WINDTREE THERAPEUTICS INC /DE/ - Annual Report: 2014 (Form 10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-K

 

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

 

For the fiscal year ended December 31, 2014

 

or

 

☐	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)

2600 Kelly Road, Suite 100

Warrington, Pennsylvania 18976-3622

(Address of principal executive offices)

(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 ☐ NO ☒

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 ☐ NO ☒

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 ☒ NO ☐

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 ☒ NO ☐

 

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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. ☒

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.

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

YES ☐ NO ☒

The aggregate market value of shares of voting and non-voting common equity held by non-affiliates of the registrant on June 30, 2014 (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 $128 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 its 2013 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 6, 2015, 85,586,914 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 2015 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission no later than 120 days, or April 30, 2015, after the registrant’s fiscal year ended December 31, 2014, and to be delivered to stockholders in connection with the 2015 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.

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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 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), materials and medical devices; and plans regarding potential strategic alliances and other collaborative arrangements to develop, manufacture and market our products.

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:

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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;

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the risk that the initial and later phases of our AEROSURF phase 2 clinical program may be interrupted, delayed, or fail, which will harm our business;

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the risk that we may be unable in the near term to secure on acceptable terms, or at all, a strategic alliance or collaboration agreement for SURFAXIN in the U.S., which also would require us to negotiate a lease extension for our manufacturing facility in Totowa, NJ (Totowa Facility) and may require us to seek consent under our Deerfield Loan; in such event, we would be exposed to risks associated with the cessation of commercialization activities for SURFAXIN and termination of manufacturing activities at the Totowa Facility;

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the risk that we may be unable to enter into strategic alliances and/or collaboration agreements that would assist and support us with the development of our KL4 surfactant pipeline products in markets outside the U.S., beginning with AEROSURF, and, if approved, commercialization of AEROSURF in markets outside the U.S.; and if we are able to enter into a strategic alliance to support the commercialization of SURFAXIN in the U.S, we may be unable to identify strategic alliances and/or collaboration agreements to support the commercialization of SURFAXIN in countries where regulatory approval is facilitated by the information contained in the SURFAXIN new drug application (NDA) approved by the U.S. Food and Drug Administration (FDA); and potentially support the development and, if approved, commercialization, of our other pipeline products;

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risks relating to our plans potentially to secure marketing and distribution capabilities in certain markets through third-party strategic alliances and/or marketing alliances and/or distribution arrangements, that could require us to give up rights to our drug products, drug product candidates and drug delivery technologies;

 

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risks relating to our and our CMOs’ ability to develop and manufacture our CAG device and related components and technologies for preclinical and clinical studies of our combination drug/device product candidates and, if approved, for commercialization;

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the risk that we, our CMOs or any of our third-party suppliers, many of which are single-source providers, may encounter problems in manufacturing our KL4 surfactant drug products and the APIs used in the manufacture of our drug products, WARMING CRADLE® dry-block heaters, CAG devices and other materials on a timely basis or in an amount sufficient to support our needs;

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risks relating to our pledge of substantially all of our assets to secure our obligations under our loan facility (Deerfield Loan) with affiliates of Deerfield Management Company, L.P., which could make it more difficult for us to secure additional capital to satisfy our obligations and require us to dedicate cash flow to payments for debt service, which would reduce the availability of our cash flow to fund working capital, capital expenditures and other investment; moreover, we may be required to seek the consent of Deerfield to enter into certain strategic transactions;

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risks that unfavorable credit and financial markets may adversely affect our ability to fund our activities, through our ATM Program or otherwise, and that our ATM Program may expire unutilized or be exhausted; and that additional equity financings could result in substantial equity dilution or result in a downward adjustment to the exercise price of five-year warrants that we issued in February 2011 (which contain price-based anti-dilution adjustments);

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risks related to our efforts to gain regulatory approval in the U.S. and elsewhere for our drug products, medical device and combination drug/device product candidates, including AEROSURF, and our lyophilized KL4 surfactant that we expect will be the drug component of AEROSURF and potentially be developed as a life cycle extension of SURFAXIN under the name SURFAXIN LS™;

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risks relating to the rigorous regulatory approval processes, including pre-filing activities, required for approval of any drug, combination drug-device product or medical device that we may develop, whether independently, with strategic development partners or pursuant to collaboration arrangements;

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the risk that the FDA or other regulatory authorities may not accept, or may withhold or delay consideration of, any applications that we may file, or may not approve our applications or may limit approval of our products to particular indications or impose unanticipated label limitations;

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the risk that we and the FDA or other regulatory authorities will not be able to agree on matters raised during the regulatory review process and other interactions, or that we may be required to conduct significant additional activities to potentially gain approval of our product candidates, if ever;

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the risk that changes in the national or international political and regulatory environment may make it more difficult to gain FDA or other regulatory approval of our drug products, medical device and combination drug/device product candidates;

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risks relating generally to our research and development activities, which among other things may involve time-consuming and expensive preclinical studies and potentially multiple clinical trials that may be subject to potentially significant delays or regulatory holds or fail;

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risks that reimbursement and health care reform may adversely affect us or that our products will not be accepted by physicians and others in the medical community;

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the risk that if we fail to maintain compliance with continued listing requirements of The Nasdaq Capital Market, our common stock may be delisted and the value of our common stock decrease;

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the risk that market conditions, the competitive landscape or other factors may make it difficult to launch and profitably sell our products;

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the risk that we, our strategic partners or collaborators will be unable to attract and retain key employees, including qualified scientific, professional and other personnel, in a competitive market for skilled personnel, which could have a material adverse effect on our commercial and development activities and our operations;

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the risks that we may be unable to maintain and protect the patents and licenses related to our products and that other companies may develop competing therapies and/or technologies;

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the risks that we may become involved in securities, product liability and other litigation and that our insurance may be insufficient to cover costs of damages and defense;

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other risks and uncertainties detailed in “Risk Factors” and elsewhere in this Annual Report on Form 10-K, and in the documents incorporated by reference in this report.

Pharmaceutical, biotechnology and medical technology companies have suffered significant setbacks conducting clinical trials, even after obtaining promising earlier preclinical and clinical data.  Moreover, data obtained from clinical trials are susceptible to varying interpretations, which could delay, limit or prevent regulatory approval.  After gaining approval of a drug product, pharmaceutical and biotechnology companies face considerable challenges in marketing and distributing their products, and may never become profitable.

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

AEROSURF^®, AFECTAIR^®, DISCOVERYLABS^®, INSPIRED INNOVATION^®, SURFAXIN^®, SURFAXIN LS™, and WARMING CRADLE^® are registered and common law trademarks of Discovery Laboratories, Inc. (Warrington, PA).

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DISCOVERY LABORATORIES, INC.

Table of Contents to Annual Report on Form 10-K

For the Fiscal Year Ended December 31, 2014

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PART I

ITEM 1.

BUSINESS.

 

COMPANY OVERVIEW

 

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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 controlled 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.
                                                     

We lease approximately 21,000 square feet of space for our manufacturing operations in Totowa, New Jersey (Totowa Facility), at an annual rent of $525,000.  In early 2014, we entered into an amendment to extend the lease through 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 assessing our strategic alternatives and thereafter may enter into discussions with the landlord potentially to enable longer-term utilization of that facility for the manufacture of SURFAXIN.  See, “Item 1 – Business – Business Operations – Manufacturing and Distribution – KL4 Surfactant.”

 

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.

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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^® (Nasdaq) under the symbol “DSCO.”  As of March 6, 2015, we had 117 stockholders of record of shares of our common stock.  We also have been advised that, as of December 14, 2014, there are approximately 18,295 beneficial owners of our common stock whose positions are held in street name.  As of March 6, 2015, there were 85,586,914 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 Nasdaq.

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.

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ITEM 6.

SELECTED FINANCIAL DATA.

 

Included in the net loss for 2014, 2013, 2012, 2011, and 2010 were non-cash charges for stock-based compensation and depreciation of $3.7 million, $2.9 million, $3.3 million, $2.2 million, and $2.8 million, respectively.

 

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ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

INTRODUCTION

Some of the information contained in this discussion and analysis or set forth elsewhere in this Annual Report on Form 10-K, including information with respect to our plans and strategy for our business and related financing activities, includes forward-looking statements that involve risks and uncertainties.  You should review the “Forward Looking Statements” and “Risk Factors” sections of this Annual Report on Form 10-K for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis or elsewhere in the Annual Report on Form 10-K.

Management’s discussion and analysis of financial condition and results of operations (MD&A) is provided as a supplement to the accompanying consolidated financial statements and footnotes to help provide an understanding of our financial condition, the changes in our financial condition and our results of operations.  This item should be read in connection with our Consolidated Financial Statements for the year ending December 31, 2014 and notes thereto (Notes) included in this Annual Report of Form 10-K.  See, “Item 8 – Financial Statements and Supplementary Data.”  Our discussion is organized as follows:

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

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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.

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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, 2014, 2013 and 2012.

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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 aerosol drug delivery technologies potentially to enable efficient delivery of our aerosolized KL4 surfactant.  We believe that our proprietary technologies may make it possible to develop a pipeline of products to address a variety of respiratory diseases for which there are few or no approved therapies.
                                                      

Our development programs have been focused initially 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.).  SURFAXIN has been commercially available in the U.S. since November 2013.  See, “Item 1 – Business – Business Strategy – SURFAXIN.”

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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, 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 respond poorly (an outcome referred to as nCPAP failure) and 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 received 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) technology.  With AEROSURF, neonatologists potentially will be able to administer aerosolized KL4 surfactant to premature infants supported with nCPAP alone, without having to resort to invasive intubation and mechanical ventilation.  By enabling delivery of our aerosolized 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 also believe that our limited capital and resources should be invested in the development of aerosolized KL4 surfactant, beginning with AEROSURF, which has the potential to generate greater value for our stockholders.  Therefore, we are pursuing, with the intention of promptly implementing, a strategic alternative for SURFAXIN that potentially could be (i) a strategic alliance or collaboration arrangement, which we expect would require a lease extension for our manufacturing facility in Totowa, NJ (Totowa Facility) and may require consent under our Deerfield Loan, or (ii) ceasing our commercialization activities for SURFAXIN.  We would prefer an alliance or collaboration arrangement with a pharmaceutical company that has existing commercial capabilities, including substantial sales, marketing and medical resources and experience in the introduction of hospital-based products.  However, there can be no assurance that we will succeed in such efforts.  In connection with either a strategic alliance or collaboration agreement for SURFAXIN or cessation of commercialization activities, we expect that we likely will incur one-time transition-related costs associated with such event.

                                                                                

In the future, we expect 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 children and adults in pediatric and adult intensive care units (PICUs and ICUs). While we currently are focused primarily on the development of AEROSURF through phase 2 clinical trials, we have explored and plan in the future to explore potential opportunities to address a variety of respiratory conditions that may benefit from KL4 surfactant therapy where there are no currently approved therapies other than supportive respiratory care.
                                                                                                          

We believe that our aerosolized KL4 surfactant, alone or in combination with other pharmaceutical compounds, has the potential to be developed to address a range of serious respiratory conditions and may be an effective intervention for such conditions as acute lung injury (ALI), including acute radiation exposure to the lung (acute pneumonitis and delayed lung injury), chemical-induced ALI, and influenza-induced ALI.  In addition, we may explore opportunities to apply KL4 surfactant therapies to treat conditions such as chronic rhinosinusitis, complications of certain major surgeries, mechanical ventilator-induced lung injury (often referred to as VILI), pneumonia, diseases involving mucociliary clearance disorders, such chronic obstructive pulmonary disease (COPD) and cystic fibrosis (CF).  We believe that we have an opportunity to develop a broad pipeline of KL4 surfactant products to address these and other conditions.
                                                      

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The reader is referred to, and encouraged to read in its entirety “Item 1 – Business – Company Overview” and “– Business Strategy,” in this Annual Report on Form 10-K, which contains a discussion of our Business and Business Strategy, as well as information concerning our proprietary technologies and our current and planned KL4 pipeline programs.

 

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

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 – Notes to consolidated financial statements – Note 3 – Accounting Policies and Recent Accounting Pronouncements.”

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 we currently cannot make a reasonable estimate of future product returns 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 a hospital, we believe the risk of material returns is significantly mitigated.  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.

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Chargebacks.  Chargebacks are discounts that occur when contracted customers purchase directly from our specialty distributor.  Contracted customers, which primarily consist of Group Purchasing Organizations member hospitals, 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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Sales discounts.  Sales discounts are offered to certain contracted customers based upon a customer’s historical volume of surfactant product purchases.  Customers must enter into a Letter of Participation (LOP) with us to receive sales discounts.  Sales discounts are periodically adjusted on a prospective basis based upon the customer’s purchases of SURFAXIN, as provided in the LOP.  The allowance for sales discounts is based on known sales to contracted customers.

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Specialty distributor deductions.  Our specialty distributor is offered various forms of consideration including allowances, service fees and prompt payment discounts.  Specialty distributor allowances and service fees are provided for in our contractual agreement and are generally a percentage of the purchase price paid by the specialty distributor.  The specialty distributor is offered a prompt pay discount for payment within a specified period.

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Returns.  Sales of our products are not subject to a general right of return; however, we will accept product that is damaged or defective when shipped or for expired product up to six months subsequent to its expiry date.

Research and development

We account for research and development expense by the following categories: (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 all regulatory approvals needed to enable the commercial launch of the product are received and the related costs will be recoverable through the commercial sale of the product.  Costs incurred prior to FDA approval of drug products and registration of medical devices is recorded in our statement of operations as research and development expense.  Inventories are evaluated for impairment through consideration of factors such as the net realizable value, lower of cost or market, obsolescence, and expiry.  Inventories do not have carrying values that exceed either cost or net realizable value.

We evaluate our expiry risk by evaluating current and future product demand relative to product shelf life. We build demand forecasts by considering factors such as, but not limited to, 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.  Depending on the terms of a warrant agreement, we use the Black-Scholes or trinomial pricing models to value the related derivative warrant liabilities.  Changes in the fair value of the warrants are reflected in the consolidated statement of operations as “Change in fair value of common stock warrant liability.”  See, “Item 8 – Notes to consolidated financial statements – Note 8 – Common Stock Warrant Liability,” for a detailed description of our accounting for derivative warrant liabilities.

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RESULTS OF OPERATIONS

Net Loss and Operating Loss

The net loss for the years ended December 31, 2014, 2013, and 2012 was $44.1 million (or $0.52 basic net loss per share), $45.2 million (or $0.82 basic net loss per share), and $37.3 million (or $0.95 basic net loss per share), respectively.  The operating loss for the years ended December 31, 2014, 2013, and 2012 was $43.3 million, $44.5 million, and $37.8 million, respectively.

Product Sales

In accordance with our revenue recognition policy, we recognize revenue on product sales once product has been sold through to the hospital and all revenue recognition criteria have been met.  For the year ended December 31, 2014, we recognized revenue in the amount of $312,000.  SURFAXIN revenue growth continues to be slower than expected and we are now considering potential strategic alternatives for SURFAXIN, including potentially (i) a strategic alliance or collaboration arrangement, which we expect would require a lease extension for our Totowa Facility and may require consent under our Deerfield Loan, or (ii) ceasing commercialization activities.  No product sales revenue was recognized for the years ended December 31, 2013 and 2012.
                                                

Grant Revenue

We recognized grant revenue of $2.5 million for the year ended December 31, 2014 under two grants discussed below.

During the second quarter of 2014, we were awarded the final $1.9 million of a $2.4 million Fast Track Small Business Innovation Research (SBIR) Grant from the National Heart, Lung, and Blood Institute (NHLBI) of the National Institutes of Health (NIH).  This award provides support for the ongoing phase 2a clinical trial for AEROSURF.  We received and expended $1.8 million in 2014 under this award. We previously received and expended $0.6 million in 2011 under this grant to support development activities related to our capillary aerosol generator technology.

During the third quarter of 2014, we were awarded a Phase II SBIR grant of $1.0 million from the National Institute of Allergy and Infectious Diseases (NIAID) of the NIH to support the development of our aerosolized KL4 surfactant as a medical countermeasure to mitigate acute and chronic/late-phase radiation-induced lung injury.  We received $0.7 million in 2014 under this award.  Over the next two years, we may be awarded up to an additional $2.0 million as part of this grant.  Phase I of this grant was awarded in 2012 for $0.6 million and we previously received and expended $0.4 million in 2013 and $0.2 million in 2012.

                                                        

                                                                                                                    

Cost of Product Sales

 

Since October 4, 2013, the date the FDA approved updated SURFAXIN product specifications, which enabled the commercial introduction of SURFAXIN, we have capitalized inventories produced to support the commercial launch.  Cost of product sales for 2014 and 2013 includes $2.4 million and $0.5 million, respectively, of 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.  The increase in cost of product sales from 2013 to 2014 is due to the manufacture of additional commercial production in 2014.

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Research and Development Expenses

Our research and development expenses are charged to operations as incurred and we account for 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 account for research and development and report by major expense category as follows: (i) salaries and benefits, (ii) contracted services, (iii) raw materials, aerosol devices and supplies, (iv) rents and utilities, (v) depreciation, (vi) contract manufacturing, (vii) travel, (viii) stock-based compensation and (ix) other.

Research and development expenses by category for the years ended December 31, 2014, 2013, and 2012 are as follows:

Research and development expenses include non-cash charges associated with stock-based compensation and depreciation of $1.8 million, $1.4 million, and $1.3 million for 2014, 2013, and 2012, respectively.

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

Product development and manufacturing includes (i) manufacturing operations, both in-house and with CMOs, validation activities, quality assurance and analytical chemistry capabilities that support the manufacture of our KL4 surfactant used in research and development activities, and our medical devices, including our CAG, (ii) design and development activities related to our CAG device for use in our AEROSURF clinical program; and (iii) pharmaceutical and manufacturing development activities, including development of a lyophilized dosage form of our KL4 surfactant.  These costs include employee expenses, facility-related costs, depreciation, costs of drug substances (including raw materials), supplies, quality control and assurance activities, analytical services, and expert consultants and outside services to support pharmaceutical and device development activities.

Product development and manufacturing expenses decreased $5.6 million from 2013 to 2014, primarily due to (i) investments in 2013 of $3.5 million to complete development activities related to our CAG for use in our AEROSURF phase 2a clinical trial,  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) a $1.4 million reduction in CMO costs related to activities in 2013 to transfer our KL4 surfactant manufacturing process to a CMO, and (iii) a $1.0 million reduction in purchases of APIs used in the manufacture of SURFAXIN commercial drug product and our lyophilized KL4 surfactant for use in preclinical and clinical development activities, including the technology transfer of our lyophilized KL4 surfactant manufacturing process to Patheon, and activities to support our AEROSURF phase 2 clinical program.

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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 with Battelle to develop a clinic-ready CAG device for use in our AEROSURF phase 2 clinical trials; (ii) costs associated with a technical transfer and further development of our KL4 surfactant manufacturing processes at Patheon; 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 lyophilized KL4 surfactant manufacturing process at Patheon, and activities to develop a clinic-ready CAG and prepare for our AEROSURF phase 2 clinical program.

We plan to continue investments in the development of our manufacturing process for our lyophilized KL4 surfactant with Patheon, and plan to manufacture drug product for preclinical and clinical activities, including for our AEROSURF clinical programs and our other KL4 surfactant development programs.  By manufacturing our drug products at our Totowa Facility and with CMOs, we believe that we will be able to bring our own manufacturing expertise to our CMOs, maintain an appropriate balance between capital investments and variable manufacturing expense, and remain flexible while potentially reducing the risk profile of meeting the long-term requirements for development and commercial supply of our drug products.  For a discussion of our long-term business strategy to provide for the long-term continuity of supply and continued integrity and reliability of our manufacturing and quality capabilities, see, “Item 1 – Business – Business Operations – Manufacturing and Distribution.

Medical and regulatory operations includes (i) medical, scientific, clinical, regulatory, data management and biostatistics activities in support of our research and development programs; and (ii) medical affairs activities to provide scientific and medical education support related primarily to SURFAXIN, as well as our other KL4 surfactant and aerosol delivery products under development.  These costs include personnel, expert consultants, outside services to support regulatory and data management, symposiums at key medical meetings, facilities-related costs, and other costs for the management of clinical trials.

                                                

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.

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, clinical site costs, clinical device and drug supply, and related external costs, such as consultant fees and expenses.

Direct preclinical and clinical programs expenses increased $2.4 million from 2013 to 2014 primarily due to (i) a $1.5 million increase in AEROSURF clinical trial activities, including the initial Phase 2a clinical trial and manufacturing of clinic-ready CAG devices to support further clinical activities and the planned AEROSURF Phase 2b clinical trial, and (ii) a $0.9 million increase in preclinical activities in connection with the two NIH grants we were awarded in 2014 and work related to our the lyophilized KL4 surfactant.

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Direct preclinical and clinical programs expenses increased $0.3 million from 2012 to 2013 primarily due to increased 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 initial 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.

If our early clinical results are encouraging, we anticipate that our direct clinical program costs will increase significantly over the next few years as we refine our development plan for AEROSURF and execute the later stages of the AEROSURF clinical development program.  If successful, we estimate incurring $15 to $20 million in 2015 and 2016 on direct clinical program costs for the AEROSURF Phase 2 program.

In addition to developing our aerosolized KL4 surfactant for AEROSURF, we have approached the FDA to determine if we potentially could gain marketing authorization for a lyophilized dosage form of SURFAXIN under a plan that we believe might be both capital efficient and capable of implementation within a reasonable time.  If achievable, and if we are successful in entering into a strategic alliance or collaboration agreement to support SURFAXIN commercialization in the U.S., we may consider implementing such a development plan with our strategic partner or other third parties.  If SURFAXIN LS is approved, we expect that our strategic partner would introduce the product commercially in the U.S. as a life-cycle extension of SURFAXIN.  If we are unable to enter into a strategic alliance or collaboration agreement to support the commercialization of SURFAXIN in the U.S., we do not plan to initiate a development program for SURFAXIN LS on our own at this time.

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

 

The increase in salaries and benefits from 2013 to 2014 is primarily due to (i) strengthening our clinical leadership team and regulatory capabilities to support our AEROSURF development program, (ii) continuing to develop our medical affairs capabilities to support the commercial introduction of SURFAXIN, and (iii) an employee severance and retention plan for employees at our manufacturing facility initially intended to retain our personnel in the event that we are unable to secure long-term utilization of the facility beyond the scheduled lease expiration on June 30, 2015.  The increase from 2012 to 2013 is primarily due to the establishment of our medical affairs organization primarily to support the commercial introduction of SURFAXIN, increased benefit costs, and employee incentive payments.

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Contracted services include the cost of preclinical studies, clinical trial activities, certain components of our manufacturing operations, quality control and analytical stability and release testing of our drug product, consulting services, aerosol device design and engineering services, etc.  The decrease from 2013 to 2014 is primarily due to the completion of our work with Battelle for a clinic-ready CAG device to be used in our initial AEROSURF phase 2a clinical trial.  The increase from 2012 to 2013 is primarily due to costs associated with initiation in June 2012 of our work with Battelle to prepare a clinic-ready CAG to be used in our initial AEROSURF phase 2a clinical trial, and investments in our manufacturing and quality activities as we prepared for the commercial introduction of SURFAXIN.

Raw materials, aerosol devices 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.  Raw materials, aerosol devices and supplies purchases increased from 2013 to 2014 primarily due to an increase in purchases of aerosol devices and supplies for use in the AEROSURF phase 2a clinical trial, partially offset by a decrease in purchases of raw materials.  The increase in raw materials, aerosol devices 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.

Rents and utilities are costs related to our leased manufacturing, laboratory, and corporate facilities. The increase from 2013 to 2014 is primarily due to (i) increased rent for our manufacturing facility in Totowa, NJ in accordance with an agreement to extend our lease effective in the third quarter of 2013 and (ii) increased utility costs at our manufacturing facility.  The decrease from 2012 to 2013 is primarily due to (i) decreased rent for our corporate and laboratory facility in Warrington, PA in accordance with an agreement to amend and extend our lease executed in January 2013, and (ii) decreased utility costs at our manufacturing facility.

Contract manufacturing represents costs related to the technology transfer of our liquid and lyophilized KL4 surfactant manufacturing processes to a CMO.  The costs in 2013 related to activities to transfer our KL4 manufacturing processes to a CMO.

The category “All other” consists primarily of ongoing research and development costs such as insurance, taxes, education and training and software licenses.  The increase from 2013 to 2014 includes $0.3 million for royalties due to Philip Morris USA and Philip Morris Products, S.A. under our license agreements for our CAG technology.

Allocation to batch production represents manufacturing, quality and analytical testing costs related to SURFAXIN batch production for commercial supply, medical affairs programs and other development activities.

A substantial portion of our cumulative losses to date relate to investments in our research and development projects, for which we incurred $75.9 million in expenses for the three-year period ended December 31, 2014.  Due to the significant risks and uncertainties inherent in the clinical development and 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 unknowns that may significantly affect cost projections and timelines.  In view 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, other risks could arise that may affect our ability to estimate projections and timelines. (See, “Item 1 – Business – Government Regulation,” and “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.  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;” “- 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.”)

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Our lead research and development projects have been focused initially on the management of RDS in premature infants.  They include (i) SURFAXIN liquid instillate, which was approved by the FDA in 2012 and introduced commercially in 2013, (ii) lyophilized KL4 surfactant, which we are developing initially for use in our AEROSURF development program and potentially SURFAXIN LS; (iii) our aerosol delivery technologies, in particular the development and manufacture of a clinic-ready CAG device to support our AEROSURF phase 2 clinical program and initiation of a program to further develop and improve our CAG device for use in a potential Phase 3 clinical program and, if approved initial commercial supply; and (iv) AEROSURF phase 2 clinical trial activities and preparatory work for the planned AEROSURF phase 3 clinical program.

To prepare for initiation of our planned AEROSURF phase 2b clinical trial and the phase 3 clinical program, we plan to make additional investments in our development capabilities, including for manufacturing development of our lyophilized KL4 surfactant, further development of our CAG device under our collaboration with Battelle, and the conduct of the planned clinical trials.  In particular, we anticipate that direct clinical program costs for AEROSURF will increase significantly over the next few years as we complete our phase 2a clinical trial, assess the results and execute the later stages of the planned AEROSURF clinical development program.

At the present time, we are focusing our development efforts primarily on RDS and the development of AEROSURF through the phase 2 clinical trials to the planned phase 3 clinical program.  In the future, we expect 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 children and adults in pediatric and adult intensive care units (PICUs and ICUs).  We believe that our aerosolized KL4 surfactant, alone or in combination with other pharmaceutical compounds, may be an effective intervention for people at risk for, or with, manifestations of, acute lung injury (ALI), including acute radiation exposure to the lung (acute pneumonitis and delayed lung injury), chemical-induced ALI, and influenza-induced ALI.  In addition, we may explore opportunities to apply KL4 surfactant therapies to treat conditions such as chronic sinusitis, complications of certain major surgeries, and mechanical ventilator-induced lung injury (often referred to as VILI), severe acute respiratory syndrome (SARS), pneumonia and sepsis.

The status of our lead projects and our other pipeline candidates, including the potential timing and milestones for each, is also discussed in “Item 1 – Business – 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

 

Selling, general and administrative expenses consist primarily of the costs of 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 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.  Excluding these charges, selling, general, and administrative expense increased $2.3 million from 2012 to 2013 due to an increase in costs in our marketing and field-based sales force to support the commercial introduction of SURFAXIN.

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Selling, general and administrative expenses include non-cash charges associated with stock-based compensation and depreciation of $2.0 million, $1.5 million, and $2.0 million, for the years ended December 31, 2014, 2013 and 2012, respectively.

In addition to developing our commercial marketing and sales organization, we have made 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.”

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 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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Other Income / (Expense)

Interest income consists of interest earned on our cash and cash equivalents.  To ensure preservation of capital, we invest our cash in an interest-bearing operating cash account and U.S. treasury-based money market funds.

Interest expense in 2014 and 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 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, committed equity financing facilities (CEFFs), at-the-market equity programs, and capital equipment financings.

                                                    

As of December 31, 2014, we had cash and cash equivalents of $44.7 million and long-term debt of $30 million under our loan with affiliates of Deerfield Management Company, L.P. (Deerfield) (see, “Item 8 – Notes to consolidated financial statements – Note 9 – Deerfield Loan”).  For the next several years, we expect that our cash outflow requirements, for development programs, operations and debt service, will outpace the rate at which we may generate revenues.  Therefore, to execute our business strategy, advance our development programs, pay debt obligations and fund our operations, we will require significant additional infusions of capital until such time as we are able to generate sufficient revenues from the sale of approved products, from potential strategic alliances and commercialization agreements, and from other sources that are sufficient to offset our cash flow requirements.  Following the approval of SURFAXIN, we established our own specialty respiratory critical care commercial and medical affairs organization and made investments in manufacturing, quality systems, supply chain, and distribution capabilities.  Notwithstanding, revenue growth has been slower than expected and we currently believe that more of our capital and resources than previously anticipated would have to be allocated to SURFAXIN.  We also believe that our limited capital and resources should be invested in the development of aerosolized KL4 surfactant, beginning with AEROSURF.  Therefore, we are pursuing, with the intention of promptly implementing, a strategic alternative for SURFAXIN that potentially could be (i) a strategic alliance or collaboration arrangement, which we expect would require a lease extension for our Totowa Facility and may require consent under our Deerfield Loan, or (ii) ceasing commercialization activities for SURFAXIN.  We would prefer an alliance or collaboration arrangement with a pharmaceutical company that has existing commercial capabilities, including substantial sales, marketing and medical resources and experience in the introduction of hospital-based products.  However, there can be no assurance that we will succeed in such efforts.  In connection with either a strategic alliance or collaboration agreement for SURFAXIN or cessation of commercialization activities, we expect that we likely will incur one-time transition-related costs associated with such event.  Before any additional financings and taking into account our plan to quickly reduce cash outflows related to SURFAXIN through either (i) a strategic alliance or, in the event we are unable to secure a strategic alliance in the near term, (ii) ceasing commercial activities, we anticipate that we will have sufficient cash available to fund our operations and debt service obligations through the first quarter of 2016.
                                                           

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To secure the necessary capital to fund our development programs, an important priority for us is to identify strategic transactions that could provide additional capital and strategic resources to support the continued development and commercial introduction of our RDS products in markets outside the U.S.  For our AEROSURF development program, we seek a significant strategic alliance with a partner that has broad experience in markets outside the U.S., including regulatory and product-development expertise and, if AEROSURF is approved, an ability to support the commercial introduction of AEROSURF in the EU and other selected markets outside the U.S.  Such alliances typically also provide financial resources, in the form of upfront payments, milestone payments, commercialization royalties and a sharing of research and development expenses.  If our efforts to secure an alliance for SURFAXIN in the U.S. are successful, we may seek a strategic alliance that could provide regulatory expertise in designated markets where regulatory marketing authorization is facilitated by the information contained in our new drug application (NDA) approved by the FDA, support the commercial introduction of SURFAXIN in such markets and provide for a sharing of revenues.  Under our Battelle Collaboration Agreement, at our discretion from time to time, we may elect to defer payment of amounts due to Battelle in respect of our share of development costs for up to 12 months.  We currently have deferred certain payments and may continue to defer payments through the completion of the development project.  In addition, 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.  We also may consider public and private equity offerings or other financing transactions, including potentially secured equipment financing facilities or other similar transactions.                                                
                                                   

Our future capital requirements will depend upon many factors, including our efforts to (i) advance the AEROSURF development program to completion of the phase 2 clinical trials as planned; (ii) reduce or eliminate our capital and resources allocated to the commercialization of SURFAXIN in the U.S. (iii) assure long-term continuity of supply for our KL4 surfactant drug product, potentially at our manufacturing facility in Totowa, NJ (Totowa Facility) and with CMOs, (iv) further the development of our CAG for use in a planned phase 3 clinical program and, if approved, early commercial activities, (v) prepare for and conduct an AEROSURF phase 3 clinical program, and (vi) secure one or more strategic alliances or other collaboration arrangements to support our development programs and commercialization of our approved products, if any, in markets outside the U.S.  We believe that we will be better positioned to enter into a significant strategic alliance for AEROSURF if we obtain encouraging results from the AEROSURF phase 2 clinical program.
                                              

Given the uncertainty associated with our business strategy as planned, there can be no assurance (i) that our AEROSURF development program will be successful within our anticipated time frame, if at all, (ii) that any of our approved products will be commercially viable, (iii) that we will be able to execute our long-term manufacturing plan to secure continuity of drug product supply, (iv) that we will be able to secure regulatory marketing authorization for AEROSURF and our other potential KL4 surfactant product candidates in the U.S. and other markets, or (v) that the ATM Program will be available when needed, if at all, or (vi) that we otherwise will be able to obtain additional capital when needed and on acceptable terms. We will require significant additional capital to execute our business strategy, pay debt service and sustain operations.  Failure to secure the necessary additional capital when needed would have a material adverse effect on our business, financial condition and results of operations.  Even if we succeed in our efforts and subsequently commercialize our products, we may never achieve sufficient sales revenue to achieve or maintain profitability.

As of December 31, 2014, we had outstanding warrants to purchase approximately 15.5 million shares of our common stock at various prices, exercisable on different dates into 2024.  This includes warrants to purchase 7 million shares that were issued to Deerfield in connection with the Deerfield Loan at an exercise price of $2.81 per share (Deerfield Warrants).  The Deerfield Warrants may be exercised for cash or on a cashless basis.  In lieu of paying cash upon exercise, the holders also may elect to reduce the principal amount of the Deerfield Loan in an amount sufficient to satisfy the exercise price of the Deerfield Warrants.  In addition to the Deerfield Warrants, we have outstanding warrants issued in February 2011 to purchase approximately 4.6 million shares of common stock that expire in February 2016 and contain anti-dilution 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 warrants.  These warrants currently have an exercise price of $1.50 per share.  If the market price of our common stock should exceed $1.50 at any time prior to the expiration date of these warrants (February 2016) and if the holders determine in their discretion to exercise these warrants (and we have an effective registration statement covering the warrant shares to be issued upon exercise of the warrants), we potentially could receive up to approximately $6.8 million.  There can be no assurance that the price of our common stock will achieve the needed level, that holders of the Deerfield Warrants would choose to exercise their warrants for cash, or that holders of any of our outstanding warrants would choose to exercise any or all of their warrants prior to the applicable warrant expiration dates.  Moreover, if our outstanding warrants are exercised, such exercises likely will be at a discount to the then-market value of our common stock and have a dilutive effect on the value of our shares of common stock at the time of exercise.

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As of December 31, 2014, 250 million shares of common stock were authorized under our Amended and Restated Certificate of Incorporation, as amended, and approximately 135.7 million shares of common stock were available for issuance and not otherwise reserved.

Cash Flows

As of December 31, 2014, 2013, and 2012, we had cash and cash equivalents of $44.7 million, $86.3 million and $26.9 million.  Cash outflows before financing activities for 2014 consisted of $41.2 million used for ongoing operating activities and $0.8 million for purchases of property and equipment.

Operating Activities

Net cash used in operating activities was $41.2 million, $40.5 million, and $32.9 million for the years ended December 31, 2014, 2013, and 2012, 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 U.S. specialty commercial and medical affairs organizations to support, and manufacturing and quality activities in preparation for, the commercial introduction of SURFAXIN; (ii) costs to develop and manufacture clinic-ready CAGs for the initial AEROSURF phase 2a clinical trial, including work that began in 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 Patheon, and activities to develop a clinic-ready CAG and prepare for our AEROSURF phase 2 clinical program.

Investing Activities

Net cash used in investing activities was $0.8 million, $0.6 million, and $0.6 million for the years ended December 31, 2014, 2013, and 2012, respectively, and represents capital expenditures.

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Financing Activities

Net cash provided by financing activities was $0.4 million, $100.5 million, and $50.2 million for the years ended December 31, 2014, 2013, and 2012, 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 that we will continue to fund, our business operations through various sources, including financings in the form of common stock offerings.  In May 2014, we filed a universal shelf registration statement on Form S-3 (No. 333-196420) (2014 Universal Shelf) with the SEC that was declared effective on June 13, 2014 for the proposed offering from time to time of up to $250 million of our securities, including common stock, preferred stock, varying forms of debt and warrant securities, or any combination of the foregoing, on terms and conditions that will be determined at the time of an offering.  The 2014 Universal Shelf replaces an expired 2011 Universal Shelf.  As of December 31, 2014, after reserves for outstanding unexercised warrants and amounts remaining available under our ATM Program, approximately $199.0 million remained available under the 2014 Universal Shelf.  The 2014 Universal Shelf will expire in June 2017.

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).

On March 21, 2012, we completed a registered public offering of 16,071,429 shares of our common stock, at a price of $2.80 per share resulting in gross proceeds of $45.0 million ($42.1 million net proceeds).  We also granted the underwriters a 30-day option to purchase up to an additional 2,410,714 shares of common stock at an offering price of $2.80 per share, which expired unexercised in April 2012.

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Warrants

During the year ended December 31, 2014, holders of the February 2011 five-year warrants exercised warrants to purchase 284,850 shares of our common stock at an exercise price of $1.50 per share, resulting in proceeds to us of $0.4 million.

During the year ended December 31, 2013, holders of the February 2011 five-year warrants exercised warrants to purchase 113,800 shares of our common stock at an exercise price of $1.50 per share, resulting in proceeds to us of $0.2 million.

During the year ended December 31, 2012, holders of the 15‑month warrants that we issued in February 2011 exercised warrants to purchase 2,238,000 shares of our common stock at an exercise price of $2.94 per share, resulting in proceeds to us of $6.6 million.  The remaining 15-month warrants to purchase 2,762,000 shares expired unexercised on May 22, 2012.  In addition, holders of the February 2011 five-year warrants exercised warrants to purchase 51,250 shares of our common stock at an exercise price ranging from $2.80 to $3.20 per share, resulting in proceeds to us of $0.2 million.  For a listing of outstanding warrants, see, “Item 8 – Notes to consolidated financial statements – Note 10 – Stockholders’ Equity – Common Shares Reserved for Future Issuance – Common shares reserved for potential future issuance upon exercise of warrants.”

At-the-Market Program (ATM Program)

Stifel ATM Program

On February 11, 2013, we entered into an At-the-Market Equity Sales Agreement (ATM Agreement) with Stifel, under which Stifel, as our exclusive agent, at our discretion and at such times that we may determine from time to time, may sell over a three-year period up to a maximum of $25,000,000 of shares of our common stock (ATM Program).  We are not required to sell any shares at any time during the term of the ATM Program.

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, 2014, 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 could sell up to a maximum of $15,000,000 of shares of our common stock through an “at-the-market” program (Lazard ATM Program).  We agreed (i) to pay Lazard a commission equal to 3.0% of the gross proceeds of any sales, and (ii) to reimburse Lazard for certain expenses incurred.  In connection with initiation of coverage of our stock by an analyst affiliated with Lazard, we agreed with Lazard to terminate the Lazard ATM Program effective August 6, 2012.

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On March 12, 2012, we completed an offering of 350,374 shares of our common stock for an aggregate purchase price of approximately $1.6 million, resulting in net proceeds to us of approximately $1.5 million, after deducting commissions.

Deerfield Loan

Long-term debt consists solely of amounts due under a $30 million loan (Deerfield Loan) with affiliates of Deerfield Management Company, L.P. (Deerfield) for the periods presented:

Under the terms of the related agreement, Deerfield advanced funds to us in two separate disbursements.  Deerfield made the first disbursement, in the amount of $10 million, on February 13, 2013, upon execution of the related agreement (First Disbursement).  Deerfield made the second disbursement, in the amount of $20 million, on December 3, 2013 (Second Disbursement), following the first commercial sale of SURFAXIN.

The amount received and outstanding under the Deerfield Loan accrues 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 and have been classified as equity.

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Future payments due under contractual obligations at December 31, 2014 are as follows:

Our operating leases consist primarily of facility leases for our operations in Pennsylvania and New Jersey.

We maintain our headquarters in Warrington, Pennsylvania.  The facility is 39,594 square feet and serves as the main operating facility for drug and device development, regulatory, analytical technical services, research and development, and administration.  In January 2013, the lease was amended to extend the term an additional five years 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 lease approximately 21,000 square feet of space for our manufacturing operations in Totowa, New Jersey, at an annual rent of $525,000.  This space is specifically designed for the manufacture and filling of sterile pharmaceuticals in compliance with cGMP and is our only manufacturing facility.  The lease expires on June 30, 2015.  See, “Item 1 – Business – Business Strategy,” and “– Business Operations – Manufacturing and Distribution,” in this Annual Report on Form 10-K.

Rent expense under these leases was $1.2 million for the year ended December 31, 2014 and $1.0 million for each of the years ended December 31, 2013, and 2012.

In October 2014, we entered into a collaboration agreement with Battelle providing for the further development of our CAG for potential use in our planned phase 3 clinical program for AEROSURF for the treatment of RDS in premature infants and, if AEROSURF is approved for commercial sale by the FDA or other regulatory authority, initial commercial supply.  Under our agreement, we and Battelle plan to design, develop, and complete the testing, verification, and documentation of an improved AEROSURF system, and share equally in the related development costs.  If this development project is successfully completed, based upon our current estimates, we expect to incur development costs of approximately $6.0 million through 2016.  See, “Item 8 – Notes to consolidated financial statements – Note 12 – Corporate Partnership, Licensing and Research Funding Agreements.”

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Effective November 30, 2014 we and our Senior Vice President, Research and Development (the Executive) agreed to terminate his employment under his existing Employment Agreement dated April 1, 2013 (Employment Agreement).  In connection therewith, upon execution by the Executive of a plenary release in form satisfactory to us, he became entitled under his Employment Agreement to certain severance and other benefits.  In addition to any benefits that were otherwise due under our vested plans or other policies, the Executive will receive the following payments and benefits: (i) a pro rata bonus equal to that percent of the Executive’s Annual Bonus Amount (as defined in the Employment Agreement) that corresponds to that percent of days that the Executive was employed by us in 2014, reduced to reflect the same percent of his pro rata Annual Bonus Amount that corresponds to the percent of the aggregate Annual Bonus Amounts actually paid to other contract executives with respect to 2014, payable at the time that our other contract executives are paid bonuses; (ii) a severance amount equal to the sum of the Executive’s base salary then in effect and his Annual Bonus Amount, payable in equal installments from November 30, 2014 to November 30, 2015 (the Severance Period); and (iii) all vested stock options, restricted stock grants and other similar equity awards held by the Executive shall continue to be exercisable during the Severance Period.  From and after the effective date of termination, all of the Executive’s unvested stock options were forfeited in accordance with the terms of our 2011 Long-Term Incentive Plan.  In addition, the Executive also is subject to non-competition and non-solicitation restrictions for 12 months and 18 months, respectively, after the date of termination under a separate confidentiality agreement.  All of our obligations under the Employment Agreement will cease if at any time during the Severance Period the executive engages in a material breach of the Employment Agreement and fails to cure such breach within five business days after receipt from us of notice of such breach.

On September 13, 2013, our Board of Directors approved an employee severance and retention plan for employees at the Totowa Facility that initially was intended to retain our manufacturing personnel should we be unable to secure long-term utilization of the Facility beyond the scheduled lease expiration on June 30, 2015.  The retention plan provides severance and retention bonuses that encourage employees to stay with us through the Facility closing date (and beyond for certain employees).  The plan has two components: (1) plant management (three individuals) has received an award of stock options that will vest in full in June 2016, and will be eligible for a retention bonus payable in June 2016, provided that they remain employed with us at that time; and (2) non-union employees (eight individuals) will be eligible to receive both severance and retention bonuses, payable upon closure of the Totowa Facility, provided that they remain employed with us through the date of closure.  If we secure an extension of our lease for the Totowa Facility beyond June 30, 2015, plant management bonuses nevertheless will be paid as provided in the plan in June 2016, and non-union employees will remain eligible to receive severance and retention bonuses under the plan upon the eventual closure of the Facility, provided they remain employed with us through the date of closure.  The total cash amount expected to be paid for severance and retention through June 2016 is approximately $0.9 million.  The plan-related expense incurred during the years ended December 31, 2014 and 2013 is $0.5 million and $0.1 million, respectively, and is included in research and development expense and cost of product sales.  The related liability as of December 31, 2014 and 2013 is $0.6 million and $0.1 million, respectively.

In addition, there are 12 employees at the Totowa Facility (approximately 11% of our total labor force) who are subject to a collective bargaining agreement and will be eligible to receive severance upon closure of the Totowa Facility.  The related liability is $0.4 million as of December 31, 2014 and 2013.

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.

Off-Balance Sheet Arrangements

We did not have any material off-balance sheet arrangements at December 31, 2014, 2013, or 2012, or during the periods then ended.

 

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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.

 

ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.

Not applicable.

 

ITEM 9A.

CONTROLS AND PROCEDURES.

(a) Evaluation of disclosure controls and procedures

Our management, including our President and Chief Executive Officer (principal executive officer) and our Senior Vice President and Chief Financial Officer (principal financial officer), do not expect that our disclosure controls or our internal control over financial reporting will prevent all error and all fraud.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake.  Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls.  The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.  Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.  Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.  In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Our President and Chief Executive Officer and our Senior Vice President and Chief Financial Officer have 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 our Senior Vice President 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 our Senior Vice President 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.

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(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 our Senior Vice President and Chief Financial Officer, our management conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2014.  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 2013 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, 2014.

Our independent registered public accounting firm has audited our internal control over financial reporting, and issued an unqualified opinion dated March 16, 2015 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, 2014 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, 2014, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 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, 2014, 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, 2014 and 2013, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for the three years in the period ended December 31, 2014 and our report dated March 16, 2015 expressed an unqualified opinion thereon.

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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 2014 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.

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DISCOVERY LABORATORIES, INC.  AND SUBSIDIARY

 

Contents