth in that Agreement. In addition, the Company affirmatively alleged that CIMA terminated the Merger Agreement and paid the termination fee not as the result of any alleged breach by aaiPharma, but rather as part of CIMA’s plan to secure and act on a “Superior Proposal” from another bidder, which allowed it to consummate a transaction with that other bidder on terms that it believed were more favorable to it than those set forth in the Merger Agreement. The case is scheduled for trial in the fall of 2005, and the parties are currently involved in document productions and written discovery. On January 14, 2005, the Minnesota court rejected a relevance objection made by the Company in response to CIMA’s discovery requests and ordered the Company to

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produce voluminous documents to CIMA. On March 21, 2005, the Minnesota court approved a motion to compel made by CIMA against the Company to produce documents by April 5, 2005 and an extensive privilege log by April 20, 2005 with respect to documents generated by the Company’s legal counsel in the internal investigation. The Company has produced the documents and has moved to delay the production of the privilege log due to its liquidity situation. The Court may deny the Company’s motion for additional time to produce the privilege log and may sanction the Company, including holding the Company in contempt or entering a default judgment against the Company. The Company intends to contest the action as vigorously as its limited resources permit.

The Company cannot predict the outcomes of these lawsuits. Future adverse findings in the above described lawsuits could have a material adverse effect on its consolidated financial condition, results of operations or cash flows.

On April 29, 2005, the Company accepted a commitment letter from Silver Point Finance, LLC to provide debtor-in-possession financing in the event the Company and its U.S. subsidiaries commence bankruptcy proceedings under chapter 11 of Title 11 of the United States Code (the “Bankruptcy Code”). The debtor-in-possession financing, which would be available only if the Company commenced bankruptcy proceedings under chapter 11 of the Bankruptcy Code and the financing was approved by the bankruptcy court, would consist of a revolving credit facility in aggregate principal amount not to exceed $30 million and a term loan facility in the aggregate principal amount of $180 million. The proceeds of the debtor-in-possession financing would be used to refinance the Company’s obligations under its existing senior credit facilities, pay fees and expenses in connection with the financing and to fund working capital and general corporate requirements while the bankruptcy proceedings were pending.

11. Financial information for subsidiary guarantors and non-guarantors

The Company’s senior subordinated notes, due April 1, 2010, are guaranteed by certain of the Company’s subsidiaries.

The following presents condensed consolidating financial information for the Company, segregating: (1) aaiPharma Inc., which issued the notes (the “Issuer”); (2) the domestic subsidiaries, which guarantee the notes (the “Guarantor Subsidiaries”); and (3) all other subsidiaries (the “Non-Guarantor Subsidiaries”). The Guarantor Subsidiaries are wholly-owned direct subsidiaries of the Company and their guarantees are full, unconditional and joint and several. Wholly-owned subsidiaries are presented on the equity basis of accounting. Certain reclassifications have been made to conform all of the financial information to the financial presentation on a consolidated basis. The principal adjusting entries eliminate investments in subsidiaries and inter-company balances and transactions.

The following information presents consolidating statements of operations, balance sheets and cash flows for the periods and as of the dates indicated:

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aaiPharma Inc.
Consolidating Statement of Operations
(In thousands)
(Unaudited)

25

aaiPharma Inc.
Consolidating Statement of Operations
(In thousands)
(Unaudited)

26

aaiPharma Inc.
Consolidating Balance Sheet
(In thousands)
(Unaudited)

27

aaiPharma Inc.
Consolidating Balance Sheet
(In thousands)

28

aaiPharma Inc.
Consolidating Statement of Cash Flows
(In thousands)
(Unaudited)