UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

Commission file number 001-14758

Questcor Pharmaceuticals, Inc.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

(510) 400-0700

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

(Title of class)

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, 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.  o

 

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

 

 

Indicate by check mark whether the Registrant is a shell company (as defined by Rule 12b-2 of the Act).  Yes o     No þ

 

The aggregate market value of the voting and non-voting Common Stock held by non-affiliates of the Registrant was approximately $164,460,000 as of June 30, 2008, based upon the last sales price of the Registrant’s Common Stock reported on the NASDAQ Stock Market. The determination of affiliate status for the purposes of this calculation is not necessarily a conclusive determination for other purposes. The calculation excludes approximately 33,622,719 shares held by directors, officers and shareholders whose ownership exceeds five percent of the Registrant’s outstanding Common Stock as of June 30, 2008. Exclusion of these shares should not be construed to indicate that such person controls, is controlled by or is under common control with the Registrant.

 

As of March 2, 2009 the Registrant had 65,708,157 shares of Common Stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Part III of this Annual Report incorporates by reference information from the definitive Proxy Statement for the Registrant’s 2009 Annual Meeting of Stockholders.

 

 

ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2008

 

TABLE OF CONTENTS

 

 

 

This Annual Report contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “forecasts,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of such terms and other comparable terminology. These statements are only predictions. Actual events or results may differ materially. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Item 1 “Business,” Item 1A “Risk Factors,” and Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as those discussed in any documents incorporated by reference herein or therein. When used in this Annual Report, the terms “Questcor,” “Company,” “we,” “our,” “ours” and “us” refer to Questcor Pharmaceuticals, Inc. and its consolidated subsidiary.

 

Overview

 

We market H.P. Acthar^® Gel (repository corticotropin injection), an injectable drug that is approved for the treatment of certain disorders with an inflammatory component, including the treatment of exacerbations associated with multiple sclerosis (“MS”), and the treatment of nephrotic syndrome. H.P. Acthar Gel (“Acthar”) is not indicated for, but is also used in treating patients with infantile spasms (“IS”), a rare form of refractory childhood epilepsy, and opsoclonus myoclonus syndrome, a rare autoimmune-related childhood neurological disorder. We also market Doral^® (quazepam), which is indicated for the treatment of insomnia characterized by difficulty in falling asleep, frequent nocturnal awakenings, and/or early morning awakenings.

 

In August 2007, we announced our Acthar-centric business strategy, which included a new pricing level for Acthar effective August 27, 2007. The strategy was adopted in order to best position Acthar to benefit patients, advance our product development programs and ensure that the company become economically viable. Since the adoption of the strategy, we have expanded our sponsorship of Acthar patient assistance and co-pay assistance programs, which provide an important safety net for uninsured and under-insured patients using Acthar, and have established a group of product service consultants and medical science liaisons to work with healthcare providers who administer Acthar. We have provided free Acthar with a commercial value of over $20 million to uninsured and under-insured patients. In addition to the free drug program, we have provided significant financial support to patients through the co-pay assistance program of the National Organization for Rare Disorders (“NORD”). As a result of these efforts, we are not aware of a single patient who needed Acthar but was not able to access it. This was not the case before our strategy change. Because we are now economically viable, we have significantly improved our ability to maintain the long-term availability of Acthar and fund important medical research projects that have the goal of improving patient care, despite the deterioration of the current U.S. economic environment. We have been working closely with the neurology community to identify promising new projects for which we can provide needed financial support. We are providing support to leading researchers in their efforts to better understand the underlying disease processes that cause infantile spasms, a subject for which there has been little research funding in recent decades. We are also in discussions with experts in other disease states with high unmet medical needs for which there is a potential therapeutic role for Acthar. As a result of these initiatives, which have been made possible by our change in strategy, we expect to fund more than a dozen new pre-clinical and clinical studies in 2009. We are also exploring conducting development efforts, or financing the development efforts of third parties, of additional pharmaceutical products addressing serious, rare conditions with unmet medical needs.

 

Acthar is currently approved in the U.S. for the treatment of exacerbations associated with MS, nephrotic syndrome and many other conditions with an inflammatory component. Pursuant to guidelines published by the American Academy of Neurology and the Child Neurology Society, many child neurologists use Acthar to treat infants afflicted with IS even though it is not approved for this indication. We are continuing to pursue a Supplemental New Drug Application (“sNDA”) to the U.S. Food and Drug Administration (“FDA”) to add the treatment of IS to the list of approved indications on the Acthar label. If the submission is accepted for filing by the FDA, we anticipate that the FDA may take final action on the sNDA in late 2009, though there can be no assurance as to the actual timetable for FDA action or whether the sNDA will be approved by the FDA. Additionally, even if

the sNDA is approved, such approval could require various actions by the Company including modification of the existing Acthar label or the adoption of FDA-mandated risk evaluation and mitigation strategies. Previously, the FDA granted Orphan Designation to the active ingredient in Acthar for the treatment of IS. As a result of this Orphan Designation, if we are successful in obtaining FDA approval for the IS indication, we will also qualify for tax credits for certain clinical testing expenses and for a seven-year exclusivity period during which the FDA is prohibited from approving any other ACTH formulation for IS unless the other formulation is demonstrated to be clinically superior to Acthar or is considered by the FDA to have an active ingredient that is different from the active ingredient of Acthar.

 

We are also currently working on a number of initiatives aimed at developing future growth opportunities for Acthar in therapeutic areas other than IS. These include in-depth evaluation of uses that are currently a part of the extensive list of on-label indications for Acthar.

 

We have observed some continued usage, as well as favorable insurance coverage, in refractory MS patients who do not respond to, or who cannot tolerate, intravenous corticosteroids, the first-line treatment of most neurologists for MS flares. Market research indicates that many MS flare patients may be in this subset. In response, we modestly increased our promotional efforts directed to MS specialists to further explore the potential of this opportunity. Early results from our increased, promotional efforts directed to MS specialists were positive, as net sales of Acthar for MS increased, reaching approximately $5.5 million in the fourth quarter of 2008. As a result, in January 2009 we announced a plan to double the size of our sales force to 30 sales representatives to ensure greater coverage of the physicians treating refractory MS patients.

 

In October 2008, we announced that we are evaluating nephrotic syndrome as a potential new growth opportunity for Acthar. Nephrotic syndrome is characterized by excessive spilling of protein from the kidneys into the urine, known as proteinuria. Acthar is specifically indicated “to induce a diuresis or a remission of proteinuria in the nephrotic syndrome without uremia of the idiopathic type or that due to lupus erythamatosus.” If not adequately treated, patients suffering from nephrotic syndrome often progress to end-stage renal disease. End-stage renal disease is a serious, life threatening condition whose current treatments are expensive. Nephrotic syndrome can be caused by a number of different diseases and disorders of the kidney. In order to increase our knowledge of the role of Acthar in the treatment of nephrotic syndrome, we have been in discussions with leading nephrologists and have initiated and funded several planned post-approval clinical trials of Acthar in the treatment of nephrotic syndrome.

 

The August 2007 implementation of our Acthar-centric business strategy fundamentally changed the nature of Questcor and the success of that strategy to date has resulted in significantly improved financial results for the year ended December 31, 2008 as compared to the prior year. Our total net sales were $95.2 million for the year ended December 31, 2008 as compared to $49.8 million for the year ended December 31, 2007. Our income before income taxes and the deemed dividend on the repurchase of our Series A preferred stock was $58.7 million for the year ended December 31, 2008 as compared to income before income taxes and the allocation of earnings to preferred stock of $23.0 million for the year ended December 31, 2007. As of December 31, 2008, our cash, cash equivalents and short-term investments totaled $55.5 million as compared to $30.2 million as of December 31, 2007.

 

During 2008, we returned approximately $46 million to shareholders through our common and preferred stock buyback efforts. In February 2008, we completed the repurchase of the outstanding 2,155,715 shares of Series A Preferred Stock from Shire Pharmaceuticals, Inc. for cash consideration of $10.3 million, or $4.80 per share. In March 2008, we announced that our board of directors approved a stock repurchase plan providing for our repurchase of up to 7 million of our common shares in either open market or private transactions. Through December 31, 2008, we have repurchased a total of 3,490,900 shares of our common stock for $15.6 million under our stock repurchase plan, at an average price of $4.46 per share. In addition, we made two repurchases outside of our share repurchase plan. On August 13, 2008, we completed a board-approved repurchase of 2,200,000 shares of our common stock from Chaumiere Consultadorio & Servicos SDC Unipessoal L.D.A., an entity owned by Paolo Cavazza and members of his family, for $10.9 million or $4.95 per share. On September 3, 2008, we completed a board-approved repurchase of an additional 1,800,000 shares of our common stock from Inverlochy Consultadorio & Servicos L.D.A., an entity owned by Claudio Cavazza, for $9.1 million or $5.06 per share.

We have registered trademarks on H.P. Acthar^® Gel and Doral^®. Each other trademark, trade name or service mark appearing in this document belongs to its respective holder. We believe that our trademarks, trade names and service marks have value and play an important role in our business efforts.

 

Our corporate office is located at 3260 Whipple Road, Union City, California 94587 and our telephone number is (510) 400-0700. Our corporate internet address is http://www.questcor.com. We do not intend for the information contained on our website to be part of this Annual Report.

 

H.P. Acthar Gel

 

H.P. Acthar Gel, which we acquired in July 2001, is a natural source, highly purified preparation of the adrenal corticotropin hormone (“ACTH”). Acthar is specially formulated to provide prolonged release after intramuscular or subcutaneous injection. A primary mechanism of action for Acthar is the stimulation of the adrenal cortex to secrete endogenous corticosteroids, including cortisol, corticosterone, aldosterone, and a number of weakly androgenic substances. It is believed by certain key medical researchers that there may be additional mechanisms of action for Acthar. Questcor has initiated the funding of studies of some of these possible mechanisms. Acthar was approved by the FDA in 1952 and is used in a wide variety of conditions, including the treatment of periodic flares associated with multiple sclerosis, infantile spasms, opsoclonus myoclonus syndrome, and nephrotic syndrome.

 

Acthar is indicated for use in acute exacerbations of MS and is prescribed currently for patients that have MS and experience debilitating, episodic flares. We promote Acthar for the treatment of exacerbations of MS. Intravenous methylprednisolone is the most common treatment of choice for this indication, but Acthar continues to be used in some patients who do not respond adequately to intravenous methylprednisolone or who cannot tolerate intravenous methylprednisolone.

 

Although the FDA-approved package labeling does not include IS as an FDA-approved indication, Acthar has historically been used to treat this condition. Based on the document entitled Practice Parameter: Medical Treatment of Infantile Spasms, a 2004 report of the American Academy of Neurology and the Child Neurology Society, we believe that there has been no clinical evidence to show that any therapy is better than Acthar for the treatment of IS. IS is an epileptic syndrome characterized by the triad of infantile spasms (generalized seizures), hypsarrhythmia and arrest of psychomotor development at seizure onset. We estimate that as many as 2,000 children annually experience bouts of this devastating syndrome in the U.S. In 90% of children with IS, the spasms occur during the first year of life, typically between 3 to 6 months of age. The first onset rarely occurs after the age of two. Patients left untreated or treated inadequately have a poor prognosis for intellectual and functional development. About two-thirds of patients are neurologically impaired prior to the onset of IS, while about one-third are otherwise normal. Rapid and aggressive therapy to control the abnormal seizure activity appears to improve the chances that these children will develop to their fullest potential.

 

The availability of Acthar in the several years before our acquisition of the drug in 2001 from Aventis Pharmaceuticals, Inc. (“Aventis,” now CSL Behring) was very restricted, so that many physicians used synthetic steroids and other unapproved products to treat IS. Acthar remains the treatment of choice among physicians. Acthar may be challenged by newer agents, such as synthetic corticosteroids, immune system suppressants known as immunosuppressants, and anti-seizure medications (in the case of IS) and other types of anti-inflammatory products for various autoimmune conditions that have inflammation as a clinical aspect of the disease. Vigabatrin is a potentially competitive product that is currently approved for use in Canada and is under review in the United States by the FDA for the treatment of infantile spasms. In January 2009 an Advisory Committee appointed by the FDA voted to recommend that the FDA approve Vigabatrin as a therapy for infantile spasms. Solu-Medrol (methylprednisolone sodium succinate) and its generic versions are the primary competitive product to Acthar for the treatment of MS flares. See section below titled “Competition” and Item 1A “Risk Factors: Risks Associated with our Current Business — We are aware of several competitors attempting to develop and market products that treat IS, which may reduce or eliminate our commercial opportunity” for a discussion of additional risks related to competition.

 

In addition to being indicated for the treatment of exacerbations of MS and nephrotic syndrome, Acthar has over fifty other labeled indications and uses in certain endocrine disorders, rheumatic disorders, collagen diseases, allergic states, ophthalmic diseases, respiratory diseases, hematologic disorders, neoplastic diseases, edematous

states, and gastrointestinal diseases. Questcor is currently studying the potential use of Acthar in these and other indications and may fund additional studies. There can be no assurance, however, that we will ever successfully market Acthar as a treatment for any of these disorders or diseases.

 

For the years ended December 31, 2008, 2007 and 2006, net sales of Acthar were $94.4 million, $48.7 million and $12.1 million, respectively.

 

Doral

 

In May 2006, we purchased the rights in the United States to Doral from MedPointe pursuant to an Assignment and Assumption Agreement. Doral is a commercial product indicated for the treatment of insomnia, characterized by difficulty in falling asleep, frequent nocturnal awakenings, and/or early morning awakenings. Sleep disturbance and insomnia are very common side effect of many diseases and disorders. Net sales of Doral were $800,000, $1.1 million and $714,000 for the years ended December 31, 2008 and 2007 and the period May 2006 through December 2006, respectively.

 

Product Development

 

In November 2006, we initiated a clinical development program under our investigational new drug application with the FDA for QSC-001, a unique orally disintegrating tablet (“ODT”) formulation of hydrocodone bitartrate and acetaminophen (“HB/APAP”) for the treatment of moderate to moderately severe pain in patients with swallowing difficulties. QSC-001 is being formulated by Eurand Pharmaceuticals, Inc. and would utilize Eurand’s proprietary Microcaps^® taste-masking and AdvaTab^tm ODT technologies. We own the world-wide rights to commercialize QSC-001 and Eurand would exclusively supply the product and receive a royalty on product sales. HB/APAP, in its variety of strengths, is one of the most frequently prescribed products in the U.S. and there are currently no ODT formulations of HB/APAP available in the United States. For the many individuals who experience significant difficulty swallowing pills, we believe QSC-001 represents a valuable option for the treatment of their pain. During the third quarter of 2008, we completed formulation development of QSC-001. Eurand would receive milestone payments upon the achievement of certain development milestones. We did not make any milestone payments to Eurand in 2008. Currently, we are seeking a partner to complete development of this product so that our research and development resources can be focused on pursuing the numerous potential growth opportunities for Acthar that have recently been identified.

 

Questcor continues to incur expenses pursuing obtaining approval for the treatment of IS with Acthar as well as funding numerous post-approval clinical trials for IS, MS, and nephrotic syndrome.

 

Our research and development expense totaled $10.6 million, $4.8 million and $3.0 million for the years ended December 31, 2008, 2007 and 2006, respectively.

 

Manufacturing

 

Our products are manufactured for us by approved contract manufacturers.

 

Acthar has a shelf life of 18 months from the date of manufacture. In 2003, we transferred the Acthar final fill and packaging process from Aventis to our contract manufacturer, Chesapeake Biological Laboratories, Inc. (“CBL”), and produced our first lot of Acthar finished vials. This transfer was approved by the FDA in January 2004. Our agreement with CBL extends through 2010. In 2004, we transferred the Acthar active pharmaceutical ingredient (“API”) manufacturing process from Aventis to our contract manufacturer, BioVectra dcl (“BioVectra”), and produced the first BioVectra API lot. The Acthar API manufacturing site transfer was approved by the FDA in June 2005. We have signed an agreement with BioVectra, which terminates on December 31, 2010 and includes a one-year extension option. While we have received approval for the Acthar finished vials and API transfers to new contract manufacturers, the processes used to manufacture and test Acthar are complex and subject to FDA inspection and approval.

 

Doral has a shelf life of 60 months from the date of manufacture. We entered into a separate supply agreement with Meda Pharmaceuticals (formerly MedPointe) for Doral with an initial term of three years. Our agreement with Meda calls for Meda to procure the raw materials and manufacture and package Doral. The supply agreement may

be extended for an additional term of three years upon the written consent of both parties prior to the end of the initial term. The API used in Doral is procured by Meda from a third party supplier. A new manufacturer of the API was approved by the FDA in November 2006.

 

There can be no assurance that any of our API or finished goods contract manufacturers will continue to meet our requirements for quality, quantity and timeliness. Also, there can be no assurance our contract manufacturers will be able to meet all of the FDA’s current good manufacturing practice (“cGMP”) requirements, nor that lots will not have to be recalled with the attendant financial consequences to us.

 

Our dependence upon others for the manufacture of API or our finished products, or for the manufacture of products that we may acquire or develop, may adversely affect the future profit margin on the sale of those products and our ability to develop and deliver products on a timely and competitive basis. We do not have substitute suppliers for our products although we strive to plan appropriately and maintain safety stocks of product to cover unforeseen events at manufacturing sites. In the event we are unable to manufacture our products, either directly or indirectly through others or on commercially acceptable terms, if at all, we may not be able to commercialize our products as planned.

 

Divested Product Lines

 

In June 2008, we sold to Hale BioPharma Ventures, LLC, a development stage company, our rights, including certain patents, relating to the nasal administration of benzodiazepines, which resulted in net proceeds of $75,000. In consideration for the purchased assets Hale BioPharma also agreed to pay Questcor potential milestone and royalty payments. The transferred products require further development and regulatory approval before any sales could occur and, accordingly, there can be no assurance that we will receive any milestone or royalty payments.

 

In June 2007, we sold to Evoke Pharma, Inc., a development stage company, our rights relating to nasally administered metaclopromide or other pharmaceutical products covered by the claims set forth in U.S. Patent Nos. 5,760,086 and 6,770,262, which resulted in net proceeds of $448,000. The purchased assets included various regulatory filings with the FDA and the unregistered trademarks “Emitasol” and “Pramidin.” In consideration for the purchased assets Evoke also agreed to pay potential milestone and royalty payments. The transferred products require further development and regulatory approval before any sales could occur and, accordingly, there can be no assurance that we will receive any milestone or royalty payments.

 

Sales and Marketing

 

We own the worldwide rights for Acthar and the U.S. rights for Doral. We do not have substantial operations outside the U.S. However, we have agreements with the following companies to market and distribute Acthar on a named patient basis in certain other countries.

 

Beacon Pharmaceuticals, Ltd.

 

We have an agreement with Beacon Pharmaceuticals, Ltd. (“Beacon”) of Tunbridge Wells, Kent, UK, for the exclusive marketing and distribution of Acthar in the United Kingdom on a named patient basis. Gross sales to Beacon were $186,000, $308,000 and $174,000 for the years ended December 31, 2008, 2007 and 2006, respectively.

 

IDIS Limited

 

We have an agreement with IDIS Limited (“IDIS”) of Sirbiton, Surrey, UK for the exclusive distribution of Acthar on a named patient basis. The agreement covers all countries of the world except: the United States; Australia and New Zealand; and the UK, where Acthar is sold through Beacon. We did not have any sales to IDIS for the year ended December 31, 2008. Gross sales to IDIS were $759,000 and $202,000 for the years ended December 31, 2007 and 2006, respectively.

Competition

 

The pharmaceutical and biotechnology industries are intensely competitive and subject to rapid and significant technological change. A number of companies are pursuing the development of pharmaceuticals and products that target the same diseases and conditions that we target. There are products and treatments on the market that compete with our products. Moreover, technology controlled by third parties that may be advantageous to our business may be acquired or licensed by our competitors, which may prevent us from obtaining this technology on favorable terms, or at all.

 

Our ability to compete will depend on our ability to acquire and commercialize pharmaceutical products that address critical medical needs, as well as our ability to attract and retain qualified personnel, and secure sufficient capital resources for the acquisition and commercialization of products.

 

Most of our competitors are larger than us and have substantially greater financial, marketing and technical resources than we have. Furthermore, if we commence commercial sales of products that we may develop, should they be approved, we will also be competing with respect to manufacturing efficiency and marketing capabilities, areas in which we have limited experience. If any of the competitors develop new products that are superior to our products, our ability to expand into the pharmaceutical markets may be materially and adversely affected.

 

Competition among products will be based, among other things, on product efficacy, safety, reliability, availability, price and patent position. An important factor will be the timing of market introduction of our or our competitors’ products. Accordingly, the relative speed with which we can acquire products and supply commercial quantities of the products to the market is expected to be an important competitive factor.

 

Certain potentially competitive products to Acthar are in various stages of development, some of which have been filed for approval with the FDA or have been approved by regulatory authorities in other countries. Vigabatrin is a potentially competitive product that is currently approved for use in Canada and is under review in the United States by the FDA for the treatment of infantile spasms. In January 2009 an Advisory Committee appointed by the FDA voted to recommend that the FDA approve Vigabatrin as a therapy for infantile spasms. An additional potentially competitive drug to Acthar that we are currently monitoring is Ganaxolone.

 

The current success of our Acthar-centric business strategy is likely to attract additional competition. See Item 1A “Risk Factors: Risks Associated with our Current Business — We are aware of several competitors attempting to develop and market products that treat IS, which may reduce or eliminate our commercial opportunity” for a discussion of additional risks related to competition.

 

Government Regulation

 

Marketed Pharmaceutical Products

 

All pharmaceutical operations associated with the production, testing, packaging and distribution of pharmaceutical products are subject to regulation by the FDA. Any restrictions or prohibitions applicable to sales of products we market could materially and adversely affect our business.

 

We market prescription drug products that have been approved by the FDA. The FDA has the authority to revoke existing approvals if new information reveals that they are not safe or effective. The FDA also regulates the promotion, including advertisement, of prescription drugs. In September 2007, the U.S. President signed the Food and Drug Administration Amendments Act of 2007, or FDAAA. The new legislation grants significant new powers to the FDA, many of which are aimed at addressing the safety of drug products before and after approval. In particular, the new law authorizes the FDA to, among other things, require post-approval studies and clinical trials, mandate changes to drug labeling to reflect new safety information, and require risk evaluation and mitigation strategies for certain drugs, including certain currently approved drugs. In addition, it significantly expands the federal government’s clinical trial registry and results databank and creates new restrictions on the advertising and promotion of drug products. Under the FDAAA, companies that violate these and other provisions of the new law are subject to substantial civil monetary penalties.

 

Although we expect these and other provisions of the FDAAA to have a substantial effect on the pharmaceutical industry, the extent of that effect is not yet known. As the FDA issues regulations, guidance and

interpretations relating to the new legislation, the impact on the industry, as well as our business, will become clearer. The new requirements and other changes that the FDAAA imposes may make it more difficult, and likely more costly, to obtain approval of new pharmaceutical products and to produce, market and distribute existing products, and may impact our pending sNDA application.

 

Drug products must be manufactured, tested, packaged, and labeled in accordance with their approvals and in conformity with cGMP standards and other requirements. Drug manufacturing facilities must be registered with and approved by the FDA and must list with the FDA the drug products they intend to manufacture or distribute. The manufacturer is subject to inspections by the FDA and periodic inspections by other regulatory agencies. The FDA has extensive enforcement powers over the activities of pharmaceutical manufacturers, including authority to seize and prohibit the sale of unapproved or non-complying products, and to halt any pharmaceutical operations that are not in compliance with cGMPs. The courts may impose criminal penalties arising from non-compliance with applicable FDA regulations.

 

In March 2007 we received a drug class action letter from the FDA requesting modifications to labeling and creation of a Medication Guide for sedative-hypnotic drug products that are indicated for the treatment of insomnia, including our product Doral. We have revised Doral’s labeling and created a Medication Guide, both of which have been approved by the FDA. In February 2008 we began shipping Doral product with the revised labeling and new Medication Guide.

 

Questcor operates in a highly regulated industry. We are subject to the regulatory authority of the Securities and Exchange Commission, the Food and Drug Administration and numerous other federal and state governmental agencies including state Attorney General Offices, which have become more active in investigating the business practices of pharmaceutical companies. From time to time, we receive informal requests for information from various governmental agencies. On February 25, 2009, we received a Civil Investigative Demand (“CID”) from the Attorney General of the State of Missouri, in connection with its investigation of our pricing practices with respect to Acthar under Missouri’s Merchandising Practices Act. We are in the process of responding to the CID and intend to cooperate with Missouri’s Attorney General Office, as we have with respect to government inquiries of all types. There can be no assurance that these types of informal requests for information or investigations will not have a material adverse effect on our business.

 

See Item 1A “Risk Factors: Other Risks Associated with our Business — We are currently subject to numerous governmental regulations and it can be costly to comply with these regulations and to develop compliant products and processes” for a discussion of risks related to government regulation of marketed pharmaceutical products.

 

Drugs in Development

 

Products in development are subject to extensive regulation by the U.S., principally under the Federal Food, Drug, and Cosmetic Act and the Public Health Service Act, and if applicable by foreign governmental authorities. In particular, drugs and biological products are subject to rigorous pre-clinical and clinical testing and other approval requirements by the FDA, state and local authorities and comparable foreign regulatory authorities. The process for obtaining the required regulatory approvals from the FDA and other regulatory authorities takes many years and is very expensive. There can be no assurance that any product developed by us and current or potential development partners will prove to meet all of the applicable standards to receive marketing approval in the U.S. or abroad. There can be no assurance that these approvals will be granted on a timely basis, if at all. Delays and costs in obtaining these approvals and the subsequent compliance with applicable federal, state and local statutes and regulations could materially adversely affect our ability to commercialize our products and our ability to earn sales revenues.

 

Product Liability Insurance

 

The clinical testing, manufacturing and marketing of our products may expose us to product liability claims, against which we maintain liability insurance. See Item 1A “Risk Factors: Other Risks Associated with our Business — If product liability lawsuits are successfully brought against us or we become subject to other forms of litigation, we may incur substantial liabilities and costs and may be required to limit commercialization of our products” for a discussion of certain risks related to product liability claims that may be made against us.

Patents and Proprietary Rights

 

Our success may depend in part upon our ability to maintain confidentiality, operate without infringing upon the proprietary rights of third parties, and obtain patent protection for our products. We rely primarily on a combination of patent, copyright, trademark and trade secret laws, confidentiality procedures, and contractual provisions to protect our intellectual property. We do not have a patent on Acthar or Doral. However, we do have U.S. and foreign patents covering our other technology.

 

Our efforts to protect our intellectual property may not be adequate. Our competitors may independently develop similar technology or duplicate our products or services. Unauthorized parties may infringe upon or misappropriate our products, services or proprietary information. In addition, the laws of some foreign countries do not protect proprietary rights as well as the laws of the United States. In the future, litigation may be necessary to enforce our intellectual property rights or to determine the validity and scope of the proprietary rights of others. Any such litigation could be time consuming and costly.

 

We could be subject to intellectual property infringement claims as we expand our product and service offerings and the number of competitors increases. Defending against these claims, even if not meritorious, could be expensive and divert our attention from operating our company. If we become liable to third parties for infringing upon their intellectual property rights, we could be required to pay a substantial damage award and be forced to develop non-infringing technology, obtain a license or cease using the applications that contain the infringing technology or content. We may be unable to develop non-infringing technology or content or obtain a license on commercially reasonable terms, or at all.

 

See Item 1A “Risk Factors: Other Risks Associated with our Business — If we are unable to protect our proprietary rights, we may lose our competitive position and future revenues” for a discussion of additional risks related to intellectual property rights.

 

Employees

 

As of December 31, 2008 and 2007 we had 46 and 32 full-time employees, respectively. As of December 31, 2008, we had 15 sales force representatives. In January 2009 we announced that we are increasing our sales force to 30 representatives in order to build upon continued positive growth trends in prescriptions of Acthar for the treatment of exacerbations associated with MS, an indication for which Acthar is already approved. We anticipate completing this phase of our sales force expansion by the end of the first quarter of 2009. Depending upon the success of the first phase of our sales force expansion, a second phase of our sales force expansion to approximately 40 representatives could occur later in 2009.

 

Our continued success will depend in large part on our ability to attract and retain key employees. We believe that our relationship with our employees is good. None of our employees are represented by a collective bargaining agreement, nor have we experienced work stoppages.

 

Website Address

 

Our website address is http://www.questcor.com. We make available free of charge through our website our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to these reports as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC.

 

Financial Information

 

Please refer to Item 6, “Selected Consolidated Financial Data,” for a review of our financial results and financial position for the five years ended December 31, 2008, and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for a review of revenue and net income (loss) for the three years ended December 31, 2008.

 

Risks Associated with our Current Business

 

Substantially all of our revenue and profits are derived from Acthar.

 

For the year ended December 31, 2008, sales of Acthar represented 99% of our total net sales. We expect to continue to rely on this product for substantially all of our revenues and profits for the foreseeable future. Also, for the year ended December 31, 2008, a significant percentage of Acthar prescriptions were for IS, which is not an approved indication for Acthar. We cannot predict whether we will continue to generate significant revenues from sales of Acthar. If the demand for Acthar declines, if competitive products are approved by the FDA, if the FDA requires us to make changes to the label of Acthar which harm our ability to market Acthar, if third-party payors refuse to provide reimbursement for purchases of Acthar, if we are forced to reduce the price for Acthar, if a greater proportion of our Acthar unit sales is comprised of product dispensed to Medicaid eligible patients and government entities where we do not expect to recognize any net sales, or if we are forced to re-negotiate important contracts or terms, our net sales from the sale of Acthar would decline. If the cost to produce Acthar increases, our gross margins on the sale of Acthar would decline. If our net sales or gross margins from the sale of Acthar decline, our ability to generate profits would be harmed.

 

We utilize CuraScript, a third party specialty distributor, to distribute Acthar. We rely on CuraScript for all of our proceeds from sales of Acthar in the United States. The outsourcing of these functions is complex, and we may experience difficulties that could reduce, delay or stop shipments of Acthar. If we encounter such distribution problems, Acthar distribution could become disrupted, resulting in lost revenues or customer dissatisfaction.

 

We rely on contract manufacturers to produce Acthar. Contract manufacturers may not be able to meet our needs with respect to timing, cost, quantity or quality. All of our manufacturers are sole-source manufacturers and no currently qualified alternative suppliers exist. If we are unable to contract for a sufficient supply of Acthar on acceptable terms, or if we encounter delays or difficulties in our relationships with our manufacturers, we will lose the ability to fulfill orders and thus will lose sales. Moreover, contract manufacturers that we use must continually adhere to current good manufacturing practices enforced by the FDA. If the facilities of these manufacturers cannot pass an inspection, supply would be disrupted. Failure to obtain products for sale for any reason may result in an inability to meet Acthar demand and a loss of potential revenues.

 

We cannot predict whether the FDA will approve our sNDA for Acthar.

 

We are continuing to pursue a Supplemental New Drug Application (“sNDA”) to the FDA to add the treatment of infantile spasms (“IS”) to the list of approved indications on the Acthar label. However, there can be no assurance as to the actual timetable for FDA action or whether the sNDA will be approved by the FDA. Additionally, even if the sNDA is approved, such approval could require various actions by the Company including modification of the existing Acthar label or the adoption of FDA-mandated risk evaluation and mitigation strategies.

 

A significant percentage of Acthar prescriptions is for IS, which is not an approved indication for Acthar. While physicians may lawfully prescribe Acthar for IS and other off-label uses, any promotion by us for off-label uses would be unlawful. The risk associated with our inability to promote Acthar could be increased by the FDA approval of a competitive product, as we would be unable to actively counter any claims made by the sales force for such competitive product.

 

We are aware of several competitors attempting to develop and market products that treat IS, which may reduce or eliminate our commercial opportunity.

 

The pharmaceutical and biotechnology industries are intensely competitive and subject to rapid and significant technological changes, and a number of companies are pursuing the development of pharmaceuticals and products that target the same diseases and conditions that we target.

 

We cannot predict with accuracy the timing or impact of the introduction of potentially competitive products or their possible effect on our sales. Certain potentially competitive products to Acthar are in various stages of

development, some of which have been filed for approval with the FDA or have been approved by regulatory authorities in other countries.

 

Vigabatrin is a potentially competitive product that is currently approved for use in numerous countries other than the U.S. and is currently under review in the United States by the FDA for the treatment of infantile spasms. In January 2009 an Advisory Committee appointed by the FDA voted to recommend that the FDA approve Vigabatrin as a therapy for infantile spasms. If Vigabatrin is approved by the FDA and is commercially launched for IS in the United States prior to our sNDA being approved, then our sales of Acthar would likely decline. Even if our sNDA is approved by the FDA on or prior to the date of the commercial launch of Vigabatrin, our sales of Acthar could decline.

 

Prednisone and prednisolone are the generic names for anti-inflammatory corticosteroid drugs that are used to treat various types of inflammation. One off-label use of these drugs has been to treat infantile spasms. Should more doctors prescribe prednisone or prednisolone to target the same diseases and conditions that Acthar targets, the result could be detrimental to current Acthar sales.

 

An additional potentially competitive drug to Acthar that we are currently monitoring is Ganaxolone. Ganaxolone is currently undergoing a Phase IIb study for the treatment of infantile spasms, but is not currently approved in any jurisdiction. Ganaxolone could potentially compete with Acthar in the future should it receive the necessary FDA and regulatory approvals.

 

Some of the companies developing competing technologies and products have significantly greater financial resources and expertise in development, manufacturing, obtaining regulatory approvals, and marketing than we do. Other smaller companies may also prove to be significant competitors, particularly through collaborative arrangements with large and established companies.

 

In addition to the possibility of competitive products not based on ACTH, a competitor could seek approval for, and the FDA could approve, a generic version of Acthar. Acthar does not have any patent or other form of exclusivity protection that would legally prevent the FDA from approving a generic version. If a competitor applied to the FDA for a generic version, we would not receive any notice from the FDA about the existence of the application.

 

We may be negatively affected by lower reimbursement levels.

 

Our ability to generate net sales is affected by the availability of third-party reimbursement for Acthar, and our ability to generate net sales will be diminished if we fail to maintain an adequate level of reimbursement for Acthar from such third party payors.

 

The sale of Acthar depends in part on the availability of reimbursement from third party payors such as private insurance plans. In the United States, there have been, and we expect there will continue to be, a number of state and federal proposals that limit the amount that private insurance plans may pay to reimburse the cost of drugs, including Acthar. We believe the increasing emphasis on managed care in the United States has and will continue to put pressure on the price and usage of Acthar, which may also impact sales of Acthar. In addition, current third-party reimbursement policies for Acthar may change at any time. Negative changes in reimbursement or our failure to obtain reimbursement for Acthar may reduce the demand for, or the price of, Acthar, which could result in lower Acthar sales, thereby weakening our competitive position and negatively impacting our results of operations.

 

Medicaid eligible patients and government entities may account for a greater proportion of our Acthar unit sales resulting in reduced net sales.

 

A portion of the estimated end-user vial demand for Acthar is for patients covered under Medicaid and other government-related programs. As required by Federal regulations, we provide rebates related to Acthar dispensed to a significant percentage of Medicaid patients. In addition, certain other government-supported agencies are permitted to purchase Acthar for a nominal amount from our specialty distributor, which then charges the discount back to us. As a result of these rebates and chargebacks, we do not generate any net sales with respect to sales which are subject to rebates or chargebacks. As a result of current economic conditions, recently adopted legislation or potential future legislation, it is possible that a greater proportion of Acthar sales will be subject to these rebates and

chargebacks, reducing our net sales. Additionally, there could be changes to Medicaid regulations resulting in higher rebates and chargebacks, which would reduce our net sales further.

 

On February 26, 2009, the U.S. President released an outline of the Administration’s budget proposals for fiscal year 2010, which begins October 1, 2009. Further detail is expected to be issued in April. The budget outline proposes that Congress should increase the amount of rebates collected from manufacturers for drugs dispensed to Medicaid patients by imposing rebates on drugs dispensed to Medicaid patients enrolled in managed care organizations, which are not subject to rebates under current law, and by increasing the amount of the minimum basic rebate. If these proposals are enacted, they would significantly increase the proportion of sales of Acthar for which we would generate no net sales revenue.

 

Federal and/or state health care reform initiatives could negatively affect our business.

 

Bills and regulations proposing comprehensive health care reform are being formulated in Congress and state legislatures as well as in agencies of those governmental bodies that could potentially limit pharmaceutical prices and establish mandatory or voluntary refunds. It is uncertain if any legislative proposals will be adopted and how federal, state or private payors for health care goods and services will respond to any health care reforms. Various governmental entities may focus on pharmaceutical prices by holding hearings or launching investigations regarding the pricing for drugs by specialty pharmaceutical companies such as ours and the ability of patients to obtain drugs. In July 2008, the Joint Economic Committee of Congress held hearings on the pricing of drugs for rare conditions. Should hearings or investigations occur that result in legislative changes or consent decrees regarding drug pricing, we may be forced to decrease our price that we charge for Acthar, thereby decreasing our net income.

 

Questcor operates in a highly regulated industry. We are subject to the regulatory authority of the Securities and Exchange Commission, the Food and Drug Administration and numerous other federal and state governmental agencies including state Attorney General Offices, which have become more active in investigating the business practices of pharmaceutical companies. From time to time, we receive informal requests for information from various governmental agencies. On February 25, 2009, we received a Civil Investigative Demand (“CID”) from the Attorney General of the State of Missouri, in connection with its investigation of our pricing practices with respect to Acthar under Missouri’s Merchandising Practices Act. We are in the process of responding to the CID and intend to cooperate with Missouri’s Attorney General Office, as we have with respect to government inquiries of all types. There can be no assurance that these types of informal requests for information or investigations will not have a material adverse effect on our business.

 

The current economic environment may impact our business.

 

The current economic environment presents us with several potential challenges. As a result of the current credit and financial market conditions, third-party payors such as private insurance companies may be unable to satisfy their reimbursement obligations or may delay payment. State and federal reimbursement programs such as Medicaid may curtail their reimbursements due to budget cuts. In addition, the economic environment could result in more patients seeking coverage for Acthar through Medicaid, where we do not generate net sales for Acthar referrals dispensed to a significant percentage of Medicaid-covered patients.

 

Due to the recent tightening of global credit and the disruption in the financial markets, there may be a disruption or delay in the performance of our third-party contractors, suppliers or collaborators, including CuraScript. If CuraScript is unable to satisfy its commitments to us, our business would be adversely affected. There may be a disruption or delay in the performance of our third-party manufacturers for Acthar. If such third party manufacturers are unable to satisfy their commitments to us, our business would be adversely affected.

 

The current global economic crisis may have a negative impact on the market values of the investments in our investment portfolio. We cannot predict future market conditions or market liquidity and there can be no assurance that the markets for these securities will not deteriorate further or that the institutions that hold these investments will be able to meet their debt obligations at the time we may need to liquidate such investments or until such time as the investments mature.

We have a history of operating losses and have only recently generated sufficient revenue to achieve profitability.

 

Since acquiring Acthar in July 2001, Questcor experienced several changes in strategy and management but was unable to achieve consistent profitability prior to the adoption of our Acthar-centric business model. As a result, from the time of our acquisition of Acthar through August 2007, we experienced operating losses of approximately $30 million. At the time of the adoption of our Acthar-centric business model, we had very limited financial resources and believed we had no access to the capital markets. While we generated operating profit in 2007 and 2008, there can be no assurance that we will continue to be profitable in future periods. Even with the early successful results of our new strategy, we still had an accumulated deficit of $16.4 million as of December 31, 2008. If we are unable to continue to generate profits, we could be required to seek additional funding through public or private sales of our equity securities, or through debt financings. To the extent that we raise additional capital by issuing equity securities, our existing shareholders’ ownership will be diluted. Any debt, receivables or royalty financing we enter into may involve covenants that restrict our operations. These restrictive covenants may include limitations on additional borrowing and specific restrictions on the use of our assets as well as prohibitions on our ability to create liens, pay dividends, redeem our stock or make investments.

 

Risks Associated with our Growth Initiatives

 

Our strategy to generate Acthar revenue from other therapeutic areas might not be successful.

 

While Acthar is already approved by the FDA for the treatment of MS, we may not be successful in promoting Acthar as a second-line treatment for MS. In January 2009, we announced an expansion of our sales force, with a plan to double the size of our sales force to 30 sales representatives. Our increasing our sales force will increase our operating expenses and there can be no assurance that we will successfully manage our sales force expansion or generate sufficient additional net sales in MS to generate an acceptable return on our investment in increasing the size of the sales force. In addition, we may not be successful in promoting Acthar as a treatment for nephrotic syndrome, another on-label indication. There is very limited data on the efficacy of Acthar in the treatment of nephrotic syndrome. It is unclear what amount of clinical or other data physicians will require prior to deciding to use Acthar in the treatment of nephrotic syndrome. Also, while there are over 50 approved indications on the Acthar label, for many of these indications it is not likely that we will be successful in generating net sales in the near future. Further, under the Food and Drug Administration Amendments Act of 2007, the FDA has greater authority to require sponsors to modify labels of previously approved drugs.

 

We have a very limited pipeline of new products.

 

Since the adoption of our Acthar-centric business model in August 2007, we have focused our research and development efforts on Acthar. Besides Acthar, our pipeline of potential new products consists of a single development program: QSC-001. In February 2009, we announced that we were seeking a partner to complete development of QSC-001. There can be no assurance that we will be able to identify such a partner or successfully negotiate a license or other agreement with commercially reasonable terms. Such terms could include deferred consideration in the form of milestone payments and royalties and there can be no assurance that any such payments or royalties would actually become due to Questcor. We are also exploring conducting development efforts, or financing the development efforts of third parties, of additional pharmaceutical products addressing serious, rare conditions with unmet medical needs.

 

Other Risks Associated with our Business

 

The loss of our key management personnel could have an adverse impact on future operations.

 

We are highly dependent on the services of the principal members of our senior management team, and the loss of a member of senior management could create significant disruption in our ability to provide Acthar to our customers. We do not carry key person life insurance for our senior management or other personnel. Additionally, the future potential growth and expansion of our business is expected to place increased demands on our management skills and resources. Recruiting and retaining management and operational personnel to perform sales and marketing, financial operations, business development, clinical development, regulatory affairs, quality

assurance, medical affairs and contract manufacturing in the future will also be critical to our success. We do not know if we will be able to attract and retain skilled and experienced management and operational personnel in the future on acceptable terms given the intense competition among numerous pharmaceutical and biotechnology companies for such personnel. If we are unable to hire necessary skilled personnel in the future, our business could be harmed.

 

We are currently subject to numerous governmental regulations and it can be costly to comply with these regulations and to develop compliant products and processes.

 

Without considering the impact of any proposed or future health care reform initiatives, no assurance can be given that we will remain in compliance with currently applicable FDA and other regulatory requirements for our currently marketed products or any new product once clearance or approval has been obtained. These requirements include, among other things, regulations regarding manufacturing practices, product labeling and post-marketing reporting, including adverse event reports and field alerts due to product quality concerns. Additionally, the facilities and procedures of our suppliers are subject to ongoing regulation, including periodic inspection by the FDA and other regulatory authorities. Any product that we develop must receive all relevant regulatory approvals or clearances before it may be marketed in a particular country.

 

A significant percentage of Acthar prescriptions is for the treatment of IS, which is not an approved indication for Acthar. While physicians may lawfully prescribe Acthar for IS and other off-label uses, any promotion by us of any off-label uses would be unlawful. Some of our practices that are intended to respond to questions from physicians with respect to off-label uses of Acthar without engaging in off-label promotion could nonetheless be construed by the FDA as off-label promotion. Although we have policies and procedures in place designed to help assure ongoing compliance with regulatory requirements regarding off-label promotion, some non-compliant actions may nonetheless occur or be deemed by regulatory authorities to have occurred. Regulatory authorities could take enforcement action against us if they believe we are promoting or have promoted our products for off-label use.

 

Also, the label for Acthar includes a list of indications for which Acthar has not been actively promoted or prescribed for in several years, if ever. It is possible that the FDA could, in the context of reviewing our sNDA for IS or otherwise, conduct a review of the Acthar label and require us to provide data to the FDA regarding the safety and efficacy of Acthar relating to these indications.

 

The regulatory process, which may include extensive pre-clinical studies and clinical trials of each product to establish its safety and efficacy, is uncertain, can take many years, and requires the expenditure of substantial resources, time and effort to ensure compliance with complex regulations. Should we fail to comply with applicable regulations, possible regulatory actions could include warning letters, fines, damages, injunctions, civil penalties, recalls, seizures of our products and criminal prosecution. These actions could result in, among other things, substantial modifications to our business practices and operations; refunds, recalls or a total or partial shutdown of production in one or more of our suppliers’ facilities while our suppliers remedy the alleged violation; the inability to obtain future pre-market clearances or approvals; and withdrawals or suspensions of current products from the market. Any of these events could disrupt our business and have a material adverse effect on our revenues and financial condition.

 

In addition, data obtained from pre-clinical and clinical activities are susceptible to varying interpretations that could delay, limit or prevent regulatory approval or clearance. In addition, delays or rejections may be encountered based upon changes in regulatory policy during the period of product development and the period of review of any application for regulatory approval or clearance for a product. Delays in obtaining regulatory approvals or clearances could:

 

 

Regulatory approval, if granted, may entail limitations on the indicated uses for which a new product may be marketed that could limit the potential market for the product. Product approvals, once granted, may be withdrawn if problems occur after initial marketing. Furthermore, manufacturers of approved products are subject to pervasive review, including compliance with detailed regulations governing FDA good manufacturing practices. The FDA periodically revises the good manufacturing practices regulations and requires manufacturers to remain current with the latest regulations.

 

In addition, we cannot predict the extent of government regulations or the impact of new governmental regulations that may result in a delay in the development, production and marketing of our products. As such, we may be required to incur significant costs to comply with current or future laws or regulations.

 

If we are unable to protect our proprietary rights, we may lose our competitive position and future revenues.

 

We do not have patents on our existing commercial products. However, our success will depend in part on our ability to do the following:

 

 

We will only be able to protect our proprietary rights from unauthorized use by third parties to the extent that these rights are covered by valid and enforceable patents or are effectively maintained as trade secrets and are otherwise protectable under applicable law. We will attempt to protect our proprietary position by filing U.S. and foreign patent applications related to our proprietary products, technology, inventions and improvements that are important to the development of our business.

 

The patent positions of biotechnology and biopharmaceutical companies involve complex legal and factual questions and, therefore, enforceability cannot be predicted with certainty. Patents, if issued, may be challenged, invalidated or circumvented. Thus, any patents that we own or license from third parties for future products may not provide any protection against competitors. Pending patent applications we may file in the future, or those we may license from third parties, may not result in patents being issued. Also, patent rights may not provide us with proprietary protection or competitive advantages against competitors with similar technology. Furthermore, others may independently develop similar technologies or duplicate any technology that we have developed or we will develop. The laws of some foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States.

 

In addition to patents for future products, we rely on trade secrets and proprietary know-how for Acthar. We currently seek protection, in part, through confidentiality and proprietary information agreements. These agreements may not provide meaningful protection or adequate remedies for proprietary technology in the event of unauthorized use or disclosure of confidential and proprietary information. The parties may not comply with or may breach these agreements. Furthermore, our trade secrets may otherwise become known to, or be independently developed by competitors.

 

Our success will further depend, in part, on our ability to operate without infringing the proprietary rights of others. If our activities infringe on patents owned by others, we could incur substantial costs in defending ourselves in suits brought against a licensor or us. Should our products or technologies be found to infringe on patents issued to third parties, the manufacture, use and sale of our products could be enjoined, and we could be required to pay substantial damages. In addition, we, in connection with the development and use of our products and technologies, may be required to obtain licenses to patents or other proprietary rights of third parties, which may not be made available on terms acceptable to us.

We may not be able to fully utilize the benefit of our net operating loss and tax credit carryforwards.

 

As of December 31, 2008, we had federal and state net operating loss carryforwards of $9.9 million and $16.8 million, respectively, and federal and California research and development tax credits of $591,000 and $940,000, respectively. Federal net operating loss carryforwards totaling $9.9 million are subject to annual limitations and will be available from 2009 through 2018, as a result of federal ownership change limitations. Of this amount, $2.1 million of federal net operating loss carryforwards are available to reduce our 2009 taxable income. The federal and state net operating loss carryforwards and the federal research and development credit carryforwards expire at various dates beginning in the years 2013 through 2026, if not utilized. Utilization of our net operating loss and research and development credit carryforwards may still be subject to substantial annual limitations due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions for ownership changes after December 31, 2008. Such an annual limitation could result in the expiration of the net operating loss and research and development credit carryforwards available as of December 31, 2008 before utilization.

 

If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results. As a result, current and potential shareholders could lose confidence in our financial reporting, which could have a negative market reaction.

 

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to report on, and requires our independent registered public accounting firm to attest to, the effectiveness of our internal control over financial reporting. At December 31, 2008, we were compliant and have implemented an ongoing program to perform the system and process evaluation and testing necessary to continue to comply with these requirements. Accordingly, we continue to incur expenses and will devote management resources to Section 404 compliance as necessary. Further, effective internal controls and procedures are necessary for us to provide reliable financial reports. If our internal controls and procedures become ineffective, we may not be able to provide reliable financial reports, our business and operating results could be harmed and current and potential shareholders may not have confidence in our financial reporting.

 

If product liability lawsuits are successfully brought against us or we become subject to other forms of litigation, we may incur substantial liabilities and costs and may be required to limit commercialization of our products.

 

Our business exposes us to potential liability risks that are inherent in the manufacturing, testing and marketing of pharmaceutical products. The use of our currently marketed products or any drug candidates ultimately developed by us or our collaborators in clinical trials may expose us to product liability claims and possible adverse publicity. Under a recent United States Supreme Court ruling, FDA approval of a drug does not prevent the filing of product liability claims in state courts, potentially making it more costly and time consuming to defend against such claims. Product liability insurance for the pharmaceutical industry is generally expensive, if available at all. We currently have product liability insurance for claims up to $10.0 million. However, if we are unable to maintain insurance coverage at acceptable costs, in a sufficient amount, or at all, or if we become subject to a product liability claim, our reputation, stock price and ability to devote the necessary resources to the commercialization of our products could be negatively impacted.

 

Business interruptions could limit our ability to operate our business.

 

Our operations are vulnerable to damage or interruption from computer viruses, human error, natural disasters, telecommunications failures, intentional acts of vandalism and similar events. In particular, our corporate headquarters is located in the San Francisco Bay area, which has a history of seismic activity. We have not established a formal disaster recovery plan, and our back-up operations and our business interruption insurance may not be adequate to compensate us for losses that occur. A significant business interruption could result in losses or damages incurred by us and require us to cease or curtail our operations.

Risks Related to our Common Stock

 

Our stock price has a history of volatility, and an investment in our stock could decline in value.

 

The price of our common stock is subject to significant volatility. The closing price per share of our common stock ranged in value from $0.35 to $9.54 during the two year period ended December 31, 2008. Any number of events, both internal and external to us, may continue to affect our stock price. For example, our quarterly revenues or earnings or losses can fluctuate based on the buying patterns of our specialty distributor and our end users. In the event that patient demand for Acthar is less than our sales to our specialty distributor, excess Acthar inventories may result at our specialty distributor and end users, which may impact future Acthar sales. Other potential events that could affect our stock price include, without limitation, our quarterly and yearly revenues and earnings or losses; our ability to acquire and market appropriate pharmaceuticals; announcement by us or our competitors regarding product development efforts, including the status of regulatory approval applications; the outcome of legal proceedings, including claims filed by us against third parties to enforce our patents and claims filed by third parties against us relating to patents held by the third parties; the launch of competing products; our ability to obtain product from our contract manufacturers; the resolution of (or failure to resolve) disputes with collaboration partners and corporate restructuring by us.

 

We have significant stock option overhang which could dilute your investment.

 

We have a substantial overhang of common stock due to a low average exercise price of employee stock options. The future exercise of employee stock options could cause substantial dilution, which may negatively affect the market price of our shares.

 

We have certain anti-takeover provisions in place.

 

Certain provisions of our articles of incorporation and the California General Corporation Law could discourage a third party from acquiring, or make it more difficult for a third party to acquire, control of our company without approval of our board of directors. These provisions could also limit the price that certain investors might be willing to pay in the future for shares of our common stock. Certain provisions allow the board of directors to authorize the issuance of preferred stock with rights superior to those of the common stock. We are also subject to Section 1101(e) of the California General Corporation Law, which, among other things, prohibits a majority shareholder holding more than 50% but less than 90% of the outstanding shares of a California corporation from consummating a cash-out merger. We also have in place a shareholder rights plan, commonly known as a “poison pill.”

 

The provisions in our articles of incorporation, our poison pill and provisions of the California General Corporation Law may discourage, delay or prevent a third party from acquiring us.

 

 

None.

 

 

At December 31, 2008, we leased two buildings. We lease our 23,000 square foot headquarters in Union City, California under a lease agreement that expires in 2011. Our headquarters is currently occupied by the Executive, Commercial Development, Finance and Administration, Sales and Marketing, Medical Affairs, Clinical Development, Regulatory Affairs, Contract Manufacturing, Quality Control and Quality Assurance departments.

 

We lease a building with 30,000 square feet of laboratory and office space in Hayward, California under a master lease that expires in November 2012. Effective November 1, 2007, we subleased 5,000 square feet of the facility through April 2009 and effective February 1, 2008, we subleased the remaining 25,000 square feet through the remainder of the term of the master lease. These subleases cover a portion of our lease commitment and all of our insurance, taxes and common area maintenance. Please refer to Note 9 of our Notes to Consolidated Financial Statements and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for further discussion related to the sublease of the Hayward facility.

We believe that our current leased office space is sufficient to meet our current business requirements and that additional office space will be available on commercially reasonable terms if required.

 

 

Questcor operates in a highly regulated industry. We are subject to the regulatory authority of the Securities and Exchange Commission, the Food and Drug Administration and numerous other federal and state governmental agencies including state Attorney General Offices, which have become more active in investigating the business practices of pharmaceutical companies. From time to time, we receive informal requests for information from various governmental agencies. On February 25, 2009, we received a Civil Investigative Demand (“CID”) from the Attorney General of the State of Missouri, in connection with its investigation of our pricing practices with respect to Acthar under Missouri’s Merchandising Practices Act. We are in the process of responding to the CID and intend to cooperate with Missouri’s Attorney General Office, as we have with respect to government inquiries of all types. There can be no assurance that these types of informal requests for information or investigations will not have a material adverse effect on our business.

 

We may become involved in litigation relating to claims arising from our ordinary course of business.

 

 

No matters were submitted to a vote of security holders for the quarter ended December 31, 2008.

 

 

Price Range of Common Stock; Holders of Record

 

Through May 15, 2008, our common stock was traded on the American Stock Exchange, Inc. Effective May 16, 2008, we switched the listing of our common stock to the NASDAQ Capital Market where our common stock is traded under the symbol “QCOR.” The following table sets forth, for the periods presented, the high and low closing price per share of our common stock.

 

 

The closing price of our common stock on March 2, 2009 was $4.85 per share. As of March 2, 2009 there were approximately 181 holders of record of our common stock.

 

Effective March 6, 2009, our common stock is traded on the NASDAQ Global Market under the symbol “QCOR.”

Stock Repurchases

 

See “Liquidity and Capital Resources — Financing Cash Flows” in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of this Form 10-K for information on our stock repurchases.

 

Dividends

 

We have never paid a cash dividend on our common stock. Any future cash dividends will depend on future earnings, capital requirements, our financial condition and other factors deemed relevant by our board of directors.

 

Equity Compensation Plans

 

For additional information regarding our equity compensation plans please see Item 12 of this Annual Report.

Stock Performance Graph

 

The following graph shows the total shareholder return, as of December 31, 2008, on an investment of $100 in cash in (i) Questcor Common Stock, (ii) the AMEX Composite Index, and (iii) the NASDAQ Pharmaceuticals Index.

 

Comparison of 5 Year Cumulative Total Return*

Among Questcor Pharmaceuticals, Inc.,

the AMEX Composite Index

and the NASDAQ Pharmaceutical Index

 

 

 

 

This stock performance graph shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or otherwise subject to the liabilities of that section, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933, as amended, or the Exchange Act, except as expressly set forth by specific reference in such filing.

 

The following table sets forth certain financial data with respect to our business. The selected consolidated financial data should be read in conjunction with our Consolidated Financial Statements and related Notes and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other information contained elsewhere in this Annual Report.

 

 

 

 

 

QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

 

 

 

 

 

 

The following discussion should be read in conjunction with our audited consolidated financial statements, and the notes thereto, contained elsewhere in this Annual Report and the statements regarding forward-looking information and the factors that could affect our future financial performance described below in this Annual Report.

 

The discussion below in this Item of this Annual Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “1933 Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “1934 Act”). Those Sections of the 1933 Act and 1934 Act provide a “safe harbor” for forward-looking statements to encourage companies to provide prospective information about their financial performance so long as they provide meaningful, cautionary statements identifying important factors that could cause actual results to differ significantly from projected results. Forward-looking statements often include the words “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” Any statements as to our expectations or beliefs concerning, or projections or forecasts of, our future financial performance or future financial condition, or with respect to trends in our business or in our markets, are forward-looking statements. Factors that could affect our future operating results and cause them to differ, possibly significantly, from those currently anticipated are described in (i) Item 1A, entitled “Risk Factors,” in Part I of this Annual Report, and (ii) the subsection entitled “Critical Accounting Policies and Use of Estimates” in Item 7 below and, accordingly, the descriptions of the Risk Factors and the Critical Accounting Policies and Use of Estimates in this Annual Report should be read in their entirety.

 

Overview

 

We market H.P. Acthar Gel (repository corticotropin injection), an injectable drug that is approved for the treatment of certain disorders with an inflammatory component, including the treatment of exacerbations associated with multiple sclerosis (“MS”), and the treatment of nephrotic syndrome. H.P. Acthar Gel (“Acthar”) is not indicated for, but is also used in treating patients with infantile spasms (“IS”), a rare form of refractory childhood epilepsy, and opsoclonus myoclonus syndrome, a rare autoimmune-related childhood neurological disorder. We also market Doral (quazepam), which is indicated for the treatment of insomnia characterized by difficulty in falling asleep, frequent nocturnal awakenings, and/or early morning awakenings.

 

In August 2007, we announced our Acthar-centric business strategy, which included a new pricing level for Acthar effective August 27, 2007. The strategy was adopted in order to best position Acthar to benefit patients, advance our product development programs and ensure that the company become economically viable. Since the adoption of the strategy, we have expanded our sponsorship of Acthar patient assistance and co-pay assistance programs, which provide an important safety net for uninsured and under-insured patients using Acthar, and have established a group of product service consultants and medical science liaisons to work with healthcare providers who administer Acthar. We have provided free Acthar with a commercial value of over $20 million to uninsured and under-insured patients. In addition to the free drug program, we have provided significant financial support to patients through the co-pay assistance program of the National Organization for Rare Disorders (“NORD”). As a result of these efforts, we are not aware of a single patient who needed Acthar but was not able to access it. This was not the case before our strategy change. Because we are now economically viable, we have significantly improved our ability to maintain the long-term availability of Acthar and fund important medical research projects that have the goal of improving patient care, despite the deterioration of the current U.S. economic environment. We have been working closely with the neurology community to identify promising new projects for which we can provide needed financial support. We are providing support to leading researchers in their efforts to better understand the underlying disease processes that cause infantile spasms, a subject for which there has been little research funding in recent decades. We are also in discussions with experts in other disease states with high unmet medical needs for which there is a potential therapeutic role for Acthar. As a result of these initiatives, which have been made possible by our change in strategy, we expect to fund more than a dozen new pre-clinical and clinical studies in 2009. We are also exploring conducting development efforts, or financing the development efforts of third parties, of additional pharmaceutical products addressing serious, rare conditions with unmet medical needs.

Acthar is currently approved in the U.S. for the treatment of exacerbations associated with MS, nephrotic syndrome and many other conditions with an inflammatory component. Pursuant to guidelines published by the American Academy of Neurology and the Child Neurology Society, many child neurologists use Acthar to treat infants afflicted with IS even though it is not approved for this indication. We are continuing to pursue a Supplemental New Drug Application (“sNDA”) to the U.S. Food and Drug Administration (“FDA”) to add the treatment of IS to the list of approved indications on the Acthar label. If the submission is accepted for filing by the FDA, we anticipate that the FDA may take final action on the sNDA in late 2009, though there can be no assurance as to the actual timetable for FDA action or whether the sNDA will be approved by the FDA. Additionally, even if the sNDA is approved, such approval could require various actions by the Company including modification of the existing Acthar label or the adoption of FDA-mandated risk evaluation and mitigation strategies. Previously, the FDA granted Orphan Designation to the active ingredient in Acthar for the treatment of IS. As a result of this Orphan Designation, if we are successful in obtaining FDA approval for the IS indication, we will also qualify for tax credits for certain clinical testing expenses and for a seven-year exclusivity period during which the FDA is prohibited from approving any other ACTH formulation for IS unless the other formulation is demonstrated to be clinically superior to Acthar or is considered by the FDA to have an active ingredient that is different from the active ingredient of Acthar.

 

The August 2007 implementation of our Acthar-centric business strategy fundamentally changed the nature of Questcor and the success of that strategy to date has resulted in significantly improved financial results for the year ended December 31, 2008 as compared to the prior year. Our total net sales were $95.2 million for the year ended December 31, 2008 as compared to $49.8 million for the year ended December 31, 2007. Our income before income taxes and the deemed dividend on the repurchase of our Series A preferred stock was $58.7 million for the year ended December 31, 2008 as compared to income before income taxes and the allocation of earnings to preferred stock of $23.0 million for the year ended December 31, 2007. As of December 31, 2008, our cash, cash equivalents and short-term investments totaled $55.5 million as compared to $30.2 million as of December 31, 2007.

 

During 2008, we returned approximately $46 million to shareholders through our common and preferred stock buyback efforts. In February 2008, we completed the repurchase of the outstanding 2,155,715 shares of Series A Preferred Stock from Shire Pharmaceuticals, Inc. for cash consideration of $10.3 million or $4.80 per share. In March 2008, we announced that our board of directors approved a stock repurchase plan providing for our repurchase of up to 7 million of our common shares in either open market or private transactions. Through December 31, 2008, we have repurchased a total of 3,490,900 shares of our common stock for $15.6 million under our stock repurchase plan, at an average price of $4.46 per share. In addition, we made two repurchases outside of our share repurchase plan. On August 13, 2008, we completed a board-approved repurchase of 2,200,000 shares of our common stock from Chaumiere Consultadorio & Servicos SDC Unipessoal L.D.A., an entity owned by Paolo Cavazza and members of his family, for $10.9 million or $4.95 per share. On September 3, 2008, we completed a board-approved repurchase of an additional 1,800,000 shares of our common stock from Inverlochy Consultadorio & Servicos L.D.A., an entity owned by Claudio Cavazza, for $9.1 million or $5.06 per share.

 

Our results of operations may vary significantly from quarter to quarter depending on, among other factors, demand for our products by patients, inventory levels of our products held by third parties, the amount of Medicaid rebates on our products dispensed to Medicaid eligible patients, the amount of chargebacks on the sale of our products by our specialty distributor to government-supported entities, the availability of finished goods from our sole-source manufacturers, the timing of certain expenses, the timing and amount of our product development expenses, the introduction of a competitive product, and our ability to develop growth opportunities for Acthar.

 

Critical Accounting Policies and Use of Estimates

 

Our management’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. On an on-going basis, we evaluate our estimates, including those related to product returns, our Medicaid rebate obligation related to our products dispensed to Medicaid eligible patients, chargebacks on sales of our products by wholesalers and our specialty distributor to government entities, bad debts, inventories, intangible assets, share-

based compensation, lease termination liability and income taxes. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

 

Sales Reserves

 

We have estimated reserves for product returns from our specialty distributor, wholesalers, hospitals and pharmacies; Medicaid rebates to all states for products dispensed to patients covered by Medicaid; government chargebacks for sales of our products by wholesalers and our specialty distributor to certain Federal government organizations including the Veterans Administration; and cash discounts for prompt payment on our sales of Doral. We estimate our reserves by utilizing historical information for our existing products and data obtained from external sources.

 

Significant judgment is inherent in the selection of assumptions and the interpretation of historical experience as well as the identification of external and internal factors affecting the estimates of our reserves for product returns, Medicaid rebates, and chargebacks. We believe that the assumptions used to estimate these sales reserves are reasonable considering known facts and circumstances. However, our product returns, Medicaid rebates, and chargebacks could differ significantly from our estimates because our analysis of product shipments, prescription trends, the amount of product in the distribution channel, and our interpretation of the Medicaid statute and regulations, may not be accurate. If actual product returns, Medicaid rebates, and chargebacks are significantly different from our estimates, such differences would be accounted for in the period in which they become known. To date, actual amounts have been generally consistent with our estimates.

 

Product Returns

 

During July 2007, we began utilizing CuraScript, a third party specialty distributor, to store and distribute Acthar. Effective August 1, 2007, we no longer sell Acthar to wholesalers and all of our proceeds from sales of Acthar in the United States are received from CuraScript. We sell Acthar to CuraScript at a discount from our list price. Gross product sales are recognized net of this discount upon receipt of the product by CuraScript. In April 2008, we announced the amendment to our distribution agreement with CuraScript, which became effective on June 1, 2008. Under the new terms, the discount provided by us to CuraScript is reduced from $1,047 per vial to $230 per vial. The new discounted sales price to CuraScript is $23,039 per vial and the stated list price remains at $23,269. However, under the new terms the pricing to CuraScript customers is unchanged. The amount of the discount to CuraScript is subject to annual adjustments based on the Consumer Price Index. In addition, the payment terms have been reduced from 60 days to 30 days from when product is received by CuraScript. Under our distribution agreement with CuraScript, if the price of Acthar is reduced, CuraScript will receive a shelf-stock adjustment credit based upon the amount of product in their inventory at the time of the price reduction. Any reduction in the selling price of Acthar is at our discretion. To date, there have been no such price reductions. We will supply replacement product to CuraScript on product returned between one month prior to expiration to three months post expiration. Returns from product lots will be exchanged for replacement product, and estimated costs for such exchanges, which include actual product material costs and related shipping charges, are included in cost of sales. A reserve for estimated future replacements has been recorded as a liability within sales-related reserves which will be reduced as future replacements occur, with an offset to product inventories.

 

We issue credit memoranda or reimburse wholesalers or their customers for product sold to wholesalers that is returned within six months beyond the expiration date. The credit memoranda or reimbursement is equal to the sales value of the product returned and the estimated amount of such obligation is recorded as a liability within sales-related reserves with a corresponding reduction in gross product sales. This liability is reduced as the obligation is satisfied, with an offset to accounts receivable. The reserve for the sales value of expired product expected to be returned by wholesalers and their customers relates to estimated returns associated with our sales of Doral and our estimate of returns associated with sales of Acthar to wholesalers prior to our transition to CuraScript in July 2007. In estimating the return rate for expired product returned by wholesalers and their customers, we primarily analyze

historical returns by product and return merchandise authorizations. We also consider current inventory on hand at wholesalers, the remaining shelf life of that inventory, and changes in demand measured by prescriptions or other data as provided by an independent third party source. We believe that the information obtained from wholesalers regarding inventory levels and from independent third parties regarding prescription demand is reliable, but we are unable to independently verify the accuracy of such data. We routinely assess our historical experience including customers’ compliance with our product return policy, and we change our reserve estimates as appropriate. A change in the rate of product returns would not have a material effect on our sales or operating income.

 

The following table summarizes the activity in the account associated with sales-related reserves for product returns under our credit memo policy:

 

 

The decrease in the provision as of December 31, 2008 relates to the transition of Acthar distribution from multiple wholesalers to our sole specialty distributor. We provide credit to wholesalers and their customers and provide replacement product to our specialty distributor. As of December 31, 2008, $147,000 of the returns reserve related to the final product lots of Acthar shipped to wholesalers under our credit memorandum policy with product expiration dates in 2007.

 

Medicaid Rebates

 

We provide a rebate related to product dispensed to Medicaid eligible patients. Our a) estimated historical rebate percentage, adjusted for b) recent and expected future utilization rates for these programs, is used to estimate the rebate units associated with product shipped during a period as follows:

 

a) The estimated historic liability included in sales-related reserves as of the end of a period is comprised of the estimated rebate units associated with estimated end user demand during the period, the estimated rebate units associated with estimated inventory in the distribution channel as of the end of the period, and the estimated rebate units, if any, associated with prior rebate periods.

 

b) In order to assess current and future rates of Medicaid utilization, we analyze inventory levels and patient prescription data received from a third party, CuraScript.

 

The rebate amount per unit is determined based on a formula established by statute and is subject to review and modification by the administrators of the Medicaid program. The rebate per unit formula is comprised of a basic rebate of 15.1% applied to the average per unit amount of payments we receive on our product sales and an additional per unit rebate that is based on our current sales price compared to our sales price on an inflation adjusted basis from a designated base period. We multiply the rebate amount per unit by the estimated rebate units to arrive at the estimated reserve for the period. This estimated reserve is deducted from gross sales in the determination of net sales. Effective January 1, 2008, the amount we rebate for each Acthar vial dispensed to a Medicaid eligible patient is approximately $2,500 higher than our price to CuraScript. Our Acthar rebate amount per unit was approximately 65% of our price to our specialty distributor through August 26, 2007 and increased to 73% of our price to our specialty distributor during the fourth quarter ended December 31, 2007. Management believes that the information received from CuraScript related to prescription data and inventory levels is reliable, but we are unable to independently verify the accuracy of such data. The Medicaid rebates associated with end user demand for a period are paid to the states by the end of the quarter following the quarter in which the rebate estimated reserve is established. We routinely assess our experience with Medicaid rebates and adjust the reserves accordingly. Revisions in the Medicaid rebate estimates are charged to income in the period in which the information that

gives rise to the revision becomes known. We consider a 2 to 3 percentage point variance to be a reasonably likely change in the percent of Medicaid rebates to related gross sales. A 2 to 3 percentage point change in the estimated rebate rate on our rebate accrual would lead to an approximate $1.0 million to $1.5 million effect on net sales and an approximate $0.9 million to $1.4 million effect on operating income in 2008.

 

In connection with the implementation of our new pricing strategy for Acthar, coupled with recent clarifications of the statute in July 2007 by program administrators, during 2007 we initiated an extensive review of the Medicaid statute and regulations. After such review and consultation with our regulatory legal counsel, we prospectively modified how we determine our rebate amount per unit to conform with the statute. The modification was implemented in August 2007 and communicated to the program administrators in September 2007. The modification increased net sales and net income applicable to common shareholders by $6.9 million, or $0.10 per diluted share, for the year ended December 31, 2007. This sales and income benefit ended during the fourth quarter of 2007.

 

The following table summarizes the activity in the account for sales-related reserves for Medicaid rebates:

 

 

The increase in the current Medicaid provision for sales made in the current year in 2008 and 2007 relates to the increased pricing level for Acthar effective August 27, 2007, which resulted in higher rebate amounts.

 

Government Chargebacks

 

Certain government-supported entities are permitted to purchase our products for a nominal amount from wholesalers and CuraScript. The wholesalers and CuraScript charge the significant discount back to us and reduce subsequent payment to us by the amount of the approved chargeback. The chargeback approximates our sales price to our customers. As a result, we recognize nominal, if any, net sales on shipments to these entities that qualify for the government chargeback. The reduction to gross sales for a period related to chargebacks is comprised of actual approved chargebacks originating during the period and an estimate of chargebacks in the ending inventory of our customers. In estimating the government chargeback reserve as of the end of a period, we estimate the amount of chargebacks in our customers’ ending inventory using actual average monthly chargeback amounts and ending inventory balances provided by our largest customers. Chargebacks are generally applied by customers against their payments to us approximately 30 to 45 days after they have provided appropriate documentation to confirm their sale to a qualified government-supported entity. We routinely assess the chargeback estimates and adjust the reserves accordingly. Revisions in chargeback estimates are charged to income in the period in which the information that gives rise to the revision becomes known. A change in the chargeback estimates would not have a material effect on our sales or operating income.

The following table summarizes the activity in the account for sales-related reserves for government chargebacks:

 

 

The increase in the current chargeback provision for sales made in the current year in 2008 and 2007 relates to the increased pricing level for Acthar effective August 27, 2007, which resulted in higher chargeback amounts.

 

Other

 

We have estimated that approximately 30% of our estimated Acthar end user unit demand is used by patients covered by Medicaid and other government related programs. Acthar gross sales were reduced by 28% to account for the estimated amount of Medicaid rebates and government chargebacks for the year ended December 31, 2008. A greater percentage of infants than adults are eligible for Medicaid which results in fewer MS patients than IS patients participating in the Medicaid program. As a result of the increased proportion of MS prescriptions in the fourth quarter of 2008, the rebate and chargeback amounts as a percentage of gross sales were lower as compared to the full year 2008.

 

At December 31, 2008 and 2007, sales-related reserves included in the accompanying Consolidated Balance Sheets were as follows:

 

 

Inventories

 

As of December 31, 2008 our net raw material and finished goods inventories totaled $2.5 million. We maintain inventory reserves primarily for excess and obsolete inventory (due to the expiration of shelf life of a product). In estimating inventory excess and obsolescence reserves, we analyze (i) the expiration date, (ii) our sales forecasts, and (iii) historical demand. Judgment is required in determining whether the forecasted sales information is sufficiently reliable to enable us to reasonably estimate excess and obsolete inventory. If actual future usage and demand for our products is less favorable than projected, additional inventory write-offs may be required in the future which would increase our cost of product sales in the period of any write-offs. We intend to control inventory levels of our products purchased by our customers. Customer inventories may be compared to both internal and external databases to determine adequate inventory levels. We may monitor our product shipments to customers and compare these shipments against prescription demand for our individual products.

Intangible and Long-Lived Assets

 

As of December 31, 2008 our intangible and long-lived assets consisted of goodwill of $299,000 generated from a merger in 1999, net purchased technology of $3.7 million related to our acquisition of Doral and $450,000 of net property and equipment. The costs related to our acquisition of Doral are being amortized over an estimated life of 15 years. The determination of whether or not our intangible and long-lived assets are impaired and the expected useful lives of purchased technology involves significant judgment. Changes in strategy or market conditions could significantly impact these judgments and require a write-down of our recorded asset balances and a reduction in the expected useful life of our purchased technology. Such a write-down of our recorded asset balances or reduction in the expected useful life of our purchased technology would increase our operating expenses. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets, we review goodwill for impairment on an annual basis or whenever events occur or circumstances change that could indicate a possible impairment may have occurred. Our fair value is compared to the carrying value of our net assets, including goodwill. If the fair value is greater than the carrying amount, then no impairment is indicated. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we review long-lived assets, consisting of property and equipment and purchased technology, for impairment whenever events or circumstances indicate that the carrying amount may not be fully recoverable. Recoverability of assets is measured by comparison of the carrying amount of the asset to the net undiscounted future cash flows expected to be generated from the use or disposition of the asset. If the future undiscounted cash flows are not sufficient to recover the carrying value of the assets, the assets’ carrying value is adjusted to fair value. As of December 31, 2008 and 2007, no impairment had been indicated.

 

Share-Based Compensation

 

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123(R)”), using the modified-prospective transition method. Under the fair value recognition provisions of SFAS No. 123(R), share-based compensation cost is estimated at the grant date based on the fair value of the award and is recognized as expense, net of estimated pre-vesting forfeitures, ratably over the vesting period of the award. We selected the Black-Scholes option pricing model as the most appropriate fair value method for our awards. Calculating share-based compensation expense requires the input of highly subjective assumptions, including the expected term of the share-based awards, stock price volatility, and pre-vesting forfeitures. We estimated the expected term of stock options granted for the year ended December 31, 2008 based on the historical term of our stock option awards. We estimated the expected term of stock options granted for the years ended December 31, 2007 and 2006 based on the simplified method provided in Staff Accounting Bulletin No. 107, Share-Based Payment. We estimated the volatility of our common stock at the date of grant based on the historical volatility of our common stock. The assumptions used in calculating the fair value of share-based awards represent our best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our share-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected pre-vesting forfeiture rate and only recognize expense for those shares expected to vest. We estimate the pre-vesting forfeiture rate based on historical experience. If our actual forfeiture rate is materially different from our estimate, our share-based compensation expense could be significantly different from what we have recorded in the current period.

 

Our net income for the year ended December 31, 2008 includes $3.9 million of share-based compensation expense related to employees and non-employee members of our board of directors, of which $2.1 million is related to our Employee Stock Purchase Plan (“ESPP”). Our net income for the year ended December 31, 2007 includes $1.8 million of share-based compensation expense related to employees and non-employee members of our board of directors. As of December 31, 2008, $4.7 million of total unrecognized compensation cost related to unvested grants of stock options and awards of restricted stock is expected to be recognized over a weighted-average period of 2.5 years.

 

On February 29, 2008, our board of directors approved a reduction in the offering period of the ESPP from 12 months to 3 months effective with the offering period that began on September 1, 2008, eliminated the ability of plan participants to increase their contribution levels during an offering period and authorized the addition of

500,000 shares to the ESPP. In addition, our board of directors approved an amendment on April 16, 2008, to permanently reduce the maximum offering period available from 27 months to 6 months and to permanently remove the ability of ESPP participants to increase their contributions during an offering period. These amendments to the ESPP were approved by our board of directors on February 29, 2008, and April 16, 2008 and by our shareholders at our annual shareholders’ meeting on May 29, 2008. These plan changes to the ESPP were effective with the offering period that began on September 1, 2008 and could lead to lower expenses for the ESPP in future periods.

 

Lease Termination Liability

 

We entered into an agreement to sublease laboratory and office space, including laboratory equipment, at our Hayward, California facility in July 2000, due to the termination of our then existing drug discovery programs. The sublease on our Hayward facility expired in July 2006. Our obligations under the Hayward master lease extend through November 2012. During the fourth quarter of 2005, the sublessee notified us that they did not intend to extend the sublease beyond the end of July 2006.

 

We determined that there was no loss associated with the Hayward facility when we initially subleased the space as we expected cash inflows from the sublease to exceed our rent cost over the term of the master lease. However, we reevaluated this in 2005 when the sublessee notified us that it would not be renewing the sublease beyond July 2006. As a result, we computed a loss and liability on the sublease in the fourth quarter of 2005 in accordance with Financial Interpretation No. 27: Accounting for a Loss on a Sublease, an interpretation of FASB 13 and APB Opinion No. 30 and FASB Technical Bulletin 79-15, Accounting for the Loss on a Sublease Not Involving the Disposal of a Segment. As of December 31, 2008 and 2007, the estimated liability related to the Hayward facility totaled $1.2 million and $1.6 million, respectively, and is included in Lease Termination and Deferred Rent Liabilities in the accompanying Consolidated Balance Sheets. The fair value of the liability was determined using a credit-adjusted risk-free rate to discount the estimated future net cash flows, consisting of the minimum lease payments under the master lease, net of estimated sublease rental income that could reasonably be obtained from the property. The most significant assumption in estimating the lease termination liability relates to our estimate of future sublease income. We base our estimate of sublease income, in part, on the opinion of independent real estate experts, current market conditions, and rental rates, among other factors. Adjustments to the lease termination liability will be required if actual sublease income differs from amounts currently expected. We review all assumptions used in determining the estimated liability quarterly and revise our estimate of the liability to reflect changes in circumstances. Effective November 1, 2007, we subleased 5,000 square feet of the facility through April 2009 and effective February 1, 2008 we subleased the remaining 25,000 square feet through the remainder of the term of the master lease. These subleases cover a portion of our lease commitment, and all of our insurance, taxes and common area maintenance. As of December 31, 2008, we are obligated to pay rent on the Hayward facility of $3.4 million. Over the remaining term of the master lease we anticipate that we will receive approximately $1.5 million in sublease income to be used to pay a portion of our Hayward facility obligation.

 

We are also required to recognize an on-going accretion expense representing the difference between the undiscounted net cash flows and the discounted net cash flows over the remaining term of the Hayward master lease using the interest method. The accretion amount represents an on-going adjustment to the estimated liability. The on-going accretion expense and any revisions to the liability are recorded in Selling, General and Administrative expense in the accompanying Consolidated Statements of Operations. During the years ended December 31, 2008, 2007 and 2006 we recognized total expense of $138,000, $1.0 million and $762,000, respectively, related to the Hayward facility.

 

Income Taxes

 

We make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes.

 

As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our current tax

exposure under the most recent tax laws and assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheets.

 

We regularly assess the likelihood that we will be able to recover our deferred tax assets, which is ultimately dependent upon us generating future taxable income. We consider all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance. If it is not considered more likely than not that we will recover our deferred tax assets, we will increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable. Changes in the valuation allowance based on our assessment will result in an income tax benefit if the valuation allowance is decreased and an income tax expense if the valuation allowance is increased. Based on taxable income for 2007, cumulative taxable income for the three most recent years, and anticipated taxable income for 2008, we reversed the valuation allowance for deferred tax assets in 2007 that we believed would be recovered based on anticipated taxable income in 2008. In 2008, we reversed the remaining valuation allowance for deferred tax assets that we believe will be recovered based on anticipated taxable income in 2009 and future years. These reversals resulted in an income tax benefit of $15.9 million in 2007 and $5.2 million in 2008 which reduced our income tax expense. Any changes in the valuation allowance based upon our future assessment will result in an income tax expense if the valuation allowance is increased.

 

At December 31, 2008, we had federal and state net operating loss carryforwards of $9.9 million and $16.8 million, respectively, and federal and California research and development tax credits of $591,000 and $940,000, respectively. Federal net operating loss carryforwards totaling $9.9 million are subject to annual limitations and will be available from 2009 through 2018, as a result of federal ownership change limitations. Of this amount, $2.1 million of federal net operating loss carryforwards are available to reduce our 2009 taxable income. The federal and state net operating loss carryforwards and the federal credit carryforwards expire at various dates beginning in the years 2013 through 2026, if not utilized.

 

Utilization of the Company’s net operating loss and research and development credit carryforwards may still be subject to substantial annual limitations due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions for ownership changes after December 31, 2008. Such an annual limitation could result in the expiration of the net operating loss and research and development credit carryforwards available as of December 31, 2008 before utilization.

 

We implemented the provisions of Financial Interpretation No. 48 as of January 1, 2007. This resulted in the reversal of fully reserved deferred tax assets totaling $315,000, which relate to uncertain tax positions, and the related valuation allowance. These unrecognized tax benefits, if recognized in full, would reduce our income tax expense by $315,000 and result in adjustments to other tax accounts, primarily deferred taxes. We had no increases or decreases in unrecognized tax benefits in 2007 and 2008 and do not currently expect any significant changes to our unrecognized tax benefits in 2009.

 

Results of Operations

 

Year ended December 31, 2008 compared to year ended December 31, 2007:

 

Total Net Sales

 

 

Total net sales for the year ended December 31, 2008 increased $45.5 million, or 91%, from the year ended December 31, 2007. For the years ended December 31, 2008 and 2007 all net sales were in the neurology therapeutic area.

Net sales of Acthar for the year ended December 31, 2008 totaled $94.4 million as compared to $48.7 million during the same period in 2007. The increase in net sales resulted from a full year under the new Acthar pricing level implemented in August 2007. In August 2007 we announced a new strategy and business model for Acthar, and initiated a new pricing level for Acthar that was effective August 27, 2007. Under the new Acthar strategy, our sales price to CuraScript, our specialty distributor of Acthar, increased to $22,222 per vial based on a list price of $23,269 per vial. Effective June 1, 2008, the discounted sales price to CuraScript increased to $23,039 per vial based on a list price of $23,269 per vial. The list price prior to the new pricing level was $1,650 per vial. While total Acthar units shipped have decreased since the implementation of the new Acthar strategy, we shipped 5,830 Acthar units to our specialty distributor during the year ended December 31, 2008. This continued ordering coupled with a positive pattern of insurance reimbursement and rapid patient access to Acthar has resulted in a significant increase in our net sales. However, future Acthar orders may be impacted by several factors, including inventory practices at specialty and hospital pharmacies, greater use of patient assistance programs, the overall pattern of usage by the healthcare community, including Medicaid and government-supported entities, the FDA approval of a competitive product, and the reimbursement policies of insurance companies.

 

During 2008 we increased our sales effort related to the use of Acthar for the treatment of exacerbations associated with MS, an indication for which Acthar is already approved. The increased sales effort resulted in positive growth trends in prescriptions of Acthar for the treatment of exacerbations associated with MS. Acthar net sales for MS as a percentage of total Acthar net sales increased in the fourth quarter of 2008 more than 50% as compared to the third quarter of 2008. In the fourth quarter of 2008, Acthar net sales for MS represented over 20% of total net sales for Acthar. There can be no guarantee that these positive growth trends will continue.

 

Our specialty distributor ships Acthar to specialty pharmacies and hospitals to meet end user demand. We track our own Acthar shipments daily, but those shipments vary compared to end user demand because of seasonal usage and changes in inventory levels at specialty pharmacies and hospitals.

 

Acthar shipments may be impacted by seasonality as well as quarter to quarter fluctuations driven by the relatively small IS patient population. During 2008, Acthar shipments did not fluctuate significantly, except in February, November and December. However, since then, shipments have rebounded and are now trending above average. We believe these fluctuations are principally due to the low incidence of IS, as a relatively small number of cases can create meaningful fluctuations. We will continue to monitor these factors as there may be volatility in our Acthar shipments and end user demand in future periods.

 

As required by federal regulations, we provide a rebate related to product dispensed to Medicaid eligible patients. In addition, certain government-supported entities are permitted to purchase our products for a nominal amount from our customers who charge back the significant discount to us. These Medicaid rebates and government chargebacks are estimated by us each quarter and reduce our gross sales in the determination of our net sales. Effective January 1, 2008, the amount we rebate for each Acthar vial dispensed to a Medicaid eligible patient is approximately $2,500 higher than our price to our specialty distributor. We have estimated that approximately 30% of our estimated Acthar end user unit demand is used by patients covered by Medicaid and other government related programs. For the year ended December 31, 2008, Acthar gross sales were reduced by 28% to account for the estimated amount of Medicaid rebates and government chargebacks. A greater percentage of infants than adults are eligible for Medicaid which results in fewer MS patients than IS patients participating in the Medicaid program. As a result of the increased proportion of MS prescriptions in the fourth quarter of 2008, the rebate and chargeback amounts as a percentage of gross sales were lower as compared to the full year 2008.

 

Cost of Sales and Gross Profit

 

Cost of sales for the year ended December 31, 2008 increased $2.0 million from the year ended December 31, 2007. Cost of sales includes material cost, packaging, warehousing and distribution, product liability insurance, royalties, quality control (which primarily includes product stability testing), quality assurance and reserves for excess or obsolete inventory. Stability testing is required on each production lot of Acthar and is conducted at third party laboratories at periodic intervals subsequent to manufacturing. Stability testing costs are expensed as incurred. We incur a royalty of 3% on total net sales of Acthar to a third party and a royalty of 1% of annual net sales over $10.0 million to another third party.

 

The increase in cost of sales was due primarily to an increase of $1.8 million in royalties on Acthar due to the increase in net sales during the year ended December 31, 2008 as compared to the same period in 2007 and an increase of approximately $580,000 in distribution costs in the year ended December 31, 2008 as compared to the same period in 2007. These increases were partially offset by decreases in product stability testing and inventory obsolescence totaling approximately $515,000 in the year ended December 31, 2008 as compared to the same period in 2007. The gross margin was 92% for the year ended December 31, 2008, as compared to 89% for the year ended December 31, 2007. The increase in the gross margin in the year ended December 31, 2008 as compared to the same period in 2007 was due primarily to the increase in net sales resulting from a full year under the new Acthar pricing level implemented in August 2007.

 

Selling, General and Administrative

 

 

Selling, general and administrative expense for the year ended December 31, 2008 increased $1.6 million as compared to the same period in 2007. The increase in selling, general and administrative expense was due primarily to an increase in share-based compensation expense and general costs associated with the support of our new Acthar strategy, offset in part by lower expenses associated with our Hayward facility and lower headcount related costs resulting from the reduction of our field organization in the second quarter of 2007.

 

We incurred a total non-cash charge of $3.9 million for SFAS No. 123(R) share-based compensation for the year ended December 31, 2008. Of this amount, $3.3 million was included in selling, general and administrative expenses, an increase of approximately $1.8 million as compared to the same period in 2007. The increase in share-based compensation expense in the year ended December 31, 2008 was primarily associated with our employee stock purchase plan. Of the total non-cash charge of $3.9 million in the year ended December 31, 2008 for share-based compensation expense, $2.1 million was related to our employee stock purchase plan. As a result of the significant increase in our stock price during the fourth quarter of 2007, many plan participants increased their contributions to maximum levels for the 12-month offering period that began on September 1, 2007. This resulted in a significant increase in the non-cash SFAS No. 123(R) expense for that 12-month offering period. In February 2008, our board of directors approved a reduction in the offering period from 12 months to 3 months effective with the offering period that began on September 1, 2008, eliminated the ability of plan participants to increase their contribution levels during an offering period and approved an amendment authorizing the addition of 500,000 shares to the plan. In addition, our board of directors approved an amendment on April 16, 2008, to permanently reduce the maximum offering period available from 27 months to 6 months and to permanently remove the ability of ESPP participants to increase their contributions during an offering period. These amendments to the plan were approved by shareholders at our annual shareholders’ meeting on May 29, 2008. We estimate that these changes could reduce the non-cash SFAS No. 123(R) expense associated with our employee stock purchase plan beginning with the offering period that began on September 1, 2008.

 

General costs associated with the support of our Acthar strategy increased by approximately $1.2 million in the year ended December 31, 2008 as compared to general costs associated with our Acthar strategy incurred during the same period in 2007.

 

Expenses associated with our Hayward facility decreased by approximately $890,000 in the year ended December 31, 2008 as compared to the same period in 2007. The decrease is due primarily to the inclusion of losses

totaling $646,000 in the year ended December 31, 2007 resulting from revisions of our estimate of our Hayward lease liability.

 

Headcount related costs included in selling, general and administrative expense, excluding share-based compensation, decreased by approximately $600,000 as compared to the same period in 2007. Selling, general and administrative expense for the year ended December 31, 2007 includes severance benefits and other associated costs related to the reduction of our field organization and the departure of our former Chief Executive Officer in the second quarter of 2007. As of December 31, 2008, we had 15 sales force representatives. In January 2009 we announced that we are increasing our sales force to 30 representatives in order to build upon continued positive growth trends in prescriptions of Acthar for the treatment of exacerbations associated with MS, an indication for which Acthar is already approved. We anticipate completing this phase of our sales force expansion by the end of the first quarter of 2009. Depending upon the success of the first phase of our sales force expansion, a second phase of our sales force expansion to approximately 40 representatives could occur later in 2009.

 

Research and Development

 

 

Research and development expense for the year ended December 31, 2008 increased $5.9 million from the year ended December 31, 2007. Costs included in research and development relate primarily to costs related to the resubmission of our Acthar sNDA for IS to the FDA, our product development efforts, outside services related to medical and regulatory affairs, compliance activities, and costs associated with our medical science liaisons. The increase in research and development expenses was due primarily to an increase in costs related to our continued efforts to complete the resubmission of our sNDA for IS. Expenses related to the resubmission of our sNDA and product development increased approximately $3.5 million in the year ended December 31, 2008 as compared to the same period in 2007. Activities associated with our medical science liaisons contributed approximately $800,000 to the increase in research and development expenses in the year ended December 31, 2008 as compared to the prior year. These activities include the initiation of basic research funding for infantile spasms. Headcount related costs, excluding share-based compensation, increased by approximately $800,000 in the year ended December 31, 2008 as compared to the same period in 2007, due primarily to the addition of headcount during 2008. A non-cash charge of $590,000 for SFAS No. 123(R) share-based compensation was included in research and development expenses in the year ended December 31, 2008, an increase of approximately $270,000 as compared to the same period in 2007.

 

Depreciation and Amortization

 

 

Depreciation and amortization expense for the year ended December 31, 2008 was consistent with depreciation and amortization expense for the year ended December 31, 2007. Depreciation and amortization expense consist of depreciation expense related to property and equipment and amortization expense related to the Doral purchased technology. Purchased technology is being amortized on a straight-line basis over fifteen years, the expected life of the Doral product rights.

Other Income, net

 

 

Other income, net for the year ended December 31, 2008 decreased $289,000 as compared to other income, net for the same period in 2007. The decrease was due primarily to the inclusion in the year ended December 31, 2007 of the gain on sale of product lines related to Emitasol, and the reversal of an accrual of $248,000 related to an agreement with Roberts Pharmaceutical Corporation, a subsidiary of Shire Pharmaceuticals, Inc. (“Shire”), as we determined that the amount would not be due to Shire under the agreement. In June 2007, we divested our non-core development stage product Emitasol (nasal metoclopramide) which resulted in a gain of $448,000. The decreases were partially offset by increased interest income resulting from higher cash balances during the year ended December 31, 2008 as compared to the same period in 2007.

 

Income Before Income Taxes and Income Tax Expense (Benefit)

 

 

Income tax expense for the year ended December 31, 2008 was $18.2 million as compared to an income tax benefit for the year ended December 31, 2007 of $14.6 million, or $0.21 per diluted share. The year ended December 31, 2008 includes a net tax benefit of $5.2 million, or $0.07 per diluted share. At December 31, 2007 we established a valuation allowance of $5.2 million for deferred tax assets related to $9.9 million of our federal net operating loss carryforwards, $591,000 of federal research and development credit carryforwards, $458,000 of California research and development credit carryforwards, and other state temporary differences, as it was not considered more likely than not as of December 31, 2007 that we would be able to utilize these tax assets to offset future taxable income. The net tax benefit is due to the reversal of this valuation allowance, as we determined in 2008 that, based on anticipated taxable income in 2009 and future years, it was more likely than not that our deferred tax assets at December 31, 2008 would be realized.

 

For the year ended December 31, 2007, we were able to use our net operating loss carryforwards to offset the majority of our 2007 taxable income. In addition, based on taxable income in the third and fourth quarters of 2007, cumulative taxable income for the three most recent years ended December 31, 2007 and anticipated taxable income for 2008, we determined in the fourth quarter of 2007 that it was more likely than not that some of our deferred tax assets at December 31, 2007 would be realized. Accordingly, we reversed the valuation allowance for such deferred tax assets at December 31, 2007 and recorded an income tax benefit of $15.9 million for the year ended December 31, 2007. This amount was offset by $1.3 million of current tax expense for the federal and California alternative minimum tax (“AMT”) and other state income taxes. The utilization of the tax loss carryforwards to offset our 2007 taxable income is limited in the calculation of AMT and as a result we recorded a current tax expense for AMT for the year ended December 31, 2007.

 

At December 31, 2008, we had federal and state net operating loss carryforwards of $9.9 million and $16.8 million, respectively, and federal and California research and development tax credits of $591,000 and $940,000, respectively. Federal net operating loss carryforwards totaling $9.9 million are subject to annual limitations and will be available from 2009 through 2018, as a result of federal ownership change limitations. Of this amount, $2.1 million of federal net operating loss carryforwards are available to reduce our 2009 taxable income. The federal and state net operating loss carryforwards and the federal credit carryforwards expire at various dates beginning in the years 2013 through 2026, if not utilized.

 

Utilization of our net operating loss and research and development credit carryforwards may still be subject to substantial annual limitations due to the ownership change limitations provided by the Internal Revenue Code and

similar state provisions for ownership changes after December 31, 2008. Such an annual limitation could result in the expiration of the net operating loss and research and development credit carryforwards available as of December 31, 2008 before utilization.

 

Net Income

 

 

For the year ended December 31, 2008, we had net income of $40.5 million as compared to net income of $37.6 million for the year ended December 31, 2007, an increase of $2.9 million. The increase resulted primarily from the implementation of our new strategy and business model for Acthar. The increase was partially offset by income tax expense of $18.2 million in the year ended December 31, 2008 as compared to the $14.6 million net income tax benefit for the year ended December 31, 2007.

 

Series A Preferred Stock Dividend and Distribution

 

 

The deemed dividend resulted from the repurchase of our Series A Preferred Stock in February 2008. On February 19, 2008, we completed the repurchase of the outstanding 2,155,715 shares of Series A Preferred Stock from Shire for cash consideration of $10.3 million or $4.80 per share (the same price per preferred share as the closing price per share of our common stock on February 19, 2008). As of December 31, 2007, the Series A Preferred Stock had a carrying amount of $5.1 million as reflected on the accompanying Consolidated Balance Sheet. The deemed dividend represents the difference between the $10.3 million repurchase payment and the $5.1 million balance sheet carrying value of the Series A Preferred Stock. The repurchase transaction had no income tax impact.

 

The $1.1 million allocation of undistributed earnings to Series A Preferred Stock for the year ended December 31, 2007 represented an allocation of a portion of our fiscal year 2007 net income to the Series A Preferred Stock for purposes of determining net income applicable to common shareholders. This is an accounting allocation only based on relative share holdings and was not an actual distribution or obligation to distribute a portion of our fiscal year 2007 net income to the Series A stockholder.

 

Net Income Applicable to Common Shareholders

 

 

For the year ended December 31, 2008, we had net income applicable to common shareholders of $35.3 million, or $0.49 per fully diluted share, as compared to net income applicable to common shareholders of $36.4 million, or $0.51 per fully diluted share for the year ended December 31, 2007, a decrease of $1.2 million. The decrease resulted primarily from income tax expense of $18.2 million in the year ended December 31, 2008 as compared to the income tax benefit of $14.6 million in the prior year, and the deemed dividend on the repurchased Series A Preferred Stock. The $5.3 million reduction to net income related to the deemed dividend on the

repurchased Series A Preferred Stock reduced fully diluted earnings per share applicable to common shareholders by $0.07.

 

Year ended December 31, 2007 compared to year ended December 31, 2006:

 

Total Net Sales

 

 

Total net sales for the year ended December 31, 2007 increased $37.0 million, or 289%, from the year ended December 31, 2006. For the years ended December 31, 2007 and 2006 all net product sales were in the neurology therapeutic area.

 

Net sales of Acthar for the year ended December 31, 2007 totaled $48.7 million as compared to $12.1 million during the same period in 2006. The increase in net sales resulted from the new Acthar pricing level implemented in August 2007. In August 2007 we announced a new strategy and business model for Acthar, and initiated a new pricing level for Acthar that was effective August 27, 2007. Under the new Acthar strategy, our sales price to CuraScript, our specialty distributor of Acthar, increased to $22,222 per vial based on a list price of $23,269 per vial. The list price prior to the new pricing level was $1,650 per vial. While total Acthar units shipped have decreased since the implementation of the new Acthar strategy, we shipped 2,185 Acthar units to our specialty distributor at the new pricing level from the implementation of the new Acthar strategy on August 27, 2007 through December 31, 2007. This continued ordering coupled with a positive pattern of insurance reimbursement resulted in a significant increase in our net sales for the year ended December 31, 2007.

 

Our specialty distributor ships Acthar to specialty pharmacies and hospitals to meet end user demand. We track our own Acthar shipments daily, but those shipments vary compared to end user demand because of seasonal usage and changes in inventory levels at specialty pharmacies and hospitals. We estimate monthly Acthar end user demand using patient referral data collected from our reimbursement support center and analysis of ordering patterns from specialty and hospital pharmacies. We generally receive this information during the 30 day period following the end of each month. We shipped 1,570 vials of Acthar to our specialty distributor during the fourth quarter of 2007. In the months since the August 27, 2007 price increase, Acthar shipments to our specialty distributor have ranged from a low of 310 vials in September 2007 to a high of 540 vials in October 2007. During the fourth quarter of 2007, there was an initial build up of Acthar inventories within the newly established specialty pharmacy network that distributes Acthar. This resulted in Acthar shipments during the fourth quarter that exceeded our end user demand estimate.

 

Acthar shipments may be impacted by seasonality as well as quarter to quarter fluctuations driven by the relatively small IS patient population. We will continue to monitor these factors as there may be volatility in our Acthar shipments and end user demand in future periods.

 

As required by federal regulations, we provide a rebate related to product dispensed to Medicaid eligible patients and certain government-supported entities are permitted to purchase our products for a nominal amount from our customers who charge back the significant discount to us. These Medicaid rebates and government chargebacks are estimated by us each quarter and reduce our gross sales in the determination of our net sales. Acthar gross sales were reduced by 24% and 18% to account for the estimated amount of Medicaid rebates and government chargebacks for the fourth quarter and year ended December 31, 2007, respectively.

 

The Medicaid rebate amount per unit is determined based on a formula established by statute and is subject to review and modification by the administrators of the Medicaid program. In connection with the implementation of the new pricing strategy for Acthar, coupled with recent clarifications of the statute in July 2007 by program administrators, we initiated an extensive review of the Medicaid statute and regulations. After such review and consultation with our regulatory legal counsel, we prospectively modified how we determine our rebate amount per unit to conform with the statute. The modification was implemented in August 2007 and communicated to the program administrators in September 2007. The modification increased net sales and net income applicable to

common shareholders by $6.9 million, or $0.10 per diluted share, for the year ended December 31, 2007. This sales and income benefit ended during the fourth quarter of 2007.

 

Cost of Sales and Gross Profit

 

 

Cost of sales for the year ended December 31, 2007 increased $2.3 million from the year ended December 31, 2006. The increase in cost of sales was due primarily to an increase of $1.4 million in royalties on Acthar due to the increase in net sales during the year ended December 31, 2007 as compared to the same period in 2006. Increases of $308,000 in product stability testing and $254,000 in distribution costs also contributed to the increase in cost of sales in the year ended December 31, 2007 as compared to the same period in 2006. The gross margin was 89% for the year ended December 31, 2007, as compared to 77% for the year ended December 31, 2006. The increase in the gross margin in the year ended December 31, 2007 as compared to the same period in 2006 was due primarily to the increase in net sales resulting from the new Acthar pricing level implemented in August 2007.

 

Selling, General and Administrative

 

 

Selling, general and administrative expense for the year ended December 31, 2007 was consistent with selling, general and administrative expense for the same period in 2006. Increased share-based compensation expense, costs associated with the reduction of our field organization and the departure of our former Chief Executive Officer and an increase in management compensation were offset by lower sales and marketing headcount related costs resulting primarily from the reduction of our field organization in the second quarter of 2007.

 

We incurred a total non-cash charge of $1.8 million for SFAS No. 123(R) share-based compensation for the year ended December 31, 2007. Of this amount, $1.5 million was included in selling, general and administrative expenses, an increase of $523,000 as compared to the same period in 2006. For the year ended December 31, 2007, management bonuses related primarily to our 2007 profitable results contributed to a $757,000 increase in bonus expense as compared to the same period in 2006. We recorded $272,000 of severance and other associated costs in the second quarter of 2007 related to the departure of our former Chief Executive Officer in May 2007. In addition, during the second quarter of 2007 we reduced our field organization from 45 sales representatives to 10 product service consultants and 3 medical science liaisons and incurred a one-time expense of $451,000 for severance benefits and other associated costs. Sales and marketing headcount related costs for the year ended December 31, 2007 decreased by approximately $1.6 million as compared to the same period in 2006 due primarily to the reduction of our field organization in the second quarter of 2007.

 

Research and Development

 

 

Research and development expense for the year ended December 31, 2007 increased $1.7 million from the year ended December 31, 2006. The costs included in research and development related primarily to our product

development efforts, outside services related to medical and regulatory affairs, compliance activities, costs associated with our medical science liaisons, and our preliminary evaluation of additional product development opportunities. The increase in research and development was due primarily to the addition of our clinical and development leadership team during the fourth quarter of 2006 and our medical science liaisons in the second quarter of 2007. Headcount related costs increased by approximately $1.3 million in the year ended December 31, 2007 as compared to the same period in 2006. An increase totaling approximately $333,000 for regulatory fees and patent-related legal fees also contributed to the increase as compared to the same period in 2006.

 

Depreciation and Amortization

 

 

Depreciation and amortization expense for the year ended December 31, 2007 increased to $498,000 from $316,000 for the year ended December 31, 2006. The increase in depreciation and amortization was due primarily to amortization expense related to the Doral purchased technology. In May 2006 we purchased the rights in the United States to Doral. Our total purchase price, including acquisition costs, allocated to the Doral product rights was $4.1 million. In addition, in January 2007, we made a $300,000 payment to IVAX to eliminate the Doral royalty obligation that was also recorded to purchased technology. Purchased technology is being amortized on a straight-line basis over fifteen years, the expected life of the Doral product rights.

 

Other Income, net

 

 

Other income, net for the year ended December 31, 2007 increased by $705,000 from the year ended December 31, 2006. The increase was due primarily to the reversal of an accrual of $248,000 in June 2007 related to an agreement with Roberts Pharmaceutical Corporation, a subsidiary of Shire, as we determined that the amount would not be due to Shire under the agreement, and a gain on sale of product rights related to Emitasol. In June 2007, we divested our non-core development stage product Emitasol (nasal metoclopramide) which resulted in net proceeds of $448,000. Under the terms of the agreement, we may receive a royalty on product sales of Emitasol as well as future payments based on the achievement of certain clinical and commercial goals. In addition, interest income for the year ended December 31, 2007 increased by $155,000 from the year ended December 31, 2006 due primarily to higher cash balances.

 

Income Before Income Taxes and Income Tax Expense (Benefit)

 

 

Income tax benefit for the year ended December 31, 2007 was $14.6 million, or $0.21 per diluted share. There was no income tax benefit or expense for the year ended December 31, 2006 as we incurred a net loss of $10.1 million and maintained a full valuation allowance against our net deferred tax assets based on our history of losses. For the year ended December 31, 2007, we were able to use our net operating loss carryforwards to offset the majority of our 2007 taxable income. In addition, based on taxable income in the third and fourth quarters of 2007, cumulative taxable income for the three most recent years and anticipated taxable income for 2008, we determined in the fourth quarter of 2007 that it was more likely than not that some of our deferred tax assets at December 31,

2007 would be realized. Accordingly, we reversed the valuation allowance for such deferred tax assets at December 31, 2007 and recorded an income tax benefit of $15.9 million for the year ended December 31, 2007. This amount was offset by $1.3 million of current tax expense for the federal and California alternative minimum tax (“AMT”) and other state income taxes. The utilization of the tax loss carryforwards to offset our 2007 taxable income is limited in the calculation of AMT and as a result we recorded a current tax expense for AMT for the year ended December 31, 2007.

 

As of December 31, 2006, we had federal and state net operating loss carryforwards of $101.4 million and $34.6 million, respectively. We also had federal and California research and development tax credits of approximately $1.9 million and $1.1 million, respectively. During 2007, we conducted a study based on historical changes in equity ownership, corporate valuations, and tax filings to determine if the utilization of any of these net operating loss carryforwards or research and development tax credits were subject to the ownership change limitations provided by the Internal Revenue Code and similar state provisions for ownership changes through December 31, 2007. This study concluded that $68.8 million of our federal net operating loss carryforwards, all of our state net operating loss carryforwards, $748,000 of our federal research and development tax credits, and all of our California research and development tax credits were available to reduce future taxable income. After offsetting our taxable income for the year ended December 31, 2007, we had remaining federal and state net operating loss carryforwards of $39.3 million and $17.4 million, respectively, and federal and California research and development tax credits of $748,000 and $1.1 million, respectively. Of these amounts, $29.4 million and $17.4 million of federal and state net operating loss carryforwards, respectively, and $157,000 and $180,000 of federal and California research and development credits, respectively, are available to reduce our 2008 taxable income. However, we established a valuation allowance of $5.2 million at December 31, 2007 for deferred tax assets related to $9.9 million of our federal net operating loss carryforwards, $591,000 of federal research and development credit carryforwards, $458,000 of California research and development credit carryforwards, and other state temporary differences, as it was not considered more likely than not as of December 31, 2007 that we would be able to utilize these tax assets to offset future taxable income.

 

Net Income (Loss)

 

 

For the year ended December 31, 2007, we had net income of $37.6 million as compared to a net loss of $10.1 million for the year ended December 31, 2006, an increase of $47.7 million. The increase resulted primarily from the implementation of our new strategy and business model for Acthar in August 2007 and the $14.6 million net income tax benefit.

 

Allocation of Undistributed Earnings to Series A Preferred Stock

 

 

The $1.1 million allocation of undistributed earnings to Series A Preferred Stock for the year ended December 31, 2007 represented an allocation of a portion of our fiscal year 2007 net income to the Series A Preferred Stock for purposes of determining net income applicable to common shareholders. This is an accounting allocation only based on relative share holdings and was not an actual distribution or obligation to distribute a portion of our fiscal year 2007 net income to the Series A stockholder. Net loss was not allocated to the Series A Preferred Stock for the year ended December 31, 2006 as the Series A Preferred Stock did not have a contractual obligation to share in our losses.

Net Income (Loss) Applicable to Common Shareholders

 

 

For the year ended December 31, 2007, we had net income applicable to common shareholders of $36.4 million, or $0.51 per fully diluted share, as compared to a net loss applicable to common shareholders of $10.1 million, or $0.18 loss per share for the year ended December 31, 2006, an increase of $46.6 million. The increase resulted primarily from the implementation of our new strategy and business model for Acthar and the $14.6 million net income tax benefit.

 

Liquidity and Capital Resources

 

During 2008 and 2007, we generated $63.5 million and $10.1 million in cash from operations, respectively, resulting from the implementation of our new strategy and business model for Acthar. Prior to the implementation of our new Acthar strategy, we principally funded our activities through various issuances of equity securities and debt and from the sale of our non-core commercial product lines in October 2005.

 

On February 19, 2008, we completed the repurchase of the outstanding 2,155,715 shares of Series A Preferred Stock from Shire Pharmaceuticals, Inc. for cash consideration of $10.3 million or $4.80 per share, the same price per preferred share as the closing price per share of our common stock on February 19, 2008.

 

On February 29, 2008, our board of directors approved a stock repurchase plan that provides for our repurchase of up to 7 million of our common shares. Stock repurchases under this program may be made through either open market or privately negotiated transactions in accordance with all applicable laws, rules and regulations. Through December 31, 2008, we had repurchased 3,490,900 common shares under our stock repurchase plan for $15.6 million, at an average price of $4.46 per share. In addition, we completed two repurchases outside of our stock repurchase plan. On August 13, 2008, we completed a board-approved repurchase of 2,200,000 shares of our common stock from Chaumiere Consultadorio & Servicos SDC Unipessoal L.D.A., an entity owned by Paolo Cavazza and members of his family, for $10.9 million or $4.95 per share, and on September 3, 2008, we completed a board-approved repurchase of an additional 1,800,000 shares of our common stock from Inverlochy Consultadorio & Servicos L.D.A., an entity owned by Claudio Cavazza, for $9.1 million or $5.06 per share.

 

In April 2008, we announced the amendment of our distribution agreement with CuraScript. The amendment was effective on June 1, 2008. Under the amended agreement, the payment terms were reduced from 60 days to 30 days. The reduction in payment terms reduced our accounts receivable balance and generated a one-time increase in our cash balance during the third quarter of 2008 of approximately $10 million.

 

 

At December 31, 2008, we had cash, cash equivalents and short-term investments of $55.5 million compared to $30.2 million at December 31, 2007. At December 31, 2008, our working capital was $59.3 million compared to $57.2 million at December 31, 2007. The increase in our working capital was principally due to increases in our cash, cash equivalents and short-term investments of $25.2 million and prepaid taxes of $3.3 million, offset by a decrease in accounts receivable of $13.2 million, a decrease of $8.6 million in our current deferred tax assets, and

decreases in sales-related reserves and accounts payable totaling $6.1 million. The increase in our cash, cash equivalents and short-term investments balance primarily reflects the $63.5 million in cash provided by our operations, offset in part by $45.9 million used to repurchase our Series A Preferred Stock and common stock. The decrease in accounts receivable reflects primarily the reduction in payment terms under our amended agreement with CuraScript, which generated a one-time decrease in our accounts receivable during the third quarter of 2008 of approximately $10 million.

 

Cash and cash equivalents were $13.3 million as of December 31, 2008 and $15.9 million as of December 31, 2007 and 2006. Cash and cash equivalents exclude our short-term investments of $42.2 million, $14.3 million and $2.5 million as of December 31, 2008, 2007 and 2006, respectively. The primary changes in our operating, investing and financing cash flows related to cash and cash equivalents are described below.

 

Operating Cash Flows

 

Net cash of $63.5 million was provided by operating activities for the year ended December 31, 2008, primarily a result of a full year under our new Acthar strategy. Primary factors contributing to the net operating cash flows included our net income of $40.5 million for the year ended December 31, 2008, and a decrease in accounts receivable of $13.2 million generated primarily by the reduction in CuraScript’s payment terms from 60 days to 30 days. Other factors contributing to the net operating cash flows include an increase of $3.6 million in sales reserves due primarily to increases in our reserve for Medicaid rebates, a decrease of $4.6 million in total deferred tax assets, and $4.1 million in non-cash share-based compensation. These factors were partially offset by an increase in prepaid taxes and a decrease in income taxes payable totaling $4.6 million.

 

Net cash of $10.1 million was provided by operating activities for the year ended December 31, 2007 as a result of the implementation of our new strategy and business model for Acthar in August 2007. Primary factors contributing to the net operating cash flows included our net income of $37.6 million for the year ended December 31, 2007, an increase of $5.4 million in sales reserves due primarily to increases in our reserve for Medicaid rebates, increases totaling $1.9 million for accrued compensation and other accrued liabilities, and $1.8 million in non-cash share-based compensation were partially offset by an increase in accounts receivable of $21.9 million and a $15.9 million increase in our total deferred tax assets.

 

Net cash of $9.7 million was used in operating activities for the year ended December 31, 2006. Primary factors contributing to the use of cash in operations included our net loss of $10.1 million for the year ended December 31, 2006, the increase in accounts receivable of $1.1 million and the increase in inventories of $1.4 million, offset by $1.2 million in non-cash share-based compensation, $316,000 in depreciation and amortization, the $649,000 increase in accounts payable and a $602,000 increase in other non-current liabilities resulting from obligations associated with our Hayward lease.

 

Investing Cash Flows

 

Net cash used in investing activities for the year ended December 31, 2008 was $27.2 million. The net cash used in investing activities resulted primarily from net purchases of short-term investments of $27.2 million.

 

Net cash used in investing activities for the year ended December 31, 2007 was $11.3 million. Net purchases of short-term investments of $11.3 million and the acquisition of purchased technology were partially offset by the proceeds from the sale of product rights related to Emitasol. In January 2007, we made a $300,000 payment to IVAX to eliminate the Doral royalty obligation that was recorded to purchased technology. In June 2007, we divested our non-core development stage product Emitasol (nasal metoclopramide) which resulted in net proceeds of $448,000.

 

Net cash used in investing activities for the year ended December 31, 2006 was $554,000. In May 2006, we acquired Doral from MedPointe (now Meda Pharmaceuticals). As consideration for the rights to Doral in the U.S., we paid MedPointe $2.5 million in cash upon the closing of the transaction and $1.5 million in December 2006 after the approval of an alternative source to manufacture and supply the active ingredient for Doral. Cash used to acquire Doral was offset by $3.7 million in net maturities of our short-term investments.

Financing Cash Flows

 

Net cash of $38.9 million was used by financing activities for the year ended December 31, 2008. We completed the repurchase of the outstanding Series A Preferred Stock for cash consideration of $10.3 million in February 2008. In addition, we repurchased a total of 7,490,900 shares of our common stock for $35.6 million under both our board-approved stock repurchase plan and repurchases made outside of our stock repurchase plan. We received a total of $2.2 million for the issuance of common stock related to the exercise of stock options and for the issuance of common stock pursuant to the employee stock purchase plan. Net cash from financing activities was increased by $4.8 million in excess tax benefits from share-based compensation plans representing primarily the benefit of tax deductions in excess of share-based compensation expense.

 

Net cash of $1.2 million was provided by financing activities for the year ended December 31, 2007. We received $961,000 for the issuance of common stock related to the exercise of stock options and warrants, and $263,000 for the issuance of common stock pursuant to the employee stock purchase plan.

 

Net cash of $5.8 million was provided by financing activities for the year ended December 31, 2006. In January 2006, we redeemed our outstanding Series B Preferred Stock with a cash payment of $7.8 million. In December 2006, we sold 10,510,000 shares of our common stock to unaffiliated institutional investors at a purchase price of $1.20 per share and 890,000 shares of our common stock to certain insiders at a purchase price of $1.45 per share. The net offering proceeds were approximately $12.7 million after deducting placement agency fees and offering expenses. We also received $533,000 for the issuance of common stock related to the exercise of stock options and warrants, and $348,000 for the issuance of common stock pursuant to the employee stock purchase plan.

 

Off Balance Sheet Arrangements

 

We had no off balance sheet arrangements during the three years ended December 31, 2008.

 

Contractual Obligations

 

The following table summarizes our contractual obligations at December 31, 2008. This table does not include potential milestone payments and assumes non-termination of agreements.

 

 

 

 

Additional Payments

 

We have entered into a development and license agreement which contains provisions for payment on completion of certain development, regulatory and sales milestones. Due to uncertainty concerning when and if the milestones may be completed, we have not included these potential future obligations in the above table.

 

In November 2006, we initiated a clinical development program under our IND application with the FDA for QSC-001, a unique orally disintegrating tablet formulation of hydrocodone bitartrate and acetaminophen for the treatment of moderate to moderately severe pain in patients with swallowing difficulties. QSC-001 is being formulated by Eurand, a specialty pharmaceutical company that develops, manufactures and commercializes enhanced pharmaceutical and biopharmaceutical products based on its proprietary drug formulation technologies. QSC-001 would utilize Eurand’s proprietary Microcaps^® taste-masking and AdvaTab^tm ODT technologies. We own the world-wide rights to commercialize QSC-001 and Eurand would exclusively supply the product and receive a royalty on product sales. We would be obligated to make milestone payments upon the achievement of certain development milestones including, but not limited to, the filing of a New Drug Application (“NDA”), the approval of an NDA, and attainment of certain levels of sales. Such potential future milestone payments total $3.3 million. We are currently seeking a partner to complete development of this product so that our research and development resources can be focused on pursuing the numerous potential growth opportunities for Acthar that have recently been identified.

 

Indemnifications

 

As permitted under California law and in accordance with its Bylaws, we indemnify our officers and directors for certain events or occurrences while the officer or director is or was serving at our request in such capacity. The potential future indemnification limit is to the fullest extent permissible under California law; however, we have a director and officer insurance policy that limits our exposure and may enable us to recover a portion of any future amounts paid. We believe the fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.

 

Employment Agreements

 

We have entered into employment agreements with our corporate officers that provide for, among other things, base compensation and/or other benefits in certain circumstances in the event of termination or a change in control. In addition, certain of the agreements provide for the accelerated vesting of outstanding unvested stock options upon a change in control.

 

Equity Transactions

 

On February 29, 2008, our board of directors approved a stock repurchase plan that provides for our repurchase of up to 7 million of our common shares. Stock repurchases under this program may be made through either open market or privately negotiated transactions in accordance with all applicable laws, rules and regulations. Through December 31, 2008, we had repurchased 3,490,900 common shares under our stock repurchase plan for $15.6 million, at an average price of $4.46 per share. In addition, we completed two repurchases outside of our stock repurchase plan. On August 13, 2008, we completed a board-approved repurchase of 2,200,000 shares of our common stock from Chaumiere Consultadorio & Servicos SDC Unipessoal L.D.A., an entity owned by Paolo Cavazza and members of his family, for $10.9 million or $4.95 per share, and on September 3, 2008, we completed a board-approved repurchase of an additional 1,800,000 shares of our common stock from Inverlochy Consultadorio & Servicos L.D.A., an entity owned by Claudio Cavazza, for $9.1 million or $5.06 per share.

 

In early March 2009, we repurchased 1,344,900 shares of our common stock at an average price of $5.04 per share, for a total purchase price of $6.8 million under our stock repurchase program approved by our board of directors in February 2008.

 

On February 29, 2008, our board of directors approved a reduction in the offering period of the Employee Stock Purchase Plan (“ESPP”) from 12 months to 3 months effective with the offering period that began on September 1, 2008, eliminated the ability of plan participants to increase their contribution levels during an offering

period and approved an amendment authorizing the addition of 500,000 shares to the ESPP. In addition, our board of directors approved an amendment on April 16, 2008, to permanently reduce the maximum offering period available from 27 months to 6 months and to permanently remove the ability of ESPP participants to increase their contributions during an offering period. These amendments to the ESPP were approved by shareholders at our annual shareholders’ meeting on May 29, 2008.

 

In May and June 2008, a total of 348,228 shares of our common stock were issued upon the cashless net exercise of 475,248 warrants in accordance with the terms of the warrants. As of December 31, 2008, we no longer have any warrants outstanding.

 

On February 19, 2008, we repurchased all of the outstanding 2,155,715 shares of Series A Preferred Stock from Shire Pharmaceuticals, Inc. for cash consideration of $10.3 million or $4.80 per share, the same price per preferred share as the closing price per share of our common stock on February 19, 2008. The existence of the Series A Preferred Stock created a complex capital structure that limited our flexibility in developing a long-term strategy and required us to take into consideration the interest of the preferred stockholder. For example, among other rights associated with the Series A Preferred Stock, the Series A Preferred Stock was convertible into 2,155,715 shares of common stock, had a $10 million liquidation preference, and required us to obtain the holder’s separate approval in the event of a merger transaction.

 

In December 2006, we sold 10,510,000 shares of our common stock to unaffiliated institutional investors at a purchase price of $1.20 per share and 890,000 shares of our common stock to certain insiders at a purchase price of $1.45 per share. The net offering proceeds were approximately $12.7 million after deducting placement agency fees and offering expenses. All of the shares were offered under an effective shelf registration statement previously filed with the Securities and Exchange Commission.

 

In January 2006 we made a total cash payment of $7.8 million to redeem our outstanding Series B Preferred Stock, pursuant to our notice to our Series B stockholders in November 2005. The redemption and conversion of the Series B Preferred Stock eliminated the Series B Preferred Stock from our capital structure and with it the Series B cash dividend obligation of 10% in each of 2006 and 2007 and 12% thereafter, the Series B liquidation preference and the Series B restrictive covenants. The Series B stockholders retained warrants to purchase 3,025,921 shares of our common stock at $0.9412 per share that were acquired by the Series B stockholders in connection with their purchase of the Series B Preferred Stock. In April and May 2006, 1,647,440 shares of our common stock were issued upon the cashless net exercise of 2,889,925 warrants issued to certain Series B stockholders.

 

Cash Requirements

 

Based on our internal forecasts and projections, we believe that our cash resources at December 31, 2008 will be sufficient to fund operations through at least December 31, 2009.

 

Our future funding requirements beyond 2009 will depend on many factors, including: the timing and extent of product sales; returns of expired product; strategic transactions, if any; licensing of products, technologies or compounds, if any; our ability to manage growth; competing technological and market developments; costs involved in filing, prosecuting, defending and enforcing patent and intellectual property claims; the receipt of licensing or milestone fees from current or future collaborative and license agreements, if established; the timing of regulatory approvals; any expansion or acceleration of our development programs; and other factors.

 

Recently Issued Accounting Standards

 

In October 2008, the FASB issued FASB Staff Position (“FSP”) FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active (“FSP FAS 157-3”). FSP FAS 157-3 clarifies the application of SFAS 157 in a market that is not active and illustrates how an entity would determine fair value when the market for a financial asset is not active. FSP FAS 157-3 provides guidance on how an entity’s own assumptions about cash flows and discount rates should be considered when measuring fair value when relevant market data does not exist, how observable market information in an inactive or dislocated market affects fair value measurements and how the use of broker and pricing service quotes should be considered when applying fair value measurements.

FSP FAS 157-3 is effective immediately as of September 30, 2008 and for all interim and annual periods thereafter. The adoption of FSP FAS 157-3 did not have a material impact on our consolidated financial statements.

 

In February 2008, the FASB issued FSP FAS 157-2, Effective Date of FASB Statement No. 157 (“FSP FAS 157-2”), which defers the effective date of SFAS No. 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), for fiscal years beginning after November 15, 2008 and interim periods within those fiscal years for items within the scope of FSP FAS 157-2. We do not expect that the adoption of FSP FAS 157-2 will have a material impact on our financial position and results of operations.

 

In December 2007, the FASB issued SFAS No. 141(R), Business Combinations (“SFAS No. 141(R)”), which replaces FAS No. 141. SFAS No. 141(R) establishes principles and requirements for how an acquirer in a business combination recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any controlling interest; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS No. 141(R) is to be applied prospectively to business combinations for which the acquisition date is on or after an entity’s fiscal year that begins after December 15, 2008. We will assess the impact of SFAS No. 141(R) if and when a future acquisition occurs.

 

In November 2007, the EITF issued EITF Issue No. 07-1, Accounting for Collaborative Arrangements Related to the Development and Commercialization of Intellectual Property (“EITF 07-1”). Companies may enter into arrangements with other companies to jointly develop, manufacture, distribute, and market a product. Often the activities associated with these arrangements are conducted by the collaborators without the creation of a separate legal entity (that is, the arrangement is operated as a “virtual joint venture”). The arrangements generally provide that the collaborators will share, based on contractually defined calculations, the profits or losses from the associated activities. Periodically, the collaborators share financial information related to product revenues generated (if any) and costs incurred that may trigger a sharing payment for the combined profits or losses. The consensus requires collaborators in such an arrangement to present the result of activities for which they act as the principal on a gross basis and report any payments received from (made to) other collaborators based on other applicable GAAP or, in the absence of other applicable GAAP, based on analogy to authoritative accounting literature or a reasonable, rational, and consistently applied accounting policy election. EITF 07-1 is effective for collaborative arrangements in place at the beginning of the annual period beginning after December 15, 2008. We do not expect that the adoption of EITF 07-1 will have a material impact on our financial position and results of operations.

 

 

Market Rate Risk

 

Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. We place our investments with high quality issuers and follow internally developed guidelines to limit the amount of credit exposure to any one issuer. Additionally, in an attempt to limit interest rate risk, we follow guidelines to limit the average and longest single maturity dates. We are adverse to principal loss and aim to ensure the safety and preservation of our invested funds by limiting default, market and reinvestment risk. None of our investments are in auction rate securities. Our investments include money market accounts, commercial paper, government-sponsored enterprises and corporate and municipal bonds.

The table below presents the amounts of our investment portfolio as of December 31, 2008 and 2007, and related average interest rates of our investment portfolio for the years ended December 31, 2008 and 2007.

 

 

 

QUESTCOR PHARMACEUTICALS, INC.
CONTENTS

 

 

 

None.

 

 

Evaluation of Disclosure Controls and Procedures

 

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our disclosure controls and procedures were designed to provide reasonable assurance that the controls and procedures would meet their objectives.

 

As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.

 

Management’s Annual Report on Internal Control over Financial Reporting

 

Internal control over financial reporting refers to the process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer, and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles, and includes those policies and procedures that:

 

(1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;

 

(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorization of our management and directors; and

(3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisitions, use or disposition of our assets that could have a material effect on the financial statements.

 

Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk. Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company.

 

Management has used the framework set forth in the report entitled Internal Control-Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission, known as COSO, to evaluate the effectiveness of our internal control over financial reporting. Based on this assessment, management has concluded that our internal control over financial reporting was effective as of December 31, 2008. Odenberg Ullakko Muranishi & Co. LLP, the independent registered public accounting firm that audited the consolidated financial statements included in this Annual Report on Form 10-K, has issued an attestation report on the effectiveness of our internal control over financial reporting as of December 31, 2008. This report, which expresses an unqualified opinion on the effectiveness of our internal control over financial reporting as of December 31, 2008, is included herein.

 

There has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

 

Not Applicable.

 

 

Biographical information for our executive officers is set forth below.

 

Don M. Bailey, 63, President and CEO, joined the Company’s Board of Directors in May 2006. Mr. Bailey was appointed our interim President in May 2007. Mr. Bailey was appointed our President and Chief Executive Officer in November 2007. Mr. Bailey is currently the non-executive Chairman of the Board of STAAR Surgical Company. STAAR Surgical Company is a leader in the development, manufacture, and marketing of minimally invasive ophthalmic products employing proprietary technologies. Mr. Bailey was the Chairman of the Board of Comarco, Inc. from 1998 until 2007 and was employed by Comarco, Inc., where he served as its Chief Executive Officer from 1991 to 2000. Mr. Bailey has been Chairman of the Board of STAAR since April 2005. Mr. Bailey holds a B.S. degree in mechanical engineering from the Drexel Institute of Technology, an M.S. degree in operations research from the University of Southern California, and an M.B.A. from Pepperdine University.

 

Stephen L. Cartt, 46, Executive Vice President, Corporate Development, joined the Company in March 2005. Mr. Cartt was a private consultant from August 2002 until March 2005. From March 2000 through August 2002, Mr. Cartt was the Senior Director of Strategic Marketing for Elan Pharmaceuticals. Mr. Cartt holds a B.S. degree from the University of California at Davis in biochemistry, and an M.B.A. from Santa Clara University.

 

Steven C. Halladay, Ph.D., 61, Senior Vice President, Clinical and Regulatory Affairs, joined the Company in October 2006. Prior to joining the Company, Dr. Halladay served as Vice President, Clinical and Regulatory Affairs of Durect Corporation from September 2002 to October 2006. Prior to joining Durect, Dr. Halladay served as Senior Executive Vice President of Clingenix, Inc. from 2000 to 2002 and as President and Chief Executive Officer of its wholly-owned subsidiary, Research Services, Inc. from 1995 to 2001. Dr. Halladay holds a B.S. from Southern Utah

University in zoology, an M.S. from the University of Arizona in toxicology and a doctorate of Philosophy from the University of Arizona Medical Center in clinical pharmacology.

 

David J. Medeiros, 57, Senior Vice President, Pharmaceutical Operations, joined the Company in June 2003 as Vice President, Manufacturing. Prior to joining the Company, Mr. Medeiros served as Senior Director, Manufacturing at Titan Pharmaceuticals, Inc. from November 2000 to June 2003. Mr. Medeiros holds a B.S. degree in chemical engineering from San Jose State University, a Master’s degree in chemical engineering from University of California, Berkeley and an M.B.A. from the University of California at Berkeley.

 

Gary M. Sawka, 62, Senior Vice President, Finance and Chief Financial Officer, joined the Company in September 2008. From February 2007 to April 2008, Mr. Sawka served as the Chief Financial Officer and Designated Responsible Individual of Tripath Technology, Inc., a former NASDAQ-listed fabless semiconductor company, during its Chapter 11 reorganization and its reverse merger. From August 2006 to February 2007, he served as a consulting Chief Financial Officer to Tripath Technology, Inc. From 2002 to 2006, Mr. Sawka worked as a financial consultant for several NASDAQ-listed companies. From 2000 to 2001, he served as Executive Vice President and Chief Financial Officer of ePlanning Securities, a national, representative-owned, independent FINRA Broker / Dealer. During the period from 1984 to 2002, Mr. Sawka served as Vice President and Chief Financial Officer of Tvia, Inc.(OTC: TVIA.PK), a fabless semiconductor company, PrimeSource Corporation, an international container leasing company specializing in high service leases, and Itel Containers International Corporation, at that time, the world’s largest international container leasing company. Since May 2007, Mr. Sawka has served on the Board of Directors of CAI International, Inc. (NYSE: CAP) an international container leasing and management company, where he is a member of the Audit and Compensation Committees and Chairs the Corporate Governance and Nominating Committee. Mr. Sawka has an M.B.A. from Harvard University Graduate School of Business Administration and a B.S. in Accounting from the University of Southern California.

 

The information related to Questcor’s Directors required by this item will be contained in our definitive proxy statement to be filed with the Securities and Exchange Commission in connection with the Annual Meeting of our Shareholders (the “Proxy Statement”), which is expected to be filed not later than 120 days after the end of our fiscal year ended December 31, 2008, and is incorporated in this report by reference.

 

The remaining information required by this item will be set forth in the Proxy Statement and is incorporated in this Annual Report by reference.

 

 

The information required by this item will be set forth in the Proxy Statement and is incorporated in this Annual Report by reference.

 

 

The following table sets forth information regarding outstanding options and shares reserved for future issuance under the Company’s existing equity compensation plans as of December 31, 2008:

 

The remaining information required by this item will be set forth in the Proxy Statement and is incorporated in this Annual Report by reference.

 

 

The information required by this item will be set forth in the Proxy Statement and is incorporated in this Annual Report by reference.

 

 

The information required by this item will be set forth in the Proxy Statement and is incorporated in this Annual Report by reference.

 

 

(a) The following documents are filed as part of this Annual Report:

 

1. Financial Statements.  Our financial statements and the Reports of Independent Registered Public Accounting Firm are included in Part IV of this Annual Report on the pages indicated:

 

 

2. Financial Statement Schedules.  The following financial statement schedule is included in Item 15(a)(2): Valuation and Qualifying Accounts.

 

(c) Exhibits