WINDTREE THERAPEUTICS INC /DE/ - Annual Report: 2013 (Form 10-K)

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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-K

x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2013

 

or

 

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

 

For the transition period from                    to

Commission file number 000-26422

DISCOVERY LABORATORIES, INC.

(Exact name of registrant as specified in its charter)

 

(215) 488-9300

 

(Registrant’s telephone number, including area code)

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

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

None

 

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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 x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  YES  o    NO x

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

 

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the 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. x

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

Large accelerated filer	o	Accelerated filer	x
Non-accelerated filer	o	Smaller reporting company	o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YES o     NO x

The aggregate market value of shares of voting and non-voting common equity held by non-affiliates of the registrant on June 30, 2013 (based on the closing price for shares of the registrant’s common stock as reported on The Nasdaq Capital Market under the symbol DSCO on that date was approximately $70 million.  In determining this amount, the registrant has assumed solely for this purpose that all of its directors, the executive officers named in Part III of this Annual Report on Form 10-K, and persons beneficially owning 10% or more of the outstanding shares of common stock of the registrant may be considered to be affiliates. This assumption shall not be deemed conclusive as to affiliate status for this or any other purpose.

As of March 7, 2014, 84,696,919 shares of the registrant’s common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE:

In accordance with General Instruction G(3) to the Annual Report on Form 10-K, portions of the registrant’s definitive Proxy Statement for its 2014 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission no later than 120 days, or April 30, 2014, after the registrant’s fiscal year ended December 31, 2013, and to be delivered to stockholders in connection with the 2014 Annual Meeting of Stockholders, are herein incorporated by reference in Part III of this Form 10-K.

Unless the context otherwise requires, all references to “we,” “us,” “our,” and the “Company” include Discovery Laboratories, Inc., and its wholly-owned, presently inactive subsidiary, Acute Therapeutics, Inc.

 

FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.  The forward-looking statements are only predictions and provide our current expectations or forecasts of future events and financial performance and may be identified by the use of forward-looking terminology, including such terms as “believes,” “estimates,” “anticipates,” “expects,” “plans,” “intends,” “may,” “will” or “should” or, in each case, their negative, or other variations or comparable terminology, though the absence of these words does not necessarily mean that a statement is not forward-looking.  Forward-looking statements include all matters that are not historical facts and include, without limitation, statements concerning: our business strategy, outlook, objectives, future milestones, plans, intentions, goals, and future financial condition, including the period of time during which our existing resources will enable us to fund our operations.  Forward-looking statements also include our financial, clinical, manufacturing and distribution plans, and our expectations related to the commercialization of SURFAXIN^® and our development and potential regulatory plans to secure marketing authorization for our products under development, starting with AEROSURF^®, if approved; our expectations, timing and anticipated outcomes of submitting regulatory filings for our products under development; our research and development programs, including planning for development activities, anticipated timing of clinical trials and potential development milestones, for our KL4 surfactant pipeline, our capillary aerosol generator (CAG) for delivery of aerosolized medications; plans for the manufacture of drug products, active pharmaceutical ingredients (APIs) and materials and medical devices; and plans regarding potential strategic alliances and other collaborative arrangements to develop, manufacture and market our products.

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We intend that all forward-looking statements be subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995.  Forward-looking statements are subject to many risks and uncertainties that could cause actual results to differ materially from any future results expressed or implied by the forward-looking statements.  We caution you therefore against relying on any of these forward-looking statements.  They are neither statements of historical fact nor guarantees or assurances of future performance.  Examples of the risks and uncertainties include, but are not limited to:

 

•

the risk that we will require in the near term, but may be unable to secure, significant additional capital to continue our operations, fund our debt service and support our research and development activities, including expensive and time-consuming clinical trials, until such time, if ever, that our revenues from all sources are sufficient to offset our cash outflows. To the extent that we raise such capital through additional financings, such additional financings could result in equity dilution;

 

The forward-looking statements contained in this report or the documents incorporated by reference herein speak only as of their respective dates.  Factors or events that could cause our actual results to differ may emerge from time to time and it is not possible for us to predict them all.  Except to the extent required by applicable laws, rules or regulations, we do not undertake any obligation to publicly update any forward-looking statements or to publicly announce revisions to any of the forward-looking statements, whether as a result of new information, future events or otherwise.

Trademark Notice

 

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DISCOVERY LABORATORIES, INC

Table of Contents to Annual Report on Form 10-K

For the Fiscal Year Ended December 31, 2013

 

PART I
	ITEM 1.	BUSINESS	1
	ITEM 1A.	RISK FACTORS	25
	ITEM 1B.	UNRESOLVED STAFF COMMENTS	57
	ITEM 2.	PROPERTIES	57
	ITEM 3.	LEGAL PROCEEDINGS	58
PART II
	ITEM 5.	MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES	58
	ITEM 6.	SELECTED FINANCIAL DATA	59
	ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	60
	ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	80
	ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA	80
	ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE	81
	ITEM 9A.	CONTROLS AND PROCEDURES	81
	ITEM 9B.	OTHER INFORMATION	83
PART III
	ITEM 10.	DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE	83
	ITEM 11.	EXECUTIVE COMPENSATION
	ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
	ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
	ITEM 14.	PRINCIPAL ACCOUNTING FEES AND SERVICES
PART IV
	ITEM 15.	EXHIBITS AND FINANCIAL STATEMENT SCHEDULES	83
SIGNATURES			84

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PART I

ITEM 1.

BUSINESS.

 

COMPANY OVERVIEW

We are a specialty biotechnology company focused on creating life-saving products for critical-care patients with respiratory disease and improving the standard of care in pulmonary medicine.  Our proprietary drug technology produces a synthetic, peptide-containing surfactant (KL4 surfactant) that is structurally similar to pulmonary surfactant, a substance produced naturally in the lung and essential for normal respiratory function and survival.  We are developing our KL4 surfactant in liquid, lyophilized and aerosolized dosage forms.  We are also developing novel drug delivery technologies potentially to enable efficient delivery of our aerosolized KL4 surfactant.  We believe that our proprietary technologies may make it possible, for the first time, to develop a significant pipeline of products to address a variety of respiratory diseases for which there frequently are few or no approved therapies.

Initial Focus – Respiratory Distress Syndrome (RDS) in Premature Infants

We are initially focused on improving the management of respiratory distress syndrome (RDS) in premature infants.  RDS is a serious respiratory condition caused by insufficient surfactant production in underdeveloped lungs of premature infants.  RDS is the most prevalent respiratory disease in the Neonatal Intensive Care Unit (NICU) and can result in long-term respiratory problems, developmental delay and death.

Our first KL4 surfactant drug product, SURFAXIN^® (lucinactant) Intratracheal Suspension for the prevention of RDS in premature infants at high risk for RDS, was approved by the United States Food and Drug Administration (FDA) in 2012.  SURFAXIN is our KL4 surfactant in liquid form and is the first synthetic, peptide-containing surfactant approved by the FDA and the only alternative to animal-derived surfactants currently used in the United States (U.S.).  Since November 2013, SURFAXIN has been commercially available in the U.S.

Premature infants with severe RDS currently are treated with surfactants that can only be administered by endotracheal intubation supported with mechanical ventilation, both invasive procedures that may each result in serious respiratory conditions and other complications.  To avoid such complications, many neonatologists treat infants with less severe RDS by less invasive means, typically nasal continuous positive airway pressure (nCPAP).  Unfortunately, a significant number of premature infants on nCPAP will not respond well (an outcome referred to as nCPAP failure) and thereafter may require delayed surfactant therapy.  Since neonatologists currently cannot predict which infants will experience nCPAP failure, neonatologists are faced with difficult choices in treating infants with less severe RDS.  This is because the medical outcomes for those infants who experience nCPAP failure and receive delayed surfactant therapy may be less favorable than the outcomes for infants who receive surfactant therapy in the first hours of life.

AEROSURF^® is an investigational combination drug/device product that combines our KL4 surfactant with our proprietary capillary aerosol generator (CAG).  With AEROSURF, neonatologists potentially will be able to administer aerosolized KL4 surfactant to premature infants supported with nCPAP, without having to use invasive intubation and mechanical ventilation.  By enabling delivery of our KL4 surfactant using less invasive procedures, we believe that AEROSURF will address a serious unmet medical need and potentially enable the treatment of a significantly greater number of premature infants with RDS who could benefit from surfactant therapy but are currently not treated.

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We are also developing a lyophilized (freeze-dried) dosage form of our KL4 surfactant that is stored as a powder and reconstituted to liquid form prior to use with the objective of improving ease of use for healthcare practitioners, as well as potentially to prolong shelf life and eliminate the need for cold-chain storage.  We are initially developing this dosage form for use in our AEROSURF development program.  We are also planning to seek regulatory advice to determine if we could gain marketing authorization for a lyophilized dosage form of SURFAXIN under a development plan that would be both capital efficient and capable of implementation within a reasonable time.  If feasible, we would likely implement such a development plan and would plan to introduce it commercially as a life-cycle extension of SURFAXIN under the name SURFAXIN LS™, in the U.S. and potentially in other markets.

The current RDS market for surfactants is estimated to be approximately $75 million annually in the U.S. and $250 to $300 million annually worldwide; however, we believe that this market has been constrained, in part, by the risks associated with surfactant administration.  We believe that our RDS programs, including our aerosolized KL4 surfactant that potentially may be administered using less invasive means, collectively and over time, have the potential to greatly improve the management of RDS and to expand the current RDS estimated worldwide annual market to more than a $1 billion per year market opportunity.

To support the commercial introduction of SURFAXIN in the U.S. and our other KL4 surfactant pipeline products, if approved, we have established our own specialty respiratory critical care commercial and medical affairs team.  This team includes medical professionals with experience in neonatal/pediatric respiratory critical care, and has focused on products that address neonatal indications, beginning with SURFAXIN.  We believe that this team will be positioned to efficiently introduce our other KL4 surfactant products under development, if approved, including AEROSURF and potentially SURFAXIN LS and future applications of our aerosolized KL4 surfactant.

In addition, we recognize that our commercial and medical affairs team could potentially support introductions of other synergistic pipeline products, including products owned or developed by third parties for the NICU/PICU.  To that end, we would consider potential transactions focused on securing commercial rights to such synergistic products, including in the form of product acquisitions, in-licensing agreements or distribution, marketing or co-marketing arrangements.

Beyond RDS

In the future, we expect that we may be able to leverage the information, data and know-how that we gain from our development efforts with SURFAXIN and AEROSURF to support development of a potential product pipeline to address serious critical care respiratory conditions in larger children and adults in pediatric and adult intensive care units (PICUS and ICUs), including acute lung injury (ALI), chronic obstructive pulmonary disease (COPD) and cystic fibrosis (CF).  At the present time, however, we are focusing our resources primarily on the commercial introduction of SURFAXIN and development of AEROSURF through phase 2 clinical trials.  Once we have achieved these objectives, we believe we would be in a better position to assess the potential of other development programs to address the critical care needs of patients in the PICU and ICU.

We also have developed a disposable aerosol-conducting airway connector for infants that is intended to simplify the delivery of aerosolized medications (including our aerosolized KL4 surfactant) and other inhaled therapies to critical-care patients requiring ventilatory support.  This device introduces aerosolized medications directly at the patient interface and minimizes the number of connections in the ventilator circuit.  We have registered this device as a Class I, exempt medical device in the U.S. under the name AFECTAIR^® and it is currently commercially available in the U.S.

 

BUSINESS STRATEGY

We continue to focus our drug research and development activities on the management of RDS in premature infants.  We believe that the RDS market represents a significant opportunity from both a medical and a business perspective.  See, “– Surfactant Replacement Therapy for Respiratory Medicine – Respiratory Distress Syndrome in Premature Infants (RDS).”  Our immediate goal is to successfully introduce SURFAXIN in the U.S. and advance development of our AEROSURF program.  Key elements of our strategy to achieve these goals include:

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With the introduction of SURFAXIN, the first synthetic, peptide-containing surfactant approved by the FDA, we believe that hospitals in the U.S., over time, will replace animal-derived surfactants, which are derived from pig and cow lungs using a chemical extraction process, with SURFAXIN and our other clinically differentiated synthetic KL4 surfactant products.

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To support the commercial introduction of SURFAXIN, we have established our own specialty respiratory critical care commercial and medical affairs organization that has experience in respiratory critical care and is focused on neonatal / pediatric indications, beginning with SURFAXIN and, in the future, AEROSURF and our other KL4 surfactant products under development, if approved.

 

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We also will seek to identify other synergistic products that may be of benefit in the NICU/PICU and could be marketed through our team.  To gain access to synergistic products, we would consider potential transactions focused on securing commercial rights in the U.S., including through product acquisitions or in-licensing, distribution, marketing or co-marketing arrangements.  We believe that this strategy provides us direct control over our U.S. sales and marketing activities, permits us to establish a strong presence in NICUs and PICUs nationwide, and potentially optimizes the economics of our business.

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To advance our AEROSURF development program in the U.S., we are conducting a phase 2 clinical program, having opened an investigational new drug (IND) application with the FDA in the fourth quarter of 2013.

 

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The first part of our clinical program, phase 2a, is designed to evaluate the safety and tolerability of a single exposure of AEROSURF in an escalating dose study evaluating three doses of increasing amounts of AEROSURF.  The comparator is nCPAP only.  We anticipate results in the second half of 2014.

 

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The next phase of our clinical program, phase 2b, will have a primary objective to determine the optimal dose and define the expected efficacy margin.  The results of this phase will inform the design of a potential phase 3 clinical trial focused on safety and efficacy.  We currently plan to initiate phase 2b in the second half of 2014 and expect to complete it in the second half of 2015.

 

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Since June 2012, we have been working with Battelle Memorial Institute (Battelle), which supported us in a multi-phase development program that culminated in the manufacture of clinic-ready CAG devices and disposable AEROSURF Delivery Packs (ADPs) for our phase 2a clinical trial.  Battelle has agreed to manufacture a sufficient number of CAG devices and ADPs to support our planned phase 2b clinical trial and other development activities.

 

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We plan to use our lyophilized KL4 surfactant in our AEROSURF program.  Our contract manufacturing organization (CMO), DSM Pharmaceuticals, Inc. (DSM) has manufactured sufficient lyophilized KL4 surfactant drug product to support our phase 2a clinical trial and we expect DSM will manufacture additional product supply to support our planned phase 2b and, potentially, phase 3 clinical trials.

 

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To advance our AEROSURF program in the European Union (EU) and potentially other markets outside the U.S., we plan to retain regulatory consultants to assist us in engaging international regulatory authorities regarding a potential AEROSURF development plan.

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While we currently intend to retain all rights and commercialize our approved products in the U.S., an important priority for us is to secure strategic resources to support the continued development and commercial introduction of our RDS products in markets outside the U.S.

 

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To advance and support our AEROSURF development activities, we seek a significant strategic alliance that potentially could provide development, regulatory and commercial market expertise as well as financial resources for our AEROSURF development program, and, if approved, support the commercial introduction of AEROSURF in the EU and other selected markets outside the U.S.  Financial resources provided by such alliances typically could take the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses.

 

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To potentially advance the introduction of SURFAXIN in markets outside the U.S. where regulatory marketing authorization is facilitated by the information contained in our new drug application (NDA) approved by the FDA, we would consider various financing or collaboration arrangements that could provide regulatory expertise and support the commercial introduction of SURFAXIN, and potentially our other FDA-approved KL4 surfactant products, in other countries.  Such countries could potentially include those in Latin America, North Africa and the Middle East.

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An important priority for us is to strengthen our long-term financial position.  We will require significant additional capital over time to advance our development programs, support the introduction of our approved products, support our operations and maximize stockholder value.  See, “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources.”

 

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We will require additional capital to fund our operations and development activities until such time as revenues from the sale of SURFAXIN and AEROSURF are sufficient, if ever, to fund our development activities and operations.  In February 2013, we entered into a loan agreement (Deerfield Loan) with affiliates of Deerfield Management Company, L.P. (Deerfield) and have received advances totaling $30 million, secured by a security interest in substantially all of our assets.  The proceeds of these loans are being used to meet our working capital requirements.  We also entered into an At-the-Market Equity Offering Sales Agreement with Stifel, Nicolaus & Company, Incorporated (Stifel), under which Stifel, as our exclusive agent, may sell through an “at-the-market” program (ATM Program), at such times that we may elect in our sole discretion, during a three-year term, up to a maximum of $25,000,000 of shares of our common stock.  At December 31, 2013, $23.0 million was available under the ATM Program.  We plan to use any proceeds from the ATM Program to meet our working capital requirements.  During 2013, we raised aggregate gross proceeds of $75.8 million through public offerings of our common stock, including under our ATM Program.  We plan to continue to carefully managing our cash resources and will seek additional capital, including potentially through future debt and equity financings, as we deem necessary to maintain and strengthen our financial position.

 

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In addition, as noted above, we expect that strategic alliances will play an important role in strengthening our financial position as well as our capabilities as we advance our KL4 surfactant development programs.

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We have invested, and will continue to invest, in improving our potential competitive position by protecting our exclusive rights in our KL4 surfactant technology, pipeline products and drug delivery technologies, including our CAG and aerosol-conducting airway connector, through patents, patent term restoration, trademarks and trade secrets.  We believe that our development programs will provide opportunities to extend our exclusivities into the future through new patents and other intellectual property.  We also hold, and will continue to seek, regulatory designations that provide post-approval market exclusivity for our pipeline products that would allow us to build our market share.  See, “– Licensing, Patents and Other Proprietary Rights and Regulatory Designations.”

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We continue to invest in quality systems and manufacturing capabilities.   We are planning for long-term continuity of supply and continued integrity and reliability of our manufacturing and quality assurance processes.  We seek to build a foundation to support our anticipated long-term needs, and intend to make appropriate capital investments in the near-term, balancing the use of our available resources while maintaining flexibility in planning our long-term manufacturing activities and goals.

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While we are currently focused on RDS, we also believe that our KL4 surfactant technology could be developed into a broad product pipeline to address a variety of debilitating respiratory conditions and diseases, including pediatric and adult indications that could represent potentially significant market opportunities.  From time to time, we have participated in investigator-initiated research programs and government funded research and preclinical development initiatives that explore the use of our KL4 surfactant in the treatment of a range of respiratory diseases, including CF and ALI.  Although there can be no assurance, we may in the future support development activities to establish a proof-of-concept and, if successful, thereafter determine whether to seek strategic alliances or collaboration arrangements or pursue other financial alternatives to fund further development and/or worldwide commercialization of additional indications, if approved.

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Our estimates of market size and business opportunities included in this Business Section and elsewhere in this Annual Report on Form 10-K are based in part on our analysis of data derived from the following sources, among others:  Annual Summary of Vital Statistics: 2010, Pediatrics, Martin et. al.; CDC National Vital Statistics, 2005; IMS Midas Data MAT, December 2011; HCUP Hospital Discharge data, 2008; Hospital Insurance Claim Database, 2009; Management and Outcomes of Very Low Birth Weight, New England Journal of Medicine (NEJM), 2008, Eichenwald, Stark; Market Intelligence Report on Number of ICU Beds in EU5 Countries; The Cystic Fibrosis Foundation website; Vermont Oxford Network Data, 2006; estimates from other companies with information on surfactant sales in countries where IMS data reporting is often incomplete or non-existent; and Discovery Labs Primary Market Research, December 2010 and May 2011; as well as our analysis of the SELECT and STAR trials described below.  In addition, our analysis and assumptions take into account estimated patient populations, expected adoption rates of our products, current pricing, and economics and anticipated potential pharmacoeconomic benefits of our drug products, if approved.  We provide estimates and projections to give the reader an understanding of our strategic priorities, but we caution that the reader should not rely on our estimates and projections.  These estimates and projections are forward-looking statements, which we intend to be subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995.  For a discussion of forward-looking statements, see, “Forward-Looking Statements” on page iii of this Annual Report on Form 10-K, and “Item 1A – Risk Factors.”

 

PROPRIETARY PLATFORM – KL4 SURFACTANT AND AEROSOL TECHNOLOGIES

Our KL4 Surfactant Technology

Pulmonary surfactants are protein and phospholipid compositions that form naturally in the human lung and are critical to survival and normal respiratory function.  They spread in a thin mono-layer to cover the entire alveolar surface, or air sacs, of the lungs and the terminal conducting airways that lead to the air sacs.  They facilitate breathing by continually modifying the surface tension of the fluid that lines the inside of the lungs.  If the lungs have a surfactant deficiency, as frequently occurs in premature infants, or experience surfactant degradation, generally due to disease, lung insult or trauma, the air sacs in the lungs will tend to collapse and will not absorb enough oxygen, resulting in severe respiratory diseases and disorders.  In addition to lowering alveolar surface tension, surfactants contribute in other important ways to respiration including, for example, by lowering the surface tension of the conducting airways and maintaining airflow and airway patency (keeping the airways open and expanded).  Many respiratory disorders are associated with surfactant deficiency or surfactant degradation.  However, the use of surfactant therapy presently has limited application and is approved by the FDA only to manage RDS in premature infants.

Our proprietary KL4 surfactant technology produces a synthetic surfactant that is structurally similar to human pulmonary surfactant and contains a proprietary synthetic peptide, KL4 (sinapultide), a 21-amino acid peptide that closely mimics the essential attributes of the human surfactant protein B (SP-B), one of four known surfactant proteins and the most important for proper functioning of the respiratory system.  Our synthetic surfactant is manufactured to approved specifications, with minimal lot-to-lot variability, and is being developed in liquid instillate, lyophilized (freeze-dried) and aerosolized dosage forms.  We have licensed exclusive worldwide rights to this technology, which was invented at The Scripps Research Institute and exclusively licensed to and further developed by an affiliate of Johnson & Johnson, Inc. (J&J).

We have demonstrated in preclinical studies that our KL4 surfactant may possess certain beneficial properties, including modulation of the inflammatory process, antimicrobial properties and non-immunogenicity.  We believe these properties may be important attributes as we develop our KL4 surfactant technology pipeline potentially to address a broad range of respiratory conditions beyond RDS that represent significant unmet medical needs.  However, the clinical relevance of such attributes has not been adequately established and, accordingly, warrants further study.

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SURFAXIN is our first KL4 surfactant approved for sale in the U.S. and is a liquid instillate that is administered using the same method of administration required for animal-derived surfactants, endotracheal intubation and mechanical ventilation.  As with the animal-derived surfactants currently marketed in the U.S., it must be stored in refrigerated conditions and warmed prior to use.

In addition to liquid instillate, our KL4 surfactant technology also can be produced in a lyophilized (freeze-dried) dosage form that is reconstituted to liquid form prior to administration.  In several experiments, we have demonstrated that our lyophilized KL4 surfactant retains the key characteristics of our liquid instillate and may provide additional benefits in a clinical setting, including potentially:

 

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improved ease of use for healthcare practitioners, including potential elimination of the drug warming process allowing for shortened preparation time; and potential elimination or reduction of continuous cold chain storage and refrigeration requirements;

 

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potential improved product stability and extended shelf life; and

 

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relatively lower viscosity, which may aid and/or improve the distribution of KL4 surfactant throughout the lung and potentially may reduce the frequency of transient peri-dosing events typically observed during administration of surfactants.

We have also demonstrated that we can aerosolize both liquid instillate and lyophilized dosage forms of our KL4 surfactant and that our aerosolized KL4 surfactant has the following important characteristics:

 

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full retention of the surface-tension lowering properties of a functioning surfactant necessary to restore lung function and maintain patency of the conducting airways;

 

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full retention of the surfactant composition upon aerosolization; and

 

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drug particle size believed to be suitable for deposition into the lung.

We initially plan to develop our aerosolized KL4 surfactant to treat RDS in premature infants and thereafter potentially to address a range of indications in neonatal, pediatric and adult critical care patient populations.  We believe our KL4 surfactant in liquid, lyophilized and aerosolized dosage forms, may be developed to expand the therapeutic options available to treat previously unaddressed respiratory problems in patients of all ages.

Our Aerosolization Delivery Technologies

We have worldwide exclusive rights to our CAG technology for use with pulmonary surfactants (alone or in combination with any other pharmaceutical compound(s)) for all respiratory diseases and conditions.  In addition, we hold in the U.S. exclusive rights to the CAG technology for use with certain non-surfactant drugs to treat a wide range of pediatric and adult respiratory indications in hospitals and other health care institutions.

Our proprietary CAG technology is designed to produce a high-quality aerosol capable of delivering our KL4 surfactant to the lung.  An aerosol is created by pumping our KL4 surfactant through a heated capillary.  Upon exiting the capillary, the aerosol cools and slows in velocity, yielding a dense aerosol with a defined particle size.  In studies conducted with our initial CAG device and our KL4 surfactant, we have generated an aerosolized KL4 surfactant at consistent and reproducible volumes suitable to deliver therapeutic dosages in a reasonable period of time.  Preclinical studies presented in 2007 at the Pediatric Academic Societies Annual Congress (PAS) comparing our CAG technology to commercially available aerosol devices indicated that our CAG device generated as much as a 10-fold higher aerosol output rate compared with the other devices studied.  We believe that our CAG technology is capable of effectively delivering our KL4 surfactant to the lung of premature infants with RDS without having to resort to invasive procedures that are currently required to administer surfactants.

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We have also developed a novel, disposable aerosol-conducting airway connector that is intended to simplify the delivery of aerosolized medications, including our aerosolized KL4 surfactant, and inhaled therapies to infants requiring ventilatory support in the NICU and PICU.  This device introduces the aerosolized medication directly at the patient interface and minimizes the number of connections in the ventilator circuit, simplifying the delivery of aerosolized medications and other inhaled therapies.

We registered this device in the U.S. under the name AFECTAIR as a Class I, exempt medical device and we have completed the European conformity (CE) marking process in the EU.  Based on in vitro studies demonstrating that AFECTAIR improves the delivery of inhaled therapies to infants requiring ventilatory support, we believe that it has the potential to greatly improve the delivery of aerosolized medications and inhaled therapies to critical-care patients. We currently are focused on gaining information and learning from the introduction of AFECTAIR in the U.S.  Thereafter, we may consider introducing AFECTAIR in markets outside the U.S.

 

SURFACTANT REPLACEMENT THERAPY FOR RESPIRATORY MEDICINE

Prior to the FDA’s approval of SURFAXIN, the only pulmonary surfactants commercially available in the U.S. were introduced in the 1990’s.  All of the available pulmonary surfactants were animal-derived and approved for RDS in premature infants.  SURFAXIN is the first synthetic, peptide-containing surfactant approved for use in neonatal medicine and provides healthcare practitioners in the U.S. with an alternative to the animal-derived surfactants that today are the standard of care to manage RDS in premature infants.  We believe that our proprietary KL4 surfactant technology makes it possible, for the first time, to develop a significant pipeline of surfactant products targeted to treat a wide range of respiratory problems, including those for which there are currently few or no approved therapies.  Our potential programs include:

Respiratory Distress Syndrome in Premature Infants (RDS)

We are currently focused primarily on addressing RDS in premature infants, one of the most common serious respiratory problems facing premature infants in the NICU.  RDS is a condition in which premature infants are born with a lack of natural lung surfactant and are unable to absorb sufficient oxygen.  Premature infants born prior to 37 weeks gestation have not fully developed their own natural lung surfactant and therefore may need surfactant treatment to sustain life.  RDS is experienced in approximately half of the babies born between 26 and 32 weeks gestational age.  The incidence of RDS approaches 100% in babies born less than 26 weeks gestational age.  RDS can result in long-term respiratory problems and death.

Premature infants with severe RDS currently are treated with surfactants (usually within the first hours of birth) that can only be administered by endotracheal intubation supported with mechanical ventilation, both invasive procedures that may each result in serious respiratory conditions and other complications.  Neonatologists generally try to avoid mechanically ventilating infants due to the perceived risks associated with intubation, such as the risk of trauma and the need for paralytic agents and sedation.  To avoid these complications, many neonatologists will administer surfactants as an initial therapy only to premature infants with severe RDS, where the potential benefits of invasive surfactant therapy more clearly outweigh the associated risks.  Unfortunately, many infants with server RDS will relapse following initial surfactant therapy and require reintubation and prolonged mechanical ventilation as well as supplemental oxygen, increasing their risk of developing further serious respiratory complications.

A common ventilatory support treatment alternative to intubation and mechanical ventilation is nCPAP, which is generally used to support all but the very low birth weight infants with severe RDS.  Unfortunately, a significant number of infants do not respond adequately to nCPAP, an outcome referred to as nCPAP failure, and thereafter may require delayed surfactant therapy administered by intubation and mechanical ventilation.  Several published studies point toward a high rate of nCPAP failure in the neonatal population (Finer et al, “Early CPAP versus surfactant in extremely preterm infants,” N Engl J Med 2010;362(21):1970-9 (Finer, et al, NEJM 2010); Morely et al, “Nasal CPAP or Intubation at Birth for Very Preterm Infants,” N Engl J Med 2008;358:700-8 (Morely et al, NEJM 2008)).  Since it currently is not possible to predict which patients will experience nCPAP failure, neonatologists are faced with difficult choices in deciding how best to treat premature infants with less severe RDS. This is because the medical outcomes for those infants who experience nCPAP failure and receive delayed surfactant therapy may be less favorable than the outcomes for those infants who receive surfactant therapy in the first hours of life.

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We estimate that approximately 360,000 low birth weight premature infants are born annually in the U.S. and at risk for RDS (approximately 600,000 in the U.S., major European medical markets, and Japan).  In the U.S., we estimate that approximately 160,000 premature infants could benefit from surfactant therapy.  However, due to the risks associated with intubation and mechanical ventilation, only approximately 45,000 of these infants currently are treated with surfactants as the initial therapy for severe RDS.  The remainder primarily receive nCPAP for less severe RDS.  As discussed above, a large percentage of these patients will fail nCPAP therapy and require delayed surfactant therapy administered via intubation and mechanical ventilation.  We estimate this delayed surfactant therapy (post-nCPAP failure) population to be another approximately 45,000 infants, bringing the total number of premature infants in the U.S who are treated with surfactants for RDS to approximately 90,000.

Neonatologists’ treatment options have not improved significantly, nor have mortality and morbidity rates for RDS meaningfully improved over the last decade.  We believe that the neonatal medical community would respond favorably to the introduction of a synthetic, peptide-containing surfactant and a less-invasive method of administration.

SURFAXIN is the first synthetic, peptide-containing surfactant that is structurally similar to pulmonary surfactant and mimics the surface-active properties of human surfactant.  SURFAXIN is a liquid instillate and is administered (usually within the first hours of birth) via endotracheal tube supported by mechanical ventilation.  SURFAXIN represents the first synthetic, peptide-containing surfactant approved for the prevention of RDS in premature infants at high risk for RDS.

Our NDA for SURFAXIN was supported by a phase 3 pivotal trial (SELECT) to evaluate the safety and efficacy of SURFAXIN for the prevention of RDS in premature infants.  Co-primary endpoints were the incidence of RDS at 24 hours and RDS-related mortality at 14 days.  The primary comparator was Exosurf® (colfosceril palmitate) with the intent of demonstrating superiority.  SURFAXIN demonstrated a statistically significant improvement in both RDS at 24 hours and RDS-related mortality through day 14.  Survanta® (beractant) served as an additional active comparator.  SURFAXIN demonstrated a statistically significant reduction in RDS-related mortality through day 14 versus Survanta.  We also conducted a supportive, multicenter, double-blind, active-controlled, phase 3 clinical trial (STAR) which was designed as a non-inferiority trial comparing SURFAXIN to Curosurf® (poractant alfa), a surfactant derived from pig lung.

The SELECT and STAR trials, as well as a pooled phase 3 analysis, have been presented at several international medical meetings and the results from the two studies were published in Pediatrics, the Official Journal of the American Academy of Pediatrics and a premier medical journal for pediatric healthcare practitioners.  Post-hoc analysis of data from our SELECT and STAR phase 3 clinical trials indicates that premature infants with RDS who were extubated after treatment with surfactant and who later required reintubation had a significantly higher rate of mortality than those infants who did not require reintubation.  The data also indicate that premature infants treated with SURFAXIN required less reintubation compared to those treated with Survanta and Curosurf.  The clinical relevance of this finding has not been adequately established and, accordingly, warrants further study.  However, pharmacoeconomic analysis suggests that lower reintubation rates may result in significant hospital cost savings associated with reduction in time spent on mechanical ventilation and reduced rates of bronchopulmonary dysplasia (BPD), air leak, sepsis, necrotizing enterocolitis (NEC), or intraventricular hemorrhage (IVH).

The FDA granted marketing approval for SURFAXIN on March 6, 2012.  In the third quarter of 2012, following a routine review, we determined that one of our analytical chemistry methods used to assess SURFAXIN drug product conformance to specifications required improvement and that an update to product specifications was needed.  We subsequently improved and validated the analytical chemistry method and submitted updated product specifications to the FDA.  In November 2013, the FDA approved our submission and we initiated the commercial introduction of SURFAXIN.

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To facilitate proper administration of SURFAXIN, we are making available to hospitals a WARMING CRADLE^® dry-block heating device that is designed to warm drug vials at the same temperature that is designated in the SURFAXIN prescribing information.  WARMING CRADLE dry-block heater is registered with the FDA as a Class I, exempt laboratory medical device.

AEROSURF is an investigational drug-device combination product that produces our KL4 surfactant in aerosolized form using our lyophilized KL4 surfactant with our CAG.  We are developing AEROSURF to potentially reduce or eliminate the need for intubation and mechanical ventilation in the treatment of RDS.  With AEROSURF, neonatologists may potentially administer our aerosolized KL4 surfactant to premature infants supported by nCPAP, without subjecting them to invasive intubation and mechanical ventilation, which are currently required to administer surfactant therapy to premature infants.  With the risk of intubation reduced or eliminated, we believe that AEROSURF could enable the treatment of a significantly greater number of premature infants with RDS who could benefit from surfactant therapy but who are currently not treated.

By enabling delivery of our aerosolized KL4 surfactant using less invasive procedures, we believe that AEROSURF will address a serious unmet medical need, provide potentially transformative clinical and pharmacoeconomic benefits, and potentially enable the treatment of a significantly greater number of premature infants with RDS who could benefit from surfactant therapy but are currently not treated.  As noted above, of the 160,000 infants that could likely benefit from surfactant therapy, approximately 115,000 currently receive nCPAP therapy as the initial therapy for RDS.  We believe, and market research with clinicians suggests, that, if AEROSURF is approved, a large majority of infants who currently receive nCPAP only will instead receive aerosolized KL4 surfactant as the initial treatment for RDS.  In addition, if AEROSURF is approved, of the 45,000 remaining premature infants who currently receive liquid surfactant administered using intubation and mechanical ventilation as the initial treatment, a significant number of these infants could potentially also receive aerosolized KL4 surfactant therapy as the initial treatment.

In addition to the potential clinical benefits of aerosolized KL4 surfactant, this therapy has the potential to provide significant pharmacoeconomic benefits for hospitals, payers and healthcare systems.  The  cost to support a mechanically ventilated RDS patient (an estimated $55,000 per patient),  is much greater than the cost to manage a patient on nCPAP (an estimated $8,000 per patient).  These costs increase even more when treating complications associated with intubation and mechanical ventilation such as bronchopulmonary dysplasia.  By providing clinical and pharmacoeconomic benefits and enabling the treatment of a significantly greater number of premature infants with RDS who could benefit from surfactant therapy but are currently not treated, we estimate that AEROSURF may, over time, expand the size of the U.S. surfactant market from a current estimated $250-$300 million per year to a range of $600 million to over $1 billion per year.

We are developing AEROSURF to deliver our aerosolized KL4 surfactant using the CAG.  To develop our CAG technology, in June 2012, we entered into a Research and Development Services Agreement with Battelle, which has a particular expertise in developing and integrating aerosol devices using innovative and advanced technologies.  Battelle assisted us with technical support and expertise and, together with our medical device engineering team, conducted a multi-phased program to finalize the design, test, and manufacture clinic-ready CAGs for our AEROSURF phase 2a clinical trial.  In addition, Battelle has agreed to manufacture a sufficient number of additional CAG devices and ADPs to support our AEROSURF phase 2b clinical trial, which we anticipate could initiate in the second half of 2014.  In addition to the CAG, we are developing a lyophilized KL4 surfactant dosage form that we intend to use initially for AEROSURF.  See, “– Lyophilized KL4 Surfactant for RDS in Premature Infants.”  We plan to develop AEROSURF using the lyophilized dosage form of our KL4 surfactant.

To prepare for our AEROSURF development activities, we previously conducted preliminary meetings with the FDA to discuss the AEROSURF development plan.  We also engaged regulatory consultants to assist us in refining and submitting our IND to implement our phase 2a clinical program.  We filed with the FDA in October 2013 and opened our IND in November 2013.  We currently plan to retain regulatory consultants to assist us in engaging international regulatory authorities regarding an AEROSURF development plan outside the U.S.

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Our phase 2a program is currently ongoing.  This initial phase of our phase 2 clinical program is designed to evaluate the safety and tolerability of a single exposure of AEROSURF in an escalating dose study evaluating three doses of increasing amounts of AEROSURF.  The comparator is nCPAP only.  We plan to conduct this trial in up to four medical centers in the U.S., and anticipate results in the second half of 2014.

The next phase, phase 2b, of our clinical program is expected to begin in the second half of 2014 and conclude in the second half of 2015.  The primary objective of this phase will be to determine the optimal dose and define the expected efficacy margin.  The design of this phase will be informed by the results of the phase 2a trial.  This phase is expected to be a multicenter trial conducted in the U.S., with results to be available in the second half of 2015.  The potential phase 3 efficacy clinical will be defined based in part on the results of the phase 2 trial.

We are developing a lyophilized (freeze-dried) dosage form of our KL4 surfactant that can be stored as a powder and reconstituted to liquid form prior to use, with the objective of improving ease of use for healthcare practitioners, as well as potentially prolonging shelf life and eliminating the need for cold-chain storage.  This lyophilized dosage form is intended initially to be used in our AEROSURF development program.  We have completed a technology transfer of our lyophilized surfactant manufacturing process to DSM, which has expertise in lyophilized products.  DSM has manufactured a supply of clinical drug product needed for the initial phase of our phase 2 program and will manufacture the clinical drug supply needed to complete our phase 2 clinical program.  We also have entered into a development agreement with DSM for the further development of this lyophilized KL4 surfactant, potentially for our AEROSURF phase 3 program and, if approved, commercial supply.

We are focused initially on developing this dosage form for use in our AEROSURF development program.  We are also planning to seek regulatory advice to determine if we could gain marketing authorization for a lyophilized dosage form of SURFAXIN under a development plan that would be both capital efficient and capable of implementation within a reasonable time.  If feasible, we would likely implement such a development plan and would plan to introduce it commercially as a life-cycle extension of SURFAXIN under the name SURFAXIN LS, in the U.S. and potentially in other markets.

Serious Respiratory Indications Associated with Inflammation of the Lungs

Many respiratory diseases are associated with an inflammatory event that causes surfactant dysfunction and a loss of patency of the conducting airways.  Scientific data support the premise that the therapeutic use of surfactants in aerosol form has the ability to reestablish airway patency, improve pulmonary mechanics and act as an anti-inflammatory.  For this reason, we believe that AEROSURF is a highly promising program and that, with the knowledge that we gain from our efforts to develop AEROSURF for the treatment of RDS in premature infants with RDS, we may be able to leverage our technology platform to potentially address serious respiratory conditions affecting pediatric and adult patient populations.  We believe that our proprietary aerosolized KL4 surfactant technology potentially may be effective as a preventive measure to treat patients at risk for ALI and, possibly in the future COPD and that investment in these indications could potentially address significant unmet medical needs.

Acute lung injury (ALI):  ALI is associated with conditions that either directly or indirectly injure the air sacs of the lung.  ALI is a syndrome of inflammation and increased permeability of the lungs with an associated breakdown of the lungs’ surfactant layer.  Among the causes of ALI are complications typically associated with certain major surgeries, mechanical ventilator-induced lung injury (often referred to as VILI), smoke inhalation, pneumonia and sepsis.  There are a significant number of patients at risk in the U.S. for ALI annually and there are no currently approved therapies other than supportive respiratory care.

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Chronic obstructive pulmonary disease (COPD):  COPD is an incurable, chronic respiratory disorder that includes both emphysema and chronic bronchitis and is characterized by obstruction to airflow that interferes with normal breathing, inflammation, mucus plugs formation, infection, and disruption of the normal lung architecture.  We believe that our KL4 surfactant has unique attributes, including potential modulation of the inflammatory process and anti-microbial properties, that, when combined with a potential ability to enhance mucus clearance may be an effective treatment for COPD, potentially improving outcomes for these very ill patients.

We have collaborated in research and preclinical studies to assess the use of our KL4 surfactant to potentially address ALI in an animal model.  In September 2012, we announced four collaborations in a series of preclinical studies funded through various U.S. government-sponsored, biodefense-related initiatives, including collaborations with: (i) University of Pennsylvania, funded by the NIH’s National Institute of Allergy and Infectious Diseases (NIAID) to assess the ability of KL4 surfactant to mitigate effects of acute radiation exposure to the lung; (ii) University of Rochester, to evaluate the use of KL4 surfactant to protect the lung in a radiation-induced multi-organ dysfunction animal model; (iii) a facility of the U.S. Department of Defense through the NIH Office of the Director and the Countermeasures Against Chemical Threats (CounterACT) program, to assess the utility of KL4 surfactant for the treatment of chemical-induced ALI; and  (iv) a program funded by NIAID, to investigate the use of KL4 surfactant as a treatment for influenza-induced ALI.

We may in the future invest in or support third-party studies of these indications.  If a proof-of-concept should be established, we will then determine whether to seek strategic alliances or collaboration arrangements or utilize other financial alternatives to fund their further development.  There can be no assurance that we will invest or support studies in these indications, that any such efforts will be successful, or that we will be able to conclude any such strategic alliance, collaboration arrangement or secure any financial alternative.

Cystic Fibrosis (CF)

CF is a life-threatening genetic disease affecting the respiratory and other body systems.  CF is characterized by a genetic mutation that results in the production of thick, viscous mucus that is difficult to clear from the airways of the lung and typically leads to life-threatening respiratory infections.  CF is the most common, life-threatening genetic disorder in the U.S.  CF occurs in approximately one in every 3,500 Caucasian live births and affects approximately 30,000 patients in the U.S. and nearly 70,000 worldwide.  Life expectancy for CF has more than doubled in the past 25 years to the mid-forties, due to significant advances in research and care.

We believe that our KL4 surfactant has unique attributes, potentially including anti-microbial properties, modulation of the inflammatory process, and lack of immunogenicity, that when combined with a potential ability to enhance mucociliary clearance, may serve as a complementary therapy to advance the treatment of CF and improve treatment outcomes for these very ill patients.  In 2009, our aerosolized KL4 surfactant was evaluated in an investigator-initiated phase 2a clinical trial in CF patients conducted at The University of North Carolina with the support of the Cystic Fibrosis Foundation.  In addition, we have received an orphan drug designation for CF from the FDA and the European Medicines Agency (EMA).

BUSINESS OPERATIONS

Research and Development

Our research and development activities are focused on developing our proprietary KL4 surfactant, CAG, and aerosol delivery technologies into a series of pipeline programs that potentially could support a significant respiratory critical care franchise.  We are initially focused on the management of RDS in premature infants.  We continually evaluate our research and development priorities in light of a number of factors, including the results obtained in our preclinical research and related activities, advances in technology, and relationship of a project to our near-term objectives; our cash flow requirements, financial liquidity, and our ability to secure the necessary capital; and the potential for development partnerships and collaboration agreements.  In connection with our evaluations, we modify and adapt our research and development plans from time to time and anticipate that we will continue to do so.

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We plan to focus our research and development resources in the near term on our RDS programs, primarily AEROSURF.  We are presently engaged in a phase 2a clinical trial for AEROSURF and are preparing to initiate a phase 2b trial, potentially in the second half of 2014.  Battelle has assisted us in the development and manufactured for us a supply of clinic-ready CAG devices to support preclinical activities and our phase 2a clinical trial.  We are working with Battelle to manufacture additional CAG devices to support additional research and development activities and our phase 2b clinical trial.  We are also working with DSM to manufacture a supply of lyophilized KL4 surfactant in mid-2014 to support the phase 2b trial and conduct further manufacturing development work for the planned phase 3 trial.

In addition to developing our lyophilized KL4 surfactant for AEROSURF, we plan to seek regulatory advice to determine if we could gain marketing authorization for a lyophilized dosage form of SURFAXIN under a development plan that would be both capital efficient and capable of implementation within a reasonable time.  If feasible, we would likely implement such a development plan and would plan to introduce it commercially as a life-cycle extension of SURFAXIN under the name SURFAXIN LS, in the U.S. and potentially in other markets.

In markets outside the U.S., for AEROSURF, we plan to engage international regulatory authorities regarding a potential AEROSURF development plan to advance AEROSURF in the EU and potentially other markets.  We also would invest in research and development activities to support a significant strategic alliance focused on the EU and/or other selected markets outside the U.S. for the development and, if approved, commercial introduction of AEROSURF.  For SURFAXIN, we would consider various financing or collaboration arrangements that could provide regulatory expertise and support the commercial introduction of SURFAXIN, and potentially our other FDA-approved KL4 surfactant products, in other countries.

To support our research and development activities, we have:

 

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physicians and scientists with expertise in pediatric and pulmonary medicine and extensive contacts in the neonatal medical community;

 

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expertise in the design and execution of preclinical experiments and studies to support drug development.  We conduct certain development-related experiments and bench studies in-house and also engage professional research laboratories as well as academic and education centers to conduct animal studies and experiments requiring specialized equipment and expertise;

 

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expertise in the design, development and management of clinical trials.  We have our own scientific, medical, biostatistics, and trial and data management capabilities.  For the initial phase of the AEROSURF program, we plan to analyze and report on our clinical trial data, supported by third-party technology systems and independent consultants, and will monitor all activities using our clinical operations capabilities.  We rely on scientific advisory committees and other medical and consulting experts to assist in the design and monitoring of clinical trials.  We also plan to rely on CROs to support operations of our planned multi-center AEROSURF trials, including potentially for locations outside the U.S.;

 

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regulatory personnel with expertise in FDA regulatory matters.  We also consult extensively with independent FDA and international regulatory experts, including former senior scientific staff of the FDA;

 

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engineering expertise to support development of our CAG and aerosol delivery technologies.  In addition to our own engineering team, we are engaged in a development program with Battelle to bring its significant expertise in developing and integrating aerosol device technologies to optimize our CAG device and manufacture clinic-ready CAG devices for our phase 2 AEROSURF clinical trials;

 

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quality operations capabilities to assure compliance with applicable regulations;

 

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manufacturing capabilities to manufacture our KL4 surfactant for use in preclinical studies.  We rely on CMOs to produce our lyophilized KL4 surfactant and to manufacture and assemble our AFECTAIR devices.  We plan to rely on third-party manufacturers to manufacture and assemble our CAG systems and related components; and

 

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our own analytical and testing laboratories, research and medical device development laboratory.  We also rely on a number of third-party analytical and testing laboratories to support our research activities and provide certain laboratory services.

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Research and development costs are charged to operations as incurred.  During the year ended December 31, 2013, we invested approximately $27.7 million for research and development expense, which includes (i) product development and manufacturing, (ii) medical and regulatory operations, and (iii) direct preclinical and clinical programs.

Manufacturing and Distribution

In 2005, we acquired manufacturing operations located in a leased facility in Totowa NJ (Totowa Facility) to manufacture SURFAXIN, our liquid instillate KL4 surfactant.  To support our manufacturing operations, in 2007, we established our own analytical and technical support laboratory at our headquarters in Warrington, Pennsylvania (Warrington Laboratory).  We use third parties for the manufacture of our lyophilized KL4 surfactant and medical devices and related components, certain analytical and laboratory services in support of our manufacturing activities, packaging and labeling, warehousing, third-party logistics services and distribution.

Our KL4 surfactant products, including SURFAXIN, must be manufactured in compliance with current good manufacturing practices (cGMP) established by the FDA and other international regulatory authorities, as applicable.  Our KL4 surfactant is a complex drug product comprised of four active pharmaceutical ingredients (APIs).  It must be aseptically manufactured as a sterile, liquid suspension and requires ongoing monitoring of drug product stability and conformance to specifications.  Like some other surfactants, it is stored and shipped in a refrigerated, cold-chain environment.  We currently rely on single source suppliers under separate product supply agreements for KL4 and POPG, two of our APIs, and source our other APIs from single source suppliers under purchase orders that we issue from time to time.  To mitigate our risk, we plan to qualify secondary suppliers for our APIs over the next 18 to 36 months.  Our risk of losing a source of supply is currently somewhat mitigated by our decision to enlarge our safety stock of all APIs when we began the commercial introduction of SURFAXIN.  While we generally purchase our primary packaging components and excipients from single-sources, these items are generally readily available from multiple manufacturers.

We conduct our manufacturing activities for SURFAXIN in our Totowa Facility and our analytical and technical support laboratory in our Warrington Laboratory.  We have a third-party agreement for packaging and vial labeling services for our SURFAXIN drug product.  Our Totowa facility consists of pharmaceutical manufacturing and development space that is designed for the manufacture and filling of sterile liquid pharmaceuticals in compliance with cGMP.  See, “Item 2 – Properties.”  These operations are configured and approved to produce SURFAXIN commercial drug product.  In addition, we also operate a microbiology laboratory at our Totowa Facility that supports our manufacturing activities.  In our Warrington Laboratory, we conduct certain analytical development and quality control activities, including release testing of all APIs as well as release and stability testing of SURFAXIN clinical and commercial drug product supply.  Our Warrington Laboratory also provides analytical testing and quality system support for our efforts to identify and protect our intellectual property, and for our lyophilized and aerosolized KL4 surfactant dosage forms as well as other potential formulations of our KL4 surfactant in support of AEROSURF and our other KL4 surfactant product candidates.

We work with a number of third-party institutions and laboratories that perform various studies as well as quality control release and stability testing and other activities related to our KL4 surfactant development and manufacturing activities, including  our biological activity test (BAT) release and stability testing.  At the present time, several of these laboratories are single-source providers.  We are implementing a plan to potentially qualify over the next 12- 24 months additional sources to meet our key release testing and stability requirements.

Importantly, as we undertake the commercial introduction of SURFAXIN and the development of AEROSURF, we are planning for long-term continuity of supply and continued integrity and reliability of our manufacturing and quality assurance processes.  We seek to build a foundation to support our anticipated long-term needs, and intend to make appropriate capital investments in the near-term, balancing the use of our available resources while maintaining flexibility in planning our manufacturing goals.

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The lease for our Totowa Facility currently expires on June 30, 2015.  We continue to explore possible alternatives that could enable longer-term utilization of that facility for the manufacture of SURFAXIN and potentially lyophilized KL4 surfactant.

 

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We completed the technology transfer of our lyophilized KL4 surfactant manufacturing process to DSM in 2013 and have manufactured a sufficient clinical supply of KL4 surfactant to support the phase 2a AEROSURF clinical trial.  We plan to manufacture additional clinical supply in mid-2014 to support our phase 2b clinical trial.  We also have entered into a development agreement with DSM for the potential further development and  manufacture of lyophilized KL4 surfactant for our AEROSURF phase 3 clinical program, as well as other potential pipeline development programs.

 

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To secure an additional source of SURFAXIN commercial drug product, in 2012 we initiated a technology transfer of our liquid KL4 surfactant manufacturing process to DSM and in August 2013 entered into a supply agreement with DSM that provides for the manufacture of commercial supply of SURFAXIN drug product through December 31, 2015, with such further extensions at that time as the parties may agree.

 

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We also have initiated a project to identify a second CMO that would manufacture clinical and commercial supply and assure a continuous and back up supply of SURFAXIN drug product.  We currently are working through potential development plans with a few CMOs and thereafter plan to initiate a technology transfer of our liquid KL4 manufacturing process.

We also believe that our in-house manufacturing capabilities, including our executive management, in-house manufacturing and quality operations managers and employees, are important to our long-term success.  Our management team includes executives experienced in pharmaceutical and biopharmaceutical drug product manufacturing, with extensive experience in manufacturing both small and large molecules, biological and sterile drug/device combination products in both domestic and overseas operations, and supply chain; as well as in worldwide quality operations to assure consistent and continued quality and cGMP compliance for our products, whether manufactured on our own or with a CMO.  Our manufacturing operations are lead by seasoned professionals with broad technical and managerial skills in all facets of our KL4 surfactant manufacturing process, expertise built on many years of accumulated knowledge in biopharmaceutical manufacturing, facility management, process and cleaning validation, sterility assurance and microbiological analyses, clean room operation and direction of formulation and aseptic filling of our drug product.  Although there can be no assurance, we believe that we can leverage the extensive experience that we have gained from having managed our own manufacturing operations since 2005 to flexibly respond over time and provide for the continued manufacture of our KL4 surfactant drug product, on our own or with our CMOs.

AEROSURF is a combination drug-device product that producing aerosolized KL4 surfactant by combining our lyophilized KL4 surfactant with our CAG device and aerosol delivery technologies.  We are developing and, if approved, will commercialize AEROSURF in the U.S. for the treatment of premature infants with RDS.  We also believe that our aerosolized KL4 surfactant may be used to address a broad range of serious respiratory conditions in the NICU as well as in children and adults in the PICU and ICU.

The CAG device includes an aerosol control unit and a disposable AEROSURF delivery pack (ADP). The ADP includes the critical drug product-contact components that are either cleaned or manufactured in an environmentally-controlled, clean area. The control unit and ADPs are assembled and packaged in a clean area.  Each of the ADP devices is tested for conformance to designated product specifications during assembly and each of the assembled control units must be quality control tested prior to release and monitored for conformance to designated product specifications.

In June 2012, we entered into an agreement with Battelle under which Battelle assisted in a multi-phase development program focused on design and testing of clinic-ready CAG devices for our AEROSURF phase 2a clinical trials, and then manufactured CAG devices for the phase2a clinical trial that is currently underway.  In addition, we recently entered into an agreement with Battelle for the manufacture and assembly of a sufficient number of control units, ADPs and related components to support our planned phase 2b clinical trial and development activities.  In the future, we expect to rely on CMOs to manufacture and assemble the CAG device and related components needed to support our development activities, planned phase 3 clinical studies and, if approved, potential commercialization of AEROSURF.

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In 2012 we entered into a supply agreement (Agreement) with Lacey Manufacturing Company, a division of Precision Products, LLC (Lacey), to manufacture AFECTAIR devices through October 2015.  Lacey operates a cGMP-compliant manufacturing facility and has significant experience with the mold injection process required to manufacture AFECTAIR devices.  In addition to providing manufacturing support, Lacey has agreed to label, package, and prepare AFECTAIR devices for shipment.

To support the commercial introduction of SURFAXIN, we have established arrangements with ASD Specialty Healthcare Inc. (ASD) and Integrated Commercialization Solutions, Inc. (ICS), affiliates of AmerisourceBergen Specialty Group, for warehousing, distribution and related services.  ICS is our third-party logistics provider and assists us with inventory tracking, customer service, order management, distribution, returned goods, contract and accounts receivable management, certain financial management services and other similar services.

In 2012, we amended and updated our agreement with ASD, which agreed to act as our exclusive specialty distributor for SURFAXIN, WARMING CRADLE dry-block heaters and AFECTAIR devices in the U.S. and provide related services.  Lacey will ship the finished product to ICS who has agreed to warehouse and provide third-party logistic services for us.  ASD has agreed to act as distributor for AFECTAIR devices.

Our collaboration with Esteve provides that Esteve has responsibility for distribution of specified KL4 surfactant products in Andorra, Greece, Italy, Portugal and Spain.  See, “– Strategic Alliances and Collaboration Arrangements – Laboratorios del Dr. Esteve, S.A.”  In other parts of the world, we plan to evaluate third-party distribution capabilities prior to commercializing in those regions.

General and Administrative

We have made significant investments in our sales and marketing capabilities and intend to continue investing in general and administrative resources primarily to support our intellectual property portfolios (including building and enforcing our patent and trademark positions), our business development initiatives, financial systems and controls, legal and corporate and healthcare compliance requirements, management information technologies, and general management capabilities.

Strategic Alliances

We have a strategic alliance with Laboratorios del Dr. Esteve, S.A. (Esteve) for the development, marketing and sales of a broad portfolio of potential KL4 surfactant products in Andorra, Greece, Italy, Portugal, and Spain (collectively, the territory).  Antonio Esteve, Ph.D., a principal of Esteve, served as a member of our Board of Directors from May 2002 until January 2013.  Under the alliance, Esteve will pay us a transfer price on sales of our KL4 surfactant products.  We will be responsible for the manufacture and supply of all of the covered products and Esteve will be responsible for all sales and marketing in the territory.  Esteve is obligated to make stipulated cash payments to us upon our achievement of certain milestones, primarily upon receipt of marketing regulatory approvals for the covered products.  In addition, Esteve has agreed to contribute to phase 3 clinical trials for the covered products by conducting and funding development performed in the territory.  As part of a 2004 restructuring in which Esteve returned certain rights to us in certain territories (Former Esteve Territories), we agreed to pay Esteve 10% of any cash up front and milestone fees (up to a maximum aggregate of $20 million) that we receive in connection with any strategic collaborations for the development and/or commercialization of certain of our KL4 surfactant products in the Former Esteve Territories.  The alliance will terminate as to each covered product, on a country-by-country basis, upon the latest to occur of: the expiration of the last patent claim related to a covered product in such country; the first commercial sale in such country of the first-to-appear generic formulation of the covered product, and the tenth anniversary of the first sale of the covered product in such country.  In addition to customary termination provisions for breach of the agreement by a party, the alliance agreement may be terminated by Esteve on 60 days’ prior written notice, up to the date of receipt of the first marketing regulatory approval, or, on up to six months’ written notice, if the first marketing regulatory approval has issued.  We may terminate the alliance agreement in the event that Esteve acquires a competitive product (as defined in the agreement).

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While we currently intend to retain all rights and commercialize our approved products in the U.S.,  we seek strategic alliances and other collaboration arrangements for the development and/or commercialization of our KL4 surfactant product candidates in markets outside the U.S.

 

LICENSING, PATENTS AND OTHER PROPRIETARY RIGHTS AND REGULATORY DESIGNATIONS

We continue to invest in maintaining and enforcing our potential competitive position through a number of means: (i) by protecting our exclusive rights in our KL4 surfactant, CAG and aerosol-conducting airway connector technologies through patents and patent extensions, (ii) by seeking regulatory exclusivities, including potential orphan drug and new drug product exclusivities, and (iii) through protecting our trade secrets and proprietary methodologies that support our manufacturing and analytical processes.

Patents and Proprietary Rights

Our precision-engineered KL4 surfactant technology, including SURFAXIN, is based on the proprietary synthetic peptide KL4 (sinapultide), a 21 amino acid protein-like substance that closely mimics the essential human lung protein SP-B.  This technology was invented at The Scripps Research Institute (Scripps) and was exclusively licensed to and further developed by J&J.  We have received an exclusive, worldwide license and sublicense from J&J and its wholly-owned subsidiary, Ortho Pharmaceutical Corporation, for, with rights to, a series of over 30 patents and patent filings (worldwide) which are important, either individually or collectively, to our strategy for commercializing our KL4 surfactant product candidates.  The license and sublicense give us the exclusive rights to such patents for the life of the patents.  Under the license agreement, we are obligated to pay the licensors fees of up to $2.5 million in the aggregate upon our achievement of certain milestones, primarily upon receipt of marketing regulatory approvals for certain designated products.  In addition, we have paid $950,000 to date for milestones that have been achieved.  In addition, we are required to make royalty payments at different rates, depending upon type of revenue and country, in amounts in the range of a high single-digit percent of net sales (as defined in the agreement) of licensed products sold by us or sublicensees, or, if greater, a percentage of royalty income from sublicensees in the low double digits.  The license agreement provides that the license will expire, on a country-by-country basis, upon the payment of royalties for all licensed products for ten years beginning on the date of the first commercial sale of  the first licensed product  in such country and thereafter until the expiration of the last licensed patent containing a valid claim covering the licensed product in such country; or for countries in the EU in which royalties are paid only by virtue of licensed know-how, upon the payment of royalties ending on the earlier of (i) the date on which the licensed know-how becomes public or (ii) the tenth anniversary of the first commercial sale of the first licensed product in any such country.  In addition to customary termination provisions for breach of the agreement by a party, we may terminate the agreement, as to countries other than the U.S. and Western Europe territories (as defined in the agreement), on a country-by-country basis, on six months’ prior written notice; and as to the entire agreement, on 60 days’ prior written notice.

Patents covering our proprietary precision-engineered surfactant technology that have been issued worldwide include composition of matter, formulation, and uses and include the following issued United States patents: U.S. Patent No. 5,407,914; U.S. Patent No. 5,952,303; U.S. Patent No. 6,013,619; and U.S. Patent No. 6, 613,764 (along with certain corresponding issued foreign counterparts).  These patents relate to precision-engineered pulmonary surfactants (including SURFAXIN), certain related peptides (amino acid protein-like substances) and compositions, methods of treating respiratory distress syndromes with these surfactants and compositions, and a pulmonary lavage method of treating RDS with these surfactants.  Our licensed patent estate also includes the U.S. and foreign patents that relate to methods of manufacturing SURFAXIN and certain peptides that may be used in the manufacture of SURFAXIN, and other aspects of our precision-engineered surfactant technology.  These patents include U.S. Patent No. 5,741,891; U.S. Patent No. 5,952,303; U.S. Patent No. 6,013,764; U.S. Patent No. 6,120,795; U.S. Patent No. 6,492,490; and U.S. Patent No. 8,217,142 (along with certain corresponding issued foreign counterparts).

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The patent term of U.S. Patent No. 5,407,914 has been extended until November 17, 2014.  U.S. Patent No. 5,952,303 will expire on March 29, 2017.  U.S. Patent No. 5,741,891 will expire on October 22, 2016.  U.S. Patent No. 6,013,764 will expire on June 25, 2017.  U.S. Patent No. 6,120,795 will expire on March 4, 2017.  U.S. Patent No. 6,492,490 and U.S. Patent No. 8,217,142 will expire on June 25, 2017.  U.S. Patent No. 6,013,619 will expire on April 28, 2017.

We also have licensed or optioned for license certain patents and pending patent applications from Scripps that relate to combination therapies of pulmonary surfactant and other drugs, and methods of use.  Some of these patent applications have issued and some are still pending in the U.S. and a number of foreign jurisdictions, including Canada, Europe and Japan.  For example, selected compositions of pulmonary surfactants and protease inhibitors and methods of administering these compositions are claimed in the U.S. Patent No. 7,863,241 titled “Compositions for treatment and prevention of pulmonary conditions” which issued on January 4, 2011 and will expire on February 17, 2025.

We have been active in seeking patent protection for our innovations relating to new dosage forms, formulations and methods of manufacturing and delivering synthetic peptide containing pulmonary surfactants.  Our patent activities have focused particularly on improved dosage forms and delivery of aerosolized pulmonary surfactant.

In November 2005, we filed U.S. and International patent applications (US 11/274,701 which is now U.S. Patent No. 7,582,312 issued on September 1, 2009 and PCT US/2005/041281, now entered national phase), directed to lyophilized formulations of synthetic peptide containing pulmonary surfactants and methods of manufacture.

In December 2005, we filed U.S. and International patent applications (US 11/316,308 which is now U.S. Patent No. 8,337,815 issued on December 25, 2012 and PCT US/2005/046862, now entered national phase), directed to synthetic peptide containing pulmonary surfactant formulations having improved viscosity characteristics, aerosolization capacity and storage stability.

In January 2006, we filed U.S. and International patent applications (US 11/326,885 which is now U.S. Patent No 7,541,331 issued on June 2, 2009 and PCT/US06/000308, now entered national phase), directed to a surfactant treatment regimen for BPD.

In September 2007, we filed U.S. and International patent applications (US 11/901,866 which is now U.S. Patent No. 8,221,772 and PCT US/2007/020260, now entered national phase) directed to surfactant compositions and methods of promoting mucus clearance and treating pulmonary disorders such as cystic fibrosis.

In March 2013, we filed International patent applications (PCT/US13/34364 and PCT/US13/34464 and commenced expedited examination in US and EU) directed to lyophilized pulmonary surfactant and methods of manufacture.

In 2008, to restructure a December 2005 strategic alliance, we entered into an Amended and Restated License Agreement with Philip Morris USA, Inc. (PMUSA) with respect to the U.S. (U.S. License Agreement), and, as PMUSA had assigned to Philip Morris Products S.A. (PMPSA) all rights in and to the CAG technology outside of the U.S. (International Rights), effective on the same date, we entered into a License Agreement with PMPSA with respect to the International Rights (International License Agreement) on substantially the same terms and conditions as the U.S. License Agreement.  In addition to customary termination provisions for breach of the agreements, we may terminate the License Agreements, in whole or in part, upon advance written notice to the licensor.  In addition, either party to each License Agreement may terminate upon a material breach by the other party (subject to a specified cure period).  Our license under each License Agreement, unless terminated earlier, will expire as to each licensed product, on a country-by-country basis, upon the latest to occur of: the date on which the sale of such licensed product ceases to be covered by a valid patent claim in such country; the date a generic form of the product is introduced in such country; or the tenth anniversary of the first commercial sale of such licensed product.

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Under the License Agreements, we are obligated to pay royalties at a rate equal to a low single-digit percent of sales of products sold in the Exclusive Field (as defined below) in the territories.  In connection with exclusive undertakings of PMUSA and PMPSA not to exploit the CAG technology for all licensed uses, we are obligated to pay royalties on all product sales, including sales of certain aerosol devices that are not based on the CAG technology; provided, however, that no royalties are payable to the extent that we exercise our right to terminate the license with respect to a specific indication.  We also are required to pay minimum royalties quarterly beginning  in 2014, but are entitled to a reduction of future royalties in the amount of any minimum royalties paid.  Our license rights extend to innovations to the CAG technology that are made under the License Agreements.  We believe that our AEROSURF aerosolized KL4 surfactant can be developed to potentially address a broad range of serious respiratory conditions.  We are developing AEROSURF to treat premature infants with or at risk for RDS using the CAG technology.

We currently hold exclusive licenses to the CAG technology both in and outside of the U.S. for use with pulmonary surfactants (alone or in combination with any other pharmaceutical compound(s)) for all respiratory diseases and conditions.  In addition, under the U.S. License Agreement, our license to use the CAG technology includes certain non-surfactant drugs to treat a wide range of pediatric and adult respiratory indications in hospitals and other health care institutions.  The aerosolization technology patents expire on various dates beginning in May 2016 and ending in 2031, or, in some cases, possibly later.

In March 2009, we filed International patent application (PCT US/2009/037409) directed to aerosol-conducting airway connectors that we plan to market under the trademark AFECTAIR and improvements of an aerosol delivery system using AFECTAIR. The International patent application is an interim phase in the prosecution of patents and is now concluded.  Beginning on September 16, 2010, this application entered national phase in US, Europe and Japan, among other countries and is currently pending.  The claims of this application are directed to a novel ventilation circuit adaptor (an aerosol-conducting airway connector)  and related aerosol circuitry that are intended to increase the efficiency of aerosol delivery to the patient by allowing more efficient delivery of aerosols to the patient, reduce drug compound dilution and wastage and result in more precise aerosol dosing.

See, “Item 1A – Risk Factors – If we cannot protect our intellectual property, other companies could use our technology in competitive products.  Even if we obtain patents to protect our products, those patents may not be sufficiently broad or they may expire and others could then compete with us;” “– Intellectual property rights of third parties could limit our ability to develop and market our products;” and “– If we cannot meet requirements under our license agreements, we could lose the rights to our products.”

AEROSURF^®, AFECTAIR^®, AFECTAIR^® DUO, DISCOVERYLABS^®, SURFAXIN^®, SURFAXIN LS™, and WARMING CRADLE^® are our registered and common law trademarks.

In addition to our patent exclusivities, we rely on trade secrets to protect and maintain our competitive position.  We take measures to protect and maintain our trade secrets and know-how licensed to us or developed by us by entering in confidentiality agreements with third parties.  Our trade secrets and know-how include information related to manufacturing processes for our drug products and devices, analytical methods and procedures, research and development activities, provisional patent applications, as well as certain information provided to FDA that was not made public which relates to our regulatory activities and clinical trials.

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Other Regulatory Designations

SURFAXIN is expected to receive  at least three years of marketing exclusivity as a new drug product based on the data from the SELECT and STAR clinical trials.  In addition, the FDA has indicated that our SURFAXIN drug product also qualifies as a “new molecular entity,” which we expect may provide extended marketing exclusivity of five years.  However, the FDA has not made its final determination as to the length of the exclusivity period for SURFAXIN.

“Orphan Drugs” are pharmaceutical products that are intended to address diseases affecting fewer than 200,000 patients in the U.S.  The Office of Orphan Product Development of the FDA grants certain advantages to the sponsors of Orphan Drugs including, but not limited to, seven years of market exclusivity upon approval of the drug, certain tax incentives for clinical research and grants to fund testing of the drug.  The FDA has granted Orphan Drug designation for our KL4 surfactant for the treatment of RDS in premature infants.  However, our indication is SURFAXIN is for the prevention, rather than treatment, of RDS, such that this designation does not apply to SURFAXIN.  If we develop AEROSURF or SURFAXIN LS for the treatment of RDS, this orphan drug designation may apply for those indications.  We are currently seeking the confirmation from the FDA.  The FDA has also granted Orphan Drug designation to (i) KL4 surfactant for the prevention and treatment of BPD in premature infants, (ii) our KL4 surfactant for the treatment of ARDS in adults, and (iii) our KL4 surfactant for the treatment of CF.

The European Commission grants “Orphan Medicinal Product” designation for pharmaceutical products for the diagnosis, prevention or treatment of a life-threatening or chronically debilitating condition affecting no more than 5 in 10,000 people which provides for exclusive marketing rights for indications in Europe for 10 years (subject to revision after six years) following marketing approval by the EMA.  In addition, the designation would enable us to receive regulatory assistance in the further development process, and to access reduced regulatory fees throughout its marketing life.  We have received Orphan Medicinal Product designation for (i) KL4 surfactant for the prevention of RDS in premature infants, (ii) KL4 surfactant for the treatment of RDS in premature infants, (iii) our KL4 surfactant for the treatment of ALI in adults (which in this circumstance encompasses ARDS), and (iv) our KL4 surfactant for the treatment of CF.

Designation as a “Fast Track” product means that the FDA has determined that the drug is intended for the treatment of a serious or life-threatening condition and demonstrates the potential to address unmet medical needs, and that the FDA will facilitate and expedite the development and review of the application for the approval of the product.  The FDA generally will review an NDA for a drug granted Fast Track designation within six months.

The FDA has granted “Fast Track” designation for (i) SURFAXIN for the prevention and treatment of BPD in premature infants, and (ii) our KL4 surfactant for the treatment of ARDS.

 

COMPETITION

We are engaged in the highly competitive fields of pharmaceutical research and development.  Competition from numerous existing companies and others entering the fields in which we operate is intense and expected to increase.  We compete with conventional pharmaceutical companies, among others.  Most of these companies have substantially greater research and development, manufacturing, marketing, financial, technological personnel and managerial resources than we do.  Acquisitions of competing companies by large pharmaceutical or health care companies could further enhance such competitors’ financial, marketing and other resources.  Moreover, competitors that are able to complete clinical trials, obtain required regulatory approvals and commence commercial sales of their products before we do may enjoy a significant competitive advantage over us.  There are also existing therapies that may compete with the products we are developing.  See, “Item 1A – Risk Factors – Our industry is highly competitive and we have less capital and resources than many of our competitors, which may give them an advantage in developing and marketing products similar to ours or make our products obsolete.”

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Currently, the FDA has approved surfactants as replacement therapy only for the prevention and/or treatment of RDS in premature infants.  Administration of these surfactants requires invasive intubation and mechanical ventilation.  The most commonly used of these approved surfactants are Curosurf (poractant alfa), which is derived from a chemical extraction process of porcine (pig) lung, and Survanta (beractant), which is derived from a chemical extraction process of bovine (cow) lung.  Curosurf is marketed in Europe by Chiesi Farmaceutici S.p.A. and in the U.S. by its wholly-owned subsidiary, Cornerstone Therapeutics Inc.  In addition, Chiesi has published the results of a preclinical study in an early-stage effort to develop a synthetic surfactant (Sato A, Ikegami M (2012) SP-B and SP-C Containing New Synthetic Surfactant for Treatment of Extremely Immature Lamb Lung. PLoS ONE 7(7): e39392.doi:10.1371/journal.pone.0039392).  Chiesi has also initiated a first-in-human phase 2 clinical trial to study the safety and tolerability of intratracheal administration of two different single doses of its investigational synthetic surfactant in preterm neonates with RDS (clinicaltrials.gov). Survanta historically has been marketed by Abbott Nutritionals, Inc. (Abbott).  However, in December 2012, Abbott distributed to its shareholder a wholly-owned subsidiary, AbbVie Inc. (AbbVie), which separated Abbott’s research-based pharmaceuticals business, including Survanta, from the remainder of its businesses.  ONY, Inc. markets Infasurf®, a surfactant derived from calf lung surfactant lavage in the U.S.

 

GOVERNMENT REGULATION

The development, manufacture, distribution, marketing and advertising of drug, device, and combination drug-device products are subject to extensive regulation by federal, state and local governmental authorities in the U.S., including the FDA, and by similar agencies in other countries.  Any product that we develop must receive all relevant regulatory approvals or clearances before it may be marketed in a particular country.  Gaining regulatory approval of a drug, device, or combination product candidate requires the expenditure of substantial resources over an extended period.  As a result, larger companies with greater financial resources will likely have a competitive advantage over us.

Drug Product Regulations

Development Activities:  To gain regulatory approval of our KL4 surfactant technology pipeline products, we must demonstrate, through experiments, preclinical studies and clinical trials that each of our drug product candidates meets the safety and efficacy standards established by the FDA and other international regulatory authorities.  In addition, we and our suppliers and CMOs must demonstrate that all development-related laboratory, clinical and manufacturing practices comply with regulations of the FDA, other international regulators and local regulators.  Regulations establish standards for such things as drug substances, materials and excipients; medical device components, subassemblies and device manufacture; drug manufacturing operations and facilities, analytical laboratories and medical device development laboratories processes and environments; in each instance, in connection with research, development, testing, manufacture, quality control, labeling, storage, record keeping, approval, advertising and promotion, and distribution of product candidates, on a product-by-product basis.  See, “Item 1A – Risk Factors – The regulatory approval process for our products is expensive and time-consuming and the outcome is uncertain.  We may not obtain required regulatory approvals to commercialize our products.”

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Preclinical Studies and Clinical Trials:  Development testing generally begins with laboratory testing and experiments, as well as research studies using animal models to obtain preliminary information on a product’s efficacy and to identify any safety issues.  The results of these studies are compiled along with other information in an investigational new drug (IND) application, which is filed with the FDA.  After resolving any questions raised by the FDA, which may involve additional testing and animal studies, clinical trials may begin.  Regulatory agencies in other countries generally require a Clinical Trial Application (CTA) to be submitted and approved before each trial can commence in each country.

Clinical trials normally are conducted in three sequential phases and may take a number of years to complete.  phase 1 consists of testing the drug product in a small number of humans, normally healthy volunteers, to determine preliminary safety and tolerable dose range.  Phase 2 usually involves studies in a limited patient population to evaluate the effectiveness of the drug product in humans having the disease or medical condition for which the product is indicated, determine dosage tolerance and optimal dosage and identify possible common adverse effects and safety risks.  Phase 3 consists of additional controlled testing at multiple clinical sites to establish clinical safety and effectiveness in an expanded patient population of geographically dispersed clinical sites to evaluate the overall benefit-risk relationship for administering the product and to provide an adequate basis for product labeling.  Phase 4 clinical trials may be conducted after approval to gain additional experience from the treatment of patients in the intended therapeutic indication.

The conduct of clinical trials is subject to stringent medical and regulatory requirements.  The time and expense required to establish clinical sites, provide training and materials, establish communications channels and monitor a trial over a long period are substantial.  The conduct of clinical trials at institutions located around the world is subject to foreign regulatory requirements governing human clinical trials, which vary widely from country to country.  Delays or terminations of clinical trials could result from a number of factors, including stringent enrollment criteria, slow rate of enrollment, size of patient population, having to compete with other clinical trials for eligible patients, geographical considerations and others.  Clinical trials are monitored by the regulatory agencies as well as medical advisory and standards boards, which could determine at any time to reevaluate, alter, suspend, or terminate a trial based upon accumulated data, including data concerning the occurrence of adverse health events during or related to the treatment of patients enrolled in the trial, and the regulator’s or monitor’s risk/benefit assessment with respect to patients enrolled in the trial.  If they occur, such delays or suspensions could have a material impact on our KL4 surfactant technology development programs.  See, “Item 1A–Risk Factors – Our research and development programs, including for AEROSURF involve significant risks and uncertainties that are inherent in the clinical development and regulatory approval processes.”

 

Regulatory Review:  The results of preclinical and clinical trials for drug products are submitted to the FDA in an NDA, with comparable filings submitted to other international regulators.  After the initial submission, the FDA has a period of time in which it must determine if the NDA is complete.  If an NDA is accepted for filing, following the FDA’s review, the FDA may grant marketing approval, request additional information, or deny the application if it determines that the application does not provide an adequate basis for approval.  If the FDA grants approval, the approval may be conditioned upon the conduct of post-marketing clinical trials or other studies to confirm the product’s safety and efficacy for its intended use.  Until the FDA has issued its approval, no marketing activities can be conducted in the U.S.  Similar regulations apply in other countries.

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After an NDA is submitted, although the statutory period provided for the FDA’s standard review is approximately one year, dealing with questions or concerns of the agency and, taking into account the statutory timelines governing such communications, may result in review periods that can take several years.  The FDA may decline to accept an NDA and may deliver what is referred to as a Complete Response Letter that describes the shortcomings of the application, including whether the applicant should consider additional clinical trials, which could have the effect of terminating a development program.

Post-approval Regulation:  Following the grant of marketing approval, the FDA regulates the marketing and promotion of drug products.  Promotional claims are generally limited to the information provided in the product package insert for each drug product, which is negotiated with the FDA during the NDA review process.  In addition, the FDA enforces regulations designed to guard against conflicts of interest, misleading advertising and improper compensation of prescribing physicians.  The FDA will review, among other things, direct-to-consumer advertising, prescriber-directed advertising and promotional materials, sales representative communications to healthcare professionals, promotional programming and promotional activities on the Internet.  The FDA will also monitor scientific and educational activities.  If the FDA determines that a company has promoted a product for an unapproved (off-label) use, or engaged in other violations, it may issue a regulatory letter and may require corrective advertising or other corrective communications to healthcare professionals.  Enforcement actions may also potentially include product seizures, injunctions and civil or criminal penalties.  The consequences of such an action and the related adverse publicity could have a material adverse effect on a developer’s ability to market its drug and its business as a whole.  Regulation and enforcement of advertising and promotion by institutions other than FDA are discussed below.

Following approval, the FDA and other international regulators will continue to monitor data to assess the safety and efficacy of an approved drug.  A post-approval discovery of previously unknown problems or failure to comply with the applicable regulatory requirements may result in restrictions on the marketing of a product or a recall or withdrawal of the product from the market, as well as possible civil or criminal sanctions.  Similar oversight is provided by international regulators.

Medical Device Products

To varying degrees, each of the regulatory agencies having oversight over medical devices, including the FDA and comparable foreign regulators, has laws and regulations governing the development, testing, manufacturing, labeling, marketing, and distribution of medical devices.  In the U.S., medical device products are subject to regulation that is intended to calibrate regulatory requirements to the issues of safety and efficacy presented by specific devices.  Medical devices are classified into one of three classes based on the level of control necessary to assure the safety and effectiveness of the device.  The three classes and the requirements that apply to them are: (i) Class I General Controls, with exemptions and without exemptions, (ii) Class II General Controls and Special Controls, with exemptions and without exemptions, and (iii) Class III General Controls and Premarket Marketing authorization.  The class to which a device is assigned determines the process that applies for gaining marketing authorization.  Most Class I devices are exempt from Premarket Notification 510(k); most Class II devices require Premarket Notification 510(k); and most Class III devices require Premarket Marketing authorization.

Combination Drug-Device Products

Combination drug products such as AEROSURF and potentially other aerosolized KL4 surfactant drug products are similarly subject to extensive regulation by federal, state and local governmental authorities in the U.S. and in other countries.  Combination products involve review of two or more regulated components that might normally be reviewed by regulatory authorities having different expertise and may involve more complicated and time-consuming regulatory coordination, approvals and clearances than a drug product alone.  The FDA has determined that our aerosolized KL4 surfactant combination drug-device product will be evaluated as a drug and, therefore, will be reviewed by the Center for Drug Evaluation and Research (CDER) of the FDA, with input from the Center for Devices and Radiological Health (CDRH).  Among other things, we will have to demonstrate compliance with both cGMP, to ensure that the drug possesses adequate strength, quality, identity and purity, and applicable Quality System Regulations (QSR), to ensure that the device is in compliance with applicable performance standards.  Although cGMP and QSR overlap in many respects, each is tailored to the particular characteristics of the types of products to which they apply, such that compliance with both cGMP and QSR may present unique problems and manufacturing challenges.

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Manufacturing Standards

The FDA and other international regulators establish requirements and standards and routinely inspect the quality system, facilities,  equipment, processes, and analytical  laboratories  used in the manufacturing and monitoring of products.  Prior to granting approval of a drug product, the FDA will conduct a pre-approval inspection of the manufacturing facilities and the facilities of suppliers to determine that the drug product is manufactured in accordance with cGMP regulations and product specifications.  Following approval, the FDA will conduct periodic inspections.  If, in connection with a facility inspection, the FDA determines that a manufacturer does not comply with cGMP, the FDA will issue an inspection report citing the potential violations and may seek a range of remedies, from administrative sanctions, including the suspension of our manufacturing operations, to seeking civil or criminal penalties.  The FDA may determine to conduct such inspections at any time and for any reason.  See, “Item 1A – Risk Factors – Manufacturing problems potentially could cause us to experience shortages of SURFAXIN and AFECTAIR product inventories, or delay our preclinical or clinical programs, which could have a material adverse effect on our business.”

International Approvals

In addition to seeking regulatory approval to market our products in the U.S., we also expect to apply for such approval with other international regulators.  Regulatory requirements and approval processes are similar in approach to that of the U.S. but are not harmonized.  International regulators are independent and not bound by the findings of the FDA and there is a risk that foreign regulators will not accept clinical trial design/results or may require additional data or other information not requested by the FDA.  Therefore, we will have to comply with both cGMP and International Conference on Harmonization (ICH) guidelines.

 

Anti-Kickback, False Claims Act, and Other Laws Regarding Advertising and Promotion

In addition to FDA’s ongoing post-approval regulation of drugs, devices, and combination products discussed above, several other types of laws and regulations, subject to differing enforcement regimes, govern advertising and promotion.   In recent years promotional activities of FDA-regulated products have come under intense scrutiny and have been the subject of enforcement action brought by the Department of Justice (DOJ), state authorities, and even private individuals.

The federal Anti-Kickback statute prohibits, among other things, knowingly and willfully offering, paying, soliciting or receiving remuneration to induce or in return for purchasing, leasing, ordering or arranging for the purchase, lease or order of any healthcare item or service reimbursable under Medicare, Medicaid or other federally financed healthcare programs. This statute has been interpreted to apply to arrangements between pharmaceutical or device manufacturers, on the one hand, and prescribers, purchasers, and formulary managers on the other. Violations are punishable by imprisonment, criminal fines, civil monetary penalties and exclusion from participation in federal healthcare programs.   Any sales or marketing practices that involve remuneration intended to induce prescribing, purchases, or recommendations may be subject to scrutiny under the Anti-Kickback statute.  Many states have likewise adopted state anti-kickback statutes, and enforcement has been significant.

 

Another development affecting the healthcare industry is the increased use of the federal civil False Claims Act to impose liability on any person or entity who, among other things, knowingly presents, or causes to be presented, a false or fraudulent claim for payment by a federal healthcare program.  If certain conditions are met, the False Claims Act allows a private individual called a “whistleblower” to bring a civil action on behalf of the federal government and to share in any monetary recovery.  In recent years, the number or suits brought by private individuals has increased dramatically.  In addition, many states have enacted false claim laws similar to the federal False Claims Act.

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A host of other laws and regulations govern the advertising and promotion of drugs and devices.  The federal “Open Payments” law (previously referred to as “Sunshine Law”), which is part of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act, each enacted in March 2010, imposes federal transparency provisions, requiring annual reporting of various types of payments to physicians and teaching hospitals.   Implementation of the Open Payments provisions has been subject to delay by the U.S. Centers for Medicare and Medicaid Services (CMS).  Under the current regime, applicable manufacturers were to begin tracking relevant transfer-of-value data in August 2013, and must report data collected between August 1 and the end of 2013 to CMS in a two-phased approach by March 31, and May 31, 2014, respectively.  CMS will publish the data on a public website later in the year.  Inaccurate or incomplete reports may be subject to enforcement.   Like the federal Open Payments law, several states have existing laws that require manufacturers to report transfers of value to select healthcare providers licensed within the state.   Additionally, other laws such as the federal Lanham Act and similar state laws allow competitors and others to initiate litigation relating to advertising claims.  Additionally, the U.S. Foreign Corrupt Practices Act and local laws of other countries potentially implicate the sale and marketing of drugs and devices internationally.  This complex patchwork of laws can change rapidly with relatively short notice.

SURFAXIN is our first approved drug product in the U.S. and AFECTAIR is our first registered medical device in the U.S.  None of our other products under development has been approved for marketing in the U.S. or elsewhere.  We may not be able to obtain regulatory approval for any of these products.  If we do not obtain the requisite governmental approvals or if we fail to obtain approvals of the scope we request, we or our licensees or strategic alliance or marketing partners may be delayed or precluded entirely from marketing our products, or the commercial use of our products may be limited.  Such events would have a material adverse effect on our business, financial condition and results of operations.  See, “Item 1A – Risk Factors – Our technology platform is based solely on our proprietary KL4 surfactant technology, our novel CAG technology, and our novel aerosol-conducting airway connector;” “– Our research and development programs, including for AEROSURF involve significant risks and uncertainties that are inherent in the clinical development and regulatory approval processes,” “– The regulatory approval process for our products is expensive and time-consuming and the outcome is uncertain.  We may not obtain required regulatory approvals to commercialize our products,” and “– Even if we succeed in gaining regulatory approval to market our drugs, if the FDA and foreign regulators later withdraw their approval or otherwise restrict marketing, our business would be materially harmed.”

Certain of our product candidates may qualify for Fast Track designation, Orphan Drug designation, or other potential expedited regulatory pathway options.  Each potential expedited regulatory pathway could provide for expedited FDA communication or approval, as well as additional potential benefits, such as additional market exclusivity or tax incentives.  See, “– Licensing, Patents and Other Proprietary Rights and Regulatory Designations – Patents and Proprietary Rights – Other Regulatory Designations,” and “Item 1A – Risk Factors – Even though some of our product candidates have qualified for expedited review, the FDA may not approve them at all or any sooner than other product candidates that do not qualify for expedited review.”

 

EMPLOYEES

As of March 7, 2014, we have 126 employees.  Of this total, 14 (approximately 11% of our total labor force) are employed at our Totowa Facility, and are subject to a collective bargaining agreement that expires on December 3, 2015.  All are employed in the U.S.  See, “Item 1A – Risk Factors – We depend upon key employees and consultants in a competitive market for skilled personnel.  If we or our partners or collaborators are unable to attract and retain key personnel, it could adversely affect our ability to develop and market our products.”

 

AVAILABLE INFORMATION

We file annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (SEC).  You may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549.  You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.  Many of our SEC filings are also available to the public from the SEC’s website at “http://www.sec.gov.”  We make available for download free of charge through our website our Annual Report on Form 10-K, our quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we have filed it electronically with, or furnished it to, the SEC.

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ITEM 1A.

RISK FACTORS.

You should carefully consider the following risks and any of the other information set forth in this Annual Report on Form 10-K and in the documents incorporated herein by reference, before deciding to invest in shares of our common stock.  The risks described below are not the only ones that we face.  Additional risks that are not presently known to us or that we currently deem immaterial may also impair our business operations.  The following risks, among others, could cause our actual results, performance, achievements or industry results to differ materially from those expressed in our forward-looking statements contained herein and presented elsewhere by management from time to time.  If any of the following risks actually occurs, our business prospects, financial condition or results of operations could be materially harmed.  In such case, the market price of our common stock would likely decline due to the occurrence of any of these risks, and you could lose all or part of your investment.

 

ITEM 1B.

UNRESOLVED STAFF COMMENTS.

 

None.

 

ITEM 2.

PROPERTIES.

We maintain our principal executive offices at 2600 Kelly Road, Suite 100, Warrington, Pennsylvania 18976-3622, which consist of 39,594 square feet of space that we lease.  On January 3, 2013, we entered into a Second Amendment to Lease Agreement (Amendment) to extend the lease for an additional five years until February 2018.  In addition, the Amendment provides for a reduction to the base rent effective as of October 1, 2012; a reduction in the security deposit over a two year period beginning in 2013, from $400,000 to $225,000; the elimination of our obligation to remove certain improvements and restore the premises; and an adjustment of our option to extend the lease to an additional period of five years through February 2023.  The total aggregate base rental payments under the lease prior to the extension were approximately $7.2 million and the total aggregate base rental payments under the extended portion of the lease are approximately $4.9 million.  We do not own any real property.

We also maintain at our Warrington location our analytical and technical support laboratory that is involved predominantly in release testing of all active pharmaceutical ingredients (APIs), release and stability testing of SURFAXIN® drug product, and supporting our research and development work for our lyophilized and aerosolized KL4 surfactant dosage forms as well as our efforts to identify and protect our intellectual property.  We also maintain a medical device development laboratory at this location that is used by our development engineering team to conduct preclinical development activities for AEROSURF® and our aerosol delivery technologies.  Having our own device development laboratory allows us to conduct a range of research activities while at the same time controlling the related expense and conserving our financial resources.  Our laboratory space includes a controlled environment with two class 10,000 hoods (for activities requiring clean room procedures).

We lease approximately 21,000 square feet of space for our manufacturing operations in Totowa, New Jersey (Totowa Facility), at an annual rent of $150,000.  In early 2014, we extended the term of this lease such that it will now expire on June 30, 2015.  This space is specifically designed for the manufacture and filling of sterile liquid pharmaceuticals in compliance with cGMP and is currently dedicated to the manufacture of SURFAXIN drug product.  We currently are in discussions with the landlord potentially to enable longer-term utilization of that facility for the manufacture of SURFAXIN and potentially lyophilized KL4 surfactant.  See, “Item 1 – Business – Business Operations – Manufacturing and Distribution – KL4 Surfactant.”

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ITEM 3.

LEGAL PROCEEDINGS.

We are not aware of any pending or threatened legal actions to which we are a party or of which our property is the subject that would, if determined adversely to us, have a material adverse effect on our business and operations.

We have from time to time been involved in disputes and proceedings arising in the ordinary course of business, including in connection with the conduct of our clinical trials.  In addition, as a public company, we are also potentially susceptible to litigation, such as claims asserting violations of securities laws.  Any such claims, with or without merit, if not resolved, could be time-consuming and result in costly litigation.  There can be no assurance that an adverse result in any future proceeding would not have a potentially material adverse effect on our business, results of operations or financial condition.

 

PART II

 

ITEM 5.

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

Market Information

Our common stock is traded on The Nasdaq Capital Market^® under the symbol “DSCO.”  As of March 7, 2014, we had 124 stockholders of record of shares of our common stock.  We also have been advised that, as of December 13, 2013, there are approximately 20,774 beneficial owners of our common stock whose positions are held in street name.  As of March 7, 2014, there were 84,696,919 shares of our common stock issued and outstanding.

The following table sets forth the quarterly sales price ranges of our common stock for the periods indicated, as reported by The Nasdaq Capital Market.

We have not paid dividends on our common stock and do not expect to declare and pay dividends on our common stock in the foreseeable future.

Sales of Unregistered Securities

During the quarter ended December 31, 2013, we issued 8,750 unregistered shares of common stock to a consultant as compensation for management consulting services rendered during the period from August 31, 2013 through November 30, 2013.  The shares were issued in reliance upon the exemption from securities registration provided by Section 4(a)(2) of the Act.

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ITEM 6.

SELECTED FINANCIAL DATA.

(1)	Included in the net loss for 2013, 2012, 2011, 2010, and 2009  were non-cash charges for stock-based compensation and depreciation of $2.9 million, $3.3 million, $2.2 million, $2.8 million, and $4.3 million, respectively.

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·

Company Overview and Business Strategy:  this section provides a general description of our company and business plans.

·

Critical Accounting Policies:  this section contains a discussion of the accounting policies that we believe are important to our financial condition and results of operations and that require the exercise of judgment and use of estimates on the part of management in their application.  In addition, all of our significant accounting policies, including the critical accounting policies and estimates, are discussed in Note 3 to the accompanying consolidated financial statements.

·

Results of Operations:  this section provides an analysis of our results of operations presented in the accompanying consolidated statements of operations, including comparisons of the results for the years ended December 31, 2013, 2012 and 2011.

·

Liquidity and Capital Resources:  this section provides a discussion of our capital resources, future capital requirements, cash flows, committed equity financing facilities, historical financing transactions, outstanding debt arrangements and commitments.

 

OVERVIEW

Discovery Laboratories, Inc. (referred to as “we,” “us,” or the “Company”) is a specialty biotechnology company focused on creating life-saving products for critical-care patients with respiratory disease and improving the standard of care in pulmonary medicine.  Our proprietary drug technology produces a synthetic, peptide-containing surfactant (KL4 surfactant) that is structurally similar to pulmonary surfactant, a substance produced naturally in the lung and essential for normal respiratory function and survival.  We are developing our KL4 surfactant in liquid, lyophilized and aerosolized dosage forms.  We are also developing novel drug delivery technologies potentially to enable efficient delivery of our aerosolized KL4 surfactant.  We believe that our proprietary technologies may make it possible, for the first time, to develop a significant pipeline of products to address a variety of respiratory diseases for which there frequently are few or no approved therapies.

We are initially focused on improving the management of respiratory distress syndrome (RDS) in premature infants.  RDS is a serious respiratory condition caused by insufficient surfactant production in underdeveloped lungs of premature infants.  RDS is the most prevalent respiratory disease in the Neonatal Intensive Care Unit (NICU) and can result in long-term respiratory problems, developmental delay and death.

Our first KL4 surfactant drug product, SURFAXIN^® (lucinactant) Intratracheal Suspension for the prevention of RDS in premature infants at high risk for RDS, was approved by the United States Food and Drug Administration (FDA) in 2012.  SURFAXIN is our KL4 surfactant in liquid form and is the first synthetic, peptide-containing surfactant approved by the FDA and the only alternative to animal-derived surfactants currently used in the United States (U.S.).  Since November 2013, SURFAXIN has been commercially available in the U.S.

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Premature infants with severe RDS currently are treated with surfactants that can only be administered by endotracheal intubation supported with mechanical ventilation, both invasive procedures that may each result in serious respiratory conditions and other complications.  To avoid such complications, many neonatologists treat infants with less severe RDS by less invasive means, typically nasal continuous positive airway pressure (nCPAP).  Unfortunately, a significant number of premature infants on nCPAP will not respond well (an outcome referred to as nCPAP failure) and thereafter may require delayed surfactant therapy.  Since neonatologists currently cannot predict which infants will experience nCPAP failure, neonatologists are faced with difficult choices in treating infants with less severe RDS.  This is because the medical outcomes for those infants who experience nCPAP failure and receive delayed surfactant therapy may be less favorable than the outcomes for infants who receive surfactant therapy in the first hours of life.

 

AEROSURF^® is an investigational combination drug/device product that combines our KL4 surfactant with our proprietary capillary aerosol generator (CAG).  With AEROSURF, neonatologists potentially will be able to administer aerosolized KL4 surfactant to premature infants supported with nCPAP, without having to use invasive intubation and mechanical ventilation.  By enabling delivery of our KL4 surfactant using less invasive procedures, we believe that AEROSURF will address a serious unmet medical need and potentially enable the treatment of a significantly greater number of premature infants with RDS who could benefit from surfactant therapy but are currently not treated.

We are also developing a lyophilized (freeze-dried) dosage form of our KL4 surfactant that is stored as a powder and reconstituted to liquid form prior to use with the objective of improving ease of use for healthcare practitioners, as well as potentially to prolong shelf life and eliminate the need for cold-chain storage.  We are initially developing this dosage form for use in our AEROSURF development program.  We are also planning to seek regulatory advice to determine if we could gain marketing authorization for a lyophilized dosage form of SURFAXIN under a development plan that would be both capital efficient and capable of implementation within a reasonable time.  If feasible, we would likely implement such a development plan and would plan to introduce it commercially as a life-cycle extension of SURFAXIN under the name SURFAXIN LS™, in the U.S. and potentially in other markets.

To support the commercial introduction of SURFAXIN in the U.S. and our other KL4 surfactant pipeline products, if approved, we have established our own specialty respiratory critical care commercial and medical affairs team.  This team includes medical professionals with experience in neonatal/pediatric respiratory critical care, and has focused on products that address neonatal indications, beginning with SURFAXIN.  We believe that this team will be positioned to efficiently introduce our other KL4 surfactant products under development, if approved, including AEROSURF and potentially SURFAXIN LS and future applications of our aerosolized KL4 surfactant.

In addition we recognize that our commercial and medical affairs team could potentially support introductions of other synergistic pipeline products, including products  owned or developed by third parties for the NICU/PICU.  To that end, we would consider potential transactions focused on securing commercial rights to such synergistic products, including in the form of product acquisitions, in-licensing agreements or distribution, marketing or co-marketing arrangements.

In the future, we expect that we may be able to leverage the information, data and know-how that we gain from our development efforts with SURFAXIN and AEROSURF to support development of a potential product pipeline to address serious critical care respiratory conditions in larger children and adults in pediatric and adult intensive care units (PICUS and ICUs), including acute lung injury (ALI), chronic obstructive pulmonary disease (COPD) and cystic fibrosis (CF).  At the present time, however, we are focusing our resources primarily on the commercial introduction of SURFAXIN and development of AEROSURF through phase 2 clinical trials.  Once we have achieved these objectives, we believe we would be in a better position to assess the potential of other development programs to address the critical care needs of patients in the PICU and ICU.

We also have developed a disposable aerosol-conducting airway connector for infants that is intended to simplify the delivery of aerosolized medications (including our aerosolized KL4 surfactant) and other inhaled therapies to critical-care patients requiring ventilatory support.  This device introduces aerosolized medications directly at the patient interface and minimizes the number of connections in the ventilator circuit.  We have registered this device as a Class I, exempt medical device in the U.S. under the name AFECTAIR and it is currently commercially available in the U.S.

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We believe the following accounting policies are the most critical for an understanding of our financial condition and results of operations.  For further discussion of our accounting policies, see, “Item 8 – Note 3 – Accounting Policies and Recent Accounting Pronouncements” in the Notes to Consolidated Financial Statements for the year ended December 31, 2013, in Part IV to this Annual Report on Form 10-K.

Product Sales

Revenues from product sales are recognized when (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the price is fixed or determinable and (4) collectability is reasonably assured. 

Our products are distributed in the U.S. using a specialty distributor.  Under this model, the specialty distributor purchases and takes physical delivery and title of product, and then sells to hospitals.  We began the commercial introduction of SURFAXIN in the fourth quarter of 2013 and, for that reason, we currently cannot make a reasonable estimate of future product returns when product is delivered to the specialty distributor.  Therefore, we currently do not recognize revenue upon product shipment to the specialty distributor, even though the distributor is invoiced upon product shipment.  Instead, we recognize revenue once product has been sold through to the hospital and all revenue recognition criteria have been met.  Once product has been delivered to the hospital, the risk of material returns is significantly mitigated. As of December 31, 2013, we have deferred revenue recognition on all product sales since the inception of the commercial launch of SURFAXIN in November 2013.  We will recognize those revenues at the point in time when all revenue recognition criteria have been met.

We will begin to recognize revenue at the time of shipment of product to our specialty distributor when we can reasonably estimate expected distributor sales deductions and returns. In developing estimates for sales returns we consider the shelf life of the product, expected demand based on market data and return rates of other surfactant products. 

Product sales are recorded net of accruals for estimated chargebacks, discounts, specialty distributor deductions and returns.

·

Chargebacks.  Chargebacks are discounts that occur when contracted customers purchase directly from our specialty distributor.  Contracted customers, which currently consist primarily of member hospitals of Group Purchasing Organizations, generally purchase the product at a discounted price.  Our specialty distributor, in turn, charges back the difference between the price initially paid by the specialty distributor and the discounted price paid to the specialty distributor by the customer.  The allowance for specialty distributor chargebacks is based on known sales to contracted customers.

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Research and development

We track research and development expense by activity, as follows: (a) product development and manufacturing, (b) medical and regulatory operations, and (c) direct preclinical and clinical programs.   Research and development expense includes personnel, facilities, manufacturing and quality operations, pharmaceutical and device development, research, clinical, regulatory, other preclinical and clinical activities and medical affairs.  Research and development costs are charged to operations as incurred.

 

Inventory

 

Inventories, which are recorded at the lower of cost or market, include materials, labor, and other direct and indirect costs and are valued at cost using the first-in, first-out method.  We capitalize inventories produced in preparation for commercial launch when it becomes probable that the related product candidate will receive regulatory approval and that the related costs will be recoverable through commercial sale of the product.  Costs incurred prior to FDA approval of SURFAXIN drug product and registration of AFECTAIR device have been recorded in our statement of operations as research and development expense.  Inventories are evaluated for impairment based on consideration of such factors as the net realizable value, lower of cost or market, obsolescence, and product expiry.  Inventories do not have carrying values that exceed either cost or net realizable value.

We establish expiry risk by evaluating current and future product demand relative to product shelf life.  We build demand forecasts based on consideration of such factors as overall market potential, market share, market acceptance and hospital ordering practices.

 

Deferred revenue

 

Deferred revenue reflects amounts related to sales of SURFAXIN to our specialty distributor, which are then deferred and recognized as revenue once product has been sold through to the hospital and all revenue recognition criteria have been met.  See, “– Product Sales.”

Warrant accounting

We account for common stock warrants in accordance with applicable accounting guidance provided in ASC Topic 815 “Derivatives and Hedging – Contracts in Entity’s Own Equity” (ASC Topic 815), as either derivative liabilities or as equity instruments depending on the specific terms of the warrant agreement.  We classify derivative warrant liabilities on the consolidated balance sheet as current liabilities, which are revalued at each balance sheet date subsequent to the initial issuance.  We use the Black-Scholes or trinomial pricing models, depending on the applicable terms of the warrant agreement, to value the derivative warrant liabilities.  Changes in the fair value of the warrants are reflected in the consolidated statement of operations as “Change in the fair value of common stock warrant liability.”  See, “Item 8 –Note 8 – Common Stock Warrant Liability,” for a detailed description of our accounting for derivative warrant liabilities.

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The increase in operating loss from 2012 to 2013 was primarily due to (i) a $3.2 million increase in investment in AEROSURF development activities, primarily to develop and manufacture a clinic-ready CAG for use in our AEROSURF phase 2 clinical program and in the technology transfer and further development of our lyophilized KL4 surfactant manufacturing process at DSM Pharmaceuticals, Inc. (DSM), (ii) a $3.2 million increase in investment in our specialty commercial and medical affairs organization that is focused on neonatal/pediatric respiratory critical care in NICUs/PICUs across the U.S.; and (iii) a $1.7 million increase in purchases of raw materials to manufacture drug product for SURFAXIN and our AEROSURF development program, which were partially offset by a $2.0 million one-time charge in the fourth quarter of 2012 associated with certain contractual severance obligations and stock-based compensation charges related to the resignation of our former Chief Executive Officer.

The increase in operating loss from 2011 to 2012 was primarily due to (i) a $6.5 million investment to establish our commercial and medical affairs organization; (ii) a $1.6 million investment to advance the development of our CAG for potential use in our AEROSURF phase 2 clinical program; and (iii) a $2.0 million one-time charge in the fourth quarter of 2012 associated with certain contractual severance obligations and stock-based compensation charges related to the resignation of our former Chief Executive Officer.

Product Sales

As of December 31, 2013, we have deferred revenue recognition on all product sales since the initiation of the commercial launch of SURFAXIN in November 2013.  In accordance with our revenue recognition policy, we will recognize revenue once product has been sold through to the hospital and all revenue recognition criteria have been met.

Grant Revenue

We recognized grant revenue of $0.4 million, $0.2 million and $0.6 million for the years ended December 31, 2013,  2012 and 2011, respectively.  The grant revenue in 2012 and 2013 represents funds received and expended under a Small Business Innovation Research (SBIR) Phase I award from National Institute of Health’s (NIH) National Institute of Allergy and Infectious Diseases (NIAID) Center for Medical Counter Measures Against Radiation and Nuclear Threats to assess the ability of KL4 surfactant to mitigate the effects of acute radiation exposure to the lung, including acute pneumonitis and delayed lung injury.  The total amount of the Phase I award was $0.6 million and we have received and expended the full amount as of December 31, 2013.

In the future, we expect that we may be able to leverage the information, data and know-how that we gain from our development efforts with SURFAXIN and AEROSURF to support development of a potential product pipeline to address serious critical care respiratory conditions in larger children and adults in pediatric and adult intensive care units (PICUS and ICUs), including acute lung injury (ALI), chronic obstructive pulmonary disease (COPD) and cystic fibrosis (CF).  While we are currently focused on RDS, we are currently, and will consider in the future, collaborating with leading research institutions to conduct preclinical studies, including those that may be funded through various U.S. government-sponsored, biodefense-related initiatives, including NIAID.

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Cost of product sales for 2013 primarily reflects inventory reserves for costs of SURFAXIN finished goods inventory that is not expected to be recoverable through commercial sale of the product during the initial launch period due to product expiration.

Research and Development Expenses

Our research and development expenses are charged to operations as incurred and we track such costs by category rather than by project.  As many of our research and development activities form the foundation for the development of our KL4 surfactant and drug delivery technologies, they are expected to benefit more than a single project.  For that reason, we cannot reasonably estimate the costs of our research and development activities on a project-by-project basis.  We believe that tracking our expenses by category is a more accurate method of accounting for these activities.  Our research and development costs consist primarily of expenses associated with (a) product development and manufacturing, (b) medical and regulatory operations, and (c) direct preclinical and clinical programs.  We also track research and development and report by major expense category as follows: (i) salaries and benefits, (ii) contracted services, (iii) rents and utilities, (iv) depreciation, (v) raw materials and supplies, (vi) contract manufacturing, (vii) stock-based compensation and (viii) other.

Research and development expenses by category for the years ended December 31, 2013, 2012 and 2011 are as follows:

⁽¹⁾  Certain prior year expenses have been reclassified to conform to 2013 presentation.

Research and development expenses include non-cash charges associated with stock-based compensation and depreciation of $1.4 million, $1.3 million, and $1.4 million for 2013, 2012, and 2011, respectively.

For a description of the clinical programs included in research and development expenses, See, “Item 1 – Business – Surfactant Replacement Therapy for Respiratory Medicine.”

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Product development and manufacturing expenses increased $4.7 million from 2012 to 2013 primarily due to increases in (i) investments in design and development activities related to our CAG for use in our AEROSURF phase 2 clinical trials,  including work with third-party device experts and work that we began in June 2012 with Battelle Memorial Institute (Battelle), which assisted in a multi-phase project to design, test, and manufacture clinic-ready CAG devices for the AEROSURF phase 2a clinical trial; (ii) costs associated with the technical transfer and further development of our KL4 surfactant manufacturing processes at DSM; and (iii) purchases of active pharmaceutical ingredients (APIs) used in the manufacture of SURFAXIN drug product and our lyophilized KL4 surfactant, for commercial use and preclinical development activities, including to complete the technical transfer and further develop our KL4 surfactant manufacturing process at DSM, and activities to develop a clinic-ready CAG and prepare for our AEROSURF phase 2 clinical program.

Product development and manufacturing expenses increased $3.4 million from 2011 to 2012 primarily due to (i) an increase in investments in manufacturing and quality activities as we prepared for commercial introduction of SURFAXIN and the AFECTAIR device for infants; (ii) costs associated with our efforts to optimize the design of our CAG with our engineering staff and third-party medical device experts, including work that we began in June 2012 with Battelle Memorial Institute (Battelle), which assisted us in a multi-phase development program focused on design, testing, and manufacturing of clinic-ready CAG devices for our AEROSURF phase 2 clinical trials, and (iii) an increase in costs associated with employee incentive compensation plans.

Product development and manufacturing expenses include non-cash charges associated with stock-based compensation and depreciation of $0.9 million, $1.0 million, and $1.2 million, for the years ended December 31, 2013, 2013 and 2011, respectively.

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Medical and regulatory operations expenses increased $1.1 million from 2012 to 2013 primarily due to a full year investment in 2013 in our medical affairs organization to support the commercial introduction of SURFAXIN and the AFECTAIR device.

Medical and regulatory operations expenses increased $1.4 million from 2011 to 2012 primarily due to (i) investment to establish our medical affairs organization in preparation for the commercial introduction of SURFAXIN and the AFECTAIR device for infants, and (ii) costs associated with employee incentive compensation plans.

Medical and regulatory operations expenses include non-cash charges associated with stock-based compensation and depreciation of $0.4 million, $0.3 million, and $0.2 million for the years ended December 31, 2013, 2012, and 2011, respectively.

Direct preclinical and clinical programs include: (i) development activities, including for the AEROSURF clinical program, toxicology studies and other preclinical studies to obtain data to support our investigational new drug (IND) application and, potentially, our New Drug Application (NDA) filings for AEROSURF, and potentially our other KL4 surfactant product candidates; and (ii) activities, if any, associated with conducting clinical trials, including patient enrollment costs, external site costs, clinical device and drug supply, and related external costs, such as research consultant fees and expenses.

Direct preclinical and clinical programs expenses increased $0.3 million from 2012 to 2013 primarily due to investments in activities to prepare for our AEROSURF phase 2 clinical program.  Such activities included manufacture of a sufficient number of clinic-ready CAG devices to support our phase 2a clinical trial, implementation of clinical data management systems and selection of clinical site locations.  Costs in 2012 included a $0.5 million charge related to a milestone payment that became payable to Johnson and Johnson (J&J) upon FDA approval of SURFAXIN in March 2012.

Direct preclinical and clinical programs expenses decreased $0.5 million from 2011 to 2012 primarily due to a decrease in costs associated with activities completed in 2011 to respond to a Complete Response Letter received from the FDA in 2009 (2009 Complete Response Letter), offset by a $0.5 million charge related to a milestone payment that became payable to J&J upon FDA approval of SURFAXIN in March 2012.

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We anticipate that direct clinical program costs associated with conducting the AEROSURF phase 2 clinical program will be approximately $8 -10 million for 2014 through the anticipated completion of the AEROSURF phase 2 program in 2015.

 

We also track our research and development expense by major expense category as shown in the following table:

The increase in salaries and benefits from 2012 to 2013 and from 2011 to 2012 is primarily due to the establishment of our medical affairs organization primarily to support the commercial introduction of SURFAXIN and AFECTAIR, increased benefit costs and employee incentive payments.

Contracted services include the cost of preclinical studies, clinical trial activities, certain components of our manufacturing operations, quality control and analytical testing of our drug product, including our BAT, consulting services, aerosol device design and engineering services, etc.  The increase from 2012 to 2013 and from 2011 to 2012 is primarily due to costs associated with work that we began in June 2012 with Battelle to optimize design, test, and manufacture clinic-ready CAG devices to be used in our AEROSURF phase 2a clinical trial, and investments in our manufacturing and quality activities as we prepare for the commercial introduction of SURFAXIN.

Raw materials and supplies consist of purchases of our active pharmaceutical ingredients (APIs) for the manufacture of our KL4 surfactant product candidates and supplies to support our manufacturing and analytical testing and development laboratories operations.  In addition, raw materials and supplies include component parts used in the development of our CAG and raw materials and supplies used in manufacturing and product development activities for our AFECTAIR aerosol-conducting airway connector. The increase in raw materials and supplies from 2012 to 2013 is primarily due to a $1.6 million increase in purchases of raw materials to manufacture drug product for SURFAXIN commercial supply and to support manufacturing development activities.  The decrease in raw materials and supplies from 2011 to 2012 is primarily due to a decrease in raw material purchases following submission in 2011 of our response to the 2009 Complete Response Letter.

Rents and utilities are costs related to our leased manufacturing, laboratory, and corporate facilities. The decrease from 2012 to 2013 is primarily due to (i) decreased rent for our corporate and laboratory facility in Warrington, PA in connection with an amended lease agreement executed in January 2013, and (ii) decreased utility costs at our manufacturing facility.  The decrease from 2011 to 2012 is primarily due to decreased utility costs at our manufacturing facility due to decreased manufacturing activity for SURFAXIN.

Depreciation is primarily associated with leasehold improvements at our laboratories and headquarters in Warrington, Pennsylvania as well as manufacturing and laboratory equipment, and leasehold improvements at the Totowa Facility. The decrease from 2012 to 2013 and from 2011 to 2012 is primarily due to capitalized assets becoming fully depreciated.

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Contract manufacturing represents costs related to the technology transfer of our liquid and lyophilized KL4 surfactant manufacturing processes to a CMO.  The increase in contract manufacturing from 2012 to 2013 was due to an increase in activities to transfer our KL4 manufacturing processes for our lyophilized KL4 surfactant as well as SURFAXIN.  The decrease in contract manufacturing costs from 2011 to 2012 is due to pacing of our technology transfer activities while we focused our efforts on responding to the 2009 Complete Response Letter and securing marketing authorization for SURFAXIN.

The category “All Other” consists primarily of ongoing research and development costs such as insurance, taxes, education and training and software licenses.

A substantial portion of our cumulative losses to date relate to investments in our research and development projects, for which we incurred $66.5 million in expenses for the three-year period ended December 31, 2013.  Due to the significant risks and uncertainties inherent in clinical development and the regulatory approval processes, the nature, timing and costs of the efforts necessary to complete individual projects in development are not reasonably estimable.  With every phase of a development project, there are significant unknowns that may significantly affect cost projections and timelines.  As a result of the number and nature of these factors, many of which are outside our control, the success, timing of completion and ultimate cost, of development of any of our product candidates is highly uncertain and cannot be estimated with any degree of certainty.

In addition to the risks and uncertainties affecting our research and development projects discussed in this MD&A, including those affecting our ability to estimate projections and timelines, see, “Item 1 – Business – Government Regulation,” and “Item 1A – Risk Factors – The regulatory approval process for our products is expensive and time-consuming and the outcome is uncertain.  We may not obtain required regulatory approvals to commercialize our products;” “– Our research and development activities involve significant risks and uncertainties that are inherent in the clinical development and regulatory approval processes;” “– Our clinical trials may be delayed, or fail, which will harm our business,” “– Manufacturing problems potentially could cause us to delay preclinical or clinical programs, or, if our products are approved, product launch, or cause us to experience shortages of products inventories, which could have a material adverse effect on our business;” as well as elsewhere in this Annual Report on Form 10-K.

Our lead development projects initially are focused on the management of RDS in premature infants, including (i) SURFAXIN liquid instillate, which has been approved by the FDA for the prevention of RDS at high risk for RDS, (ii) our lyophilized KL4 surfactant, which we are developing initially for use in our AEROSURF development program and, if we determine that we could gain marketing authorization for a lyophilized dosage form of SURFAXIN under a development plan that would be both capital efficient and capable of implementation within a reasonable time, we would likely implement such a plan and would plan to introduce it commercially as a life-cycle extension of SURFAXIN under the name SURFAXIN LS; and (iii) our aerosol delivery technology, including preparation of a clinic-ready CAG device to support our AEROSURF phase 2 clinical program.

With respect to activities in support of our AEROSURF development program, from 2012 through December 2013, we invested approximately $7 million to develop the CAG and complete the technology transfer and further develop our lyophilized KL4 surfactant manufacturing process at DSM, in preparation for initiation of the AEROSURF phase 2 program.  In addition, as noted above, we anticipate that direct clinical program costs associated with conducting the AEROSURF phase 2 clinical program will be approximately $8 - 10 million for 2014 through the anticipated completion of the AEROSURF phase 2 program in 2015.

The status of our lead projects and our other pipeline candidates, including the potential timing and milestones for each, is discussed in “Item 1 – Business – Surfactant Replacement Therapy for Respiratory Medicine.”  See also, “Item 1 – Business – Business Strategy,” and “Item 1A – Risk Factors – We may not successfully develop and market our products, and even if we do, we may not become profitable,”  “– We will require significant additional capital to continue our planned research and development activities and continue to operate as a going concern.  Moreover, such additional financing could result in equity dilution.”

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In the future, we expect that we may be able to leverage the information, data and know-how that we gain from our development efforts with SURFAXIN and AEROSURF to support development of a potential product pipeline to address serious critical care respiratory conditions in larger children and adults in pediatric and adult intensive care units (PICUS and ICUs), including Acute Lung Injury (ALI), Chronic Obstructive Pulmonary Disorder (COPD) and Cystic Fibrosis (CF).  At the present time, we are focusing our resources primarily on the commercial introduction of SURFAXIN and development of AEROSURF through phase 2 clinical trials.  Once we have achieved these objectives, we believe we would be in a better position to assess the potential of other development programs to address the critical care needs of patients in the PICU and ICU.  See, “Item 1 – Business – Business Strategy,” and “– Surfactant Replacement Therapy For Respiratory Medicine.”

Ultimately, if we do not successfully develop and gain marketing approval for our drug product candidates, in the U.S. or elsewhere, we will not be able to commercialize, or generate any revenues from the sale of our products and the value of our company and our financial condition and results of operations will be substantially harmed.

Selling, General and Administrative Expenses

 

(in thousands)		Years Ended December 31,
		2013				2012				2011
Selling, General and Administrative Expenses		$	16,718			$	16,444			$	7,864

 

Selling, general and administrative expenses consist primarily of the costs sales and marketing activities, executive management, business development, intellectual property, finance and accounting, legal, human resources, information technology, facility and other administrative costs.

Selling, general and administrative expenses increased $0.3 million from 2012 to 2013 primarily due to an increase in investments in our marketing and field-based sales force to execute the commercial introduction of SURFAXIN and the AFECTAIR device for infants.  Selling, general and administrative expenses in 2012 include a $2.0 million one-time charge associated with certain contractual cash severance obligations and stock-based compensation charges related to the resignation of our former Chief Executive Officer.

 Selling, general and administrative expenses increased $8.6 million from 2011 to 2012 primarily due to (i) investments in our marketing and field-based sales force to support the anticipated commercial introduction of SURFAXIN; (ii) marketing-related activities primarily for SURFAXIN; (iii) a $2.0 million one-time charge associated with certain contractual cash severance obligations and stock-based compensation charges related to the resignation of our former Chief Executive Officer; and (iv) increased costs associated with employee incentive compensation plans.

Selling, general and administrative expenses include non-cash charges associated with stock-based compensation and depreciation of $1.5 million, $2.0 million, and $0.7 million, for the years ended December 31, 2013, 2012 and 2011, respectively.  The 2012 amount includes $0.8 million of stock-based compensation charges related to the resignation of our former Chief Executive Officer.

In addition to developing our commercial marketing and sales organization, we have made additional investments to enhance certain of our general and administrative resources, including in legal, finance and accounting, and information technologies, to support the commercial introduction of our products.  With these investments, we believe that our general and administrative resources will be sufficient to support our business operations.

We plan to continue our investments in prosecuting and maintaining our existing patent portfolio and trademarks, and in protecting our trade secrets and regulatory exclusivity designations, including potential orphan drug and new drug product exclusivities.  We also plan, when appropriate, to invest in potential patent extensions, new patents, new trademarks, and new regulatory exclusivity designations, when available.  See, “Item 1 – Business – Licensing, Patents and Other Proprietary Rights and Regulatory Designations.”

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Change in Fair Value of Common Stock Warrant Liability

We account for common stock warrants in accordance with applicable accounting guidance provided in ASC Topic 815, “Derivatives and Hedging Contracts in Entity’s Own Equity”, either as derivative liabilities or as equity instruments depending on the specific terms of the warrant agreement.  Derivative warrant liabilities are valued at the date of initial issuance and as of each subsequent balance sheet date using the Black-Scholes or trinomial pricing models, depending on the terms of the applicable warrant agreement.  Changes in the fair value of the warrants are reflected in the consolidated statement of operations as “Change in the fair value of common stock warrant liability.”

The form of warrant agreement for the registered warrants that we issued in our May 2009 and February 2010 public offerings generally provide that, in the event a related registration statement or an exemption from registration is not available for the issuance or resale of the warrant shares upon exercise of the warrant, the holder may exercise the warrant on a cashless basis.  Notwithstanding the availability of cashless exercise, generally accepted accounting principles (GAAP) provide that these registered warrants are deemed to be subject to potential net cash settlement and must be classified as derivative liabilities because (i) under federal securities laws, providing freely-tradable shares upon exercise of the warrants may not be within our control in all circumstances, and (ii) the warrant agreements do not expressly provide that there is no circumstance in which we may be required to effect a net cash settlement of the warrants.  The accounting guidance expressly precludes an evaluation of the likelihood that cash settlement could occur.  Accordingly, the May 2009 and February 2010 warrants have been classified as derivative liabilities and reported, at each balance sheet date, at estimated fair value determined using the Black-Scholes option-pricing model.

The form of warrant agreement for the registered five-year warrants that we issued in the February 2011 public offering (February 2011 five-year warrants) contain anti-dilutive provisions that adjust the exercise price if we issue any common stock, securities convertible into common stock, or other securities (subject to certain exceptions) at a value below the then-existing exercise price of the February 2011 five-year warrants.  Although by their express terms, these warrants are not subject to potential cash settlement, due to the nature of the anti-dilution provisions, these warrants have been classified as derivative liabilities and reported, at each balance sheet date, at estimated fair value determined using a trinomial pricing model.

Changes in our common stock warrant liability are primarily related to changes in our common stock share price during the periods.

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(in thousands)		Years Ended December 31,
Other Income / (Expense):		2013				2012				2011
Interest income		$	3			$	3			$	13
Interest expense			(1,471	)			(13	)			(20	)
Other income / (expense)			–				(41	)			(6	)
Other income / (expense), net		$	(1,468	)		$	(51	)		$	(13	)

 

Interest expense in 2013 consists of interest expense associated with the Deerfield Loan (see, “– Liquidity and Capital Resources – Deerfield Loan”) and interest expense incurred under our equipment financing facilities.  Interest expense for 2012 and 2011 consists of interest expense incurred under our equipment loan.

The following amounts comprise the Deerfield Loan interest expense for the periods presented:

 

Cash interest expense represents interest at an annual rate of 8.75% calculated on the outstanding principal amount for the period, paid in cash on a quarterly basis.  Non-cash amortization of debt discount represents the amortization of transaction fees and the fair value of the Deerfield Warrants.  The amortization of debt costs represents professional fees incurred in connection with the Deerfield Loan.

 

LIQUIDITY AND CAPITAL RESOURCES

We have incurred substantial losses since inception, due to investments in research and development, manufacturing, and, more recently, commercialization and medical affairs activities, and we expect to continue to incur substantial losses over the next several years.  Historically, we have funded our business operations through various sources, including public and private securities offerings, debt facilities, strategic alliances, the use of committed equity financing facilities (CEFFs) and at-the-market equity programs, and capital equipment financings.

As of December 31, 2013, we had cash and cash equivalents of $86.3 million and $30 million ($18.4 million net of discount) of long-term debt under our Deerfield Loan with affiliates of Deerfield Management  Company, L.P. (Deerfield).  See, “– Deerfield Loan.”  During 2013, we raised aggregate gross proceeds of $75.8 million through public offerings of our common stock, including under our ATM Program (see, “– At-the-Market Program (ATM Program)”).  In February 2013, we entered into the Deerfield Loan and, upon execution of the agreement, Deerfield advanced to us $10 million ($9.85 million net of transaction fee).  In May 2013, we completed a public offering of 10.847 million shares of common stock, including 1.347 million shares under an option granted to and exercised by the underwriters, at an offering price of $1.50 per share, resulting in gross proceeds of $16.3 million ($15.1 million net of commissions, discounts and expenses).  In October 2013, we completed an offering under the ATM Program and issued 713,920 shares of our common stock resulting in net proceeds to us of approximately $1.8 million (net of  commissions).  In November 2013, we completed a public offering of 28.75 million shares of common stock, including 3.75 million shares under an option granted to and exercised by the underwriters for over-allotments, at an offering price of $2.00 per share resulting in gross proceeds of $57.5 million ($53.9 million net of commissions, discounts and expenses).  In December 2013, we received an additional $20 million under the Deerfield Loan ($19.7 million net of transaction fee), which became available under the Deerfield Loan upon the first commercial sale of SURFAXIN.  Before any additional financings, including under our ATM Program, we anticipate that we will have sufficient cash available to fund our operations and debt service obligations through the third quarter of 2015.

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Our future capital requirements depend upon many factors, primarily the success of our efforts to (i) execute the commercial introduction of SURFAXIN in the U.S.; (ii) advance the AEROSURF development program to completion of the phase 2 clinical program as planned in the second half of 2015; and (iii) secure one or more strategic alliances or other collaboration arrangements to support the development and, if approved, commercial introduction of AEROSURF and potentially SURFAXIN in markets outside the U.S.  We believe that, if we are able to complete the AEROSURF phase 2 clinical program on a timely basis and obtain encouraging results, and if we are able to successfully advance the commercial introduction of SURFAXIN, our ability to enter into a significant strategic alliance will be enhanced.  There can be no assurance, however, that our efforts will be successful, or that we will be able to obtain additional capital to support our activities when needed on acceptable terms, if at all.

 

Even if we succeed with the commercial introduction of SURFAXIN, given the time required to secure formulary acceptance at our target hospitals, we expect our revenues from SURFAXIN to be modest in the first 12-24 months and then increase slowly over time.  For the next several years, we expect that our cash outflows for marketing, commercial and medical activities, development programs, operations and debt service will far outpace the rate at which we may generate revenues.  Therefore, to execute our business strategy and fund our operations over the long term, we will require significant additional infusions of capital until such time as the net revenues from the sale of approved products, from potential strategic alliances and from other sources are sufficient to offset our cash flow requirements.  To secure the necessary capital to fund our development programs, we would prefer to enter into strategic alliances or collaboration arrangements with partners having broad experience in markets outside the U.S., including regulatory and product-development expertise as well as an ability to commercialize our products, if approved.  Such alliances typically would also provide financial resources, in the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses.  Collaboration, co-marketing and other similar arrangements would provide, in addition to an ability to introduce our products in markets outside the U.S., a sharing of revenues.  Under our ATM Program, subject to market conditions, we may sell up to approximately $23 million of common stock at such times and in such amounts that we deem appropriate, subject to a 3% commission.  However, use of the ATM Program is subject to market and other conditions and the ATM Program could be cancelled at any time by either party.  We also may consider public and private equity offerings or other financing transactions, including potentially secured equipment financing facilities or other similar transactions.  There can be no assurance, however, that our AEROSURF and other research and development projects will be successful, that our products under development will obtain necessary regulatory approval in the U.S. and other markets, that any approved product, including SURFAXIN, will be commercially viable, that the ATM Program will be available when needed, if at all, or that we will be able to obtain additional capital when needed on acceptable terms, if at all.  Even if we succeed in raising additional capital and developing and subsequently commercializing product candidates, we may never achieve sufficient sales revenue to achieve or maintain profitability.

The accompanying financial statements have been prepared assuming that we will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.  For the next several years, our ability to continue as a going concern will be dependent on our ability to raise additional capital, to fund our research and development and commercial programs and meet our obligations, including debt service, on a timely basis.  If we are unable to successfully raise sufficient additional capital when needed, we will likely not have sufficient cash flows and liquidity to fund our business operations, which could significantly limit our ability to continue as a going concern.  In that event, we may be forced to further limit our programs and consider other means of creating value for our stockholders, such as licensing the development and commercialization of products that we consider valuable and would otherwise likely develop ourselves.  If we are unable to raise the necessary capital, we may be forced to curtail all of our activities and, ultimately, potentially cease operations.  Even if we are able to raise additional capital, such financings may only be available on unattractive terms, or could result in significant dilution of stockholders’ interests and, in such event, the market price of our common stock may decline.  The balance sheets do not include any adjustments relating to recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue in existence.

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Although we currently believe that we will be able to successfully execute our business strategy, there can be no assurance that we will be successful.  We will require significant additional capital to satisfy debt obligations and sustain operations, and to complete the development and support the commercial introduction of our products.  Failure to secure the necessary additional capital would have a material adverse effect on our business, financial condition and results of operations.

Cash Flows

As of December 31, 2013, 2012 and 2011, we had cash and cash equivalents of $86.3 million, $26.9 million and $10.2 million.  Cash outflows before financing activities for 2013 consisted of $40.5 million used for ongoing operating activities and $0.6 million for purchases of property and equipment.  During 2013, we raised aggregate net proceeds of $100.4 million, including a $30 million ($29.6 million net of expenses) advanced under the Deerfield Loan, $15.1 million and $53.9 million of net proceeds from registered public offerings that we completed in May 2013 and November 2013, respectively, and $1.8 million of net proceeds from a financing under the ATM Program.

Operating Activities

Net cash used in operating activities was $40.5 million, $32.9 million, and $22.7 million for the years ended December 31, 2013, 2012 and 2011, respectively.  Net cash used in operating activities is a result of our net losses for the period, adjusted for non-cash items and changes in working capital.

The increase in net cash used in operating activities from 2012 to 2013 is primarily due to (i) investment in our specialty commercial and medical affairs organization that is focused on neonatal/pediatric respiratory critical care in NICUs/PICUs across the U.S., and manufacturing and quality activities in preparation for the commercial introduction of SURFAXIN; (ii) costs to develop and manufacture clinic-ready CAGs for the AEROSURF phase 2a clinical trial, including work with third party device experts and work that began June 2012 with Battelle, which assisted in a multi-phase project to design, test, and manufacture clinic-ready CAG devices; and (iii) purchases of APIs used in the manufacture of SURFAXIN drug product and our lyophilized KL4 surfactant, for commercial use and preclinical development activities, including to complete the technical transfer and further develop our KL4 surfactant manufacturing process at DSM, and activities to develop a clinic-ready CAG and prepare for our AEROSURF phase 2 clinical program.

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Financing Activities

Net cash provided by financing activities was $100.5 million, $50.2 million, and $22.8 million for the years ended December 31, 2013, 2012, and 2011, respectively, summarized as follows:

The following sections provide a more detailed discussion of our cash flows from available financing facilities and activities.

Financings Pursuant to Common Stock Offerings

Historically, we have funded, and expect to continue to fund, our business operations through various sources, including financings pursuant to common stock offerings.

Registered Public Offerings

On November 5, 2013, we completed a registered public offering of 25,000,000 shares of our common stock, at a price of $2.00 per share resulting in gross proceeds of $50.0 million ($46.8 million net proceeds).  We also granted the underwriters a 30-day option to purchase up to an additional 3,750,000 shares of common stock at an offering price of $2.00 per share.  On November 8, 2013, the underwriters exercised their option in full, resulting in additional gross proceeds of $7.5 million ($7.1 million net proceeds).

On May 10, 2013, we completed a registered public offering of 9,500,000 shares of our common stock, at a price of $1.50 per share resulting in gross proceeds of $14.3 million ($13.2 million net proceeds).  We also granted the underwriters a 30-day option to purchase up to an additional 1,425,000 shares of common stock at an offering price of $1.50 per share.  On May 28, 2013, the underwriters exercised their option to purchase 1,347,000 shares of common stock at a price of $1.50 per share, resulting in additional gross proceeds of $2.0 million ($1.9 million net proceeds).

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Committed Equity Financing Facility (CEFF)

From 2004 through June 2013, we maintained one or more Committed Equity Financing Facilities (CEFFs) with Kingsbridge Capital Limited (Kingsbridge), a private investment group, under which Kingsbridge was committed to purchase, subject to certain conditions, newly-issued shares of our common stock.  The CEFFs allowed us, at our discretion, to raise capital, at the time and in amounts deemed suitable to us, to support our business plans.  We were not obligated to utilize any of the funds available under any CEFF and our ability to access funds at any time was subject to certain conditions, including stock price and volume limitations.

As of December 31, 2013, we have no CEFF agreements.  Three CEFF agreements, dated May 22, 2008, December 12, 2008, and June 11, 2010 (2010 CEFF) expired in June 2011, February 2011, and June 2013, respectively.  There were no financings under the May 2008 CEFF or December 2008 CEFF during 2013, 2012 and 2011.

The 2010 CEFF Agreement originally provided for the purchase of the lesser of up to 2.1 million shares or a maximum of $35 million, and expired in June 2013.  There were no financings completed under the 2010 CEFF in 2012 and 2013.

In 2011, we received $1.3 million of gross proceeds from the issuance of 514,990 shares at an average discounted price of $2.56 per share under the 2010 CEFF.

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If we issue a sale notice to Stifel, we may designate the minimum price per share at which shares may be sold and the maximum number of shares that Stifel is directed to sell during any selling period.  As a result, prices are expected to vary as between purchasers and during the term of the offering.  Stifel may sell the shares by any method deemed to be an “at-the-market” equity offering as defined in Rule 415 promulgated under the Securities Act of 1933, as amended, which may include ordinary brokers’ transactions on The Nasdaq Capital Market^®, or otherwise at market prices prevailing at the time of sale or prices related to such prevailing market prices, or as otherwise agreed by Stifel and us.  Either party may suspend the offering under the ATM Agreement by notice to the other party.

The ATM Agreement will terminate upon the earliest of: (1) the sale of all shares subject to the ATM Agreement, (2) February 11, 2016 or (3) the termination of the ATM Agreement in accordance with its terms.  Either party may terminate the ATM Agreement at any time upon written notification to the other party in accordance with the ATM Agreement, and upon such termination, the offering will terminate.

We agreed to pay Stifel a commission equal to 3.0% of the gross sales price of any shares sold pursuant to the ATM Agreement. With the exception of expenses related to the shares, Stifel will be responsible for all of its own costs and expenses incurred in connection with the offering.

On October 15, 2013, we completed an offering under the ATM Program and issued 713,920 shares of our common stock for an aggregate purchase price of approximately $2.0 million, resulting in net proceeds to us of approximately $1.8 million, after deducting commissions.  As of December 31, 2013, approximately $23 million remained available under the ATM Program.

Lazard ATM Program

On December 14, 2011, we entered into a Sales Agency Agreement (Agency Agreement) with Lazard Capital Markets LLC (Lazard), under which Lazard, as our exclusive agent, at our discretion and at such times that we may determine from time to time, could sell over a two-year period up to a maximum of $15,000,000 of shares of our common stock through an “at-the-market” program (Lazard ATM Program).

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(in thousands)
Note Payable		$	30,000
Unamortized discount			(11,646	)
Long-term debt, net of discount		$	18,354

 

The amount received and outstanding under the Deerfield Loan will accrue interest at an annual rate of 8.75%, payable quarterly in cash.  The Deerfield Loan agreement contains customary terms and conditions but does not require us to meet minimum financial and revenue performance covenants.  In connection with each advance, we paid Deerfield a transaction fee equal to 1.5% of the amount disbursed.  The Deerfield Loan agreement also contains various representations and warranties and affirmative and negative covenants customary for financings of this type, including restrictions on our ability to incur additional indebtedness and grant additional liens on our assets.  In addition, all amounts outstanding under the Deerfield Loan may become immediately due and payable upon (i) an “Event of Default,” as defined in the Deerfield Loan agreement, in which case Deerfield would have the right to require us to repay the outstanding principal amount of the loan, plus any accrued and unpaid interest thereon, or (ii) the occurrence of certain events as defined in the facility agreement, including, among other things, the consummation of a change of control transaction or the sale of more than 50% of our assets (a Major Transaction).

In connection with the execution of the Deerfield Loan and receipt of the First Disbursement, we issued to Deerfield warrants to purchase approximately 2.3 million shares of our common stock at an exercise price of $2.81 per share.  Upon receipt of the Second Disbursement, we issued to Deerfield warrants to purchase an additional 4.7 million shares of our common stock at an exercise price of $2.81 per share (together with the warrants issued in connection with the First Disbursement, the Deerfield Warrants).  The number of shares of common stock into which the Deerfield Warrants are exercisable and the exercise price of any Deerfield Warrant will be adjusted to reflect any stock splits, recapitalizations or similar adjustments in the number of outstanding shares of common stock.  The Deerfield Warrants will expire on the sixth anniversary of the facility agreement, February 13, 2019, and contain certain limitations that generally prevent the holder from acquiring shares upon exercise of the Deerfield Warrants or any part thereof that would result in the number of shares beneficially owned by such holder to exceed 9.985% of the total number of shares of our common stock then issued and outstanding.  For a discussion of additional rights of the holders, see, “Item 8 – Notes to consolidated financial statements – Note 9 – Deerfield Loan.”

We have recorded the loan as long-term debt at its face value of $30.0 million less debt discounts and issuance costs consisting of (i) $11.7 million fair value of the Deerfield Warrants issued upon the First Disbursement and the Second Disbursement (7 million warrants in total), and (ii) a $450,000 transaction fee.  The discount is being accreted to the $30 million loan over its term using the effective interest method.  The Deerfield Warrants are derivatives that qualify for an exemption from liability accounting as provided for in ASC Topic 815 “Derivatives and Hedging – Contracts in Entity’s Own Equity” (ASC 815) and have been classified as equity.

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Future payments due under contractual obligations at December 31, 2013 are as follows:

 

Operating Lease Agreements

We lease our headquarters location in Warrington, Pennsylvania.  The facility consists of 39,594 square feet and also serves as the main operating location for drug and device development, regulatory, analytical technical services, research and development, and administration.  In January 2013, we entered into an lease amendment to extend the term an additional five years, from February 2013 through February 2018.  The total aggregate base rental payments under the lease prior to the extension were approximately $7.2 million and the total aggregate base rental payments under the extended portion of the lease are approximately $4.9 million.

We also lease approximately 21,000 square feet of space at our Totowa Facility, our only manufacturing facility, at an annual rent of $150,000.  We have secured an extension of the lease, which was originally scheduled to expire in December 2014, until June 30, 2015.  We currently are in discussions with the landlord potentially to extend the lease through the end of 2016.  We are also exploring possible alternatives that could enable longer-term utilization of the Totowa Facility for the manufacture of SURFAXIN drug product and potentially lyophilized KL4 surfactant.  The total aggregate payments over the term of the lease are $1.4 million.  See, “Item 1 – Business – Business Operations – Manufacturing and Distribution,” and “Item 2 – Properties.”

Rent expense under the foregoing leases was $1.0 million for each of the years ended December 31, 2013, 2012 and 2011, respectively.

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In December 2012, we entered into a separation agreement (CEO Agreement) with our former Chief Executive Officer and Chairman of the Board of Directors.  Pursuant to the CEO Agreement, the executive resigned his positions with us effective December 31, 2012, and was entitled to (i) on December 31, 2012, a cash payment equal to the sum of (a) all unpaid compensation accrued through December 31, 2012, less any applicable withholding, any unreimbursed employee business expenses (subject to submission of appropriate documentation), and a severance payment in the amount of $1,250,000, less any applicable withholding; (ii) the accelerated vesting of all outstanding stock options which remain exercisable to the end of their respective stated terms; and (iii) through July 31, 2013, reimbursement of $2,000 per month, plus a tax-gross up adjustment, for temporary living expenses.  We also agreed to pay the executive’s attorneys’ fees incurred in connection with negotiating the CEO Agreement.

In July 2011, we entered into a separation agreement (EVP Agreement) with a former executive who served as our Executive Vice President, General Counsel and Corporate Secretary.  Pursuant to the EVP Agreement, the executive resigned his positions with us effective July 31, 2011, and was entitled to (i) payment of accrued vacation pay, (ii) the right to continue to hold a restricted stock award for 15,000 shares (RSA) without any continuing service obligation (as defined in the RSA), (iii) extended health benefits for up to 18 months, and, (iv) depending on the circumstances, outplacement services.  In addition, we paid the former executive, in 2012, severance in the amount of $400,000, which amount was reduced by any outstanding amount due under a promissory note that the former execute had issued to us in 2001. The EVP Agreement also contained a general release by both parties and a 12-month non-competition covenant by the former executive.

Off-Balance Sheet Arrangements

We did not have any material off-balance sheet arrangements at December 31, 2013, 2012 or 2011, or during the periods then ended.

 

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Not applicable.

 

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

See, Index to Consolidated Financial Statements on Page F-1 attached hereto.

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Our President and Chief Executive Officer and Chief Financial Officer has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Exchange Act) as of the end of the period covered by this Annual Report on Form 10-K.  Based on this evaluation, our President and Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our President and Chief Executive Officer and Chief Financial Officer, to allow for timely decisions regarding required disclosures, and recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

(b) Management’s Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) promulgated under the Exchange Act.  Our internal control system is designed to provide reasonable assurance to our management and board of directors regarding the preparation and fair presentation of published financial statements.  All internal control systems, no matter how well designed, have inherent limitations.  Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

Under the supervision and with the participation of our management, including our President and Chief Executive Officer and Chief Financial Officer, our management conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2013.  In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated 1992 Framework.  Based on our assessment, our management believes that our internal control over financial reporting is effective based on those criteria, as of December 31, 2013.

Our independent registered public accounting firm has audited our internal control over financial reporting, and issued an unqualified opinion dated March 17, 2014 on our internal control over financial reporting, which opinion is included herein.

(c)	Changes in internal controls

There were no changes in our internal control over financial reporting identified in connection with the evaluation described above that occurred during the quarter ended December 31, 2013 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Discovery Laboratories, Inc.

We have audited Discovery Laboratories, Inc. and subsidiary’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) (the COSO criteria). Discovery Laboratories, Inc. and subsidiary’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed 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. A company’s internal control over financial reporting 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 the assets of the company; (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 receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Discovery Laboratories, Inc. and subsidiary maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Discovery Laboratories, Inc. and subsidiary as of December 31, 2013 and 2012, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for the three years in the period ended December 31, 2013 and our report dated March 17, 2014 expressed an unqualified opinion thereon.

 

/s/ Ernst & Young

 

Philadelphia, Pennsylvania

March 17, 2014

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ITEM 9B.

OTHER INFORMATION.

Not applicable.

PART III

Except as set forth below, the information required by Items 10 through 14 of Part III is incorporated herein by reference to our definitive proxy statement or an amendment to this annual report on Form 10-K, in either case, to be filed with the Securities and Exchange Commission within 120 days after the end of our 2012 fiscal year.

 

ITEM 10.

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.

We have adopted a Code of Business Conduct and Ethics that applies to our officers, including our principal executive, financial and accounting officers, and our directors and employees.  We have posted the Code of Business Conduct and Ethics on our Internet website at “http://www.DiscoveryLabs.com” under the “Company” tab in the Corporate Governance section.  We intend to make all required disclosures on a Current Report on Form 8-K concerning any amendments to, or waivers from, our Code of Business Conduct and Ethics with respect to our executive officers and directors.  Our website and the information contained therein or connected thereto are not incorporated into this Annual Report on Form 10-K.

 

PART IV

 

ITEM 15.

EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.

The consolidated financial statements required to be filed in this Annual Report on Form 10-K are listed on the Index to Consolidated Financial Statements on page F-1 hereof.

Exhibits are listed on the Index to Exhibits at the end of this Annual Report on Form 10-K.  The exhibits required to be filed pursuant to Item 601 of Regulation S-K, which are listed on the Index in response to this Item, are incorporated herein by reference.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

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INDEX TO EXHIBITS

The following exhibits are included with this Annual Report on Form 10-K.

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+	Confidential treatment requested as to certain portions of these exhibits.  Such portions have been redacted and filed separately with the Commission.

 

*	A management contract or compensatory plan or arrangement required to be filed as an exhibit to this annual report pursuant to Item 15(b) of Form 10-K.

90

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F - 2

DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY