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CONFIDENTIAL
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February 21, 2006
Mr. John Cash
Accounting Branch Chief
Securities and Exchange Commission
Division of Corporation Finance
Mail Stop 7010
Washington, D.C. 20549-7010
Re: Kinetic Concepts, Inc.
Form 10-K for Fiscal Year Ended December 31, 2004
Form 10-Q for Fiscal Quarters Ended September 30, 2005
File No. 1-09913
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Dear Mr. Cash:
Set forth below are the responses of Kinetic Concepts, Inc. (the
"Company") to the comments raised by the staff of the Securities and Exchange
Commission (the "Commission") in a letter to the Company dated February 2, 2006
(the "Comment Letter"). For your convenience, we have numbered each of the
Company's responses to correspond to the numbered comments in the Comment
Letter. Additionally, the text of each of the numbered comments in the Comment
Letter has been duplicated in bold type to precede each of the Company's
responses.
Form 10-Q for the Period Ended September 30, 2005
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Financial Statements - Note 5. Litigation Settlement
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1. We note your response to prior comment 3, however it remains unclear to
us what specific events and circumstances occurred, from the date you
filed your FY 2004 10-K until the date you disclosed the settlement
with Novamedix, which significantly changed your assessment of this
litigation. Please tell us:
o The underlying estimates and assumptions you used to determine
the original range of loss of $3,000,000 to $10,000,000.
Response
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The Novamedix case involved three basic claims: patent infringement,
unfair competition and breach of confidentiality. Over the life of the case, KCI
had believed that it would prevail on the patent claims, which were the primary
source of alleged damages in the case. With the assistance of outside counsel,
KCI determined that it was likely to incur damages on at least one of the minor
claims involved in the case, unfair competition or breach of confidentiality.
This determination established a "probable loss" under SFAS 5. KCI believed that
a reasonable estimate of the range of loss was between $3 million and $10
million, based on the following factors:
1. Under the controlling agreement at issue in the case, KCI
believed that UK law likely would have applied to the unfair
competition and breach of confidentiality claims. Under UK
law, damages for unfair competition and breach of
confidentiality in a case of this nature would likely have
been limited to a maximum measuring period of three years.
2. KCI believed that a negative verdict on the unfair
competition or breach of confidentiality claim was both
probable and reasonably estimable between $3 million and $10
million for the applicable three-year measuring period. This
range of loss was calculated based on management's analysis
of the Company's PlexiPulse line of business for the relevant
three-year period, together with damages estimates made in
the professional judgment of counsel.
o The specific facts and circumstances that resulted in your
original range of loss being materially inadequate.
o The reasons why you accepted the $75 million settlement.
o The underlying estimates and assumptions you used to determine
you should accept the settlement.
Response
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In September 2004, the Court in the case issued a patent ruling that
was favorable to KCI, which confirmed management's belief that the patent claims
were not viable, and that KCI would prevail on those claims. In 2005, there were
several important developments which, taken together as a whole, led management
and the Board of Directors to change their assessment of the case leading up to
the settlement in September 2005. Set forth below is a detailed description of
the timing of developments and the Company's related 10-Q disclosures preceding
the settlement of the Novamedix case in the third quarter of 2005.
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Date Description
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February 22, 2005 to o On February 22, 2005, the Magistrate issued an order
May 3, 2005 clarifying and changing a previous ruling on the
claim construction of patents involved in the case.
The order broadened the claim construction of the
Novamedix patents at issue and created the potential
to "revive" some of the patent claims at trial,
which KCI previously thought were no longer viable.
o KCI disagreed with the Magistrate's findings in the
order, which were subject to the approval of the
Federal District Judge.
o On March 8, 2005, KCI submitted its arguments to the
District Court disputing the Magistrate's order.
o KCI filed its 10-Q on May 3, 2005, wherein it
disclosed the Magistrate's February ruling in the
legal proceedings and contingency disclosures. While
management continued to believe that KCI would
ultimately prevail on the patent claims, the
Magistrate's ruling did create the uncertainty that
the patent claims might be revived. The disclosure
was updated to reflect this uncertainty by removing
the statement that the litigation was not likely to
have a material adverse effect on the business,
financial condition or results of operations.
However, management continued to believe that a loss
with respect to the patent claims was not probable
under SFAS 5, and therefore no changes were made
with respect to the Company's recorded loss
contingency on the case.
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May 4, 2005 to o On June 15, 2005, the Federal District Judge in the
August 4, 2005 case confirmed the Magistrate's patent ruling. This
ruling effectively revived the Novamedix patent
claims at the trial court level. The Court also set
a trial date in the case for January 2006.
o On July 29, 2005 the parties agreed to mediate the
case on September 16, 2005. This represented a good
opportunity to determine Novamedix's expectations in
the case.
o Thereafter, management decided to engage a different
law firm to provide a fresh independent assessment
of the case. At this time, the Novamedix case had
been in the courts for over 12 years and management
believed that input from independent counsel could
help management and the Board of Directors determine
how to best approach the September 16 mediation.
o KCI filed its next 10-Q on August 4, 2005, wherein
it disclosed the June 15 ruling of the District
Judge in the case. At that time, management
continued to believe that its arguments against the
patent rulings were legally sound, that KCI had a
strong likelihood of prevailing on the patent
claims, and that a loss with respect to the patent
claims was not probable under SFAS 5. Due to the
uncertainty of the potential varying damage models
that could be presented at trial relating to the
patent claims, it was not possible to estimate a
potential range of damages related to the revived
patent claims. Because of the increased risk to KCI
caused by the revived patent claims, KCI's
disclosure regarding the Novamedix case was updated
to reflect the possibility that "damages that may be
awarded to Novamedix could be significant."
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August 15, 2005 o On August 15, 2005, the Company's General Counsel
and Associate General Counsel for Litigation met
with KCI's newly engaged independent counsel at
their offices to discuss the Novamedix case.
o At that meeting, based on prior experience with
similar matters, counsel provided the following
assessment:
1. Both sides in the case were very well
represented by capable trial counsel.
2. The outcome of the case was very difficult to
predict due to the risk and uncertainty posed by
a jury trial for these types of claims, further
complicated by the recent patent rulings.
3. It was difficult to predict the disposition of
the case on appeal if KCI were unsuccessful at
trial, but KCI had good arguments against the
Court's patent rulings.
4. The September mediation likely would be the last
good opportunity to resolve the case prior to
trial, and that KCI should consider making a
serious effort to resolve the matter at the
mediation.
5. Based on the procedural history of the case (the
case had been on the Court's docket for over 12
years), it was unlikely that KCI could obtain a
continuance to move the trial to a later time.
This would be problematic due to the timing of
the BlueSky litigation, as discussed below.
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August 22, 2005 to o On August 22, 2005, the Company's General Counsel
September 15, 2005 gave an extensive update on Novamedix and other
litigation matters to the Board of Directors at its
regularly scheduled third quarter meeting. As part
of the update, the Board was informed of the
following items regarding the Novamedix case:
1. The Novamedix trial was scheduled for January
2006, four months prior to the trial date for
KCI's ongoing major patent litigation with
BlueSky Medical.
2. The trial team representing KCI in the Novamedix
case was the same trial team representing KCI in
the BlueSky case.
3. It was unlikely that KCI could obtain a
continuance in the Novamedix case to a later
time.
4. Intense trial preparation for the Novamedix case
would need to begin in November 2005 and
continue through the trial date.
5. In the BlueSky case, there was an important
December 2005 discovery deadline, which likely
would be moved into the first quarter of 2006.
Many critical depositions, expert reports and
trial preparations would be taking place for the
BlueSky case while the Novamedix case was being
prepared and tried.
6. Independent counsel's assessment of the case and
encouragement to make an attempt to resolve the
matter at mediation.
o At the meeting, the Board felt strongly that the
Novamedix trial would be a major distraction from
the more important BlueSky case. The BlueSky case
involves a line of products with approximately $706
million in U.S. revenue for 2005, while the
Novamedix case involved a line of products with
approximately $6.0 million in 2005 revenue.
o The Board encouraged management to make a strong
effort to resolve the matter at the September
mediation and directed management to make a business
assessment of an appropriate settlement range.
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September 16, 2005 o On September 16, 2005, the mediation was held as
scheduled. Near the end of the all-day mediation
sessions, it became apparent that KCI was unlikely
to settle the case for less than $75 million dollars
and a cross-licensing arrangement of the
technologies involved.
o Given the one-time nature of the proposed settlement
and the lack of impact on business operations,
together with the potential for disruption of the
BlueSky trial preparation, KCI management decided to
consider the proposed settlement terms.
o The parties agreed to take the proposed settlement
terms of $75 million and a licensing arrangement to
their respective Boards.
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September 17, 2005 o On September 17, 2005, KCI held a special Board
meeting to discuss a potential Novamedix settlement.
At that time, after considerable discussion, the
Board authorized a settlement for $75 million and
the basic license terms proposed at the mediation.
o In considering whether to settle the case for $75
million, management and the Board of Directors did
not attempt to prepare elaborate damage modeling or
estimates for consideration. Rather, the Board's
main reasons for accepting the settlement were the
following strategic considerations:
1. A trial date of January 2006 had been set in the
case, which would interfere with preparation for
the BlueSky trial.
2. The Court's patent rulings in the case increased
the risks and uncertainties posed by a jury
trial for these types of claims.
3. The Board placed particular importance on the
relative insignificance of the product line
involved in the Novamedix case, as compared to
the Company's most significant product line
involved in the BlueSky case.
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September 19-30, 2005 o On September 19, 2005, the parties attended a
follow-up conference call with the mediator to
attempt to make progress on the terms of a proposed
settlement.
o Following that call, the parties continued
negotiating settlement terms.
o On September 30, 2005, the parties completed
negotiations and entered into a final settlement
agreement.
o On September 30, 2005, KCI issued a press release
announcing the terms of the settlement, including
the financial impact of the $75 million settlement
payment.
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In summary, there was no single event occurring during 2005 that caused
management and the Board of Directors to change their disposition toward the
case. Instead, management and the Board made a business decision in the third
quarter of 2005 to settle the case based on a number of factors, of which the
most critical factors were the following:
1. The setting of a trial date for January 2006 during a critical
phase of the BlueSky trial preparation;
2. The same trial team representing KCI in both the Novamedix and
BlueSky matters;
3. The scheduling of mediation for September 2005;
4. The assessment of the case by independent counsel in August 2005
and the perceived risk of a substantially larger damages award;
5. The Board's assessment that the case involved a relatively
insignificant part of the Company's business, that the ultimate
outcome of the case was difficult to predict, and that the
scheduling of the Novamedix trial had strategic implications and
unduly interfered with the trial team's preparation for the BlueSky
case.
If a settlement in this case had not been reached, management and the Board of
Directors intended to pursue the defense of the case to the fullest.
o The reasons why you retained an independent outside counsel when
you did and the reasons why you did not believe outside counsel
was necessary any earlier.
Response
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The Novamedix case was filed in 1992. At that time, KCI engaged an
outside law firm to handle the litigation. The outside firm handling the case
has been KCI's primary trial counsel in this case and other major Company
litigation for over 20 years, and remained KCI's primary trial counsel on the
case through the settlement. When the parties agreed in July 2005 to mediate the
case, management decided to engage a different law firm to provide a fresh
assessment of the case, which had been in the courts for over 12 years. At that
time, management believed that input from independent counsel could help
management and the Board of Directors determine how to best approach the
September 16 mediation.
o The reasons why you did not disclose the original range of loss
of $3,000,000 to $10,000,000.
Response
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Although KCI had reserved $3 million in the financial statements,
management did not believe that the range of loss of $3 to $10 million with
respect to an insignificant product line was material to investors, from either
a balance sheet, statement of operations or cash flow perspective.
o The reasons why you first disclosed in your 6/30/05 Form 10-Q
that damages awarded may be significant and why you did not
provide any quantification of the potential damages.
Response
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As indicated above, at the time the 6/30/05 Form 10-Q was filed,
management believed that KCI would ultimately prevail on the patent claims in
the case, and that a loss with respect to the patent claims was not probable
under SFAS 5. However, the patent rulings in the case had effectively revived
the Novamedix patent claims, which carried the risk of larger damages than the
other claims in the case. Thus, despite KCI's belief that it would prevail on
the claims, management decided it was appropriate to disclose the possibility of
a significant damages award. Due to the uncertainty of the potential varying
damage models that could be presented at trial relating to the patent claims, it
was not possible to estimate a potential range of damages related to the revived
patent claims, which could be disclosed in the 10-Q.
o The reasons why you did not disclose the September 30, 2005
settlement until October 25, 2005.
Response
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As we previously noted in our January 20 letter, the settlement was
publicly announced by press release on September 30, 2005. A copy of the press
release has been provided to the Staff on a supplemental basis.
2. Based on your current disclosures, it is not clear to us if or how the
patent infringement settlement with Novamedix may impact future results
of operations and cash flows. With a view to future disclosure, please
tell us the amount of revenues you generated each period related to the
products that were the subject of this litigation. Please also tell us,
if and how you expect the settlement to impact future results and cash
flows.
Response
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Set forth below, please find the disclosure that the Company plans to
include in the footnotes to the 2005 Form 10-K.
Litigation Settlement
On September 30, 2005, KCI reached an agreement to settle its
litigation with Novamedix Limited, a subsidiary of Orthofix
International NV. The case was originally filed by Novamedix in 1992
and relates to KCI's PlexiPulse line of foot pump products used for the
prevention of deep-vein thrombosis. Under the terms of the settlement,
KCI paid Novamedix $75.0 million. The settlement payment resulted in a
charge of $72.0 million, net of recorded reserves of $3.0 million, or
$47.4 million and $0.65 per diluted share, net of taxes, during the
third quarter of 2005. The settlement resolves and settles all claims
between the parties in the case and allows KCI to continue selling the
PlexiPulse line of products going forward under a royalty-free license
without further claim of infringement by Novamedix. Total revenues for
the PlexiPulse product line were $6.0 million, $6.9 million and $7.6
million for 2005, 2004 and 2003, respectively. The Novamedix settlement
will not have a continuing impact on future operations or cash flows.
Financial Statements - Note 7. Commitments and Contingencies
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3. Based on your current disclosures, it is not clear to us how the
pending patent infringement litigation with BlueSky may impact future
results of operations and cash flows. With a view to future disclosure,
please tell us the amount of revenues you generated each period related
to products that are the subject of this litigation. Please also help
us understand, with additional specificity, how an unfavorable
resolution of this litigation may impact future results and cash flows.
Response
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Unlike the litigation with Novamedix, the Company is the plaintiff
seeking injunctive relief and damages for infringement by BlueSky for selling a
product that competes with the V.A.C. If the Company does not prevail in the
litigation, the Company's V.A.C. product will be subject to increased
competition. The Company is unable to assess the scope of impact of an adverse
determination on future results of operations and cash flows with certainty.
Set forth below, please find the disclosure that the Company plans to
include in the footnotes to the 2005 Form 10-K relating to the BlueSky
litigation. The Company plans to include similar disclosures in Business, Risk
Factors, Legal Proceedings, and MD&A.
Commitments and Contingencies
On August 28, 2003, KCI and its affiliates, together with Wake
Forest University Health Sciences, filed a patent infringement lawsuit
against BlueSky Medical Group, Inc., Medela, Inc., Medela AG and
Patient Care Systems, Inc. in the United States District Court for the
Western District of Texas, San Antonio Division. We have alleged
infringement of three V.A.C. patents, two of which are owned by Wake
Forest, arising from the manufacturing and marketing of a pump and
dressing kits by BlueSky. We have also asserted causes of action for
breach of contract, tortious interference, unfair competition and
conspiracy. We are seeking damages and injunctive relief in the case.
BlueSky and Medela have asserted counterclaims against us for
declarations of non-infringement and patent invalidity, and violations
of federal anti-trust laws. A trial date has been set for May 31, 2006.
On June 28, 2005, the Court issued a ruling on a Markman
hearing, construing certain terms of U.S. Patent No. 5,636,643 (the
"643 patent") and ruling that other terms were definite and did not
require construction by the Court. On September 7, 2005, we entered
into a settlement with Patient Care Systems ("PCS"), pursuant to which
the Court has entered a final judgment and permanent injunction
prohibiting PCS from further acts of infringement, unfair competition
or false advertising through the sale or marketing of BlueSky products.
On November 2, 2005, the Court denied defendants' motions for summary
judgment to dismiss our claims of tortious interference, unfair
competition and conspiracy, but dismissed our breach of contract claim
against Medela. Medela remains a defendant in the lawsuit for our
claims of conspiracy, patent infringement and other claims. On January
26, 2006, the Court issued a ruling on a Markman hearing on
construction of claims in U.S. Patent number 5,645,081 (the "081
patent") and additional claims in the 643 patent. Although it is not
possible to reliably predict the outcome of this litigation, we believe
our claims are meritorious. However, we may be unable to obtain an
injunction against BlueSky, and we may not prevail in this litigation.
If we do not obtain an injunction or otherwise prevail, our share of
the advanced wound-care market for our V.A.C. system could be
significantly reduced due to increased competition, and pricing of
V.A.C. systems could decline significantly, either of which would
materially and adversely affect our operating results. We derived
$706.0 million in revenue from our domestic V.A.C. products, relating
to the patents at issue, or approximately 58% of our total revenue for
the year ended December 31, 2005. U.S. V.A.C. revenue was $562.6
million and $399.9 million for 2004 and 2003, respectively.
***
Subsequent Event
On January 26, 2006, the United States District Court for the
Western District of Texas issued its ruling on the November Markman
hearing in KCI's patent suit against BlueSky Medical. In its ruling,
the Court construed certain terms of U.S. Patent Nos. 5,636,643 and
5,645,081. KCI continues to believe that its case against the
defendants is meritorious and intends to continue the vigorous
prosecution of the case.
Please fee free to call me at (650) 470-4590 should you have any
further questions regarding this matter. Also, please note that Messrs. Seidel
and Landon, the General Counsel and CFO of the Company, would be available at
your convenience to discuss the foregoing.
Sincerely,
/s/ Gregory C. Smith
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Gregory C. Smith
cc: Bret Johnson, SEC
Anne McConnell, SEC
Stephen D. Seidel, Kinetic Concepts, Inc.
Martin J. Landon, Kinetic Concepts, Inc.