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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 2002
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number: 0-13976
AKORN, INC.
(Name of registrant as specified in its charter)
<Table>
LOUISIANA 72-0717400
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
</Table>
2500 MILLBROOK DRIVE, BUFFALO GROVE, ILLINOIS 60089
(Address of principal executive offices and zip code)
REGISTRANT'S TELEPHONE NUMBER: (847) 279-6100
SECURITIES REGISTERED UNDER SECTION 12(b) OF THE EXCHANGE ACT:
None
SECURITIES REGISTERED UNDER SECTION 12(g) OF THE EXCHANGE ACT:
Common Stock, No Par Value
(Title of Class)
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12
months (or for such shorter period that the Registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days. Yes
- --- No
Indicate by check mark if disclosure of delinquent filers in response to Item
405 of Regulation S-K is not contained in this form, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes
- --- No
The aggregate market value of the voting stock of the Registrant held by
non-affiliates (affiliates being, for these purposes only, directors, executive
officers and holders of more than 5% of the Registrant's common stock) of the
Registrant as of April 28, 2003 was approximately $12,882,647.
The number of shares of the Registrant's common stock, no par value per share,
outstanding as of May 12, 2003 was 19,729,759.
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FORWARD-LOOKING STATEMENTS AND FACTORS AFFECTING FUTURE RESULTS
Certain statements in this Form 10-K constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act.
When used in this document, the words "anticipate," "believe," "estimate" and
"expect" and similar expressions are generally intended to identify
forward-looking statements. Any forward-looking statements, including statements
regarding the intent, belief or expectations of the Company or its management
are not guarantees of future performance. These statements involve risks and
uncertainties and actual results may differ materially from those in the
forward-looking statements as a result of various factors, including but not
limited to:
- the Company's ability to restructure or refinance its debt to its senior
lenders, which is currently in default, but subject to a forbearance
agreement;
- the Company's ability to obtain further extensions of the forbearance
agreement which originally expired on January 3, 2003, but has
subsequently been extended for successive short-term periods, the latest
of which expires on June 30, 2003;
- the Company's ability to avoid further defaults under debt covenants;
- the Company's ability to generate cash from operations sufficient to
meet its working capital requirements;
- the Company's ability to obtain additional funding to operate and grow
its business;
- the Company's ability to resolve its Food and Drug Administration
compliance issues at its Decatur, Illinois facility;
- the effects of federal, state and other governmental regulation of the
Company's business;
- the Company's success in developing, manufacturing and acquiring new
products;
- the Company's ability to bring new products to market and the effects of
sales of such products on the Company's financial results;
- the effects of competition from generic pharmaceuticals and from other
pharmaceutical companies;
- availability of raw materials needed to produce the Company's products;
and
- other factors referred to in this Form 10-K and the Company's other
Securities and Exchange Commission filings.
See "Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Factors That May Affect Future Results". The
Company does not intend to update these forward looking statements.
1
FORM 10-K TABLE OF CONTENTS
<Table>
<Caption>
PAGE
----
PART I
Item 1. Description of Business..................................... 3
Item 2. Description of Properties................................... 9
Item 3. Legal Proceedings........................................... 9
Item 4. Submission of Matters to a Vote of Security Holders......... 13
PART II
Item 5. Market for Common Equity and Related Stockholder Matters.... 14
Item 6. Selected Consolidated Financial Data........................ 15
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 15
Item 7A Quantitative and Qualitative Disclosures about Market
Risk........................................................ 36
Item 8. Financial Statements and Supplementary Data................. 37
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 69
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 70
Item 11. Executive Compensation...................................... 71
Item 12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters.................. 74
Item 13. Certain Relationships and Related Transactions.............. 76
Item 14. Controls and Procedures..................................... 78
PART IV
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form
8-K......................................................... 79
Schedule II................................................. 82
Signatures.................................................. 83
Certifications.............................................. 84
</Table>
2
PART I
ITEM 1. DESCRIPTION OF BUSINESS
Akorn, Inc. ("Akorn" or the "Company") manufactures and markets diagnostic
and therapeutic pharmaceuticals in specialty areas such as ophthalmology,
rheumatology, anesthesia and antidotes, among others. Customers include
physicians, optometrists, wholesalers, group purchasing organizations and other
pharmaceutical companies. Akorn is a Louisiana corporation founded in 1971 in
Abita Springs, Louisiana. In 1997, the Company relocated its headquarters and
certain operations to Illinois.
As described more fully herein, the Company has had three consecutive years
of operating losses, is in default under its existing credit agreement and is a
party to governmental proceedings and potential claims by the Food and Drug
Administration ("FDA") that could have material adverse effect on the Company.
Although the Company has entered into a Forbearance Agreement with its senior
lenders and obtained extensions thereof through June 30, 2003, is working with
the FDA to favorably resolve such proceedings, has appointed a new interim chief
executive officer and implemented other management changes and has taken
additional steps to return to profitability, there is substantial doubt about
the Company's ability to continue as a going concern. The Company's ability to
continue as a going concern is dependent upon its ability to (i) continue to
finance it current cash needs, (ii) continue to obtain extensions of the
Forbearance Agreement, (iii) successfully resolve the ongoing governmental
proceeding with the FDA and (iv) ultimately refinance its senior bank debt and
obtain new financing for future operations and capital expenditures. See Item
7.- "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Financial Condition and Liquidity."
The Company classifies its operations into three identifiable business
segments, ophthalmic, injectable and contract services. These three segments are
discussed in greater detail below. For information regarding revenues and gross
profit for each of the Company's segments, see Note L "Segment Information" to
the consolidated financial statements included in Item 8 of this report.
Ophthalmic Segment. The Company markets a line of diagnostic and
therapeutic ophthalmic pharmaceutical products. Diagnostic products, primarily
used in the office setting, include mydriatics and cycloplegics, anesthetics,
topical stains, gonioscopic solutions, angiography dyes and others. Therapeutic
products, sold primarily to wholesalers and other national account customers,
include antibiotics, anti-infectives, steroids, steroid combinations, glaucoma
medications, decongestants/antihistamines and anti-edema medications.
Non-pharmaceutical products include various artificial tear solutions,
preservative-free lubricating ointments, lid cleansers, vitamin supplements and
contact lens accessories. The Company exited the surgical products business in
late 2002. The impact was not material to the Company's financial results.
Injectable Segment. The Company markets a line of specialty injectable
pharmaceutical products, including anesthesia and products used in the treatment
of rheumatoid arthritis and pain management. These products are marketed to
wholesalers and other national account customers as well as directly to medical
specialists.
Contract Services Segment. The Company manufactures products for third
party pharmaceutical and biotechnology customers based on their specifications.
Manufacturing. The Company has two manufacturing facilities located in
Decatur, Illinois and Somerset, New Jersey. See "Item 2. Description of
Property." The Company manufactures a diverse group of sterile pharmaceutical
products, including solutions, ointments and suspensions for its ophthalmic and
injectable segments. The Decatur facilities manufacture product for all three of
the Company's segments. The Somerset facility manufactures product for the
ophthalmic segment. The Company is also in the process of adding freeze-dried
(lyophilized) manufacturing capabilities at its Decatur facility. See "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Factors That May Affect Future Results -- Dependence on
Development of Pharmaceutical Products and Manufacturing Capabilities."
3
Sales and Marketing. While the Company is working to expand its proprietary
product base through internal development, the majority of current products are
non-proprietary. The Company relies on its efforts in marketing, distribution,
development and low cost manufacturing to maintain and increase market share.
The ophthalmic segment uses a three-tiered sales effort. Outside sales
representatives sell directly to physicians and group practices. In-house sales
(telemarketing) and customer service (catalog sales) sell to optometrists and
other customers. A national accounts group sells to wholesalers, retail chains
and other group purchasing organizations. This national accounts group also
markets the Company's injectable pharmaceutical products, which the Company also
sells through telemarketing and direct mail activities to individual specialty
physicians and hospitals. The contract services segment markets its contract
manufacturing services through direct mail, trade shows and direct industry
contacts.
Research and Development. As of December 31, 2002, the Company had 19
Abbreviated New Drug Applications ("ANDAs") for generic pharmaceuticals in
various stages of development. The Company filed 12 of these ANDAs along with a
New Drug Application ("NDA") supplement in 2002. See "Government Regulation."
The Company plans to continue to file ANDAs on a regular basis as pharmaceutical
products come off patent allowing the Company to compete by marketing generic
equivalents. However, unless and until the issues pending before the FDA with
respect to the Company are favorably resolved, it is doubtful that the FDA will
approve any NDAs or ANDAs submitted by the Company. The FDA approved the NDA for
Paremyd, on December 5, 2001, which was launched during the first quarter of
2002.
In the fourth quarter of 2002, the Company completed a phase 1 clinical
trial on nine patients using a new, patent pending formulation of indocyanine
green ("ICG") for the indication in Age Related Macular Degeneration ("AMD").
Additionally, in 2002, the Company was issued two U.S. patents, #6,351,663 and
#6,443,976 relating to ICG and the diagnosis and treatment of abnormal
vasculature. If the Company's developmental efforts are successful, the Company
currently anticipates filing an NDA within the next four years. The Company also
anticipates filing an NDA supplement within the next three years for an
indication for ICG for intra-ocular staining.
On February 18, 2003, the Company announced that it had received approval
from the FDA for its ANDA for Lidocaine Jelly, 2% ("Lidocaine Jelly"), a
bioequivalent to Xylocaine Jelly (R), a product of AstraZeneca PLC used
primarily as a topical anesthetic by urologists and hospitals. According to
industry sources, it is estimated that the total annual U.S. market for
comparable products was approximately $30 million in 2002. The Company
anticipates that its product, which will be manufactured at its Somerset, New
Jersey facility, will be commercially available in the second quarter of 2003.
Pre-clinical and clinical trials required in connection with the
development of pharmaceutical products are performed by contract research
organizations under the direction of Company personnel. No assurance can be
given as to whether the Company will file NDAs, or any ANDAs, when anticipated,
whether the Company will develop marketable products based on these filings or
as to the actual size of the market for any such products. See "Government
Regulation" and "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Factors That May Affect Future
Results -- Dependence on Development of Pharmaceutical Products and
Manufacturing Capabilities."
The Company also maintains a business development program that identifies
potential product acquisition or product licensing candidates. The Company has
focused its business development efforts on niche products that complement its
existing product lines and that have few or no competitors in the market. In
2000, the Company entered into an exclusive cross marketing agreement with
Novadaq Technologies, Inc. for cardiac angiography procedures employing ICG.
Under the terms of the agreement, as amended on January 25, 2002, Novadaq will
assume all further costs associated with development of the technology. The
Company, in consideration of foregoing any share of future net profits, obtained
an equity ownership interest in Novadaq and the right to be the exclusive
supplier of ICG for use in Novadaq's diagnostic procedures.
At December 31, 2002, 12 full-time employees of the Company were involved
in research and development and product licensing.
4
Research and development costs are expensed as incurred. Such costs
amounted to $1,886,000, $2,598,000 and $4,132,000 for the years ended December
31, 2002, 2001 and 2000, respectively.
Patents and Proprietary Rights. The Company considers the protection of
discoveries in connection with its development activities important to its
business. The Company has sought, and intends to continue to seek, patent
protection in the United States and selected foreign countries where deemed
appropriate. As of December 31, 2002, the Company had received six U.S. patents
and had two additional U.S. patent applications and one international patent
application pending. In February of 2002, the U.S. Patent and Trademark Office
notified the Company that U.S. patent number 6,351,663 titled "Methods for
diagnosing and treating abnormal vasculature using fluorescent dye angiography
and dye enhanced photocoagulation" had been issued to the Company. Two of the
patents held by the Company cover ophthalmic products and processes under
development and the remaining four patents are methods patents relating to a
currently marketed injectable product.
The Company had also licensed two U.S. patents from the Johns Hopkins
University, Applied Physics Laboratory ("JHU/APL") for the development and
commercialization of AMD diagnosis and treatment using ICG. However, a dispute
arose between the Company and JHU/APL regarding the two patents licensed for AMD
and the Company's performance required by December 31, 2001 under the terms of
the applicable License Agreement. In July 2002, the Company and JHU/APL agreed
to terminate their license agreement and as a result, the Company no longer has
any rights to the JHU/APL patents. See "Item 3. Legal Proceedings." Although the
Company has relinquished its rights to the JHU/APL Patents, the Company is
actively pursuing alternative treatment methods for AMD using ICG. There can be
no assurance that the Company will obtain U.S. or foreign patents or, if
obtained, that they will provide substantial protection or be of commercial
benefit.
The Company also relies upon trademarks, trade secrets, unpatented
proprietary know-how and continuing technological innovation to maintain and
develop its competitive position. The Company enters into confidentiality
agreements with certain of its employees pursuant to which such employees agree
to assign to the Company any inventions relating to the Company's business made
by them while in the Company's employ. However, there can be no assurance that
others may not acquire or independently develop similar technology or, if
patents are not issued with respect to products arising from research, that the
Company will be able to maintain information pertinent to such research as
proprietary technology or trade secrets. See "Item 7. Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Factors That
May Affect Future Results -- Patents and Proprietary Rights".
Employee Relations. At December 31, 2002, the Company had 326 full-time
employees, 290 of whom were employed by Akorn and 36 by its wholly owned
subsidiary, Akorn (New Jersey), Inc. The Company enjoys good relations with its
employees, none of whom are represented by a collective bargaining agent.
Competition. The marketing and manufacturing of pharmaceutical products is
highly competitive, with many established manufacturers, suppliers and
distributors actively engaged in all phases of the business. Most of the
Company's competitors have substantially greater financial and other resources,
including greater sales volume, larger sales forces and greater manufacturing
capacity. See "Item 7. Management's Discussion and Analysis of Operations --
Factors That May Affect Future Results -- Competition; Uncertainty of
Technological Change."
The companies that compete with the ophthalmic segment include Alcon
Laboratories, Inc., Allergan Pharmaceuticals, Inc., Ciba Vision and Bausch &
Lomb, Inc. ("B&L"). The ophthalmic segment competes primarily on the basis of
price and service. The ophthalmic segment purchases some ophthalmic products
from B&L, who is in direct competition with the Company in several markets.
The companies that compete with the injectable segment include both generic
and name brand companies such as Abbott Laboratories, Gensia, American
Pharmaceutical Products, Elkin Sinn and American Regent. The injectable segment
competes primarily on the basis of price.
Competitors in the contract services segment include Cook Imaging (Baxter),
Chesapeake Biological Laboratories and Ben Venue. The contract services segment
competes primarily on the basis of price and
5
technical capabilities. The manufacturing of products in all three segments must
be performed under government mandated Current Good Manufacturing Practices
("cGMP").
Suppliers and Customers. No supplier of products accounted for more than
10% of the Company's purchases in 2002, 2001 or 2000. The Company requires a
supply of quality raw materials and components to manufacture and package
pharmaceutical products for itself and for third parties with which it has
contracted. The principal components of the Company's products are active and
inactive pharmaceutical ingredients and certain packaging materials. Many of
these components are available from only a single source and, in the case of
many of the Company's ANDAs and NDAs, only one supplier of raw materials has
been identified. Because FDA approval of drugs requires manufacturers to specify
their proposed suppliers of active ingredients and certain packaging materials
in their applications, FDA approval of any new supplier would be required if
active ingredients or such packaging materials were no longer available from the
specified supplier. The qualification of a new supplier could delay the
Company's development and marketing efforts. If for any reason the Company is
unable to obtain sufficient quantities of any of the raw materials or components
required to produce and package its products, it may not be able to manufacture
its products as planned, which could have a material adverse effect on the
Company's business, financial condition and results of operations. See "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Factors That May Affect Future Results -- Dependence on Supply of
Raw Materials and Components".
A small number of large wholesale drug distributors account for a large
portion of the Company's gross sales, revenues and accounts receivable. Those
distributors are:
- AmerisourceBergen Corporation ("AmerisourceBergen"), which was formed in
2001 by the merger of AmeriSource Health Corporation and Bergen Brunswig
Corporation;
- Cardinal Health, Inc. ("Cardinal"); and
- McKesson Drug Company ("McKesson").
These three wholesale drug distributors accounted for approximately 57% of
total gross sales and 42% of revenues in 2002, and 61% of gross accounts
receivables as of December 31, 2002. The difference between gross sales and
revenue is that gross sales do not reflect the deductions for chargebacks,
rebates and product returns (See Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Critical Accounting Policies).
The percentages of gross sales, revenue and gross trade receivables attributed
to each of these three wholesale drug distributors for the years ended December
31, 2002 and December 31, 2001 were as follows:
<Table>
<Caption>
2002 2002 2001 2001
GROSS 2002 GROSS ACCT. GROSS 2001 GROSS ACCT.
SALES REVENUE RECEIVABLES SALES REVENUE RECEIVABLES
----- ------- ------------ ----- ------- ------------
AmerisourceBergen Corporation.......... 28% 22% 28% 19% 10% 25%
Cardinal Health, Inc................... 18% 12% 27% 14% 9% 11%
McKesson Drug Company.................. 11% 8% 6% 9% 5% 11%
</Table>
AmerisourceBergen, Cardinal and McKesson are distributors of the Company's
products as well as a broad range of health care products for many other
companies. None of these distributors is an end user of the Company's products.
If sales to any one of these distributors were to diminish or cease, the Company
believes that the end users of its products would find little difficulty
obtaining the Company's products either directly from the Company or from
another distributor. However, the loss of one or more of these customers,
together with a delay or inability to secure an alternative distribution source
for end users, could have a material negative impact on the Company's revenue
and results of operations and lead to a violation of debt covenants. A change in
purchasing patterns, an increase in returns of the Company's products, delays in
purchasing products and delays in payment for products by one or more
distributors also could have a material negative impact on the Company's revenue
and results of operations and lead to a violation of debt covenants. See "Item
7. Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Factors That May Affect Future Results -- Dependence on Small
Number of Distributors."
6
Backorders. As of December 31, 2002, the Company had approximately $5.4
million of products on backorder as compared to approximately $4.0 million of
backorders as of December 31, 2001. This increase in backorders is due the fact
that one of the Company's production rooms at it's Decatur, Illinois facility
was not fully operational in the fourth quarter of 2002 pending requalification
under cGMP of that production room. The Company anticipates filling all open
backorders during 2003.
Government Regulation. Pharmaceutical manufacturers and distributors are
subject to extensive regulation by government agencies, including the FDA, the
Drug Enforcement Administration ("DEA"), the Federal Trade Commission ("FTC")
and other federal, state and local agencies. The federal Food, Drug and Cosmetic
Act (the "FDC Act"), the Controlled Substance Act and other federal statutes and
regulations govern or influence the development, testing, manufacture, labeling,
storage and promotion of products. The FDA inspects drug manufacturers and
storage facilities to determine compliance with its cGMP regulations,
non-compliance with which can result in fines, recall and seizure of products,
total or partial suspension of production, refusal to approve new drug
applications and criminal prosecution. The FDA also has the authority to revoke
approval of drug products.
FDA approval is required before any drug can be manufactured and marketed.
New drugs require the filing of an NDA, including clinical studies demonstrating
the safety and efficacy of the drug. Generic drugs, which are equivalents of
existing, off-patent brand name drugs, require the filing of an ANDA. An ANDA
does not, for the most part, require clinical studies since safety and efficacy
have already been demonstrated by the product originator. However, the ANDA must
provide data demonstrating the equivalency of the generic formulation in terms
of bioavailability. The time required by the FDA to review and approve NDA's and
ANDA's is variable and essentially beyond the control of the Company.
In October 2000, the FDA issued a warning letter to the Company following
the FDA's routine cGMP inspection of the Company's Decatur manufacturing
facilities. An FDA warning letter is intended to provide notice to a company of
violations of the laws administered by the FDA. Its primary purpose is to elicit
voluntary corrective action. The letter warns that if voluntary action is not
forthcoming, the FDA may use other legal means to compel compliance. These
include seizure of products and/or injunction of the company and responsible
individuals. The October, 2000 warning letter addressed several deviations from
regulatory requirements including general documentation and cleaning validation
issues and requested corrective actions be undertaken by the Company. The
Company initiated corrective actions and responded to the warning letter.
Subsequently, the FDA conducted another inspection in late 2001 and identified
additional deviations from regulatory requirements including cleaning validation
and process control issues. This led to the FDA leaving the warning letter in
place and issuing a Form 483 to document its findings. While no further
correspondence was received from the FDA, the Company responded to the
inspectional findings. This response described the Company's plan for addressing
the issues raised by the FDA and included improved cleaning validation, enhanced
process controls and approximately $2.0 million of capital improvements. In
August 2002, the FDA conducted an inspection of the Decatur facility and
identified deviations from cGMPs. The Company responded to these observations in
September 2002. In response to the Company's actions, the FDA conducted another
inspection of the Decatur facility during the period from December 10, 2002 to
February 6, 2003. This inspection identified deviations from regulatory
requirements including the manner in which the Company processes and
investigates manufacturing discrepancies and failures, customer complaints and
the thoroughness of equipment cleaning validations. Deviations identified during
this inspection had been raised in previous FDA inspections. The Company has
responded to these latest findings in writing and in a meeting with the FDA in
March 2003. The Company set forth its plan for implementing comprehensive
corrective actions, provided a progress report to the FDA on April 15 and May
15, 2003 and has committed to providing the FDA an additional periodic report of
progress on June 15, 2003.
As a result of the latest inspection and the Company's response, the FDA
may take any of the following actions: (i) accept the Company's reports and
response and take no further action against the Company; (ii) permit the Company
to continue its corrective actions and conduct another inspection (which likely
would not occur before the fourth quarter of 2003) to assess the success of
these efforts; (iii) seek to enjoin the Company from further violations, which
may include temporary suspension of some or all operations and
7
potential monetary penalties; or (iv) take other enforcement action which may
include seizure of Company products. At this time, it is not possible to predict
the FDA's course of action.
The Company believes that unless and until the FDA chooses option (i) or,
in the case of option (ii), unless and until the issues identified by the FDA
have been successfully corrected and the corrections have been verified through
reinspection, it is doubtful that the FDA will approve any NDAs or ANDAs that
may be submitted by the Company. This has adversely impacted, and is likely to
continue to adversely impact the Company's ability to grow sales. However, the
Company believes that unless and until the FDA chooses option (iii) or (iv), the
Company will be able to continue manufacturing and distributing its current
product lines.
If the FDA chooses option (iii) or (iv), such action could significantly
impair the Company's ability to continue to manufacture and distribute its
current product line and generate cash from its operations, could result in a
covenant violation under the Company's senior debt or could cause the Company's
senior lenders to refuse further extensions of the Company's senior debt, any or
all of which would have a material adverse effect on the Company's liquidity.
Any monetary penalty assessed by the FDA also could have a material adverse
effect on the Company's liquidity. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operation -- Financial Condition
and Liquidity".
In February of 2003, the Company recalled two products, Fluress and
Fluoracaine, due to container/ closure integrity problems resulting in leaking
containers. The recall has been classified by the FDA as a Class II recall,
which means that the use of, or exposure to, a violative product may cause
temporary or medically reversible adverse health consequences or that the
probability of serious health consequences as a result of such use or exposure
is remote. To date, the Company has not received any notification or complaints
from end users of the recalled products. Because the Company had curtailed the
production of these items due to the above container/closure integrity issues,
the financial impact to the Company of this recall is not expected to be
material.
In March of 2003, as a result of the most recent FDA inspection, the
Company recalled twenty-four lots of product produced from the period December
2001 to June 2002 in one of its production rooms at its Decatur, Illinois
facility. The majority of the lots recalled were for third party contract
customer products. Subsequent to this decision and after discussions with the
FDA, eight of the original twenty-four lots have been exempted from the recall
due to medical necessity. At this time, the FDA has not reached a conclusion on
the classification of this recall. To date, the Company has not received any
notification or complaints from end users of the recalled products. Due to the
passage of time between the production of theses lots and the recall, the
Company believes that its customers do not hold significant inventories of these
products. As a result, the Company believes the financial impact of this recall
will not be material.
The Company also manufactures and distributes several controlled-drug
substances, the distribution and handling of which are regulated by the DEA.
Failure to comply with DEA regulations can result in fines or seizure of
product. See "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Factors That May Affect Future Results --
Government Regulation".
On March 6, 2002, the Company received a letter from the United States
Attorney's Office, Central District of Illinois, Springfield, Illinois, advising
the Company that the DEA had referred a matter to that office for a possible
civil legal action for alleged violations of the Comprehensive Drug Abuse
Prevention Control Act of 1970, 21 U.S.C. sec. 801, et. seq. and regulations
promulgated under the Act. The alleged violations relate to record keeping and
controls surrounding the storage and distribution of controlled substances. On
November 6, 2002, the Company entered into a Civil Consent Decree with the DEA.
Under terms of the Civil Consent Decree, the Company, without admitting any of
the allegations in the complaint from the DEA, has agreed to pay a fine of
$100,000, upgrade its security system and to remain in substantial compliance
with the Comprehensive Drug Abuse Prevention Control Act of 1970. If the Company
does not remain in substantial compliance during the two-year period following
the entry of the Civil Consent Decree, the Company, in addition to other
possible sanctions, may be held in contempt of court and ordered to pay an
additional $300,000 fine. See Item 3. "Legal Proceedings".
8
The Company does not anticipate any material adverse effect from compliance
with federal, state and local provisions that have been enacted or adopted
regulating the discharge of materials into the environment, or otherwise
relating to the protection of the environment.
ITEM 2. DESCRIPTION OF PROPERTIES
Since August 1998, the Company's headquarters and certain administrative
offices, as well as a finished goods warehouse, have been located in leased
space at 2500 Millbrook Drive, Buffalo Grove, Illinois. The Company leased
approximately 24,000 square feet until June 2000 at which time it expanded to
the current occupied space of approximately 48,000 square feet. From May 1997 to
August 1998, the Company's headquarters and ophthalmic division offices were
located in approximately 11,000 square feet of leased space in Lincolnshire,
Illinois. The Company sublets portions of the space leased in Lincolnshire. The
Company's former headquarters, consisting of approximately 30,000 square feet
located on ten acres of land in Abita Springs, Louisiana, was sold in February
1999.
The Company owns a 76,000 square foot facility located on 15 acres of land
in Decatur, Illinois. This facility is currently used for packaging,
distribution, warehousing and office space. In addition, the Company owns a
55,000 square-foot manufacturing facility in Decatur, Illinois. The Decatur
facilities support all three of the Company's segments. The Company leases
approximately 7,000 square feet of office and warehousing space in San Clemente,
California, formerly used as a sales office to support the Injectable segment.
The Company successfully sublet this space through the term of the lease when
the San Clemente operations were closed and relocated to Buffalo Grove in July
of 2001. The Company's Akorn (New Jersey) subsidiary also leases approximately
40,000 square feet of space in Somerset, New Jersey. This space is used for
manufacturing, research and development and administrative activities related to
the ophthalmic segment. The Company does not have any idled manufacturing
facilities, however, the capacity utilization at both its Decatur and Somerset
facilities was approximately 50% during the year ended December 31, 2002. The
Company can produce approximately 65 batches, per month, at full capacity.
Operating the manufacturing facilities at the reduced level has contributed to
the generation of negative manufacturing variances.
The Company is in the process of completing an expansion of its Decatur,
Illinois facility to add capacity to provide Lyophilization manufacturing
services, which manufacturing capability the Company currently does not have.
Subject to the Company's ability to refinance its senior debt and obtain new
financing for future operations and capital expenditures, the Company
anticipates the completion of the Lyophilization expansion in the second half of
2004. As of December 31, 2002, the Company had spent approximately $16.4 million
on the expansion and anticipates the need to spend approximately $1.0 million of
additional funds (excluding capitalized interest) to complete the expansion. The
majority of the additional spending will be focused on validation testing of the
Lyophilization facility as the major capital equipment items are currently in
place. Once the Lyophilization facility is validated, the Company will proceed
to produce stability batches to provide the data necessary to allow the
Lyophilization facility to be inspected and approved by the FDA.
The current combined space is considered adequate to accommodate the
Company's manufacturing needs for the foreseeable future. Lyophilization
capabilities are not currently needed by the Company, but would give the Company
the capability to manufacture additional products for its contract customers and
allow the Company to internally produce one of its currently outsourced
products.
ITEM 3. LEGAL PROCEEDINGS
On March 27, 2002, the Company received a letter informing it that the
staff of the SEC's regional office in Denver, Colorado, would recommend to the
SEC that it bring an enforcement action against the Company and seek an order
requiring the Company to be enjoined from engaging in certain conduct. The staff
alleged that the Company misstated its income for fiscal years 2000 and 2001 by
allegedly failing to reserve for doubtful accounts receivable and overstating
its accounts receivable balance as of December 31, 2000. The staff alleged that
internal control and books and records deficiencies prevented the Company from
accurately recording, reconciling and aging its accounts receivable. The Company
also learned that certain of its former officers, as well as a then current
employee had received similar notifications. Subsequent to the issuance of the
Company's consolidated financial statements for the year ended December 31,
2001, management of the
9
Company determined it needed to restate the Company's financial statements for
2000 and 2001 to record a $7.5 million increase to the allowance for doubtful
accounts as of December 31, 2000, which it had originally recorded as of March
31, 2001.
On February 27, 2003, the Company reached an agreement in principle with
the staff of the SEC's regional office in Denver, Colorado, that would resolve
the issues arising from the staff's investigation and proposed enforcement
action as discussed above. The Company has offered to consent to the entry of an
administrative cease and desist order as proposed by the staff, without
admitting or denying the findings set forth therein. The proposed consent order
finds that the Company failed to promptly and completely record and reconcile
cash and credit remittances, including from its top five customers, to invoices
posted in its accounts receivable sub-ledger. According to the findings in the
proposed consent order, the Company's problems resulted from, among other
things, internal control and books and records deficiencies that prevented the
Company from accurately recording, reconciling and aging its receivables. The
proposed consent order finds that the Company's 2000 Form 10-K and first quarter
2001 Form 10-Q misstated its account receivable balance or, alternatively,
failed to disclose the impairment of its accounts receivable and that its first
quarter 2001 Form 10-Q inaccurately attributed the increased accounts receivable
reserve to a change in estimate based on recent collection efforts, in violation
of Section 13(a) of the Exchange Act and rules 12b-20, 13a-1 and 13a-13
thereunder. The proposed consent order also finds that the Company failed to
keep accurate books and records and failed to devise and maintain a system of
adequate internal accounting controls with respect to its accounts receivable in
violation of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act. The
proposed consent order does not impose a monetary penalty against the Company or
require any additional restatement of the Company's financial statements. The
Company has recently become aware of and informed the SEC staff of certain
weaknesses in its internal controls, which it is in the process of addressing.
It is uncertain at this time what effect these actions will have on the
agreement in principle currently pending with the SEC staff. The proposed
consent order does not become final until it is approved by the SEC.
Accordingly, the Company may incur additional costs and expenses in connections
with this proceeding.
The Company was party to a License Agreement with JHU/APL effective April
26, 2000, and amended effective July 15, 2001 (See Note C -- "Product and Other
Acquisitions" to the consolidated financial statements included in Item 8).
Pursuant to the License Agreement, the Company licensed two patents from JHU/APL
for the development and commercialization of a diagnosis and treatment for
age-related macular degeneration ("AMD") using Indocyanine Green ("ICG"). A
dispute arose between the Company and JHU/APL concerning the License Agreement.
Specifically, JHU/APL challenged the Company's performance required by December
31, 2001 under the License Agreement and alleged that the Company was in breach
of the License Agreement. The Company denied JHU/APL's allegations and contended
that it had performed in accordance with the terms of the License Agreement. As
a result of the dispute, on March 29, 2002, the Company commenced a lawsuit in
the U.S. District Court for the Northern District of Illinois, seeking
declaratory and other relief against JHU/APL. On July 3, 2002, the Company
reached an agreement with JHU/APL with regard to the dispute that had risen
between the two parties. The Company and JHU/APL mutually agreed to terminate
their license agreement. As a result, the Company no longer has any rights to
the JHU/APL patent rights as defined in the license agreement. In exchange for
relinquishing its rights to the JHU/APL patent rights, the Company received an
abatement of the $300,000 due to JHU/APL at March 31, 2002 and a payment of
$125,000 to be received by August 3, 2002. The Company also has the right to
receive 15% of all cash payments and 20% of all equity received by JHU/APL from
any license of the JHU/APL patent rights less any cash or equity returned by
JHU/APL to such licensee. The combined total of all such cash and equity
payments are not to exceed $1,025,000. The $125,000 payment is considered an
advance towards cash payments due from JHU/APL and will be credited against any
future cash payments due the Company as a result of JHU/APL's licensing efforts.
As a result of the resolved dispute discussed above, the Company recorded an
asset impairment charge of $1,559,500 in 2002. The impairment amount represents
the net value of the asset recorded on the balance sheet of the Company less the
$300,000 payment abated by JHU/APL and the $125,000 payment from JHU/APL. The
$125,000 payment was received on August 3, 2002. In the fourth quarter of 2002,
the Company learned that JHU/APL had licensed their two patents related to AMD
to Novadaq Technologies, Inc. ("Novadaq"). In connection with the settlement of
a
10
prior dispute with Novadaq in January 2002 (as discussed below), the Company had
previously acquired an equity interest in Novadaq. Pursuant to the settlement
with JHU/APL, the Company is entitled to 20% of all equity received by Johns
Hopkins from any license of the patent rights. Therefore, the Company received
an additional 132,000 shares of Novadaq, valued at $23,000 which was recorded as
a gain in the fourth quarter of 2002.
In October 2000, the FDA issued a warning letter to the Company following
the FDA's routine cGMP the inspection of the Company's Decatur manufacturing
facilities. This letter addressed several deviations from regulatory
requirements including cleaning validations and general documentation and
requested corrective actions be undertaken by the Company. The Company initiated
corrective actions and responded to the warning letter. Subsequently, the FDA
conducted another inspection in late 2001 and identified additional deviations
from regulatory requirements including process controls and cleaning
validations. This led to the FDA leaving the warning letter in place and issuing
a Form 483 to document its findings. While no further correspondence was
received from the FDA, the Company responded to the inspectional findings. This
response described the Company's plan for addressing the issues raised by the
FDA and included improved cleaning validation, enhanced process controls and
approximately $2.0 million of capital improvements. In August 2002, the FDA
conducted an inspection of the Decatur facility and identified cGMP deviations.
The Company responded to these observations in September 2002. In response to
the Company's actions, the FDA conducted another inspection of the Decatur
facility during the period from December 10, 2002 to February 6, 2003. This
inspection identified deviations from regulatory requirements including the
manner in which the Company processes and investigates manufacturing
discrepancies and failures, customer complaints and the thoroughness of
equipment cleaning validations. Deviations identified during this inspection had
been raised in previous FDA inspections. The Company has responded to these
latest findings in writing and in a meeting with the FDA in March 2003. The
Company set forth its plan for implementing comprehensive corrective actions,
has provided a progress report to the FDA on April 15, and May 15, 2003 and has
committed to providing the FDA an additional periodic report of progress on June
15, 2003.
As a result of the latest inspection and the Company's response, the FDA
may take any of the following actions: (i) accept the Company's reports and
response and take no further action against the Company; (ii) permit the Company
to continue its corrective actions and conduct another inspection (which likely
would not occur before the fourth quarter of 2003) to assess the success of
these efforts; (iii) seek to enjoin the Company from further violations, which
may include temporary suspension of some or all operations and potential
monetary penalties; or (iv) take other enforcement action which may include
seizure of Company products. At this time, it is not possible to predict the
FDA's course of action.
The Company believes that unless and until the FDA chooses option (i) or,
in the case of option (ii), unless and until the issues identified by the FDA
have been successfully corrected and the corrections have been verified through
reinspection, it is doubtful that the FDA will approve any NDAs or ANDAs that
may be submitted by the Company. This has adversely impacted, and is likely to
continue to adversely impact the Company's ability to grow sales. However, the
Company believes that unless and until the FDA chooses option (iii) or (iv), the
Company will be able to continue manufacturing and distributing its current
product lines.
If the FDA chooses option (iii) or (iv), such action could significantly
impair the Company's ability to continue to manufacture and distribute its
current product line and generate cash from its operations, could result in a
covenant violation under the Company's senior debt or could cause the Company's
senior lenders to refuse further extensions of the Company's senior debt, any or
all of which would have a material adverse effect on the Company's liquidity.
Any monetary penalty assessed by the FDA also could have a material adverse
effect on the Company's liquidity. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operation -- Financial Condition
and Liquidity".
On March 6, 2002, the Company received a letter from the United States
Attorney's Office, Central District of Illinois, Springfield, Illinois, advising
the Company that the DEA had referred a matter to that office for a possible
civil legal action for alleged violations of the Comprehensive Drug Abuse
Prevention Control Act of 1970, 21 U.S.C. sec. 801, et. seq. and regulations
promulgated under the Act. The alleged
11
violations relate to record keeping and controls surrounding the storage and
distribution of controlled substances. On November 6, 2002, the Company entered
into a Civil Consent Decree with the DEA. Under terms of the Consent Decree, the
Company, without admitting any of the allegations in the complaint from the DEA,
has agreed to pay a fine of $100,000, upgrade its security system and to remain
in substantial compliance with the Comprehensive Drug Abuse Prevention Control
Act of 1970. If the Company does not remain in substantial compliance during the
two-year period following the entry of the civil consent decree, the Company, in
addition to other possible sanctions, may be held in contempt of court and
ordered to pay an additional $300,000 fine.
On August 9, 2001, the Company was served with a Complaint, which had been
filed on August 8, 2001 in the United States District Court for The Northern
District of Illinois, Eastern Division. The suit named the Company as well as
Mr. Floyd Benjamin, the former president and chief executive officer of the
Company, and Dr. John N. Kapoor, the Company's current chairman of the board and
then interim chief executive officer as defendants. The suit, which was filed by
Michelle Golumbski, individually, and on behalf of all others similarly
situated, alleged various violations of the federal securities laws in
connection with the Company's public statements and filings with the SEC during
the period from February 20, 2001 through May 22, 2001. The plaintiff
subsequently voluntarily dismissed her claims against Akorn, Inc., Mr. Floyd
Benjamin and Dr. John N. Kapoor, and, in exchange for the Company's consent to
this voluntary dismissal, also provided, through counsel, a written statement
that the plaintiff would not reassert her claims against any of the defendants
in any subsequent actions. The Company did not provide the plaintiff with any
compensation in consideration for this voluntary dismissal.
On April 4, 2001, the International Court of Arbitration (the "ICA") of the
International Chamber of Commerce notified the Company that Novadaq had filed a
Request for Arbitration with the ICA on April 2, 2001. Akorn and Novadaq had
previously entered into an Exclusive Cross-Marketing Agreement dated July 12,
2000 (the "Agreement"), providing for their joint development and marketing of
certain devices and procedures for use in fluorescein angiography (the
"Products"). Akorn's drug indocyanine green ("ICG") would be used as part of the
angiographic procedure. The FDA had requested that the parties undertake
clinical studies prior to obtaining FDA approval. In its Request for
Arbitration, Novadaq asserted that under the terms of the Agreement, Akorn
should be responsible for the costs of performing the requested clinical trials,
which were estimated to cost approximately $4,400,000. Alternatively, Novadaq
sought a declaration that the Agreement should be terminated as a result of
Akorn's alleged breach. Finally, in either event, Novadaq sought unspecified
damages as a result of the alleged failure or delay on Akorn's part in
performing its obligations under the Agreement. In its response, Akorn denied
Novadaq's allegations and alleged that Novadaq had breached the agreement. On
January 25, 2002, the Company and Novadaq reached a settlement of the dispute.
Under terms of a revised agreement entered into as part of the settlement,
Novadaq will assume all further costs associated with development of the
technology. The Company, in consideration of foregoing any share of future net
profits, obtained an equity ownership interest in Novadaq, the right to be the
exclusive supplier of ICG for use in Novadaq's diagnostic procedures and the
right to designate a representative on the Novadaq Board of Directors. In
addition, Antonio R. Pera, Akorn's then President and Chief Operating Officer,
was named to Novadaq's Board of Directors. In conjunction with the revised
agreement, Novadaq and the Company each withdrew their respective arbitration
proceedings. Subsequent to the resignation of Mr. Pera on June 7, 2002, the
Company named Ben J. Pothast, its Chief Financial Officer, to fill the vacancy
on the Novadaq Board of Directors created by his departure.
On December 19, 2002 and January 22, 2003, the Company received demand
letters regarding claimed wrongful deaths allegedly associated with the use of
the drug Inapsine, which the Company produced. The total amount of the claims
asserted is $3.8 million. The Company has just begun the investigation of the
facts and circumstances surrounding these claims and cannot as of yet determine
the potential liability, if any, from these claims. The Company has submitted
these claims to its product liability insurance carrier. The Company intends to
vigorously defend itself in regards to these claims.
12
The Company is a party to legal proceedings and potential claims arising in
the ordinary course of its business. The amount, if any, of ultimate liability
with respect to such matters cannot be determined. Despite the inherent
uncertainties of litigation, management of the Company at this time does not
believe that such proceedings will have a material adverse impact on the
financial condition, results of operations, or cash flows of the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the quarter
ended December 31, 2002.
13
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock was traded on the NASDAQ National Market under
the symbol AKRN until June 24, 2002. The Company was notified on that day that,
due to non-compliance with the NASDAQ report filing requirements, the Company's
stock would cease being listed effective the opening of business on June 25,
2002. The non-compliance related to the Company's Form 10-K filing with the SEC
for the year ended December 31, 2001 that contained unaudited financial
statements. Subsequently, the Company's stock has traded in the Over-the-Counter
market and is listed on the Pink Sheets under the symbol AKRN.PK.
On April 28, 2003, there were approximately 609 holders of record of the
Company's Common Stock. This number does not include shareholders for which
shares are held in a 'nominee' or 'street' name. The closing price of the
Company's Common Stock on April 28, 2003 was $0.50 per share.
High and low bid prices for the periods indicated were:
<Table>
<Caption>
HIGH LOW
----- -----
Year Ended December 31, 2002:
1st Quarter............................................... $4.00 $3.31
2nd Quarter............................................... 3.73 0.60
3rd Quarter............................................... 1.60 0.60
4th Quarter............................................... 1.50 0.60
Year Ended December 31, 2001:
1st Quarter............................................... $6.25 $1.97
2nd Quarter............................................... 3.25 1.03
3rd Quarter............................................... 4.23 2.79
4th Quarter............................................... 4.74 2.76
</Table>
The Company did not pay cash dividends in 2002, 2001 or 2000 and does not
expect to pay dividends on our common stock in the foreseeable future. Moreover,
the Company is currently prohibited by its credit agreement from making any
dividend payment.
14
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected consolidated financial information
for the Company for the years ended December 31, 2002, 2001, 2000, 1999 and
1998.
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
---------------------------------------------------
2002 2001 2000 1999 1998
-------- -------- -------- ------- --------
INCOME DATA (000's)
Revenues................................. $ 51,419 $ 41,545 $ 66,221 $64,632 $ 56,667
Gross profit............................. 20,537 6,398 28,131 33,477 29,060
Operating income (loss).................. (3,565) (21,074) (1,731) 12,122 9,444
Interest expense......................... (3,150) (3,768) (2,400) (1,921) (1,451)
Pretax income (loss)..................... (6,713) (24,926) (4,014) 10,639 7,686
Income tax provision (benefit)........... 6,239 (9,780) (1,600) 3,969 3,039
Net income (loss)........................ (12,952) (15,146) (2,414) 6,670 4,647
Weighted average shares outstanding:
Basic.................................. 19,589 19,337 19,030 18,269 17,891
Diluted................................ 19,589 19,337 19,030 18,573 18,766
PER SHARE
Equity................................... $ 0.58 $ 1.23 $ 1.85 $ 1.85 $ 1.40
Net income:
Basic.................................. $ (0.66) $ (0.78) $ (0.13) $ 0.37 $ 0.26
Diluted................................ $ (0.66) $ (0.78) $ (0.13) $ 0.36 $ 0.25
Price: High.............................. $ 4.00 $ 6.44 $ 13.63 $ 5.56 $ 9.19
Low................................ $ 0.60 $ 1.03 $ 3.50 $ 3.50 $ 2.54
BALANCE SHEET (000's)
Current assets........................... $ 13,239 $ 28,580 $ 37,522 $35,851 $ 24,948
Net fixed assets......................... 35,314 33,518 34,031 20,812 15,860
Total assets............................. 63,538 84,546 91,917 76,098 61,416
Current liabilities...................... 43,803 52,937 15,768 9,693 13,908
Long-term obligations.................... 8,383 7,779 40,918 32,015 21,228
Shareholders' equity..................... 11,352 23,830 35,231 34,390 26,280
CASH FLOW DATA (000's)
From operations.......................... $ 9,359 $ (444) $ 362 $ 131 $ 1,093
Dividends paid........................... -- -- -- -- --
From investing........................... (5,315) (4,126) (17,688) (6,233) (13,668)
From financing........................... (9,035) 9,118 18,108 5,391 10,898
Change in cash and cash equivalents...... (4,991) 4,548 782 (711) (1,677)
</Table>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
The Company's revenues are derived from sales of diagnostic and therapeutic
pharmaceuticals by the ophthalmic segment, from sales of diagnostic and
therapeutic pharmaceuticals by the injectable segment, and from contract
services revenue. The following table sets forth the percentage relationships
that certain items
15
from the Company's Consolidated Statements of Income bear to revenues for the
years ended December 31, 2002, 2001 and 2000.
<Table>
<Caption>
YEARS ENDED
DECEMBER 31,
------------------
2002 2001 2000
---- ---- ----
Revenues
Ophthalmic................................................ 58% 41% 42%
Injectable................................................ 25 23 38
Contract Services......................................... 17 36 20
--- --- ---
Total revenues.............................................. 100 100 100
Gross profit................................................ 40 15 42
Selling, general and administrative expenses................ 41 45 24
Provision for bad debts..................................... -- 11 12
Amortization of intangibles................................. 3 4 2
Research and development expenses........................... 4 6 6
--- --- ---
Operating loss.............................................. (7) (51) (3)
Net loss.................................................... (25) (36) (4)
</Table>
CRITICAL ACCOUNTING POLICIES
REVENUE RECOGNITION
The Company recognizes revenue upon the shipment of goods or upon the
delivery of goods, depending on the sales terms. Revenue is recognized when all
obligations of the Company have been fulfilled and collection of the related
receivable is probable. The Company records a provision at the time of sale for
estimated chargebacks, rebates and product returns. Additionally, the Company
maintains an allowance for doubtful accounts and slow moving and obsolete
inventory. These provisions and allowances are analyzed and adjusted, if
necessary, at each balance sheet date.
ALLOWANCE FOR CHARGEBACKS AND REBATES
The Company maintains an allowance for chargebacks and rebates. These
allowances are reflected as a reduction of accounts receivable.
The Company enters contractual agreements with certain third parties such
as hospitals and group-purchasing organizations to sell certain products at
predetermined prices. The parties have elected to have these contracts
administered through wholesalers. When a wholesaler sells products to one of the
third parties that is subject to a contractual price agreement, the difference
between the price to the wholesaler and the price under contract is charged back
to the Company by the wholesaler. The Company tracks sales and submitted
chargebacks by product number for each wholesaler. Utilizing this information,
the Company estimates a chargeback percentage for each product. The Company
reduces gross sales and increases the chargeback allowance by the estimated
chargeback amount for each product sold to a wholesaler. The Company reduces the
chargeback allowance when it processes a request for a chargeback from a
wholesaler. Actual chargebacks processed can vary materially from period to
period.
Prior to March 31, 2001, the Company used historical trends and actual
experience to estimate its chargeback allowance. In May 2001, management
obtained wholesaler inventory reports as of March 31, 2001 to aid in performing
a detailed business review in an effort to better understand its current cash
flow constraints. The Company assessed the reasonableness of its chargeback
allowance by applying the product chargeback percentage based on historical
activity to the quantities of inventory on hand per the wholesaler inventory
reports. The Company had not previously obtained these reports due to the cost
of obtaining such reports and also due to the fact that the Company had not seen
any indication that its historical trends analysis was not reasonable.
Previously management believed that wholesalers maintained limited inventory
levels to balance maintaining available stock for a given product with the cost
of storing such inventory. Accordingly, management previously considered recent
sales activity in estimating wholesaler on-hand inventory levels for
16
the purpose of assessing the reasonableness of the allowance. However, the
reports of wholesaler inventory information suggested that the wholesalers had
greater levels of on-hand inventory than had previously been estimated and the
Company used this new information to enhance its methodology of estimating the
allowance.
Similarly, the Company maintains an allowance for rebates related to
contract and other programs with the wholesalers. The rebate allowance also
reduces gross sales and accounts receivable by the amount of the estimated
rebate amount when the Company sells its products to the wholesalers. The
Company uses historical trends and actual experience to estimate its rebate
allowances. At each balance sheet date, the Company evaluates the allowance
against actual rebates processed and such amount can vary materially from period
to period.
The recorded allowances reflect the Company's current estimate of the
future chargeback and rebate liability to be paid or credited to the wholesaler
under the various contracts and programs. For the years ended December 31, 2002,
2001 and 2000, the Company recorded chargeback and rebate expense of
$15,418,000, $28,655,000, and $29,558,000, respectively. The allowance for
chargebacks and rebates was $4,302,000 and $4,190,000 as of December 31, 2002
and 2001, respectively.
Based upon the wholesaler's March 31, 2001 inventories and historical
chargeback and rebate activity, the Company recorded an allowance of $6,961,000,
which resulted in an expense of $12,000,000 for the three months ended March 31,
2001, as compared to an allowance of $3,296,000 recorded at December 31, 2000.
During the quarter ended June 30, 2001, the Company further refined its
estimates of the chargeback and rebate liability determining that an additional
$2,250,000 provision needed to be recorded. The additional increase to the
allowance was necessary to reflect the continuing shift of sales to customers
who purchase their products through group purchasing organizations and buying
groups. The Company had previously seen a greater level of list price business
than is occurring in the current business environment.
ALLOWANCE FOR PRODUCT RETURNS
The Company also maintains an allowance for estimated product returns. This
allowance is reflected as a reduction of accounts receivable balances. The
Company evaluates the allowance balance against actual returns processed. Actual
returns processed can vary materially from period to period. For the years ended
December 31, 2002, 2001, and 2000 the Company recorded a provision for product
returns of $2,574,000, $4,103,000, and $1,159,000, respectively. The allowance
for potential product returns was $1,166,000 and $548,000 at December 31, 2002
and 2001, respectively.
In addition to considering in process product returns and assessing the
potential implications of historical product return activity, the Company also
considers the wholesaler's inventory information to assess the magnitude of
unconsumed product that may result in a product return to the Company in the
future. Such wholesaler inventory information had not been historically
purchased and therefore, had not been considered in assessing the reasonableness
of the allowance prior to March 31, 2001. Historical returns had not been
significant. Based on the wholesaler's inventory information, which demonstrated
higher levels of on-hand product than previously estimated by management,
combined with increased levels of return activity, the Company increased its
allowance for potential product returns to $2,232,000 at March 31, 2001 from
$232,000 at December 31, 2000. The provision for the three months ended March
31, 2001 was $2,559,000.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
The Company maintains an allowance for doubtful accounts, which reflects
trade receivable balances owed to the Company that are believed to be
uncollectible. This allowance is reflected as a reduction of accounts receivable
balances. In estimating the allowance for doubtful accounts, the Company has:
- Identified the relevant factors that might affect the accounting
estimate for allowance for doubtful accounts, including: (a) historical
experience with collections and write-offs; (b) credit quality of
customers; (c) the interaction of credits being taken for discounts,
rebates, allowances and other adjustments; (d) balances of outstanding
receivables, and partially paid receivables; and
17
(e) economic and other exogenous factors that might affect
collectibility (e.g., bankruptcies of customers, "channel" factors,
etc.).
- Accumulated data on which to base the estimate for allowance for
doubtful accounts, including: (a) collections and write-offs data; (b)
information regarding current credit quality of customers; and (c)
information regarding exogenous factors, particularly in respect of
major customers.
- Developed assumptions reflecting management's judgments as to the most
likely circumstances and outcomes, regarding, among other matters: (a)
collectibility of outstanding balances relating to "partial payments;"
(b) the ability to collect items in dispute (or subject to
reconciliation) with customers; and (c) economic and other exogenous
factors that might affect collectibility of outstanding
balances -- based upon information available at the time.
For the years ended December 31, 2002, 2001 and 2000, the Company recorded
a provision (recovery) for doubtful accounts of ($55,000), $4,480,000, and
$8,127,000, respectively. The allowance for doubtful accounts was $1,200,000 and
$3,706,000 as of December 31, 2002 and 2001, respectively. As of December 31,
2002, the Company had a total of $2,592,000 of past due gross accounts
receivable, of which $674,000 was over 60 days past due. The Company performs
monthly a detailed analysis of the receivables due from its wholesaler customers
and provides a specific reserve against known uncollectible items for each of
the wholesaler customers. The Company also includes in the allowance for
doubtful accounts an amount that it estimates to be uncollectible for all other
customers based on a percentage of the past due receivables. The percentage
reserved increases as the age of the receivables increases. Of the recorded
allowance for doubtful accounts of $1,200,000, the portion related to the
wholesaler customers is $822,000 with the remaining $378,000 reserve for all
other customers.
ALLOWANCE FOR DISCOUNTS
The Company maintains an allowance for discounts, which reflects discounts
available to certain customers based on agreed upon terms of sale. This
allowance is reflected as a reduction of accounts receivable. The Company
evaluates the allowance balance against actual discounts taken. For the years
ended December 31, 2002 and 2001, the Company recorded a provision for discounts
of $1,014,000 and $886,000, respectively. Prior to 2001, the Company did not
grant discounts. The allowance for discounts was $172,000 and $143,000 as of
December 31, 2002 and 2001, respectively.
ALLOWANCE FOR SLOW-MOVING INVENTORY
The Company maintains an allowance for slow-moving and obsolete inventory
based upon recent sales activity by unit and wholesaler inventory information.
The Company estimates the amount of inventory that may not be sold prior to its
expiration. In 2001, upon obtaining the wholesaler's inventory reports, the
Company learned that the wholesalers had greater levels of on-hand inventory
than had been previously estimated. This provided the Company with greater
insight as to the potentially lower buying patterns of the wholesalers than had
been previously forecasted and contemplated in estimating the levels of
inventory in assessing the adequacy of the allowance. For the years ended
December 31, 2002, 2001 and 2000, the Company recorded a provision for inventory
obsolescence of $838,000, $1,830,000, and $3,983,000, respectively. The
allowance for inventory obsolescence was $1,206,000 and $1,845,000 as of
December 31, 2002 and 2001, respectively.
INCOME TAXES
The Company files a consolidated federal income tax return with its
subsidiary. Deferred income taxes are provided in the financial statements to
account for the tax effects of temporary differences resulting from reporting
revenues and expenses for income tax purposes in periods different from those
used for financial reporting purposes. The Company records a valuation allowance
to reduce the deferred tax assets to the amount that is more likely than not to
be realized. In performing its analysis of whether a valuation allowance to
reduce the deferred tax asset was necessary, the Company considered both
negative and positive evidence. Based upon this analysis, the negative evidence
outweighed the positive evidence in determining the amount of
18
the deferred tax assets that is more likely than not to be realized. Based upon
its analysis, beginning with the September 30, 2002 deferred tax assets, the
Company has established a valuation allowance to reduce the deferred tax assets
to zero. The expense of $9.2 million related to establishing the deferred tax
assets valuation allowance has been recorded in the income tax provision
(benefit).
INTANGIBLES
Intangibles consist primarily of product licensing and other such costs
that are capitalized and amortized on the straight-line method over the lives of
the related license periods or the estimated life of the acquired product, which
range from 17 months to 18 years. Accumulated amortization at December 31, 2002
and 2001 was $8,543,000 and $7,132,000, respectively. The Company annually
assesses the impairment of intangibles based on several factors, including
estimated fair market value and anticipated cash flows. On July 3, 2002, the
Company settled a License Agreement dispute with JHU/APL (See Note
M-"Commitments and Contingencies" to the consolidated financial statements in
Item 8) on two licensed patents. As a result of the resolved dispute, the
Company recorded an asset impairment charge of $1,559,500 in the second quarter
of 2002, representing the net value of the asset recorded on the balance sheet
of the Company less the $300,000 payment abated by JHU/APL and the $125,000
payment received from JHU/APL.
During the third quarter of 2002, the Company recorded an impairment charge
of $257,000 related to the product license intangible assets for the products
Sublimaze, Inapsine, Paradrine and Dry Eye test. The Company determined that
projected profitability on the products was not sufficient to support the
carrying value of the intangible asset. The recording of this charge reduced the
carrying value of the intangible assets related to these product licenses to
zero. These charges are reflected in the selling, general and administrative
expense category of the consolidated statement of operations. See Note
Q -- "Asset Impairment Charges" to the consolidated financial statements in Item
8.
COMPARISON OF TWELVE MONTHS ENDED DECEMBER 31, 2002 AND 2001
Consolidated revenues increased 23.8% for the year ended December 31, 2002
compared to the prior year. Results for 2002 exclude shipments made at or near
the end of the year for which shipping terms are FOB destination and,
accordingly, revenue is not recognized until delivery occurs. The revenue
related to these shipments recognized in the first quarter of 2003 was $601,000.
Prior year revenues reflect virtually all shipments to customers as virtually
all sales terms were FOB shipping point. See Note A -- "Summary of Significant
Accounting Policies" to the consolidated financial statements included in Item
8.
Ophthalmic segment revenues increased 74.7%, primarily reflecting lower
charges related to chargebacks and returns in 2002 (See Note A -- "Summary of
Significant Accounting Policies" to the consolidated financial statements
included in Item 8.) as compared to 2001, and, to a lesser extent, increased
angiography and ointment product sales. The 2002 sales mix reflects the
Company's shift in sales and marketing efforts within the Ophthalmic segment to
those key product lines that generate higher margins. Injectable revenues
increased 34.3% compared to the same period in 2001 primarily due to the lower
level of chargebacks and returns and a 52% increase in anesthesia and antidote
product sales in 2002. The Company believes the 2002 Ophthalmic and Injectable
revenues are sustainable for 2003. Contract Services revenues decreased 40.7%
compared to the same period in 2001 due mainly to customer concerns about the
status of the ongoing FDA issues at the Company's Decatur facility. The Company
anticipates that revenues from the Contract Services segment will continue to
lag historical levels and that Opthalmic and Injectable segment revenues are not
likely to grow until the issues surrounding the FDA review are resolved.
Consolidated gross margin increased to 39.9% from 15.4% for the prior year
due primarily to the aforementioned increase in revenues in 2002 as compared to
2001, as well as an increase in the reserve for slow-moving, unsaleable and
obsolete inventory items recorded in 2001. See Note E -- "Inventory" to the
consolidated financial statements in Item 8. Improvements in gross margin also
resulted from the Company's continued focus on shifting the product mix to
higher gross margin products in the angiography, antidote and ointment product
lines.
19
Selling, general and administrative ("SG&A") expenses increased 10.4% for
the year as compared to 2001. This is due to a $1,559,500 impairment charge
related to the JHU/APL settlement (See Note M -- "Commitments and Contingencies"
to the consolidated financial statements included in Item 8), a $545,000 asset
impairment charge related to abandoned construction projects, a $257,000
intangible asset charge and higher legal and marketing expenditures in 2002.
SG&A expenses in 2001 included $1,117,000 of restructuring-related charges
consisting primarily of severance and lease costs.
The provision for bad debt decreased from $4,480,000 in 2001 to a $55,000
recovery in 2002. The decrease is primarily related to the Company's increased
efforts to collect past due receivables. As a result of the Company's continued
collection efforts, the Company does not expect the provision for bad debts to
be material in 2003.
Amortization of intangibles decreased from $1,493,000 to $1,411,000, or
5.5% over the comparable period in the prior year, reflecting the exhaustion of
amortization for certain product intangibles due to the write-off of intangibles
which were determined to have been impaired in 2002, offset in part by inception
of the intangible amortization related to the product launch of Paremyd.
Research and development ("R&D") expense decreased 27.4% for the year
reflecting the Company's scaled back research activities to preserve capital and
to focus on strategic product niches such as controlled substances and
ophthalmic products which it believes will add greater value. The lower level of
R&D in 2002 also reflects the Company's refocusing of resources away from R&D to
resolve issues in the FDA's Form 483 notification.
Interest expense of $3,150,000 was 16.4% lower than the $3,768,000 recorded
in 2001, due to a lower debt balance and lower interest rates in 2002.
An income tax provision of $6,239,000 was recorded for 2002, compared to an
income tax benefit of $9,780,000 recorded in 2001. The 2002 income tax provision
primarily relates to the valuation allowance of $9,216,000 recorded during 2002.
In performing its analysis of whether a valuation allowance to reduce the
deferred tax asset was necessary, the Company considered both negative and
positive evidence, which could be objectively verified. Based upon this
analysis, the negative evidence, primarily the three consecutive years of
operating losses, outweighed the positive evidence in determining the amount of
the deferred tax assets that is more likely than not to be realized. Based upon
its analysis, beginning with the September 30, 2002 deferred tax assets, the
Company established a valuation allowance to reduce the deferred tax assets to
zero.
Net loss for 2002 was $12,952,000, or $0.66 per share, compared to a net
loss of $15,146,000, or $0.78 per share, for the prior year. The improvement in
revenue and gross profit was offset by the increase in the provision for income
taxes reflecting the reduction of deferred tax credits to zero.
COMPARISON OF TWELVE MONTHS ENDED DECEMBER 31, 2001 AND 2000
Consolidated revenues decreased 37.3% for the year ended December 31, 2001
compared to the prior year. Ophthalmic segment revenues decreased 38.9%,
primarily reflecting the decline in sales in the antibiotic, glaucoma and
artificial tear product lines. The remaining decline in ophthalmic revenues
reflects the effect of increases to the allowance for chargebacks and rebates
and returns discussed above. Ophthalmic revenues were also negatively impacted
by price competition for some of the Company's higher volume product lines. The
reduction in revenues was due to both declines in unit price as well as volume.
Injectable segment revenues decreased 61.3%, primarily due to the increases in
the allowances for chargebacks, rebates and returns and a 35% reduction in
anesthesia and antidote product sales. The sharp reduction is attributable to
excessive wholesaler inventories that were reduced during the year without
compensating purchases made by the wholesalers. Contract services revenues
increased 10.6% compared to the same period in 2000, primarily due to price
increases necessary to cover increasing production costs.
Consolidated gross profit decreased 77.3% for the year, with gross margins
decreasing from 42.5% to 15.4%. This reflects the effects of the aforementioned
decline in revenues, as well as an increase in the reserve for slow-moving,
unsaleable and obsolete inventory items. In addition, the Company incurred
unfavorable manufacturing variances at the Somerset, New Jersey facility and its
Decatur, Illinois facility, which eroded
20
the gross margin percentage. These variances were the result of reduced activity
in the plant, primarily caused by the previously discussed reduction in sales
that resulted from the wholesaler inventories being reduced without compensating
purchases.
SG&A expenses increased 17.5% for the year as compared to 2000, primarily,
due to asset impairment charges related to discontinued products of $2,132,000
and restructuring-related charges of $1,117,000 consisting primarily of
severance and lease costs.
The provision for bad debt decreased by 45.1% compared to 2000. The
decrease is primarily related to the Company's increased efforts to collect past
due receivables.
Amortization of intangibles decreased 1.6% for the year, reflecting the
exhaustion of certain product intangibles.
R&D expenses decreased 37.1%, primarily reflecting a scaling back of
research and development activities.
Interest expense increased 57.0% compared to 2000, reflecting higher
interest rates on higher average outstanding debt balances and amortization
related to the convertible debt issued during the year (See Note G -- "Financing
Arrangements" to the consolidated financial statements included in Item 8)
partially offset by capitalized interest related to the lyophilized
pharmaceuticals manufacturing line expansion.
Income tax benefit of $9,780,000 was recorded for the year compared to an
income tax benefit of $1,600,000 recorded in 2000 reflecting a greater level of
operating losses. The effective tax rate for the year was 39.5% compared to an
effective tax rate in 2000 of 39.9%.
Net loss for 2001 was $15,146,000, or $0.78 per share, compared to net loss
of $2,414,000, or $0.13 per share, for the prior year. The decrease in earnings
resulted from the aforementioned items.
FINANCIAL CONDITION AND LIQUIDITY
Overview
The Company has experienced losses from operations in 2002 and 2001 of $3.6
million and $21.2 million, respectively. The Company also recorded an operating
loss of $1.7 million in 2000.
As of December 31, 2002, the Company had cash and cash equivalents of
$364,000. The net working capital deficiency at December 31, 2002 was
$30,564,000 versus $24,359,000 at December 31, 2001, resulting primarily from a
decrease in the deferred tax assets from 2001 as a result of the valuation
allowance as described above. The negative working capital position reflects the
classification of the Company's senior debt obligation as a current liability,
the balance of which decreased from $45,072,000 at December 31, 2001 to
$35,859,000 as of December 31, 2002.
During the year ended December 31, 2002, the Company generated $9,359,000
in cash from operations, primarily from receivable collection efforts and the
collection of income tax refunds due to the Company. Investing activities, which
include the purchase of equipment required $5,315,000 in cash and included
$2,758,000 related to the lyophilized (freeze-dried) pharmaceuticals
manufacturing line expansion. Financing activities used $9,035,000 in cash
primarily for reduction of the outstanding senior bank debt.
The accompanying financial statements have been prepared on a going concern
basis, which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business. Accordingly, the financial
statements do not include any adjustments relating to the recoverability and
classification of recorded asset amounts or the amounts and classification of
liabilities that might be necessary should the Company be unable to continue as
a going concern.
As described more fully herein, the Company has had three consecutive years
of operating losses, is in default under its existing credit agreement and is a
party to governmental proceedings and potential claims by the FDA that could
have a material adverse effect on the Company. Although the Company has entered
into a Forbearance Agreement (as defined below) with its senior lenders and
obtained extensions thereof through
21
June 30, 2003, is working with the FDA to favorably resolve such proceedings,
has appointed a new interim chief executive officer and implemented other
management changes and has taken additional steps to return to profitability,
there is substantial doubt about the Company's ability to continue as a going
concern. The Company's ability to continue as a going concern is dependent upon
its ability to (i) continue to finance it current cash needs, (ii) continue to
obtain extensions of the Forbearance Agreement, (iii) successfully resolve the
ongoing governmental proceeding with the FDA and (iv) ultimately refinance its
senior bank debt and obtain new financing for future operations and capital
expenditures. If it is unable to do so, it may be required to seek protection
from its creditors under the federal bankruptcy code.
While there can be no guarantee that the Company will be able to continue
to finance its current cash needs, the Company generated positive cash flow from
operations in 2002. In addition, as of April 30, 2003, the Company had
approximately $400,000 in cash and equivalents and approximately $1.4 million of
undrawn availability under the second line of credit described below.
There also can be no guarantee that the Company will successfully resolve
the ongoing governmental proceedings with the FDA. However, the Company has
submitted to the FDA and begun to implement a plan for comprehensive corrective
actions at its Decatur, Illinois facility.
Moreover, there can be no guarantee that the Company will be successful in
obtaining further extensions of the Forbearance Agreement or in refinancing the
senior debt and obtaining new financing for future operations. However, the
Company is current on its interest payment obligations to its senior lenders,
management believes that the Company has a good relationship with its senior
lenders and, as required, the Company has retained a consulting firm, submitted
a restructuring plan and engaged an investment banker to assist in raising
additional financing and explore other strategic alternatives for repaying the
senior bank debt. The Company has also added key management personnel, including
the appointment of a new interim chief executive officer, and additional
personnel in critical areas, such as quality assurance. Management has reduced
the Company's cost structure, improved the Company's processes and systems and
implemented strict controls over capital spending. Management believes these
activities have improved the Company's profitability and cash flow from
operations and improved its prospects for refinancing its senior debt and
obtaining additional financing for future operations.
As a result of all of the factors cited in the preceding three paragraphs,
management believes that the Company should be able to sustain its operations
and continue as a going concern. However, the ultimate outcome of this
uncertainty cannot be presently determined and, accordingly, there remains
substantial doubt as to whether the Company will be able to continue as a going
concern. Further, even if the Company's efforts to raise additional financing
and explore other strategic alternatives result in a transaction that repays the
senior bank debt, there can be no assurance that the current common stock will
have any value following such a transaction. In particular, if any new financing
is obtained, it likely will require the granting of rights, preferences or
privileges senior to those of the common stock and result in substantial
dilution of the existing ownership interests of the common stockholders.
The Credit Agreement
In 1997, the Company entered into a $15 million revolving credit
arrangement with The Northern Trust Company, increased to $25 million in 1998,
and subsequently increased to $45 million in 1999, subject to certain financial
covenants and secured by substantially all of the assets of the Company. This
credit agreement, as amended effective January 1, 2002 (the "Credit Agreement"),
requires the Company to maintain certain financial covenants. These covenants
include minimum levels of cash receipts, limitations on capital expenditures, a
$750,000 per quarter limitation on product returns and required amortization of
the loan principal. The agreement also prohibits the Company from declaring any
cash dividends on its common stock and identifies certain conditions in which
the principal and interest on the Credit Agreement would become immediately due
and payable. These conditions include: (a) an action by the FDA which results in
a partial or total suspension of production or shipment of products, (b) failure
to invite the FDA in for re-inspection of the Decatur manufacturing facilities
by June 1, 2002, (c) failure to make a written response, within 10 days, to the
FDA, with a copy to the lender, to any written communication received from the
FDA
22
after January 1, 2002 that raises any deficiencies, (d) imposition of fines
against the Company in an aggregate amount greater than $250,000, (e) a
cessation in public trading of the Company's stock other than a cessation of
trading generally in the United States securities market, (f) restatement of or
adjustment to the operating results of the Company in an amount greater than
$27,000,000, (g) failure to enter into an engagement letter with an investment
banker for the underwriting of an offering of equity securities by June 15,
2002, (h) failure to not be party to such an engagement letter at any time after
June 15, 2002 or (i) experiencing any material adverse action taken by the FDA,
the SEC, the DEA or any other governmental authority based on an alleged failure
to comply with laws or regulations. The amended Credit Agreement required a
minimum payment of $5.6 million, which relates to an estimated federal tax
refund, with the balance of $39.2 million due June 30, 2002. The Company
remitted the $5.6 million payment on May 8, 2002. The Company is also obligated
to remit any additional federal tax refunds received above the estimated $5.6
million.
The Company's senior lenders agreed to extend the Credit Agreement to July
31, 2002 and then again to August 31, 2002. These two extensions contain the
same covenants and reporting requirements except that the Company is not
required to comply with conditions (g) and (h) above which relate to the
offering of equity securities. In both instances, the balance of $39.2 million
was due at the end of the extension term.
On September 16, 2002, the Company was notified by its senior lenders that
it was in default due to failure to pay the principal and interest owed as of
August 31, 2002 under the then most recent extension of the Credit Agreement.
The senior lenders also notified the Company that they would forbear from
exercising their remedies under the Credit Agreement until January 3, 2003 if a
forbearance agreement could be reached. On September 20, 2002, the Company and
its senior lenders entered into an agreement under which the senior lenders
would agree to forbear from exercising their remedies (the "Forbearance
Agreement") and the Company acknowledged its current default. The Forbearance
Agreement provides a second line of credit allowing the Company to borrow the
lesser of (i) the difference between the Company's outstanding indebtedness to
the senior lenders and $39,200,000, (ii) the Company's borrowing base and (iii)
$1,750,000, to fund the Company's day-to-day operations. The Forbearance
Agreement requires that, except for then-existing defaults, the Company continue
to comply with all of the covenants in its Credit Agreement and provides for
certain additional restrictions on operations and additional reporting
requirements. The Forbearance Agreement also requires automatic application of
cash from the Company's operations to repay borrowings under the new revolving
loan, and to reduce the Company's other obligations to the senior lenders. In
the event that the Company is not in compliance with the continuing covenants
under the Credit Agreement and does not negotiate amended covenants or obtain a
waiver thereof, then the senior lenders, at their option, may demand immediate
payment of all outstanding amounts due and exercise any and all available
remedies, including, but not limited to, foreclosure on the Company's assets.
This could result in the Company seeking protection from its creditors and a
reorganization under the federal bankruptcy code.
The Company, as required in the Forbearance Agreement, agreed to provide
the senior lenders with a plan for restructuring its financial obligations on or
before December 1, 2002 and agreed to retain a consulting firm by September 27,
2002, and, in furtherance of that commitment, on September 26, 2002, the Company
entered into an agreement (the "Consulting Agreement") with a consulting firm
(AEG Partners, LLC (the "Consultant")) whereby the Consultant would assist in
the development and execution of this restructuring plan and provide oversight
and direction to the Company's day-to-day operations. On November 18, 2002, the
Consultant notified the Company of its intent to resign from the engagement
effective December 2, 2002, based upon the Company's alleged failure to
cooperate with the Consultant, in breach of the Consulting Agreement. The
Company's senior lenders, upon learning of the Consultant's action, notified the
Company by letter dated November 18, 2002, that, as a result of the Consultant's
resignation, the Company was in default under terms of the Forbearance Agreement
and the Credit Agreement and demanded payment of all outstanding principal and
interest on the loan. This notice was followed by a second letter dated November
19, 2002, in which the senior lenders gave notice of their exercise of certain
remedies available under the Credit Agreement including, but not limited to,
their setting off the Company's deposits with the senior lenders against the
Company's obligations to the senior lenders. The Company immediately entered
into discussions with the Consultant which led, on November 21, 2002, to the
Consultant rescinding its notification of
23
resignation and to the senior lenders withdrawing their demand for payment and
restoring the Company's accounts.
During the Company's discussions with the Consultant, the Company agreed to
establish a special committee of the Board (the "Corporate Governance
Committee") consisting of Directors Ellis and Bruhl, with Mr. Ellis serving as
Chairman. The Consultant will interface with the Corporate Governance Committee
regarding the Company's restructuring actions. The Company also agreed that the
Consultant will oversee the Company's interaction with all regulatory agencies
including, but not limited to, the FDA. In addition, the Company has agreed to a
"success fee" arrangement with the Consultant. Under terms of the arrangement,
if the Consultant is successful in obtaining an extension to January 1, 2004 or
later on the Company's senior debt, the Consultant will be paid a cash fee equal
to 1 1/2% of the amount of the senior debt which is refinanced or restructured.
Additionally, the success fee arrangement provides that the Company will issue
1,250,000 warrants to purchase common stock at an exercise price of $1.00 per
warrant share to the Consultant upon the date on which each of the following
conditions have been met or waived by the Company: (i) the Forbearance Agreement
shall have been terminated, (ii) the Consultant's engagement pursuant to the
Consulting Agreement shall have been terminated and (iii) the Company shall have
executed a new or restated multi-year credit facility. All unexercised warrants
shall expire on the fourth anniversary of the date of issuance.
As required by the Forbearance Agreement, a restructuring plan was
developed by the Company and the Consultant and presented to the Company's
senior lenders in December 2002. The restructuring plan requested that the
senior lenders convert the Company's senior debt to a term note that would
mature no earlier than February 2004 and increase the current line of credit
from $1.75 million to $3 million to fund operations and capital expenditures. In
light of the FDA's re-inspection of the Decatur facility in early December 2002,
the Company and the senior lenders agreed to defer further discussions of that
request until completion of the re-inspection and the Company's response
thereto. As a result, the senior lenders have agreed to successive short-term
extensions of the Forbearance Agreement, the latest of which is an eleventh
amendment to the Forbearance Agreement expiring on June 30, 2003. Following
completion of the FDA inspection of the Decatur facility on February 6, 2003 and
issuance of the FDA findings, the senior lenders have indicated that they are
not willing to convert the senior debt to a term loan but discussions continue
regarding a possible increase in the revolving line of credit. As required by
the Company's senior lenders, on May 9, 2003, the Company engaged Leerink Swann,
an investment banking firm, to assist in raising additional financing and
explore other strategic alternatives for repaying the senior bank debt. Subject
to the absence of any additional defaults and subject to the senior lenders'
satisfaction with the Company's progress in resolving the matters raised by the
FDA and in obtaining additional financing and exploring other strategic
alternatives, the Company expects to continue obtaining short-term extensions of
the Forbearance Agreement. However, there can be no assurances that the Company
will be successful in obtaining further extensions of the Forbearance Agreement
beyond June 30, 2003.
FDA Proceeding
As discussed above, the Company is also a party to a governmental
proceeding by the FDA (See Item 3. "Legal Proceedings"). While the Company is
cooperating with the FDA and seeking to resolve the pending matter, an
unfavorable outcome such proceeding may have a material impact on the Company's
operations and its financial condition, results of operations and/or cash flows
and, accordingly, may constitute a material adverse action that would result in
a covenant violation under the Credit Agreement or cause the Company's senior
lenders to refuse to further extend the forbearance agreement, any or all of
which could have a material adverse effect on the Company's Liquidity.
Facility Expansion
The Company is in the process of completing an expansion of its Decatur,
Illinois facility to add capacity to provide Lyophilization manufacturing
services, which manufacturing capability the Company currently does not have.
Subject to the Company's ability to refinance its senior debt and obtain new
financing for future operations and capital expenditures, the Company
anticipates the completion of the Lyophilization expansion in the second half of
2004. As of December 31, 2002, the Company had spent approximately $16.4 million
on
24
the expansion and anticipates the need to spend approximately $1.0 million of
additional funds (excluding capitalized interest) to complete the expansion. The
majority of the additional spending will be focused on validation testing of the
Lyophilization facility as the major capital equipment items are currently in
place. Once the Lyophilization facility is validated, the Company will proceed
to produce stability batches to provide the data necessary to allow the
Lyophilization facility to be inspected and approved by the FDA.
Subordinated Debt
On July 12, 2001 the Company entered into a $5,000,000 subordinated debt
transaction with the John N. Kapoor Trust dtd. 9/20/89 (the "Trust"), the sole
trustee and sole beneficiary of which is Dr. John N. Kapoor, the Company's
Chairman of the Board of Directors. The transaction is evidenced by a
Convertible Bridge Loan and Warrant Agreement (the "Trust Agreement") in which
the Trust agreed to provide two separate tranches of funding in the amounts of
$3,000,000 ("Tranche A" which was received on July 13, 2001) and $2,000,000
("Tranche B" which was received on August 16, 2001). As part of the
consideration provided to the Trust for the subordinated debt, the Company
issued the Trust two warrants which allow the Trust to purchase 1,000,000 shares
of common stock at a price of $2.85 per share and another 667,000 shares of
common stock at a price of $2.25 per share. The exercise price for each warrant
represented a 25% premium over the share price at the time of the Trust's
commitment to provide the subordinated debt. All unexercised warrants expire on
December 20, 2006.
Under the terms of the Trust Agreement, the subordinated debt bears
interest at prime plus 3%, which is the same rate the Company pays on its senior
debt. Interest cannot be paid to the Trust until the repayment of the senior
debt pursuant to the terms of a subordination agreement, which was entered into
between the Trust and the Company's senior lenders. Should the subordination
agreement be terminated, interest may be paid sooner. The convertible feature of
the Trust Agreement, as amended, allows for conversion of the subordinated debt
plus interest into common stock of the Company, at a price of $2.28 per share of
common stock for Tranche A and $1.80 per share of common stock for Tranche B.
The Company, in accordance with Accounting Principles Board ("APB") Opinion
No. 14, recorded the subordinated debt transaction such that the convertible
debt and warrants have been assigned independent values. The fair value of the
warrants was estimated on the date of grant using the Black-Scholes option
pricing model with the following assumptions: (i) dividend yield of 0%, (ii)
expected volatility of 79%, (iii) risk free rate of 4.75%, and (iv) expected
life of 5 years. As a result, the Company assigned a value of $1,516,000 to the
warrants and recorded this amount as additional paid in capital. In accordance
with Emerging Issues Task Force Abstract 00-27, the Company has also computed
and recorded a value related to the "intrinsic" value of the convertible debt.
This calculation determines the value of the embedded conversion option within
the debt that has become beneficial to the owner as a result of the application
of APB Opinion No. 14. This value was determined to be $1,508,000 and was
recorded as additional paid in capital. The remaining $1,976,000 was recorded as
long-term debt. The resultant debt discount of $3,024,000, equivalent to the
value assigned to the warrants and the "intrinsic" value of the convertible
debt, is being amortized and charged to interest expense over the life of the
subordinated debt.
In December 2001, the Company entered into a $3,250,000 five-year loan with
NeoPharm, Inc. ("NeoPharm") to fund the Company's efforts to complete its
lyophilization facility located in Decatur, Illinois. Under the terms of the
Promissory Note, dated December 20, 2001, interest accrues at the initial rate
of 3.6% and will be reset quarterly based upon NeoPharm's average return on its
cash and readily tradable long and short-term securities during the previous
calendar quarter. The principal and accrued interest is due and payable on or
before maturity on December 20, 2006. The note provides that the Company will
use the proceeds of the loan solely to validate and complete the lyophilization
facility located in Decatur, Illinois and to address the issues set forth in the
Form 483 and warning letter received from the FDA. The Promissory Note is
subordinated to the Company's senior debt owed to The Northern Trust Company but
is senior to the Company's subordinated debt owed to the Trust. The note was
executed in conjunction with a Processing Agreement that provides NeoPharm, Inc.
with the option of securing at least 15% of the capacity of the Company's
lyophilization facility each year. Dr. John N. Kapoor, the Company's chairman is
also chairman of NeoPharm and holds a substantial stock position in NeoPharm as
well as in the Company.
25
Contemporaneous with the completion of the Promissory Note between the
Company and NeoPharm, the Company entered into an agreement with the Trust,
which amended the Trust Agreement. The amendment extended the Trust Agreement to
terminate concurrently with the Promissory Note on December 20, 2006. The
amendment also made it possible for the Trust to convert the interest accrued on
the $3,000,000 tranche into common stock of the Company. Previously, the Trust
could only convert the interest accrued on the $2,000,000 tranche. The terms of
the agreement to change the convertibility of the Tranche A interest and the
convertibility of the Tranche B interest for the extension of the term require
shareholder approval to be received by August 31, 2002, which was subsequently
extended to June 30, 2003. If the Company's shareholders do not approve these
changes, the Company would be in default under the Trust Agreement and, at the
option of the Trust, the Subordinated Debt could be accelerated and become due
and payable on June 30, 2003. Any default under the Trust Agreement would
constitute an event of default under both the Credit Agreement and the NeoPharm
Promissory Note. In the event of default amounts due under the Credit Agreement
and the NeoPharm Promissory Note could be declared to be due and payable,
notwithstanding the Forebearance Agreement which is presently in place between
the Company and its senior lender. The Company expects that it will reach
agreement with the Trust to extend, if necessary, the shareholder approval date
until the next shareholders meeting.
Other Indebtedness
In June 1998, the Company entered into a $3,000,000 mortgage agreement with
Standard Mortgage Investors, LLC of which there were outstanding borrowings of
$1,917,000 and $2,189,000 at December 31, 2002 and 2001, respectively. The
principal balance is payable over 10 years, with the final payment due in June
2007. The mortgage note bears an interest rate of 7.375% and is secured by the
real property located in Decatur, Illinois.
The fair value of the debt obligations approximated the recorded value as
of December 31, 2002. The promissory note between the Company and NeoPharm, Inc.
bears interest at a rate that is lower than the Company's current borrowing rate
with its senior lenders. Accordingly, the computed fair value of the debt, which
the Company estimates to be approximately $2,649,000, would be lower than the
current carrying value of $3,250,000.
CONTRACTUAL OBLIGATIONS
(In Thousands)
The following table details the Company's future contractual obligations
through 2008. The Company's ability to satisfy these obligations is primarily
dependent upon its ability to obtain additional financing or renegotiate its
current financing arrangement.
<Table>
<Caption>
DESCRIPTION TOTAL 2003 2004-5 2006-7 2008 +
- ----------- ------- ------- ------ ------- ------
Long Term Debt, including current maturities... $45,732 $35,859 $ 656 $ 9,010 $ 207
Short Term Debt................................ -- -- -- -- --
Capital Leases................................. -- -- -- -- --
Operating Leases............................... 9,070 1,524 2,948 2,856 1,742
Purchase Obligations........................... -- -- -- -- --
Other Long Term Liabilities.................... -- -- -- -- --
------- ------- ------ ------- ------
Total:....................................... $54,802 $37,023 $3,604 $11,866 $1,949
</Table>
26
SELECTED QUARTERLY DATA
In Thousands, Except Per Share Amounts
<Table>
<Caption>
NET INCOME (LOSS)
--------------------------------
GROSS PER SHARE PER SHARE
REVENUES PROFIT (LOSS) AMOUNT BASIC DILUTED
-------- ------------- -------- --------- ---------
Year Ended December 31, 2002:
1st Quarter............................ $13,443 $ 6,349 $ 151 $ 0.01 $ 0.01
2nd Quarter............................ 14,165 6,366 (783) (0.04) (0.04)
3rd Quarter............................ 12,121 4,456 (9,387) (0.48) (0.48)
4th Quarter............................ 11,690 3,366 (2,933) (0.15) (0.15)
------- ------- -------- ------ ------
Total............................... $51,419 $20,537 $(12,952) $(0.66) $(0.66)
Year Ended December 31, 2001:
1st Quarter............................ $ 5,834 $(6,025) $ (8,376) $(0.43) $(0.43)
2nd Quarter............................ 10,410 2,282 (6,275) (0.33) (0.33)
3rd Quarter............................ 12,692 4,863 (536) (0.03) (0.03)
4th Quarter............................ 12,609 5,278 41 0.00 0.00
------- ------- -------- ------ ------
Total............................... $41,545 $ 6,398 $(15,146) $(0.78) $(0.78)
======= ======= ======== ====== ======
</Table>
FACTORS THAT MAY AFFECT FUTURE RESULTS
Existing Credit Obligations
At December 31, 2002, the Company had total outstanding indebtedness of
$43,658,000, or 69% of total capitalization. This significant debt load limits
the Company's operating flexibility and imposes numerous restrictive covenants
on the Company by its senior lenders, thereby significantly reducing the ability
of the Company to acquire or develop new products, increase its sales force and
expand and improve its facilities. In addition, the Company is currently in
default in the payment of principal under its Credit Agreement and has failed to
comply with many of the financial and other covenants required by the Credit
Agreement. Although the Company has negotiated a Forbearance Agreement with the
senior lenders which has been extended most recently through June 30, 2003 and,
as required by the senior lenders, has retained a consultant, submitted a
restructuring plan and engaged an investment banker to consider strategic
alternatives, to continue operations the Company will be required to negotiate
further extensions of the Forbearance Agreement and ultimately refinance its
senior debt. There can be no guarantee that the Company will be successful in
obtaining such further forbearance extensions or senior debt refinancing to
allow it to continue as a going concern. See Item 7. -- "Management's Discussion
and Analysis -- Financial Condition and Liquidity".
Ability to Obtain Additional Funding for Operations
In addition to refinancing its senior debt, the Company may require
additional funds to operate and grow its business. The Company may seek
additional funds through public and private financing, including equity and debt
offerings. However, adequate funds through the financial markets or from other
sources may not be available when needed or on terms favorable to the Company or
its stockholders. In addition, because the Company's Common Stock was delisted
from the NASDAQ National Market on June 25, 2002 and currently trades in the
Over-the-Counter market Pink Sheets (See Item 5. -- "Market for Common Equity
and Related Stockholder Matters"), the Company may experience further difficulty
accessing the capital markets. Without sufficient additional funding, the
Company may be required to delay, scale back or abandon some or all of its
product development, manufacturing, acquisition, licensing and marketing
initiatives. Further, such additional financing, if obtained, likely will
require the granting of rights, preferences or privileges senior to those of the
common stock and result in substantial dilution of the existing ownership
interests of the common stockholders.
27
Government Regulation
Federal and state government agencies regulate virtually all aspects of the
Company's business. The development, testing, manufacturing, processing,
quality, safety, efficacy, packaging, labeling, record keeping, distribution,
storage and advertising of the Company's products, and disposal of waste
products arising from such activities, are subject to regulation by the FDA,
DEA, FTC, the Consumer Product Safety Commission, the Occupational Safety and
Health Administration and the Environmental Protection Agency. Similar state and
local agencies also have jurisdiction over these activities. Failure to comply
with applicable statutes and government regulations could have a material
adverse effect on the Company's business, financial condition and results of
operations. Because the Company's business involves the manufacture and
distribution of pharmaceutical products, the specific regulations of the FDA and
DEA that are applicable to the Company are discussed in more detail below.
New, modified and additional regulations, statutes or legal interpretation,
if any, could, among other things, require changes to manufacturing methods,
expanded or different labeling, the recall, replacement or discontinuation of
certain products, additional record keeping and expanded documentation of the
properties of certain products and scientific substantiation. Such changes or
new legislation could have a material adverse effect on the Company's business,
financial condition and results of operations.
FDA Regulations All pharmaceutical manufacturers, including the Company,
are subject to regulation by the FDA under the authority of the FDC Act. Under
the FDC Act, the federal government has extensive administrative and judicial
enforcement powers over the activities of pharmaceutical manufacturers to ensure
compliance with FDA regulations. Those powers include, but are not limited to,
the authority to initiate court action to seize unapproved or non-complying
products, to enjoin non-complying activities, to halt manufacturing operations
that are not in compliance with current good manufacturing practices ("cGMP"),
to recall products which present a health risk, and to seek civil monetary and
criminal penalties. Other enforcement activities include refusal to approve
product applications or the withdrawal of previously approved applications. Any
such enforcement activities, including the restriction or prohibition on sales
of products marketed by the Company or the halting of manufacturing operations
of the Company, could have a material adverse effect on the Company's business,
financial condition and results of operations. In addition, product recalls may
be issued at the discretion of the Company, the FDA or other government agencies
having regulatory authority for pharmaceutical product sales. Recalls may occur
due to disputed labeling claims, manufacturing issues, quality defects or other
reasons. No assurance can be given that restriction or prohibition on sales,
halting of manufacturing operations or recalls of the Company's pharmaceutical
products will not occur in the future. Any such actions could have a material
adverse effect on the Company's business, financial condition and results of
operations. Further, such actions, in certain circumstances, could constitute an
event of default under the Company's senior debt.
All "new drugs" must be the subject of an FDA-approved new drug application
("NDA") before they may be marketed in the United States. Certain prescription
drugs are not currently required to be the subject of an approved NDA but,
rather, may be marketed pursuant to an FDA regulatory enforcement policy
permitting continued marketing of those drugs until the FDA determines whether
they are safe and effective. All generic equivalents to previously approved
drugs or new dosage forms of existing drugs must be the subject of an
FDA-approved abbreviated new drug application ("ANDA") before they may be
marketed in the United States. The FDA has the authority to withdraw existing
NDA and ANDA approvals and to review the regulatory status of products marketed
under the enforcement policy. The FDA may require an approved NDA or ANDA for
any drug product marketed under the enforcement policy if new information
reveals questions about the drug's safety or efficacy. All drugs must be
manufactured in conformity with cGMP and drugs subject to an approved NDA or
ANDA must be manufactured, processed, packaged, held, and labeled in accordance
with information contained in the NDA or ANDA.
The Company and its third-party manufacturers are subject to periodic
inspection by the FDA to assure such compliance. The FDA imposes additional
stringent requirements on the manufacture of sterile pharmaceutical products to
ensure the sterilization processes and related control procedures consistently
produce a sterile product. Additional sterile manufacturing requirements include
the submission for expert
28
review of detailed documentation for sterilization process validation in drug
applications beyond those required for general manufacturing process validation.
Various sterilization process requirements are the subject of detailed FDA
guidelines, including requirements for the maintenance of microbiological
control and quality stability. Pharmaceutical products must be distributed,
sampled and promoted in accordance with FDA requirements. The FDA also regulates
drug labeling and the advertising of prescription drugs. A finding by a
governmental agency or court that the Company is not in compliance could have a
material adverse effect on the Company's business, financial condition and
results of operations.
The Company currently is a party to a governmental proceeding by the FDA
(See Item 3. -- "Legal Proceedings"). While the Company is cooperating with the
FDA and is seeking to resolve the pending matter, an unfavorable outcome in such
proceeding may have a material impact on the Company's operations and its
financial condition, results of operations and/or cash flows and, accordingly,
may constitute a material adverse action that would result in a covenant
violation under the Credit Agreement or cause the Company's senior leaders to
refuse to further extend the Forbearance Agreement, any or all of which could
have a material adverse effect on the Company's liquidity.
While the Company believes that all of its current pharmaceuticals are
lawfully marketed in the United States under current FDA enforcement policies or
have received the requisite agency approvals for manufacture and sale, such
marketing authority is subject to withdrawal by the FDA. In addition,
modifications or enhancements of approved products are in many circumstances
subject to additional FDA approvals which may or may not be granted and which
may be subject to a lengthy application process. Any change in the FDA's
enforcement policy or any decision by the FDA to require an approved NDA or ANDA
for a Company product not currently subject to the approved NDA or ANDA
requirements or any delay in the FDA approving an NDA or ANDA for a Company
product could have a material adverse effect on the Company's business,
financial condition and results of operations.
A number of products marketed by the Company are "grandfathered" drugs that
are permitted to be manufactured and marketed without FDA-issued ANDAs or NDAs
on the basis of their having been marketed prior to enactment of relevant
sections of the FDC Act. The regulatory status of these products is subject to
change and/or challenge by the FDA, which could establish new standards and
limitations for manufacturing and marketing such products, or challenge the
evidence of prior manufacturing and marketing upon which grandfathering status
is based. The Company is not aware of any current efforts by the FDA to change
the status of any of its "grandfathered" products, but there can be no assurance
that such initiatives will not occur in the future. Any such change in the
status of the Company's "grandfathered" products could have a material adverse
effect on the Company's business, financial condition and results of operations.
DEA Regulations The Company also manufactures and sells drugs which are
"controlled substances" as defined in the federal Controlled Substances Act and
similar state laws, which establishes, among other things, certain licensing,
security and record keeping requirements administered by the DEA and similar
state agencies, as well as quotas for the manufacture, purchase and sale of
controlled substances. The DEA could limit or reduce the amount of controlled
substances which the Company is permitted to manufacture and market. On November
6, 2002, the Company entered into a Civil Consent Decree with respect to
violations alleged by the DEA relating to record keeping and controls
surrounding the storage and distribution of controlled substances. Under the
terms of the Civil Consent Decree, the Company, without admitting any of the
allegations in the complaint from the DEA, has agreed to pay a fine of $100,000,
upgrade its securing and to remain in substantial compliance with the
Comprehensive Drug Abuse Prevention Control Act of 1970. If the Company does not
remain in substantial compliance during the two-year period following the entry
of the Civil Consent Decree, the Company, in addition to other possible
sanctions, may be held in contempt of court and ordered to pay an additional
$300,000 fine. See Item 3. "Legal Proceedings". A failure to comply with DEA
requirements or the Civil Consent Decree could have a material adverse effect on
the Company's business, financial condition and results of operations.
29
Dependence on Development of Pharmaceutical Products and Manufacturing
Capabilities
The Company's strategy for growth is dependent upon its ability to develop
products that can be promoted through current marketing and distributions
channels and, when appropriate, the enhancement of such marketing and
distribution channels. As of December 31, 2002, the Company had 19 ANDAs in
various stages of development of which 12 have been filed. Additionally, there
are two NDA supplements in process relating to the usage of Indocyanine Green
for age-related macular degeneration and intra-ocular staining. See "Item 1.
Description of Business -- Research and Development." The Company may not meet
its anticipated time schedule for the filing of ANDAs and NDAs or may decide not
to pursue ANDAs or NDAs that it has submitted or anticipates submitting. The
internal development of new pharmaceutical products by the Company is dependent
upon the research and development capabilities of the Company's personnel and
its infrastructure. There can be no assurance that the Company will successfully
develop new pharmaceutical products or, if developed, successfully integrate new
products into its existing product lines. In addition, there can be no assurance
that the Company will receive all necessary approvals from the FDA or that such
approvals will not involve delays, which adversely affect the marketing and sale
of the Company's products. Unless and until the issues pending before the FDA
with respect to the Company are resolved, it is doubtful that the FDA will
approve any NDAs or ANDAs submitted by the Company. The Company's failure to
develop new products, to successfully resolve the compliance issues at its
Decatur, Illinois facility or to receive FDA approval of ANDAs or NDAs, could
have a material adverse effect on the Company's business, financial condition
and results of operations.
In connection with the February 2003 recall of Fluress and Fluoracaine due
to container closure issues, the Company has temporarily suspended production of
these products pending requalification in a new container. A delay beyond the
second quarter in restarting production of these products could adversely effect
revenue and cash from operations. Another part of the Company's growth strategy
is to develop the capability to manufacture lyophilized (freeze-dried)
pharmaceutical products. While the Company has devoted resources to developing
these capabilities, it may not be successful in developing these capabilities,
or the Company may not realize the anticipated benefits from developing these
capabilities.
Generic Substitution
The Company's branded pharmaceutical products are subject to competition
from generic equivalents and alternative therapies. Generic pharmaceuticals are
the chemical and therapeutic equivalents of brand-name pharmaceuticals and
represent an increasing proportion of pharmaceuticals dispensed in the United
States. There is no proprietary protection for most of the branded
pharmaceutical products sold by the Company and other pharmaceutical companies
sell generic and other substitutes for most of its branded pharmaceutical
products. In addition, governmental and cost-containment pressures regarding the
dispensing of generic equivalents will likely result in generic substitution and
competition generally for the Company's branded pharmaceutical products.
Although the Company attempts to mitigate the effect of this substitution
through, among other things, creation of strong brand-name recognition and
product-line extensions for its branded pharmaceutical products, there can be no
assurance that the Company will be successful in these efforts. Increased
competition in the sale of generic pharmaceutical products could have a material
adverse effect on the Company's business, financial condition and results of
operations.
Dependence on Generic and Off-Patent Pharmaceutical Products
The success of the Company depends, in part, on its ability to anticipate
which branded pharmaceuticals are about to come off patent and thus permit the
Company to develop, manufacture and market equivalent generic pharmaceutical
products. Generic pharmaceuticals must meet the same quality standards as
branded pharmaceuticals, even though these equivalent pharmaceuticals are sold
at prices that are significantly lower than that of branded pharmaceuticals.
Generic substitution is regulated by the federal and state governments, as is
reimbursement for generic drug dispensing. There can be no assurance that
substitution will be permitted for newly approved generic drugs or that such
products will be subject to government reimbursement. In addition, generic
products that third parties develop may render the Company's generic products
noncompetitive or obsolete. Although the Company has successfully brought
generic pharmaceutical products to market
30
in a timely manner in the past, there can be no assurance that the Company will
be able to consistently bring these products to market quickly and efficiently
in the future. An increase in competition in the sale of generic pharmaceutical
products or the Company's failure to bring such products to market before its
competitors could have a material adverse effect on the Company's business,
financial condition and results of operations.
Risks and Expense of Legal Proceedings
As discussed above, the Company is currently involved in several pending or
threatened legal actions with both private parties and certain government
agencies. See Item 3. "Legal Proceedings". While the Company believes that its
positions in these various matters are meritorious, to the extent that the
Company's personnel must spend time and the Company must expend resources to
pursue or contest these various matters, or any additional matters that may be
asserted from the time to time in the future, this represents time and money
that is not available for other actions that the Company might otherwise pursue
which could be beneficial to the Company's future. In addition, to the extent
that the Company is unsuccessful in any legal proceedings, the consequences
could have a negative impact on the Company or its operations. These
consequences could include, but not be limited to, fines, penalties,
injunctions, the loss of patent or other rights, the need to write down or off
the value of assets (which could negatively impact the Company's earnings and/or
cause the violation of debt covenants) and a wide variety of other potential
remedies or actions that could be taken against the Company. While the Company
will continue to vigorously pursue its rights in all such matters, no assurance
can be given that the Company will be successful in any of these proceedings or,
even if successful, that the Company would be able to recoup any of the moneys
expended in pursuing such matters.
Competition; Uncertainty of Technological Change
The Company competes with other pharmaceutical companies, including major
pharmaceutical companies with financial resources substantially greater than
those of the Company, in developing, acquiring, manufacturing and marketing
pharmaceutical products. The selling prices of pharmaceutical products typically
decline as competition increases. Further, other products now in use, under
development or acquired by other pharmaceutical companies, may be more effective
or offered at lower prices than the Company's current or future products. The
industry is characterized by rapid technological change that may render the
Company's products obsolete, and competitors may develop their products more
rapidly than the Company. Competitors may also be able to complete the
regulatory process sooner, and therefore, may begin to market their products in
advance of the Company's products. The Company believes that competition in
sales of its products is based primarily on price, service and technical
capabilities. There can be no assurance that: (i) the Company will be able to
develop or acquire commercially attractive pharmaceutical products; (ii)
additional competitors will not enter the market; or (iii) competition from
other pharmaceutical companies will not have a material adverse effect on the
Company's business, financial condition and results of operations.
Dependence on Supply of Raw Materials and Components
The Company requires a supply of quality raw materials and components to
manufacture and package pharmaceutical products for itself and for third parties
with which it has contracted. The principal components of the Company's products
are active and inactive pharmaceutical ingredients and certain packaging
materials. Many of these components are available from only a single source and,
in the case of many of the Company's ANDAs and NDAs, only one supplier of raw
materials has been identified. Because FDA approval of drugs requires
manufacturers to specify their proposed suppliers of active ingredients and
certain packaging materials in their applications, FDA approval of any new
supplier would be required if active ingredients or such packaging materials
were no longer available from the specified supplier. The qualification of a new
supplier could delay the Company's development and marketing efforts. If for any
reason the Company is unable to obtain sufficient quantities of any of the raw
materials or components required to produce and package its products, it may not
be able to manufacture its products as planned, which could have a material
adverse effect on the Company's business, financial condition and results of
operations.
31
Dependence on Third-Party Manufacturers
The Company derives a significant portion of its revenues from the sale of
products manufactured by third parties, including its competitors in some
instances. There can be no assurance that the Company's dependence on third
parties for the manufacture of such products will not adversely affect the
Company's profit margins or its ability to develop and deliver its products on a
timely and competitive basis. If for any reason the Company is unable to obtain
or retain third-party manufacturers on commercially acceptable terms, it may not
be able to distribute certain of its products as planned. No assurance can be
made that the manufacturers utilized by the Company will be able to provide the
Company with sufficient quantities of its products or that the products supplied
to the Company will meet the Company's specifications. Any delays or
difficulties with third-party manufacturers could adversely affect the marketing
and distribution of certain of the Company's products, which could have a
material adverse effect on the Company's business, financial condition and
results of operations.
Dependence on Small Number of Distributors
A small number of large wholesale drug distributors account for a large
portion of the Company's gross sales, revenues and accounts receivable. The
following three distributors, AmerisourceBergen, Cardinal and McKesson,
accounted for approximately 57% of total gross sales and 42% of total revenues
in 2002, and 61% of gross trade receivables as of December 31, 2002. In addition
to acting as distributors of the Company's products, these three companies also
distribute a broad range of health care products for many other companies. None
of these distributors is an end user of the Company's products. If sales to any
one of these distributors were to diminish or cease, the Company believes that
the end users of its products would find little difficulty obtaining the
Company's products either directly from the Company or from another distributor.
However, the loss of one or more of these customers, together with a delay or
inability to secure an alternative distribution source for end users, could have
a material negative impact on the Company's revenue and results of operations
and lead to a violation of debt covenants. A change in purchasing patterns, an
increase in returns of the Company's products, delays in purchasing products and
delays in payment for products by one or more distributors also could have a
material negative impact on the Company's revenue and results of operations and
lead to a violation of debt covenants.
Product Liability
The Company faces exposure to product liability claims in the event that
the use of its technologies or products or those it licenses from third parties
is alleged to have resulted in adverse effects in users thereof. Receipt of
regulatory approval for commercial sale of such products does not mitigate such
product liability risks. While the Company has taken, and will continue to take,
what it believes are appropriate precautions, there can be no assurance that it
will avoid significant product liability exposure. In addition, future product
labeling may include disclosure of additional adverse effects, precautions and
contraindications, which may adversely impact sales of such products. The
Company currently has product liability insurance in the amount of $5.0 million
for aggregate annual claims with a $50,000 deductible per incident and a
$250,000 aggregate annual deductible. However, there can be no assurance that
such insurance coverage will be sufficient to fully cover potential claims.
Additionally, there can be no assurance that adequate insurance coverage will be
available in the future at acceptable costs, if at all, or that a product
liability claim would not have a material adverse effect on the Company's
business, financial condition and results of operations.
Patents and Proprietary Rights
The patent position of competitors in the pharmaceutical industry generally
is highly uncertain, involves complex legal and factual questions, and is the
subject of much litigation. There can be no assurance that any patent
applications relating to the Company's potential products or processes will
result in patents being issued, or that the resulting patents, if any, will
provide protection against competitors who: (i) successfully challenge the
Company's patents; (ii) obtain patents that may have an adverse effect on the
Company's ability to conduct business; or (iii) are able to circumvent the
Company's patent position. It is possible that other parties have conducted or
are conducting research and could make discoveries of pharmaceutical
formulations
32
or processes that would precede any discoveries made by the Company, which could
prevent the Company from obtaining patent protection for these discoveries or
marketing products developed therefrom. Consequently, there can be no assurance
that others will not independently develop pharmaceutical products similar to or
obsoleting those that the Company is planning to develop, or duplicate any of
the Company's products. The inability of the Company to obtain patents for its
products and processes or the ability of competitors to circumvent or obsolete
the Company's patents could have a material adverse effect on the Company's
business, financial condition and results of operations.
Exercise of Warrants, Conversion of Subordinated Debt, May have Dilutive
Effect
Under the terms of a $5,000,000 subordinated debt transaction, which the
Company entered into on July 12, 2001 with the John N. Kapoor Trust dtd. 9/20/89
(the "Trust"), the sole trustee and sole beneficiary of which is Dr. John N.
Kapoor, the Company's current Chairman of the Board of Directors, the Trust
agreed to provide the Company with $5,000,000 of subordinated debt in two
separate tranches of $3,000,000 ("Tranche A") and $2,000,000 ("Tranche B"). In
return for providing the subordinated debt, the Trust was granted Warrants to
purchase 1,000,000 shares of common stock, at a purchase price of $2.85 per
share for Tranche A and 667,000 shares of common stock, at a purchase price of
$2.25 per share, for Tranche B. In addition, Tranche A, plus the interest on
Tranche A, is convertible into common stock of the Company at a price of $2.28
per share, and Tranche B, plus the interest on Tranche B, is convertible into
common stock of the Company at a price of $1.80 per share. The subordinated debt
warrants mature on December 20, 2006.
On November 21, 2002, the Company entered into a success fee arrangement
with its restructuring consultants AEG Partners which provides that the Company
will issue 1,250,000 warrants to purchase common stock at an exercise price of
$1.00 per warrant share upon the date on which each of the following conditions
have been met or waived by the Company: (i) the Forbearance Agreement shall have
been terminated, (ii) the consultants engagement pursuant to its consulting
agreement shall have been terminated and (iii) the Company shall have executed a
new or restated multi-year credit facility. All unexercised warrants shall
expire on the fourth anniversary of the date of issuance.
If the price per share of the Company's common stock at the time of
exercise of the Warrants or conversion of the subordinated debt is in excess of
the various Warrant exercise or conversion prices, exercise of the Warrants and
conversion of the subordinated debt would have a dilutive effect on the
Company's common stock. The amount of such dilution, however, cannot currently
be determined as it would depend on the difference between the stock price and
the price at which the warrants were exercised or the subordinated debt was
converted at the time of exercise or conversion.
Need to Attract and Retain Key Personnel in Highly Competitive Marketplace
The Company's performance depends, to a large extent, on the continued
service of its key research and development personnel, other technical
employees, managers and sales personnel and its ability to continue to attract
and retain such personnel. Competition for such personnel is intense,
particularly for highly motivated and experienced research and development and
other technical personnel. The Company is facing increasing competition from
companies with greater financial resources for such personnel. There can be no
assurance that the Company will be able to attract and retain sufficient numbers
of highly-skilled personnel in the future, and the inability to do so could have
a material adverse effect on the Company's business, operating results and
financial condition and results of operations.
Dependence on Key Executive Officers
The Company's success will depend, in part, on its ability to attract and
retain key executive officers. The inability to find or the loss of one or more
of the Company's key executive officers could have a material adverse effect on
the Company's business, financial condition and results of operations.
33
Quarterly Fluctuation of Results; Possible Volatility of Stock Price
The Company's results of operations may vary from quarter to quarter due to
a variety of factors including, but not limited to, the timing of the
development and marketing of new pharmaceutical products, the failure to develop
such products, delays in obtaining government approvals, including FDA approval
of NDAs or ANDAs for Company products, expenditures to comply with governmental
requirements for manufacturing facilities, expenditures incurred to acquire and
promote pharmaceutical products, changes in the Company's customer base, a
customer's termination of a substantial account, the availability and cost of
raw materials, interruptions in supply by third-party manufacturers, the
introduction of new products or technological innovations by the Company's
competitors, loss of key personnel, changes in the mix of products sold by the
Company, changes in sales and marketing expenditures, competitive pricing
pressures, expenditures incurred to pursue or contest pending or threatened
legal action and the Company's ability to meet its financial covenants. There
can be no assurance that the Company will be successful in avoiding losses in
any future period. Such fluctuations may result in volatility in the price of
the Company's Common Stock.
Relationships with Other Entities; Conflicts of Interest
Mr. John N. Kapoor, Ph.D., the Company's current Chairman of the Board and
Chief Executive Officer from March 2001 to December 2002, and a principal
shareholder, is affiliated with EJ Financial Enterprises, Inc., a health care
consulting investment company ("EJ Financial"). EJ Financial is involved in the
management of health care companies in various fields, and Dr. Kapoor is
involved in various capacities with the management and operation of these
companies. The John N. Kapoor Trust, the beneficiary and sole trustee of which
is Dr. Kapoor, is a principal shareholder of each of these companies. As a
result, Dr. Kapoor does not devote his full time to the business of the Company.
Although such companies do not currently compete directly with the Company,
certain companies with which EJ Financial is involved are in the pharmaceutical
business. Discoveries made by one or more of these companies could render the
Company's products less competitive or obsolete. In addition, one of these
companies, NeoPharm, Inc. of which Dr. Kapoor is Chairman and a major
stockholder, recently entered into a loan agreement with the Company. The
Company also owes EJ Financial $18,000 in consulting fees for each of 2002 and
2001, as well as expense reimbursements of approximately $2,000 and $182,000 for
2002 and 2001, respectively. Further, the John N. Kapoor Trust has loaned the
Company $5,000,000 resulting in Dr. Kapoor effectively becoming a major creditor
of the Company as well as a major shareholder. See "Financial Condition and
Liquidity." Potential conflicts of interest could have a material adverse effect
on the Company's business, financial condition and results of operations.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivatives Instruments and Hedging Activities." SFAS No. 133 establishes
accounting and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging activities.
SFAS No. 133, as amended by SFAS No. 137 and No. 138, was effective for the
Company's fiscal 2001 financial statements and was adopted by the Company on
January 1, 2001. Adoption of these standards did not have an effect on the
Company's financial position or results of operations.
In June 2001, the FASB issued three statements, SFAS No. 141, "Business
Combinations," SFAS No. 142, "Goodwill and Other Intangible Assets," and SFAS
No. 143, "Accounting for Asset Retirement Obligations."
SFAS No. 141 supercedes APB Opinion No. 16, "Business Combinations," and
eliminates the pooling-of-interests method of accounting for business
combinations, thus requiring all business combinations be accounted for using
the purchase method. In addition, in applying the purchase method, SFAS No. 141
changes the criteria for recognizing intangible assets apart from goodwill.
The following criteria is to be considered in determining the recognition
of the intangible assets: (1) the intangible asset arises from contractual or
other legal rights, or (2) the intangible asset is separable or
34
dividable from the acquired entity and capable of being sold, transferred,
licensed, rented, or exchanged. The requirements of SFAS No. 141 are effective
for all business combinations completed after June 30, 2001. The adoption of
this new standard did not have an effect on the Company's financial statements.
SFAS No. 142 supercedes APB Opinion No. 17, "Intangible Assets," and
requires goodwill and other intangible assets that have an indefinite useful
life to no longer be amortized; however, these assets must be reviewed at least
annually for impairment. The Company has adopted SFAS No. 142 as of January 1,
2002. The adoption of this new standard did not have an effect on the Company's
financial statements as no impairments were recognized upon adoption.
SFAS No. 143 requires entities to record the fair value of a liability for
an asset retirement obligation in the period in which it is incurred. When the
liability is initially recorded, the entity capitalizes a cost by increasing the
carrying amount of the related long-lived asset. Over time, the liability is
accreted to its present value each period, and the capitalized cost is
depreciated over the useful life of the related asset. Upon settlement of the
liability, an entity either settles the obligation for its recorded amount or
incurs a gain or loss upon settlement. The adoption of this new standard did not
have an effect on the Company's financial statements.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This statement addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
This statement supercedes SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." This statement
also supercedes the accounting and reporting provisions of APB Opinion No. 30,
"Reporting the Results of Operations -- Reporting the Effects of Disposal of a
Segment of a Business and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions," for the disposal of a segment of a business (as
previously defined in that Opinion). SFAS No. 144 is effective January 1, 2002.
The adoption of this new standard did not have a significant effect on the
financial statements.
In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements
No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." This statement updates, clarifies and simplifies existing
accounting pronouncements. SFAS No. 145 rescinds SFAS No. 4, "Reporting Gains
and Losses from Extinguishments of Debt", which requires all gains and losses
from extinguishments of debt to be aggregated and, if material, classified as an
extraordinary item, net of related income tax effect. As a result, the criteria
in APB Opinion No. 30 will now be used to classify those gains and losses. SFAS
No. 64, "Extinguishment of Debt Made to Satisfy Sinking-Fund Requirements",
amended SFAS No. 4, is no longer necessary because SFAS No. 4 has been
rescinded. SFAS No. 145 amends SFAS No. 13 "Accounting for Leases", to require
that certain lease modifications that have economic effects similar to
sale-leaseback transactions be accounted for in the same manner as
sale-leaseback transactions. Certain provisions of SFAS No. 145 are effective
for fiscal years beginning after May 15, 2002, while other provisions are
effective for transactions occurring after May 15, 2002. The adoption of SFAS
No. 145 did not have a significant impact on the Company's financial statements.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities". SFAS No. 146 requires the Company
to recognize costs associated with exit or disposal activities when they are
incurred rather than at the date of a commitment to an exit or disposal plan.
The Company will adopt SFAS No. 146 for exit or disposal activities initiated
after December 31, 2002. The Company does not anticipate that adoption of this
standard did not have a material effect on its financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation -- Transition and Disclosure, an amendment of FASB Statement No.
123". This Statement amends SFAS No. 123, "Accounting for Stock-Based
Compensation", to provide alternative methods of transition for a voluntary
change to the fair value method of accounting for stock-based employee
compensation. In addition, this Statement amends the disclosure requirements of
SFAS No. 123 to require prominent disclosure in both annual and interim
financial statements. Certain of the disclosure requirements are required for
fiscal years ending after December 15, 2002 and are included in the notes to the
consolidated financial statements.
35
In November 2002, the FASB issued Interpretation No. 45 ("FIN 45"),
"Guarantor's Accounting and Disclosure Requirement for Guarantees, Including
Indirect Guarantees of Indebtedness to Others, an interpretation of FASB
Statements Nos. 5, 57 and 107 and a rescission of FASB Interpretation No. 34".
This Interpretation elaborates on the disclosure to be made by a guarantor in
its interim and annual financial statements about its obligations under
guarantees issued. The Interpretation also clarifies that a guarantor is
required to recognize, at inception of a guarantee, a liability for the fair
value of the obligation undertaken. The initial recognition and measurement
provisions of the Interpretation are applicable to guarantees issued or modified
after December 31, 2002 and are not expected to have a material effect on the
Company's financial statements. The disclosure requirements are effective for
financial statements of interim or annual periods ending after December 15,
2002. The Company has determined that FIN 45 will not have an impact on its
financial condition, results of operations or cash flows.
In January 2003 the FASB issued Interpretation No. 46. ("FIN 46"),
"Consolidation of Variable Interest Entities" with the objective of improving
financial reporting by companies involved with variable interest entities. A
variable interest entity is a corporation, partnership, trust, or other legal
structure used for business purposes that either (a) does not have equity
investors with voting rights, or (b) has equity investors that do not provide
sufficient financial resources for the equity to support its activities.
Historically, entities generally were not consolidated unless the entity was
controlled through voting interests. FIN 46 changes that by requiring a variable
interest entity to be consolidated by a company if that company is subject to a
majority of risk of loss from the variable interest entity's activities or
entitled to receive a majority of the entity's residual returns, or both. A
company that consolidates a variable interest entity is called the "primary
beneficiary" of that entity. FIN 46 also requires disclosures about variable
interest entities that a company is not required to consolidate but in which it
has significant variable interest. The consolidation requirements of FIN 46
apply immediately to variable interest entities created after January 1, 2003.
The consolidation requirements of FIN 46 apply to existing entities in the first
fiscal year or interim period beginning after June 15, 2003. Also, certain
disclosure requirements apply to all financial statements issued after January
31, 2003, regardless of when the variable interest entity was established. The
Company has determined that FIN 46 will not have an impact on its financial
condition, results of operations or cash flows.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is subject to market risk associated with changes in interest
rates. The Company's interest rate exposure involves three debt instruments. The
Credit Agreement and the subordinated convertible debentures issued to the John
N. Kapoor Trust bear the same interest rate, which fluctuates at Prime plus 300
basis points. The promissory note issued to NeoPharm, Inc. ("NeoPharm") bears
interest at an initial rate of 3.6% and will be reset quarterly based upon
NeoPharm's average return on its cash and readily tradable long and short-term
securities during the previous calendar quarter. All of the Company's remaining
long-term debt is at fixed interest rates. Management estimates that a change of
100 basis points in its variable rate debt from the interest rates in effect at
December 31, 2002 would result in a $439,000 change in annual interest expense.
The Company's financial instruments consist mainly of cash, accounts
receivable, accounts payable and debt. The carrying amounts of these
instruments, except debt, approximate fair value due to their short-term nature.
The carrying amounts of the Company's bank borrowings under its credit facility
approximate fair value because the interest rates are reset periodically to
reflect current market rates.
The fair value of the debt obligations approximated the recorded value as
of December 31, 2002. The promissory note between the Company and NeoPharm, Inc.
bears interest at a rate that is lower than the Company's current borrowing rate
with its senior lenders. Accordingly, the computed fair value of the debt, which
the Company estimates to be approximately $2,649,000, would be lower than the
current carrying value of $3,250,000.
36
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements are included in Part II, Item 8 of this
Form 10-K/A.
<Table>
INDEX:
Independent Auditors' Report................................ 38
Consolidated Balance Sheets as of December 31, 2002 and
2001...................................................... 39
Consolidated Statements of Operations for the years ended
December 31, 2002, 2001 and 2000.......................... 40
Consolidated Statements of Shareholders' Equity for the
years ended December 31, 2002, 2001 and 2000.............. 41
Consolidated Statements of Cash Flows for the years ended
December 31, 2002, 2001 and 2000.......................... 42
Notes to Consolidated Financial Statements.................. 43
</Table>
37
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of Akorn, Inc.:
We have audited the accompanying consolidated financial statements of
Akorn, Inc. and subsidiary (the "Company") as of December 31, 2002 and 2001, and
for each of the three years in the period ended December 31, 2002, as listed in
the Index at Item 8. Our audits also included the financial statement schedule
listed in the Index at Item 15(a).2. These financial statements and financial
statement schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of Akorn, Inc. and subsidiary at
December 31, 2002 and 2001, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2002 in
conformity with accounting principles generally accepted in the United States of
America. Also, in our opinion, such financial statement schedule, when
considered in relation to the basic consolidated financial statements taken as a
whole, presents fairly in all material respects the information set forth
therein.
The accompanying consolidated financial statements for the year ended
December 31, 2002 have been prepared assuming that the Company will continue as
a going concern. As discussed in Note A to the consolidated financial
statements, the Company's losses from operations in recent years, working
capital deficiency as of December 31, 2002, the need to refinance or extend its
debt on a long-term basis and the need to successfully resolve the ongoing
governmental proceedings, raise substantial doubt about its ability to continue
as a going concern. Management's plans concerning these matters are also
described in Note A. The consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
Deloitte & Touche LLP
Chicago, Illinois
May 9, 2003
38
AKORN, INC.
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT PAR VALUE DATA)
<Table>
<Caption>
DECEMBER 31,
------------------
2002 2001
-------- -------
ASSETS
CURRENT ASSETS
Cash and cash equivalents................................. $ 364 $ 5,355
Trade accounts receivable (less allowance for doubtful
accounts of $1,200 and $3,706 at December 31, 2002 and
2001, respectively).................................... 1,421 5,902
Inventory................................................. 10,401 8,135
Deferred income taxes..................................... -- 2,069
Income taxes recoverable.................................. 670 6,540
Prepaid expenses and other current assets................. 383 579
-------- -------
TOTAL CURRENT ASSETS................................... 13,239 28,580
OTHER ASSETS
Intangibles, net.......................................... 14,142 18,485
Deferred income taxes..................................... -- 3,850
Investment in Novadaq Technologies........................ 713 --
Other..................................................... 130 113
-------- -------
TOTAL OTHER ASSETS..................................... 14,985 22,448
PROPERTY, PLANT AND EQUIPMENT, NET.......................... 35,314 33,518
-------- -------
TOTAL ASSETS........................................... $ 63,538 $84,546
======== =======
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Current installments of long-term debt.................... $ 35,859 $45,072
Trade accounts payable.................................... 5,756 3,035
Accrued compensation...................................... 836 760
Accrued expenses and other liabilities.................... 1,352 4,070
-------- -------
TOTAL CURRENT LIABILITIES.............................. 43,803 52,937
Long-term debt.............................................. 7,799 7,574
Other long-term liabilities................................. 584 205
TOTAL LIABILITIES...................................... 52,186 60,716
-------- -------
COMMITMENTS AND CONTINGENCIES (Notes C, H and M)
SHAREHOLDERS' EQUITY
Preferred stock, $1.00 par value -- authorized 5,000,000
shares; none issued
Common stock, no par value -- authorized 40,000,000
shares; issued and outstanding 19,656,582 and
19,247,299 shares at December 31, 2002 and 2001,
respectively........................................... 26,866 26,392
Accumulated deficit....................................... (15,514) (2,562)
-------- -------
TOTAL SHAREHOLDERS' EQUITY............................. 11,352 23,830
-------- -------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY.................. $ 63,538 $84,546
======== =======
</Table>
See notes to the consolidated financial statements.
39
AKORN, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
-----------------------------
2002 2001 2000
-------- -------- -------
Revenues.................................................... $ 51,419 $ 41,545 $66,221
Cost of sales............................................... 30,882 35,147 38,090
-------- -------- -------
GROSS PROFIT.............................................. 20,537 6,398 28,131
Selling, general and administrative expenses................ 20,860 18,900 16,084
Provision (recovery) for bad debts.......................... (55) 4,480 8,127
Amortization of intangibles................................. 1,411 1,494 1,519
Research and development expenses........................... 1,886 2,598 4,132
-------- -------- -------
24,102 27,472 29,862
-------- -------- -------
OPERATING LOSS............................................ (3,565) (21,074) (1,731)
Interest and other income (expense):
Interest expense.......................................... (3,150) (3,768) (2,400)
Other income (expense), net............................... 2 (84) 117
-------- -------- -------
(3,148) (3,852) (2,283)
-------- -------- -------
LOSS BEFORE INCOME TAXES.................................... (6,713) (24,926) (4,014)
Income tax (benefit) provision.............................. 6,239 (9,780) (1,600)
-------- -------- -------
NET LOSS.................................................. $(12,952) $(15,146) $(2,414)
======== ======== =======
NET LOSS PER SHARE:
BASIC.................................................. $ (0.66) $ (0.78) $ (0.13)
======== ======== =======
DILUTED................................................ $ (0.66) $ (0.78) $ (0.13)
======== ======== =======
SHARES USED IN COMPUTING NET LOSS PER SHARE:
BASIC.................................................. 19,589 19,337 19,030
======== ======== =======
DILUTED................................................ 19,589 19,337 19,030
======== ======== =======
</Table>
See notes to the consolidated financial statements.
40
AKORN, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(IN THOUSANDS)
<Table>
<Caption>
RETAINED
COMMON STOCK EARNINGS
---------------- (ACCUMULATED
SHARES AMOUNT DEFICIT) TOTAL
------ ------- ------------ -------
Balances at January 1, 2000.......................... 18,651 $19,392 $ 14,998 $34,390
Net loss............................................. -- -- (2,414) (2,414)
Exercise of stock options............................ 576 3,105 -- 3,105
Shares issued in connection with the employee stock
purchase plan...................................... 20 150 -- 150
------ ------- -------- -------
Balances at December 31, 2000........................ 19,247 22,647 12,584 35,231
Net loss............................................. -- -- (15,146) (15,146)
Warrants issued in connection with convertible
debentures......................................... -- 1,516 -- 1,516
Intrinsic value of conversion feature in connection
with the issuance of convertible debentures........ -- 1,508 -- 1,508
Exercise of stock options............................ 175 583 -- 583
Shares issued in connection with the employee stock
purchase plan...................................... 44 138 -- 138
------ ------- -------- -------
Balances at December 31, 2001........................ 19,466 26,392 (2,562) 23,830
Net loss............................................. (12,952) (12,952)
Intrinsic value of conversion feature in connection
with the issuance of convertible debentures........ -- 114 -- 114
Exercise of stock options............................ 92 253 -- 253
Shares issued in connection with the employee stock
purchase plan...................................... 99 107 -- 107
------ ------- -------- -------
Balances at December 31, 2002........................ 19,657 $26,866 $(15,514) $11,352
====== ======= ======== =======
</Table>
See notes to the consolidated financial statements.
41
AKORN, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
------------------------------
2002 2001 2000
-------- -------- --------
OPERATING ACTIVITIES
Net loss.................................................... $(12,952) $(15,146) $ (2,414)
Adjustments to reconcile net loss to net cash from
operating activities:
Depreciation and amortization.......................... 4,510 4,286 3,539
Impairment of long-lived assets........................ 2,362 2,132 --
Loss (gain) on disposal of intangible/fixed assets..... (23) 78 --
Deferred income taxes.................................. 5,919 (2,813) (3,675)
Amortization of debt discount.......................... 519 431 --
Changes in operating assets and liabilities:
Accounts receivable.................................. 4,481 10,722 1,071
Income taxes recoverable............................. 5,870 (6,540) --
Inventory, prepaid expenses and other assets......... (2,087) 6,351 2,173
Trade accounts payable, accrued expenses and other
liabilities....................................... 758 611 718
Income taxes payable................................. -- (556) (1,050)
-------- -------- --------
NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES......... 9,357 (444) 362
INVESTING ACTIVITIES
Purchases of property, plant and equipment.................. (5440) (3,626) (15,239)
Proceeds received for intangible asset...................... 125 -- --
Purchase of product intangibles and product licensing
fees...................................................... (500) (2,449)
-------- -------- --------
NET CASH USED IN INVESTING ACTIVITIES....................... (5,315) (4,126) (17,688)
FINANCING ACTIVITIES
Proceeds from exercise of stock options..................... 474 721 3,255
Repayments of long-term debt................................ (11,994) (1,153) (22,206)
Proceeds from issuance of long-term debt.................... 2,487 8,034 37,100
Proceeds from issuance of stock warrants.................... 1,516 --
Principal payments under capital lease obligations.......... -- (41)
-------- -------- --------
NET CASH PROVIDED BY FINANCING ACTIVITIES................... (9,033) 9,118 18,108
-------- -------- --------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS............ (4,991) 4,548 782
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR.............. 5,355 807 25
-------- -------- --------
CASH AND CASH EQUIVALENTS AT END OF YEAR.................... $ 364 $ 5,355 $ 807
======== ======== ========
</Table>
See notes to the consolidated financial statements.
42
AKORN, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Business: Akorn, Inc. ("Akorn" or the "Company") manufactures and markets
diagnostic and therapeutic pharmaceuticals in specialty areas such as
ophthalmology, rheumatology, anesthesia and antidotes, among others. Customers
include physicians, optometrists, wholesalers, group purchasing organizations
and other pharmaceutical companies.
Consolidation: The accompanying consolidated financial statements include
the accounts of Akorn, Inc. and its wholly owned subsidiary, Akorn (New Jersey),
Inc. (collectively, the "Company"). Intercompany transactions and balances have
been eliminated in consolidation. During 2000, the Company dissolved the
inactive subsidiaries Compass Vision, Inc., Spectrum Scientific Pharmaceuticals,
Inc. and Walnut Pharmaceuticals, Inc. The dissolution of these subsidiaries did
not have a material impact on the balances and activities of the Company.
Basis of Presentation: The accompanying financial statements have been
prepared on a going concern basis, which contemplates the realization of assets
and the satisfaction of liabilities in the normal course of business.
Accordingly, the financial statements do not include any adjustments relating to
the recoverability and classification of recorded asset amounts or the amounts
and classification of liabilities that might be necessary should the Company be
unable to continue as a going concern. The Company has experienced losses from
operations in 2002, 2001 and 2000 of $3.6 million, $21.1 million and $1.7
million, respectively, and has a working capital deficiency of $30.6 million as
of December 31, 2002.
As described more fully herein, the Company has had three consecutive years
of operating losses, is in default under its existing credit agreement and is a
party to governmental proceedings and potential claims by the Food and Drug
Administration ("FDA") that could have a material adverse effect on the Company.
Although the Company has entered into a Forbearance Agreement (as defined below)
with its senior lenders, is working with the FDA to favorably resolve such
proceeding, has appointed a new interim chief executive officer and implemented
other management changes and has taken steps to return to profitability, there
is substantial doubt about the Company's ability to continue as a going concern.
The Company's ability to continue as a going concern is dependent upon its
ability to (i) continue to finance its current cash needs, (ii) continue to
obtain extensions of the Forbearance Agreement, (iii) successfully resolve the
ongoing governmental proceeding with the FDA and (iv) ultimately refinance its
senior bank debt and obtain new financing for future operations and capital
expenditures. If it is unable to do so, it may be required to seek protection
from its creditors under the federal bankruptcy code.
While there can be no guarantee that the Company will be able to continue
to finance its current cash needs, the Company generated positive cash flow from
operations in 2002. In addition, as of April 30, 2003, the Company had
approximately $400,000 in cash and equivalents and approximately $1.4 million of
undrawn availability under its second line of credit described below.
There can also be no guarantee that the Company will successfully resolve
the ongoing governmental proceedings with the FDA. However, the Company has
submitted to the FDA and begun to implement a plan for comprehensive corrective
actions at its Decatur, Illinois facility.
Moreover, there can be no guarantee that the Company will be successful in
obtaining further extensions of the Forbearance Agreement or in refinancing the
senior debt and obtaining new financing for future operations. However, the
Company is current on its interest payment obligations to its senior lenders,
management believes that the Company has a good relationship with its senior
lenders and, as required, the Company has retained a consulting firm, submitted
a restructuring plan and engaged an investment banker to assist in raising
additional financing and explore other strategic alternatives for repaying the
senior bank debt. The Company has also added key management personnel, including
the appointment of a new interim chief executive officer, and additional
personnel in critical areas, such as quality assurance. Management has reduced
the Company's cost structure, improved the Company's processes and systems and
implemented
43
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED)
strict controls over capital spending. Management believes these activities have
improved the Company's profitability and cash flow from operations and improve
its prospects for refinancing its senior debt and obtaining additional financing
for future operations.
As a result of all of the factors cited in the preceding paragraphs,
management of the Company believes that the Company should be able to sustain
its operations and continue as a going concern. However, the ultimate outcome of
this uncertainty cannot be presently determined and, accordingly, there remains
substantial doubt as to whether the Company will be able to continue as a going
concern. Further, even if the Company's efforts to raise additional financing
and explore other strategic alternatives result in a transaction that repays the
senior bank debt, there can be no assurance that the current common stock will
have any value following such a transaction. In particular, if any new financing
is obtained, it likely will require the granting of rights, preferences or
privileges senior to those of the common stock and result in substantial
dilution of the existing ownership interests of the common stockholders.
As discussed in Note G -- "Financing Arrangements", the Company has
significant borrowings which require, among other things, compliance with
various covenants. The borrowings are incurred primarily under an amended and
restated revolving credit agreement (the "Credit Agreement").
On September 16, 2002, the Company was notified by its senior lenders that
it was in default due to failure to pay the principal and interest owed as of
August 31, 2002 under the then most recent extension of the Credit Agreement.
The senior lenders also notified the Company that they would forbear from
exercising their remedies under the Credit Agreement until January 3, 2003 (as
indicated below, subsequently extended to June 30, 2003) if a forbearance
agreement could be reached. On September 20, 2002, the Company and its senior
lenders entered into an agreement under which the senior lenders would agree to
forbear from exercising their remedies (the "Forbearance Agreement") and the
Company acknowledged its current default. The Forbearance Agreement provides a
second line of credit allowing the Company to borrow the lesser of (i) the
difference between the Company's outstanding indebtedness to the senior lenders
and $39,200,000, (ii) the Company's borrowing base and (iii) $1,750,000, to fund
the Company's day-to-day operations. The Forbearance Agreement provides for
certain additional restrictions on operations and additional reporting
requirements. The Forbearance Agreement also requires automatic application of
cash from the Company's operations to repay borrowings under the new revolving
loan, and to reduce the Company's other obligations to the senior lenders.
The Company, as required in the Forbearance Agreement, agreed to provide
the senior lenders with a plan for restructuring its financial obligations on or
before December 1, 2002, and agreed to retain a consulting firm by September 27,
2002 to assist in the development and execution of this restructuring plan and,
in furtherance of that commitment, on September 26, 2002, the Company entered
into an agreement (the "Consulting Agreement") with a consulting firm (AEG
Partners, LLC (the "Consultant")) whereby the Consultant would assist in the
development and execution of this restructuring plan and provide oversight and
direction to the Company's day-to-day operations. On November 18, 2002, the
Consultant notified the Company of its intent to resign from the engagement
effective December 2, 2002, based upon the Company's alleged failure to
cooperate with the Consultant, in breach of the Consulting Agreement. The
Company's senior lenders, upon learning of the Consultant's action, notified the
Company by letter dated November 18, 2002, that, as a result of the Consultant's
resignation, the Company was in default under terms of the Forbearance Agreement
and the Credit Agreement and demanded payment of all outstanding principal and
interest on the loan. This notice was followed by a second letter dated November
19, 2002, in which the senior lenders gave notice of their exercise of certain
remedies available under the Credit Agreement including, but not limited to,
their setting off the Company's deposits with the senior lender against the
Company's obligations to the senior lenders. The Company immediately entered
into discussions with the Consultant which led, on November 21, 2002, to the
Consultant rescinding its notification of resignation and to the senior lenders
withdrawing their demand for payment and restoring the Company's accounts.
During the Company's discussions with the Consultant, the Company agreed to
establish a special committee of the Board (the "Corporate Governance
Committee") consisting of Directors Ellis and Bruhl,
44
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED)
with Mr. Ellis serving as Chairman. The Consultant will interface with the
Corporate Governance Committee regarding the Company's restructuring actions.
The Company also agreed that the Consultant will oversee the Company's
interaction with all regulatory agencies including, but not limited to, the FDA.
In addition, the Company has agreed to a "success fee" arrangement with the
Consultant. Under terms of the arrangement, if the Consultant is successful in
obtaining an extension to January 1, 2004 or later on the Company's senior debt,
the Consultant will be paid a cash fee equal to 1 1/2% of the amount of the
senior debt which is refinanced or restructured. Additionally, the success fee
arrangement provides that the Company will issue 1,250,000 warrants to purchase
common stock at an exercise price of $1.00 per warrant share to the Consultant
upon the date on which each of the following conditions have been met or waived
by the Company: (i) the Forbearance Agreement shall have been terminated, (ii)
the Consultant's engagement pursuant to the Consulting Agreement shall have been
terminated and (iii) the Company shall have executed a new or restated
multi-year credit facility. All unexercised warrants shall expire on the fourth
anniversary of the date of issuance.
As required by the Forbearance Agreement, a restructuring plan was
developed by the Company and the Consultant and presented to the Company's
senior lenders in December 2002. The restructuring plan requested that the
senior lenders convert the Company's senior debt to a term note that would
mature no earlier than February 2004 and increase the current line of credit
from $1.75 million to $3 million to fund operations and capital expenditures. In
light of the FDA's re-inspection of the Decatur facility in early December 2002,
the Company and the senior lenders agreed to defer further discussions of that
request until completion of the re-inspection and the Company's response
thereto. As a result, the senior lenders have agreed to successive short-term
extensions of the Forbearance Agreement, the latest of which is an eleventh
amendment to the Forbearance Agreement expiring on June 30, 2003. Following
completion of the FDA inspection of the Decatur facility on February 6, 2003 and
issuance of the FDA findings, the senior lenders have indicated that they are
not willing to convert the senior debt to a term loan but discussions continue
regarding a possible increase in the revolving line of credit. As required by
the Company's senior lenders, on May 9, 2003, the Company engaged Leerink Swann,
an investment banking firm, to assist in raising additional financing and
explore other strategic alternatives for repaying the senior bank debt. Subject
to the absence of any additional defaults and subject to the senior lenders'
satisfaction with the Company's progress in resolving the matters raised by the
FDA and in obtaining additional financing and exploring other strategic
alternatives, the Company expects to continue obtaining short-term extensions of
the Forbearance Agreement. However, there can be no assurance that the Company
will be successful in obtaining further extensions of the Forbearance Agreement
beyond June 30, 2003.
The Company is also a party to a governmental proceeding by the FDA (See
Note M -- "Commitments and Contingencies"). While the Company is cooperating
with the FDA and seeking to resolve the pending matter, an unfavorable outcome
in such proceeding may have a material impact on the Company's operations and
its financial condition, results of operations and/or cash flows and,
accordingly, may constitute a material adverse action that would result in a
covenant violation under the Credit Agreement.
In the event that the Company is not in compliance with the Credit
Agreement covenants and does not negotiate amended covenants or obtain a waiver
thereof, then the senior lenders, at their option, may demand immediate payment
of all outstanding amounts due and exercise any and all available remedies,
including, but not limited to, foreclosure on the Company's assets.
Use of Estimates: The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
materially from those estimates. Significant estimates and assumptions relate to
the allowance for doubtful accounts, the allowance for chargebacks, the
allowance for rebates, the reserve for slow-moving and obsolete inventory, the
allowance for product returns, the allowance for discounts, the carrying value
of intangible assets and the carrying value of deferred tax assets.
45
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED)
Revenue Recognition: The Company recognizes product sales for its
ophthalmic and injectable business segments upon the shipment of goods for
customers whose terms are FOB shipping point. The Company has several customers
whose terms are FOB destination point and recognizes revenue upon delivery of
the product to these customers. Revenue is recognized when all obligations of
the Company have been fulfilled and collection of the related receivable is
probable. Provision for estimated chargebacks, rebates, discounts and product
returns is made at the time of sale and is analyzed and adjusted, if necessary,
at each balance sheet date.
The Contract Services segment, which produces products for third party
customers, based upon their specification, at a pre-determined price, also
recognizes sales upon the shipment of goods or upon delivery of the product as
appropriate. Revenue is recognized when all obligations of the Company have been
fulfilled and collection of the related receivable is probable.
Royalty revenue is recognized in the period to which such revenue relates
based upon when the Company receives notification (monthly or quarterly) from
the counterparty that such counterparty has sold product for which Akorn is
entitled to a royalty.
The Company adopted Emerging Issues Task Force Abstract ("EITF") No. 01-9
as of January 1, 2002 and now presents the cost related to group purchasing
organization administration fees as a reduction of revenue as opposed to
selling, general and administrative expenses. 2001 and 2000 amounts have been
reclassified to conform with that of the 2002 presentation. In 2002, 2001, and
2000 these costs amounted to $848,000, $703,000 and $706,000, respectively.
Cash Equivalents: The Company considers all highly liquid investments with
maturity of three months or less, when purchased, to be cash equivalents.
Accounts Receivable: The nature of the Company's business inherently
involves, in the ordinary course, significant amounts and substantial volumes of
accounting activity (i.e., transactions and estimates) relating to allowances
for product returns, chargebacks, rebates and discounts given to customers. This
is a natural circumstance of the pharmaceutical industry and not specific to the
Company and inherently lengthens the collection process. Depending on the
product, the end-user customer, the specific terms of national supply contracts
and the particular arrangements with the Company's wholesaler customers, certain
rebates, chargebacks and other credits are deducted from the Company's accounts
receivable. The process of claiming these deductions depends on wholesalers
reporting to Akorn the amount of deductions that were earned under the
respective terms with end-user customers (which in turn depends on which
end-user customer, with different pricing arrangements might be entitled to a
particular deduction). This process can lead to "partial payments" against
outstanding invoices as the wholesalers take the claimed deductions at the time
of payment.
Allowance for Chargebacks and Rebates: The Company enters contractual
agreements with certain third parties such as hospitals and group-purchasing
organizations to sell certain products at predetermined prices. The parties have
elected to have these contracts administered through wholesalers. When a
wholesaler sells products to one of the third parties that is subject to a
contractual price agreement, the difference between the price to the wholesaler
and the price under contract is charged back to the Company by the wholesaler.
The Company reduces gross sales and accounts receivable by the estimated
chargeback amount when it sells product to a wholesaler. The Company evaluates
the chargeback allowance against actual chargebacks processed by wholesalers.
Actual chargebacks processed can vary materially from period to period.
Similarly, the Company maintains an allowance for rebates related to
contract and other programs with wholesalers. These allowances also reduce gross
sales and accounts receivable by the amount of the estimated rebate amount when
the Company sells its products to the wholesalers. The Company evaluates the
allowance against actual rebates processed and such amount can vary materially
from period to period.
The recorded allowances reflect the Company's current estimate of the
future chargeback and rebate liability to be paid or credited to the wholesaler
under the various contracts and programs. For the years ended
46
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED)
December 31, 2002, 2001 and 2000, the Company recorded chargeback and rebate
expense of $15,418,000, $28,655,000, and $29,558,000, respectively. The
allowance for chargebacks and rebates was $4,302,000 and $4,190,000 as of
December 31, 2002 and 2001.
In May 2001, the Company completed an analysis of its March 31, 2001
allowance for chargebacks and rebates. In performing such analysis, the Company
utilized recently obtained reports of wholesalers' inventory information, which
had not been previously obtained or utilized. Based on the wholesalers' March
31, 2001 inventories and historical chargeback and rebate activity, the Company
recorded an allowance of $6,961,000, which resulted in an expense of $12,000,000
for the three months ended March 31, 2001, as compared to an allowance of
$3,296,000 recorded at December 31, 2000.
During the quarter ended June 30, 2001, the Company further refined its
estimates of the chargeback and rebate liability determining that an additional
$2,250,000 provision needed to be recorded. This additional increase to the
allowance was necessary to reflect the continuing shift of sales to customers
who purchase their products through group purchasing organizations and buying
groups.
Allowance for Product Returns: The Company also maintains an allowance for
estimated product returns. This allowance is reflected as a reduction of
accounts receivable balances. The Company evaluates the allowance balance
against actual returns processed. Actual returns processed can vary materially
from period to period. For the years ended December 31, 2002, 2001, and 2000 the
Company recorded a provision for product returns of $2,574,000, $4,103,000, and
$1,159,000, respectively. The allowance for potential product returns was
$1,166,000 and $548,000 at December 31, 2002 and 2001, respectively.
In addition to considering in process product returns and assessing the
potential implications of historical product return activity, the Company also
considers the wholesaler's inventory information to assess the magnitude of
unconsumed product that may result in a product return to the Company in the
future. Such wholesaler inventory information had not been historically
purchased and therefore, had not been considered in assessing the reasonableness
of the allowance prior to March 31, 2001. Historical returns had not been
significant. Based on the wholesaler's inventory information, which demonstrated
higher levels of on-hand product than previously estimated by management,
combined with increased levels of return activity, the Company increased its
allowance for potential product returns to $2,232,000 at March 31, 2001 from
$232,000 at December 31, 2000. The provision for the three months ended March
31, 2001 was $2,559,000.
Allowance for Doubtful Accounts: The Company maintains an allowance for
doubtful accounts, which reflects trade receivable balances owed to the Company
that are believed to be uncollectible. This allowance is reflected as a
reduction of accounts receivable. For the years ended December 31, 2002, 2001
and 2000, the Company recorded a provision (recovery) for doubtful accounts of
($55,000), $4,480,000, and $8,127,000, respectively. The allowance for doubtful
accounts was $1,200,000 and $3,706,000 as of December 31, 2002 and 2001,
respectively.
In late 2000, the Company began reconciling and making collection attempts
of certain outstanding and past-due receivables, primarily involving certain of
its major customers (including wholesalers). The Company was confronted with
customers unwilling to pay invoiced amounts without the Company meeting certain
high levels of evidentiary support. The Company concluded it would be unable to
collect these amounts from certain customers. As a result, the Company recorded
bad debt expense of $7,520,000 during the fourth quarter of 2000. During the
second quarter of 2001, the Company used then available information and recent
experience to update its analysis and estimated that it needed to increase its
allowance for doubtful accounts to $12,928,000 at June 30, 2001 from $8,321,000
at December 31, 2000. The expense for the three months ended June 30, 2001 was
$4,610,000.
Allowance for Discounts: The Company maintains an allowance for discounts,
which reflects discounts available to certain customers based on agreed upon
terms of sale. This allowance is reflected as a reduction of accounts
receivable. The Company evaluates the allowance balance against actual discounts
taken. For the years ended December 31, 2002 and 2001, the Company recorded a
provision for discounts of $1,014,000 and
47
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED)
$886,000, respectively. Prior to 2001, the Company did not grant discounts. The
allowance for discounts was $172,000 and $143,000 and as of December 31, 2002
and 2001, respectively.
Inventory: Inventory is stated at the lower of cost (average cost method)
or market (see Note E -- "Inventory"). The Company maintains an allowance for
slow-moving and obsolete inventory based upon recent sales activity by unit and
wholesaler inventory information. The Company estimates the amount of inventory
that may not be sold prior to its expiration. In 2001, upon obtaining the
wholesaler's inventory reports, the Company learned that the wholesalers had
greater levels of on-hand inventory than had been previously estimated. This
provided the Company with greater insight as to the potentially lower buying
patterns of the wholesalers than had been previously forecasted and contemplated
in estimating the levels of inventory in assessing the adequacy of the
allowance. For the years ended December 31, 2002, 2001 and 2000, the Company
recorded a provision for inventory obsolescence of $838,000, $1,830,000, and
$3,983,000, respectively. The allowance for inventory obsolescence was
$1,206,000 and $1,845,000 as of December 31, 2002 and 2001, respectively.
Intangibles: Intangibles consist primarily of product licensing and other
such costs that are capitalized and amortized on the straight-line method over
the lives of the related license periods or the estimated life of the acquired
product, which range from 17 months to 18 years. Accumulated amortization at
December 31, 2002 and 2001 was $8,543,000 and $7,132,000, respectively. The
Company annually assesses the impairment of intangibles based on several
factors, including estimated fair market value and anticipated cash flows. In
2002, the Company recorded impairment charges on certain intangible assets (see
Note Q -- "Asset Impairment Charges"). A summary of the Company's acquired
amortizable intangible assets as of December 31, 2002 is as follows (in
thousands):
<Table>
<Caption>
AS OF DECEMBER 31, 2002
--------------------------------------------
GROSS CARRYING ACCUMULATED NET CARRYING
AMOUNT AMORTIZATION AMOUNT
-------------- ------------ ------------
Product Licenses....................................... $22,685 $8,543 $14,142
</Table>
The amortization expense of the above-listed acquired intangible assets for
each of the five years ending December 31, 2007 will be as follows (in
thousands):
<Table>
For the year ended 12/31/03................................. $1,397
For the year ended 12/31/04................................. 1,382
For the year ended 12/31/05................................. 1,335
For the year ended 12/31/06................................. 1,282
For the year ended 12/31/07................................. 1,282
</Table>
Property, Plant and Equipment: Property, plant and equipment is stated at
cost, less accumulated depreciation. Depreciation is provided using the
straight-line method in amounts considered sufficient to amortize the cost of
the assets to operations over their estimated service lives. The average
estimated service lives of buildings, leasehold improvements, furniture and
equipment, and automobiles are approximately 30, 10, 10, and 5 years,
respectively.
Net Loss Per Common Share: Basic net loss per common share is based upon
weighted average common shares outstanding. Diluted net income loss per common
share is based upon the weighted average number of common shares outstanding,
including the dilutive effect of stock options, warrants and convertible debt
using the treasury stock method.
48
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED)
The following table shows basic and diluted earnings per share computations
for the years ended December 31, 2002, 2001 and 2000 (in thousands, except per
share information):
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
-----------------------------
2002 2001 2000
---- ---- ----
Net loss per share -- basic:
Net loss.................................................. $(12,952) $(15,146) $(2,414)
Weighted average number of shares outstanding............. 19,567 19,337 19,030
Net loss per share -- basic................................. $ (0.66) $ (0.78) $ (0.13)
======== ======== =======
Net loss per share -- diluted:
Net loss.................................................. $(12,952) $(15,146) $(2,414)
Net loss adjustment for interest on convertible Debt...... -- --
-------- -------- -------
Net income loss, as adjusted.............................. $(12,952) $(15,146) $(2,414)
======== ======== =======
Weighted average number of shares outstanding............. 19,589 19,337 19,030
Additional shares assuming conversion of convertible debt
and convertible interest on debt(1).................... -- -- --
Additional shares assuming conversion of warrants(2)...... -- -- --
Additional shares assuming conversion of options(3)....... -- -- --
-------- -------- -------
Weighted average number of shares outstanding, as
Adjusted............................................... 19,589 19,337 19,030
======== ======== =======
Net income loss per share -- diluted........................ $ (0.66) $ (0.78) $ (0.13)
======== ======== =======
</Table>
- ---------------
(1) For 2002 and 2001, debt and interest convertible into 2,572 and 2,519 shares
of common stock respectively, was excluded from the computation of diluted
earnings per share, as the inclusion of such shares would be antidilutive.
(2) For 2002 and 2001, warrants to purchase 1,667 shares of common stock were
excluded from the computation of diluted earnings per share, as the
inclusion of such shares would be antidilutive.
(3) For 2002, 2001 and 2000, options to purchase 3,289, 3,226 and 1,827 shares
of common stock, respectively, were excluded from the computation of diluted
earnings per share as the inclusion of such shares would be antidilutive.
Stock Based Compensation: The Company applies the intrinsic-value-based
method of accounting prescribed by Accounting Principles Board ("APB") Opinion
No. 25, "Accounting for Stock Issued to Employees" to account for its fixed-plan
stock options. Under this method, compensation expense is recorded on the date
of grant only if the current market price of the underlying stock exceeded the
exercise price. Statement of Financial Accounting Standards ("SFAS") No. 123,
"Accounting for Stock-Based Compensation", established accounting and disclosure
requirements using a fair-value-based method of accounting for stock-based
employee compensation plans. As allowed by SFAS No. 123, the Company has elected
to continue to apply the intrinsic-value-based method of accounting described
above, and has adopted only the disclosure requirements of SFAS No. 123. The
Company account s for the plans under APB Opinion No. 25, under which no
compensation cost has been recognized for the stock option awards to employees,
since the exercise price of the options granted is equal to the market value on
the date of the grant. See Note I -- "Stock Options and Employee Stock Purchase
Plan".
Income Taxes: The Company files a consolidated federal income tax return
with its subsidiary. Deferred income taxes are provided in the financial
statements to account for the tax effects of temporary differences resulting
from reporting revenues and expenses for income tax purposes in periods
different from those used for financial reporting purposes. The Company records
a valuation allowance to reduce the deferred tax assets to the amount that is
more likely than not to be realized. In performing its analysis of whether a
valuation allowance to reduce the deferred tax asset was necessary, the Company
considered both negative and positive evidence. Based upon this analysis, the
negative evidence outweighed the positive evidence in determining the amount of
the deferred tax assets that is more likely than not to be realized. Based upon
its above analysis,
49
NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED)
beginning with the September 30, 2002 deferred tax assets, the Company
established a valuation allowance to reduce the deferred tax assets to zero. The
expense of $9.2 million related to establishing the deferred tax assets
valuation allowance has been recorded in the income tax provision (benefit).
Fair Value of Financial Instruments: The Company's financial instruments
include cash, accounts receivable, accounts payable and term debt. The fair
values of cash, accounts receivable and accounts payable approximate fair value
because of the short maturity of these instruments. The carrying amounts of the
Company's bank borrowings under its credit facility approximate fair value
because the interest rates are reset periodically to reflect current market
rates. The promissory note between the Company and NeoPharm, Inc. bears interest
at a rate that is lower than the Company's current borrowing rate with its
senior lenders. Accordingly, the computed fair value of the debt, which the
Company estimates to be approximately $2,649,000, would be lower than the
current carrying value of $3,250,000.
Reclassifications: Certain prior year amounts have been reclassified to
conform to 2002 presentation.
NOTE B -- NONCASH TRANSACTIONS
In July 2001, the Company amended a license agreement with The Johns
Hopkins University, Applied Physics Laboratory ("JHU/APL") (See "Note
C -- Product and Other Acquisitions"). As part of that amendment, the Company
delivered research and development equipment in lieu of a $100,000 payment. The
Company recorded a gain of $51,000 upon transfer of the equipment.
In the first quarter of 2002, the Company received an equity ownership in
Novadaq Technologies, Inc., ("Novadaq"), of 4,000,000 common shares
(representing approximately 16.4% of the outstanding shares) as part of the
settlement between the Company and Novadaq (See Note M -- "Commitments and
Contingencies"). The Company had previously advanced $690,000 to Novadaq for
development costs and recorded these advances as an intangible asset. Based on
the settlement, the Company has reclassified these advances as an Investment in
Novadaq Technologies, Inc. The Company has determined this investment should be
valued using the cost method as described in Accounting Principles Board Opinion
("APB") No. 18, "The Equity Method of Accounting for Investments in Common
Stock."
In the fourth quarter of 2002, the Company learned that JHU/APL had
licensed its two patents related to AMD (see Note M -- "Commitments and
Contingencies") to Novadaq. Pursuant to the settlement with JHU/APL, the Company
is entitled to 20% of all equity received by JHU/APL from any license of the
patent rights. Therefore, the Company received an additional 132,000 shares of
Novadaq, valued at $23,000 which was recorded as a gain in the fourth quarter of
2002.
NOTE C -- PRODUCT AND OTHER ACQUISITIONS
In April 2000, the Company entered into a worldwide license agreement with
JHU/APL. This license provided the Company exclusive rights to two patents
covering the methodology and instrumentation for a method of treating
age-related macular degeneration. Upon signing the agreement, the Company made
an initial payment under the agreement of $1,484,500. In July 2001, this license
agreement was amended such that the Company relinquished the international
rights to the two patents in exchange for a reduced financial obligation. The
Company retained the exclusive rights in the United States of America. Future
payments of $600,000 were required under terms of the amendment. The Company
subsequently relinquished its rights to these patents and recorded an impairment
charge of $1,559,500 in the second quarter of 2002. See "Note M -- Commitments
and Contingencies".
50
NOTE D -- ALLOWANCE FOR DOUBTFUL ACCOUNTS
The activity in the allowance for doubtful accounts for the periods
indicated is as follows (in thousands):
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
--------------------------
2002 2001 2000
------- ------- ------
Balance at beginning of year................................ $ 3,706 $ 8,321 $ 226
Provision (recovery) for bad debts.......................... (55) 4,480 8,127
Accounts written off........................................ (2,451) (9,095) (32)
------- ------- ------
Balance at end of year...................................... $ 1,200 $ 3,706 $8,321
======= ======= ======
</Table>
NOTE E -- INVENTORY
The components of inventory are as follows (in thousands):
<Table>
<Caption>
DECEMBER 31,
----------------
2002 2001
------- ------
Finished goods.............................................. $ 3,460 $2,906
Work in process............................................. 1,877 1,082
Raw materials and supplies.................................. 5,064 4,147
------- ------
$10,401 $8,135
======= ======
</Table>
Inventory at December 31, 2002 and 2001 is reported net of reserves for
slow-moving, unsalable and obsolete items of $1,206,000 and $1,845,000,
respectively.
NOTE F -- PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consists of the following (in thousands):
<Table>
<Caption>
DECEMBER 31,
-------------------
2002 2001
-------- --------
Land........................................................ $ 396 $ 396
Buildings and leasehold improvements........................ 8,890 8,208
Furniture and equipment..................................... 27,390 25,724
Automobiles................................................. 55 55
-------- --------
36,731 34,383
Accumulated depreciation.................................... (19,236) (16,440)
-------- --------
17,495 17,943
Construction in progress.................................... 17,819 15,575
-------- --------
$ 35,314 $ 33,518
======== ========
</Table>
Construction in progress represents capital expenditures principally
related to the Company's lyophilization project that will enable the Company to
perform processes in-house, which are currently being performed by a
sub-contractor. The Company capitalized interest expense related to the
lyophilization project of $1,150,000 and $1,111,000 in 2002 and 2001,
respectively. Subject to the Company's ability to refinance its senior debt and
obtain new financing for future operations and capital expenditures, the Company
anticipates completion of the lyophilization project in the second half of 2004.
In the third quarter of 2002, the Company recorded a charge of $545,000 to write
off abandoned construction projects and dispose of certain other fixed assets.
51
NOTE G -- FINANCING ARRANGEMENTS
The Company's long-term debt consists of (in thousands):
<Table>
<Caption>
DECEMBER 31,
-----------------
2002 2001
------- -------
Credit Agreement with The Northern Trust Company............ $35,565 $44,800
Subordinated convertible debentures......................... 5,000 5,000
Mortgages payable secured by real property located in
Decatur, Illinois......................................... 1,917 2,189
Promissory note to NeoPharm, Inc............................ 3,250 3,250
------- -------
45,732 55,239
Less unamortized discount on subordinated convertible
debentures................................................ 2,074 2,593
Less current portion........................................ 35,859 45,072
------- -------
Long-term debt.............................................. $ 7,799 $ 7,574
------- -------
</Table>
Maturities of debt are as follows (in thousands):
<Table>
Year ending December 31:
2003........................................................ $35,859
2004........................................................ 316
2005........................................................ 340
2006........................................................ 8,616
2007........................................................ 394
Thereafter.................................................. 207
-------
Total..................................................... $45,732
=======
</Table>
In December 1997, the Company entered into a $15,000,000 revolving Credit
Agreement with The Northern Trust Company, which was increased to $25,000,000 on
June 30, 1998 and to $45,000,000 on December 28, 1999. This Credit Agreement is
secured by substantially all of the assets of the Company and its subsidiaries
and contains a number of restrictive covenants. There were outstanding
borrowings of $35,565,000 and $44,800,000 at December 31, 2002 and 2001,
respectively. The interest rate as of December 31, 2002 was 7.25%.
On April 16, 2001, the Credit Agreement was amended (the "2001 Amendment")
and included, among other things, extension of the term of the agreement,
establishment of a payment schedule, revision of the method by which the
interest rate was to be determined, and the amendment and addition of certain
covenants. The 2001 Amendment also required the Company to obtain subordinated
debt of $3 million by May 15, 2001 and waived certain covenant violations
through March 31, 2001. The 2001 Amendment required payments throughout 2001
totaling $7.5 million, with the balance of $37.5 million due January 1, 2002.
The method used to calculate interest was changed to the prime rate plus 300
basis points. Previously, the interest rate was computed at the federal funds
rate or LIBOR plus an applicable percentage, depending on certain financial
ratios.
On July 12, 2001, the Company entered into a forbearance agreement (the
"Prior Agreement") with its senior lenders under which the lenders agreed to
forbear from taking action against the Company to enforce their rights under the
then existing Credit Agreement until January 2, 2002. As part of the Prior
Agreement, the Company acknowledged the existence of certain events of default.
These events included a default on a $1.3 million principal payment, failure to
timely make monthly interest payments due on May 31, 2001 and June 30, 2001
(these interest payments were subsequently made on July 27, 2001) and failure to
receive $3.0 million of cash proceeds of subordinated debt by May 15, 2001
(these proceeds were subsequently received on July 13, 2001).
52
NOTE G -- FINANCING ARRANGEMENTS -- (CONTINUED)
The Company received two extensions, which extended the Prior Agreement to
February 1, 2002 and March 15, 2002, respectively. Both of these extensions
carried the same reporting requirements and covenants while establishing new
cash receipts covenants for the months of January and February in 2002.
On April 12, 2002, in lieu of further extending the Prior Agreement, the
Company entered into an amendment to the Credit Agreement (the "2002
Amendment"), effective January 1, 2002. The 2002 Amendment included, among other
things, extension of the term of the agreement, establishment of a payment
schedule and the amendment and addition of certain covenants. The new covenants
include minimum levels of cash receipts, limitations on capital expenditures, a
$750,000 per quarter limitation on product returns and required amortization of
the loan principal. The agreement also prohibits the Company from declaring any
cash dividends on its common stock and identifies certain conditions in which
the principal and interest on the Credit Agreement would become immediately due
and payable. These conditions include: (a) an action by the FDA which results in
a partial or total suspension of production or shipment of products, (b) failure
to invite the FDA in for re-inspection of the Decatur manufacturing facilities
by June 1, 2002, (c) failure to make a written response, within 10 days, to the
FDA, with a copy to the lender, to any written communication received from the
FDA after January 1, 2002 that raises any deficiencies, (d) imposition of fines
against the Company in an aggregate amount greater than $250,000, (e) a
cessation in public trading of the Company's stock other than a cessation of
trading generally in the United States securities market, (f) restatement of or
adjustment to the operating results of the Company in an amount greater than
$27,000,000, (g) failure to enter into an engagement letter with an investment
banker for the underwriting of an offering of equity securities by June 15,
2002, (h) failure to not be party to an engagement letter at any time after June
15, 2002 or (i) experience any material adverse action taken by the FDA, the
SEC, the DEA or any other governmental authority based on an alleged failure to
comply with laws or regulations. The Credit Agreement required a minimum payment
of $5.6 million, which relates to an estimated federal tax refund, with the
balance of $39.2 million due June 30, 2002. The Company remitted the $5.6
million payment on May 8, 2002. The Company is also obligated to remit any
additional federal tax refunds received above the estimated $5.6 million.
The Company's senior lenders agreed to extend the Credit Agreement, as
amended, to July 31, 2002 and then again to August 31, 2002. These two
extensions contain the same covenants and reporting requirements except that the
Company is not required to comply with conditions (g) and (h) which relate to
the offering of equity securities. In both instances, the balance of $39.2
million was due at the end of the extension term.
On September 16, 2002, the Company was notified by its senior lenders that
it was in default due to failure to pay the principal and interest owed as of
August 31, 2002 under the then most recent extension of the Credit Agreement.
The senior lenders also notified the Company that they would forbear from
exercising their remedies under the Credit Agreement until January 3, 2003 if a
forbearance agreement could be reached.
On September 20, 2002, the Company and its senior lenders entered into an
agreement under which the senior lenders would agree to forbear from exercising
their remedies (the "Forbearance Agreement") and the Company acknowledged its
current default. The Forbearance Agreement provides a second line of credit
allowing the Company to borrow the lesser of (i) the difference between the
Company's outstanding indebtedness to the senior lenders and $39,200,000, (ii)
the Company's borrowing base and (iii) $1,750,000, to fund the Company's
day-to-day operations. The Forbearance Agreement requires that, except for
existing defaults, the Company continue to comply with all of the covenants in
the Credit Agreement and provides for certain additional restrictions on
operations and additional reporting requirements. The Forbearance Agreement also
requires automatic application of cash from the Company's operations to repay
borrowings under the new revolving loan, and to reduce the Company's other
obligations to the senior lenders.
The Company, as required in the Forbearance Agreement, agreed to provide
the senior lenders with a plan for restructuring its financial obligations on or
before December 1, 2002, and agreed to retain a consulting firm by September 27,
2002 to assist in the development and execution of this restructuring plan and,
in furtherance of that commitment, on September 26, 2002, the Company entered
into an agreement (the
53
NOTE G -- FINANCING ARRANGEMENTS -- (CONTINUED)
"Consulting Agreement") with a consulting firm (AEG Partners, LLC (the
"Consultant")) whereby the Consultant would assist in the development and
execution of this restructuring plan and provide oversight and direction to the
Company's day-to-day operations. On November 18, 2002, the Consultant notified
the Company of its intent to resign from the engagement effective December 2,
2002, based upon the Company's alleged failure to cooperate with the Consultant,
in breach of the Consulting Agreement. The Company's senior lenders, upon
learning of the Consultant's action, notified the Company by letter dated
November 18, 2002, that, as a result of the Consultant's resignation, the
Company was in default under terms of the Forbearance Agreement and the Credit
Agreement and demanded payment of all outstanding principal and interest on the
loan. This notice was followed by a second letter dated November 19, 2002, in
which the senior lenders gave notice of their exercise of certain remedies
available under the Credit Agreement including, but not limited to, their
setting off the Company's deposits with the senior lenders against the Company's
obligations to the senior lenders. The Company immediately entered into
discussions with the Consultant which led, on November 21, 2002, to the
Consultant rescinding its notification of resignation and to the senior lenders
withdrawing their demand for payment and restoring the Company's accounts.
During the Company's discussions with the Consultant, the Company agreed to
establish a special committee of the Board (the "Corporate Governance
Committee") consisting of Directors Ellis and Bruhl, with Mr. Ellis serving as
Chairman. The Consultant will interface with the Corporate Governance Committee
regarding the Company's restructuring actions. The Company also agreed that the
Consultant will oversee the Company's interaction with all regulatory agencies
including, but not limited to, the FDA. In addition, the Company has agreed to a
"success fee" arrangement with the Consultant. Under terms of the arrangement,
if the Consultant is successful in obtaining an extension to January 1, 2004 or
later on the Company's senior debt, the Consultant will be paid a cash fee equal
to 1 1/2% of the amount of the senior debt which is refinanced or restructured.
Additionally, the success fee arrangement provides that the Company will issue
1,250,000 warrants to purchase common stock at an exercise price of $1.00 per
warrant share to the Consultant upon the date on which each of the following
conditions have been met or waived by the Company: (i) the Forbearance Agreement
shall have been terminated, (ii) the Consultant's engagement pursuant to the
Consulting Agreement shall have been terminated and (iii) the Company shall have
executed a new or restated multi-year credit facility. All unexercised warrants
shall expire on the fourth anniversary of the date of issuance.
As required by the Forbearance Agreement, a restructuring plan was
developed by the Company and the Consultant and presented to the Company's
senior lenders in December 2002. The restructuring plan requested that the
senior lenders convert the Company's senior debt to a term note that would
mature no earlier than February 2004 and increase the current line of credit
from $1.75 million to $3 million to fund operations and capital expenditures. In
light of the FDA's re-inspection of the Decatur facility in early December 2002,
the Company and the senior lenders agreed to defer further discussions of that
request until completion of the re-inspection and the Company's response
thereto. As a result, the senior lenders have agreed to successive short-term
extensions of the Forbearance Agreement, the latest of which is an eleventh
amendment to the Forbearance Agreement expiring on June 30, 2003. Following
completion of the FDA inspection of the Decatur facility on February 6, 2003 and
issuance of the FDA findings, the senior lenders have indicated that they are
not willing to convert the senior debt to a term loan but discussions continue
regarding a possible increase in the revolving line of credit. As required by
the Company's senior lenders, on May 9, 2003, the Company engaged Leerink Swann
as an investment banking firm, to assist in raising additional financing and
explore other strategic alternatives for repaying the senior bank debt. Subject
to the absence of any additional defaults and subject to the senior lenders'
satisfaction with the Company's progress in resolving the matters raised by the
FDA and in obtaining additional financing and exploring other strategic
alternatives, the Company expects to continue obtaining short-term extensions of
the Forbearance Agreement. However, the can be no assurances that the Company
will be successful in obtaining further extensions of the Forbearance Agreement
beyond June 30, 2003.
The Company is also a party to governmental proceedings by the FDA (See
Note M -- "Commitments and Contingencies"). While the Company is cooperating
with the FDA and seeking to resolve the pending matter, an unfavorable outcome
in such proceeding may have a material impact on the Company's operations
54
NOTE G -- FINANCING ARRANGEMENTS -- (CONTINUED)
and its financial condition, results of operations and/or cash flows and,
accordingly, may constitute a material adverse action that would result in a
covenant violation under the Credit Agreement.
In the event that the Company is not in compliance with the Credit
Agreement covenants and does not negotiate amended covenants or obtain a waiver
thereof, then the senior lenders, at their option, may demand immediate payment
of all outstanding amounts due and exercise any and all available remedies,
including, but not limited to, foreclosure on the Company's assets.
On July 12, 2001 as required under the terms of the Prior Agreement, the
Company entered into a $5,000,000 subordinated debt transaction with the John N.
Kapoor Trust dtd. 9/20/89 (the "Trust"), the sole trustee and sole beneficiary
of which is Dr. John N. Kapoor, the Company's Chairman of the Board of
Directors. The transaction is evidenced by a Convertible Bridge Loan and Warrant
Agreement (the "Trust Agreement") in which the Trust agreed to provide two
separate tranches of funding in the amounts of $3,000,000 ("Tranche A" which was
received on July 13, 2001) and $2,000,000 ("Tranche B" which was received on
August 16, 2001). As part of the consideration provided to the Trust for the
subordinated debt, the Company issued the Trust two warrants which allow the
Trust to purchase 1,000,000 shares of common stock at a price of $2.85 per share
and another 667,000 shares of common stock at a price of $2.25 per share. The
exercise price for each warrant represented a 25% premium over the share price
at the time of the Trust's commitment to provide the subordinated debt. All
unexercised warrants expire on December 20, 2006.
Under the terms of the Trust Agreement, the subordinated debt bears
interest at prime plus 3%, which is the same rate the Company pays on its senior
debt. Interest cannot be paid to the Trust until the repayment of the senior
debt pursuant to the terms of a subordination agreement, which was entered into
between the Trust and the Company's senior lenders. Should the subordination
agreement be terminated, interest may be paid sooner. The convertible feature of
the Trust Agreement, as amended, allows for conversion of the subordinated debt
plus interest into common stock of the Company, at a price of $2.28 per share of
common stock for Tranche A and $1.80 per share of common stock for Tranche B.
The Company, in accordance with APB Opinion No. 14, recorded the
subordinated debt transaction such that the convertible debt and warrants have
been assigned independent values. The fair value of the warrants was estimated
on the date of grant using the Black-Scholes option pricing model with the
following assumptions: (i) dividend yield of 0%, (ii) expected volatility of
79%, (iii) risk free rate of 4.75%, and (iv) expected life of 5 years. As a
result, the Company assigned a value of $1,516,000 to the warrants and recorded
this amount as additional paid in capital. In accordance with EITF Abstract No.
00-27, the Company has also computed and recorded a value related to the
"intrinsic" value of the convertible debt. This calculation determines the value
of the embedded conversion option within the debt that has become beneficial to
the owner as a result of the application of APB Opinion No. 14. This value was
determined to be $1,508,000 and was recorded as additional paid in capital. The
remaining $1,976,000 was recorded as long-term debt. The resultant debt discount
of $3,024,000, equivalent to the value assigned to the warrants and the
"intrinsic" value of the convertible debt, is being amortized and charged to
interest expense over the life of the subordinated debt.
In December 2001, the Company entered into a $3,250,000 five-year loan with
NeoPharm, Inc. ("NeoPharm") to fund the Company's efforts to complete its
lyophilization facility located in Decatur, Illinois. Under the terms of the
Promissory Note, dated December 20, 2001, interest accrues at the initial rate
of 3.6% and will be reset quarterly based upon NeoPharm's average return on its
cash and readily tradable long and short-term securities during the previous
calendar quarter. The principal and accrued interest is due and payable on or
before maturity on December 20, 2006. The note provides that the Company will
use the proceeds of the loan solely to validate and complete the lyophilization
facility located in Decatur, Illinois. The Promissory Note is subordinated to
the Company's senior debt but is senior to the Company's subordinated debt owed
to the Trust. The note was executed in conjunction with a Processing Agreement
that provides NeoPharm with the option of securing at least 15% of the capacity
of the Company's lyophilization facility each year. Dr. John N. Kapoor, the
Company's chairman is also chairman of NeoPharm and holds a substantial stock
position in NeoPharm as well as in the Company.
55
NOTE G -- FINANCING ARRANGEMENTS -- (CONTINUED)
Contemporaneous with the completion of the Promissory Note between the
Company and NeoPharm, the Company entered into an agreement with the Trust,
which amended the Trust Agreement. The amendment extended the Trust Agreement to
terminate concurrently with the Promissory Note on December 20, 2006. The
amendment also made it possible for the Trust to convert the interest accrued on
the $3,000,000 tranche into common stock of the Company. Previously, the Trust
could only convert the interest accrued on the $2,000,000 tranche. The terms of
the agreement to change the convertibility of the Tranche A interest and the
convertibility of the Tranche B interest for the extension of the term require
shareholder approval to be received by August 31, 2002, which was subsequently
extended to June 30, 2003. If the Company's shareholders do not approve these
changes, the Company would be in default under the Trust Agreement and, at the
option of the Trust; the Subordinated Debt could be accelerated and become due
and payable on June 30, 2003. Any default under the Trust Agreement would
constitute an event of default under both the Credit Agreement and the NeoPharm
Promissory Note. In the event of default, amounts due under the Credit Agreement
and the NeoPharm Promissory Note could be declared to be due and payable,
notwithstanding the Forbearance Agreement which is presently in place between
the Company and its senior lender. The Company expects that it will reach
agreement with the Trust to extend, if necessary, the shareholder approval date
until the next shareholders' meeting.
In June 1998, the Company entered into a $3,000,000 mortgage agreement with
Standard Mortgage Investors, LLC of which there were outstanding borrowings of
$1,917,000 and $2,189,000 at December 31, 2002 and 2001, respectively. The
principal balance is payable over 10 years, with the final payment due in June
2007. The mortgage note bears an interest rate of 7.375% and is secured by the
real property located in Decatur, Illinois.
NOTE H -- LEASING ARRANGEMENTS
The Company leased certain equipment under capital lease arrangements that
expired in 2000. Depreciation expense provided on these assets was $109,000 for
the year ended December 31, 2000.
The Company leases real and personal property in the normal course of
business under various operating leases, including non-cancelable and
month-to-month agreements. Payments under these leases were $1,838,000,
$1,841,000, and $1,159,000 for the years ended December 31, 2002, 2001 and 2000,
respectively.
The following is a schedule, by year, of future minimum rental payments
required under non-cancelable operating leases (in thousands):
<Table>
Year ending December, 31
2003........................................................ $1,524
2004........................................................ 1,469
2005........................................................ 1,479
2006........................................................ 1,985
2007 and thereafter......................................... 871
------
Total....................................................... $7,328
======
</Table>
The Company currently sublets portions of its leased space. Rental income
under these subleases was $55,000, $56,000 and $227,000 in 2002, 2001 and 2000,
respectively.
NOTE I -- STOCK OPTIONS AND EMPLOYEE STOCK PURCHASE PLAN
Under the 1988 Incentive Compensation Program (the "Incentive Program") any
officer or key employee of the Company is eligible to receive options as
designated by the Company's Board of Directors. As of December 31, 2002,
4,600,000 shares of the Company's Common Stock are reserved for issuance under
the Incentive Program. The exercise price of the options granted under the
Incentive Program may not be less than 50 percent of the fair market value of
the shares subject to the option on the date of grant, as determined by the
Board of Directors. All options granted under the Incentive Program during the
years ended
56
NOTE I -- STOCK OPTIONS AND EMPLOYEE STOCK PURCHASE PLAN -- (CONTINUED)
December 31, 2002, 2001 and 2000 have exercise prices equivalent to the market
value of the Company's Common Stock on the date of grant. Options granted under
the Incentive Program generally vest over a period of three years and expire
within a period of five years.
Under the 1991 Stock Option Plan for Directors (the "Directors' Plan"),
which expired in December 2001, persons elected as directors of the Company were
granted nonqualified options at the fair market value of the shares subject to
option on the date of the grant. As of December 31, 2002, 500,000 shares of the
Company's Common Stock are reserved for issuance under the Directors' Plan.
Options granted under the Directors' Plan vest immediately and expire five years
from the date of grant.
A summary of the status of the Company's stock options as of December 31,
2002, 2001 and 2000 and changes during the years ended December 31, 2002, 2001
and 2000 is presented below (shares in thousands):
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
--------------------------------------------------------------
2002 2001 2000
------------------ ------------------ ------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
------ -------- ------ -------- ------ --------
Outstanding at beginning of period.......... 3,226 $3.72 1,827 $4.78 1,901 $3.64
Granted..................................... 1,131 $2.23 2,039 $3.05 644 $6.80
Exercised................................... (92) $2.19 (175) $2.48 (576) $3.14
Expired/Canceled............................ (976) $4.82 (465) $5.40 (142) $5.30
----- ----- -----
Outstanding at end of period................ 3,289 $2.93 3,226 $3.72 1,827 $4.78
===== ===== =====
Options exercisable at end of period........ 1,940 $3.10 1,735 $3.92 1,054 $4.08
Options available for future grant.......... 1,349 1,660 1,234
Weighted average fair value of options
granted during the period................. $1.56 $2.02 $5.17
</Table>
The fair value of each option granted during the year ended December 31,
2002 is estimated on the date of grant using the Black-Scholes option pricing
model with the following assumptions: (i) dividend yield of 0%, (ii) expected
volatility of 86%, (iii) risk-free interest rate of 4.4% and (iv) expected life
of 5 years.
The fair value of each option granted during the year ended December 31,
2001 is estimated on the date of grant using the Black-Scholes option pricing
model with the following assumptions: (i) dividend yield of 0%, (ii) expected
volatility of 79%, (iii) risk-free interest rate of 4.4% and (iv) expected life
of 5 years.
The fair value of each option granted during the year ended December 31,
2000 is estimated on the date of grant using the Black-Scholes option pricing
model with the following assumptions: (i) dividend yield of 0%, (ii) expected
volatility of 98%, (iii) risk-free interest rate of 5.0% and (iv) expected life
of 5 years.
57
NOTE I -- STOCK OPTIONS AND EMPLOYEE STOCK PURCHASE PLAN -- (CONTINUED)
The following table summarizes information about stock options outstanding
at December 31, 2002 (shares in thousands):
<Table>
<Caption>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
---------------------------------------------------- ----------------------------------
NUMBER NUMBER
OUTSTANDING WEIGHTED AVERAGE EXERCISABLE AT
DECEMBER 31, REMAINING WEIGHTED AVERAGE DECEMBER 31, WEIGHTED AVERAGE
RANGE OF EXERCISE PRICES 2002 CONTRACTUAL LIFE EXERCISE PRICE 2002 EXERCISE PRICE
- ------------------------ ------------ ---------------- ---------------- -------------- ----------------
$0.70 -- $1.00.......... 208 4.6 years $0.98 52 $0.98
$1.20 -- $1.25.......... 392 4.7 years $1.20 98 $1.20
$1.74 -- $2.24.......... 268 3.4 years $2.05 254 $2.05
$2.25 -- $2.99.......... 1,070 3.4 years $2.32 785 $2.32
$3.00 -- $4.00.......... 765 4.0 years $3.48 331 $3.48
$4.06 -- $4.82.......... 169 1.2 years $4.26 159 $4.24
$5.00 -- $5.57.......... 223 2.9 years $5.35 128 $5.38
$6.06 -- $6.25.......... 93 2.2 years $6.23 67 $6.24
$7.71 -- $8.38.......... 50 1.2 years $7.96 41 $7.99
$9.31 -- $11.88......... 30 2.5 years $9.93 25 $9.85
----- -----
3,289 1,940
===== =====
</Table>
The Company applies APB Opinion No. 25 and related interpretations in
accounting for its plans. Accordingly, no compensation expense has been
recognized for its stock option plans.
Had compensation cost for the Company's stock-based compensation plans been
determined based on SFAS No. 123, the Company's loss and net income loss per
share for the years ended December 31, 2002, 2001 and 2000 would have been the
pro forma amounts indicated below (in thousands, except per share amounts):
<Table>
<Caption>
2002 2001 2000
------------ ------------ -----------
Net Loss, as reported............................... $(12,952,000) $(15,146,000) $(2,414,000)
Add stock based employee compensation expense,
included in reported net loss, net of tax......... -- -- --
Deduct total stock-based employee compensation
expense determined under fair-value-based method
for all rewards, net of tax....................... $ (1,665,000) $ (1,754,000) $(1,766,000)
Pro forma net loss.................................. $(14,617,000) $(16,900,000) $(4,180,000)
Basic and diluted loss per share of common stock
As reported....................................... $ (0.66) $ (0.78) $ (0.13)
============ ============ ===========
Pro forma......................................... $ (0.75) $ (0.87) $ (0.22)
============ ============ ===========
</Table>
The Akorn, Inc. Employee Stock Purchase Plan permits eligible employees to
acquire shares of the Company's common stock through payroll deductions not
exceeding 15% of base wages, at a 15% discount from market price. A maximum of
1,000,000 shares of the Company's common stock may be acquired under the terms
of the Plan. Purchases of shares issued from treasury stock approximated 7,000
shares during the year ended December 31, 1999. New shares issued under the plan
approximated 99,267 in 2002, 44,000 in 2001 and 20,000 in 2000.
58
NOTE J -- INCOME TAXES
The income tax provision (benefit) consisted of the following (in
thousands):
<Table>
<Caption>
CURRENT DEFERRED TOTAL
------- -------- -------
Year ended December 31, 2002
Federal................................................... $ (293) $ 3,585 $ 3,292
State..................................................... 613 2,334 2,947
------- ------- -------
$ 320 $ 5,919 $ 6,239
======= ======= =======
Year ended December 31, 2001
Federal................................................... $(6,714) $ (746) $(7,460)
State..................................................... (253) (2,067) (2,320)
------- ------- -------
$(6,967) $(2,813) $(9,780)
======= ======= =======
Year ended December 31, 2000
Federal................................................... $ 1,680 $(3,186) $(1,506)
State..................................................... 395 (489) (94)
------- ------- -------
$ 2,075 $(3,675) $(1,600)
======= ======= =======
</Table>
Income tax expense (benefit) differs from the "expected" tax expense
(benefit) computed by applying the U.S. Federal corporate income tax rate of 34%
to income before income taxes as follows (in thousands):
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
-----------------------------
2002 2001 2000
------- ------- -------
Computed "expected" tax expense (benefit)................... $(2,283) $(8,475) $(1,365)
Change in income taxes resulting from:
State income taxes, net of federal income tax............. (323) (1,245) (185)
Valuation allowance change................................ 9,216 -- --
Other, net................................................ (371) (60) (50)
------- ------- -------
Income tax expense (benefit)................................ $ 6,239 $(9,780) $(1,600)
======= ======= =======
</Table>
Deferred tax assets at December 31, 2002 and 2001 include (in thousands):
<Table>
<Caption>
DECEMBER 31, DECEMBER 31,
2002 2001
------------ ------------
Deferred tax assets:
Other accrued expenses.................................... $ 469 $ 2,537
Intangible assets......................................... 490 525
Net operating loss carry forwards......................... 9,295 5,052
Other..................................................... 2,431 571
------- -------
$12,685 $ 8,685
------- -------
Valuation allowance....................................... (9,216) --
------- -------
$ 3,469 $ 8,685
Deferred tax liabilities:
Property, plant and equipment, net........................ (2,669) (2,593)
Intangible assets......................................... -- (15)
Other..................................................... (800) (158)
------- -------
$(3,469) $(2,766)
------- -------
Net......................................................... $ 0 $ 5,919
======= =======
</Table>
59
NOTE J -- INCOME TAXES -- (CONTINUED)
The deferred taxes are classified in the accompanying balance sheets as
follows (in thousands):
<Table>
<Caption>
DECEMBER 31, DECEMBER 31,
2002 2001
------------ ------------
Deferred tax asset -- current............................... $0 $2,069
Deferred tax asset -- noncurrent............................ 0 3,850
-- ------
$0 $5,919
== ======
</Table>
The Company records a valuation allowance to reduce the deferred tax assets
to the amount that is more likely than not to be realized. In performing its
analysis of whether a valuation allowance to reduce the deferred tax asset was
necessary, the Company considered both negative and positive evidence. Based
upon this analysis, the negative evidence outweighed the positive evidence in
determining the amount of the deferred tax assets that is more likely than not
to be realized. Based upon its above analysis, beginning with the September 30,
2002 deferred tax assets, the Company established a valuation allowance to
reduce the deferred tax assets to zero. The expense of $9.2 million related to
establishing the deferred tax assets valuation allowance has been recorded in
the income tax provision (benefit). The Company's net operating loss carry
forwards expire in 2021.
NOTE K -- RETIREMENT PLAN
All employees who have attained the age of 21 are eligible for
participation in the Company's 401(k) Plan. The plan-related expense recognized
for the years ended December 31, 2002, 2001 and 2000 totaled $242,000, $234,000
and $285,000, respectively. The employer's matching contribution is a percentage
of the amount contributed by each employee and is funded on a current basis.
NOTE L -- SEGMENT INFORMATION
The Company classifies its operations into three business segments,
Ophthalmic, Injectable and Contract Services. The Ophthalmic segment
manufactures, markets and distributes diagnostic and therapeutic
pharmaceuticals. The Injectable segment manufactures, markets and distributes
injectable pharmaceuticals, primarily in niche markets. The Contract Services
segment manufactures products for third party pharmaceutical and biotechnology
customers based on their specifications. The Company's basis of accounting in
preparing its segment information is consistent with that used in preparing its
consolidated financial statements.
60
NOTE L -- SEGMENT INFORMATION -- (CONTINUED)
Selected financial information by industry segment is presented below (in
thousands):
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
----------------------------
2002 2001 2000
------- -------- -------
Revenues
Ophthalmic............................................. $29,579 $ 16,936 $27,713
Injectable............................................. 12,977 9,663 24,998
Contract Services...................................... 8,863 14,946 13,510
------- -------- -------
Total revenues.................................... $51,419 $ 41,545 $66,221
======= ======== =======
Gross profit
Ophthalmic............................................. $13,917 $ (751) $ 8,743
Injectable............................................. 5,955 2,739 16,089
Contract Services...................................... 665 4,410 3,299
------- -------- -------
Total gross profit................................ 20,537 6,398 28,131
Operating expenses..................................... 24,102 27,472 29,862
------- -------- -------
Total operating loss.............................. (3,565) (21,074) (1,731)
Interest and other expense, net........................ (3,148) (3,852) (2,283)
------- -------- -------
Loss before income taxes............................... $(6,713) $(24,926) $(4,014)
======= ======== =======
</Table>
The Company manages its business segments to the gross profit level and
manages its operating costs on a company-wide basis. The Company does not
identify assets by segment for internal purposes.
NOTE M -- COMMITMENTS AND CONTINGENCIES
On March 27, 2002, the Company received a letter informing it that the
staff of the SEC's regional office in Denver, Colorado, would recommend to the
SEC that it bring an enforcement action against the Company and seek an order
requiring the Company to be enjoined from engaging in certain conduct. The staff
alleged that the Company misstated its income for fiscal years 2000 and 2001 by
allegedly failing to reserve for doubtful accounts receivable and overstating
its accounts receivable balance as of December 31, 2000. The Company had
originally recorded a $7.5 million increase to the allowance for doubtful
accounts in its quarter ended March 31, 2001. The staff alleged that internal
control and books and records deficiencies prevented the Company from accurately
recording, reconciling and aging its accounts receivables. The Company also
learned that certain of its former officers, as well as a current employee had
received similar notifications. Subsequent to the issuance of the Company's
consolidated financial statements for the year ended December 31, 2001,
management of the Company determined it needed to restate the Company's
financial statements for 2000 and 2001 to record a $7.5 million increase to the
allowance for doubtful accounts as of December 31, 2000, which it had originally
recorded as of March 31, 2001. See Note S -- "Subsequent Events".
The Company was party to a License Agreement with JHU/APL effective April
26, 2000, and amended effective July 15, 2001 (See Note C -- "Product and Other
Acquisitions"). Pursuant to the License Agreement, the Company licensed two
patents from JHU/APL for the development and commercialization of a diagnosis
and treatment for age-related macular degeneration ("AMD") using Indocyanine
Green ("ICG"). A dispute arose between the Company and JHU/APL concerning the
License Agreement. Specifically, JHU/APL challenged the Company's performance
required by December 31, 2001 under the License Agreement and alleged that the
Company was in breach of the License Agreement. The Company denied JHU/APL's
allegations and contended that it had performed in accordance with the terms of
the License Agreement. As a result of the dispute, on March 29, 2002, the
Company commenced a lawsuit in the U.S. District Court for the Northern District
of Illinois, seeking declaratory and other relief against
61
NOTE M -- COMMITMENTS AND CONTINGENCIES -- (CONTINUED)
JHU/APL. On July 3, 2002, the Company reached an agreement with JHU/APL with
regard to the dispute that had risen between the two parties. The Company and
JHU/APL mutually agreed to terminate their license agreement. As a result, the
Company no longer has any rights to the JHU/APL patent rights as defined in the
License Agreement. In exchange for relinquishing its rights to the JHU/APL
patent rights, the Company received an abatement of the $300,000 due to JHU/APL
at March 31, 2002 and a payment of $125,000 to be received by August 3, 2002.
The Company also has the right to receive 15% of all cash payments and 20% of
all equity received by JHU/APL from any license of the JHU/APL patent rights
less any cash or equity returned by JHU/APL to such licensee. The combined total
of all such cash and equity payments are not to exceed $1,025,000. The $125,000
payment is considered an advance towards cash payments due from JHU/APL and will
be credited against any future cash payments due the Company as a result of
JHU/APL's licensing efforts. As a result of the resolved dispute discussed
above, the Company recorded an asset impairment charge of $1,559,500 in the
second quarter of 2002. The impairment amount represents the net value of the
asset recorded on the balance sheet of the Company less the $300,000 payment
abated by JHU/APL and the $125,000 payment from JHU/APL. The $125,000 payment
was received on August 3, 2002.
In the fourth quarter of 2002, the Company learned that JHU/APL had
licensed their two patents related to AMD to Novadaq Technologies, Inc.
("Novadaq"). In connection with the settlement of a prior dispute with Novadaq
in January 2002 (as discussed below), the Company had previously acquired an
equity interest in Novadaq. Pursuant to the settlement with JHU/APL, the Company
is entitled to 20% of all equity received by JHU/APL from any license of the
patent rights. Therefore, the Company received an additional 132,000 shares of
Novadaq, valued at $23,000 which was recorded as a gain in the fourth quarter of
2002.
In October 2000, the FDA issued a warning letter to the Company following
the FDA's routine cGMP inspection of the Company's Decatur manufacturing
facilities. An FDA warning letter is intended to provide notice to a company of
violations of the laws administered by the FDA. Its primary purpose is to elicit
voluntary corrective action. The letter warns that if voluntary action is not
forthcoming, the FDA may use other legal means to compel compliance. These
include seizure of products and/or injunction of the Company and responsible
individuals. This letter addressed several deviations from regulatory
requirements including cleaning validations and general documentation and
requested corrective actions be undertaken by the Company. The Company initiated
corrective actions and responded to the warning letter. Subsequently, the FDA
conducted another inspection in late 2001 and identified additional deviations
from regulatory requirements, including cleaning validations and process control
issues. This led to the FDA leaving the warning letter in place and issuing a
Form 483 to document its findings. While no further correspondence was received
from the FDA, the Company responded to the inspectional findings. This response
described the Company's plan for addressing the issues raised by the FDA and
included improved cleaning validation, enhanced process controls and
approximately $2.0 million of capital improvements. In August 2002, the FDA
conducted an inspection of the Decatur facility and identified deviations from
cGMPs. The Company responded to these observations in September 2002. In
response to the Company's actions, the FDA conducted another inspection of the
Decatur facility during the period December 10, 2002 to February 6, 2003. This
inspection identified deviations from regulatory requirements including the
manner in which the Company processes and investigates manufacturing
discrepancies and failures, customer complaints and the thoroughness of
equipment cleaning validations. Deviations identified during this inspection had
been raised in previous FDA inspections. The Company has responded to these
latest findings in writing and in a meeting with the FDA in March 2003. The
Company set forth its plan for implementing comprehensive corrective actions,
has provided a progress report to the FDA on April 15 and May 15, 2003 and has
committed to providing the FDA an additional periodic report of progress on June
15, 2003.
As a result of the latest inspection and the Company's response, the FDA
may take any of the following actions: (i) accept the Company's reports and
response and take no further action against the Company; (ii) permit the Company
to continue its corrective actions and conduct another inspection (which likely
would not occur before the fourth quarter of 2003) to assess the success of
these efforts; (iii) seek to enjoin the Company from further violations, which
may include temporary suspension of some or all operations and
62
NOTE M -- COMMITMENTS AND CONTINGENCIES -- (CONTINUED)
potential monetary penalties; or (iv) take other enforcement action which may
include seizure of Company products. At this time, it is not possible to predict
the FDA's course of action.
The Company believes that unless and until the FDA chooses option (i) or,
in the case of option (ii), unless and until the issues identified by the FDA
have been successfully corrected and the corrections have been verified through
reinspection, it is doubtful that the FDA will approve any NDAs or ANDAs that
may be submitted by the Company. This has adversely impacted, and is likely to
continue to adversely impact the Company's ability to grow sales. However, the
Company believes that unless and until the FDA chooses option (iii) or (iv), the
Company will be able to continue manufacturing and distributing its current
product lines.
If the FDA chooses option (iii) or (iv), such action could significantly
impair the Company's ability to continue to manufacture and distribute its
current product line and generate cash from its operations, could result in a
covenant violation under the Company's senior debt or could cause the Company's
senior lenders to refuse further extensions of the Company's senior debt any or
all of which, would have a material adverse effect on the Company's liquidity.
Any monetary penalty assessed by the FDA also could have a material adverse
effect on the Company's liquidity. See "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operation -- Financial Condition
and Liquidity".
On March 6, 2002, the Company received a letter from the United States
Attorney's Office, Central District of Illinois, Springfield, Illinois, advising
the Company that the DEA had referred a matter to that office for a possible
civil legal action for alleged violations of the Comprehensive Drug Abuse
Prevention Control Act of 1970, 21 U.S.C.& 801, et. seq. and regulations
promulgated under the Act. The alleged violations relate to record keeping and
controls surrounding the storage and distribution of controlled substances. On
November 6, 2002, the Company entered into a Civil Consent Decree with the DEA.
Under terms of the Consent Decree, the Company, without admitting any of the
allegations in the complaint from the DEA, has agreed to pay a fine of $100,000,
upgrade its security system and to remain in substantial compliance with the
Comprehensive Drug Abuse Prevention Control Act of 1970. If the Company does not
remain in substantial compliance during the two-year period following the entry
of the civil consent decree, the Company, in addition to other possible
sanctions, may be held in contempt of court and ordered to pay an additional
$300,000 fine.
On August 9, 2001, the Company was served with a Complaint, which had been
filed on August 8, 2001 in the United States District Court for The Northern
District of Illinois, Eastern Division. The suit named the Company as well as
Mr. Floyd Benjamin, the former president and chief executive officer of the
Company, and Dr. John N. Kapoor, the Company's current chairman of the board and
the then interim chief executive officer, as defendants. The suit, which was
filed by Michelle Golumbski, individually, and on behalf of all others similarly
situated, alleged various violations of the federal securities laws in
connection with the Company's public statements and filings with the SEC during
the period from February 20, 2001 through May 22, 2001. The plaintiff
subsequently voluntarily dismissed her claims against Akorn, Inc., Mr. Floyd
Benjamin and Dr. John N. Kapoor, and, in exchange for the Company's consent to
this voluntary dismissal, also provided, through counsel, a written statement
that the plaintiff would not reassert her claims against any of the defendants
in any subsequent actions. The Company did not provide the plaintiff with any
compensation in consideration for this voluntary dismissal.
On April 4, 2001, the International Court of Arbitration (the "ICA") of the
International Chamber of Commerce notified the Company that Novadaq
Technologies, Inc. ("Novadaq") had filed a Request for Arbitration with the ICA
on April 2, 2001. Akorn and Novadaq had previously entered into an Exclusive
Cross-Marketing Agreement dated July 12, 2000 (the "Agreement"), providing for
their joint development and marketing of certain devices and procedures for use
in fluorescein angiography (the "Products"). Akorn's drug indocyanine green
("ICG") would be used as part of the angiographic procedure. The FDA had
requested that the parties undertake clinical studies prior to obtaining FDA
approval. In its Request for Arbitration, Novadaq asserted that under the terms
of the Agreement, Akorn should be responsible for the costs of performing the
requested clinical trials, which were estimated to cost approximately
$4,400,000.
63
NOTE M -- COMMITMENTS AND CONTINGENCIES -- (CONTINUED)
Alternatively, Novadaq sought a declaration that the Agreement should be
terminated as a result of Akorn's alleged breach. Finally, in either event,
Novadaq sought unspecified damages as a result of the alleged failure or delay
on Akorn's part in performing its obligations under the Agreement. In its
response, Akorn denied Novadaq's allegations and alleged that Novadaq had
breached the agreement. On January 25, 2002, the Company and Novadaq reached a
settlement of the dispute. Under terms of a revised agreement entered into as
part of the settlement, Novadaq will assume all further costs associated with
development of the technology. The Company, in consideration of foregoing any
share of future net profits, obtained an equity ownership interest in Novadaq
and the right to be the exclusive supplier of ICG for use in Novadaq's
diagnostic procedures. In addition, Antonio R. Pera, Akorn's then President and
Chief Operating Officer, was named to Novadaq's Board of Directors. In
conjunction with the revised agreement, Novadaq and the Company each withdrew
their respective arbitration proceedings. Subsequent to the resignation of Mr.
Pera on June 7, 2002, the Company named Bernard J. Pothast, its Chief Financial
Officer, to fill the vacancy on the Novadaq Board of Directors created by his
departure.
On December 19, 2002 and January 22, 2003, the Company received demand
letters regarding claimed wrongful deaths allegedly associated with the use of
the drug Inapsine, which the Company produced. The total claims of these two
items total $3.8 million. The Company has just begun the investigation of the
facts and circumstances surrounding these claims and cannot as of yet determine
the potential liability, if any, from these claims. The Company has submitted
these claims to its product liability insurance carrier. The Company intends to
vigorously defend itself in regards to these claims.
The Company is a party in legal proceedings and potential claims arising in
the ordinary course of its business. The amount, if any, of ultimate liability
with respect to such matters cannot be determined. Despite the inherent
uncertainties of litigation, management of the Company at this time does not
believe that such proceedings will have a material adverse impact on the
financial condition, results of operations, or cash flows of the Company.
NOTE N -- SUPPLEMENTAL CASH FLOW INFORMATION (IN THOUSANDS)
<Table>
<Caption>
YEAR ENDED DECEMBER 31,
------------------------
2002 2001 2000
------ ------ ------
Interest and taxes paid:
Interest (net of amounts capitalized)..................... $3,150 $3,308 $2,596
Income taxes.............................................. 613 38 1,625
Noncash investing and financing activities:
Intangible asset received in exchange for research
equipment.............................................. -- 100 --
Reduction of liability in exchange for intangible asset... 300 -- --
Investment in Novadaq received in exchange for intangible
asset equipment........................................ 713 -- --
</Table>
NOTE O -- RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 133, "Accounting for Derivatives Instruments and Hedging Activities." SFAS
No. 133 establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts, and for hedging activities. SFAS No. 133, as amended by SFAS No. 137
and No. 138, was effective for the Company's fiscal 2001 financial statements
and was adopted by the Company on January 1, 2001. Adoption of these standards
did not have any effect on the Company's financial position or results of
operations.
In June 2001, the FASB issued three statements, SFAS No. 141, "Business
Combinations," SFAS No. 142, "Goodwill and Other Intangible Assets," and SFAS
No. 143, "Accounting for Asset Retirement Obligations."
64
NOTE O -- RECENT ACCOUNTING PRONOUNCEMENTS -- (CONTINUED)
SFAS No. 141 supercedes APB Opinion No. 16, "Business Combinations," and
eliminates the pooling-of-interests method of accounting for business
combinations, thus requiring all business combinations be accounted for using
the purchase method. In addition, in applying the purchase method, SFAS No. 141
changes the criteria for recognizing intangible assets apart from goodwill. The
following criteria is to be considered in determining the recognition of the
intangible assets: (1) the intangible asset arises from contractual or other
legal rights, or (2) the intangible asset is separable or dividable from the
acquired entity and capable of being sold, transferred, licensed, rented, or
exchanged. The requirements of SFAS No. 141 are effective for all business
combinations initiated after June 30, 2001. The adoption of this new standard
did not have any effect on the Company's financial statements.
SFAS No. 142 supercedes APB Opinion No. 17, "Intangible Assets," and
requires goodwill and other intangible assets that have an indefinite useful
life to no longer be amortized; however, these assets must be reviewed at least
annually for impairment. The Company has adopted SFAS No. 142 as of January 1,
2002 and no impairments were recognized upon adoption.
SFAS No. 143 requires entities to record the fair value of a liability for
an asset retirement obligation in the period in which it is incurred. When the
liability is initially recorded, the entity capitalizes a cost by increasing the
carrying amount of the related long-lived asset. Over time, the liability is
accreted to its present value each period, and the capitalized cost is
depreciated over the useful life of the related asset. Upon settlement of the
liability, an entity either settles the obligation for its recorded amount or
incurs a gain or loss upon settlement. The Company has adopted SFAS No. 143 as
of January 1, 2002. The adoption of this new standard did not have any effect on
the Company's financial statements.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This statement addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
This statement supercedes SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." This statement
also supercedes the accounting and reporting provisions of APB Opinion No. 30,
"Reporting the Results of Operations -- Reporting the Effects of Disposal of a
Segment of a Business and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions," for the disposal of a segment of a business (as
previously defined in that Opinion). SFAS No. 144 is effective January 1, 2002.
The adoption of this new standard did not have any effect on the Company's
financial statements upon adoption.
In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements
No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." This statement updates, clarifies and simplifies existing
accounting pronouncements. SFAS No. 145 rescinds SFAS No. 4, "Reporting Gains
and Losses from Extinguishments of Debt", which requires all gains and losses
from extinguishments of debt to be aggregated and, if material, classified as an
extraordinary item, net of related income tax effect. As a result, the criteria
in APB Opinion No. 30 will now be used to classify those gains and losses. SFAS
No. 64, "Extinguishment of Debt Made to Satisfy Sinking-Fund Requirements",
amended SFAS No. 4, is no longer necessary because SFAS No. 4 has been
rescinded. SFAS No. 145 amends SFAS No. 13 "Accounting for Leases", to require
that certain lease modifications that have economic effects similar to
sale-leaseback transaction be accounted for in the same manner as sale-leaseback
transactions. Certain provisions of SFAS No. 145 are effected for fiscal years
beginning after May 15, 2002, while other provisions are effected for
transactions occurring after May 15, 2002. The adoption of SFAS No. 145 did not
have a significant impact on the Company's financial statements.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities". SFAS No. 146 requires the Company
to recognize costs associated with exit or disposal activities when they are
incurred rather than at the date of a commitment to an exit or disposal plan.
The Company will adopt SFAS No. 146 for exit or disposal activities initiated
after December 31, 2002. The adoption of this standard did not have a material
effect on its financial statements.
65
NOTE O -- RECENT ACCOUNTING PRONOUNCEMENTS -- (CONTINUED)
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation -- Transition and Disclosure, an amendment of FASB Statement No.
123". This Statement amends FASB Statement No. 123, "Accounting for Stock-Based
Compensation", to provide alternative methods of transition for a voluntary
change to the fair value method of accounting for stock-based employee
compensation. In addition, this Statement amends the disclosure requirements of
Statement No. 123 to require prominent disclosure in both annual and interim
financial statements. Certain of the disclosure requirements are required for
fiscal years ending after December 15, 2002 and are included in the notes to the
consolidated financial statements.
In November 2002, the FASB issued Interpretation No. 45 ("FIN 45"),
Guarantor's Accounting and Disclosure Requirement for Guarantees, Including
Indirect Guarantees of Indebtedness to Others, an interpretation of FASB
Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34.
This Interpretation elaborates on the disclosure to be made by a guarantor in
its interim and annual financial statements about its obligations under
guarantees issued. The Interpretation also clarifies that a guarantor is
required to recognize, at inception of a guarantee, a liability for the fair
value of the obligation undertaken. The initial recognition and measurement
provisions of the Interpretation are applicable to guarantees issued or modified
after December 31, 2002 and are not expected to have a material effect on the
Company's financial statements. The disclosure requirements are effective for
financial statements of interim or annual periods ending after December 15,
2002. The Company has determined that FIN 45 did not have any effect on the
Company's financial statements for fiscal 2002.
In January, 2003, the FASB issued Interpretation No. 46 ("FIN 46"),
"Consolidation of Variable Interest Entities", with the objective of improving
financial reporting by companies involved with variable interest entities. A
variable interest entity is a corporation, partnership, trust, or other legal
structure used for business purposes that either (a) does not have equity
investors with voting rights, or (b) has equity investors that do not provide
sufficient financial resources for the equity to support its activities.
Historically, entities generally were not consolidated unless the entity was
controlled through voting interests. FIN 46 changes that by requiring a variable
interest entity to be consolidated by a company if that company is subject to a
majority of risk of loss from the variable interest entity's activities or
entitled to receive a majority of the entity's residual returns, or both. A
company that consolidates a variable interest entity is called the "primary
beneficiary" of that entity. FIN 46 also requires disclosures about variable
interest entities that a company is not required to consolidate but in which it
has significant variable interest. The consolidation requirements of FIN 46
apply immediately to variable interest entities created after January 1, 2003.
The consolidation requirements of FIN 46 apply to existing entities in the first
fiscal year or interim period beginning after June 15, 2003. Also, certain
disclosure requirements apply to all financial statements issued after January
31, 2003, regardless of when the variable interest entity was established. The
Company has determined that FIN 46 will not have an impact on its financial
condition, results of operations or cash flows.
NOTE P -- CUSTOMER AND SUPPLIER CONCENTRATION
A small number of wholesale drug distributors account for a large portion
of the Company's revenues. In 2002, sales to three wholesale drug distributors
accounted for 57% of total gross sales, 42% of total revenues and approximately
61% of gross trade receivables as of December 31, 2002. Two customers each have
accounted for more than 10% of the Company's revenues during 2002. During 2001,
two customers of the Company, AmeriSource Health Corporation and Bergen Brunswig
Corporation completed a merger to form a new combined entity, AmerisourceBergen
Corporation ("AmerisourceBergen"). This new merged customer accounts for
approximately 22% of the Company's 2002 revenues. In 2002, the Company realized
approximately 12% of its revenues from Cardinal Health, Inc. ("Cardinal"). Both
Cardinal and AmerisourceBergen are distributors of the Company's products as
well as a distributor of a broad range of health care products for many
companies. Neither company is an end user of the Company's products. If sales to
either AmerisourceBergen or Cardinal were to diminish or cease, the Company
believes that the end users of its products would find little difficulty
obtaining the Company's products either directly from the Company or from
another distributor. The accounts receivable balance for AmerisourceBergen and
Cardinal were approximately
66
NOTE P -- CUSTOMER AND SUPPLIER CONCENTRATION -- (CONTINUED)
28% and 27% of gross trade receivables, respectively, as of December 31, 2002.
No single customer accounted for more than 10% of the Company's revenues during
2001. During 2000, the Company realized approximately 12% of its revenues from
Cardinal. The accounts receivable balance for Cardinal was approximately 22% of
gross trade receivables at December 31, 2000.
No supplier of products accounted for more than 10% of the Company's
purchases in 2002, 2001 or 2000. The Company requires a supply of quality raw
materials and components to manufacture and package pharmaceutical products for
itself and for third parties with which it has contracted. The principal
components of the Company's products are active and inactive pharmaceutical
ingredients and certain packaging materials. Many of these components are
available from only a single source and, in the case of many of the Company's
ANDAs and NDAs, only one supplier of raw materials has been identified. Because
FDA approval of drugs requires manufacturers to specify their proposed suppliers
of active ingredients and certain packaging materials in their applications, FDA
approval of any new supplier would be required if active ingredients or such
packaging materials were no longer available from the specified supplier. The
qualification of a new supplier could delay the Company's development and
marketing efforts. If for any reason the Company is unable to obtain sufficient
quantities of any of the raw materials or components required to produce and
package its products, it may not be able to manufacture its products as planned,
which could have a material adverse effect on the Company's business, financial
condition and results of operations.
NOTE Q -- ASSET IMPAIRMENT CHARGES
In the third quarter of 2002, the Company recorded an impairment charge of
$545,000 in selling, general and administration expenses, to write-off abandoned
construction projects and dispose of certain other fixed assets.
During the third quarter of 2002, the Company recorded an impairment charge
of $257,000 related to the product license intangible assets for the products
Sublimaze, Inapsine, Paradrine and Dry Eye test. The Company determined that
projected profitability on the products was not sufficient to support the
carrying value of the intangible asset. The recording of this charge reduced the
carrying value of the intangible assets related to these product licenses to
zero. The charge is reflected in the selling, general and administrative expense
category of the consolidated statement of operations.
In the second quarter of 2002, the Company settled a dispute with JHU/APL
regarding a license agreement and the associated patent (See Note M --
"Commitments and Contingencies" in the notes to the consolidated financial
statements) with a net carrying value of $1,559,500 which was written-off as an
impaired intangible asset during the second quarter.
In May 2001, the Company discontinued one of its products due to
uncertainty of product availability from a third-party manufacturer, rising
manufacturing costs and delays in obtaining FDA approval to manufacture the
product in-house. The Company recorded an asset impairment charge of $1,170,000
related to manufacturing equipment specific to the product and an asset
impairment charge of $140,000 related to the remaining balance of the product
acquisition intangible asset during the first quarter of 2001.
In November 2001, the Company decided to no longer sell one of its products
due to unavailability of raw material at a competitive price and declining
market share. The Company recorded an asset impairment charge of $725,000
related to the remaining balance of the product acquisition intangible asset
during the fourth quarter of 2001.
NOTE R -- RESTRUCTURING CHARGES
During 2001, the Company adopted a restructuring program to properly size
its operations to then current business conditions. These actions were designed
to reduce costs and improve operating efficiencies. The program included, among
other items, severance of employees, plant-closing costs related to the
Company's San Clemente, CA sales office and rent for unused facilities under
lease in San Clemente and Lincolnshire, IL. The restructuring, affecting all
three business segments, reduced the Company's workforce by 50
67
NOTE R -- RESTRUCTURING CHARGES -- (CONTINUED)
employees, primarily sales and manufacturing related, representing 12.5% of the
total workforce. Activities previously executed in San Clemente have been
relocated to the Company's headquarters.
The restructuring program costs are included in selling, general and
administrative expenses in the accompanying consolidated statement of operations
and resulted in a charge to operations of approximately $1,117,000 consisting of
severance costs of $398,000, lease costs of $625,000 and other costs of $94,000.
At December 31, 2002, the amount remaining in the accruals for the restructuring
program was approximately $40,000. Approximately $589,000 of the restructuring
accrual was paid by December 31, 2001 ($181,000 severance, $314,000 lease costs,
$94,000 other) and the remainder was paid by June 30, 2002, except for $176,000
in lease costs that continued through February of 2003.
NOTE S -- SUBSEQUENT EVENTS
On February 27, 2003, the Company reached an agreement in principle with
the staff of the SEC's regional office in Denver, Colorado, that would resolve
the issues arising from the staff's investigation and proposed enforcement
action as discussed above. The Company has offered to consent to the entry of an
administrative cease and desist order as proposed by the staff, without
admitting or denying the findings set forth therein. The proposed consent order
finds that the Company failed to promptly and completely record and reconcile
cash and credit remittances, including from its top five customers, to invoices
posted in its accounts receivable sub-ledger. According to the findings in the
proposed consent order, the Company's problems resulted from, among other
things, internal control and books and records deficiencies that prevented the
company from accurately recording, reconciling and aging its receivables. The
proposed consent order finds that the Company's 2000 Form 10-K and first quarter
2001 Form 10-Q misstated its account receivable balance or, alternatively,
failed to disclose the impairment of its accounts receivable and that its first
quarter 2001 Form 10-Q inaccurately attributed the increased accounts receivable
reserve to a change in estimate based on recent collection efforts, in violation
of Section 13(a) of the Exchange Act and rules 12b-20, 13a-1 and 13a-13
thereunder. The proposed consent order also finds that the Company failed to
keep accurate books and records and failed to devise and maintain a system of
adequate internal accounting controls with respect to its accounts receivable in
violation of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act. The
proposed consent order does not impose a monetary penalty against the Company or
require any additional restatement of the Company's financial statements. The
Company has recently become aware of and informed the SEC staff of certain
weaknesses in its internal controls, which it is in the process of addressing.
It is uncertain at this time what effect that these actions will have on the
agreement in principle currently pending with the SEC staff. The proposed
consent order does not become final until it is approved by the SEC.
Accordingly, the Company may incur additional costs and expenses in connections
with this proceeding.
On December 18, 2002, Dr. John N. Kapoor submitted his resignation as Chief
Executive Officer of the Company. Dr. Kapoor will remain Chairman of the Board
of Directors of the Company. On February 17, 2003, Arthur S. Przybyl was named
Interim Chief Executive Officer of the Company.
On February 18, 2003 the Company announced that it had received approval
from the FDA for its Abbreviated New Drug Application ("ANDA") for Lidocaine
Jelly, 2% ("Lidocaine Jelly"), a bioequivalent to Xylocaine Jelly (R), a product
of AstraZeneca PLC used primarily as a topical anesthetic by urologists and
hospitals. This product will be manufactured at the Company's Somerset, New
Jersey facility.
In February of 2003, the Company recalled two products, Fluress and
Fluoracaine, due to container/ closure integrity problems resulting in leaking
containers. The recall has been classified by the FDA as a Class II recall,
which means that the use of, or exposure to, a violative product may cause
temporary or medically reversible adverse health consequences or that the
probability of serious health consequences as the result of such use or exposure
is remote. To date, the Company has not received any notification or complaints
from end users of the recalled products. The financial impact to the Company of
this recall is not expected to be material to the financial statements.
68
NOTE S -- SUBSEQUENT EVENTS -- (CONTINUED)
In March of 2003, as a result of the most recent FDA inspection, the
Company recalled twenty-four lots of product produced from the period December
2001 to June 2002 in one of its production rooms at its Decatur, IL facility.
The majority of the lots recalled were for third party contract customer
products. Subsequent to this decision and after discussions with the FDA, eight
of the original twenty-four lots have been exempted from the recall due to
medical necessity. At this time, the FDA has not reached a conclusion on the
classification of this recall. To date, the Company has not received any
notification or complaints from end users of the recalled products. The Company
believes the financial impact of this recall will not be material to the
financial statements.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
The Report on Form 8-K filed by the Company with the SEC on May 1, 2003 is
hereby incorporated by reference.
69
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth the directors and executive officers of the
Company as of April 15, 2003. Each officer serves as such at the pleasure of the
Board of Directors.
<Table>
<Caption>
NAME AGE ARTICLE II. POSITION WITH THE COMPANY
- ---- --- -------------------------------------
John N. Kapoor, Ph.D. ..... 59 Director, Chairman of the Board
Arthur S. Przybyl.......... 46 President and Interim Chief Executive Officer
Bernard J. Pothast......... 41 Sr. Vice President, Chief Financial Officer, Secretary and Treasurer
Daniel E. Bruhl, M.D. ..... 60 Director
Doyle S. Gaw............... 71 Director
Jerry N. Ellis............. 65 Director
Ronald M. Johnson.......... 57 Director
</Table>
Dr. Bruhl, Mr. Gaw and Mr. Ellis comprise Akorn's audit committee. Dr.
Bruhl and Mr. Gaw comprise Akorn's compensation committee.
John N. Kapoor, Ph.D. Dr. Kapoor has served as Chairman of the Board of the
Company since May 1995 and from December 1991 to January 1993. Dr. Kapoor served
as Chief Executive Officer of the Company from March 2001 to December 2002. Dr.
Kapoor also served as acting Chairman of the Board of the Company from April
1993 to May 1995 and Chief Executive Officer of the Company from May 1996 to
November 1998. Dr. Kapoor serves as Chairman of the Board of Option Care, Inc.
(an infusion services and supplies company) and was Chief Executive Officer of
Option Care, Inc. from August 1993 to April 1996. Dr. Kapoor is the president of
E.J. Financial Enterprises, Inc. (a health care consulting and investment
company) and has served as Chairman of the Board of NeoPharm, Inc. (a specialty
pharmaceutical company) since July 1990. Dr. Kapoor is a director of First
Horizon Pharmaceutical Corporation (a distributor of pharmaceuticals) and of
Introgen Therapeutics, Inc. (a gene therapy company).
Arthur S. Przybyl, Mr. Przybyl has served as interim Chief Executive
Officer since February 2003, having served as President and Chief Operating
Officer since September, 2002. Mr. Przybyl joined the company in August 2002 as
senior vice president sales and marketing. Prior to joining Akorn, Mr. Przybyl
served as president and chief executive officer for Hearing Innovations Inc., an
innovative, start-up developer of medical devices for the profoundly deaf and
tinnitus markets. Previous to that, he served as president and chief operating
officer for Bioject, Inc., a NASDAQ company specializing in needle-free
technology.
Bernard J. Pothast. Mr. Pothast has served as Senior Vice President of the
Company since June 2002 and Vice President, Chief Financial Officer, Secretary
and Treasurer of the Company since September 2001. From 1998 to 2001, he was
Director of Financial Planning and Analysis of Moore North America (a business
form printing company). From 1995 to 1998, Mr. Pothast was Director of Business
Planning and Corporate Finance of GATX Corporation (a transportation and
logistics company). From 1990 to 1995, he was Manager of Financial Reporting and
Analysis for The Perseco Company (a packaging and logistics company). Mr.
Pothast began his career at the public accounting firm of Ernst & Young. Mr.
Pothast is also a director of Novadaq Technologies, Inc., a privately held
research company.
Daniel E. Bruhl, M.D. Dr. Bruhl has served as a Director of the Company
since 1983. Dr. Bruhl is an ophthalmologist, President of the Surgery Center of
Fort Worth and a director of Medsynergies, Inc., (private ophthalmology practice
management company). Dr. Bruhl was a director of Surgical Care Affiliates
(outpatient surgery center company) from 1983 to 1996, when it merged with
Healthsouth Corporation.
Doyle S. Gaw. Mr. Gaw has served as a Director of the Company since 1975.
Mr. Gaw is a private investor.
Jerry N. Ellis. Mr. Ellis has served as a Director of the Company since
2001. Mr. Ellis is an Adjunct Professor in the Department of Accounting at The
University of Iowa. Mr. Ellis was a consultant to Arthur
70
Andersen, LLP from 1994 to 2000 and a Partner at Arthur Andersen in the Dallas,
Madrid and Chicago offices from 1973 to 1994. Mr. Ellis is a director of First
Horizon Pharmaceutical Corporation (a distributor of pharmaceuticals).
Ronald M. Johnson. Mr. Johnson was appointed by the Board of Directors to
the Board as of March 22, 2003. Mr. Johnson is currently Executive Vice
President of Quintiles Consulting, a company which provides consulting services
to pharmaceutical, medical device, biologic and biotechnology industries in
their efforts to meet the regulatory requirements of the FDA. Prior to joining
Quintiles in 1997, Mr. Johnson spent thirty years with the FDA holding various
senior level positions primarily in the compliance and enforcement areas.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
During 2002, Mr. Przybyl and Mr. Pothast, both officers of the Company,
failed to file timely with the SEC one Form 4 to report current transactions, as
required by Section 16(a) of the Securities Exchange Act of 1934. All such
transactions have been reported on amended statements or annual statements on
Form 5.
ITEM 11. EXECUTIVE COMPENSATION
The following table summarizes the compensation paid by the Company for
services rendered during the years ended December 31, 2002, 2001 and 2000 to
each person who, during 2002, served as the chief executive officer of the
Company and to each other executive officer of the Company whose total annual
salary and bonus for 2002 exceeded $100,000 (each a "Named Executive Officer").
SUMMARY COMPENSATION TABLE
<Table>
<Caption>
LONG-TERM
COMPENSATION
------------
ANNUAL COMPENSATION SECURITIES
NAME AND PRINCIPAL -------------------------------------------------- UNDERLYING ALL OTHER(1)
POSITION TIME PERIOD SALARY BONUS(2) OPTIONS/SARS COMPENSATION
------------------ ----------- ------ -------- ------------ ------------
John N. Kapoor(3)......... Year ended December 31, 2002 $ -- $ -- -- $ --
Chairman Year ended December 31, 2001 2,083 -- 500,000 --
Year ended December 31, 2000 50,000 -- 5,000 --
Arthur S. Przybyl(4)...... Year ended December 31, 2002 93,482 -- 300,000 3,308
President and Interim Year ended December 31, 2001 -- -- -- --
Chief Executive Officer Year ended December 31, 2000 -- -- -- --
Antonio R. Pera(5)........ Year ended December 31, 2002 140,000 -- 50,000 148,000
Former President and Year ended December 31, 2001 145,186 -- 500,000 12,591
Chief Operating Officer Year ended December 31, 2000 -- -- -- --
Bernard J. Pothast(6)..... Year ended December 31, 2002 148,263 -- 100,000 --
Sr. Vice President, Year ended December 31, 2001 39,094 -- 75,000 --
Chief Financial Officer, Year ended December 31, 2000 -- -- -- --
Secretary and Treasurer
</Table>
- ---------------
(1) Represents contributions to the Company's Savings and Retirement Plan,
except as indicated in notes (4), (5), (6) and (7).
(2) There were no executive officer bonuses awarded for 2002, 2001 or 2000.
(3) Dr. Kapoor currently serves as Chairman and served as Chief Executive
Officer of the Company from March 2001 to December 2002. In lieu of a salary
for 2001, the Company issued Dr. Kapoor options to purchase 500,000 shares
of the Company's common stock. Dr. Kapoor was not paid a salary or granted
options in 2002.
(4) Mr. Przybyl became President and Chief Operating Officer on September 23,
2002. His "Other Compensation" for 2002 includes $3,307 for auto allowance.
Mr. Przybyl became Interim Chief Executive Officer on February 17, 2003.
71
(5) Mr. Pera became President and COO of the Company on June 4, 2001. Mr. Pera's
"Other Compensation" for 2002 includes $140,000 for severance, $6,000 for
auto allowance and $2,000 for Company sponsored life insurance. His "Other
Compensation" for 2001 includes $7,000 for auto allowance and $4,486 for
Company sponsored life insurance. Mr. Pera's employment with the Company
terminated June 7, 2002.
(6) Mr. Pothast has been Chief Financial Officer, Secretary and Treasurer of the
Company since September 2001.
OPTION/SAR GRANTS IN LAST FISCAL YEAR
The following table sets forth certain information with respect to stock
options granted to each of the Named Executive Officers in the fiscal year ended
December 31, 2002, including the potential realizable value over the five-year
term of the options, based on assumed rates of stock appreciation of 5% and 10%
of the market price of the underlying security on the date of grant, compounded
annually. These assumed rates of appreciation comply with the rules of the SEC
and do not represents Akorn's estimate of future stock price. Actual gains, if
any, on stock option exercises will be dependent on the future performance of
Akorn's common stock.
<Table>
<Caption>
POTENTIAL REALIZABLE
INDIVIDUAL GRANTS VALUE AT ASSUMED
-------------------------------- ANNUAL RATES OF STOCK
NUMBER OF PERCENT OF TOTAL PRICE APPRECIATION FOR
SECURITIES OPTIONS/SARS EXERCISE OPTION TERM
UNDERLYING GRANTED TO OR BASE ----------------------------------
OPTIONS/SARS EMPLOYEES IN PRICE EXPIRATION
NAME GRANTED (#) FISCAL YEAR ($/SH) DATE 5%($) 10%($)
---- ------------ ---------------- -------- ---------- -------- --------
Arthur S. Przybyl........... 175,000(1) 40% 1.00 8/05/07 223,349 281,839
125,000(1) 1.20 9/16/07 191,442 241,577
Antonio R. Pera............. 50,000(1) 40% 3.54 2/19/07 225,902 285,060
Bernard J. Pothast.......... 25,000(1) 40% 3.54 2/19/07 112,901 142,530
75,000(1) 1.20 9/16/07 114,865 144,946
</Table>
- ---------------
(1) Issued pursuant to the Amended and Restated 1988 Incentive Compensation
Program.
AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR
AND FY-END OPTION/SAR VALUES
<Table>
<Caption>
NUMBER OF VALUE OF
SECURITIES UNDERLYING UNEXERCISED IN-THE-
UNEXERCISED OPTIONS/ MONEY OPTIONS/SARS AT
SARS AT FY-END (#) FY-END ($)(1)
SHARES --------------------- ---------------------
ACQUIRED ON VALUE EXERCISABLE/ EXERCISABLE/
NAME EXERCISE (#) REALIZED ($) UNEXERCISABLE UNEXERCISABLE
---- --------------- ------------ --------------------- ---------------------
John N. Kapoor................. 5,000 $20,475 383,438/250,000 --/ --
Antonio R. Pera................ -- -- 550,000/ -- --/ --
Arthur S. Przybyl.............. -- -- 75,000/125,000 12,500/50,000
Bernard J. Pothast............. -- -- 62,500/112,500 938/ 3,750
</Table>
- ---------------
(1) Value of Unexercised in-the-Money options calculated using the 12/31/02
closing price of $1.25.
EMPLOYMENT AGREEMENTS
In May 2001 the Company entered into an employment agreement with Mr. Pera
pursuant to which Mr. Pera served as President and Chief Operating Officer of
the Company. The employment agreement provides for an annual salary of $260,000,
increased annually at the discretion of the Board of Directors, plus bonuses
determined by a formula stated in the agreement. In addition, the employment
agreement contains
72
restrictive covenants concerning the use of confidential information,
non-competition and non-solicitation of the Company's employees, both during the
term of and after termination of Mr. Pera's employment with the Company. Mr.
Pera's employment with the Company terminated on June 7, 2002. In accordance
with the employment agreement and the severance agreement executed at the time
of his termination, the Company is committed to pay Mr. Pera salary continuance
for one year, provide continuation of health benefits and fully vest all stock
option grants.
In September 2001, Mr. Pothast received and accepted an employment offer
letter for the position of Vice President Finance and Chief Financial Officer of
the Company. His letter provides for an annual salary of $135,000 (to be
increased to $150,000 following the Company's first full quarter of positive
operating income), a discretionary bonus of up to 30% of his base salary, a
grant of options to purchase 75,000 shares of the Company's common stock,
severance for six months of his base salary if he is terminated without cause,
and other customary benefits for employees of the Company.
In January 2003, Mr. Przybyl received and accepted an employment offer
letter of the position of Interim Chief Executive Officer of the Company. His
letter provides for an annual salary of $260,000, a discretionary bonus of up to
50% of his base salary, a grant of options to purchase 50,000 shares of the
Company's common stock, severance for one year at his base salary if he is
terminated without cause, and other customary benefits for employees of the
Company. The Company currently has no other employment agreements in place. In
connection with his serving as interim Chief Executive Officer of the Company,
the Company has provided to Mr. Przybyl supplemental indemnity assurances with
respect to any claims associated with his execution, filing and submission Chief
Executive Officer Certifications of SEC reports for periods preceding his direct
supervision of financial and accounting matters.
COMPENSATION COMMITTEE INTERLOCKS
Dr. Bruhl and Mr. Gaw, who currently comprise the Compensation Committee,
are each independent, non-employee directors of the Company. No executive
officer of the Company served as a director or member of (i) the compensation
committee of another entity in which one of the executive officers of such
entity served on the Company's Compensation Committee, (ii) the board of
directors of another entity in which one of the executive officers of such
entity served on the Company's Compensation Committee, or (iii) the compensation
committee of any other entity in which one of the executive officers of such
entity served as a member of the Company's Board of Directors, during the year
ended December 31, 2002.
COMPENSATION OF DIRECTORS
Each director who is not a salaried officer of the Company receives a fee
for his services as a director of $2,500 per regular meeting of the Board of
Directors, $500 per telephone meeting and $500 per committee meeting, plus
reimbursement of his expenses related to those services
All directors of the Company participate in the Company's Stock Option Plan
for Directors, pursuant to which each director of the Company is granted an
option to acquire 5,000 shares of Company common stock on the day after each
annual meeting of shareholders at which he is elected to serve as a director.
Any director appointed between annual meetings is entitled to receive a pro rata
portion of an option to acquire 5,000 shares. The Compensation Committee may, in
its sole discretion, grant an option to purchase up to 100,000 shares to a
person who is not already a director and who becomes a director at any time; no
member of the Compensation Committee is eligible to be granted such an option
and any director who has been granted such an option is not permitted to serve
on the Compensation Committee for one year after such grant. Options granted
under the plan vest immediately and expire five years from the date of grant.
Upon joining the Board in 2001, Mr. Ellis was granted an option under the plan
for 20,000 shares. The option exercise price for all options granted under the
plan is the fair market value of the shares covered by the option at the time of
the grant.
73
COMPENSATION COMMITTEE REPORT
The Compensation Committee of the Board of Directors reviews, analyzes and
makes recommendations related to compensation packages for the Company's
executive officers, evaluates the performance of the Chief Executive Officer and
the Chief Operating Officer and administers the grant of stock options under the
Company's Incentive Compensation Program.
The Company's executive compensation policies are designed to (a) provide
competitive levels of compensation to attract and retain qualified executives,
(b) reward achievements in corporate performance, (c) integrate pay with annual
and long-term performance goals and (d) align the interests of executives with
the goals of shareholders.
Compensation paid to Company executives consists of salaries, annual cash
incentive bonuses and long-term incentive opportunities in the form of stock
options.
Salary
Mr. Przybyl's salary for 2002 was fixed in his employment offer letter at
an annual rate of $260,000. Mr. Pera's salary for 2002 and 2001 was fixed in his
employment agreement.
Incentive Bonus
Annual incentive compensation for executive officers during 2002, 2001 and
2000 was based on corporate earnings objectives as well as position-specific
performance objectives. There were no performance bonuses granted to executive
officers for 2002 or 2001.
Stock Options
The Committee's practice with respect to stock options has been to grant
options based upon the attainment of Company performance goals and to vest
options based on the passage of time. The option grants noted in the
compensation tables include grants upon initial employment and annual grants as
well as grants issued under the Stock Option Plan for Directors to those named
executive officers that are also directors.
It is the responsibility of the Committee to address the issues raised by
tax laws under which certain non-performance based compensation in excess of $1
million per year paid to executives of public companies is non-deductible to the
Company and to determine whether any actions with respect to this limit need to
be taken by the Company. It is not anticipated that any executive officer of the
Company will receive any compensation in excess of this limit.
SUBMITTED BY THE COMPENSATION COMMITTEE OF THE BOARD OF DIRECTORS
Daniel E. Bruhl, M.D. Doyle S. Gaw
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
As of April 28, 2003, the following persons were directors, nominees, Named
Executive Officers (as defined in "Executive Compensation" above), or others
with beneficial ownership of five percent or more of the Company's common stock.
The information set forth below has been determined in accordance with Rule
13d-3 under the Securities Exchange Act of 1934 based upon information furnished
to the Company or to the SEC by the persons listed. Unless otherwise noted the
address of each of the following persons is 2500 Millbrook Drive, Buffalo Grove,
Illinois 60089.
74
<Table>
<Caption>
BENEFICIAL OWNER SHARES BENEFICIALLY OWNED PERCENT OF CLASS
- ---------------- ------------------------- ----------------
DIRECTORS AND NOMINEES
John N. Kapoor, Ph.D..................................... 9,198,146(1) 37.72%
Daniel E. Bruhl, M.D..................................... 316,767(2) 1.61%
Doyle S. Gaw............................................. 107,860(2) 0.55%
Jerry N. Ellis........................................... 20,000(2) 0.10%
Ronald M. Johnson........................................ --(3)
NAMED EXECUTIVE OFFICERS
Arthur S. Przybyl........................................ 94,947(4) 0.48%
Bernard J. Pothast....................................... 75,000(5) 0.38%
Directors and officers as a group (6 persons)............ 9,812,720(6) 39.88%
OTHER BENEFICIAL OWNERS
Arjun C. Waney(7)........................................ 1,918,500 9.76%
</Table>
- ---------------
(1) Of such 9,198,146 shares, (i) 851,800 are owned directly by the John N.
Kapoor Trust dated September 20, 1989 (the "Trust") of which Dr. Kapoor is
the sole trustee and beneficiary, (ii) 3,395,000 are owned by EJ
financial/Akorn Management, L.P. of which Dr. Kapoor is managing general
partner, (iii) 25,000 are owned directly by Dr. Kapoor, (iv) 63,000 are
owned by a trust, the trustee of which is Dr. Kapoor's wife and the
beneficiaries of which are their children, (v) 633,438 are issuable pursuant
to options granted by the Company directly to Dr. Kapoor, (vii) 1,667,000
are issuable upon exercise of warrants issued to the John N. Kapoor Trust
dated September 20, 1989, (viii) 2,426,900 are issuable upon the conversion
of a convertible note held by the John N. Kapoor Trust dated September 20,
1989 and (ix) 376,658 are issuable upon the conversion of interest related
to the convertible note held by the John N. Kapoor Trust dated September 20,
1989.
(2) The reported shares include options to purchase shares. The shares reported
for Directors Bruhl, Gaw and Ellis include options to purchase 20,000,
20,000 and 20,000 shares, respectively. In addition, Dr. Bruhl's retirement
plan holds 64,266 of the listed shares.
(3) Mr. Johnson was appointed to the Akorn board on March 22, 2003.
(4) Mr. Przybyl's shares reported include options to purchase 87,500 shares.
These stock options represent presently exercisable options from three
separate grants totaling 350,000 shares, each of which vest in four equal
increments, one quarter on the grant date and one quarter for each of the
next three successive anniversary dates.
(5) Mr. Pothast's shares reported include options to purchase 75,000 shares.
These stock options represent presently exercisable options from three
separate grants totaling 200,000 shares, each of which vest in four equal
increments, one quarter on the grant date and one quarter for each of the
next three successive anniversary dates.
(6) Of such 9,812,720 shares, 4,949,838 are not presently outstanding, but are
issuable pursuant to option rights described in the preceding footnotes.
(7) Of such 1,918,500 shares, (i) 458,500 are owned by Argent Fund Management
Ltd., a United Kingdom corporation having a mailing address of 67 Cheval
Place, London SW7 1HP, U.K. ("Argent") for which Mr. Waney serves as
Chairman and Managing Director and of which 51% is owned by Mr. Waney, (ii)
628,400 are owned by First Winchester Investments Ltd., a British Virgin
Islands corporation having a mailing address of 8 Church Street, St. Helier,
Jersey JE4 0SG, Channel Islands, which operates as an equity fund for
investors unrelated to Mr. Waney and whose investments are directed by
Argent, (iii) 506,000 are owned by Mr. Waney through certain Individual
Retirement Accounts maintained in the United States, and (iv) 325,600 are
owned directly by Mr. Waney and his spouse.
75
EQUITY COMPENSATION PLANS
Equity Compensation Plans Approved by Stockholders.
The stockholders have approved the Akorn, Inc. 1988 Incentive Compensation
Program, under which any officer or key employee of the Company is eligible to
receive stock options as designated by the Company's Board of Directors, and the
Akorn, Inc. 1991 Stock Option (the "1991 Directors' Plan"), under which, prior
to the Plan's expiration in December 2001, options were issuable to directors of
the Company.
Equity Compensation Plans not Approved by Stockholders.
With the expiration of the 1991 Directors' Plan, the Board of Directors has
approved, subject to obtaining stockholders' approval at the Company's next
Annual Meeting, the Akorn, Inc. 2002 Stock Option Plan for Directors (the "2002
Directors' Plan"). The terms of the proposed plan are almost identical to the
1991 Director's Plan, with the following exceptions: (i) only independent
Directors will be eligible to receive options under the proposed plan (versus
all Directors under the 1991 plan) and (ii) Directors will receive annual grants
of 15,000 shares of common stock which will vest over one year (versus 5,000
vesting over six months). Additionally, the number of shares authorized for the
Director's plan will be increased from 500,000 shares to 1,000,000 shares.
On November 21, 2002, the Company entered into a success fee arrangement
with its restructuring consultants AEG Partners which provides that the Company
will issue 1,250,000 warrants to purchase common stock at an exercise price of
$1.00 per warrant share upon the date on which each of the following conditions
have been met or waived by the Company: (i) the Forbearance Agreement shall have
been terminated, (ii) the consultants engagement pursuant to its consulting
agreement shall have been terminated and (iii) the Company shall have executed a
new or restated multi-year credit facility. All unexercised warrants shall
expire on the fourth anniversary of the date of issuance.
Summary Table. The following table sets forth certain information as of
December 31, 2002, with respect to compensation plans under which shares of
Akorn common stock were issuable as of that date.
<Table>
<Caption>
NUMBER OF SECURITIES
REMAINING AVAILABLE FOR FUTURE
NUMBER OF SECURITIES TO ISSUANCE UNDER EQUITY
BE ISSUED UPON EXERCISE WEIGHTED-AVERAGE PRICE COMPENSATION PLANS
OF OUTSTANDING OPTIONS, OF OUTSTANDING OPTIONS, (EXCLUDING SECURITIES REFLECTED
PLAN CATEGORY WARRANTS AND RIGHT. WARRANT AND RIGHTS IN THE FIRST COLUMN)
- ------------- ----------------------- ----------------------- -------------------------------
Equity Compensation plans
approved by security
holders:....................... 2,087,625 $3.9816 2,052,751
Equity Compensation plans not
approved by security
holders:....................... 623,750 $1.2892 1,626,250
--------- ------- ---------
TOTAL.......................... 1,711,375 -- 3,679,001
========= ======= =========
</Table>
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Mr. John N. Kapoor, Ph.D., the Company's current Chairman of the Board and
Chief Executive Officer from March 2001 to December 2002, and a principal
shareholder, is affiliated with EJ Financial Enterprises, Inc., a health care
consulting investment company ("EJ Financial"). EJ Financial is involved in the
management of health care companies in various fields, and Dr. Kapoor is
involved in various capacities with the management and operation of these
companies. The John N. Kapoor Trust, the beneficiary and sole trustee of which
is Dr. Kapoor, is a principal shareholder of each of these companies. As a
result, Dr. Kapoor does not devote his full time to the business of the Company.
Although such companies do not currently compete directly with the Company,
certain companies with which EJ Financial is involved are in the pharmaceutical
business. Discoveries made by one or more of these companies could render the
Company's products less competitive or obsolete. In addition, one of these
companies, NeoPharm, Inc. of which Dr. Kapoor is Chairman and a major
stockholder, recently entered into a loan agreement with the Company. The
Company also owes EJ Financial $18,000 in consulting fees for each of 2002 and
2001, as well as expense
76
reimbursements of $1,987.30 and $182,369.84 for 2002 and 2001, respectively.
Further, The John N. Kapoor Trust has loaned the Company $5,000,000 resulting in
Dr. Kapoor becoming a major creditor of the Company as well as a major
shareholder.
On March 21, 2001, in consideration of Dr. Kapoor assuming the positions of
President and interim CEO of the Company, the Compensation Committee of the
Board of Directors agreed to issue Dr. Kapoor 500,000 options under the Amended
and Restated Akorn, Inc. 1988 Incentive Compensation Program in lieu of cash
compensation.
On July 12, 2001, the Company entered into a $5,000,000 subordinated debt
transaction with the John N. Kapoor Trust dtd. 9/20/89 (the "Trust"), the sole
trustee and sole beneficiary of which is Dr. John N. Kapoor, the Company's
Chairman of the Board of Directors. The transaction is evidenced by a
Convertible Bridge Loan and Warrant Agreement (the "Trust Agreement") in which
the Trust agreed to provide two separate tranches of funding in the amounts of
$3,000,000 ("Tranche A" which was received on July 13, 2001) and $2,000,000
("Tranche B" which was received on August 16, 2001). As part of the
consideration provided to the Trust for the subordinated debt, the Company
issued the Trust two warrants which allow the Trust to purchase 1,000,000 shares
of common stock at a price of $2.85 per share and another 667,000 shares of
common stock at a price of $2.25 per share. The exercise price for each warrant
represented a 25% premium over the share price at the time of the Trust's
commitment to provide the subordinated debt. All unexercised warrants will
expire on December 20, 2006.
Under the terms of the Trust Agreement, the subordinated debt bears
interest at prime plus 3%, which is the same rate the Company pays on its senior
debt. Interest cannot be paid to the Trust until the repayment of the senior
debt pursuant to the terms of a subordination agreement, which was entered into
between the Trust and the Company's senior lenders. Should the subordination
agreement be terminated, interest may be paid sooner. The convertible feature of
the Trust Agreement, as amended, allows for conversion of the subordinated debt
plus interest into common stock of the Company, at a price of $2.28 per share of
common stock for Tranche A and $1.80 per share of common stock for Tranche B.
In December 2001, the Company entered into a $3,250,000 five-year loan with
NeoPharm, Inc. ("NeoPharm") to fund Akorn's efforts to complete its
lyophilization facility located in Decatur, Illinois. Under the terms of the
promissory note, dated December 20, 2001, evidencing the loan (the Promissory
Note") interest will accrue at the initial rate of 3.6% and will be reset
quarterly based upon NeoPharm's average return on its cash and readily tradable
long and short-term securities during the previous calendar quarter. The
principal and accrued interest is due and payable on or before maturity on
December 20, 2006. The note provides that Akorn will use the proceeds of the
loan solely to validate and complete the lyophilization facility located in
Decatur, Illinois. In consideration for the loan, under a separate manufacturing
agreement between the Company and NeoPharm, the Company, upon completion of the
lyophilization facility, agrees to provide NeoPharm with access to at least 15%
of the capacity of Akorn's lyophilization facility each year. The Promissory
Note is subordinated to Akorn's senior debt owed to The Northern Trust Company
but is senior to Akorn's subordinated debt owed to the Trust. Dr. John N.
Kapoor, the Company's chairman is also chairman of NeoPharm and holds a
substantial stock position in that company as well as in the Company.
Commensurate with the completion of the Promissory Note between the Company
and NeoPharm, the Company entered into an agreement with the Trust, which
amended the Trust Agreement. The amendment extended the Trust Agreement to
terminate concurrently with the Promissory Note on December 20, 2006. The
amendment also made it possible for the Trust to convert the interest accrued on
the $3,000,000 tranche into common stock of the Company. Previously, the Trust
could only convert the interest accrued on the $2,000,000 tranche. The change
related to the convertibility of the interest accrued on the $3,000,000 tranche
requires that shareholder approval be received by August 31, 2002, which date
has been extended to June 30, 2003.
The Company has an equity ownership interest in Novadaq Technologies, Inc.
("Novadaq") of 4,132,000 common shares, representing approximately 16.9% of the
outstanding stock of Novadaq. Previously, the Company had entered into a
marketing agreement with Novadaq, which was terminated in early 2002. The
77
Company, as part of the termination settlement, received the aforementioned
shares and entered into an agreement with Novadaq to be the exclusive future
supplier of Indocyanine Green for use in Novadaq's diagnostic procedures. The
Company also has the right to appoint one individual to the Board of Directors
of Novadaq. Ben J. Pothast, the Company's Chief Financial Officer, currently
serves in this capacity.
ITEM 14. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are designed
to ensure that information required to be disclosed in the Company's Exchange
Act reports is recorded, processed, summarized and reported within the periods
specified in the SEC's rules and forms and that such information is accumulated
and communicated to the Company's management including its Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow timely decisions
regarding required disclosure.
Within 90 days of this report, the Company carried out an evaluation, under
the supervision and with the participation of our management, including the
Company's Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of the Company's disclosure controls
and procedures. Based on that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that, as of the evaluation date, the disclosure
controls and procedures are effective in timely communicating to them the
material information relating to the Company required to be included in the
Company's periodic SEC filings.
As discussed in greater detail in the Company's Report on Form 8-K dated
May 1, 2003, Deloitte & Touche LLP ("Deloitte") informed the Company that, in
connection with its audit of the Company's consolidated financial statements for
the year ended December 31, 2002, it noted certain matters involving the
Company's internal controls that Deloitte considered to be material weaknesses.
Although the Company does not necessarily agree with Deloitte's judgment that
there existed material weaknesses in the Company's internal controls, the
Company is in the process of implementing procedures designed to address all
relevant internal control issues.
To date, the Company has expanded its interim evaluation of accounts
receivable for purposes of determining the allowance for doubtful accounts and
has reassigned certain personnel to strengthen the accounting for fixed assets.
78
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a).2. Financial Statement Schedule. The following Financial Statement
Schedule is filed with this Annual Report on Form 10-K on the page
indicated:
Description Page
II. Valuation and Qualifying
Accounts 82
(a).3. Exhibits
Those exhibits marked with an asterisk (*) refer to exhibits filed
herewith. The other exhibits are incorporated herein by reference, as indicated
in the following list.
<Table>
(2.0) Agreement and Plan of Merger among Akorn, Inc., Taylor, and
Pasadena Research Laboratories, Inc. dated May 7, 1996,
incorporated by reference to the Company's report on Form
10-K for the fiscal year ended June 30, 1996.
(3.1) Restated Articles of Incorporation of the Company dated
September 6, 1991, incorporated by reference to Exhibit 3.1
to the Company's report on Form 10-K for the fiscal year
ended June 30, 1991.
(3.2) Articles of Amendment to Articles of Incorporation of the
company dated February 28, 1997, incorporated by reference
to Exhibit 3.2 to the Company's report on Form 10-K for the
transition period from July 1, 1996 to December 31, 1996.
(3.3) Current Composite of By-laws of the Company, incorporated by
reference to Exhibit 3.3 to the Company's report on Form
10-K for the transition period from July 1, 1996 to December
31, 1996.
(4.1) Specimen Common Stock Certificate, incorporated by reference
to Exhibit 4.1 to the Company's report on Form 10-K for the
fiscal year ended June 30, 1988.
(10.1) Consulting Agreement dated November 15, 1990 by and between
E. J. Financial Enterprises, Inc., a Delaware corporation,
and the Company, incorporated by reference to Exhibit 10.24
to the Company's report on Form 10-K for the fiscal year
ended June 30, 1991.
(10.2) Amendment No. 1 to the Amended and Restated Akorn, Inc. 1988
Incentive Compensation Program, incorporated by reference to
Exhibit 10.33 to the Company's report on Form 10-K for the
fiscal year ended June 30, 1992.
(10.3) 1991 Akorn, Inc. Stock Option Plan for Directors,
incorporated by reference to Exhibit 4.3 to the Company's
registration statement on Form S-8, registration number
33-44785.
(10.4) Common Stock Purchase Warrant dated September 3, 1992,
issued by the Company to the John N. Kapoor Trust dated
September 20, 1989, incorporated by reference to Exhibit No.
7 to Amendment No. 3 to Schedule 13D, dated September 10,
1992, filed by John N. Kapoor and the John N. Kapoor Trust
dated September 20, 1989.
(10.5) Amended and Restated Credit Agreement dated September 15,
1999 among the Company, Akorn (New Jersey), Inc. and The
Northern Trust Company (the "Credit Agreement"),
incorporated by reference to Exhibit 10.5 to the Company's
report on Form 10-K for the fiscal year ended December 31,
1999.
(10.6) Amendment No. 1 to the Credit Agreement dated December 28,
1999, incorporated by reference to Exhibit 10.6 to the
Company's report on Form 10-K for the fiscal year ended
December 31, 1999.
(10.7) Amendment No. 2 to the Credit Agreement dated February 15,
2001, incorporated by reference to Exhibit 10.1 to the
Company's report on Form 8-K filed on April 17, 2001.
(10.8) Amendment No. 3 to the Credit Agreement dated April 16,
2001, incorporated by reference to Exhibit 10.2 to the
Company's report on Form 8-K filed on April 17, 2001.
</Table>
79
<Table>
(10.9) Promissory Note among the Company, Akorn (New Jersey), Inc.
and The Northern Trust Company dated April 16, 2001,
incorporated by reference to Exhibit 10.3 to the Company's
report on Form 8-K filed on April 17, 2001.
(10.10) Letter of Commitment to the Company from John. N. Kapoor,
incorporated by reference to Exhibit 10.3 to the Company's
report on Form 8-K filed on April 17, 2001.
(10.11) Promissory Note among the Company, Akorn (New Jersey), Inc.
and The Northern Trust Company dated April 16, 2001,
incorporated by reference to Exhibit 10.3 to the Company's
report on Form 8-K filed on April 17, 2001.
(10.12) Convertible Bridge Loan and Warrant Agreement dated as of
July 12, 2001, by and between Akorn, Inc. and the John N.
Kapoor Trust dtd. 9/20/89, incorporated by reference to
Exhibit 10.1 to the Company's report on Form 8-K filed on
July 26, 2001.
(10.13) The Tranche A Common Stock Purchase Warrant, dated July 12,
2001, incorporated by reference to Exhibit 10.2 to the
Company's report on Form 8-K filed on July 26, 2001.
(10.14) The Tranche B Common Stock Purchase Warrant, dated July 12,
2001, incorporated by reference to Exhibit 10.3 to the
Company's report on Form 8-K filed on July 26, 2001.
(10.15) Registration Rights Agreement dated July 12, 2001, by and
between Akorn, Inc. and the John N. Kapoor Trust dtd.
9/20/89, incorporated by reference to Exhibit 10.4 to the
Company's report on Form 8-K filed on July 26, 2001.
(10.16) Forbearance Agreement by and among Akorn, Inc., Akorn (New
Jersey), Inc. and The Northern Trust Company, dated as of
July 12, 2001, incorporated by reference to Exhibit 10.5 to
the Company's report on Form 8-K filed on July 26, 2001.
(10.161) *Offer Letter dated September 4, 2001 from the Company to
Mr. Pothast.
(10.17) Promissory Note among the Company, Akorn (New Jersey), Inc.
and NeoPharm, Inc. dated December 20, 2001, incorporated by
reference to Exhibit 10.17 to the Company's report on Form
10-K for fiscal year ended December 31, 2001.
(10.18) Processing Agreement dated December 20, 2001, by and between
Akorn, Inc. and NeoPharm, Inc., incorporated by reference to
Exhibit 10.18 to the Company's report on Form 10-K for
fiscal year ended December 31, 2001.
(10.19) Subordination, Standby and Intercreditor Agreement dated
December 20, 2001, by and between NeoPharm, Inc. and The
Northern Trust Company, incorporated by reference to Exhibit
10.19 to the Company's report on Form 10-K for fiscal year
ended December 31, 2001.
(10.20) Subordination and Intercreditor Agreement dated December 20,
2001, by and between NeoPharm, Inc. and the John N. Kapoor
trust dtd. 9/20/89, incorporated by reference to Exhibit
10.20 to the Company's report on Form 10-K for fiscal year
ended December 31, 2001.
(10.21) Waiver Letter dated December 20, 2001 by and between the
Company, Akorn (New Jersey), Inc. and The Northern Trust
Company, incorporated by reference to Exhibit 10.21 to the
Company's report on Form 10-K for fiscal year ended December
31, 2001.
(10.22) Supply Agreement dated January 4, 2002, by and between
Akorn, Inc. and Novadaq Technologies, Inc., incorporated by
reference to Exhibit 10.22 to the Company's report on Form
10-K for fiscal year ended December 31, 2001.
(10.23) Mutual Termination and Settlement Agreements by and between
Akorn, Inc. and Johns Hopkins University/Applied Physics
Laboratory dtd. July 3, 2002, incorporated by reference to
Exhibit 10.23 to the Company's report on Form 10-K for
fiscal year ended December 31, 2001.
(10.24) Amendment No. 4 to the Credit Agreement dated January 1,
2002, by and among the Company, Akorn (NJ) Inc. and The
Northern Trust Company, incorporated by reference to Exhibit
10.24 to the Company's report on Form 10-K for fiscal year
ended December 31, 2001.
(10.25) Amendment No. 5 to the Credit Agreement dated June 30, 2002,
by and among the Company, Akorn (NJ) Inc. and The Northern
Trust Company, incorporated by reference to Exhibit 10.25 to
the Company's report on Form 10-K for fiscal year ended
December 31, 2001.
</Table>
80
<Table>
(10.26) Amendment No. 6 to the Credit Agreement dated July 31, 2002, by and among the Company, Akorn (NJ) Inc.
and The Northern Trust Company, incorporated by reference to Exhibit 10.26 to the Company's report on
Form 10-K for fiscal year ended December 31, 2001.
(10.27) Pre-Negotiation Agreement by and among Akorn, Inc., Akorn (NJ) Inc. and The Northern Trust Company,
dated as of September 20, 2002, incorporated by reference to Exhibit 10.27 to the Company's report on
Form 10-K for fiscal year ended December 31, 2001.
(10.28) Amendment #1 to the Pre-Negotiation Agreement by and among the Company, Akorn (NJ) Inc. and The
Northern Trust Company dated as of October 18, 2002, incorporated by reference to Exhibit 10.28 to the
Company's report on Form 10-Q for the period ended September 30, 2002.
(10.29) *Amendment #2 to the Pre-Negotiation Agreement by and among the Company, Akorn (NJ) Inc. and The
Northern Trust Company dated as of November 26, 2002.
(10.30) *Amendment #3 to the Pre-Negotiation Agreement by and among the Company, Akorn (NJ) Inc. and The
Northern Trust Company dated as of December 30, 2002.
(10.31) *Amendment #4 to the Pre-Negotiation Agreement by and among the Company, Akorn (NJ) Inc. and The
Northern Trust Company dated as of January 16, 2003.
(10.32) *Amendment #5 to the Pre-Negotiation Agreement by and among the Company, Akorn (NJ) Inc. and The
Northern Trust Company dated as of January 31, 2003.
(10.33) *Amendment #6 to the Pre-Negotiation Agreement by and among the Company, Akorn (NJ) Inc. and The
Northern Trust Company dated as of February 14, 2003.
(10.34) *Amendment #7 to the Pre-Negotiation Agreement by and among the Company, Akorn (NJ) Inc. and The
Northern Trust Company dated as of February 28, 2003.
(10.35) *Amendment #8 to the Pre-Negotiation Agreement by and among the Company, Akorn (NJ) Inc. and The
Northern Trust Company dated as of March 14, 2003.
(10.36) *Amendment #9 to the Pre-Negotiation Agreement by and among the Company, Akorn (NJ) Inc. and The
Northern Trust Company dated as of April 4, 2003.
(10.37) *Amendment #10 to the Pre-Negotiation Agreement by and among the Company, Akorn (NJ) Inc. and The
Northern Trust Company dated as of May 1, 2003.
(10.38) *Amendment #11 to the Pre-Negotiation Agreement by and among the Company, Akorn (NJ) Inc. and The
Northern Trust Company dated as of May 9, 2003.
(10.39) Engagement Letter by and among the Company and AEG Partners LLC dated as of September 26, 2002,
incorporated by reference to Exhibit 10.39 to the Company's Report on Form 10-Q for the period ended
September 30, 2002.
(10.40) *Amendment to Engagement Letter by and among the Company and AEG Partners LLC dated as of November 21,
2002.
(10.41) *Offer Letter dated January 22, 2003 from the Company to Arthur S. Przybyl.
(10.42) *Indemnification Agreement dated May 15, 2003 by and between the Company and Arthur S. Przybyl.
(23.1) *Consent of Deloitte & Touche LLP.
(99.1) *Certifications Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(99.2) Report on Form 8-K filed by the Company on May 1, 2003, incorporated by reference to such filing.
</Table>
(b) Reports on Form 8-K:
The Company filed a Current Report on Form 8-K on December 20, 2002 to
disclose pursuant to Item 5 of Form 8-K that Dr. John Kapoor resigned as CEO of
the Company.
81
AKORN, INC.
VALUATION AND QUALIFYING ACCOUNTS
YEAR ENDED DECEMBER 31, 2002, 2001 AND 2000
<Table>
<Caption>
ADDITIONS
BALANCE AT CHARGED TO BALANCE
BEGINNING OF COSTS AND AT END
DESCRIPTION PERIOD EXPENSES DEDUCTIONS OF PERIOD
- ----------- ------------ ----------- ------------ ----------
Allowance for doubtful accounts
2000.................................... $ 226,000 $ 8,127,000 $ (32,000) $8,321,000
2001.................................... 8,321,000 4,480,000 (9,095,000) 3,706,000
2002.................................... 3,706,000 (55,000) (2,451,000) 1,200,000
Allowance for returns
2000.................................... $ -- $ 1,159,000 $ (927,000) $ 232,000
2001.................................... 232,000 4,103,000 (3,787,000) 548,000
2002.................................... 548,000 2,574,000 (1,956,000) 1,166,000
Allowance for discounts
2001.................................... $ -- $ 886,000 $ (743,000) $ 143,000
2002.................................... 143,000 1,014,000 (985,00) 172,000
Allowance for chargebacks and rebates
2000.................................... $3,174,000 $29,558,000 $(29,436,000) $3,296,000
2001.................................... 3,296,000 28,655,000 (27,761,000) 4,190,000
2002.................................... 4,190,000 15,418,000 (15,306,000) 4,302,000
Allowance for inventory obsolescence
2000.................................... $ 134,000 $ 3,983,000 $ (946,000) $3,171,000
2001.................................... 3,171,000 1,830,000 (3,156,000) 1,845,000
2002.................................... 1,845,000 838,000 (1,477,000) 1,206,000
</Table>
82
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
AKORN, INC.
By: /s/ ARTHUR S. PRZYBYL
------------------------------------
Arthur S. Przybyl
Interim Chief Executive Officer
Date: May 21, 2003
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant, and in the capacities and on the dates indicated.
<Table>
<Caption>
SIGNATURE TITLE DATE
- --------- ----- ----
/s/ ARTHUR S. PRZYBYL Interim Chief Executive Officer May 21, 2003
- ------------------------------------------ (Principal Executive Officer)
Arthur S. Przybyl
/s/ BERNARD J. POTHAST Chief Financial Officer May 21, 2003
- ------------------------------------------ (Principal Financial Officer and
Bernard J. Pothast Principal Accounting Officer)
/s/ JOHN KAPOOR Director, Board Chairman May 21, 2003
- ------------------------------------------
Dr. John Kapoor
/s/ JERRY N. ELLIS Director May 21, 2003
- ------------------------------------------
Jerry N. Ellis
/s/ DANIEL E. BRUHL Director May 21, 2003
- ------------------------------------------
Daniel E. Bruhl, M.D.
/s/ DOYLE S. GAW Director May 21, 2003
- ------------------------------------------
Doyle S. Gaw
/s/ RONALD M. JOHNSON Director May 21, 2003
- ------------------------------------------
Ronald M. Johnson
</Table>
83
CERTIFICATION OF CHIEF EXECUTIVE OFFICER
I, Arthur S. Przybyl, certify that:
1. I have reviewed this annual report on Form 10-K of Akorn, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report.
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
A) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this annual report is being prepared;
B) Evaluated the effectiveness of the registrants disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the "Evaluation Date"); and
C) Presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons performing the
equivalent functions);
A) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
B) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
the other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
/s/ ARTHUR S. PRZYBYL
--------------------------------------
Arthur S. Przybyl
Interim Chief Executive Officer
Date: May 21, 2003
84
CERTIFICATION OF CHIEF FINANCIAL OFFICER
I, Bernard J. Pothast, certify that:
1. I have reviewed this annual report on Form 10-K of Akorn, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report.
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
A) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this annual report is being prepared;
B) Evaluated the effectiveness of the registrants disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the "Evaluation Date"); and
C) Presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons performing the
equivalent functions);
A) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
B) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
the other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
/s/ BERNARD J. POTHAST
--------------------------------------
Bernard J. Pothast
Chief Financial Officer
Date: May 21, 2003
85