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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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 SEPTEMBER 30, 2011

Or

 

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM              TO             

Commission File Number: 000-31255

 

 

ISTA PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

DELAWARE		33-0511729
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

50 Technology Drive, Irvine, California 92618

(Address of principal executive offices)

(949) 788-6000

(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  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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

 

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

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

The number of shares of the registrant’s common stock, $0.001 par value, outstanding as of September 30, 2011 was 41,501,397.

 

 

 

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Table of Contents

TABLE OF CONTENTS

 

				Page No
PART I FINANCIAL INFORMATION (unaudited)
Item 1		Financial Statements		3
		Condensed Balance Sheets—September 30, 2011 and December 31, 2010		3
		Condensed Statements of Operations—Three and Nine months ended September 30, 2011 and 2010		4
		Condensed Statement of Stockholders’ Deficit—Nine months ended September 30, 2011		5
		Condensed Statements of Cash Flows—Nine months ended September 30, 2011 and 2010		6
		Notes to Condensed Financial Statements		7
Item 2		Management’s Discussion and Analysis of Financial Condition and Results of Operations		18
Item 3		Quantitative and Qualitative Disclosure About Market Risk		28
Item 4		Controls and Procedures		28
PART II OTHER INFORMATION
Item 1		Legal Proceedings		29
Item 1A		Risk Factors		29
Item 6		Exhibits		30
		Signatures		31
		Index to Exhibits		32

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PART I FINANCIAL INFORMATION

 

Item 1.

Financial Statements

ISTA PHARMACEUTICALS INC.

Condensed Balance Sheets

(in thousands, except per share data)

(unaudited)

 

		September  30, 2011				December  31, 2010
ASSETS
Current assets:
Cash and cash equivalents		$	51,861			$	78,777
Accounts receivable, net of allowances of $0 and $1 for September 30, 2011 and December 31, 2010, respectively			61,442				33,497
Inventory, net of allowances of $966 and $1,275 for September 30, 2011 and December 31, 2010, respectively			6,267				6,130
Other current assets			5,803				3,454
Total current assets			125,373				121,858
Property and equipment, net			10,403				10,352
Deferred financing costs, net			1,135				1,885
Deposits and other assets			586				145
Total assets		$	137,497			$	134,240
LIABILITIES AND STOCKHOLDERS’ DEFICIT
Current liabilities:
Accounts payable		$	7,701			$	4,158
Accrued compensation and related expenses			6,357				6,428
Revolving Credit Facility			24,000				13,000
Current portion of Facility Agreement			21,450				21,450
Current portion of obligations under capital leases			122				143
Allowance for rebates and chargebacks			13,579				9,273
Allowance for product returns			7,922				8,623
Royalties payable			39,449				25,567
Other accrued expenses			12,332				17,394
Total current liabilities			132,912				106,036
Deferred rent and other long term liabilities			2,086				2,287
Obligations under capital leases			176				123
Facility Agreement, net of current portion and unamortized discounts and derivatives			19,182				38,706
Warrant liability			17,901				66,185
Total liabilities			172,257				213,337
Commitments and contingencies
Stockholders’ deficit:
Preferred stock, $0.001 par value; 5,000 shares authorized of which 1,000 shares have been designated as Series A Participating Preferred Stock at September 30, 2011 and December 31, 2010; no shares issued and outstanding			—				—
Common stock, $0.001 par value; 100,000 shares authorized at September 30, 2011 and December 31, 2010; 41,501 and 33,589 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively			41				33
Additional paid-in capital			408,457				323,442
Accumulated deficit			(443,258	)			(402,572	)
Total stockholders’ deficit			(34,760	)			(79,097	)
Total liabilities and stockholders’ deficit		$	137,497			$	134,240

See accompanying notes

 

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ISTA PHARMACEUTICALS INC.

Condensed Statements of Operations

(in thousands, except per share data)

(unaudited)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2011				2010				2011				2010
Revenues:
Product sales, net		$	41,386			$	42,020			$	115,244			$	105,393
Total revenues			41,386				42,020				115,244				105,393
Cost of products sold			10,140				9,678				28,440				25,171
Gross profit			31,246				32,342				86,804				80,222
Costs and expenses:
Research and development			7,720				7,945				26,914				17,779
Selling, general and administrative			19,644				19,614				69,929				60,383
Total costs and expenses			27,364				27,559				96,843				78,162
Income (loss) from operations			3,882				4,783				(10,039	)			2,060
Other income (expense):
Interest expense			(1,671	)			(2,078	)			(5,806	)			(6,222	)
Gain on derivative valuation			75				117				69				130
Gain (loss) on warrant valuation			28,328				(26,338	)			(24,910	)			7,159
Total other income (expense)			26,732				(28,299	)			(30,647	)			1,067
Net income (loss)		$	30,614			$	(23,516	)		$	(40,686	)		$	3,127
Net income (loss) per common share, basic		$	0.74			$	(0.70	)		$	(1.08	)		$	0.09
Shares used in computing net income (loss) per common share, basic			41,492				33,483				37,632				33,418
Net income (loss) per common share, diluted		$	0.64			$	(0.70	)		$	(1.08	)		$	0.07
Shares used in computing net income (loss) per common share, diluted			47,898				33,483				37,632				42,939

See accompanying notes

 

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ISTA PHARMACEUTICALS, INC.

Condensed Statement of Stockholders’ Deficit

(in thousands, except share data)

(unaudited)

 

																		Total Stockholders’ Equity (Deficit)
										Additional Paid-in Capital
		Common Stock												Accumulated Deficit
		Shares				Amount
Balance at December 31, 2010			33,589,335			$	33			$	323,442			$	(402,572	)		$	(79,097	)
Reduction of common stock due to unvested restricted stock awards			(377,039	)			—				—				—				—
Issuance of common stock from exercises of stock options			534,019				2				2,414				—				2,416
Restricted stock issuances			90,187				—				—				—				—
Issuance of common stock from warrant exercises			7,594,502				6				6,230				—				6,236
Transfer of warrant liability to additional paid-in capital upon exercises of warrants			—				—				73,194				—				73,194
Common stock issued under ESPP			70,393				—				311				—				311
Stock-based compensation costs			—				—				2,866				—				2,866
Net loss			—				—				—				(40,686	)			(40,686	)
Comprehensive loss			—				—				—				(40,686	)			(40,686	)
Balance at September 30, 2011			41,501,397			$	41			$	408,457			$	(443,258	)		$	(34,760	)

See accompanying notes

 

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ISTA PHARMACEUTICALS INC.

Condensed Statements of Cash Flows

(in thousands)

(unaudited)

 

		Nine Months Ended September 30,
		2011				2010
OPERATING ACTIVITIES
Net (loss) income		$	(40,686	)		$	3,127
Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities:
Stock-based compensation costs			2,866				2,899
Amortization of deferred financing costs			750				804
Amortization of discounts on Facility Agreement			1,995				2,136
Change in value of warrants related to Facility Agreement			24,910				(7,159	)
Change in value of derivative related to Facility Agreement			(69	)			(130	)
Depreciation and amortization			1,696				906
Changes in operating assets and liabilities:
Accounts receivable, net			(27,945	)			(9,117	)
Inventory, net			(137	)			(92	)
Other current assets			(2,349	)			(571	)
Accounts payable			3,543				1,648
Accrued compensation and related expenses			(71	)			(2,055	)
Allowance for rebates and chargebacks			4,306				3,138
Allowance for product returns			(701	)			1,703
Royalties payable			13,882				13,317
Other accrued expenses			(5,062	)			4,366
Deferred rent and other long term liabilities			(201	)			—
Net cash (used in) provided by operating activities			(23,273	)			14,920
INVESTING ACTIVITIES
Purchases of equipment			(1,564	)			(1,456	)
Deposits and other assets			(441	)			6
Net cash used in investing activities			(2,005	)			(1,450	)
FINANCING ACTIVITIES
Proceeds from exercise of warrants			6,236				—
Proceeds from exercise of stock options			2,416				11
Proceeds from issuance of common stock for ESPP			311				153
Payments under capital leases			(151	)			(123	)
Repayments on Facility Agreement			(21,450	)			—
Proceeds from Revolving Credit Facility			50,000				39,000
Repayments on Revolving Credit Facility			(39,000	)			(39,000	)
Net cash (used in) provided by financing activities			(1,638	)			41
(Decrease) increase in cash and cash equivalents			(26,916	)			13,511
Cash and cash equivalents at beginning of period			78,777				53,702
Cash and cash equivalents at end of period		$	51,861			$	67,213
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the period for interest		$	3,214			$	3,293
Transfer of warrant liability to additional paid-in capital upon exercise of warrants		$	73,194			$	—

See accompanying notes

 

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ISTA PHARMACEUTICALS INC.

Notes to Condensed Financial Statements

(unaudited)

1. The Company

ISTA Pharmaceuticals, Inc. (“ISTA,” the “Company,” or “we”) was incorporated as Advanced Corneal Systems, Inc. in California in February 1992 to discover, develop and market new remedies for diseases and conditions of the eye. In March 2000, we changed our name to ISTA Pharmaceuticals, Inc., and we reincorporated in Delaware in August 2000. BROMDAY™, BEPREVE^®, ISTALOL^®, VITRASE^®, XIBROM (bromfenac ophthalmic solution)^®, XIBROM™, REMURA™, T-PRED™, PROLENSA™, BEPOSONE™, BEPOMAX™, ISTA^®, ISTA Pharmaceuticals, Inc.^® and the ISTA logo are our trademarks, either owned or under license.

We are a rapidly growing commercial-stage, multi-specialty pharmaceutical company developing, marketing and selling our own products in the United States, or the U.S., and Puerto Rico. We are the third largest branded prescription eye care business in the U.S. and have a growing allergy drug franchise. We manufacture our finished good products through third-party contracts, and we in-license or acquire new products and technologies to add to our internal development efforts from time to time. Our products and product candidates seek to treat allergy and serious diseases of the eye and include therapies for ocular inflammation and pain, glaucoma, dry eye and ocular and nasal allergies. The U.S. prescription markets which our therapies seek to address include key segments of the $6.5 billion ophthalmic pharmaceutical market and the $2.5 billion nasal allergy market.

We currently have four products available for sale in the U.S. and Puerto Rico: BROMDAY (bromfenac ophthalmic solution) 0.09%, for the treatment of postoperative inflammation and reduction of ocular pain in patients who have undergone cataract extractions, BEPREVE (bepotastine besilate ophthalmic solution) 1.5%, for the treatment of ocular itching associated with allergic conjunctivitis, ISTALOL (timolol maleate ophthalmic solution) 0.05%, for the treatment of glaucoma and VITRASE (hyaluronidase injection) ovine, 200 USP units/ml, for use as a spreading agent. In addition, we have several eye and allergy product candidates in various stages of development, including treatments for dry eye, ocular inflammation and pain and nasal allergies.

Due to the rapid adoption of BROMDAY™ (bromfenac ophthalmic solution) 0.09%, the first and only once-daily non-steroidal anti-inflammatory prescription eye drop for the treatment of postoperative inflammation and reduction of ocular pain in patients who have undergone cataract extractions, we stopped shipping twice-daily XIBROM (bromfenac ophthalmic solution)^® 0.09% in February 2011. At that time, we anticipated wholesalers would continue to sell XIBROM to pharmacies until their inventories were depleted. As of September 30, 2011, most of the wholesalers’ inventories were depleted. Thus, we believe that the conversion of XIBROM to BROMDAY has been well accepted by the markets.

2. Summary of Significant Accounting Policies

Basis of Presentation

Our unaudited condensed financial statements have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. The accompanying unaudited condensed financial statements do not include certain footnotes and financial presentations normally required under generally accepted accounting principles in the United States, or GAAP, and, therefore should be read in conjunction with the consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2010 filed with the Securities and Exchange Commission, or the SEC, on February 25, 2011.

In the opinion of management, all adjustments (consisting of normal recurring adjustments) necessary for the fair presentation of the unaudited condensed balance sheets as of September 30, 2011 and December 31, 2010, the condensed statements of operations for the three and nine months ended September 30, 2011 and 2010, the condensed statement of stockholders’ deficit for the nine months ended September 30, 2011 and the condensed statements of cash flows for the nine months ended September 30, 2011 and 2010, have been made. The interim results of operations are not necessarily indicative of the results to be expected for the full fiscal year.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported in the condensed financial statements and accompanying notes. Actual results could differ significantly from those estimates.

 

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Revenue Recognition

Product Revenues. We recognize revenues from product sales when there is persuasive evidence that an arrangement exists, when title has passed, the price is fixed or determinable, and we are reasonably assured of collecting the resulting receivable. We recognize product revenues net of estimated allowances for rebates, chargebacks, product returns and other discounts, such as wholesaler fees. If actual future payments for allowances for discounts, product returns, wholesaler fees, rebates and chargebacks materially exceed the estimates we made at the time of sale, our financial position, results of operations and cash flows may be negatively impacted.

We establish allowances for estimated rebates, chargebacks and product returns based on numerous qualitative and quantitative factors, including:

 

•

the number of agreements with customers and specific contractual terms;

 

•

the estimated level of units in the distribution channel;

 

•

historical rebates, chargebacks and returns of products;

 

•

direct communication with customers;

 

•

anticipated introduction of competitive products or generics;

 

•

anticipated pricing strategy changes by us and/or our competitors;

 

•

analysis of prescription data gathered by a third-party prescription data provider;

 

•

the impact of wholesaler distribution agreements;

 

•

the impact of changes in state and federal regulations; and

 

•

the estimated remaining shelf-life of products.

In our analyses, we utilize on-hand unit data purchased from the major wholesalers, as well as prescription data purchased from a third-party data provider, to develop estimates of sales by wholesalers to pharmacies and others. We utilize an internal analysis to compare, on a historical basis, net product shipments versus both estimated prescriptions written and product returns. Based on such analysis, we develop an estimate of the quantity of product which may be subject to various discounts, product returns, rebates, chargebacks and wholesaler fees.

We record estimated allowances for rebates, chargebacks, product returns and other discounts, such as wholesaler fees, in the same period when revenue is recognized. The objective of recording the allowances for such deductions at the time of sale is to provide a reasonable estimate of the aggregate amount of credit to our direct customers or payments to our indirect customers. Customers typically process their claims for allowances such as early pay discounts promptly, usually within the established payment terms. We monitor actual credit memos issued to our customers and compare such actual amounts to the estimated provisions, in the aggregate, for each allowance category to assess the reasonableness of the various reserves at each balance sheet date. Differences between our estimated allowances and actual credits issued have not been significant, and are accounted for in the current period as a change in estimate.

In general, we are obligated to accept from our customers the return of products that have reached their expiration date. We authorize returns for damaged products, expiring and expired products in accordance with our return goods policy and procedures, and have established reserves for such amounts at the time of sale. We typically refund the agreed proportion of the sales price by the issuance of a credit, rather than a cash refund or exchange for inventory, and the returned product is destroyed. With the launch of each of our products, we record a sales return allowance, which is larger for stocking orders than subsequent re-orders. To date, actual product returns have not exceeded our estimated allowances for returns. Although we believe that our estimates and assumptions are reasonable as of the date made, actual results may differ significantly from these estimates. Our financial position, results of operations and cash flows may be materially and negatively impacted if actual returns materially exceed our estimated allowances for returns.

We identify product returns by their manufacturing lot number. Because we manufacture in bulk, lot sizes can be large and, as a result, sales of any individual lot may occur over several periods. As a result, we are unable to specify if actual returns or credits relate to a sale that occurred in the current period or a prior period, and therefore, we cannot specify how much of the allowance recorded relates to sales made in prior periods. Since there have been no material differences between estimates recorded and actual credits issued, we believe our systems and procedures are adequate for managing our business.

 

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Allowances for product returns were $7.9 million and $8.6 million as of September 30, 2011 and December 31, 2010, respectively. These allowances reflect an estimate of our liability for products that may be returned by the original purchaser in accordance with our stated return policy, which allows customers to return products within six months of their respective expiration dates and for a period up to twelve months after such products have reached their respective expiration dates. We estimate our liability for product returns at each reporting period based on the estimated units in the channel and the other factors discussed above. As a percentage of gross product revenues, the reserve for product returns was 1.2% and 2.7% for the three months ended September 30, 2011 and 2010, respectively; and was 1.4% and 2.5% for the nine months ended September 30, 2011 and 2010, respectively. The decrease is due to lower product returns, improved product shelf life, continued acceptance and sale of our products and the discontinuation of XIBROM in early 2011.

We also periodically offer promotional discounts to our existing customer base. These discounts are usually calculated as a percentage of the current published list price. Accordingly, the discounts are recorded as a reduction of revenue in the period that the program is offered. In addition to promotional discounts, at the time we implement a price increase, we generally offer our existing customers an opportunity to purchase a limited quantity of products at the previous list price. Shipments resulting from these programs generally are not in excess of ordinary levels and therefore, we recognize the related revenue upon receipt by the customer and include the sale in estimating our various product-related allowances. In the event we determine that these sales represent purchases of inventory in excess of ordinary levels for a given wholesaler, the potential impact on product returns exposure would be specifically evaluated and reflected as a reduction to revenue at the time of such sale.

Allowances for estimated rebates and chargebacks were $13.6 million and $9.3 million as of September 30, 2011 and December 31, 2010, respectively. Other discounts, such as wholesaler fees and prompt pay discounts, were $6.9 million and $5.0 million as of September 30, 2011 and December 31, 2010, respectively. These allowances reflect an estimate of our liability for items such as rebates due to various governmental organizations under the Medicare/Medicaid regulations, rebates due to managed care organizations under specific contracts, chargebacks due to various organizations purchasing certain of our products through federal contracts and/or group purchasing agreements and fees charged by certain wholesalers under distribution agreements. We estimate our liability for rebates, chargebacks and other discounts, such as wholesaler fees, at each reporting period based on the assumptions described above.

As a percentage of gross product revenues, the allowance for rebates, chargebacks and other discounts such as wholesaler fees was 22.6% and 17.4% for the three months ended September 30, 2011 and 2010, respectively; and was 22.1% and 17.5% for the nine months ended September 30, 2011 and 2010, respectively. The increase is primarily due to growth in the number and utilization of managed care contracts, federal contracts, and wholesaler distribution agreements and the impact of higher Medicaid and Medicare rebates required under the recent healthcare legislation. For the nine months ended September 30, 2011, we recorded estimated new Medicare rebates required under the legislation, commonly known as “donut-hole” rebates, of $0.9 million.

License Revenue. Amounts received for product and technology license fees under multiple-element arrangements are deferred and recognized over the period of such services or performance if such arrangements require on-going services or performance. Amounts received for milestones are recognized upon achievement of the milestone, unless we have ongoing performance obligations. Any amounts received prior to satisfying our revenue recognition criteria will be recorded as deferred income in the accompanying condensed balance sheets.

Cash and Cash Equivalents

Cash and cash equivalents consist of cash in banks and short-term U.S. Treasury investments with maturities of three months or less when purchased. Cash and cash equivalents are carried at cost, which we believe approximates fair value because of the short-term maturity of these instruments. Cash and cash equivalents are maintained at financial institutions and, at times, balances may exceed federally insured limits. We have never experienced any losses related to these balances. All of our non-interest bearing cash balances were fully insured at September 30, 2011 and December 31, 2010, due to a temporary federal program in effect through December 31, 2012. Under the program, there is no limit to the amount of insurance for eligible accounts. Beginning in 2013, insurance coverage will revert to $250,000 per depositor at each financial institution, and our non-interest bearing cash balances may exceed federally insured limits. We had total cash and cash equivalents of approximately $51.9 million and $78.8 million as of September 30, 2011 and December 31, 2010, respectively, of which, $15 million and $60 million at September 30, 2011 and December 31, 2010, respectively, were invested in low interest bearing U.S. Treasury Funds.

Concentration of Credit Risk and Customer Risk

Financial instruments that potentially subject us to a significant concentration of credit risk principally consist of trade receivables. Wholesale distributors account for a substantial portion of trade receivables. Accounts receivable from

 

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McKesson HBOC, Cardinal Health, Inc., and AmeriSource Bergen Corp. accounted for 42%, 43% and 11%, respectively, of our total accounts receivable as of September 30, 2011. Accounts receivable from McKesson HBOC, Cardinal Health, Inc., and AmeriSource Bergen Corp. accounted for 37%, 43% and 14%, respectively, of our total accounts receivable as of December 31, 2010. We maintain reserves for bad debt and such losses, in the aggregate, have not exceeded our estimates.

Sales to Cardinal Health, Inc., McKesson HBOC, and AmeriSource Bergen Corp. accounted for 39%, 35% and 19%, respectively, of our net revenues for the nine months ended September 30, 2011. Sales to Cardinal Health, Inc., McKesson HBOC, and AmeriSource Bergen Corp. accounted for 41%, 33% and 16%, respectively, of our net revenues for the nine months ended September 30, 2010.

Inventory

Inventory at September 30, 2011 was $6.3 million, which was comprised of $3.2 million of raw materials, $0.8 million of work-in-progress and $3.3 million of finished goods and included $1.0 million in inventory reserves. Inventory at December 31, 2010 was $6.1 million, which was comprised of $3.5 million of raw materials, $0.1 million of work-in-progress and $3.8 million of finished goods and included $1.3 million in inventory reserves. Inventory, net of allowances, is stated at the lower of cost or market. Cost is determined by the first-in, first-to-expire method.

Inventory is reviewed periodically for slow-moving or obsolete status. We adjust our inventory to reflect situations in which the cost of inventory is not expected to be recovered. We would record a reserve to adjust inventory to its net realizable value if: (i) a launch of a new product is delayed, inventory may not be fully utilized and could be subject to impairment, (ii) when a product is close to expiration and not expected to be sold, (iii) when a product has reached its expiration date or (iv) when a product is not expected to be saleable. In determining the reserves for these products, we consider factors such as the amount of inventory on hand and its remaining shelf life, and current and expected market conditions, including management forecasts and levels of competition. We have evaluated the current level of inventory considering historical trends and other factors, and based on our evaluation, have recorded adjustments to reflect inventory at its net realizable value. These adjustments are estimates, which could vary significantly from actual results if future economic conditions, customer demand, competition or other relevant factors differ from expectations. These estimates require us to make assessments about the future demand for our products in order to categorize the status of such inventory items as slow-moving, obsolete or in excess-of-need. These future estimates are subject to the ongoing accuracy of our forecasts of market conditions, industry trends, competition and other factors. Differences between our estimated reserves and actual inventory adjustments have not been significant, and are accounted for in the current period as a change in estimate.

Costs incurred for the manufacture of validation batches for pre-approval products are recorded as research and development expenses in the period in which those costs are incurred.

Supply Concentration Risks

Some materials used in our products are currently obtained from a single source. We have a supply agreement with Senju Pharmaceuticals, Co. Ltd., or Senju, for bepotastine besilate, which is the active pharmaceutical ingredient in BEPREVE. Currently, Senju is our sole source for bepotastine besilate for BEPREVE. We have a supply agreement with Regis Technologies, Inc., or Regis, for bromfenac, which is the active pharmaceutical ingredient in BROMDAY and was also used for XIBROM. Currently, Regis is our sole source for bromfenac. We also have supply agreements with Bausch & Lomb, Incorporated to manufacture finished product of BROMDAY, BEPREVE and ISTALOL. Currently, Bausch & Lomb Incorporated is our sole source for finished product of BROMDAY, BEPREVE and ISTALOL.

Ovine hyaluronidase, the active pharmaceutical ingredient used in VITRASE, is processed in several stages to produce a highly purified raw material for formulation. In June 2010, we received approval from the U.S. Food and Drug Administration, or the FDA, to manufacture hyaluronidase at our Irvine, California manufacturing facility and began production in July 2010. We have a supply agreement with Alliance Medical Products to manufacture finished product of VITRASE. Currently, Alliance Medical Products is our sole source for finished product of VITRASE.

Fair Value of Financial Instruments

Our financial instruments include cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, current and long-term debt, certain derivatives related to our debt obligations and common stock warrants issued to lenders. The carrying amount of cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities are considered to be representative of their respective fair values because of the short-term nature of those instruments. The carrying amount of our revolving credit facility with Silicon Valley Bank, or the Revolving Credit Facility, approximates fair value since the interest rate approximates the market rate for debt securities with similar terms and risk characteristics. Although our facility agreement, or the Facility Agreement, with certain accredited institutional investors, collectively known as the Lenders, is considered a financial instrument, we are unable to reasonably determine fair value.

 

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Fair Value Measurements

We account for fair value measurements under the Financial Standards Accounting Board, or the FASB, Accounting Standard Codification 820 “Fair Value Measurements and Disclosures”, or ASC 820, which defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. ASC 820 establishes a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows:

 

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Level 1 — Quoted prices in active markets for identical assets or liabilities.

 

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Level 2 — Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

 

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Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.

We have segregated all assets and liabilities measured at fair value on a recurring basis into the most appropriate level within the fair value hierarchy based on the inputs used to determine the fair value at the measurement date in the table below. As of September 30, 2011 and December 31, 2010, all of our assets and liabilities are valued using Level 1 inputs except for the derivative and warrants related to our Facility Agreement. We have valued the warrants using a Black-Scholes model, which we believe is the appropriate valuation model based on the terms of the warrants and based on assumptions and data available as of September 30, 2011 and December 31, 2010, including but not limited to our stock price, risk-free interest rates and stock price volatility.

Assets and liabilities measured at fair value on a recurring basis are summarized below (in thousands) (unaudited):

 

		Fair Value Measurements using												Total Carrying Value at
		Level 1				Level 2				Level 3
September 30, 2011
Cash and cash equivalents, including U.S. Treasury Funds		$	51,861			$	—			$	—			$	51,861
Derivative (Facility Agreement)			—				—				(100	)			(100	)
Warrants			—				—				(17,901	)			(17,901	)
December 31, 2010
Cash and cash equivalents, including U.S. Treasury Funds		$	78,777			$	—			$	—			$	78,777
Derivative (Facility Agreement)			—				—				(169	)			(169	)
Warrants			—				—				(66,185	)			(66,185	)

 

		Fair Value  Measurements Using Significant Unobservable Inputs (Level 3) Derivatives				Fair Value  Measurements Using Observable Inputs Other Than Level 1 (Level 3) Warrants
Balance at December 31, 2010		$	(169	)		$	(66,185	)
Total gains or losses (realized or unrealized)			69				(24,910	)
Transfer of warrant liability to additional paid-in capital upon exercises of warrants			—				73,194
Balance at September 30, 2011		$	(100	)		$	(17,901	)

Comprehensive (Loss) Income

Accounting Standards Codification 220 “Comprehensive Income,” or ASC 220, requires reporting and displaying comprehensive income (loss) and its components, which includes net income (loss) and unrealized gains and losses on investments and foreign currency translation gains and losses. Total comprehensive (loss) income for the nine months ended September 30, 2011 and 2010 was $(40.7) million and $3.1 million, respectively.

 

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Stock-Based Compensation

We recognize compensation costs for all stock-based awards made to employees and directors. The fair value of stock-based awards is estimated at grant date using an option pricing model and the portion that is ultimately expected to vest is recognized as compensation cost over the requisite service period.

Since stock-based compensation is recognized only for those awards that are ultimately expected to vest, we have applied an estimated forfeiture rate to unvested awards for the purpose of calculating compensation cost. These estimates will be revised, if necessary, in future periods if actual forfeitures differ from estimates. Changes in forfeiture estimates impact compensation cost in the period in which the change in estimate occurs.

We use the Black-Scholes option-pricing model to estimate the fair value of stock-based awards. The determination of fair value using the Black-Scholes option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables, including expected stock price volatility, risk-free interest rate, expected dividends and projected employee stock option exercise behaviors. We estimate the expected term based on the contractual term of the awards and employees’ exercise and expected post-vesting termination behavior.

Stock Options

The amount of compensation expense recorded is based on the market value of the shares on the date of grant. Expenses related to the vesting of stock options were $0.9 million for both the three months ended September 30, 2011 and 2010, respectively, and $2.5 million and $2.6 million for the nine months ended September 30, 2011 and 2010, respectively. At September 30, 2011, there was $6.2 million of total unrecognized compensation cost related to non-vested stock options, which is expected to be recognized over a remaining weighted average vesting period of approximately 2.4 years.

Restricted Stock Awards

The amount of compensation expense recorded is based on the market value of the shares on the date of issuance. Expenses related to the vesting of restricted stock were $0.2 million and $0.1 million for the three months ended September 30, 2011 and 2010, respectively, and $0.4 million and $0.3 million for the nine months ended September 30, 2011 and 2010, respectively. As of September 30, 2011, there was approximately $1.3 million of unamortized compensation cost related to restricted stock awards, which is expected to be recognized ratably over the vesting period of four years.

We have excluded 377,039 unvested restricted stock awards from our calculation of common stock outstanding, which has been included erroneously in prior periods. The exclusion did not have a material impact on our basic or diluted earnings per share for any prior reported periods.

Net Income (Loss) Per Share

Basic net income (loss) per common share is computed by dividing the net income (loss) for the period by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing the net income for the period by the weighted-average number of common and common equivalent shares, such as stock options, unvested restricted shares and warrants, outstanding during the period. Diluted earnings per common share consider the impact of potentially dilutive securities except in periods in which there is a loss because the inclusion of the potential common shares would have an anti-dilutive effect. Diluted earnings per share excludes the impact of potential common shares related to our stock options, unvested restricted shares and warrants, in periods in which the exercise or conversion price is greater than the average market price of our common stock during the period.

Basic and diluted net income (loss) per share was calculated as follows (in thousands, unaudited):

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2011				2010				2011				2010
Numerator for basic and diluted income (loss) per share:
Net income (loss)		$	30,614			$	(23,516	)		$	(40,686	)		$	3,127
Denominator:
Denominator for basic income per share — weighted-average shares			41,492				33,483				37,632				33,418
Effect of dilutive securities			6,406				—				—				9,521
Denominator for diluted income per share — adjusted weighted-average shares			47,898				33,483				37,632				42,939

Diluted net income per share of common stock includes the dilutive effect of stock options, unvested restricted stock and warrants. For the three months ended September 30, 2011, we excluded approximately 6.8 million stock options, 1.8 million warrants and 0.2 restricted stock awards from the calculation of diluted income per share, because their exercise

 

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prices rendered them anti-dilutive. For the nine months ended September 30, 2010, approximately 6.7 million stock options and 6.2 million warrants were excluded from the calculation of diluted income per share because their exercise prices rendered them anti-dilutive. As we incurred net losses for the nine months ended September 30, 2011 and three months ended September 30, 2010, respectively, we have not computed the diluted earnings per share, as the potentially dilutive securities would have an anti-dilutive effect on earnings.

Common shares issued for nominal consideration, if any, would be included in the per share calculations as if they were outstanding for all periods presented. We have further determined that warrants issued in conjunction with our Facility Agreement represent participating securities, requiring the use of the two-class method for the calculation of basic and diluted earnings per share. Because net losses are not allocated to the warrant holders, the two-class method does not affect our calculation of earnings per share for the nine months ended September 30, 2011 and three months ended September 30, 2010, respectively. The two-class method for the three months ended September 30, 2011 and the nine months ended September 30, 2010 reflects the amount of unallocated undistributed earnings calculated using the participation percentage.

The following table sets forth the calculation of unallocated undistributed earnings using the two-class method for amounts attributable to our common stock and our warrants (in thousands) (unaudited):

 

		Three Months  Ended September 30, 2011				Nine Months  Ended September 30, 2010
Net income attributable to shareholders		$	30,614			$	3,127
Common stock unallocated earnings			26,243				2,158
Warrant unallocated earnings			4,371				969
Total unallocated earnings		$	30,614			$	3,127

Executive Employment Agreements

We have agreements with each of our officers which provides that any unvested stock options and restricted shares then held by such officer will become fully vested and, with respect to stock options, immediately exercisable, in the event of a change in control of the Company and, for certain officers, if within twenty-four months following such change in control such officer’s employment is terminated by the Company without cause or such officer resigns for good reason within sixty days of the event forming the basis for such good reason termination.

Revolving Credit Facility

Under our Revolving Credit Facility we may borrow up to the lesser of $25.0 million or 80% of eligible accounts receivable, plus the lesser of 25% of net cash and cash equivalents or $10.0 million. As of September 30, 2011, we had $24.4 million available under the Revolving Credit Facility, of which we borrowed $24.0 million. All outstanding amounts under the Revolving Credit Facility bear interest at a variable rate equal to the lender’s prime rate plus a margin of 0.50%. In no event shall the interest rate on outstanding borrowings be less than 4.50%, which is payable on a monthly basis. The Revolving Credit Facility also contains customary covenants regarding the operation of our business and financial covenants relating to ratios of current assets to current liabilities and is collateralized by all of our assets. An event of default under the Revolving Credit Facility will occur if, among other things, (i) we are delinquent in making payments of principal or interest on the Revolving Credit Facility; (ii) we fail to cure a breach of a covenant or term of the Revolving Credit Facility; (iii) we make a representation or warranty under the Revolving Credit Facility that is materially inaccurate; (iv) we are unable to pay our debts as they become due, certain bankruptcy proceedings are commenced or certain orders are granted against us, or we otherwise become insolvent; or (v) an acceleration event occurs under certain types of other indebtedness outstanding from time to time. If an event of default occurs, the indebtedness to Silicon Valley Bank could be accelerated, such that it becomes immediately due and payable. We also had letters of credit of $0.6 million outstanding. As of September 30, 2011, we were in compliance with all of the covenants under the Revolving Credit Facility. During certain months in the fourth quarter, we may not be able to fulfill our adjusted quick ratio covenant. We are in discussions with Silicon Valley Bank, and, if successful, will either modify the covenant under the Revolving Credit Facility or seek a waiver for the covenant. However, no assurance can be given as to the outcome of our negotiations. Our failure to amend the covenant or obtain a waiver could cause us an inability to borrow under our Revolving Credit Facility. All amounts borrowed in September 2011 under the Revolving Credit Facility were repaid in October 2011. As of November 4, 2011, there were no borrowings under the Revolving Credit Facility. The Revolving Credit Facility expires on March 31, 2012.

Facility Agreement

Pursuant to a facility agreement, or the Facility Agreement, certain investors and lenders, collectively called the Lenders, loaned us $65 million. In August 2011, we repaid the first installment of $21.5 million to the Lenders. On September 30, 2011, we had total remaining indebtedness under the Facility Agreement of $43.6 million, which excludes unamortized discounts of $3.1 million and the value of the derivative of $0.1 million. Outstanding amounts under the Facility Agreement accrue interest at a rate of 6.5% per annum, payable quarterly in arrears. We are required to repay the Lenders 33% of the original principal amount (or $21.5 million) on September 26, 2012, and 34% of the original principal amount (or $22.0 million) on September 26, 2013.

 

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Any amounts drawn under the Facility Agreement may become immediately due and payable upon (i) an “event of default,” as defined in the Facility Agreement, in which case the Lenders would have the right to require us to repay 100% of the principal amount of the loan, plus any accrued and unpaid interest thereon, or (ii) the consummation of certain change of control transactions, in which case the Lenders would have the right to require us to repay 110% of the outstanding principal amount of the loan, plus any accrued and unpaid interest thereon. An event of default under the Facility Agreement will occur if, among other things, (i) we fail to make payment when due; (ii) we fail to comply in any material respect with any covenant of the Facility Agreement, and such failure is not cured; (iii) any representation or warranty made by us in any transaction document was incorrect, false, or misleading in any material respect as of the date it was made; (iv) we are generally unable to pay our debts as they become due or a bankruptcy or similar proceeding is commenced by or against us; or (v) cash and cash equivalents on the last day of each calendar quarter are less than $10 million. The Facility Agreement also contains customary covenants regarding operations of our business. As of September 30, 2011, we were in compliance with all the covenants under the Facility Agreement.

In connection with the Facility Agreement, we entered into a security agreement with the Lenders, pursuant to which, as security for our repayment obligations under the Facility Agreement, we granted to the Lenders a security interest in certain of our intellectual property, including intellectual property relating to BROMDAY, BEPREVE, ISTALOL, VITRASE, REMURA, PROLENSA and XIBROM and each other product marketed by or under license from us, and certain personal property relating thereto.

Because the consummation of certain change in control transactions results in a premium of the outstanding principal, the premium put feature is a derivative that is required to be bifurcated from the host debt instrument and recorded at fair value at each quarter end. The value of the derivative at September 30, 2011 was $0.1 million and is marked-to-market and adjusted quarterly through other expense.

In connection with the Facility Agreement, we issued to the Lenders warrants to purchase an aggregate of 15 million shares of our common stock at an exercise price of $1.41 per share, of which 6.9 million warrants expiring in 2014 remain outstanding. If we issue or sell shares of our common stock (other than certain “excluded shares,” as such term is defined in the Facility Agreement), we will issue concurrently therewith additional warrants to purchase such number of shares of common stock that will entitle the Lenders to maintain the same beneficial ownership in the Company after the issuance as they had prior to such issuance, as adjusted on a prorata basis for repayments of the outstanding principal amount under the loan, with such warrants being issued at an exercise price equal to the greater of $1.41 per share and the closing price of the common stock on the date immediately prior to the issuance. The anti-dilutive element in the warrant agreement requires us to follow the Derivatives and Hedging Topic of the FASB Accounting Standards Codification, or the Codification. The Codification requires us to classify our warrants as a liability, which are marked to market and adjusted quarterly. We recorded a non-cash valuation loss of $24.9 million, or $0.66 per diluted share for the nine months ended September 30, 2011 and a non-cash valuation gain of $7.2 million, or $0.17 per diluted share for the nine months ended September 30, 2010. We also recorded a non-cash valuation gain of $28.3 million, or $0.59 per diluted share for the three months ended September 30, 2011 and a non-cash valuation loss of $26.3 million, or $0.79 per diluted share for the three months ended September 30, 2010. The change in the valuation of the warrants was primarily driven by changes in our stock price, related volatility and the weighted average number of warrants outstanding. During the nine months ended September 30, 2011, some of the Lenders and their assignees exercised a total of 8.1 million warrants, of which a portion were exercised for cash and a portion were exercised on a cashless basis.

A reconciliation of warrant activity for the nine months ended September 30, 2011 is as follows (in thousands) (unaudited):

 

		Warrants								Common Stock
Balance at December 31, 2010							15,000
Less: warrants exercised / common stock issued
For cash			(4,423	)							4,423
On a cashless basis			(3,666	)							3,172
Total warrants exercised / common stock issued							(8,089	)			7,595
Balance at September 30, 2011							6,911

 

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Commitments and Contingencies

We are subject to routine claims and litigation incidental to our business. In the opinion of management, the resolution of such claims is not expected to have a material adverse effect on our operating results or financial position.

Legal Proceedings

Bromfenac Royalty Litigation. We initiated legal action in April 2010 against Senju seeking a declaratory judgment with regard to our royalty obligations to Senju in connection with bromfenac products and a recovery of overpaid XIBROM royalties and other damages. The only U.S. patent applicable to XIBROM and, now to BROMDAY, expired in January 2009 and, according to U.S. case law and the terms of our agreement with Senju, we believe no bromfenac product royalties are due after patent expiration. In August 2010, the U.S. District Court for the Central District of California stayed our action against Senju, and, in September 2010, Senju initiated an arbitration proceeding regarding the same dispute with the International Chamber of Commerce, or the ICC. The order staying our action against Senju will not become appealable until after the arbitration is concluded and a judgment is entered in the court case. The arbitration proceeding, the outcome of which may also affect our BROMDAY royalty obligations, is in its early stages.

In June 2010, we initiated a legal action by filing a Complaint against AcSentient, Inc. and AcSentient II, LLC, which we collectively refer to as AcSentient, seeking a declaratory judgment with regard to our bromfenac royalty obligations under the Asset Purchase Agreement dated May 3, 2002 between the Company and AcSentient, Inc. The only U.S. patent applicable to XIBROM and, now, to BROMDAY expired in January 2009 and, according to U.S. case law and the terms of our agreement with AcSentient, Inc., we believe no XIBROM and BROMDAY royalties are due after patent expiration. A declaratory judgment that we are seeking from the Court in regard to royalty obligations to AcSentient may apply not only to XIBROM, but also to BROMDAY, which was approved by the FDA in October 2010. In November 2010, the Superior Court of the State of California, County of Orange stayed our case against AcSentient and ruled that the dispute had to be arbitrated. We will have an opportunity to appeal that Court’s ruling after the final judgment is entered by the Court. In January 2011, AcSentient filed a request for arbitration with the ICC. That arbitration is in its early stages.

There can be no assurance about when these two disputes will be resolved, and we cannot predict the final outcome or financial impact of either. Until these two disputes are resolved, for accounting purposes, we have been and intend to continue to reserve for BROMDAY and XIBROM royalties, which would have been payable to Senju and AcSentient if the relevant contractual royalty obligations were existing and enforceable. As of September 30, 2011, we had approximately $33.5 million reserved for such contingent XIBROM and BROMDAY royalties.

Subpoenas From the U.S. Attorney, Western District of New York. In April 2008, we received subpoenas from the office of the U.S. Attorney for the Western District of New York requesting information regarding the marketing activities related to XIBROM. We are cooperating with the government’s investigation. From April 2008 through September 30, 2011, we have incurred approximately $4.0 million in legal fees associated with this criminal investigation and expect to incur significant expenses in the future. In October 2011, we, and certain of our officers and current and former employees received correspondence from the government identifying them as targets. Tolling agreements have been executed to allow cooperation and discussions regarding resolution. If the government chooses to engage in civil litigation or initiate a criminal prosecution against us, our officers or our current or former employees, as a result of its review of the requested documents and other evidence, we may have to incur significant amounts to defend such actions or pay or incur substantial fines or penalties, on behalf of ourselves, our officers or our current or former employees, any of which could significantly deplete our cash resources. The case is ongoing and the likelihood of an unfavorable outcome and/or the amount/range of loss or additional expenses, cannot be reasonably estimated.

TRICARE Retail Pharmacy Program. Section 703 of the National Defense Authorization Act of 2008, enacted on January 28, 2009, requires that pharmaceutical products purchased through the Department of Defense, or DoD, TRICARE Retail Pharmacy program be subject to the Federal Ceiling Price discount under the Veterans Health Care Act of 1992. DoD issued a rule pursuant to Section 703 that requires manufacturers to provide DoD with a quarterly refund on pharmaceutical products utilized through the TRICARE Retail Pharmacy program, and to pay rebates to DoD on TRICARE Retail Pharmacy purchases retroactive to

 

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January 28, 2008. We have requested a waiver of the retroactive rebate for TRICARE Retail Pharmacy utilization for the period from January 28, 2008 to May 26, 2009 (the effective date of the DoD rule). In addition, the regulation was the subject of litigation by others, and it was our position that the retroactive application of the regulation was contrary to established case law. As of September 30, 2011, we determined that our payment of the retroactive rebate (from January 28, 2008 to May 26, 2009) created by the regulation is neither reasonably estimable nor probable as of September 30, 2011. In late October 2011, the United States District Court for the District of Columbia issued its decision in Coalition for Common Sense in Government Procurement v. United States, No. 08-996 (D.C. Dist. Ct. Oct. 25, 2011) upholding the DoD's regulation. It is uncertain whether the decision will be appealed, and if so, whether such appeal would be successful. In addition, the foregoing court decision does not impact our currently pending request for a waiver of the retroactive rebate.

FDA Complaint. We filed a Citizen Petition, or CP, with the FDA in March 2011. The CP requested the FDA to refrain from granting tentative or final approval of any abbreviated new drug application, or ANDA, for bromfenac sodium ophthalmic solution 0.09% that utilizes the labeling for discontinued XIBROM (bromfenac ophthalmic solution)^® 0.09% or omits any portion of the BROMDAY label relating to the once-per-day dosing. In May 2011, the FDA partially denied our CP and approved a generic version of twice-daily bromfenac ophthalmic solution 0.09%, which is substitutable for one bottle size of our twice-daily XIBROM (bromfenac ophthalmic solution)^® 0.09%. In May 2011, we filed a Complaint in the United States District Court for the District of Columbia alleging that the FDA’s approval of a generic version of XIBROM was arbitrary, capricious, and contrary to law. We also filed papers seeking injunctive relief with respect to the FDA’s approval of a generic version of twice-daily bromfenac ophthalmic solution 0.09% and relief from denial of our 2011 CP requesting that the FDA refrain from granting tentative or final approval of any abbreviated new drug application for bromfenac sodium ophthalmic solution 0.09% that utilizes the labeling for discontinued XIBROM or omits any portion of the BROMDAY label relating to the once-per-day dosing. Although our request for a temporary injunction was denied by the Court in May 2011, our subsequent motion for summary judgment seeking revocation of the approval of the generic bromfenac product, as well as the FDA’s counter-motion for summary judgment, have been fully briefed before the Court.

We are involved in other claims and legal proceedings incidental to our business from time to time. Except as described immediately above, we do not believe that pending actions or proceedings, either individually or in the aggregate, will have a material adverse effect on our financial condition, results of operations or cash flows, and adequate provision has been made for the resolution of such actions and proceedings.

Segment Reporting

We currently operate in only one segment.

Income Taxes

We account for income taxes under the Income Tax Topic of the FASB Accounting Standards Codification. As of September 30, 2011 and December 31, 2010, there are no unrecognized tax benefits included in the balance sheet that would, if recognized, affect the effective tax rate.

Our practice is to recognize interest and/or penalties related to income tax matters in income tax expense. We had no accrual for interest or penalties on our condensed balance sheets at September 30, 2011 and December 31, 2010, respectively, and have not recognized interest and/or penalties in the condensed statement of operations for the three and nine months ended September 30, 2011.

We are subject to taxation in the United States and various state jurisdictions. Our tax years for 2007 and forward are subject to examination by federal tax authorities, as are the years 2006 and forward by state tax authorities. Net operating loss carryforwards from the years 1995 forward are also subject to adjustment.

At December 31, 2010, we had net deferred tax assets of $42.9 million. Due to uncertainties surrounding our ability to generate future taxable income to realize these assets, a full valuation has been established to offset the net deferred tax asset. Additionally, the future utilization of our net operating loss and research and development credit carryforwards to offset future taxable income may be subject to an annual limitation, pursuant to Internal Revenue Code Sections 382 and 383, as a result of ownership changes that may have occurred previously or that could occur in the future due to the exercise of warrants or other transactions. Due to the existence of the valuation allowance, future changes in our unrecognized tax benefits will not impact our effective tax rate.

At December 31, 2010, we had federal and state net operating loss carryforwards of approximately $117.5 million and $72.3 million, respectively, after utilizing $17.8 million to offset taxable income in 2010 and limiting our net operating loss carryforwards due to previous ownership changes under Internal Revenue Code Section 382. Federal tax loss carryforwards continue to expire in 2011 unless previously utilized. California tax loss carryforwards begin to expire in 2012, unless previously utilized. In addition, we have federal and California research and development tax credit carryforwards of $9.6 million and $6.2 million, respectively. The federal research and development credit carryforwards will begin to expire in 2011 unless previously utilized. The California research and development credit carryforwards carry forward indefinitely.

 

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New Accounting Pronouncements

In June 2011, the FASB updated the accounting guidance on Topic 220, entitled “Comprehensive Income”, relating to presentation of comprehensive income. This guidance requires companies to present total comprehensive income, the components of net income and the components of other comprehensive income, or OCI, either in a single continuous statement of comprehensive income or in two but consecutive statements. Additionally, companies are required to present on the face of the financial statements the reclassification adjustments that are reclassified from OCI to net income, where the components of net income and the components of OCI are presented. This guidance is effective beginning in our fiscal 2012 year. The adoption of this guidance is not expected to have a material impact on our financial position or results of operations.

In June 2011, the FASB updated the accounting guidance on alignment of disclosures for GAAP and the International Financial Reporting Standards, or IFRS, by updating Topic 820 entitled “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS”, relating to presentation of fair value measurements reported in financial statements. The updated guidance requires companies to align fair value measurement and disclosure requirements between GAAP and IFRS. The updated guidance is effective beginning in our fiscal 2012 year and earlier adoption is not permitted. The adoption of this guidance is not expected to have a material impact on our financial position or results of operations.

In December 2010, the FASB updated the accounting guidance relating to the disclosure of supplementary pro forma information for business combinations. The updated guidance requires companies to provide additional comparative pro forma financial information along with the nature and amount of any material nonrecurring pro forma adjustments related to the business combination. The updated guidance is effective for business combinations which have an acquisition date in fiscal years beginning on or after December 15, 2010, or our 2011 fiscal year. The adoption of this guidance is not expected to have a material impact on our financial position or results of operations.

In December 2010, the FASB issued an Accounting Standards Update, Entitled “Other Expenses (Topic 720): Fees Paid to the Federal Government by Pharmaceutical Manufacturers (A consensus of the FASB Emerging Issues Task Force)”. ASU 2010-27 addresses how pharmaceutical companies should recognize and classify in their income statements fees mandated by the Patient Protection and Affordable Care Act, of 2010 and the Health Care and Education Affordability Reconciliation Act of 2010 and subsequent legislation passed during the third quarter of 2010, which we collectively refer to as the Healthcare Reform Act. The Healthcare Reform Act imposes an annual fee on the pharmaceutical manufacturing industry for each year beginning on or after January 1, 2011. For reporting entities that are subject to the pharmaceutical fee mandated by the Healthcare Reform Act, the amendments in ASU 2010-27 specify the liability for the fee should be estimated and recorded in full upon the first qualifying sale with a corresponding deferred cost that is amortized to expense using a straight–line method of allocation unless another method better allocates the fee over the calendar year that it is payable. ASU 2010-27 is effective for calendar years beginning after December 31, 2010, or our 2011 fiscal year, when the fee initially becomes payable. We adopted the provisions of ASU 2010-27 on January 1, 2011 and the adoption did not have a material effect to our financial position or results of operations.

In April 2010, the FASB issued ASU 2010-17, Revenue Recognition — Milestone Method (Topic 605): Milestone Method of Revenue Recognition, or ASU 2010-17. ASU 2010-17 provides guidance on applying the milestone method to milestone payments for achieving specified performance measures when those payments are related to uncertain future events. Under ASU 2010-17, entities can make an accounting policy to recognize arrangement consideration received for achieving specified performance measures during the period in which the milestones are achieved, provided certain criteria are met for the milestones to be considered substantive. ASU 2010-17 is effective on a prospective basis for research and development milestones achieved in fiscal years, beginning on or after June 15, 2010, which for us means our fiscal year 2011. We adopted the provisions of ASU 2010-17 on January 1, 2011 and the adoption did not have a material effect to our financial position or results of operations.

 

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Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995 and concern matters that involve risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Discussions containing forward-looking statements may be found in the material set forth under “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and in other sections of this Quarterly Report on Form 10-Q. Words such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” or similar words are intended to identify forward-looking statements, although not all forward-looking statements contain these words. Although we believe that our opinions and expectations reflected in the forward-looking statements are reasonable as of the date of this Quarterly Report on Form 10-Q, we cannot guarantee future results, levels of activity, performance or achievements, and our actual results may differ substantially from the views and expectations set forth in this Quarterly Report on Form 10-Q. We expressly disclaim any intent or obligation to update any forward-looking statements after the date hereof to conform such statements to actual results or to changes in our opinions or expectations. Readers are urged to carefully review and consider the various disclosures made by us, which attempt to advise interested parties of the risks, uncertainties, and other factors that affect our business, including without limitation the disclosures made under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Quarterly Report on Form 10-Q and the audited financial statements and the notes thereto and disclosures made under the captions “Management Discussion and Analysis of Financial Condition and Results of Operations”, “Risk Factors”, “ Consolidated Financial Statements” and “Notes to Consolidated Financial Statements” included in our Annual Report on Form 10-K for the year ended December 31, 2010, filed with the Securities and Exchange Commission, or the SEC, on February 25, 2011. We obtained the market data and industry information contained in this Quarterly Report on Form 10-Q from internal surveys, estimates, reports and studies, as appropriate, as well as from market research, publicly available information and industry publications. Although we believe our internal surveys, estimates, reports, studies and market research, as well as industry publications, are reliable, we have not independently verified such information, and, as such, we do not make any representation as to its accuracy.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our audited financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2010, filed with the SEC, on February 25, 2011 and the unaudited condensed financial statements and related notes included in this Quarterly Report on Form 10-Q. References in this Quarterly Report on Form 10-Q to “ISTA,” “we,” “our,” “us,” or the “Company” refer to ISTA Pharmaceuticals, Inc.

Overview

We are a rapidly growing commercial-stage, multi-specialty pharmaceutical company developing, marketing and selling our own products in the U.S. and Puerto Rico. We are the third largest branded prescription eye care business in the U.S. and have a growing allergy drug franchise. We manufacture our finished good products through third-party contracts, and we in-license or acquire new products and technologies to add to our internal development efforts from time to time. Our products and product candidates seek to treat allergy and serious diseases of the eye and include therapies for ocular inflammation and pain, glaucoma, dry eye and ocular and nasal allergies. The U.S. prescription markets which our therapies seek to address include key segments of the $6.5 billion ophthalmic pharmaceutical market and the $2.5 billion nasal allergy market.

We currently have four products available for sale in the U.S. and Puerto Rico: BROMDAY (bromfenac ophthalmic solution) 0.09% for the treatment of postoperative inflammation and reduction of ocular pain in patients who have undergone cataract extractions, BEPREVE (bepotastine besilate ophthalmic solution) 1.5% for the treatment of ocular itching associated with allergic conjunctivitis, ISTALOL (timolol maleate ophthalmic solution) 0.05% for the treatment of glaucoma and VITRASE (hyaluronidase injection) ovine, 200 USP units/ml for use as a spreading agent. Until February 28, 2011, we sold XIBROM (bromfenac ophthalmic solution) 0.09%, which was prescribed for the treatment of inflammation and pain following cataract surgery. Effective February 2011, we stopped shipping XIBROM and focused on the conversion of XIBROM sales to BROMDAY sales. For the week ended September 30, 2011, 97.6% of the new prescriptions for our bromfenac franchise were converted to BROMDAY. In addition, we have several eye and allergy product candidates in various stages of development, including treatments for dry eye, ocular inflammation and pain and nasal allergies.

We have incurred losses since inception and have a stockholders’ deficit of $34.8 million through September 30, 2011.

 

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During the three months ended September 30, 2011 and through the date of this filing, the following events occurred:

 

•

In early September 2011, we launched a twin-pack size of BROMDAY. This size of BROMDAY will also allow us to offer BROMDAY to our customers in an alternative pack size.

 

•

On October 13, 2011, we announced statistically significant results from our Phase 3 clinical program for PROLENSA™ (bromfenac ophthalmic solution). PROLENSA is a low concentration of bromfenac in a modified ophthalmic solution developed to treat pain and inflammation associated with cataract surgery. The new, optimized formulation used for PROLENSA enhances the penetration of the drug into ocular tissues, allowing us to lower the concentration of the active ingredient, bromfenac, while maintaining the convenience of once-daily use of BROMDAY. In both Phase 3 studies, PROLENSA was statistically significantly better than placebo and met the primary efficacy endpoint of absence of ocular inflammation 14 days following surgery and the secondary efficacy endpoint of elimination of ocular pain one day post-surgery. There were no serious drug-related ocular or systemic adverse events, and PROLENSA's safety profile was found to be consistent with our currently marketed topical nonsteroidal anti-inflammatory drug, or NSAID, compound, BROMDAY™ (bromfenac ophthalmic solution) 0.09%. The two clinical studies had the lowest number of adverse events (greater than 2%) than any of our bromfenac clinical trials for cataract surgery to date, and, to the best of our knowledge, PROLENSA contains the lowest concentration of bromfenac currently under investigation in any clinical trials for inflammation and pain associated with cataract surgery. We plan to file a New Drug Application with the FDA for PROLENSA in the first quarter of 2012, with a commercial launch planned for late 2012 or early 2013.

 

•

On July 28, 2011, we announced top-line results from the first of our two Phase 3 studies to evaluate the short-term safety and efficacy of two concentrations of REMURA (bromfenac ophthalmic solution for dry eye) in alleviating the signs and symptoms of dry eye disease. Our Phase 3 safety and efficacy program, which consisted of two studies known as EAST and WEST, was conducted under a Special Protocol Assessment, or SPA, agreed upon with the FDA. According to preliminary analysis of the top-line results from the WEST study, while REMURA was highly effective in treating a sign and symptom of dry eye, it was not statistically significantly better than placebo, a common outcome reported in studies testing other dry eye therapies. From baseline, both concentrations of REMURA and the placebo showed highly statistically significant improvement (p < 0.0001) in one sign and one symptom. The co-primary end-points identified in the SPA require REMURA to achieve a statistically significant difference from placebo, not baseline, which was not achieved in the WEST Study. All three formulations were rated by patients as very comfortable. Since REMURA did not meet its co-primary end points in the WEST study, armed with this data, we amended the statistical plan to appropriately focus the EAST study.

 

•

On October 13, 2011, we announced top-line results from the second of our two Phase 3 studies to evaluate the short-term safety and efficacy of two concentrations of REMURATM (bromfenac ophthalmic solution for dry eye) in alleviating the signs and symptoms of dry eye disease. In the EAST study, REMURA was highly effective in treating a sign and symptom of dry eye but was not statistically significantly better than placebo in the entire patient cohort, a common outcome reported in studies testing other dry eye therapies. In both Phase 3 studies, safety data demonstrated REMURA was well-tolerated, with an adverse event profile similar to placebo and consistent with those observed previously with REMURA in a Phase 2 study and with other prescription dry eye drops. All three formulations were rated by patients as very comfortable. For the EAST study, we amended the statistical plan to focus on the subpopulation identified in the WEST study as responders. The EAST study did not show a significant difference from placebo in this subpopulation, which we believe is partly due to the fact that the EAST study enrolled far fewer patients with mild to moderate dry eye disease. We will complete a full analysis of the data, but focus our efforts on the potential use of the vehicle as an over-the-counter artificial tear product.

 

•

According to a paper published in September 2011 in the issue of RETINA, The Journal of Retinal and Vitreous Diseases, a pilot study suggested that the topical NSAID, eye drop of XIBROM (bromfenac ophthalmic solution) 0.09%, administered twice daily may have an additive effect when used with intravitreal LUCENTIS® (ranibizumab injection) in reducing retinal thickness in neovascular age-related macular degeneration, or NV AMD. AMD robs the patient of all but the outermost, peripheral vision, leaving only dim images or black holes at the center of vision, and is the leading cause of vision loss and blindness among Americans who are aged 65 and older. Retinal specialists believe reducing the macular thickness (the width of the central retina) may help preserve or improve patients' vision over the long term. Thirty eyes were tested consecutively and were randomized in a 2:1 ratio of combination therapy (intravitreal LUCENTIS and topical XIBROM) and LUCENTIS alone. All patients received LUCENTIS therapy monthly for 4 months, then as needed on a monthly basis in accordance with standard of care. Patients receiving XIBROM self-administered 1 drop twice a day for

 

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12 months. Three-quarters of subjects enrolled had pre-existing minimally classic or occult NV AMD and a history of LUCENTIS use. Endpoints included adverse events, mean change in visual acuity, change in macular thickness, number of subjects with a 50um (micrometer) or more reduction in macular thickness and mean number of LUCENTIS injections over the 12-month period. This is the second independent study suggesting that use of XIBROM may be safe and effective as an adjunct therapy for AMD, and it is the longest performed to date with twice-daily XIBROM 0.09% dosing (12 months).

Results of Operations

Three Months Ended September 30, 2011 and 2010

Revenues. Net revenues were $41.4 million for the three months ended September 30, 2011, as compared to $42.0 million for the three months ended September 30, 2010. The 1% decrease is the result of lower revenues in the BROMDAY/XIBROM franchise and higher managed care and government rebates, partially offset by growth in our remaining products. The decrease in XIBROM/BROMDAY is primarily due to a lower average price per BROMDAY prescription as compared to the product it replaced, XIBROM. We recently launched BROMDAY in a twin-pack configuration containing two bottles of BROMDAY priced at approximately double the single bottle price. We anticipate the launch of the BROMDAY twin pack will increase the average price per BROMDAY prescription over time. We recorded $3.7 million in revenues for BROMDAY twin-pack size during the three months ended September 30, 2011.

The following table sets forth our net revenues for each of our products for the three months ended September 30, 2011 and 2010, respectively (dollars in millions), and the corresponding percentage change.

 

		Three Months Ended September 30,
		2011				2010				% Change
BROMDAY and XIBROM		$	24.9			$	29.6				(16	%)
BEPREVE			5.4				3.9				38	%
ISTALOL			7.0				5.3				32	%
VITRASE			4.1				3.2				28	%
Total revenues		$	41.4			$	42.0				(1	%)

Gross margin and cost of products sold. Gross margin for the three months ended September 30, 2011 was 76% of net revenues, or $31.2 million, as compared to 77% of net revenues, or $32.3 million, for the three months ended September 30, 2010. The decrease in the gross margin percentage is primarily the result of lower revenues from BROMDAY and the impact of higher rebates as discussed above. Cost of products sold was $10.1 million for the three months ended September 30, 2011, as compared to $9.7 million for the three months ended September 30, 2010. Cost of products sold consisted primarily of standard costs for each of our commercial products, distribution costs, royalties, inventory reserves and other costs of products sold. The increase in cost of products sold is primarily the result of the growth of units sold.

Research and development expenses. Research and development expenses were $7.7 million for the three months ended September 30, 2011, as compared to $7.9 million for the three months ended September 30, 2010. The decrease in research and development expenses of $0.2 million is due primarily to decreased medical affairs and manufacturing costs, and partially offset by timing associated with the initiation and completion of clinical trials, as described below.

Generally, our research and development resources are not dedicated to a single project but are applied to multiple product candidates in our portfolio. As a result, we manage and evaluate our research and development expenditures generally by the type of costs incurred. We generally classify and separate research and development expenditures into amounts related to clinical development costs, regulatory costs, pharmaceutical development costs, manufacturing development costs, and medical affairs costs. In addition, we also record as research and development expenses any upfront and milestone payments to third parties prior to regulatory approval of a product candidate under our licensing agreements unless there is an alternative future use. For the three months ended September 30, 2011, approximately 50% of our research and development expenditures were for clinical development costs, 14% were for regulatory costs, 4% were for pharmaceutical development costs, 8% were for manufacturing development costs, 21% were for medical affairs costs, and 3% were for stock-based compensation costs ($0.3 million).

Changes in our research and development expenses are primarily due to the following:

 

•

Clinical Development Costs — Clinical development costs, which include clinical investigator fees, clinical trial monitoring costs, data management and statistical analysis, for the three months ended September 30, 2011 were $3.9 million as compared to $3.8 million for the three months ended September 30, 2010.

 

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•

Regulatory Costs — Regulatory costs, which include compliance expenses for existing products and other activity for pipeline projects, were $1.0 million and $0.9 million for the three months ended September 30, 2011 and 2010, respectively.

 

•

Pharmaceutical Development Costs — Pharmaceutical development costs, which include costs related to the testing and development of our pipeline products, were $0.3 million for both the three months ended September 30, 2011 and 2010, respectively.

 

•

Manufacturing Development Costs — Manufacturing development costs, which include costs related to production scale-up and validation, raw material qualification, and stability studies, were $0.6 million and $0.7 million for the three months ended September 30, 2011 and 2010, respectively.

 

•

Medical Affairs Costs — Medical affairs costs, which include activities that relate to medical information and communication in support of our products, were $1.6 million for the three months ended September 30, 2011 as compared to $1.9 million for the three months ended September 30, 2010. The decrease is primarily attributable to lower continuing medical education costs.

Our research and development activities reflect our efforts to advance our product candidates through the various stages of product development. The expenditures that will be necessary to execute our development plans are subject to numerous uncertainties, which may affect our research and development expenditures and capital resources. For instance, the duration and the cost of clinical trials may vary significantly depending on a variety of factors including a trial’s protocol, the number of patients in the trial, the duration of patient follow-up, the number of clinical sites in the trial, and the length of time required to enroll suitable patient subjects. Even if earlier results are positive, we may obtain different results in later stages of development, including failure to show the desired safety or efficacy, which could impact our development expenditures for a particular product candidate. Although we spend a considerable amount of time planning our development activities, we may be required to deviate from our plan based on new circumstances or events or our assessment from time to time of a product candidate’s market potential, other product opportunities and our corporate priorities. Any deviation from our plan may require us to incur additional expenditures or accelerate or delay the timing of our development spending. Furthermore, as we obtain results from trials and review the path toward regulatory approval, we may elect to discontinue development of certain product candidates in certain indications, in order to focus our resources on more promising candidates or indications. As a result, the amount or ranges of costs and timing to complete our product development programs and each future product development program is not estimable.

Selling, general and administrative expenses. Selling, general and administrative expenses were $19.6 million for both the three months ended September 30, 2011 and September 30, 2010, respectively. Included in expenses for the three months ended September 30, 2011 are $0.9 million for costs incurred in connection with the bromfenac royalty litigation. No similar expenses were recorded in the comparable period in 2010.

Stock-based compensation costs. Total stock-based compensation costs for the three months ended September 30, 2011 and 2010 were $1.1 million and $1.0 million, respectively. For the three months ended September 30, 2011 and 2010, we granted stock options to employees to purchase 81,400 shares of common stock (at a weighted average exercise price of $6.51 per share) and 60,000 shares of common stock (at a weighted average exercise price of $3.11 per share), respectively, equal to the fair market value of our common stock at the time of grant. We also issued 4,000 and 3,333 restricted stock awards for the three months ended September 30, 2011 and 2010, respectively. Included in stock-based compensation costs were $0.2 million and $0.1 million for the three months ended September 30, 2011 and 2010, respectively, related to restricted stock awards.

Interest expense. Interest expense was $1.7 million and $2.1 for the three months ended September 30, 2011 and 2010, respectively. The decrease in interest expense was due to the repayment of $21.5 million on our Facility Agreement.

The components of interest expense are as follows (in millions):

 

		Three Months Ended September 30,
		2011				2010
Interest related to the Facility Agreement		$	0.8			$	1.1
Amortization of the discount on the Facility Agreement			0.5				0.6
Amortization of deferred financing costs			0.2				0.2
Amortization of derivative on the Facility Agreement			0.1				0.1
Interest related to the Revolving Credit Facility			0.1				0.1
Interest expense		$	1.7			$	2.1

 

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Gain (loss) on warrant valuation. For the three months ended September 30, 2011, we recorded a non-cash valuation gain of $28.3 million, or $0.59 per diluted share, as compared to a non-cash valuation loss of $26.3 million, or $0.79 per diluted share, for the three months ended September 30, 2010. The change in the valuation of the warrants for the three months ended September 30, 2011 and 2010 was primarily driven by changes in our stock price and the number of weighted average warrants outstanding, offset by increases in related volatility.

Nine months ended September 30, 2011 and 2010

Revenues. Net revenues were $115.2 million for the nine months ended September 30, 2011, as compared to $105.4 million for the nine months ended September 30, 2010. The 9% increase is the result of growth in all of our products, partially offset by a lower average price for BROMDAY than the product it replaced, XIBROM, and higher managed care and government rebates. We recently launched BROMDAY in a twin-pack configuration containing two bottles of BROMDAY priced at approximately double the single bottle price. We anticipate the launch of the BROMDAY twin pack will increase the average price per BROMDAY prescription over time. We recorded $3.7 million in revenues for BROMDAY twin-pack size during the nine months ended September 30, 2011.

The following table sets forth our net revenues for each of our products for the nine months ended September 30, 2011 and 2010, respectively (dollars in millions), and the corresponding percentage change.

 

		Nine Months Ended September 30,
		2011				2010				% Change
BROMDAY and XIBROM		$	61.4			$	71.0				(14	%)
BEPREVE			21.8				10.6				106	%
ISTALOL			21.2				15.0				41	%
VITRASE			10.8				8.8				23	%
Total revenues		$	115.2			$	105.4				9	%

Gross margin and cost of products sold. Gross margin for the nine months ended September 30, 2011 was 75% of net revenues, or $86.8 million, as compared to 76% of net revenues, or $80.6 million, for the nine months ended September 30, 2010. The decrease in the gross margin percentage is primarily the result of lower revenues from BROMDAY and the impact of higher rebates as discussed above. Cost of products sold was $28.4 million for the nine months ended September 30, 2011, as compared to $25.2 million for the nine months ended September 30, 2010. Cost of products sold consisted primarily of standard costs for each of our commercial products, distribution costs, royalties, inventory reserves and other costs of products sold. The increase in cost of products sold is primarily the result of the growth of units sold.

Research and development expenses. Research and development expenses were $26.9 million for the nine months ended September 30, 2011, as compared to $17.8 million for the nine months ended September 30, 2010. The increase in research and development expenses of $9.1 million is due primarily to timing associated with the initiation and completion of clinical trials and increased medical affairs costs, as described below.

Generally, our research and development resources are not dedicated to a single project but are applied to multiple product candidates in our portfolio. As a result, we manage and evaluate our research and development expenditures generally by the type of costs incurred. We generally classify and separate research and development expenditures into amounts related to clinical development costs, regulatory costs, pharmaceutical development costs, manufacturing development costs, and medical affairs costs. In addition, we also record as research and development expenses any upfront and milestone payments to third parties prior to regulatory approval of a product candidate under our licensing agreements unless there is an alternative future use. For the nine months ended September 30, 2011, approximately 54% of our research and development expenditures were for clinical development costs, 12% were for regulatory costs, 4% were for pharmaceutical development costs, 9% were for manufacturing development costs, 18% were for medical affairs costs, and 3% were for stock-based compensation costs ($0.8 million).

Changes in our research and development expenses are primarily due to the following:

 

•

Clinical Development Costs — Clinical development costs for the nine months ended September 30, 2011 were $14.6 million as compared to $6.1 million for the nine months ended September 30, 2010. The increase in costs resulted from the ongoing Phase 3 efficacy and safety dry eye trials for REMURA, the completed Phase 2 bepotastine besilate nasal spray clinical trials and the recently completed Phase 3 trials related to PROLENSA.

 

•

Regulatory Costs — Regulatory costs were $3.2 million and $2.9 million for the nine months ended September 30, 2011 and 2010, respectively. These costs were primarily higher due to increased personnel costs.

 

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•

Pharmaceutical Development Costs — Pharmaceutical development costs were $1.0 million for both the nine months ended September 30, 2011 and 2010, respectively.

 

•

Manufacturing Development Costs — Manufacturing development costs were $2.3 million and $2.6 million for the nine months ended September 30, 2011 and 2010, respectively. The decrease is primarily due to lower costs for supplies for clinical trials.

 

•

Medical Affairs Costs — Medical affairs costs for the nine months ended September 30, 2011 were $5.0 million as compared to $4.4 million for the nine months ended September 30, 2010, or an increase of $0.6 million. The increase is primarily attributable to increased personnel costs, continuing medical education costs and post-marketing clinical studies.

Selling, general and administrative expenses. Selling, general and administrative expenses were $69.9 million for the nine months ended September 30, 2011, as compared to $60.4 million for the nine months ended September 30, 2010. The $9.5 million increase primarily reflect expenses of $3.4 million of higher legal costs associated with the bromfenac royalty litigation and our complaint against the FDA regarding the approval of a generic version of XIBROM, $4.6 million in legal, professional and other fees incurred in connection with financing and due diligence activities to pursue a potential acquisition of a company with marketed products, for which we were successful in securing a financing commitment but were unsuccessful in concluding the acquisition, and higher sales and marketing costs of $1.3 million, which includes launch and promotional costs associated with our products, primarily BROMDAY.

Stock-based compensation costs. Total stock-based compensation costs for both of the nine months ended September 30, 2011 and 2010 were $2.9 million, respectively. For the nine months ended September 30, 2011 and 2010, we granted stock options to employees to purchase 835,140 shares of common stock (at a weighted average exercise price of $7.00 per share) and 929,302 shares of common stock (at a weighted average exercise price of $3.57 per share), respectively, equal to the fair market value of our common stock at the time of grant. We also issued 147,543 and 155,152 restricted stock awards for the nine months ended September 30, 2011 and 2010, respectively. Included in stock-based compensation costs for the nine months ended September 30, 2011 and 2010 were $0.4 million and $0.3 million, respectively, related to restricted stock awards.

Interest expense. Interest expense was $5.8 million and $6.2 million for the nine months ended September 30, 2011 and 2010, respectively. The decrease in interest expense was due to the repayment of $21.5 million on our Facility Agreement.

The components of interest expense are as follows (in millions):

 

		Nine Months Ended September 30,
		2011				2010
Interest related to the Facility Agreement		$	2.9			$	3.2
Amortization of the discount on the Facility Agreement			1.8				1.9
Amortization of deferred financing costs			0.8				0.8
Amortization of derivative on the Facility Agreement			0.2				0.2
Interest related to the Revolving Credit Facility			0.1				0.1
Interest expense		$	5.8			$	6.2

Gain (loss) on warrant valuation. For the nine months ended September 30, 2011, we recorded a non-cash valuation loss of $24.9 million, or $0.59 per diluted share, as compared to a non-cash valuation gain of $7.2 million, or $0.17 per diluted share, for the nine months ended September 30, 2010. The change in the valuation of the warrants for the nine months ended September 30, 2011 and 2010 was primarily driven by changes in our stock price and offset by related volatility. For the nine months ended September 30, 2011, the warrant valuation also was impacted by the exercise of 8.1 million warrants by some of the Lenders and their assignees as we reclassified the relevant warrant liability to equity upon the issuance of the shares of common stock.

 

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Liquidity and Capital Resources

As of September 30, 2011, we had $51.9 million in cash and negative working capital of $7.5 million. In August 2011, we repaid $21.5 million of our $65 million Facility Agreement out of cash on hand. Historically, we have financed our operations primarily through sales of our debt and equity securities and cash receipts from product sales. Since March 2000, we have received gross proceeds of approximately $352.9 million from sales of our common stock, including the recent issuance of our common stock upon the exercise of warrants, and the issuance of promissory notes and convertible debt.

Under our revolving credit facility with Silicon Valley Bank, or the Revolving Credit Facility, we may borrow up to the lesser of $25.0 million or 80% of eligible accounts receivable, plus the lesser of 25% of net cash and cash equivalents or $10.0 million. As of September 30, 2011, we had $24.4 million available under the Revolving Credit Facility, of which we borrowed $24.0 million. All outstanding amounts under the Revolving Credit Facility bear interest at a variable rate equal to the lender’s prime rate plus a margin of 0.50%. In no event shall the interest rate on outstanding borrowings be less than 4.50%, which is payable on a monthly basis. The Revolving Credit Facility also contains customary covenants regarding the operation of our business and financial covenants relating to ratios of current assets to current liabilities and is collateralized by all of our assets. An event of default under the Revolving Credit Facility will occur if, among other things, (i) we are delinquent in making payments of principal or interest on the Revolving Credit Facility; (ii) we fail to cure a breach of a covenant or term of the Revolving Credit Facility; (iii) we make a representation or warranty under the Revolving Credit Facility that is materially inaccurate; (iv) we are unable to pay our debts as they become due, certain bankruptcy proceedings are commenced or certain orders are granted against us, or we otherwise become insolvent; or (v) an acceleration event occurs under certain types of other indebtedness outstanding from time to time. If an event of default occurs, the indebtedness to Silicon Valley Bank could be accelerated, such that it becomes immediately due and payable. We also had letters of credit of $0.6 million outstanding. As of September 30, 2011, we were in compliance with all of the covenants under the Revolving Credit Facility. During certain months in the fourth quarter, we may not be able to fulfill our adjusted quick ratio covenant. We are in discussions with Silicon Valley Bank, and, if successful, will either modify the covenant under the Revolving Credit Facility or seek a waiver for the covenant. However, no assurance can be given as to the outcome of our negotiations. Our failure to amend the covenant or obtain a waiver could cause us an inability to borrow under our Revolving Credit Facility. All amounts borrowed in September 2011 under the Revolving Credit Facility were repaid in October 2011. As of November 4, 2011, there were no borrowings under the Revolving Credit Facility. The Revolving Credit Facility expires on March 31, 2012.

Pursuant to a facility agreement, or the Facility Agreement, certain investors and lenders, collectively called the Lenders, loaned us $65 million. On September 30, 2011, we had total indebtedness under the Facility Agreement of $43.6 million, which excludes unamortized discounts of $3.1 million and the value of the derivative of $0.1 million. Outstanding amounts under the Facility Agreement accrue interest at a rate of 6.5% per annum, payable quarterly in arrears. We are required to repay the Lenders 33% of the original principal amount (or $21.5 million) on September 26, 2012, and 34% of the original principal amount (or $22.0 million) on September 26, 2013.

Any amounts drawn under the Facility Agreement may become immediately due and payable upon (i) an “event of default,” as defined in the Facility Agreement, in which case the Lenders would have the right to require us to repay 100% of the principal amount of the loan, plus any accrued and unpaid interest thereon, or (ii) the consummation of certain change of control transactions, in which case the Lenders would have the right to require us to repay 110% of the outstanding principal amount of the loan, plus any accrued and unpaid interest thereon. An event of default under the Facility Agreement will occur if, among other things, (i) we fail

 

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to make payment when due; (ii) we fail to comply in any material respect with any covenant of the Facility Agreement, and such failure is not cured; (iii) any representation or warranty made by us in any transaction document was incorrect, false, or misleading in any material respect as of the date it was made; (iv) we are generally unable to pay our debts as they become due or a bankruptcy or similar proceeding is commenced by or against us; or (v) cash and cash equivalents on the last day of each calendar quarter are less than $10 million. The Facility Agreement also contains customary covenants regarding operations of our business. As of September 30, 2011, we were in compliance with all the covenants under the Facility Agreement.

In connection with the Facility Agreement, we entered into a security agreement with the Lenders, pursuant to which, as security for our repayment obligations under the Facility Agreement, we granted to the Lenders a security interest in certain of our intellectual property, including intellectual property relating to BROMDAY, BEPREVE, ISTALOL, VITRASE, REMURA, PROLENSA and XIBROM and each other product marketed by or under license from us, and certain personal property relating thereto.

For the nine months ended September 30, 2011, we used $23.3 million of cash from operations, primarily the result of a net loss, partially offset by certain non-cash charges and a net reduction in working capital of $14.7 million. We incurred a net loss of $40.7 million, which included a loss on warrant valuation ($24.9 million) and other non-cash charges of $7.2 million. Non-cash charges consisted primarily of stock-based compensation costs ($2.9 million), amortization of discounts on the Facility Agreement ($2.0 million), depreciation and amortization ($1.7 million) and amortization of deferred financing costs ($0.8 million), and offset by the gain on derivative valuation ($0.1 million). For the nine months ended September 30, 2010, we generated $14.9 million of cash from operations, primarily due to increase in royalties’ payable of $13.3 million and other changes in operating assets and liabilities, offset by the increase in accounts receivable of $9.1 million. We had net income of $3.1 million, which included the warrant valuation gain of $7.2 million and other non-cash charges of $6.6 million. Non-cash charges consisted primarily of stock-based compensation costs ($2.9 million), amortization of discounts on the Facility Agreement ($2.1 million), depreciation and amortization ($0.9 million) and amortization of deferred financing costs ($0.8 million), partially offset by the gain on derivative valuation ($0.1 million).

For the nine months ended September 30, 2011 and 2010, we used $2.0 million and $1.5 million, respectively, of cash from investing activities, primarily due to the purchases of property and equipment.

For the nine months ended September 30, 2011, we used cash from financing activities of $1.6 million, primarily due to the repayment of the first installment of the $21.5 million against the Facility Agreement, offset by net borrowings under our Revolving Credit Facility ($11.0 million), exercises of warrants ($6.2 million), exercises of stock options granted to our employees ($2.4 million) and issuance of stock to our employees under our Employee Stock Purchase Plan ($0.3 million). For the nine months ended September 30, 2010, we generated negligible cash from financing activities.

We believe that current cash and cash equivalents, together with amounts available for borrowing under our Revolving Credit Facility and cash generated from operations, will be sufficient to meet anticipated cash needs for operating and capital expenditures for at least the next twelve months.

However, our actual future capital requirements will depend on many factors, including the following:

 

•

the success of the commercialization of our products;

 

•

our sales and marketing activities;

 

•

the expansion of our commercial infrastructure related to our approved products and product candidates;

 

•

the results of our clinical trials and requirements to conduct additional clinical trials;

 

•

the introduction of potential generic products;

 

•

the rate of progress of our research and development programs;

 

•

the time and expense necessary to obtain regulatory approvals;

 

•

activities and payments in connection with potential acquisitions of companies, products or technologies;

 

•

scheduled principal payments under our Facility Agreement;

 

•

the outcome of pending litigation;

 

•

competitive, technological, market and other developments; and

 

•

our ability to establish and maintain partnering relationships.

These factors may cause us to seek to raise additional funds through additional sales of our debt, or equity or other securities. We have a universal shelf registration statement on file with the SEC where we will be able to offer and sell up to $150 million of any

 

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form of securities including, but not limited to, equity, debt and other securities as described in the registration statement. Our intent with respect to the registration statement is to provide us with flexibility for financing future growth through acquisitions and strategic transactions, and does not reflect a change in our financing strategy. At present, we have no specific plans to issue any form of securities under the registration statement. Also, there can be no assurance that funds from these sources will be available when needed or, if available, will be on terms favorable to us or to our stockholders. If additional funds are raised by issuing equity securities, the percentage ownership of our stockholders will be reduced, our stockholders may experience additional dilution or such equity securities may provide for rights, preferences or privileges senior to those of the holders of our common stock.

We have incurred losses since inception and have a stockholders’ deficit of $34.8 million through September 30, 2011. Excluding the non-cash warrant valuation adjustment during the fiscal year 2010, we generated a net income of $2.2 million. While we anticipate continuing to be profitable in 2011 and beyond (excluding any non-cash warrant valuation adjustments, non-cash stock based compensation and non-cash interest), we might not be able to remain profitable.

Legal Proceedings

Bromfenac Royalty Litigation. We initiated legal action in April 2010 against Senju seeking a declaratory judgment with regard to our royalty obligations to Senju in connection with bromfenac products and a recovery of overpaid XIBROM royalties and other damages. The only U.S. patent applicable to XIBROM and, now to BROMDAY, expired in January 2009 and, according to U.S. case law and the terms of our agreement with Senju, we believe no bromfenac product royalties are due after patent expiration. In August 2010, the U.S. District Court for the Central District of California stayed our action against Senju, and, in September 2010, Senju initiated an arbitration proceeding regarding the same dispute with the International Chamber of Commerce, or the ICC. The order staying our action against Senju will not become appealable until after the arbitration is concluded and a judgment is entered in the court case. The arbitration proceeding, the outcome of which may also affect our BROMDAY royalty obligations, is in its early stages.

In June 2010, we initiated a legal action by filing a Complaint against AcSentient, Inc. and AcSentient II, LLC, which we collectively refer to as AcSentient, seeking a declaratory judgment with regard to our bromfenac royalty obligations under the Asset Purchase Agreement dated May 3, 2002 between the Company and AcSentient, Inc. The only U.S. patent applicable to XIBROM and, now, to BROMDAY expired in January 2009 and, according to U.S. case law and the terms of our agreement with AcSentient, Inc., we believe no XIBROM and BROMDAY royalties are due after patent expiration. A declaratory judgment that we are seeking from the Court in regard to royalty obligations to AcSentient may apply not only to XIBROM, but also to BROMDAY, which was approved by the FDA in October 2010. In November 2010, the Superior Court of the State of California, County of Orange stayed our case against AcSentient and ruled that the dispute had to be arbitrated. We will have an opportunity to appeal that Court’s ruling after the final judgment is entered by the Court. In January 2011, AcSentient filed a request for arbitration with the ICC. That arbitration is in its early stages.

There can be no assurance about when these two disputes will be resolved, and we cannot predict the final outcome or financial impact of either. Until these two disputes are resolved, for accounting purposes, we have been and intend to continue to reserve for BROMDAY and XIBROM royalties, which would have been payable to Senju and AcSentient if the relevant contractual royalty obligations were existing and enforceable. As of September 30, 2011, we had approximately $33.5 million reserved for such contingent XIBROM and BROMDAY royalties.

Subpoenas From the U.S. Attorney, Western District of New York. In April 2008, we received subpoenas from the office of the U.S. Attorney for the Western District of New York requesting information regarding the marketing activities related to XIBROM. We are cooperating with the government’s investigation. From April 2008 through September 30, 2011, we have incurred approximately $4.0 million in legal fees associated with this criminal investigation and expect to incur significant expenses in the future. In October 2011, we, and certain of our officers and current and former employees received correspondence from the government identifying them as targets. Tolling agreements have been executed to allow cooperation and discussions regarding resolution. If the government chooses to engage in civil litigation or initiate a criminal prosecution against us, our officers or our current or former employees, as a result of its review of the requested documents and other evidence, we may have to incur significant amounts to defend such actions or pay or incur substantial fines or penalties, on behalf of ourselves, our officers or our current or former employees, any of which could significantly deplete our cash resources. The case is ongoing and the likelihood of an unfavorable outcome and/or the amount/range of loss or additional expenses, cannot be reasonably estimated.

TRICARE Retail Pharmacy Program. Section 703 of the National Defense Authorization Act of 2008, enacted on January 28, 2009, requires that pharmaceutical products purchased through the Department of Defense, or DoD, TRICARE Retail Pharmacy program be subject to the Federal Ceiling Price discount under the Veterans Health Care Act of 1992. DoD issued a rule pursuant to Section 703 that requires manufacturers to provide DoD with a quarterly refund on pharmaceutical products utilized through the TRICARE Retail Pharmacy program, and to pay rebates to DoD on TRICARE Retail Pharmacy purchases retroactive to January 28, 2008. We have requested a waiver of the retroactive rebate for TRICARE Retail Pharmacy utilization for the period from January 28, 2008 to May 26, 2009 (the effective date of the DoD rule). In addition, the regulation was the subject of litigation by others, and it was our position that the retroactive application of the regulation was contrary to established case law. As of September 30, 2011, we determined that our payment of the retroactive rebate

 

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(from January 28, 2008 to May 26, 2009) created by the regulation is neither reasonably estimable nor probable as of September 30, 2011. In late October 2011, the United States District Court for the District of Columbia issued its decision in Coalition for Common Sense in Government Procurement v. United States, No. 08-996 (D.C. Dist. Ct. Oct. 25, 2011) upholding the DoD's regulation. It is uncertain whether the decision will be appealed, and if so, whether such appeal would be successful. In addition, the foregoing court decision does not impact our currently pending request for a waiver of the retroactive rebate.

FDA Complaint. We filed a Citizen Petition, or CP, with the FDA in March 2011. The CP requested the FDA to refrain from granting tentative or final approval of any abbreviated new drug application, or ANDA, for bromfenac sodium ophthalmic solution 0.09% that utilizes the labeling for discontinued XIBROM (bromfenac ophthalmic solution)^® 0.09% or omits any portion of the BROMDAY label relating to the once-per-day dosing. In May 2011, the FDA partially denied our CP and approved a generic version of twice-daily bromfenac ophthalmic solution 0.09%, which is substitutable for one bottle size of our twice-daily XIBROM (bromfenac ophthalmic solution)^® 0.09%. In May 2011, we filed a Complaint in the United States District Court for the District of Columbia alleging that the FDA’s approval of a generic version of XIBROM was arbitrary, capricious, and contrary to law. We also filed papers seeking injunctive relief with respect to the FDA’s approval of a generic version of twice-daily bromfenac ophthalmic solution 0.09% and relief from denial of our 2011 CP requesting that the FDA refrain from granting tentative or final approval of any abbreviated new drug application for bromfenac sodium ophthalmic solution 0.09% that utilizes the labeling for discontinued XIBROM or omits any portion of the BROMDAY label relating to the once-per-day dosing. Although our request for a temporary injunction was denied by the Court in May 2011, our subsequent motion for summary judgment seeking revocation of the approval of the generic bromfenac product, as well as the FDA’s counter-motion for summary judgment, have been fully briefed before the Court.

New Accounting Pronouncements

In June 2011, the FASB updated the accounting guidance on Topic 220, entitled “Comprehensive Income”, relating to presentation of comprehensive income. This guidance requires companies to present total comprehensive income, the components of net income and the components of other comprehensive income, or OCI, either in a single continuous statement of comprehensive income or in two but consecutive statements. Additionally, companies are required to present on the face of the financial statements the reclassification adjustments that are reclassified from OCI to net income, where the components of net income and the components of OCI are presented. This guidance is effective beginning in our fiscal 2012 year. The adoption of this guidance is not expected to have a material impact on our financial position or results of operations.

In June 2011, the FASB updated the accounting guidance on alignment of disclosures for GAAP and the International Financial Reporting Standards, or IFRS, by updating Topic 820 entitled “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS”, relating to presentation of fair value measurements reported in financial statements. The updated guidance requires companies to align fair value measurement and disclosure requirements between GAAP and IFRS. The updated guidance is effective beginning in our fiscal 2012 year and earlier adoption is not permitted. The adoption of this guidance is not expected to have a material impact on our financial position or results of operations.

In December 2010, the FASB updated the accounting guidance relating to the disclosure of supplementary pro forma information for business combinations. The updated guidance requires companies to provide additional comparative pro forma financial information along with the nature and amount of any material nonrecurring pro forma adjustments related to the business combination. The updated guidance is effective for business combinations which have an acquisition date in fiscal years beginning on or after December 15, 2010, or our 2011 fiscal year. The adoption of this guidance is not expected to have a material impact on our financial position or results of operations.

In December 2010, the FASB issued an Accounting Standards Update, Entitled “Other Expenses (Topic 720): Fees Paid to the Federal Government by Pharmaceutical Manufacturers (A consensus of the FASB Emerging Issues Task Force)”. ASU 2010-27 addresses how pharmaceutical companies should recognize and classify in their income statements fees mandated by the Patient Protection and Affordable Care Act, of 2010 and the Health Care and Education Affordability Reconciliation Act of 2010 and subsequent legislation passed during the third quarter of 2010, which we collectively refer to as the Healthcare Reform Act. The Healthcare Reform Act impose an annual fee on the pharmaceutical manufacturing industry for each year beginning on or after January 1, 2011. For reporting entities that are subject to the pharmaceutical fee mandated by the Healthcare Reform Act, the amendments in ASU 2010-27 specify the liability for the fee should be estimated and recorded in full upon the first qualifying sale with a corresponding deferred cost that is amortized to expense using a straight–line method of allocation unless another method better allocates the fee over the calendar year that it is payable. ASU 2010-27 is effective for calendar years beginning after December 31, 2010, or our 2011 fiscal year, when the fee initially becomes payable. We adopted the provisions of ASU 2010-27 on January 1, 2011 and the adoption did not have a material effect to our financial position or results of operations.

 

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In April 2010, the FASB issued ASU 2010-17, Revenue Recognition – Milestone Method (Topic 605): Milestone Method of Revenue Recognition, or ASU 2010-17. ASU 2010-17 provides guidance on applying the milestone method to milestone payments for achieving specified performance measures when those payments are related to uncertain future events. Under ASU 2010-17, entities can make an accounting policy to recognize arrangement consideration received for achieving specified performance measures during the period in which the milestones are achieved, provided certain criteria are met for the milestones to be considered substantive. ASU 2010-17 is effective on a prospective basis for research and development milestones achieved in fiscal years, beginning on or after June 15, 2010, which for us means our fiscal year 2011. We adopted the provisions of ASU 2010-17 on January 1, 2011 and the adoption did not have a material effect to our financial position or results of operations.

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

The primary objective of our investment policy is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk.

Interest Rate Risk

Some of the securities that we have invested in are subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing interest rate and the prevailing interest rate later increases, the principal amount of our investment will probably decline. Seeking to minimize this risk, historically we maintained our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and auction rate securities. All of our cash is held in non-interest bearing accounts, which is fully insured by the Federal Deposit Insurance Corporation. When our cash is invested in short-term investments, the average duration is usually less than one year.

All outstanding amounts under our Revolving Credit Facility bear interest at a variable rate equal to the lender’s prime rate plus a margin of 0.50%. In no event shall the interest rate on outstanding borrowings be less than 4.50%. Interest is payable on a monthly basis and may expose us to market risk due to changes in interest rates. As of September 30, 2011, we had $24.0 million in borrowings under our Revolving Credit Facility. The interest rate at September 30, 2011 was 4.50%. A 10% change in interest rates on our Revolving Credit Facility would not have had a material effect on our net loss for the nine months ended September 30, 2011.

We have operated primarily in the United States. Accordingly, we have not had any significant exposure to foreign currency rate fluctuations.

 

Item 4.

Controls and Procedures

Evaluation of disclosure controls and procedures

Our management, with the participation and under the supervision of our Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer), has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e)) under the Securities Exchange Act of 1934, as amended, which we refer to as the Exchange Act, as of the end of the period covered by this Quarterly Report on Form 10-Q. The Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer) have concluded, based on their evaluation of these controls and procedures required by paragraph (b) of Rules 13a-15 and 15d under the Exchange Act, that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report on Form 10-Q to provide reasonable assurance that information required to be disclosed by us in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the applicable rules and forms promulgated by the Securities and Exchange Commission. A controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls are met, and no evaluation of controls can provide absolute assurance that all controls and instances of fraud, if any, within a company have been detected.

Changes in internal control over financial reporting

We have not made any significant changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended September 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II - OTHER INFORMATION

 

Item 1.

Legal Proceedings

Legal Proceedings

Subpoenas From the U.S. Attorney, Western District of New York. In April 2008, we received subpoenas from the office of the U.S. Attorney for the Western District of New York requesting information regarding the marketing activities related to XIBROM. We are cooperating with the government’s investigation. From April 2008 through September 30, 2011, we have incurred approximately $4.0 million in legal fees associated with this criminal investigation and expect to incur significant expenses in the future. In October 2011, we, and certain of our officers and current and former employees received correspondence from the government identifying them as targets. Tolling agreements have been executed to allow cooperation and discussions regarding resolution. If the government chooses to engage in civil litigation or initiate a criminal prosecution against us, our officers or our current or former employees, as a result of its review of the requested documents and other evidence, we may have to incur significant amounts to defend such actions or pay or incur substantial fines or penalties, on behalf of ourselves, our officers or our current or former employees, any of which could significantly deplete our cash resources. The case is ongoing and the likelihood of an unfavorable outcome and/or the amount/range of loss or additional expenses, cannot be reasonably estimated.

TRICARE Retail Pharmacy Program. Section 703 of the National Defense Authorization Act of 2008, enacted on January 28, 2009, requires that pharmaceutical products purchased through the Department of Defense, or DoD, TRICARE Retail Pharmacy program be subject to the Federal Ceiling Price discount under the Veterans Health Care Act of 1992. DoD issued a rule pursuant to Section 703 that requires manufacturers to provide DoD with a quarterly refund on pharmaceutical products utilized through the TRICARE Retail Pharmacy program, and to pay rebates to DoD on TRICARE Retail Pharmacy purchases retroactive to January 28, 2008. We have requested a waiver of the retroactive rebate for TRICARE Retail Pharmacy utilization for the period from January 28, 2008 to May 26, 2009 (the effective date of the DoD rule). In addition, the regulation was the subject of litigation by others, and it was our position that the retroactive application of the regulation was contrary to established case law. As of September 30, 2011, we determined that our payment of the retroactive rebate (from January 28, 2008 to May 26, 2009) created by the regulation is neither reasonably estimable nor probable as of September 30, 2011. In late October 2011, the United States District Court for the District of Columbia issued its decision in Coalition for Common Sense in Government Procurement v. United States, No. 08-996 (D.C. Dist. Ct. Oct. 25, 2011) upholding the DoD's regulation. It is uncertain whether the decision will be appealed, and if so, whether such appeal would be successful. In addition, the foregoing court decision does not impact our currently pending request for a waiver of the retroactive rebate.

FDA Complaint. We filed a Citizen Petition, or CP, with the FDA in March 2011. The CP requested the FDA to refrain from granting tentative or final approval of any abbreviated new drug application, or ANDA, for bromfenac sodium ophthalmic solution 0.09% that utilizes the labeling for discontinued XIBROM (bromfenac ophthalmic solution)^® 0.09% or omits any portion of the BROMDAY label relating to the once-per-day dosing. In May 2011, the FDA partially denied our CP and approved a generic version of twice-daily bromfenac ophthalmic solution 0.09%, which is substitutable for one bottle size of our twice-daily XIBROM (bromfenac ophthalmic solution)^® 0.09%. In May 2011, we filed a Complaint in the United States District Court for the District of Columbia alleging that the FDA’s approval of a generic version of XIBROM was arbitrary, capricious, and contrary to law. We also filed papers seeking injunctive relief with respect to the FDA’s approval of a generic version of twice-daily bromfenac ophthalmic solution 0.09% and relief from denial of our 2011 CP requesting that the FDA refrain from granting tentative or final approval of any abbreviated new drug application for bromfenac sodium ophthalmic solution 0.09% that utilizes the labeling for discontinued XIBROM or omits any portion of the BROMDAY label relating to the once-per-day dosing. Although our request for a temporary injunction was denied by the Court in May 2011, our subsequent motion for summary judgment seeking revocation of the approval of the generic bromfenac product, as well as the FDA’s counter-motion for summary judgment, have been fully briefed before the Court.

 

Item 1A.

Risk Factors

Information about material risks related to our business, financial condition and results of operations for the quarterly period ended September 30, 2011 does not materially differ from that described in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2010, as filed with the SEC on February 25, 2011, other than the following additional risk factor:

If generic manufacturers obtain approval for generic versions of our products, our business, results of operations and financial condition may suffer.

In January 2009, the patent on XIBROM expired, and we lost regulatory exclusivity for XIBROM. Because of the patent expiration, competitors became eligible to receive approval for ANDAs for ophthalmic formulations of bromfenac with indications identical to XIBROM. Generic manufacturers pursuing ANDA approval are not required to conduct costly and time-consuming clinical trials to establish the safety and efficacy of their products. Rather, they are permitted to rely on the innovator’s data regarding safety and efficacy. Thus, generic manufacturers can sell their products at prices much lower than those charged by innovative pharmaceutical companies who have incurred substantial expenses associated with the research and development of the product.

 

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In October 2010, the FDA approved BROMDAY for the treatment of postoperative inflammation and reduction of ocular pain in patients who have undergone cataract extractions. We were granted three years of marketing exclusivity under the Drug Price Competition and Patent Term Restoration Act, commonly known as the Hatch-Waxman Act. There can be no assurances that we will be able to generate revenues from BROMDAY similar to the levels achieved from sales of XIBROM. We launched BROMDAY in November 2010, and we focused our sales and marketing efforts on encouraging physicians to transition from prescribing twice-daily XIBROM to prescribing once-daily BROMDAY.

In May 2011, the FDA approved a generic version of twice-daily bromfenac ophthalmic solution 0.09%, which is substitutable for one bottle size of our twice-daily XIBROM (bromfenac ophthalmic solution)^® 0.09%. We stopped shipping XIBROM after February 2011. The introduction of a generic version of XIBROM could have an adverse impact on our business, results of operations and financial condition.

 

Item 6.

Exhibits

 

Exhibit Number		Description
31.1		Certification of Principal Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.
31.2		Certification of Principal Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934.
32.1		Certification of Principal Executive Officer Pursuant to Rule 13a-14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.
32.2		Certification of Principal Financial Officer Pursuant to Rule 13a-14(b)/15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.
101.INS		XBRL Instance Document
101.SCH		XBRL Taxonomy Extension Schema Document
101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF		XBRL Taxonomy Extension Definition Linkbase Document
101.LAB		XBRL Taxonomy Extension Label Linkbase Document
101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document

 

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Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, ISTA Pharmaceuticals, Inc. has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

		ISTA PHARMACEUTICALS, INC. (Registrant)
Dated: November 4, 2011		/s/ Vicente Anido, Jr., Ph.D.
		Vicente Anido, Jr., Ph.D. President and Chief Executive Officer (Principal Executive Officer)
Dated: November 4, 2011		/s/ Lauren P. Silvernail
		Lauren P. Silvernail Chief Financial Officer and Vice President, Corporate Development (Principal Financial Officer)

 

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INDEX TO EXHIBITS

 

Exhibit Number		Description
31.1		Certification of Principal Executive Officer Pursuant to Rule 13a-14(a) / 15d-14(a) of the Securities Exchange Act of 1934.
31.2		Certification of Principal Financial Officer Pursuant to Rule 13a-14(a) / 15d-14(a) of the Securities Exchange Act of 1934.
32.1		Certification of Principal Executive Officer Pursuant to Rule 13a-14(b) / 15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.
32.2		Certification of Principal Financial Officer Pursuant to Rule 13a-14(b) / 15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.
101.INS		XBRL Instance Document
101.SCH		XBRL Taxonomy Extension Schema Document
101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF		XBRL Taxonomy Extension Definition Linkbase Document
101.LAB		XBRL Taxonomy Extension Label Linkbase Document
101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document

 

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