In February 2006, VaxGen raised net proceeds of $25.2 million through a private placement to a group of accredited institutional investors. In connection with this financing, VaxGen issued to the investors five-year warrants initially exercisable to purchase 699,996 shares of common stock at an exercise price of $9.24 per share. Because VaxGen did not file all of its delinquent periodic reports with the SEC by September 30, 2006, the warrants became exercisable for an additional 350,000 shares of common stock, at a price of $9.24 per share. Because VaxGen again did not file all of its delinquent periodic reports with the SEC by January 31, 2007, the warrants became exercisable for an additional 350,000 shares of common stock, at a price of $9.24 per share.
In June 2007, the Company and the Chemo-Sero-Therapeutic Research Institute of Japan, or Kaketsuken, terminated by mutual consent their agreement to co-develop a next-generation, attenuated smallpox vaccine, LC16m8, for use in the United States and elsewhere. Under the terms of the termination agreement, VaxGen will transfer to Kaketsuken or its designee all reports, data and materials and all intellectual property rights that relate to conducting non-clinical and clinical development of LC16m8 in the U.S. In return, Kaketsuken has released VaxGen from ongoing development obligations.
In February 2007, the Board of Directors granted to executive officers options for 1,590,000 shares and implemented an option exchange program allowing executive officers to exchange old options for 714,700 shares for new options for 178,675 shares. All of the options were granted effective February 12, 2007 with an exercise price of $2.23, the closing market price of one share of the Company’s common stock on that date. Each will vest monthly on a pro-rata basis over one to four years. The Board also approved two potential retention bonus payments. The aggregate first retention bonus payment of $0.3 million was made to the executives during the three months ended September 30, 2007. Additionally, a second cash bonus payment of the same amount will be made, conditioned upon the executive remaining a regular full-time employee in good standing through the completion of a strategic transaction and other terms.
This discussion and analysis should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2005, and our unaudited condensed consolidated financial statements and related notes thereto appearing in Item 1 of this Quarterly Report on Form 10-Q. In addition to the other information contained or incorporated by reference in this Quarterly Report on Form 10-Q, you should carefully consider the risk factors described in Part II – Item 1A herein when evaluating an investment in our common stock. This Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934, or Exchange Act. All statements other than statements of historical fact are “forward-looking statements” for purposes of these provisions, including any statements of the plans and objectives of management for future operations, any statements regarding future operations, any statements concerning proposed new products or services, any statements regarding pending or future mergers or acquisitions, any statements regarding future economic conditions or performance, and any statement of assumptions underlying any of the foregoing. In some cases, forward-looking statements can be identified by the use of terminology such as “may,” “will,” “expects,” “plans,” “anticipates,” “estimates,” “potential” or “continue” or the negative thereof or other comparable terminology.
There can be no assurance that such expectations or any of the forward-looking statements will prove to be correct, and actual results could differ materially from those projected or assumed in the forward-looking statements. Our forward-looking statements are subject to inherent risks and uncertainties including, but not limited to, the risk factors set forth in this Quarterly Report. Factors that could cause or contribute to such differences include, but are not limited to, our limited cash resources, our ability to finance our research, our significant corporate and SEC-related expenses and limited revenue to offset these expenses, availability of appropriate prospective acquisitions or investment opportunities, litigation and the risks discussed in our other SEC filings. All forward-looking statements and reasons why results may differ included in this Quarterly Report are made as of the date hereof, and we assume no obligation to update any such forward-looking statement or reason why actual results might differ. When used in the report, unless otherwise indicated, “we,” “our” and “us” refers to VaxGen.
We are a biopharmaceutical company focused on the development, manufacture and commercialization of biologic products for the prevention and treatment of human infectious disease. Our business strategy focuses on the development and commercialization of biologic products to counter potential bioterrorism threats, principally vaccines against inhalation anthrax and smallpox. We were
incorporated in 1995 and formed to complete the development of an investigational recombinant protein vaccine intended to prevent infection by HIV. In 2002, we broadened our product development portfolio to also include biodefense vaccines.
On August 6, 2004, we announced that we had received notification from Nasdaq that our stock would discontinue trading on Nasdaq effective August 9, 2004. This action followed our appeal to Nasdaq for a listing extension after not meeting the stated time requirements to file Quarterly Reports on Form 10-Q for the quarters ended March 31 and June 30, 2004, respectively. We intend to apply for relisting on Nasdaq or listing on another exchange upon filing our remaining, outstanding and delinquent reports. Our common stock is currently quoted on the OTC Pink Sheets under the symbol VXGN.PK.
In February 2006, we raised net proceeds of $25.2 million through a private placement to a group of accredited institutional investors.
In September 2002, we were awarded a $20.9 million cost-plus contract, or 2002 Anthrax Contract, from the National Institute of Allergy and Infectious Diseases, or NIAID, to develop a new anthrax vaccine candidate and to create a feasibility plan for how we would manufacture an emergency stockpile of 25 million doses of the vaccine. On September 30, 2003, NIAID awarded us a second cost-plus contract, or 2003 Anthrax Contract, valued at $80.3 million for the advanced development of our anthrax vaccine candidate, collectively referred to as the Anthrax Contracts.
In November 2004, we were awarded a contract for $877.5 million to provide 75 million doses of our recombinant anthrax vaccine to the U.S. government Strategic National Stockpile, or SNS, for civilian defense, or SNS Contract. In November 2006, we received a clinical hold notification from the Food and Drug Administration that postponed the initiation of the second Phase 2 trial for our investigational anthrax vaccine, rPA102. On December 19, 2006, the U.S. Department of Health and Human Services, or HHS, terminated for default the SNS Contract. HHS based the decision on its determination that we “failed to successfully cure the condition endangering performance and failed to” meet a milestone imposed by HHS that required us to initiate a clinical trial of the vaccine candidate by December 18, 2006. Following the HHS decision, we ceased actively developing rPA102, scaled back our biodefense activities and are actively pursuing strategic and other alternatives.
Celltrion
Prior to implementing the consolidation provisions within Interpretation No. 46,Consolidation of Variable Interest Entities - an interpretation of ARB No. 51, was originally issued by the Financial Accounting Standards Board, or FASB, in January 2003 and was revised in December 2003, referred to, as revised, as FIN 46R, on January 1, 2004, we had reflected our investment in Celltrion, Inc., or Celltrion, in our consolidated financial statements using the equity method. In September 2005, we entered into agreements to sell 1.2 million of our shares in Celltrion to a group of Korean investors and raise $15.1 million in gross proceeds. Nexol Co., Ltd, or Nexol, purchased 250,000 of these shares. Subsequent to this transaction, Nexol and its affiliates, collectively, became the largest stockholder of Celltrion. Upon this reconsideration event, we were no longer the primary beneficiary of Celltrion and, in accordance with FIN 46R, Celltrion was deconsolidated from VaxGen. From July 1, 2005 through June 30, 2006 our investment in Celltrion was accounted for under the equity method.
In June 2006, we entered into agreements to sell and option our remaining Celltrion common stock to Nexol and its affiliates. We received gross proceeds of $79.0 million from the sale of 3.6 million shares of our Celltrion common stock. We recognized $4.9 million of expenses associated with this sale, resulting in a net gain on the sale of investment in affiliate of $61.2 million. As a result of these agreements, we were no longer entitled to hold two seats on Celltrion’s Board of Directors or appoint an executive officer. Accordingly, we no longer had the ability to exercise significant influence over operating and financial policies of Celltrion, and as of July 1, 2006, we will account for our investment in Celltrion under the cost method. At June 30, 2006, our ownership interest in Celltrion was 8%.
Celltrion is a development stage bio-manufacturing company incorporated on February 26, 2002 and since that date its principal activities have consisted of design and construction of a manufacturing facility in Incheon, Republic of Korea, and partially funding the construction of our U.S. biopharmaceutical manufacturing facility, as well as raising capital and recruiting scientific and management personnel.
Subsequent Events
In December 2006, we received gross proceeds of $51.3 million from the sale of substantially all of our Celltrion common stock to Nexol and its affiliates.
In December 2006, HHS terminated for default the SNS Contract. In April 2007, we entered into a settlement agreement with HHS, in which HHS modified the SNS Contract from a termination for default to a termination for convenience. The settlement agreement also released both parties of all liabilities associated with our three anthrax government contracts. We also mutually terminated the 2003 Anthrax Contract for the convenience of the government.
In January and May 2007, we restructured operations to significantly reduce operating costs and announced we were actively pursuing avenues to enhance stockholder value through a strategic transaction.
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In June 2007, the Company and the Chemo-Sero-Therapeutic Research Institute of Japan, or Kaketsuken, terminated by mutual consent their agreement to co-develop a next-generation, attenuated smallpox vaccine, LC16m8, for use in the United States and elsewhere. Under the terms of the termination agreement, VaxGen will transfer to Kaketsuken or its designee all reports, data and materials and all intellectual property rights that relate to conducting non-clinical and clinical development of LC16m8 in the U.S. In return, Kaketsuken has released VaxGen from ongoing development obligations.
In February 2007, the Board of Directors granted to executive officers options for 1,590,000 shares and implemented an option exchange program allowing executive officers to exchange old options for 714,700 shares for new options for 178,675 shares. The Board also approved two potential retention bonus payments.
See Note 13, Subsequent Events, to the unaudited condensed consolidated financial statements for more information regarding events occurring after June 30, 2006.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Reference should be made to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, filed with the SEC on May 30, 2007, for a description of our critical accounting policies. There have been no significant changes to our policies since we filed that report other than our adoption of FAS No. 123 (revised 2004), Share-Based Payment, or FAS 123R.
Stock-based Compensation Expense
Effective January 1, 2006, we adopted the fair value recognition provisions of FAS 123R, using the modified prospective transition method, and therefore have not restated prior periods’ results. Under this method we recognize compensation expense for all stock-based payments granted after January 1, 2006, and prior to but not yet vested as of January 1, 2006, in accordance with FAS 123R. Under the fair value recognition provisions of FAS 123R, we recognize stock-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest on a straight-line basis over the requisite service period of the award. Prior to FAS 123R adoption, we accounted for stock-based payments under APB 25 and accordingly, recognized compensation expense for options that were granted at an exercise price below their deemed fair market value and for modifications to options.
Determining the appropriate fair value model and calculating the fair value of stock-based payment awards require the input of various highly-subjective assumptions, including the expected life of the stock-based payment awards, our stock price volatility and the expected forfeiture rate of our options. Management determined the expected stock price volatility assumption based upon the Company’s historical volatility. We believe this method of computing volatility is more reflective and a better indicator of the expected future volatility, than using an average of a comparable market index or of a comparable company in the same industry. The expected term of options granted was derived from the short-cut method described in SEC’s SAB No. 107. The risk-free rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The assumptions used in calculating the fair value of stock-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. See Note 2 and 8 to the Condensed Consolidated Financial Statements for a further discussion on stock-based compensation.
RESULTS OF OPERATIONS
Comparison of Fiscal Quarters and Six Months Ended June 30, 2006 and 2005
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Revenues
| | | | | | | | | |
| | Three Months Ended
June 30, | | Percent
change
2006/2005 | | Six Months Ended
June 30, | | Percent
change
2006/2005 | |
| |
| | |
| | |
| | 2006 | | 2005 | | | 2006 | | 2005 | | |
| |
| |
| |
| |
| |
| |
| |
| | (in thousands) | | | | (in thousands) | | | |
Revenues | | | $ | 4,607 | | | | $ | 9,981 | | | (54 | )% | | | $ | 10,912 | | | | $ | 17,627 | | | (38 | )% | |
Revenues in the three and six months ended June 30, 2006 and 2005 were primarily from our Anthrax Contracts principally reflecting work performed for NIAID. In 2006, NIAID-related activities decreased from the comparable period in the prior year as our efforts shifted from work done under the Anthrax Contracts to work under the SNS Contract. Related party services revenues were earned as part of a consulting services agreement with Celltrion to provide technical assistance related to the design, engineering and construction of Celltrion’s manufacturing facility. VaxGen recognized $0.6 million and $1.0 million of revenue from Celltrion during the three and six months ended June 30, 2006. These services were considered to be inter-company in 2005, while Celltrion was consolidated with VaxGen, and therefore were eliminated. The amounts earned vary with the level of services required. Celltrion did not earn any revenues during these periods.
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Revenues earned in one period are not indicative of revenues to be earned in future periods. We expect future quarters’ revenues to be progressively less, as efforts shift from work done under the Anthrax Contracts to work under the SNS Contract or otherwise unfunded by NAIAD.
Research and development expenses
| | | | | | | | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Percent
change
2006/2005 | | Six Months Ended
June 30, | | Percent
change
2006/2005 | |
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| | |
| | 2006 | | 2005 | | | 2006 | | 2005 | | |
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| | (in thousands) | | | | | (in thousands) | | | | |
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Research and development expenses | | $ | 13,794 | | $ | 18,004 | | | (23)% | | $ | 27,970 | | $ | 33,506 | | | (17)% | |
Research expenses include costs associated with research and testing of our product candidates and include the costs of internal personnel, outside contractors, allocated overhead and laboratory supplies. Product development expenses include costs of preclinical development and conducting clinical trials, costs of internal personnel, drug supply costs, research fees charged by outside contractors, allocated overhead and co-development costs.
The decrease of $4.2 million in research and development expenses in the three months ended June 30, 2006 over the comparable period in 2005 was primarily due to:
| | |
| • | Outside consultant expenses, which decreased by $1.2 million primarily due to reduced activities related to our Anthrax Contracts since June 30, 2005; |
| | |
| • | Costs for materials and supplies, which decreased by $0.9 million primarily associated with reduced activities related to our Anthrax Contracts; |
| | |
| • | Celltrion’s research and development expenses, which decreased by $0.9 million because effective July 1, 2005 Celltrion’s operating expenses were not included in our consolidated results; |
| | |
| • | Clinical expenses, which decreased by $0.6 million primarily associated with reduced activities related to our Anthrax Contracts; and |
| | |
| • | Facility expenses, which decreased by $0.6 million primarily associated with reduced activities related to our Anthrax Contracts. |
The decrease of $5.5 million in research and development expenses in the six months ended June 30, 2006 over the comparable period in 2005 was primarily due to:
| | |
| • | Costs for materials and supplies, which decreased by $3.1 million primarily associated with reduced activities related to our Anthrax Contracts; |
| | |
| • | Celltrion’s research and development expenses, which decreased by $1.6 million because effective July 1, 2005 Celltrion’s operating expenses were not included in our consolidated results; |
| | |
| • | Stock-based compensation charges, which decreased by $1.2 million. In 2006, we recorded $0.9 million due to the adoption of FAS 123R and $0.3 million in other non-cash compensation related to stock option modifications. In 2005, we recorded $2.2 million due to the modification of offering periods under our employee stock purchase plan, or ESPP, and $0.2 million in other non-cash compensation; |
| | |
| • | Facility expenses, which decreased by $0.8 million primarily associated with reduced activities related to our Anthrax Contracts; |
| | |
| • | Clinical expenses, which decreased by $0.6 million primarily associated with reduced activities related to our Anthrax Contracts; |
| | |
| • | Outside consultant expenses, which decreased by $0.4 million primarily due to additional operational assistance required since June 30, 2005; and |
| | |
| • | Allocations from general and administrative expense for facilities and other overhead costs, which increased by $2.2 million due to changes in the relative headcounts by department. |
The process of conducting preclinical studies and clinical trials necessary to obtain the U.S. Food and Drug Administration, or FDA, approval is costly and time consuming. The probability of success for each product candidate and clinical trial may be affected by a variety of factors, including, among others, the quality of product candidate early clinical data, investment in the program, competition, manufacturing capabilities and commercial viability. As a result of the uncertainties discussed above, the uncertainty associated with clinical trial enrollments and the risks inherent in the development process, we are unable to determine the duration
20
and completion costs of current or future clinical stages of our product candidates. Development timelines, probability of success and development costs vary widely. While we are primarily focused on developing our anthrax product candidate, we anticipate that we will make determinations as to which additional programs to pursue and how much funding to direct to each program on an ongoing basis in response to the scientific and clinical success of each product candidate, as well as an ongoing assessment as to each product candidate’s commercial potential.
We expect quarterly research and development expenses to decrease substantially during the remainder of 2006 as our efforts shift from work done under the Anthrax Contracts to work under the SNS Contract.
General and administrative expenses
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| | Three Months Ended
June 30, | | Percent
change
2006/2005 | | Six Months Ended
June 30, | | Percent
change
2006/2005 | |
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| | |
| | 2006 | | 2005 | | | 2006 | | 2005 | | |
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| | (in thousands)
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General and administrative expenses | | $ | 7,740 | | $ | 8,985 | | | (14)% | | $ | 14,387 | | $ | 16,112 | | | (11)% | |
General and administrative expenses consist primarily of compensation costs, occupancy costs including depreciation expense, fees for accounting, legal and other professional services and other general corporate expenses.
The decrease of $1.2 million in general and administrative expenses in the three months ended June 30, 2006 over the comparable period of 2005 was primarily due to:
| | |
| • | Celltrion’s general and administrative expenses, which decreased by $2.3 million due to Celltrion’s operating expenses not being included in our consolidated results effective July 1, 2005; |
| | |
| • | Overhead costs allocated to research and development, which increased by $0.8 million in 2006 (reducing general and administrative expenses) resulting from changes in the relative headcounts by department; and |
| | |
| • | Professional fees, which increased by $1.9 million due to audit and other fees and expenses associated with our efforts to comply with various reporting and regulatory requirements including the Sarbanes-Oxley Act of 2002. |
| | |
The decrease of $1.7 million in general and administrative expenses in the six months ended June 30, 2006 over the comparable period of 2005 was primarily due to: |
| | |
| • | Celltrion’s general and administrative expenses, which decreased by $3.9 million due to Celltrion’s operating expenses not being included in our consolidated results effective July 1, 2005; |
| | |
| • | Overhead costs allocated to research and development, which increased by $2.2 million in 2006 (reducing general and administrative expenses) resulting from changes in the relative headcounts by department; |
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| • | Occupancy costs, principally, rent and security services, which increased by $0.7 million due to our amended lease in April 2005 to secure space to support the production of our recombinant anthrax vaccine candidate as well as our other programs; |
| | |
| • | Depreciation expense, which increased by $0.9 million due to expanded operations since June 30, 2005 and the implementation of our enterprise resource planning system; and |
| | |
| • | Professional fees, which increased by $2.8 million due to audit and other fees and expenses associated with our efforts to comply with various reporting and regulatory requirements including the Sarbanes-Oxley Act of 2002. |
We expect that quarterly general and administrative expenses will be lower than the corresponding periods in 2005 during the remainder of 2006, but will continue to reflect the significant resources required to support our public reporting requirements.
Other income (expense)
| | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| |
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| |
| | 2006 | | 2005 | | 2006 | | 2005 | |
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| | (in thousands) | | (in thousands) | |
Interest expense | | $ | (614 | ) | $ | (988 | ) | $ | (1,244 | ) | $ | (1,114 | ) |
Interest income and other | | | 187 | | | 415 | | | 453 | | | 467 | |
Valuation adjustments | | | (1,858 | ) | | (176 | ) | | (1,463 | ) | | (176 | ) |
Equity in loss of affiliate | | | (2,784 | ) | | — | | | (5,290 | ) | | — | |
Gain on foreign currency transactions | | | 4,519 | | | — | | | 4,678 | | | — | |
Gain on sale of investment in affiliate | | | 61,198 | | | — | | | 61,198 | | | — | |
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Other income (expense) | | $ | 60,648 | | $ | (749 | ) | $ | 58,332 | | $ | (823 | ) |
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21
The increase in other income of $61.4 million in the three months ended June 30, 2006 from the comparable period in 2005 was primarily due to:
| | |
| • | Gain on sale of investment resulting from our June 2006 sale of 3.6 million of our Celltrion common stock to Nexol and its affiliates for gross proceeds of $79.0 million, net of $11.8 million in basis, $4.9 million in expenses and the deferral of $1.1 million related to the option sold along with the shares; |
| | |
| • | Realized foreign currency gains increased primarily due to the collection of the June 2006 proceeds from the sale of Celltrion common stock; |
| | |
| • | Effective July 1, 2005, we recognize our share of Celltrion’s losses under the equity method. For the three months ended June 30, 2005, Celltrion was consolidated with VaxGen; |
| | |
| • | In 2006 and 2005, 5 1/2% interest on the $31.5 million of our Convertible Senior Subordinated Notes, due April 1, 2010, or Notes, was recorded, whereas in 2005 there was also $0.3 million of interest expense on Celltrion’s debt; |
| | |
| • | Expenses for mark-to-market adjustments related to the valuation of our outstanding derivatives on our Notes, changed primarily due to changes in the likelihood of a change in control potentially triggering the redemption option related to the Notes; and |
| | |
| • | Interest income and other decreased primarily due to lower overall cash, cash equivalent and investment balances due to the cash flow used in operating activities, primarily for our operating losses. |
| | |
The increase in other income of $59.2 million in the six months ended June 30, 2006 from the comparable period in 2005 was primarily due to: |
|
| • | Gain on sale of investment resulting from our June 2006 sale of 3.6 million of our Celltrion common stock to Nexol and its affiliates for gross proceeds of $79.0 million, net of $11.8 million in basis, $4.9 million in expenses and $1.1 million related to the option sold along with the shares; |
| | |
| • | Realized foreign currency gains increased primarily due to the collection of the 2005 and 2006 proceeds from the sale of Celltrion common stock; |
| | |
| • | Effective July 1, 2005, we recognize our share of Celltrion’s losses under the equity method. For the six months ended June 30, 2005, Celltrion was consolidated with VaxGen; |
| | |
| • | In 2006 and 2005, interest on our Notes was recorded, whereas in 2005 there was also $0.5 million of interest expense on Celltrion’s debt; and |
| | |
| • | Expenses for mark-to-market adjustments related to the valuation of our outstanding derivatives on our Notes changed primarily due to changes in the likelihood of a change in control potentially triggering the redemption option related to the Notes. |
We anticipate future investment income will fluctuate and will be primarily driven by our future cash, cash equivalent and investment balances. Valuation adjustments will continue to be impacted by changes in our common stock price, our volatility and our expectations relative to a change in control. No changes in our debt levels are anticipated and therefore quarterly interest expense is expected to remain at the three months ended June 30, 2006 level throughout 2006. As a result of the sale of Celltrion common stock in June 2006, our accounting treatment for the remaining investment in Celltrion will be recorded under the cost method; accordingly, we will no longer have further equity in loss of affiliate charges. In addition, if the option to purchase our remaining Celltrion shares is exercised prior to 2007, we would expect a significant gain from the sale and from the resulting foreign currency transaction.
Minority interest in loss of variable interest entity
| | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| |
| |
| |
| | 2006 | | 2005 | | 2006 | | 2005 | |
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| | (in thousands) | | (in thousands) | |
Minority interest in loss of variable interest entity | | $ | — | | $ | 2,426 | | $ | — | | $ | 4,109 | |
Minority interest in loss of variable interest entity for the three and six months ended June 30, 2005 reflects the interests of Celltrion’s other stockholders in the net loss of Celltrion. For the three and six months ended June 30, 2006, Celltrion was not consolidated with VaxGen.
See Note 12, Segment Information, included in the notes to the unaudited condensed consolidated financial statements in Part I – Item 1 of this report for segment information.
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LIQUIDITY AND CAPITAL RESOURCES
| | | | | | | |
| | 2006 | | 2005 | |
| |
| |
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| | (in thousands) | |
As of June 30: | | | |
Cash, cash equivalents and investment securities | | $ | 82,285 | | $ | 36,339 | |
Working capital | | | 69,946 | | | 6,351 | |
Six months ended June 30: | | | | | | | |
Cash provided by (used in): | | | | | | | |
Operating activities | | $ | (32,223 | ) | $ | (27,525 | ) |
Investing activities | | | 86,287 | | | (25,766 | ) |
Financing activities | | | 22,861 | | | 49,618 | |
Effect of exchange rate changes on cash and cash equivalents | | | — | | | 125 | |
Capital expenditures (included in investing activities above) | | | (2,060 | ) | | (28,760 | ) |
Our primary financing requirements are for funding our day-to-day working capital requirements and capital equipment expenditures related to the manufacturing facilities in California. Through June 30, 2006, we financed our operations primarily through sales of our common stock, the issuance of Series A Preferred Stock, the issuance of the Notes, sales of our Celltrion common stock as well as through revenues from research contracts and grants. From time-to-time, as part of our investment strategy, we enter into reverse repurchase agreements to increase our return on investments and improve our liquidity. Reverse repurchase agreements involve a purchase of securities and an agreement to resell the same securities at a later date at an agreed-upon price. The primary risk associated with short-term collateralized borrowings is that the counterparty might be unable to perform under the terms of the contract. Our exposure is limited, however, because we generally invest in overnight agreements.
In April 2005, we raised aggregate net proceeds of $29.7 million through a private placement of $31.5 million of Notes due April 1, 2010. The Notes require us to make semi-annual payments of interest in cash at a rate of 5 1/2%, due April 1 and October 1. If a change in control occurs, as defined in the indenture, on or prior to the stated maturity of the Notes, the holders of the Notes may require under certain circumstances us to repurchase the Notes and pay a make-whole premium to the holders of the Notes. If the stock price on the effective date of redemption is less than $12.30 per share, no make-whole premium will be paid. If the holders request such a repurchase, we or our successor entity, may choose to pay in cash, common stock or a combination of cash and common stock.
In September 2005, we entered into agreements to sell 1.2 million of our shares in Celltrion to a group of Korean investors and raise $15.1 million in gross proceeds. Nexol purchased 250,000 of these shares. Subsequent to this transaction, Nexol and its affiliates, collectively, became the largest stockholder of Celltrion. Upon this reconsideration event, we were no longer the primary beneficiary of Celltrion and, in accordance with FIN 46R, Celltrion was deconsolidated from VaxGen. From July 1, 2005 through June 30, 2006 our investment in Celltrion was accounted for under the equity method. In June 2006, we entered into agreements to sell and option our remaining Celltrion common stock to Nexol and its affiliates. We received gross proceeds of $79.0 million from the sale of 3.6 million shares of our Celltrion common stock. We recognized $4.9 million of expenses associated with this sale. As a result of these agreements, we were no longer entitled to hold two seats on Celltrion’s Board of Directors or appoint a Representative Director. Accordingly, we no longer had the ability to exercise significant influence over operating and financial policies of Celltrion, and as of July 1, 2006, we will account for our investment in Celltrion under the cost method. At June 30, 2006, our ownership interest in Celltrion was 8%. See Note 13, Subsequent Events, for a further discussion regarding financings.
Our future capital requirements will depend on several factors, including:
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| • | Our ability to negotiate government contracts or grants, particularly our ability to win contracts to continue to develop or to sell our vaccine candidates; |
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| • | The timing of collection of accounts receivable from our government contracts and grants; |
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| • | Progress of internal research and development projects; |
| | |
| • | Levels and timing of capital expenditures on the manufacturing facilities in the Republic of Korea and California; and |
| | |
| • | Our ability to identify and exploit business development opportunities. |
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Net cash used in operating activities of $32.2 million and $27.5 million for the six months ended June 30, 2006 and 2005, respectively, was primarily attributable to our operating losses although the effect of non-cash charges upon operating activities was significant in both periods and included:
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| • | Equity in loss of affiliate of $5.3 million and zero for the six months ended June 30, 2006 and 2005, respectively. Effective July 1, 2005, we recognize our share of Celltrion’s losses under the equity method. For the six months ended June 30, 2005, Celltrion was consolidated with VaxGen; |
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| • | Realized foreign currency gains of $4.7 million and zero for the six months ended June 30, 2006 and 2005, respectively. Realized foreign currency gains increased primarily due to the collection of the 2005 and 2006 proceeds from the sale of Celltrion shares; |
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| • | Stock-based compensation expense of $1.8 million in 2006 and $3.9 million in 2005. The decrease from 2005 is primarily the result of modifications to the Company’s employee stock purchase plan in 2005; |
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| • | Valuation adjustments of $1.5 million and $0.2 million in the six months ended June 30, 2006 and 2005, respectively, reflecting changes in the fair value of outstanding derivatives from our debt; and |
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| • | Depreciation and amortization of $3.1 million and $2.5 million for the six months ended June 30, 2006, and 2005, respectively. The increase from 2005 is primarily the result of depreciation on manufacturing equipment leasehold improvements placed into service since June 30, 2005. |
The $61.2 million gain on the 2006 sale of 3.6 million shares of our investment in Celltrion was removed from operating activities and the net proceeds received are reflected in investing activities.
Cash used in operating activities was also affected by the following:
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| • | Accrued and other current liabilities, which increased by $0.2 million in 2006 and by $5.3 million in 2005 primarily due to the timing of payments and the reduced level of operating activities at June 30, 2006; |
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| • | Accounts payable, which decreased by $0.3 million in 2006, increased by $2.3 million in 2005 primarily due to the timing of payments and the reduced level of operating activities at June 30, 2006; and |
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| • | Receivables, which increased by $5.6 million in 2006 and by $9.7 million in 2005 primarily due to reduced revenues earned from the U.S. government and the timing of payments received. |
Net cash provided by investing activities consisted primarily of the $76.5 million in net proceeds from the sale of our Celltrion common stock net of activities relating to the purchase and sale of investment securities as well as capital expenditures. Capital expenditures in the six months ended June 30, 2006 and 2005 were made in connection with the expansion of the Korean manufacturing facility (zero and $22.4 million, respectively) and research and development laboratories and leasehold improvements associated with the California manufacturing facility and office facilities ($0.7 million and $4.8 million, respectively). In addition, during the six months ended June 30, 2006 and 2005 we purchased $1.4 million and $1.5 million of software related to the implementation of a new enterprise resource planning system. We expect minimal capital expenditures during the remainder of 2006 because the California manufacturing facilities are now substantially complete and Celltrion is no longer consolidated.
Net cash provided by our financing activities decreased to $22.9 million in the six months ended June 30, 2006 from $49.6 million in the comparable period in 2005. In February 2006, we raised net proceeds of $25.2 million through a private placement of 3,500,000 shares of our common stock at $7.70 per share at a discount to the $9.20 per share closing price. In April 2005, we raised net proceeds of $29.7 million through a private placement of the Notes due April 1, 2010. In March 2005, Celltrion issued 1,949,700 shares of preferred stock at a price of 5,000 Korean Won ($4.99 equivalent) per share, resulting in proceeds of 9,749 million Korean Won ($9.5 million equivalent). In January 2003, Celltrion obtained collaterized long-term financing of 52,000 million Korean Won (equivalent to $44.2 million) with a nine-year term from a Korean bank, or Loan. Funds from the Loan, $10.5 million in the six months ended June 30, 2005, were used for construction of the Incheon administration buildings and manufacturing facility.
At June 30, 2006, $82.3 million, or 59%, of our assets consisted of cash, cash equivalents and investment securities. We had working capital of $69.9 million at June 30, 2006, compared to $6.4 million at June 30, 2005. This $63.5 million increase in working capital is primarily due to the following:
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| • | Cash, cash equivalents and investment securities, which increased by $45.9 million primarily as a result of the June 2006 sale of 3.6 million shares of Celltrion common stock, net of operating losses; |
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| • | Due to related parties, which decreased by $12.8 million primarily as a result of the deconsolidation of Celltrion effective July 1, 2005; |
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| • | Current obligations, which decreased by $7.2 million primarily as a result of the deconsolidation of Celltrion effective July 1, 2005; |
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| • | Receivables, which decreased by $5.4 million primarily due to reduced revenues earned from the U.S. government; and |
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| • | Accrued and other current liabilities, which decreased by $5.5 million primarily due to the timing of payments. |
We continually review alternatives to obtain additional financing and to increase revenues by procuring future contracts to supply anthrax and smallpox vaccines to the U.S. government and other potential customers. Some of our alternatives to obtain additional financing include the sale of our common stock, obtaining additional debt and the sale of some or all of our investment in Celltrion. There can be no assurances that we will be successful in these efforts. The reaudit of our financial statements for the three years ended December 31, 2003, the resulting restatement of periodic reports previously filed with the SEC, the lapsing of our resale registration statements, the extended period while we have not been current in our SEC reporting and the delisting of our common stock will likely have an adverse impact on whether financing will be available or the terms of that financing. See Subsequent Events in Note 13 for further discussion on additional financings.
Off-Balance Sheet Arrangements
As of June 30, 2006, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Recent Accounting Pronouncements
In April 2005, the FASB issued FIN 46(R)-6,Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R), or FSP FIN 46R-6. FSP FIN 46R-6 addresses certain major implementation issues related to FIN 46(R). Specifically, FSP FIN 46R-6 addresses how a reporting enterprise should determine the variability to be considered in applying FIN 46R. The variability that is considered in applying FIN 46R affects the determination of (a) whether the entity is a variable interest entity or VIE, (b) which interests are “variable interests” in the entity, and (c) which party, if any, is the primary beneficiary of the VIE. That variability will affect any calculation of expected losses and expected residual returns, if such a calculation is necessary. The effective date and transition requirements prescribed by FSP FIN 46R-6 are complex. For example, an enterprise is required to apply the guidance in the FSP prospectively to all entities (including newly created entities) with which that enterprise first becomes involved and to all entities previously required to be analyzed under FIN 46R when a “reconsideration event” has occurred as defined in FIN 46R beginning the first day of the first reporting period beginning after June 15, 2006. Retrospective application is permitted but not required; however, a company that chooses retrospective application must do so no later than the end of the first annual reporting period ending after July 15, 2006. We do not expect the adoption of FAS 155 will have a material impact on our consolidated financial position, results of operations or cash flows.
In February 2006, the FASB issued FAS No. 155,Accounting for Certain Hybrid Financial Instruments, or FAS 155, which amends FAS No. 133,Accounting for Derivative Instruments and Hedging Activities and FAS No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and improves the financial reporting of certain hybrid financial instruments by requiring more consistent accounting that eliminates exemptions and provides a means to simplify the accounting for these instruments. Specifically, FAS 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. FAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. We do not expect the adoption of FAS 155 will have a material impact on our consolidated financial position, results of operations or cash flows.
In March 2006, the EITF reached a tentative consensus on Issue No. 06-3,How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross Versus Net Presentation), or EITF 06-3. EITF 06-3 addresses income statement classification and disclosure requirements of externally-imposed taxes on revenue-producing transactions. EITF 06-3 is effective for periods beginning after December 15, 2006. We do not expect the implementation of EITF 06-3 to have a material impact on our consolidated financial position, results of operations or cash flows.
In July 2006, the FASB issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109, or FIN 48, which clarifies the accounting for uncertainty in tax positions. FIN 48 requires that we recognize in our financial statements the impact of a tax position if that position is more likely than not of being sustained upon audit, based on the technical merits of the position. FIN 48 is effective for fiscal years beginning after December 15, 2006 which is the beginning of our fiscal 2007. We do not expect the adoption of FIN 48 will have a material impact on our consolidated financial position, results of operations or cash flows.
In September 2006, the FASB issued FAS No. 157, Fair Value Measurement, or FAS 157. FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are evaluating the impact of adopting FAS 157 on our consolidated financial position, results of operations and cash flows.
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In September 2006, the SEC published Staff Accounting Bulletin Topic 1N,Financial Statements — Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements, or SAB 108. SAB 108 addresses how a company should quantify the effect of an error on the financial statements. The SEC staff concludes in SAB 108 that a dual approach should be used to compute the amount of a misstatement. Specifically, the amount should be computed using both the “rollover” (current year income statement perspective) and “iron curtain” (year-end balance sheet perspective) methods. SAB 108 does not address how to evaluate materiality, that is, how to assess the quantitative and qualitative effects of a misstatement on the financial statements. The SEC staff’s views on evaluating the materiality of an error are covered in SAB Topic 1M, Financial Statements — Materiality, or SAB 99. Companies that will need to change their method for computing the amount of an error must adopt the dual approach for fiscal years ending after November 15, 2006, which is effective with our year ended December 31, 2006. A change in the method of quantifying errors represents a change in accounting policy. Accordingly, if the use of the dual approach results in a larger, material misstatement, we will have to adjust its financial statements. Under FAS 154, changes in accounting policy generally are accounted for using retrospective application; however, SAB 108 permits public companies to report the cumulative effect of the new policy as an adjustment to opening retained earnings. We do not expect the adoption of SAB 108 to have a material impact on our consolidated financial position, results of operations or cash flows.
In November 2006, the FASB ratified EITF Issue No. 06-6,Application of EITF Issue No. 05-7, ‘Accounting for Modifications to Conversion Options Embedded in Debt Instruments and Related Issues’, or EITF 06-6. EITF 06-6 addresses the modification of a convertible debt instrument that changes the fair value of an embedded conversion option and the subsequent recognition of interest expense for the associated debt instrument when the modification does not result in a debt extinguishment pursuant to EITF 96-19. The consensus should be applied to modifications or exchanges of debt instruments occurring in interim or annual periods beginning after November 29, 2006. We do not expect the adoption of EITF 06-6 to have a material impact on our consolidated financial position, results of operations or cash flows.
In November 2006, the FASB ratified EITF Issue No. 06-7,Issuer’s Accounting for a Previously Bifurcated Conversion Option in a Convertible Debt Instrument When the Conversion Option No Longer Meets the Bifurcation Criteria in FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, or EITF 06-7. At the time of issuance, an embedded conversion option in a convertible debt instrument may be required to be bifurcated from the debt instrument and accounted for separately by the issuer as a derivative under FAS 133, based on the application of EITF Issue 00-19,Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, or EITF 00-19. Subsequent to the issuance of the convertible debt, facts may change and cause the embedded conversion option to no longer meet the conditions for separate accounting as a derivative instrument, such as when the bifurcated instrument meets the conditions of EITF 00-19 to be classified in stockholders’ equity. Under EITF 06-7, when an embedded conversion option previously accounted for as a derivative under FAS 133 no longer meets the bifurcation criteria under that standard, an issuer shall disclose a description of the principal changes causing the embedded conversion option to no longer require bifurcation under FAS 133 and the amount of the liability for the conversion option reclassified to stockholders’ equity. EITF 06-7 should be applied to all previously bifurcated conversion options in convertible debt instruments that no longer meet the bifurcation criteria in FAS 133 in interim or annual periods beginning after December 15, 2006, regardless of whether the debt instrument was entered into prior or subsequent to the effective date of EITF 06-7. Earlier application of EITF 06-7 is permitted in periods for which financial statements have not yet been issued. We do not expect the adoption of EITF 06-7 to have a material impact on our consolidated financial position, results of operations or cash flows.
In February 2007, the FASB issued FAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115, or FAS 159, which permits all entities to choose to measure eligible items, including many financial instruments, at fair value at specified election dates. A business entity will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (a) may be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. Most of the provisions in FAS 159 are elective; however, the amendment to FAS No. 115,Accounting for Certain Investments in Debt and Equity Securities,applies to all entities with available-for-sale and trading securities. FAS 159 is effective for fiscal years beginning after November 15, 2007. We are evaluating the impact of adopting FAS 159 on our consolidated financial position, results of operations and cash flows.
In June 2007, the EITF published Issue No. 07-3,Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities, or EITF 07-3. The EITF reached a consensus that these payments made by an entity to third parties should be deferred and capitalized. Such amounts should be recognized as an expense as the related goods are delivered or the related services are performed. Entities should report the effects of applying this Issue as a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. EITF 07-3 is effective beginning on January 1, 2008. Earlier application is not permitted. We do not expect that adoption of this new Standard will have a material effect on our financial position or results of operations.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our operations and cash flows are subject to fluctuations due to changes in interest rates in our investment portfolio of debt securities and to foreign currency exchange rates.
Interest Rate Risk
We are exposed to market rate changes by debt securities included in our investment portfolio. By policy, we invest in debt instruments of the U.S. government, federal agencies and high-quality corporate issuers, limit the amount of credit exposure to any one issuer, and limit duration by restricting the term. Investments in both fixed rate and floating rate instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may decrease due to changes in interest rates or due to losses we may suffer when securities decline in market value. At June 30, 2006, we held available-for-sale securities in the principal amount of $0.8 million. If market interest rates were to increase immediately and uniformly by 10% from levels at June 30, 2006, the fair value of our portfolio would decline by an immaterial amount, and would not have a significant effect on our operations or cash flows. Our exposure to losses as a result of interest rate changes is managed through investing in a portfolio of securities with a weighted-average maturity of one year or less.
Indebtedness
At June 30, 2006, our outstanding non-current liabilities include $31.5 million of our Notes due April 1, 2010 which we sold in a private placement in April 2005. As the Notes bear interest at a fixed rate, our interest expense under the Notes would not be affected by interest rate changes. As of June 30, 2006, we did not invest in derivative financial instruments, interest rate swaps or other investments that alter interest rate exposure.
Foreign Currency Risk
Our exposure to foreign currency exchange rates is related primarily to our investment in Celltrion. Our investment in this international business is subject to risks, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility when compared to the United States dollar. Accordingly, our future results could be materially affected by changes in these or other factors. As exchange rates vary, our share in Celltrion’s results, when translated, may vary from expectations and could adversely impact overall profitability. If market foreign currency exchange rates were to change the impact would be reflected in the balance of our investment in Celltrion and in accumulated other comprehensive income. Such a change would not have a significant effect on our operations or cash flows. As of June 30, 2006, we did not invest in derivative financial instruments, currency swaps or other investments that alter foreign currency exposure.
Derivative Valuation Risk
The terms of our Notes include put features not under our control. These features are considered to be an embedded derivative liability and we determined the fair value of this derivative to be $1.8 million on the date of issuance. Due to the quarterly revaluation of the embedded derivative liability, we recorded in our statements of operations other expense of $1.9 million and $1.5 million for the three and six months ended June 30, 2006, respectively. At June 30, 2006, the embedded derivative liability was valued at $4.4 million. We determine the fair value of the derivative liabilities using the Monte Carlo Simulation methodology. This methodology allows flexibility in incorporating various assumptions such as probabilities of certain triggering events. The valuations are based on the information available as of the various valuation dates. Factors affecting the amount of these liabilities include expectations regarding triggering events, the market value of our common stock, the estimated volatility of our common stock, our market capitalization, the risk free interest rate and other assumptions. The inputs for the valuation analysis of the derivatives include the probabilities of certain triggering events, which we believed to be unlikely as of June 30, 2006. A change in this probability and or a change in the market value of our common stock could have a significant impact on the results of our operations; however, there would not be any impact on our cash flows.
ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Disclosure controls and procedures are designed to ensure that the information required to be disclosed in our reports which we file or submit under the Securities Exchange Act of 1934 is (i) accumulated and communicated to our management (including the Chief Executive Officer and Chief Financial Officer) as appropriate to allow timely decisions regarding required disclosures, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Based upon the material weaknesses in our internal control over financial reporting as described below, our Chief Executive Officer and Chief Financial
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Officer have concluded that our disclosure controls and procedures were not effective as of the end of the period covered by this report.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.
We previously identified the following material weaknesses:
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1) | We did not maintain an effective control environment, specifically, the following material weaknesses were identified within the control environment: |
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| a) | We did not maintain an effective control environment based on criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO. Specifically, the financial reporting organization structure was not adequate to support the size, complexity or activities of the Company. In addition, certain finance positions were staffed with individuals who did not possess the level of accounting knowledge, experience and training in the application of GAAP commensurate with our financial reporting requirements. |
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| b) | We did not maintain effective financial reporting processes, including sufficient formalized and consistent finance and accounting polices and procedures; nor did we prevent or detect instances of non-compliance with certain such policies and procedures that do exist. Specifically, we lacked formalized reporting policies and procedures. |
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| c) | We did not maintain effective monitoring controls and related segregation of duties over automated and manual transactions processes. Specifically, we failed to implement processes to ensure periodic monitoring of our existing internal control activities over financial reporting to identify and assess significant risk that may impact financial statements and related disclosures. Additionally, inadequate segregation of duties led to untimely identification and resolution of accounting and discourse matters and failure to perform timely and effective supervision and reviews. |
The above control deficiencies resulted in audit adjustments to our 2006 interim and annual consolidated financial statements. These control deficiencies affect substantially all financial statement accounts, which could result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected.
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2) | The material weakness in our control environment contributed to the existence of the following control deficiencies, each of which is considered to be a material weakness: |
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| a) | We did not maintain effective controls over our process to ensure the complete, accurate and timely preparation and review of our consolidated financial statements in accordance with GAAP. Specifically, we did not have effective controls over the process for identifying, accumulating and reviewing all required supporting information to ensure the completeness, accuracy and timely preparation and review of our consolidated financial statements and disclosures. This control deficiency resulted in audit adjustments to our fiscal 2006 interim and annual consolidated financial statements. Additionally, this control deficiency could result in a misstatement of substantially all financial statement accounts that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected. |
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| b) | We did not maintain effective controls to ensure that journal entries, both recurring and non-recurring, were consistently reviewed and approved in a timely manner to ensure the validity, completeness and accuracy of recorded entries. This control deficiency resulted in audit adjustments to our fiscal 2006 interim and annual consolidated financial statements. Additionally, this control deficiency could result in a misstatement of substantially all financial statement accounts that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected. |
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| c) | We did not maintain effective controls over the procurement process. Specifically, effective controls were not in place to ensure the appropriate controls over the approval of new vendors, authorization of purchase orders, including categorization of appropriate expense line items, the receipt of goods and the approval and authorization of vendor payments. This control deficiency could result in a misstatement of current liabilities and operating expenses that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected. |
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| d) | We did not maintain effective controls over the completeness and accuracy of certain revenue and expense accruals. Specifically, we failed to identify, analyze and review certain accruals at period end relating to certain accounts receivable, accounts payable, accrued liabilities, revenue and other direct expenses to ensure that they were accurately, completely and properly recorded. This control deficiency resulted in audit adjustments to our fiscal 2006 interim and annual consolidated financial statements. Additionally, this control deficiency could result in a misstatement of the aforementioned accounts that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected. |
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| e) | We did not maintain effective controls over the existence, completeness and valuation of fixed assets and related depreciation expense. Specifically, effective controls were not designed and in place to ensure that fixed asset additions and disposals were recorded, as well as, the periodic physical verification of fixed assets. This control deficiency resulted in audit adjustments to our fiscal 2006 interim and annual consolidated financial statements. Additionally, this control deficiency could result in a misstatement of fixed assets and depreciation expense that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected. |
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| f) | We did not maintain effective controls over spreadsheets. Specifically, we did not maintain effective controls over the completeness, accuracy and validity of spreadsheets used in our financial reporting process to maintain effective version control and ensure that access was restricted to appropriate personnel, and that unauthorized modification of the data or formulas within spreadsheets was prevented. This control deficiency resulted in audit adjustments to our fiscal 2006 interim and annual consolidated financial statements. Additionally, this control deficiency could result in a misstatement of substantially all financial statement accounts that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected. |
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| g) | We did not design and maintain effective controls over the completeness, accuracy and valuation of our payroll and payroll expense. Specifically, we did not design and maintain effective controls over the administration of employee data or controls to provide reasonable assurance regarding the proper authorization of non-recurring payroll changes. This control deficiency could result in a misstatement of the aforementioned accounts that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected. |
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| h) | We did not design and maintain effective controls over the completeness, accuracy, existence and valuation of our research grant and contract revenue accounts. Specifically, we did not design and maintain effective controls to provide reasonable assurance that indirect and provisional rates used to calculate manufacturing overhead and technical overhead were complete and accurate. This control deficiency resulted in audit adjustments to our fiscal 2006 interim and annual consolidated financial statements. Additionally, this control deficiency could result in a misstatement of the aforementioned accounts that would result in a material misstatement to our interim or annual consolidated financial statements that would not be prevented or detected. |
As described in Item 9A of our Annual Report on Form 10-K for the year ended December 31, 2005, which we refer to as our 2005 10-K, our management has established a plan for remediation of the material weaknesses in our internal control over financial reporting.
The certifications of our principal executive officer and principal financial officer required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 are attached as exhibits to this Quarterly Report on Form 10-Q. The disclosures set forth in this Item 4 contain information concerning the evaluation of our disclosure controls and procedures and changes in internal control over financial reporting, referred to in the certifications. Those certifications should be read in conjunction with this Item 4 for a complete understanding of the matters covered by the certifications.
Our management undertook and completed reconciliations, analyses, reviews and control procedures in addition to those historically completed to confirm that this Quarterly Report fairly presents in all material aspects our financial position, results of operations and cash flows as of, and for the period presented in accordance with U.S. generally accepted accounting principles.
Changes in Internal Control over Financial Reporting
During the second quarter of 2006, we instituted a new enterprise resource planning system, primarily used for automated general ledger and accounts payable transactions. Our internal control over financial reporting has been altered accordingly for this change in accounting system. There have been no other significant changes in our internal control over financial reporting during the three months ended June 30, 2006. We continue to develop our control procedures surrounding the implementation of our new accounting system and we continue to develop a remediation plan to address our previously disclosed material weaknesses in our internal control over financial reporting. The development of our remediation plan is described Item 9A of our 2005 10-K. We expect that the implementation of this plan will extend throughout 2007.
Inherent Limitations on Effectiveness of Controls
Our management, including the Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.
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PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None.
ITEM 1A. RISK FACTORS
You should carefully consider the following risk factors as well as other information in our filings under the Exchange Act before making any investment decisions regarding our common stock. The risks and uncertainties described herein are not the only ones we face. Additional risks and uncertainties that we do not know or that we currently deem immaterial may also impair our business, financial condition, operating results and prospects. If events corresponding to any of these risks actually occur, they could materially adversely affect our business, financial condition, operating results or prospects. In that case, the trading price of our common stock could decline. When used in this report, unless otherwise indicated, “we,” “our” and “us” refers to VaxGen. Risk factors which have materially changed since our 2005 10-K are marked with an “*”.
We do not have current financial statements, and therefore you are not able to evaluate our current financial condition or operating history and results.*
We have had to restate certain historical financial statements and have engaged our new independent registered public accounting firm to reaudit those financial statements. In July 2004, we announced that we were reauditing and restating our financial statements for the fiscal years ended December 31, 2003 and 2002 because we determined that we should recognize revenue from certain government contracts as costs were incurred, instead of after completing contract milestones. In October 2004, we announced that we would also be reauditing and restating our financial statements for the fiscal year ended December 31, 2001. In connection with the restatement of our financial statements for the fiscal year ended December 31, 2001, we also made adjustments to our balance sheet as of December 31, 2000. In July 2005, we concluded that our historical accounting for our 2002 investment in Celltrion was also not in conformity with generally accepted accounting principles in the United States of America, or U.S. GAAP, and was, therefore, inappropriate. Our 2002 and 2003 restated financial statements reflect the recording of our investment in Celltrion at fair value and the recognition of our share of Celltrion’s net losses using the equity method of accounting. This process has taken additional time to complete and has delayed the completion of the reaudit and restatement of our financial statements.
From January 1, 2004 to June 30, 2005, we were required to consolidate Celltrion’s financial statements into our own. From July 1, 2005 to June 30, 2006, we were required to account for our investment in Celltrion under the equity method. Celltrion maintains its records in accordance with Korean accounting principles; however, we require financial statements that are prepared in accordance with U.S. GAAP and which have been audited in conformity with U.S. Auditing Standards. Celltrion maintains its records in accordance with Korean accounting principles; however, we require financial statements that are prepared in accordance with U.S. GAAP and which have been audited in conformity with U.S. Auditing Standards. Celltrion’s internal control over financial reporting may be insufficient to enable them to report their interim U.S. GAAP financial results to us on a timely basis.
We are not currently listed on a national exchange, including the Nasdaq Global Market or Nasdaq SmallCap Market, and cannot assure you we will ever be listed.
As a result of our failure to timely file periodic reports, we were delisted from Nasdaq, and our common stock is not currently listed on any other national stock exchange. Until we complete all necessary filings with the SEC pursuant to Sections 13 and 15(d) of the Exchange Act, we will not be able to apply for our common stock to be listed on a national exchange. We do not know when, if ever, this will be completed, and thus, whether our common stock will ever be listed. In addition, we cannot be certain that Nasdaq will approve our stock for relisting or that another exchange will approve our stock for listing. In order to be eligible for relisting or listing, we must meet Nasdaq’s or anther exchange’s initial listing criteria, and we believe we will need to be in compliance with Sections 13 and 15(d) of the Exchange Act. Our common stock is currently quoted on the Pink Sheets, LLC.
We are currently ineligible to register securities with the SEC, and we may never regain compliance.
Until we have filed current financial statements and made all the necessary filings with the SEC pursuant to Sections 13 and 15(d) of the Exchange Act, we will not be able to register any securities for re-sale. Until we are able to register securities with the SEC for resale, any purchasers who purchase our common stock or other securities directly from us will have to rely on an exemption from the federal and state securities laws in order to resell their securities. We cannot estimate when, if ever, we will have filed outstanding periodic reports and regained compliance with Sections 13 and 15(d) of the Exchange Act.
Our internal controls may be insufficient to ensure timely and reliable financial information.
We believe we need to correct deficiencies in our internal controls and procedures for financial reporting. These deficiencies include inadequate controls and procedures relating to revenue recognition for government contracts, account reconciliations, segregation of
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duties, journal entries, accounting for investments in affiliates, accounting for equity securities and derivatives, accounting for stock-based compensation, cut-off procedures and depth of accounting knowledge.
Failure to address these deficiencies in a timely manner might increase the risk of future financial reporting misstatements and may prevent us from being able to meet our filing deadlines. Under the supervision of our Audit Committee, we are continuing the process of identifying and implementing corrective actions where required to improve the design and effectiveness of our internal controls, including the enhancement of systems and procedures. Significant additional resources will be required to establish and maintain appropriate controls and procedures and to prepare the required financial and other information during this process.
Even after corrective actions are implemented, the effectiveness of our controls and procedures may be limited by a variety of risks including:
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| • | faulty human judgment and simple errors, omissions or mistakes; |
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| • | collusion of two or more people; |
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| • | inappropriate management override of procedures; and |
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| • | the risk that enhanced controls and procedures may still not be adequate to assure timely and reliable financial information. |
If we fail to have effective internal controls and procedures for financial reporting in place, we could be unable to provide timely and reliable financial information. Additionally, if we fail to have effective internal controls and procedures for financial reporting in place, it could adversely affect our financial reporting requirements under our government contracts.
We will need to raise additional capital, and any inability to raise required funds could harm our business.*
In February 2006, we raised net proceeds of $25.2 million through a private placement to a group of accredited institutional investors. In June 2006, we received gross proceeds of $79.0 million from the sale of 3.6 million shares of our Celltrion common stock. We also provided the buyers with the right through the end of 2006 to purchase our 2.2 million remaining shares of Celltrion common stock at a price of 22,000 Korean Won, or Option. If exercised in its entirety, the Option could result in potential gross proceeds of $51.0 million (translated at June 30, 2006). We will, however, still need to raise substantial additional capital in order to satisfy the requirements under the SNS Contract for acceptance of our anthrax vaccine and to continue operations. We may attempt to raise these funds through equity or debt financings, collaborative arrangements with corporate partners or from other sources, including the sale of all or a portion of our interest in Celltrion. The reaudit of our financial statements for the three years ended December 31, 2003, the resulting restatement of periodic reports previously filed with the SEC, the lapsing of our resale registration statements, the extended period while we have not been current in our SEC reporting and the delisting of our common stock will likely have an adverse impact on whether financing will be available or the terms of that financing.
If additional funds are raised through the issuance of preferred equity or debt securities, these securities could have rights, preferences and privileges senior or otherwise superior to those of our common shares, and debt financings will likely involve covenants restricting our business activities. Any sale of additional equity or convertible debt securities will be dilutive to existing stockholders. We cannot guarantee you that additional funds will be available on acceptable terms, or at all. If we are unable to raise additional capital when necessary, we may be required to relinquish our rights to certain key technologies, vaccine candidates or marketing territories under the terms of certain of our collaborative agreements. Furthermore, if we are unable to raise additional capital when necessary, we may be unable to perform under our existing contracts, we may default on our contracts, our contracts may be terminated and we may not be able to secure new contracts.
Our operating results may be adversely impacted by recently adopted changes in accounting for stock options.*
The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123(R),Share-Based Payment, or FAS 123R, in December 2004, FAS123R, which we implemented effective January 1, 2006, requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. The future impact of adoption of FAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. We use the Black-Scholes option pricing model allowed under FAS 123R.
If we fail to meet our obligations under the Notes, our payment obligations may be accelerated.
In April 2005, we raised gross proceeds of $31.5 million through a private placement of Notes due April 1, 2010. The Notes have the following features:
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| • | require semi-annual payment of interest in cash at a rate of 5 1/2%; |
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| • | convert, at the option of the holder, into shares of our common stock at an initial conversion price of approximately $14.76 per share subject to adjustment; |
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| • | will be provisionally redeemable at our option in cash upon the occurrence of certain circumstances, including among others, that the closing price of VaxGen common stock exceeds approximately $22.14 per share subject to adjustment, for at least 20 trading days within a period of 30 consecutive trading days; |
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| • | if a change in control, as defined in our indentures, occurs on or prior to the stated maturity of the Notes, the holders of the Notes may require us to repurchase the Notes and pay a make-whole premium to the holders of the Notes. If the holders request such a repurchase, we or the successor entity, may choose to pay in cash, common stock or a combination of cash and common stock; and |
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| • | constitute senior subordinated obligations. |
Under the terms of the Notes, if certain events occur, including, without limitation, our failure to pay any installment of principal or interest due under the Notes, then the holders may, among other things, elect to accelerate our obligations under the Notes and declare the outstanding principal balance of the Notes and accrued but unpaid interest thereon immediately due and payable. In the event that the holders declare the Notes immediately due and payable or seek to foreclose on any of our assets, it would have a material adverse effect on our financial position and we may not have sufficient cash to satisfy our obligation.
Our indebtedness could adversely affect our financial health, limit our cash flow available to invest in the ongoing requirements of our business and adversely affect the price of our common stock.
Our existing indebtedness consists of $31.5 million in Notes. This indebtedness, and any future indebtedness we may incur, could have important consequences, including the following:
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| • | making it more difficult for us to satisfy our financial and payment obligations, or to refinance maturing indebtedness; |
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| • | making us more vulnerable to a downturn in the economy or our business; |
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| • | limiting our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions and other general corporate purposes; |
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| • | requiring application of a significant portion of our cash flow from operations to the payment of debt service costs, which would reduce the funds available to us for our operations; |
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| • | limiting our flexibility in planning for, or reacting to, changes in our industry, business and markets; and |
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| • | placing us at a competitive disadvantage to the extent we are more highly leveraged than some of our competitors. |
We may incur significant additional indebtedness in the future to fund our continued operations or future acquisitions. To the extent new debt is added to our current debt levels, the substantial leverage risks described above would increase. We may be required to repurchase the Notes if certain change in control events occur.
We may fail to meet the requirements, as stated in our contract, for acceptance of our anthrax vaccine into the SNS of the U.S. government, which could cause us to suffer losses and the contract to be terminated.
The U.S. government has undertaken commitments to acquire improved countermeasures against bioterrorism, including the stockpiling of vaccines for anthrax and smallpox. On November 4, 2004, we were awarded the SNS Contract to supply the U.S. government with up to 75 million doses of our anthrax vaccine candidate over five years. If we fail to meet the requirements of the SNS Contract or otherwise breach the contract, the government could terminate the SNS Contract. For example, we estimate that we will be prepared to deliver validated drug product in the fourth quarter of 2006, rather than during the first half of 2006 as originally planned. If the U.S. government does not agree to amend the SNS Contract schedules, we will not be able to meet the schedule set forth in the SNS Contract and the U.S. government may terminate the contract for default and seek its excess re-procurement costs.
We are communicating with HHS regarding a potential modification to our SNS Contract. We currently anticipate that this potential modification will establish a new schedule for delivery of the vaccine into the SNS stockpile to accommodate certain delays in the development of the vaccine and additional requirements by HHS. Because the potential modification and its content are still under
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discussion, we cannot assure that the modification will be issued by HHS in our favor, if at all. If HHS does not approve the modification, we will not be able to perform the first delivery under the SNS Contract, in which event HHS may declare us in default under the SNS contract. Additionally, HHS may require additional data prior to accepting delivery of a validated recombinant anthrax vaccine, which could delay delivery of the vaccine. Due to the evolving nature of biodefense product procurement by HHS and the risks and uncertainties associated with pharmaceutical product development, we cannot be certain of the timing of deliveries or that the vaccine can be delivered.
In addition, the SNS Contract is primarily a fixed-price contract and, if we do not perform efficiently, we could suffer losses under the contract. In accordance with its standard contracting terms, the U.S. government may terminate the SNS Contract at its convenience at any time. We need to substantially increase our employee base to fulfill certain requirements under the SNS Contract, and are in the process of doing so. However, there is no guarantee that we will be able to find and hire additional suitable employees or that we will be able to integrate them into our operations properly so as to enable us to fulfill the requirements of the SNS Contract. Any failure to adequately staff our operations will have a material adverse effect on our business.
The government’s determination to award future contracts to us may be challenged by an interested party, such as another bidder, at the Government Accountability Office or in federal court.
The laws and regulations governing the procurement of goods and services by the U.S. government provide procedures by which other bidders and other interested parties may challenge the award of a government contract. Such protests could be filed even if there are not any valid legal grounds on which to base the protest. If any such protests are filed, the government agency may decide to suspend our performance under the contract while such protests are being considered by the Government Accountability Office or the applicable federal court, thus potentially delaying delivery of goods and services and payment. In addition, we may be forced to expend considerable funds to defend the award. If a protest is successful, the government may be ordered to terminate our contract for its convenience and resolicit bids. The government could even be directed to award the contract to one of the other bidders.
The U.S. Congress may instigate an inquiry into the award of the SNS Contract to us which could adversely impact our business.
At least two Senate offices, including that of Senator Charles Grassley, have made inquiries about the award of the SNS Contract. Senator Charles Grassley, Chairman of the U.S. Senate Finance Committee, sent a letter to HHS on January 28, 2005 requesting information about the SNS Contract and its award to us. The letter alleges that HHS may have acted prematurely in awarding the SNS Contract to us. There can be no assurance that the U.S. Senate Finance Committee or other Congressional committees or members of Congress will not pursue an inquiry into the SNS Contract. Such an inquiry, if it were initiated, could include public hearings that could lead to negative publicity, a change to the SNS Contract, and an adverse effect on the value of our common stock. In addition, our competitors may attempt to create negative perceptions about VaxGen among members of Congress or the public that could encourage such inquiries. A formal U.S. Congressional inquiry would distract management, require significant human and financial resources to defend, could harm our reputation and could ultimately lead to audit or modification of contract terms or provisions of the SNS Contract by the U.S. government at its sole discretion, all of which may adversely impact our business.
The award of the SNS Contract does not mean there will be any future contracts awarded.
The award of one government contract does not secure or increase the likelihood of the award of future contracts. By law, the U.S. government must seek competitive offers when procuring goods and services. In addition, if we do not perform in accordance with the terms of the SNS Contract, we may receive a poor performance report, which would be considered by the U.S. government in making any future awards, thus making it more difficult for us to win the award of such future contracts. Accordingly, we cannot be certain that we will be awarded any future government contracts, including any contract to supply an additional government stockpile of anthrax vaccine. It is possible that future awards to provide the U.S. government with emergency stockpiles of anthrax vaccine will be granted solely to another supplier. If the U.S. government makes significant future contract awards for the supply of its emergency stockpile to our competitors, such as Emergent BioDefense Operations Lansing Inc., or Emergent, formerly BioPort Corp, our business will be harmed and it is unlikely that we will be able to ultimately commercialize that particular vaccine. In addition, the determination of when and whether a product is ready for large scale purchase and potential use will be made by the Office of Public Health Emergency Preparedness in consultation with other governmental agencies including the FDA and the Centers for Disease Control. President Bush has proposed, and Congress is considering, measures to accelerate the development of biodefense products through the National Institutes of Health, or NIH, funding, the review process by the FDA and the final government procurement contracting authority. While this may help speed the approval of our vaccine candidates, it may also encourage competitors to develop their own vaccine candidates. If competitive vaccine candidates gain approval, we could face severe competition, which could harm our business.
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If the U.S. government fails to continue funding our anthrax vaccine candidate development efforts or fails to purchase sufficient quantities of any future biodefense vaccine candidate, we may be unable to generate sufficient revenues to continue operations.
We have received funding from the U.S. government for the development of our anthrax vaccine candidate. Changes in government budgets and agendas may result in future funding being decreased and de-prioritized, and government contracts typically contain provisions that permit cancellation in the event that funds are unavailable to the governmental agency. Furthermore, we cannot be certain of the timing of any future funding, and substantial delays or cancellations of funding could also result from protests or challenges from third parties or for other reasons. If the U.S. government fails to continue to adequately fund our research and development programs, we may be unable to generate sufficient revenues to continue operations. Similarly, if we develop an anthrax vaccine candidate that is approved by the FDA, but the U.S. government does not place sufficient orders for this product, our future business will be harmed.
We may encounter difficulties managing the change and growth of our operations, which could adversely affect our business.
We have experienced a period of rapid change in our business as a result of increased emphasis on biodefense opportunities. In addition, we expect to experience substantial changes in 2006 in manufacturing, quality systems, clinical and regulatory functions associated with the completion of the Anthrax Contracts and the shifting of our focus to the SNS Contract. This change in our business has strained and may continue to strain our administrative, financial and operational functions. We will need to, among other things, expand our staff and improve our systems and procedures to manage and maintain an adequate system of internal controls. Furthermore, we made substantial capital expenditures in order to fulfill certain obligations under the SNS Contract. We plan additional capital expenditures in this regard, but at substantially lower levels than what we have already made. These additional capital expenditures will be primarily for redundancy, safety and corporate expansion. If we are unable to manage the changes of our business effectively, we may be unable to perform under our existing contracts or obtain future government contracts, both of which would harm our results of operations and financial condition.
U.S. government agencies have special contracting requirements, which create additional risks.
We have entered into contracts with NIAID and HHS and a license agreement with the U.S. Army Medical Research Institute of Infectious Diseases, or USAMRIID, which are U.S. government agencies. Substantially all of our revenue is derived from government contracts and grants. In contracting with government agencies, we are subject to various U.S. government agency contract requirements. Future sales to U.S. government agencies will depend, in part, on our ability to meet U.S. government agency contract requirements, which we cannot be certain of satisfying.
U.S. government contracts typically contain termination provisions unfavorable to the non-governmental party, and are subject to audit and modification by the government at its sole discretion, which subjects us to additional risks.
These risks include the ability of the U.S. government to unilaterally:
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| • | suspend or prevent us for a set period of time from receiving new government contracts or extending existing contracts based on violations or suspected violations of laws or regulations; |
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| • | terminate our existing government contracts; |
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| • | reduce the scope and value of our existing government contracts; |
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| • | audit and object to our contract-related costs and fees, including allocated indirect costs; |
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| • | control and potentially prohibit the export of our products; and |
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| • | change certain terms, conditions and requirements of our contracts. |
The U.S. government may terminate any of its contracts with us either for its convenience or if we default by failing to perform in accordance with the contract schedule and terms. Termination for convenience provisions generally enable us to recover only our costs incurred or committed, and settlement expenses and profit on the work completed prior to termination. Termination for default provisions do not permit these recoveries and make us liable for excess costs incurred by the U.S. government in procuring undelivered items from another source. In addition, the U.S. government could bring criminal and civil charges against us based on intentional or unintentional violations of the representations and certifications that we have made in all our government contracts.
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As a U.S. government contractor, we are required to comply with applicable laws, regulations and standards relating to our accounting practices and are subject to periodic audits and reviews. As part of any such audit or review, the U.S. government may review the adequacy of, and our compliance with, our internal control systems and policies, including those relating to our purchasing, property, estimating, compensation and management information systems. Based on the results of its audits, the U.S. government may adjust our contract-related costs and fees, including allocated indirect costs. In addition, if an audit or review uncovers any improper or illegal activity, we may be subject to civil and criminal penalties and administrative sanctions, including termination of our contracts, forfeiture of profits, suspension of payments, fines and suspension or prohibition from doing business with the U.S. government.
We could also suffer serious harm to our reputation if allegations of impropriety were made against us. Although adjustments arising from government audits and reviews have not seriously harmed our business in the past, future audits and reviews could cause adverse effects. In addition, under U.S. government purchasing regulations, some of our costs, including most financing costs, amortization of intangible assets, portions of our research and development costs, and some marketing expenses, may not be reimbursable or allowed under our contracts. Our NIAID Contracts and part of our SNS Contract contain cost-reimbursement terms and provisions. All of the costs that we incur under our NIH cost-reimbursement contracts will be subject to audit by the U.S. government, and the U.S. government will also determine the final indirect cost rate that we may charge. These audits could result in claims by the U.S. government for any unallowable or unallocable costs that we charged, or excess indirect costs, and for penalties that may be imposed for claiming unallowable costs.
In the future, if we must comply with some or all of the U.S. government-specific cost accounting standards, it is possible that we will need to expend substantial resources to modify our accounting processes and procedures. Further, as a U.S. government contractor, we are subject to an increased risk of investigations, criminal prosecution, civil fraud, whistleblower lawsuits and other legal actions and liabilities to which purely private sector companies are not.
In addition, with respect to the technology we received from USAMRIID, our license agreement with USAMRIID provides that USAMRIID reserves the right to require us and our affiliates to grant a nonexclusive, partially exclusive, or exclusive sublicense in any field of use to a responsible applicant, upon terms that are reasonable under the circumstances and under applicable law, to fulfill public health or safety needs. While we would be given an opportunity to appeal such a decision, the government’s exercise of such rights could give our competitors an opportunity to exploit the licensed patents and thereby undermine our competitive position. In addition, the license agreement requires us to manufacture products licensed under the agreement in the United States, which will result in less flexibility in commercializing our products.
Our fixed price and cost plus contracts may commit us to unfavorable terms.
We provide our products and services primarily through fixed-price and cost-plus contracts. In a fixed-price contract, we must fully absorb our cost overruns, notwithstanding the difficulty of estimating costs that are related to performance in accordance with contract specifications. The failure to anticipate technical problems, estimate costs accurately or control costs during performance of a fixed-price contract may reduce the profitability of a fixed-price contract or cause a loss. In a cost-plus contract, we are allowed to recover our approved costs, plus a fee, which may be fixed or variable depending on the contract arrangement. The total price on a cost-plus contract is based primarily on allowable costs incurred, but generally is subject to contract funding limitations. U.S. government regulations require us to notify our customer of any cost overruns or under runs on a cost-plus contract. If we incur costs in excess of the funding limitation in the contract, we may not be able to recover those cost overruns.
We license our vaccine candidates from third parties. If we fail to perform our obligations under these license agreements, we could lose our ability to develop and commercialize our vaccine candidates.
We license our anthrax vaccine candidate from USAMRIID and we license our smallpox vaccine candidate from Kaketsuken. Each of these license agreements requires that we perform certain obligations, including diligence obligations. If we fail to comply with our obligations under these agreements in a timely fashion, our licensors could terminate our rights to develop and commercialize our anthrax and smallpox vaccine candidates, which would seriously harm our business and prospects. These agreements may also require us to indemnify our licensors for various liabilities that may arise from the development and commercialization (including manufacture) of our vaccine candidates, whether or not the reason for the liability is within our control.
Our license agreement with Kaketsuken for our smallpox vaccine candidate may restrict our ability to develop and commercialize other smallpox vaccine products.
For a period of five years after the termination of our LC16m8 Agreement with Kaketsuken for our smallpox vaccine candidate, we may not, without Kaketsuken’s prior written consent, file for or obtain regulatory approval, sell and/or otherwise deal in any product having a similar activity to LC16m8. During the term of the LC16m8 Agreement, we may not, without the prior written consent of Kaketsuken, develop, sell, commercialize and/or otherwise deal in any products which may compete with or adversely affect LC16m8. These restrictions will be waived if the LC16m8 Agreement is terminated due to Kaketsuken’s uncured material breach of
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the LC16m8 Agreement or the FDA determines that LC16m8 is not approvable in the United States. These restrictions may adversely affect our ability to pursue attractive business opportunities.
Our suppliers may fail to provide, or may be delayed in providing, us with the necessary materials to produce our vaccine candidates.
We rely on suppliers to provide us with the necessary materials to produce our vaccine candidates. Any significant delays in obtaining any of these materials from our suppliers or other failure by our suppliers to perform as agreed may cause us to fail to perform under our contracts, which may cause us to be in breach under those contracts and cause those contracts to be terminated. We cannot assure you that we will not face shortages from one or more of these suppliers in the future. In particular, depending on both our and Kaketsuken’s supply needs for LC16m8, we may be unable to obtain adequate bulk vaccine material from Kaketsuken. We cannot ensure that if a shortage of LC16m8 bulk material occurs, the bulk manufacturing technology will be transferred to us on terms favorable to us or at all.
Our subcontractors may fail to perform, or may be delayed in performing, certain tasks related to our ability to provide our vaccine candidates to the government under our contracts.
We rely on suppliers to provide us with the necessary materials to produce our vaccine candidates. Any significant delays in obtaining any of these materials from our suppliers or other failure by our suppliers to perform as agreed may cause us to fail to perform under our contracts, which may cause us to be in breach under those contracts and cause those contracts to be terminated. We cannot assure you that we will not face shortages from one or more of these suppliers in the future. In particular, depending on both our and Kaketsuken’s supply needs for LC16m8, we may be unable to obtain adequate bulk vaccine material from Kaketsuken. We cannot ensure that if a shortage of LC16m8 bulk material occurs the bulk manufacturing technology will be transferred to us at terms favorable to us or at all.
We have only a limited operating history and we expect to continue to generate operating losses.
To date, we have engaged primarily in research, development and clinical testing. Since our inception in 1995, we have not been profitable from operations, and we cannot be certain that we will ever achieve or sustain operating profitability. We have a large accumulated deficit. Developing our product candidates will require significant additional research and development, including non-clinical testing and clinical trials, as well as regulatory approval. We expect these activities, together with our general and administrative expenses, to result in operating losses for the foreseeable future. Our ability to achieve operating profitability will depend, in part, on our ability to procure future contracts to supply the anthrax and smallpox vaccines to the U.S. government, to successfully complete development of our proposed products, to obtain required regulatory approvals and to manufacture and market our products directly or through business partners. We cannot assure you that we will be able to accomplish any of these objectives.
Vaccine development is a long, expensive and uncertain process and the approval requirements for vaccines used to fight bioterrorism are still evolving. If we are unable to successfully develop and test our vaccine candidates in accordance with these requirements, our business will suffer.
We are subject to rigorous and extensive regulation by the FDA and comparable foreign regulatory authorities. In the United States, our vaccine candidates for anthrax and smallpox are regulated by the FDA as biological drug products, known as Biologics. In order to obtain approval from the FDA to market our vaccine candidates, other than to the SNS under the terms of our SNS Contract, we will be required to submit to the FDA a Biologics License Application, or BLA, which must include both preclinical and clinical trial data as prescribed by the FDA’s current regulatory criteria for vaccines such as our product candidates, as well as extensive data regarding the manufacturing procedures and processes for the vaccine candidates. Ordinarily, the FDA requires a sponsor to support a BLA application with substantial evidence of the product’s safety and effectiveness in treating the targeted indication based on data derived from adequate and well-controlled clinical trials, including Phase 3 efficacy trials conducted in patients with the disease or condition being targeted. Because humans are not normally exposed to anthrax or smallpox, statistically significant effectiveness of our biodefense product candidates cannot be demonstrated in humans, but instead must be demonstrated, in part, by utilizing animal models before they can be approved for marketing.
Specifically, we intend to pursue FDA approval of our anthrax and smallpox vaccine candidates under requirements published by the FDA in 2002 that allow the FDA to approve certain vaccines used to reduce or prevent the toxicity of chemical, biological, radiological or nuclear substances based on human clinical data to demonstrate safety and immune response, and evidence of effectiveness derived from appropriate non-clinical studies and any additional supporting data. We cannot predict whether we will obtain regulatory approval for any of our product candidates pursuant to these provisions, or at all. We may fail to obtain approval from the FDA or foreign regulatory authorities, or experience delays in obtaining such approvals, due to varying interpretations of data or failure to satisfy current safety, efficacy, and quality control requirements. Until we receive FDA approval, we will not receive certain payments under the SNS contract. Further, our business is subject to substantial risk because the FDA’s current policies governing biodefense vaccines may change suddenly and unpredictably and in ways that could impair our ability to obtain regulatory
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approval of these products. We cannot guarantee that the FDA will approve our anthrax and smallpox vaccine candidates on a timely basis or at all.
Delays in successfully completing our clinical trials could jeopardize our ability to obtain regulatory approval or market our vaccine candidates on a timely basis.
Our business prospects will depend on our ability to complete patient enrollment in clinical trials, to obtain satisfactory results, to obtain required regulatory approvals and to successfully commercialize our vaccine candidates. Vaccine development to show adequate evidence of effectiveness in animal models and safety and immune response in humans is a long, expensive and uncertain process, and delay or failure can occur at any stage of our non-clinical studies or clinical trials. Any delay or significant adverse clinical events arising during any of our clinical trials could force us to abandon a vaccine candidate altogether or to conduct additional clinical trials in order to obtain approval from the FDA or foreign regulatory bodies. These development efforts and clinical trials are lengthy and expensive, and the outcome is uncertain. Completion of our clinical trials, announcement of results of the trials and our ability to obtain regulatory approvals could be delayed for a variety of reasons, including:
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| • | slower-than-anticipated enrollment of volunteers in the trials; |
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| • | lower-than-anticipated recruitment or retention rate of volunteers in the trials; |
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| • | serious adverse events related to the vaccine candidates; |
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| • | unsatisfactory results of any clinical trial; |
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| • | the failure of our principal third-party investigators to perform our clinical trials on our anticipated schedules; or |
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| • | different interpretations of our preclinical and clinical data, which could initially lead to inconclusive results. |
Our development costs will increase if we have material delays in any clinical trial or if we need to perform more or larger clinical trials than planned. If the delays are significant, or if any of our vaccine candidates do not prove to be safe or effective or do not receive required regulatory approvals, our financial results and the commercial prospects for our product candidates will be harmed. Furthermore, our inability to complete our clinical trials in a timely manner could jeopardize our ability to obtain regulatory approval.
The independent clinical investigators that we rely upon to conduct our clinical trials may not be diligent, careful or timely, and may make mistakes in the conduct of our clinical trials.
We depend on independent clinical investigators to conduct our clinical trials. The investigators are not our employees, and we cannot control the amount or timing of resources that they devote to our vaccine development programs. If independent investigators fail to devote sufficient time and resources to our vaccine development programs, or if their performance is substandard or fails to comply with the protocol and applicable laws and regulatory standards, FDA approval of our vaccine candidates may be delayed or prevented. These independent investigators may also have relationships with other commercial entities, some of which may compete with us. If these independent investigators assist our competitors at our expense, it could harm our competitive position.
If we fail to comply with extensive regulations enforced by domestic and foreign regulatory authorities both before and after we obtain approval of our vaccine candidates, the commercialization of our product candidates could be prevented, delayed or suspended.
Vaccine candidates are subject to extensive government regulations related to development, testing, manufacturing and commercialization in the United States and other countries. Our vaccine candidates are in the preclinical and clinical stages of development and have not received required regulatory approval from the FDA to be commercially marketed and sold in the United States. With the exception of LC16m8, which is approved and sold in Japan, our vaccine candidates have not received required regulatory approval from foreign regulatory agencies to be commercially marketed and sold. The process of obtaining and complying with FDA, other governmental and foreign regulatory approvals and regulations is costly, time consuming, uncertain and subject to unanticipated delays. Despite the time and expense exerted, regulatory approval is never guaranteed.
We also are subject to the following regulatory risks and obligations, among others;
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| • | the FDA or foreign regulators may refuse to approve an application if they believe that applicable regulatory criteria are not satisfied; |
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| • | the FDA or foreign regulators may require additional testing for safety and effectiveness; |
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| • | the FDA or foreign regulators may interpret data from non-clinical testing and clinical trials in different ways than we interpret them; |
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| • | if regulatory approval of a product is granted, the approval may be limited to specific indications or limited with respect to its distribution. In addition, many foreign countries control pricing and coverage under their respective national social security systems; |
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| • | the FDA or foreign regulators may not approve our manufacturing processes or manufacturing facilities; |
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| • | the FDA or foreign regulators may change their approval policies or adopt new regulations; |
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| • | even if regulatory approval for any product is obtained, the marketing license will be subject to continual review, and newly discovered or developed safety or effectiveness data may result in suspension or revocation of the marketing license; |
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| • | if regulatory approval of the vaccine candidate is granted, the marketing of that vaccine would be subject to adverse event reporting requirements and a general prohibition against promoting products for unapproved or “off-label” uses; and |
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| • | in some foreign countries, we may be subject to official release requirements that require each batch of the vaccine we produce to be officially released by regulatory authorities prior to its distribution by us. |
Failure to comply with the regulatory requirements of the FDA and other applicable foreign regulatory bodies may subject us to administrative or judicially imposed sanctions, including:
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| • | warning letters; |
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| • | civil penalties; |
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| • | criminal penalties; |
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| • | injunctions; |
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| • | product seizure or detention, including any products that we manufacture under the SNS Contract; |
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| • | product recalls; |
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| • | total or partial suspension of production; and |
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| • | suspension or revocation of the marketing license. |
We and our subcontractors are subject to ongoing regulatory review and periodic inspection and approval of manufacturing procedures and operations, including compliance with cGMP regulations.
The manufacturing methods, equipment and processes used by us and our subcontractors must comply with the FDA’s current Good Manufacturing Practices, or cGMP, regulations. The cGMP requirements govern, among other things, recordkeeping, production processes and controls, personnel and quality control. The FDA must approve the facilities used to manufacture our products before they can be used to commercially manufacture our vaccine products or commence deliveries under the SNS Contract, and these facilities are subject to ongoing and periodic inspections. If we or our subcontractors fail to comply with cGMP requirements, or fail to pass a pre-approval inspection of our manufacturing facility in connection with the SNS Contract, we may not receive regulatory approval, and we would be subject to possible judicial or administrative sanctions. In addition, preparing a manufacturing facility for commercial manufacturing may involve unanticipated delays and the costs of complying with the cGMP regulations may be significant. Any material changes we make to our manufacturing processes after we obtain approval of a product may require approval by the FDA, state or foreign regulatory authorities.
Our product development efforts may not yield marketable products due to results of studies or trials, failure to achieve regulatory approvals or market acceptance, proprietary rights of others or manufacturing issues.
Our success depends on our ability to successfully develop and obtain regulatory approval to market new biopharmaceutical products. Development of a product requires substantial technical, financial and human resources. Our potential products may appear to be promising at various stages of development yet fail to reach the market for a number of reasons, including:
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| • | the lack of adequate quality or sufficient prevention benefit, or unacceptable safety during preclinical studies or clinical trials; |
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| • | their failure to receive necessary regulatory approvals; |
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| • | the existence of proprietary rights of third parties; or |
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| • | the inability to develop manufacturing methods that are efficient, cost-effective and capable of meeting stringent regulatory standards. |
Political or social factors may delay or impair our ability to market our vaccine products.
Products developed to treat diseases caused by or to combat the threat of bioterrorism will be subject to changing political and social environments. The political and social responses to bioterrorism have been highly charged and unpredictable. Political or social pressures may delay or cause resistance to bringing our products to market or limit pricing of our products, which would harm our business.
We may fail to protect our intellectual property or may infringe on the intellectual property rights of others, either of which could harm our business.
If we are unable to protect our intellectual property, we may be unable to prevent other companies from using our technology in competitive products. If we infringe on the intellectual property rights of others, we may be prevented from developing or marketing our product candidates. We rely on patent and other intellectual property protection to prevent our competitors from manufacturing and marketing our product candidates. Given the rights retained and licenses granted to the U.S. government with regard to our anthrax vaccine candidate, to the extent that the U.S. government or foreign governments or organizations procuring vaccines through treaties or agreements with the U.S. government constitute the primary market for any of our products, the licenses granted by the U.S. government may not provide us with a competitive advantage.
In addition, under our U.S. government contracts, we have a duty to disclose each invention that we conceive or reduce to practice in performing the agreement, and if we wish to retain title to such invention, we must affirmatively elect to do so. If we fail to strictly follow these disclosure requirements, the U.S. government could take title to such inventions and preclude us from using them. For each invention to which we retain title, the U.S. government has both a worldwide, irrevocable, royalty-free license to practice or have practiced such invention on behalf of the U.S. government, and certain “march-in” rights pursuant to which the U.S. government could require us to license the invention that we own to third parties, including our competitors.
Our technology, including technology licensed from Kaketsuken and USAMRIID, or technology that we may license in the future, if any, will be protected from unauthorized use by others only to the extent that it is covered by valid and enforceable patents, or effectively maintained as trade secrets and exclusively licensed to us. The patent positions of pharmaceutical and biotechnology companies can be highly uncertain and involve complex legal and factual questions. Accordingly, we cannot predict the scope and breadth of patent claims that may be afforded to other companies’ patents. In addition, we could incur substantial costs in litigation if we are required to defend against patent suits brought by third parties, or if we initiate these suits, even in such instances in which the outcome is favorable to us.
The degree of future protection for our proprietary rights is uncertain, and we cannot ensure that:
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| • | others will not independently develop similar or alternative technologies or duplicate any of our technologies; |
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| • | any patents issued to us or licensed from Kaketsuken or USAMRIID or other parties, or that we may license in the future, if any, will provide a basis for commercially viable products or will provide us with any competitive advantages or will not be challenged by third parties; |
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| • | we or any of our current or future licensors will adequately protect trade secrets; |
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| • | we will develop additional proprietary technologies that are patentable; or the patents of others will not have a material adverse effect on our business. |
We cannot be certain that patents issued to us in the future, if any, or patents that we have licensed from Kaketsuken and USAMRIID, or that we may license in the future, if any, will be enforceable and afford protection against competitors. In this regard, the U.S. government has the right to use, for or on behalf of the U.S. government, any technologies developed by us under our U.S. government contracts and we cannot prohibit third parties, including our competitors, from using those technologies in providing products and services to the U.S. government. Accordingly, under our license agreement with USAMRIID granting us an exclusive
39
license to commercialize the anthrax vaccine, the U.S. government retains a license for any federal government agency to practice USAMRIID’s anthrax-related inventions, by or on behalf of the government, thereby allowing the use of the inventions in support of government contracts with other parties, including our competitors.
Moreover, we could lose the USAMRIID license if the U.S. government terminates the license if we or any of our sublicensees:
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| • | fail to diligently develop a vaccine product in accordance with the development plan described in the agreement; |
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| • | materially breach the agreement; |
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| • | make a materially false statement (or fail to provide required information) in a plan or report required under the agreement; |
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| • | fail to make payments required under the agreement; or |
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| • | file for bankruptcy. |
In addition, we cannot assure you that our operations or technology will not infringe intellectual property rights of others. The United States Patent and Trademark Office keeps United States patent applications confidential while the applications are pending. As a result, we cannot determine which inventions third parties claim in pending patent applications that they have filed. We may need to engage in litigation to defend or enforce our patent and license rights or to determine the scope and validity of the proprietary rights of others. If we infringe the intellectual property of others, there can be no assurance that we would be able to obtain licenses to use the technology on commercially reasonable terms or at all. Failure to obtain licenses could force us to cease development or sale of a product candidate.
We face competition from several companies with greater financial, personnel and research and development resources than ours.
Our competitors are developing vaccine candidates for anthrax and smallpox, which could compete with the vaccine candidates we are developing. Our commercial opportunities will be reduced or eliminated if our competitors develop and market products for any of the diseases that we target that:
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| • | are more effective; |
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| • | have fewer or less severe adverse side effects; |
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| • | are more adaptable to various modes of dosing; |
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| • | are easier to administer; or |
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| • | are less expensive than the products or product candidates we are developing. |
Even if we are successful in developing effective vaccine products, and obtain FDA and other regulatory approvals necessary for commercializing them, our products may not compete effectively with other successful products. Researchers are continually learning more about diseases, which may lead to new technologies for treatment. Our competitors may succeed in developing and marketing products either that are more effective than those that we may develop, alone or with our collaborators, making our products obsolete, or that are marketed before any products we develop are marketed.
Our competitors include fully integrated pharmaceutical companies and biotechnology companies that currently have drug and target discovery efforts, as well as universities and public and private research institutions. Many of the organizations competing with us may have substantially greater capital resources, larger research and development staffs and facilities, greater experience in drug development and in obtaining regulatory approvals, and greater marketing capabilities than we do.
Natural disasters, including earthquakes, may damage our facilities.
Our corporate and manufacturing facilities are primarily located in California. Our facilities in California are in close proximity to known earthquake fault zones. As a result, our corporate, research and manufacturing facilities are susceptible to damage from earthquakes and other natural disasters, such as fires, floods and similar events. Although we maintain general business insurance against fires and some general business interruptions, there can be no assurance that the scope or amount of coverage will be adequate in any particular case.
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If we fail to manage successfully any company or product acquisitions, joint ventures or in-licensed product candidates, we may be limited in our ability to develop our product candidates and to continue to expand our product candidate pipeline.
Our current vaccine product development programs were initiated through in-licensing or collaborative arrangements. These collaborations include licensing proprietary technology from, and other relationships with, biotechnology companies and government research institutes and organizations. As part of our business strategy, we intend to continue to expand our product pipeline and capabilities through company or product acquisitions, in-licensing or joint venture arrangements.
Any such activities will be accompanied by certain risks including:
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| • | exposure to unknown liabilities of acquired companies; |
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| • | higher than anticipated acquisition costs and expenses; |
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| • | the difficulty and expense of integrating operations and personnel of acquired companies; |
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| • | disruption of our ongoing business; |
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| • | diversion of management’s time and attention; and |
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| • | possible dilution to stockholders. |
If our competitors successfully enter into partnering or license agreements or we are unable to reach agreement on license or partnering agreements on terms acceptable to us, we may then be precluded from pursuing those specific opportunities. Since each of these opportunities is unique, we may not be able to find a substitute. In addition, if we are unable to manage successfully any acquisitions, joint ventures and other collaboration opportunities, we may be limited in our ability to develop new products and therefore to continue to expand our product pipeline.
Our use of hazardous materials and chemicals require us to comply with regulatory requirements and exposes us to potential liabilities.
Our research and development involves the controlled use of hazardous materials and chemicals. We are subject to federal, state, local and foreign laws governing the use, manufacture, storage, handling and disposal of such materials. We cannot eliminate the risk of accidental contamination or injury from these materials. In the event of such an accident, we could be held liable for significant damages or fines. These damages could exceed our resources and any applicable insurance coverage. In addition, we may be required to incur significant costs to comply with regulatory requirements in the future.
We may become subject to product liability claims, which could reduce demand for our product candidates or result in damages that exceed our insurance coverage.
We face an inherent risk of exposure to product liability suits in connection with vaccines being tested in human clinical trials or sold commercially. We may become subject to a product liability suit if any vaccine we develop causes injury, or if vaccinated individuals subsequently become infected or otherwise suffer adverse effects from our vaccines or products. Regardless of merit or eventual outcome, product liability claims may result in decreased demand for a vaccine or product, injury to our reputation, withdrawal of clinical trial volunteers and loss of revenues.
If a product liability claim is brought against us, the cost of defending the claim could be significant and any adverse determination could result in liabilities in excess of our insurance coverage. We currently have product liability insurance, including clinical trial liability, in the amount of $25.0 million for our anthrax and smallpox programs. Additionally, we are applying for indemnification under the Support Anti-terrorism by Fostering Effective Technologies Act of 2002 which preempts and modifies tort laws so as to limit the claims and damages potentially faced by companies who provide certain “qualified” anti-terrorism products. However, we cannot be certain that our current insurance can be maintained, or that additional insurance coverage could be obtained on acceptable terms, if at all.
Legislation limiting or restricting liability for medical products used to fight bioterrorism is new, and we cannot be certain that any such protections will apply to our vaccines or products.
The Public Readiness and Emergency Preparedness Act, or Public Readiness Act, was signed into law December 2005 and creates general immunity for manufacturers of countermeasures, including security countermeasures (as defined in Section 319F-2(c)(1)(B)), when the Secretary of HHS issues a declaration for their manufacture, administration or use. The declaration is meant to provide
41
general immunity from all claims under state or federal law for loss arising out of the administration or use of a covered countermeasure. Manufacturers are exempt from this protection in cases of willful misconduct.
Upon a declaration by the Secretary of HHS, a compensation fund is created to provide “timely, uniform, and adequate compensation to eligible individuals for covered injuries directly caused by the administration or use of a covered countermeasure”. The “covered injuries” to which the program applies are defined as serious physical injuries or death. Individuals are permitted to bring a willful misconduct action against a manufacturer only after they have exhausted their remedies under the compensation program. However, a willful misconduct action could be brought against us if an individual(s) exhausted their remedies under the compensation program and thereby expose us to liability.
We may become subject to standard product liability suits and other third party claims if vaccines or products developed by us and which fall outside of the Public Readiness Act cause injury or if vaccinated individuals subsequently become infected or otherwise suffer adverse effects from such vaccines or products.
We may be subject to claims that our employees or we have wrongfully used or disclosed alleged trade secrets of their former employers.
As is commonplace in the biotechnology industry, we employ individuals who were previously employed at other biotechnology or pharmaceutical companies, including our competitors or potential competitors. Although no claims against us are currently pending, we may be subject to claims that these employees, or we, have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to management.
Failure to hire and retain key management employees could adversely affect our ability to obtain financing, develop our products, conduct clinical trials or execute our business strategy.
We are highly dependent on our senior management and scientific staff. These individuals have played a critical role in raising capital, negotiating business development opportunities, developing the vaccine candidates, conducting clinical trials and manufacturing product candidates. We face intense competition for qualified personnel, and the existence of non-competition agreements between prospective employees and their former employers may prevent us from hiring those individuals or subject us to suit from their former employers. We do not maintain non-compete agreements with any of our employees. If we lose the services of any key members of our senior management or scientific staff, temporarily or permanently, and we are unable to recruit qualified replacements where we deem it necessary, we may be unable to achieve our business objectives.
Our stockholders could experience substantial dilution as result of the issuance of additional shares of common or preferred stock.
Our Board of Directors has the authority to establish the designation of up to 20,000,000 shares of preferred stock that are convertible into common stock without any action by our stockholders, and to fix the rights, preferences, privileges and restrictions, including voting rights, of such shares. In February 2006, we raised net proceeds of $25.2 million through a private placement of 3.5 million shares of common stock at $7.70 per share to a group of accredited institutional investors. We also issued to the investors five-year warrants initially exercisable to purchase 699,996 shares of common stock at an exercise price of $9.24 per share. Because we did not file all of our delinquent periodic reports with the SEC by January 31, 2007, the warrants became exercisable for an additional 700,000 shares of common stock, at a price of $9.24 per share. We may raise additional funds through public or private offerings of our preferred stock or our common stock, or through issuance of debt securities that are convertible into shares of our common stock. The issuance of additional shares of our common stock, or conversion of preferred stock or debt securities into shares of common stock, would further dilute the percentage ownership of our stockholders.
Shares of our common stock eligible for future sale may adversely affect the market for our common stock.
After we have filed all of our outstanding periodic reports with the SEC, if at all, from time to time, certain of our stockholders may be eligible to sell all or some of their shares of our common stock by means of effective resale registration statements. We agreed to register for resale under the Securities Act the shares of our common stock issuable upon conversion of the Notes and the shares of our common stock issued in private placements of our common stock in November 2004 and February 2006. We have agreed to file registration statements for these shares within 30 days following the first date we become current in our reporting requirements under the Exchange Act and to use our best efforts to cause the registration statements to become effective in no event later than 120 days after the filing of these registration statements. In addition, pursuant to Rule 144 generally, a stockholder (or stockholders whose shares are aggregated) who has satisfied a one year holding period may, under certain circumstances, sell within any three month period a number of securities which does not exceed the greater of 1% of the then outstanding shares of common stock or the average weekly trading volume of the class during the four calendar weeks prior to such sale. Rule 144 also permits, under certain circumstances, the sale of securities, without any limitation, by our stockholders that are non-affiliates that have satisfied a two year
42
holding period, such as certain of those stockholders who purchased shares of our common stock in our November 2004 private placement. Any substantial sale of our common stock effective resale registration statements or pursuant to Rule 144 or pursuant to any resale prospectus may have material adverse effect on the market price of our securities.
Our stock price is likely to be volatile.
Currently, our common stock is traded over the counter, or OTC, and is quoted on the OTC Pink Sheets LLC. Stocks traded OTC typically are subject to greater volatility than stocks traded on stock exchanges, such as the Nasdaq Global Market or the Nasdaq Capital Market, due to the fact that OTC trading volumes are generally significantly less than on stock exchanges. This lower volume may allow a relatively few number of stock trades to greatly affect the stock price. As such, the trading price of our common stock has been and is likely to continue to be extremely volatile. For example, between August 9, 2004 and June 30, 2006, the closing price of our common stock, as quoted on the Pink Sheets, has ranged from a high of $18.55 per share to a low of $3.38 per share.
Our stock price could continue to be subject to wide fluctuations in response to a variety of factors, including the following:
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| • | timing and consistency of filing financial statements; |
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| • | failure to win future government contracts or the termination of our existing contracts and government activities relating to contracts for anthrax or smallpox vaccines; |
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| • | adverse results or delays in clinical trials; |
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| • | delays in our product development efforts; |
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| • | real or perceived safety issues with any of our vaccine candidates; |
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| • | failure to obtain or maintain required regulatory approvals; |
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| • | delays in completion and/or validation of manufacturing activities relating to our partially owned facilities in the Republic of Korea; |
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| • | changes in financial estimates by securities analysts and our failure to meet or exceed such estimates; |
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| • | rumors about our business prospects, product development efforts or the progress, timing and completion of our clinical trials; |
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| • | new products or services offered by us or our competitors or announcements relating to product developments by our competitors; |
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| • | issuances of debt or equity securities; |
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| • | actual or expected sales by our stockholders of substantial amounts of our common stock, including shares issued upon exercise of outstanding options and warrants; and |
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| • | other events or factors, many of which are beyond our control. |
In addition, the stock market in general, and the Nasdaq Global Market and biotechnology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of these companies. Broad market and industry factors may negatively affect the market price of our common stock, regardless of actual operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against companies. If we face securities litigation in the future, even if meritless or unsuccessful, it would result in substantial costs and a diversion of management attention and resources, which could have a material adverse effect on our business.
We could experience equipment, raw material, manufacturing, quality control or other production problems, especially in periods of increasing volume.
There can be no assurance that we will be able to meet our projected manufacturing capacity. We have made and intend to continue to make significant capital expenditures to expand our manufacturing capacity. However, since customer demand is difficult to predict,
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we may be unable to ramp up our production quickly enough to timely fill new customer orders. This could cause us to lose new business and possibly existing business. In addition, if we overestimate customer demand, we could incur significant costs from creating excess capacity. We may experience manufacturing complications associated with increasing our manufacturing capacity, including the adequate production capacity to meet order requirements and delivery schedules. We may also experience difficulties implementing new manufacturing processes or outsourcing some of our manufacturing. The addition of fixed overhead costs increases our breakeven point and results in lower profit margins unless compensated for by increased product sales. When purchasing raw materials for our anticipated demand, we take into consideration the order-to-delivery lead times of vendors and the economic purchase order quantity for such raw materials. If we over-estimate customer demand, excess raw material inventory can result, which would have an adverse effect on our results of operations.
Failure of any portion of our infrastructure at our California manufacturing facility could have a material adverse effect on our business.
We are highly dependent on our wholly owned manufacturing infrastructure in California to achieve our business objectives. If we experience a problem that impairs our manufacturing infrastructure, such as a computer virus, intentional disruption of information technology systems by a third party, a work stoppage, terrorist attack or manufacturing failure, the resulting disruptions could impede our ability to book or process orders, manufacture and ship in a timely manner or otherwise carry on our business in the ordinary course. Any such events could cause us to lose significant customers or net sales and could require us to incur significant expense to eliminate these problems and address related security concerns.
We have no history of paying dividends on our common stock.
We have never paid cash dividends on our common stock and do not anticipate paying any cash dividends on our common stock in the foreseeable future. We plan to retain any future earnings to finance our growth. If we decide to pay dividends to the holders of our common stock, such dividends may not be paid on a timely basis.
Our charter documents and Delaware law may discourage an acquisition of VaxGen.
Provisions of our certificate of incorporation, by-laws, and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. We may issue shares of preferred stock in the future without stockholder approval and upon such terms as our board of directors may determine. Our issuance of this preferred stock could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from acquiring, a majority of our outstanding stock. Our charter and by-laws also provide that special stockholders meetings may be called only by our Chairman of the board of directors, by our Secretary at the written request of the chairman or by our board of directors, with the result that any third-party takeover not supported by the board of directors could be subject to significant delays and difficulties.
If we fail to cause a registration statement to be declared effective in accordance with the timetable set forth in the Notes, or in accordance with agreements we have made in connection with private placements of our common stock, we will be subject to liquidated damages or liability for breach of contract.
We agreed to register under the Securities Act shares of our common stock issuable upon conversion of the Notes, as well as shares issued or issuable in private placements of our common stock. We have agreed to file registration statements for these shares within 30 days following the first date we become current in our reporting requirements under the Exchange Act, and to use our best efforts to cause the registration statements to become effective in no event later than 120 days after the filing of such registration statements. We have also made other customary agreements regarding such registrations, including matters relating to indemnification, maintenance of the registration statements, payment of expenses and compliance with state “blue sky” laws. We may be liable for liquidated damages to each Note holder and purchaser in the private placements (a) if the registration statements are not filed on or prior to 30 days of becoming current in our reporting requirements; (b) if the registration statements are not declared effective by the SEC on or prior to 120 days from filing; or (c) if the registration statements (after being declared effective) cease to be effective in a manner that violates such agreements, collectively referred to as a Registration Default. In the event of a Registration Default, we may be required to pay liquidated damages. Should we become obligated to make payment of these liquidated damages, it could have a material adverse effect on our financial position and our results of operations, particularly if we become obligated to make a payment in full for all liquidated damages potentially due and payable under these agreements.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
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ITEM 6. EXHIBITS
(a) Exhibits required by Item 601 of Regulation S-K:
The following exhibits are filed as part of this report:
(Note: Management contracts and compensatory plans or arrangements are identified with a “+” in the following list.)
| | | | | | | | | | | | | |
| | | | Incorporated by Reference | |
Exhibit
No. | | Exhibit | | Form | | File No. | | Filing Date | | Exhibit
No. | | Filed
Herewith | |
| |
| |
| |
| |
| |
| |
| |
10.1 | | Modification #01 to Contract No. HHS0100200500001C, between the Department of Health and Human Services, Office of Research and Development Coordination and Office of Public Health Emergency Preparedness and VaxGen, Inc., dated May 5, 2006.* | | 8-K | | 0-26483 | | 5-11-06 | | 10.1 | | | |
| | | | | | | | | | | | | |
10.2 | | Share Purchase Agreement, between Nexol Co., Ltd., Nexol Biotech Co., Ltd., Nexol Venture Capital Co., Ltd. and VaxGen, Inc., dated June 28, 2006. | | 8-K | | 0-26483 | | 7-06-06 | | 10.1 | | | |
| | | | | | | | | | | | | |
31.1 | | Certification of Chief Executive Officer | | | | | | | | | | X | |
| | | | | | | | | | | | | |
31.2 | | Certification of Principal Financial Officer | | | | | | | | | | X | |
| | | | | | | | | | | | | |
32.1 | | Section 1350 Certification | | | | | | | | | | X | |
| | | | | | | | | | | | | |
* Confidential treatment requested. The redacted portions have been separately filed with the SEC as required by Rule 406 of Regulation C.
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| |
| VaxGen, Inc. |
| |
Dated:August 29, 2007 | By: /s/ James P. Panek |
|
|
| |
| James P. Panek |
| Chief Executive Officer |
| (Principal Executive Officer) |
| |
Dated:August 29, 2007 | By: /s/ Matthew J. Pfeffer |
|
|
| |
| Matthew J. Pfeffer |
| Chief Financial Officer |
| (Principal Financial Officer) |
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