**U. S. SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-KSB**

 

 

**(MARK ONE)**

 

| **ý**                                       |   | **ANNUAL REPORT UNDER SECTION 13 OR 15 (d) OF  THE SECURITIES EXCHANGE ACT OF 1934**    |
|--------------------------------------------------|--------|-----------------------------------------------------------------------------------------|
|                                             |   |                                                                                    |
| **FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2001** |
|                                             |   |                                                                                    |
| **o**                                            |   | **TRANSITION REPORT UNDER SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**COMMISSION FILE NUMBER 1-7335**

 

**LEE PHARMACEUTICALS**

(Nameof small business issuer in its charter)

 

| **CALIFORNIA**                                          |   | **95-2680312**                        |
|---------------------------------------------------------|--------|---------------------------------------|
| (State  or other jurisdiction of                        |   | (I.R.S.  Employer Identification No.) |
| incorporation  or organization)                         |   |                                  |
|                                                    |   |                                  |
| **1444 SANTA ANITA AVENUE, SOUTH EL MONTE, CALIFORNIA** |   | **91733**                             |
| (Address  of principal executive offices)               |   | (Zip  code)                           |

 

 

ISSUER'STELEPHONE NUMBER:  **(626) 442-3141**

 

 

SECURITIESREGISTERED UNDER SECTION 12(b) OF THE EXCHANGE ACT

 

| ** **              |   | **Name of Each Exchange** |
|-------------------------|--------|---------------------------|
| **Title of Each Class** |   | **on Which Registered**   |
|                    |   |                      |
| None                    |   |                      |

 

 

SECURITIES REGISTEREDUNDER SECTION 12 (g) OF THE EXCHANGE ACT: Common stock, par value $.10 per share

 

Check whether the issuer(1) filed all reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes           ý  No  o

 

 

Check if there is nodisclosure of delinquent filers in response to Item 405 of Regulation S-B isnot contained in this form, and no disclosure will be contained, to the best ofregistrant's knowledge, in definitive proxy or information statements incorporatedby reference in Part III of this Form 10-KSB or any amendment to this Form10-KSB.  ý

 

State issuer's revenuesfor its most recent fiscal year: $9,477,000 Gross

 

As of the close ofbusiness on November 30, 2001, the aggregate market value of Lee Pharmaceuticalscommon stock held by nonaffiliates was $305,367.

 

State the number ofshares outstanding of each of the issuer's classes of common equity, as of thelatest practicable date.  Common stock,par value $.10; 4,135,162 shares outstanding as of the close of business onNovember 30, 2001.

 

DOCUMENTS INCORPORATEDBY REFERENCE:  NONE

 

**PART I**

 

**ITEM 1.****                            ****DESCRIPTIONOF BUSINESS.**

 

TheCompany is engaged in the development, purchase, manufacture, and marketing ofconsumer personal care products and professional dental products, all of whichare targeted for the improved well-being of the human body.  The Company's business is directed to twomain areas:  (a) the development andmarketing of a range of consumer products including over-the-counter items,health and beauty aids, cosmetics and prescription drug products containingcontrolled substances and (b) the manufacture and sale of materials andsupplies for use in the professional dental health field.  For all years presented, revenues, operatingresults and identifiable assets of the consumer products group were in excessof 93% of total Company operations.

 

TheCompany's executive offices are located at 1444 Santa Anita Avenue, South ElMonte, California 91733, and its telephone number is (626) 442-3141. The Company  was incorporated in April 1971 as aCalifornia corporation.

 

**Consumer products segment**

 

TheCompany manufactures and sells lip balm, lip gloss, hair removal products,antacid tablets, nasal care products, artificial fingernail extenders andrelated fingernail products, a variety of over-the-counter items andprescription drug products.  TheCompany's product lines have been developed internally or by outside productline acquisitions.

 

Infiscal 2000, the Company continued the expansion of the Lee® Lip-Ex®line to include 6 new "fun" flavored SPF 15 sticks.  In addition, a new line of lip gloss called"SippersTM" was introduced.  The SippersTM include 6 fun flavored lip glossespackaged in stick format.  The targetmarkets include women and teenagers.** **OnNovemer 15, 1999, the Company purchased Cope®, a tension headacherelief tablet, and Astring-o-Sol®, a concentrated mouthwash, fromU.S. Dermatologics, Inc.  In addition,on January 31, 2000, the Company acquired Serutan®, toastedgranules, a bulk-forming laxative, from Numark Laboratories, Inc.

 

OnOctober 30, 2000, the Company acquired the Sloans® Liniment handpain relief medication from C.B. Fleet Co., Inc.  On February 12, 2001, the Company purchased the Black Draught®laxative product line from The Monticello Companies, Inc.  On August 22, 2001, the Company acquired theDeWitt's® analgesic pills for backache and joint pain relief fromThe Monticello Companies, Inc. Subsequent to fiscal year end 2001, the Company exercised an option toresell the product line back to The Monticello Companies, Inc.  Also, during fiscal 2001, the Companyexpanded its private label offerings to include several major grocery chains,drug wholesalers and retail chains.

 

**Domestic consumer products marketing**

 

Consumer products aresold nationally, principally through major retail drug, food and discountdepartment store chains.  In addition,the Lee® Lip-Ex® lip balm and Aquafilter®brands have national distribution in convenience and independent noveltystores.   Retail distribution isprimarily accomplished through a network of independent general merchandisesales representatives.  All lines areadvertised in a variety of media, including television, magazines andnewspapers.

 

**Consumerproducts competition**

 

The Consumer ProductsDivision of the Company operates in a highly competitive environment.  In the area of fingernail extension andover-the-counter drugs, the Company competes with many companies, most of whichare larger and with greater financial resources.

 

Competition in thedepilatory product category is intense, with competitors even more numerousthan in the artificial fingernail field. The acquisition of Zip Wax and Bikini Bare brands of hair removalproducts has given the Company two brands in this category.

 

The Company continues toexpand its product line via a combination of acquisitions and in-housedevelopment activity.  The Company'sconsumer products line is no longer restricted solely to the cosmeticsbusiness.

 

**Regulation of consumer products**

 

The Company's consumerproducts are regulated by the Food and Drug Administration.  The regulations deal principally withconsumer safety and with the effectiveness of the products for the purposes forwhich they are proposed to be used.  Formany years, the regulations were applied only in cases of adulteration ormisbranding.  Under the Fair Packagingand Labeling Act (1966), the FDA has moved to require new labeling data as toingredients for all consumer products.

 

The Company believesthat all its consumer products are manufactured and sold in compliance with thelaws of each state and that no pre-marketing clearance of its products isrequired from any state.  The Companymaintains a comprehensive data file on each of its consumer products andbelieves that it would be able to apply for any required clearancesexpeditiously if data were ever required for its cosmetic, drug or foodproducts.

 

To the extent theCompany's products are marketed in foreign countries, foreign laws areapplicable as well as FDA regulations which control export of cosmetics.  To date, where regulations have beenestablished by foreign ministries of health which differ from those establishedin the United States, the Company has been able to make acceptablesubstitutions.  As a result, marketingof the products has not been significantly impeded by foreign regulations.

 

Material Safety DataSheets (MSDS) are available on all its consumer finished products.  The MSDSs are supplied to the Company'scustomers upon request.

All products for exportshipped by air or sea which contain listed hazardous materials meet UnitedNations Standards as of January 1991. The requirements are based on the U.N.'s performance-oriented packaging(POP) specifications found in the "Transport of Dangerous Goods"commonly called "The Orange Book".

 

**Dental products segment**

 

Fromits inception in 1971 through 2001, the Company at various times introduceddental products designed to satisfy specific material or supply requirements ofthe practicing dental professional and of the orthodontic and endodonticspecialist.

 

Itsdental product line consists of a variety of restorative materials (fillingmaterials, core build up materials), Beta Quartz glass ceramic inserts,splints, orthodontic brackets, Maryland bridge adhesives, and enamel and dentinbonding materials and related products.

 

In1991, the Company licensed the right to certain patents and technologydeveloped by the American Dental Association Health Foundation through researchit sponsored at the Paffenbarger Center for Excellence in Dental Research atthe National Institute of Technology and Standards for fabricating dentalinserts and inlays of special formulas of Beta Quartz.  The Company has been marketing nine shapesand sizes, and has introduced twenty-six more sizes and shapes which areintended to offer the dentist several new classes of restorations betweenamalgam and composite restorations on the one hand, and laboratory inlays onthe other hand.  Beta Quartz designs areintended to permit the dentist to prepare inlays in one visit, directly at thechairside, without the need for time consuming impressions, or the need forexpensive laboratory work.

 

**Dental marketing in the United States**

 

TheCompany markets its dental, orthodontic and endodontic products in the UnitedStates through telephone solicitation, direct mail, and dental dealers.  The Company plans and executes its ownmarketing programs.

 

**Dental marketing outside the United States**

 

TheCompany markets dental products outside the United States through foreigndental distributors who either solicit individual dentists and orthodontistsand sell the Company's products to them directly for use in the treatment oftheir patients, or sell through local dealers whom they engage to sell the Company'sproducts on their behalf.  The Companyplans and executes its own international marketing programs and regularlydisplays its dental products at international conventions by way of itsdistributors.

 

**Dentalcompetition**

 

Thedental preventive and restorative materials industry is highly competitive, andthe Company's market share in the total industry is insignificant.  The Company competes with largercorporations which have greater financial resources.

 

**Regulation of Dental Products**

 

**Food and Drug Administration**

 

Dental materials areclassified as devices under the Medical Device Amendments of 1976 to theFederal Food, Drug and Cosmetic Act.

 

All the dental deviceproducts marketed by the Company were registered as devices with the FDA at themandatory time (December 31, 1977).  Allnew devices marketed after May 28, 1976, must be processed under the FDApremarketing notification regulation (510 k) for determination of equivalencyto preenactment devices, or the product must be submitted as a new device whichrequires providing considerable extra test data.

 

The Safe Medical DevicesAct (SMDA) became law on November 28, 1990, requiring all serious injuries andserious illness contributed to or caused by medical devices to be reported todistributors, manufacturers and the FDA. SMDA also requires all premarket submissions to the FDA to containadequate information on safety and effectiveness.

 

As required by the FDA,the Company observes certain procedures and policies in the manufacture,quality control, and after-sale monitoring of performance for itsproducts.  Although the various criteriato be used by the FDA in regulating devices have not been finalized, theCompany believes that all of its products and procedures comply with allcurrent and anticipated device regulations. Over half the Company's products fall into the FDA's Class IIclassification which requires that those products must meet certain performancestandards.  The Company believes thatall affected products meet all current performance standards.

 

For those productsplaced in Class II, final marketing approval from the FDA is contingent onfinal acceptance of the Panel's findings and on development of standards (inlarge part being done by the American Dental Association).  It is expected that, based upon currentavailable information, most of the Company's products will meet the standardscurrently anticipated; for the products that do not meet the standards, theCompany will have to submit adequate data directly to the FDA.  Failure to gain approval by the FDA couldimpede the marketing of these devices to the point of removal from the marketuntil such time as clearance is obtained.

 

**Othergovernmental regulations**

 

To the extent theCompany's products are marketed in foreign countries, the Company believes ithas complied with the laws of such countries, and with the FDA regulationswhich control export of devices.  Inthose countries which ban use of certain ingredients, the Company has reformulatedcertain of its products to meet the specifications of that particular country.

 

There is generally worldwide movement to increase and/or streamline the regulations controlling medicaldevices.  The twenty two countries inEurope have consolidated their regulations into a joint code referred to as ISO9000.  This code regulates themanufacture and distribution of medical devices in Europe.  One of the provisions of the code is thatthe Company maintain a quality control system very much like the FDA system,but with some differences.  It appearsthat these differences are being negotiated so that both regulations will beequivalent.

Prior to this time, theCompany generally had to apply to each individual country to obtain permissionto sell in that country.  With theconsolidated regulations, a company needs only to apply to one.  At the moment all test data needed for anapplication must be generated in Europe or validated in Europe.  The resolution of differences between theFDA and the ISO 9000 regulations will probably result in U.S. data beingaccepted in Europe, and vice versa. Whether this consolidation will apply to prescription drugs isuncertain.

 

The Company elected tohave three of its major dental brands obtain the CE markings in order tocontinue to distribute those brands throughout Europe.  The Company received the CE Markings onProsthodent®and Insta-Bond®.

 

The Company believesthat all its dental products are manufactured and sold in compliance with thelaws of each state and country to whom the Company exports and that no premarketingclearance of its products is required from any state.

 

**Departmentof Transportation**

 

TheMaterials Transportation Bureau administers the Hazardous Materials Regulation,effective July 7, 1975.  It has beenascertained that those dental products and components marketed by the Companywhich fall within the provisions of the regulations are brought into complianceby proper labeling and/or filing for exemptions.  The Company believes that it is in full compliance with allbureau regulations applicable to its products and that compliance with theseregulations will not significantly impede the marketing of its products.

 

**Applicableto All Segments**

 

**Foreign and Domestic Operationsand Export Sales**
|                                             |   | **Year  ended September 30** |   |
|--------------------------------------------------|--------|------------------------------|--------|
|                                             |   | **2001**                     |   | **2000** |   | **1999** |   |
|                                             |   | **(000)**                    |   | **(000)** |   | **(000)** |   |
|                                             |   |                         |   |   |   |   |   |
| United  States export sales (except Canada) |   | $                            | 224    |   | $ | 276 |   | $ | 241 |   |
| United  States domestic sales (including Canada) |   | $                            | 9,253  |   | $ | 9,586 |   | $ | 8,779 |   |

 

 

**Research program**

 

The recent Company trend has been in thedirection of brand acquisitions rather than extensive internal research anddevelopment.  Effective July 1996 theCompany eliminated its internal research and development department, anddecided that future testing and research, that cannot be absorbed by itsquality assurance and production control departments, will be placed outsidethe Company.  The Company follows thepolicy of expensing all research and development costs when incurred.  The Company did not have any internalresearch and development expenses during fiscal years September 30, 2001 and2000.

 

**Rawmaterials**

 

The raw materials usedby the Company in the manufacture of most of its dental and consumer productsare obtained from commercial sources where they are presently available insufficient quantities and are refined by the Company as needed for use in itsproducts.  The Company generally carriessufficient amounts of raw materials inventory to meet the delivery requirementsof customers.

 

**Patents and trademarks**

 

                        TheCompany has adopted the policy of making patent disclosures on its products andof filing applications for patents on the products or on aspects of theirmanufacture or use when appropriate. The Company owns nine U.S. patents, including Dental Restoration Systemand Method and owns the rights in a number of other U. S. patent applicationspending.  The Company believes that,while patent protection is desirable in certain areas, it is not essential;therefore, certain foreign patents have been abandoned as not necessary to theinterest of the Company.

 

                        UnitedStates trademarks for the major dental products as well as some consumerproducts, have been granted.  Additionaltrademarks for other products have been applied for, both in the U. S. and inforeign countries.  Trademarks forcertain minor products, or in countries with minor market potential, have beenabandoned as not necessary to the interest of the Company.

 

**Currentregulatory registration**

 

The Company has alicense to manufacture and sell two dental products from the American Dental AssociationHealth Research Foundation, which operates a dental research facility in thecomplex of the National Institute of Standards and Technology.

 

The Company isregistered with the Federal and State of California FDA agencies as amanufacturer and distributor of Drugs, Medical Devices, Processed Foods andCosmetics.  The Company is alsoregistered as a waste generator with the Environmental Protection Agency (EPA).

 

The Company has CECertifications on two dental products which are distributed in Europe:  Prosthodent® VL Core Build UpMaterial and Lee Insta-Bond® Orthodontic Bracket Adhesive.

 

Effective November 23,1998, the Company applied for and was granted a Controlled Substance Licensewith the Drug Enforcement Agency (DEA). The license is issued for one year and grants the Company the right todistribute prescription drug products containing controlled substance (s).  As of February 28, 2001, the Company's DEAlicense was renewed.

 

**Environmentalprotection regulation and litigation**

 

The Company owns amanufacturing facility located in South El Monte, California.  The California Regional Water QualityControl Board (The "RWQCB") ordered the Company in 1988 and 1989 toinvestigate the contamination on its property (relating to soil and groundwatercontamination).  The Company engaged aconsultant who performed tests and reported to the then Chairman of theCompany.  The Company resisted furtherwork on its property until the property upgradient was tested in greater detailsince two "apparent source" lots had not been tested.  On August 12, 1991, the RWQCB issued a"Cleanup and Abatement Order" directing the Company to conductfurther testing and cleanup the site. In October 1991, the Company received from an environmental consultingfirm an estimate of $465,200 for investigation and cleanup costs.  The Company believed that this estimate wasinconclusive and overstated the contamination levels.  The Company believes that subsequent investigations will supportthe Company’s conclusions  about that estimate.  The Company did not complete the testing forthe reasons listed above as well as "financial constraints".  In June 1992, the RWQCB requested that theEPA evaluate the contamination and take appropriate action.  At the EPA's request, Ecology & Environment,Inc. conducted an investigation of soil and groundwater on the Company'sproperty.  Ecology & EnvironmentInc.'s Final Site Assessment Report, which was submitted to the EPA in June1994, did not rule out the possibility that some of the contaminationoriginated on-site, and resulted from either past or current operations on theproperty.  The Company may be liable forall or part of the costs of remediating the contamination on its property.  The EPA has not taken any further action inthis matter, but may do so in the future.

 

The Company and nearbyproperty owners, in consort with their comprehensive general liability (CGL)carriers , engaged a consultant to perform a site investigation with respect tosoil and shallow groundwater contamination over the entire city block.  The CGL carriers provided $290,000 infunding which paid for the $220,000 study, $20,000 in legal fees for projectoversight, and a $50,000 balance in the operating fund.  Earlier the Company had accrued $87,500 asits proportionate share of the earlier quote of $175,000. Since that time, theoverall scope of the project was increased to $205,000 plus $15,000 for wastewater disposal, bringing the total to the above listed $220,000.  The $87,500 accrual was not spent on this project(as the entire cost was borne by the CGL carriers), but remains on the books asan accrual against the cost of remediation of the same site that was includedin the study.

 

The tenants of nearbyproperties upgradient have sued the Company alleging that hazardous materialsfrom the Company's property caused contamination on the properties leased bythe tenants.  The case name is DelRay Industrial Enterprises, Inc. v. Robert Malone, et al., LosAngeles County Superior Court, Northwest District, commenced August 21,1991.  In this action, the plaintiffalleges environmental contamination by defendants of its property, and seeks acourt order preventing further contamination and monetary damages.  The Company does not believe there is anybasis for the allegations and is vigorously defending the lawsuit.

 

The Company's South ElMonte manufacturing facility is also located over a large area of possiblycontaminated regional groundwater which is part of the San Gabriel ValleySuperfund Site.  The Company has beennotified that it is a potentially responsible party  ("PRP")  for thecontamination.   In 1995, the Companywas informed that the EPA estimated the cleanup costs for the South El Monte’sportion of the San Gabriel Valley Superfund Site to be $30 million.  The Company’s potential share of such amounthas not been determined.  Superfund PRPsare jointly and severally liable for superfund site costs, and are responsiblefor negotiating among themselves the allocation of the costs based on, amongother things, the outcome of environmental investigation.

 

In August 1995, theCompany was informed that the EPA entered into an Administrative Order ofConsent with Cardinal Industrial Finishes ("Cardinal") for a PRP leadremedial investigation and feasibility study (the "Study") which, theEPA states, will both characterize the extent of groundwater contamination inSouth El Monte and analyze alternatives to control the spread ofcontamination.  The Company and othersentered into the South El Monte Operable Unit Site Participation Agreement withCardinal pursuant to which, among other things, Cardinal contracted with anenvironmental firm to conduct the Study. The Study has been completed. The Company's share of the cost of the Study was $15,000 and was accruedfor in the financial statements as of September 30, 1995.  The South El Monte Operable Unit (SEMOU)participants developed four remedial alternatives.  The capital cost of the four alternatives range from $0 (noaction) up to $3.49 million.  Theestimated annual operating cost for the four alternatives range from $0 (noaction) to $770,300.  Over a 30-yearperiod, the total cost of the four alternatives range from $0 (no action) up to$13.05 million.  The EPA prefers analternative which estimates the capital cost up to $3.08 million, the annualoperating cost at $.48 million, and the 30-year period total cost up toapproximately $9.09 million.  Theselection of the actual alternative implemented is subject to publiccomment.  At the present time, the Companydoes not know what its share of the cost may be, if any.  Therefore, no additional accrual has beenrecognized as a liability on the Company's books.  The Company requested that the EPA conduct an"ability-to-pay evaluation" to determine whether the Company isentitled to an early settlement of this matter based upon a limited ability topay costs associated with site investigation and remediation.  In August 2000, the EPA informed the Companythat it does not qualify for an early settlement at this time.

 

The EPA has informed theCompany that it has learned that the intermediate zone groundwatercontamination in the western portion of the SEMOU has migrated further west andhas now impacted the City of Monterey Park and Southern California WaterCompany production wells.  The EPAstated that the City of Monterey Park Water Department, San Gabriel ValleyWater Company and Southern California Water Company are planning to buildtreatment facilities for their wells. The EPA stated that these three water purveyors contacted some of theSEMOU PRPs, other than the Company, to seek funding to develop groundwatertreatment facilities for the contaminated wells.  A group of these PRPs calling themselves the "South El MonteCooperative Group" has been formed and purportedly has reached a generalagreement with the water purveyors to fund the development of treatmentfacilities and

use the water purveyors' wells in anattempt to contain the groundwater contamination to meet EPA's goals.  At this time, the EPA has not reviewed orapproved any specific plan to address contamination at the purveyor wells, norhas the EPA compromised its right to recover response costs from any person whois legally responsible for contamination within the SEMOU.  As of the date of this report, the Companyhas not been contacted by the South El Monte Cooperative Group in respect toits participation in any proposed cleanup activity.  As a result, the Company is not able to determine what contribution,if any, it may be assessed in connection with this cleanup activity.

 

By letter dated November13, 2000, the Company was notified that the City of Monterey Park, San GabrielValley Water Company and Southern California Water Company intend to bring suitunder the Safe Drinking Water and Toxic Enforcement Act of 1986 alleging thatthe Company has knowingly released volatile organic compounds in the soil andshallow groundwater beneath the Company's property between at least on orbefore November 8, 1996 and the present and has failed to promptly clean up allof the contamination.  As of the date ofthis report, the Company has not been served with this lawsuit.

 

The City of South ElMonte, the city in which the Company has its manufacturing facility, is locatedin the San Gabriel Valley.  The SanGabriel Valley has been declared a Superfund site.  The 1995 Water Quality Control Plan issued by the CaliforniaRegional Water Quality Control Board states that the primary groundwater basinpollutants in the San Gabriel Valley are volatile organic compounds fromindustry, nitrates from subsurface sewage disposal and past agriculturalactivities.  In addition, the Plan notedthat hundreds of underground storage tanks leaking gasoline and other toxicchemicals have existed in the San Gabriel Valley.  The California Department of Toxic Substance Control has declaredlarge areas of the San Gabriel Valley to be environmentally hazardous andsubject to cleanup work.

 

The Company believes theCity of South El Monte does not appear to be located over any of the majorplumes.  However, the EPA has announcedit is studying the possibility that, although the vadose soil and groundwater,while presenting cleanup problems, there may be a contamination by DNAPs (densenon-aqueous phase liquids), i.e., "sinkers", usually chlorinatedorganic cleaning solvents.  The EPA hasproposed to drill six "deep wells" throughout the City of South ElMonte at an estimated cost of $1,400,000. The EPA is conferring with SEMPOA (South El Monte Property OwnersAssociation) as to cost sharing on this project.  SEMPOA has obtained much lower preliminary cost estimates.  The outcome cost and exact scope of this areunclear at this time.

 

The Company and otherproperty owners engaged Geomatrix Consultants, Inc., to do a survey of vadosesoil and shallow groundwater in the "hot spots" detected in theprevious studies.  Geomatrix issued areport dated December 1, 1997 (the “Report”), on the impact of volatile organiccompounds on the soil and groundwater at the Lidcombe and Santa Anita Avenue sitelocated in South El Monte, California (which includes the Company’sfacilities).  The Report indicatedgenerally low concentrations of tetrachloroethene, trichloaethene andtrichloroethane in the groundwater of the upgradient neighbor.  The Report was submitted to the RWQCB forits comments and response.  A meetingwith the parties and RWQCB was held on February 10, 1998.  The RWQCB had advised companies that vadosesoil contamination is minimal and requires no further action.  However, there is an area of shallowgroundwater which has a higher than desired level of chlorinated solvents, andthe RWQCB requested a proposed work plan be submitted by Geomatrix.  Geomatrix has submitted a "FocusedFeasibility Study" which concludes that there are five possible methodsfor cleanup.  The most expensive are fora pump and sewer remediation which would cost between $1,406,000 and$1,687,000.  The Company is activelyexploring the less expensive alternative remediation methods, of which the twoproposed alternatives range in cost between $985,000 and $1,284,000.  Since there are four economic entitiesinvolved, the Company's best estimate at this time, in their judgment, would bethat their forecasted share would be $287,000 less the liability alreadyrecognized on the books of $165,000 thereby requiring an additional $122,000liability.  Accordingly, the Companyrecorded an additional accrual of $122,000 in the third quarter of fiscal1998.  The $122,000 accrual is inaddition to the $79,000 accrual for the Monterey Site as will be explained inthe following paragraph.  The $79,000accrual, in the third quarter of fiscal 1998, related to the Monterey Site isnot included in the $287,000 figure above. In April 2000, the Company received a Notice of Violation from theRWQCB.  The Notice of Violation statesthat the Company and other property owners were required to submit agroundwater remedial action plan by November 1, 1999, and that the RWQCB hasbeen advised that the Company and the other property owners were unable tosubmit the required remedial action plan because the Company and the otherproperty owners could not agree on the allocation of financial responsibilityto prepare the action plan.  The RWQCBstated that it will no longer encourage the cooperative approach among theCompany and the other property owners in completing the cleanup requirementsand will pursue appropriate measures, including when necessary, enforcementactions.  The RWQCB states that it mayimpose civil liability penalties of up to $1,000 per day from November 1, 1999for failure to file the action plan.  Inlight of these events, no assurances can be given that the cleanup costs andpossible penalties will not exceed the amount of the Company's current accrualsof $287,000 (which includes the $122,000 charge to income in the third quarterof fiscal 1998).

 

In July 2000, theproperty owners formed the Lidcombe & Santa Anita Avenue Work Group (LSAAW)in response to the RWQCB request for the preparation of an action plan.  The LSAAW submitted a Focused FeasibilityStudy to the RWQCB for their review and approval of the selected remedialaction method for the site.  Afterreceiving RWQCB approval, LSAAW obtained three cost proposals to implement theRWQCB approved pump and treat remedial method. According to these cost proposals, the lowest estimated costs for anassumed five (5) years of pump and treat remediation is $600,000.  This cost is lower than the previous costproposed work plan, discussed above, from Geomatrix Consultants, Inc.  The capital costs including contingenciesare approximately $300,000.

 

The LSAAW is hopeful theWater Quality Authority (WQA) is willing and able to reauthorize its grant forone-half (1/2) of the capital costs of its remediation system construction notto exceed $150,000.  It is estimated atthis time that the reserves for the Company's share of this cost proposal areadequate since its prior accrual was based on the higher cost estimate fromGeomatrix.

 

Without any priorcorrespondence or inkling of the Company's potential liability, the EPAinformed the Company that the Company may have potential liability for theongoing remediation of Operating Industries, Inc. (as they have gone out ofbusiness) Landfill Superfund Site in Monterey Park, California (the "MontereySite").  The Monterey Site is a 190acre landfill that operated from 1948 to 1984, in which the Company disposed ofnon toxic pH balanced waste water on six occasions between 1974 and 1978.  Over 4,000 companies have been identified ashaving contributed waste to the Monterey Site. The EPA has offered to settle the Company's potential liability withrespect to the Monterey Site for a cost to the Company of $79,233.  The Company accrued a $79,000 charge in thethird quarter of fiscal 1998 with respect to this possible liability.  The Company has elected to file for relieffrom these obligations under the financial hardship option in the EPA'sresponse form.  On June 30, 2000, theEPA informed the Company that the EPA believed the Company is able to pay thefull settlement cost, but offered to reduce the amount of the settlement to$75,271.

 

The Company was notifiedby the EPA that the Company may have potential liability for waste material itdisposed of at the Casmalia Disposal Site ("Site") located on a252-acre parcel in Santa Barbara County, California.  The Site was operational from 1973 to 1989, and over 10,000separate parties disposed of waste there. The EPA stated that federal, state and local governmental agencies alongwith the numerous private entities that used the Site for waste disposal willbe expected to pay their share as part of this settlement.  The U.S. EPA is also pursuing theowner(s)/operator(s) of the Site to pay for Site remediation.  The EPA has a settlement offer to the Companywith respect to the Site for a cost of $373,950.  The Company accrued a $374,000 charge in the first quarter offiscal 1999 with respect to this possible liability.  The Company has elected to file for relief from these obligationsunder the financial hardships option in the EPA's response form.  The Company, the EPA and certain PRPs haveentered into an agreement tolling the applicable statutes of limitation.  The Company has been notified by the EPAthat their request for a waiver, due to financial hardship, was "partiallygranted."  Improvements in thebidding process has lowered the Company's estimated share down to $245,000(from $374,000) and of that, the EPA was requesting that the Company pay $113,000,as a result of their findings on the application for waiver due to financialhardship.  The Company is consideringthe EPA's request.

 

The total amount ofenvironmental investigation and cleanup costs that the Company may incur withrespect to the foregoing is not known at this time.  However, based upon information available to the Company at thistime, the Company has expensed since 1988 a total of $860,000, of which $89,000were legal fees, exclusive of legal fees expended in connection with the SECenvironmental investigation.  The actualcosts could differ materially from the amounts expensed for environmentalinvestigation and cleanup costs to date.

 

As of September 30,2001, no additional amounts have been incurred and no settlements have beenreached.

 

**Other regulations**

 

                        Duringthe last several years, several state, local and federal agencies havefinalized or proposed regulations relating to hazardous materials. Theseinclude Los Angeles County Hazardous Materials Business Plan, California andfederal OSHA "right to know" laws, EPA "community right toknow" laws and Extremely Hazardous Substance Regulations, Los AngelesCounty's program for monitoring and closing underground tanks, the CaliforniaSafe Drinking and Toxic Enforcement Act of 1986 (Prop 65), CaliforniaConnelly-Sterling Toxic Hot Spots Information Act  and AQMD's New Source of Carcinogenic Air Contaminants (Rule1401).  The Company believes it is incompliance with these regulations that are in effect and is anticipating itwill be in compliance with those of these acts yet to be finalized.

 

                        TheInternal Standards Organization in September 1996 released specifications (ISO14000) for companies to use as guidelines in reducing worldwide contaminationand improving on recycling operations. The Company believes that demonstrating that the Company meets thesespecifications is good citizenship and also in time will be necessary forinternational trade.  The Company isproceeding to apply for an ISO 14000 rating.

 

**Employees**

 

The Company's work forceof 82 presently includes 31 permanent employees, both salaried and hourly, and51 personnel leased through employment agencies.

 

**Other**

 

The Company is notdependent upon any one supplier for any important raw material item.  Most raw material items are commodities andreadily available in the market.  Inmost instances, the Company utilizes two or more suppliers to furnish rawmaterials as needed.  Sources arebelieved to be sufficient to satisfy current and anticipated needs.

 

Demand for some of theCompany's principal product lines is not seasonal.  The depilatory line of products is, however, generally seasonal,with demand significantly higher during the spring and summer months.

 

Although the Companydoes not believe that it is dependent upon any one customer or distributor, acustomer accounted for 10% and 16% of the Company's net revenues during fiscal2001 and 2000, respectively.  No othercustomer accounted for 8% or more of the Company's net revenues for thosefiscal years.

 

Backlog is not asignificant factor in the Company's business. Most orders are filled immediately and in any event, are cancelableunder certain conditions.  There are nomaterial contracts with distributors.

 

Consumer ProductsDivision returns must include proof of purchase, sales receipt and a writtenexplanation of the reason for the return. The Company generally provides credits for replacement of product,however, on occasion it may provide a cash refund.

 

In addition,discontinued or overstocked items may be returned once the customer receives acomputer printed "return authorization" and "shippinglabels" for full case stock of factory fresh product to be sent freightprepaid to the Company's warehouse.  Thecustomer will not receive credit for additional merchandise that may have beenadded to the return.

The Company's salesreturn policy for the Dental Division, is as follows: "products returnedto Lee Pharmaceuticals for credit must be sent postage paid and within 90 daysof purchase".  Defective merchandisecan be replaced free of charge at any time prior to the date ofexpiration.  Excessively used orimproperly stored merchandise is not eligible for replacement.

 

**ITEM 2.****                            ****DESCRIPTION OF PROPERTY.**

 

TheCompany occupies, through ownership or lease, seven buildings on contiguouslots in South El Monte, California. The Company owns the following:

 
| **Address**              |   | **Approximate** **square****footage** |   | **Usage**                        |
|--------------------------|--------|--------------------------------------------|--------|----------------------------------|
|                     |   |                                       |   |                             |
| 1428  Santa Anita Avenue |   | 10,400                                     |   | Chemical  processing and filling |

 

The Company leases thefollowing:

 
| **Address**                   |   | **Approximate  square  footage** |   | **Aggregate  annual  rental** |   | **Lease  expiration  date** |   | **Usage**                                                                                                                                                         |   |
|-------------------------------|--------|----------------------------------|--------|-------------------------------|--------|-----------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                          |   |                             |   |                          |   |                        |   |                                                                                                                                                              |   |
| 1434 Santa Anita  Avenue      |   | 11,200                           |   | $62,748*                      |   | 11/30/2005                  |   | Inventory  control, personnel, data processing, accounting offices and dental  production/shipping.                                                               |   |
|                          |   |                             |   |                          |   |                        |   |                                                                                                                                                              |   |
| 1460 Santa Anita  Avenue (1)  |   | 14,560                           |   | 81,576*                       |   | 11/30/2005                  |   | Effective  January 15, 1996, the building was subleased.                                                                                                          |   |
|                          |   |                             |   |                          |   |                        |   |                                                                                                                                                              |   |
| 1470 Santa Anita  Avenue (2)  |   | 8,400                            |   | 47,062*                       |   | 11/30/2005                  |   | Effective  July 16, 1996, the building was subleased.                                                                                                             |   |
|                          |   |                             |   |                          |   |                        |   |                                                                                                                                                              |   |
| 1500 Santa Anita  Avenue      |   | 17,600                           |   | 98,604*                       |   | 11/30/2005                  |   | Warehouse,  consumer packaging operations, injection molding and corrugated printing.                                                                             |   |
|                          |   |                             |   |                          |   |                        |   |                                                                                                                                                              |   |
| 1516 Santa Anita  Avenue      |   | 17,600                           |   | 98,604*                       |   | 11/30/2005                  |   | Sales/marketing  offices, purchasing, consumer shipping, and warehouse.                                                                                           |   |
|                          |   |                             |   |                          |   |                        |   |                                                                                                                                                              |   |
| 1444 Santa Anita  Avenue (3)  |   | 9,800                            |   | 73,800*                       |   | 11/30/2005                  |   | Executive  office, consumer production, quality control and bottle printing.                                                                                      |   |
|                          |   |                             |   |                          |   |                        |   |                                                                                                                                                              |   |
| 1427 Lidcombe Avenue          |   | 6,000                            |   | 33,616*                       |   | 11/30/2005                  |   | Maintenance  and chemical processing (rear building).                                                                                                             |   |
|                          |   |                             |   |                          |   |                        |   |                                                                                                                                                              |   |
| 1425 Lidcombe Avenue          |   | 6,000                            |   | 33,616*                       |   | 11/30/2005                  |   | Chemical  processing and packaging.                                                                                                                               |   |
|                          |   |                             |   |                          |   |                        |   |                                                                                                                                                              |   |
| 1445 Lidcombe Avenue  (3) (4) |   | 9,200                            |   | 69,288*                       |   | 11/30/2005                  |   | As  of November 1996, the sublessee is on a month to month agreement with a  45-day advance notice to relocate.   The gross monthly rental income is $4,322. |   |

 

*                 Revisedbiannually for consumer price index change.

 

(1)          TheCompany entered into a sublease agreement, effective December 1, 2000, which expiresNovember 30, 2002.  The gross annualrental income is $87,360.  This newsublease replaces the sublease which expired November 30, 2000.

 

(2)          TheCompany entered into a sublease agreement, effective April 1, 2001, whichexpires November 30, 2005.  The grossannual rental income is $49,392.  Thisnew sublease replaces the sublease which expired November 30, 2000.

 

(3)          Thisproperty is treated as a sale leaseback agreement between the Company andRonald G. Lee, President.  The monthlylease payments were set at the prevailing rates in the area at the time theleases were written.

 

(4)          Thegross monthly rental income is $4,322. Effective November 8, 2001, the gross monthly rental income will be$4,598.  The Company will continue tosublease the building until the owner can locate a buyer or the Company givesnotice to the tenant and takes back the facility to expand its operations.

 

All of the Company'sbusiness segments use the properties owned or leased by the Company except for1470 Santa Anita Avenue (sublease expires November 30, 2005), 1460 Santa AnitaAvenue (sublease expires November 30, 2002), and 1445 Lidcombe Avenue(subleased effective November 8, 1995).

 

The Company has a rightof first refusal to acquire most of the buildings which it leases.

 

The Company believesthat its existing facilities are adequate to enable it to continue to produceits products at their present volume together with any moderate increasesthereto.

 

**ITEM 3.****                            ****LEGALPROCEEDINGS.**

 

Inthe ordinary course of its business, the Company is involved from time to timein litigation.  In the opinion ofmanagement of the Company none of the litigation currently pending will have amaterial effect on its business or financial condition.  See Item I – "Applicable to AllSegments - Environmental protection regulation and litigation" foradditional information concerning certain litigation.

 

**ITEM 4.****                            ****SUBMISSION OF MATTERS TO A VOTEOF SECURITY HOLDERS.**

 

Not applicable.

 

 

**PART II**

 

**ITEM 5.****                            ****MARKETFOR COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS.**

 

The Company’s CommonStock trades on the electronic over-the-counter bulletin board under thetrading symbol LPHM.  For the two mostrecent fiscal years, its shares have closed at high and low trading prices asfollows:

 

|        |   | **QTR** |   | **High** |   | **Low** |   |
|-------------|--------|---------|--------|----------|--------|---------|--------|
| **FY 2001** |   | 1Q      |   | $        | .2100  |    | $      | .1575 |   |
|        |   | 2Q      |   | .2000    |   | .1500   |   |
|        |   | 3Q      |   | .1800    |   | .1300   |   |
|        |   | 4Q      |   | .1600    |   | .1300   |   |
| **FY 2000** |   | 1Q      |   | $        | .2300  |    | $      | .1600 |   |
|        |   | 2Q      |   | .8500    |   | .1600   |   |
|        |   | 3Q      |   | .3200    |   | .1800   |   |
|        |   | 4Q      |   | .2200    |   | .1800   |   |

 

There were approximately 722 shareholders ofrecord of the Company's Common Stock as of the close of business on September30, 2001.

 

The Company has not paid any cash dividends andhas no present intention of paying cash dividends in the foreseeable future.

 

**ITEM 6.****                            ****MANAGEMENT'SDISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS.**

 

**Fiscal years ended September 30, 2001, and September 30, 2000**

 

In fiscal 2001, netrevenues decreased 4% to $8,469,000 from $8,801,000 in fiscal 2000.  The decrease in net revenues was attributedto a reduction in sales of Take-Off® ($286,000), depilatories($248,000), Aquafilter® ($123,000) and other over-the-counter items($535,000).  The decrease in netrevenues was partially offset by the higher sales volume generated from the Lee®Lip-Ex® lip balm ($634,000) plus the volume from newly acquiredbrands such as: Black Draught® and Sloans® (totaling$149,000).  In addition, the Companyreported a sales volume increase in Nosebetter® ($55,000).  The Company's sales returns decreasedapproximately $53,000 or 5% when comparing fiscal years 2001 and 2000.  The Company continued to experience thediscontinuance of a few of the Company's SKUs (stock keeping units) at the retail store level.  However, the expansion efforts into theconvenience and independent novelty stores has been positive.

 

Cost of sales as apercentage of gross revenues for fiscal 2001 and 2000 was 46% and 43%respectively.  The higher cost of salespercentage was due to a change in the product mix and lower pricedcommodity-type goods with an accompanying higher cost of goods attached tothem, thereby generating lower gross margins on sales of these relatedproducts.  In addition, the Companyincurred higher raw material costs, increased direct labor costs as a result ofa rise in the minimum hourly wage ($6.25 effective January 1, 2001 versus$5.75) and increased building rental expense due to a Consumer Price Index(CPI) adjustment.

 

Selling and advertisingexpenses decreased $360,000 or 13% when comparing fiscal years 2001 and2000.  The decreased expenses wereprimarily due to the following factors: (1) lower amortization expense($391,000) because of the finalization of several write-off periods associatedwith prior product brand acquisitions, (2) less royalty expenses ($37,000) and(3) lower sales aid expenses ($34,000). The above decreases were partially offset by increases in: (1) highersalesmen salaries and related fringe benefits due to the hiring of two highersalaried salesmen who replaced lower salaried sales personnel ($78,000), (2)increased travel and entertainment expenses ($38,000) and (3) increasedconvention/show expense ($36,000) as a result of more shows attended.

 

General andadministrative expenses increased $29,000 or 3% when comparing fiscal years2001 and 2000.  This increase wasprincipally due to: (1) higher building rental expenses as a result of aConsumer Price Index (CPI) adjustment ($9,000), (2) increased printing materialcosts ($8,000) and (3) higher bank analysis charges plus credit cardstransaction charges due to more payments made by credit cards ($6,000).

Interest expensedecreased $69,000 or 8% when comparing fiscal years 2001 and 2000.  This decrease was due to reduced borrowingsfrom the Company's related parties along with a lower average prime interestrate (8.08% versus 8.92%) in reference to certain loans which are tied toprime, and reduced borrowings from the Company's asset based financing lender.

 

Gain on sale ofbuildings relates to the sale leaseback arrangement since 1991 whereby theCompany is recognizing a constant deferred gain over the lease term.  The remaining balance of $11,000 wasrecognized as deferred gain in fiscal 2001.

 

Other income increased$71,000 or 71% to $70,000 from a $1,000 loss when comparing fiscal years 2001and 2000, respectively.  Thissignificant increase was primarily attributed to the gain from the sale of oneof the Company's prior (September 1997) product acquisitions.

 

The Company recognized$124,000 of extraordinary income in the fourth quarter of fiscal 2001.  The extraordinary income of $124,000 wasrelated to the extinguishment of debt associated with a note payable - relatedparty and renegotiation of two notes payable pertaining to prior product lineacquisitions.  There was no comparableextraordinary item during fiscal 2000.

 

The Company accrued a$374,000 charge in the first quarter of fiscal year 1999, as an extraordinaryitem, with respect to a possible liability. The Company was notified by the EPA that the Company may have potentialliability for waste material it disposed of at the Casmalia Disposal Site("Site") located on a 252-acre parcel in Santa Barbara County,California.  The EPA stated thatfederal, state and local governmental agencies along with the numerous privateentities that used the Site for waste disposal will be expected to pay theirshare as part of this settlement.  TheEPA has a settlement offer to the Company with respect to the Site for a costof $373,950.  The Company has elected tofile for relief from these obligations under the financial hardships option inthe EPA's response form.  The Company,the EPA and certain PRPs have entered into an agreement tolling the applicablestatutes of limitation.  The Company hasbeen notified by the EPA that their request for a waiver, due to financialhardship, was "partially granted." Improvements in the bidding process has lowered the Company's estimatedshare down to $245,000 (from $374,000) and of that, the EPA was requesting thatthe Company pay $113,000, as a result of their findings on the application forwaiver due to financial hardship.  TheCompany is considering the EPA's request.

 

**Liquidity and capital resources**

 

Working capital was anegative $l,750,000 at September 30, 2001, as compared with a negative$2,332,000 at September 30, 2000.  Theincrease in working capital of $582,000 was basically due to a decrease incurrent liabilities of $1,006,000 (current portion - notes payable, other), thelowering of current debt associated with acquisitions and a reduction in bankoverdraft ($265,000).  Current assetsshowed a decrease in accounts receivable and deposits.  These decreases were partially offset by theincrease in inventories.  The ratio ofcurrent assets to current liabilities was .7 to 1 at September 30, 2001 and .6to 1 at September 30, 2000.

 

In comparing fiscalyears 2001 and 2000, accounts receivable turnover increased (9.2 versus 9.0)and the number of day's sales were in average accounts receivable improved (32days versus 33 days).  This data wasrelatively constant during fiscal years 2001 and 2000 due to continuedcollection efforts.  Accounts payable asa percentage of total costs and expenses remained constant at 12% in fiscal2001 and 2000.

 

The increase ininventory of $122,000 was due to the added inventory acquired from product lineacquisitions.

 

Effective February 20,2001, the Company renewed its accounts receivable financing, maturing May 2003,whereby 75% of the eligible domestic accounts receivable, not to exceed thegreater of $1,400,000 or $1,400,000 less amounts advanced on inventory, can beadvanced.  The agreement is renewablefor successive one year periods thereafter. Also, the agreement requires minimum monthly interest of $3,000 with aninterest rate of 8% above Union Bank of California's prime rate.  The financing agreement includes a $300,000term loan on inventory which is incorporated in the working capital line ofcredit above.  The inventory term loanrequires monthly payments of $5,000 with an interest rate of 8% above UnionBank of California's prime rate. Additionally, there is a separate $400,000 term loan on the Company'sequipment.  This financing is secured bya security interest in all of the Company's assets and requires monthlypayments of $10,000 plus interest at Union Bank of California's prime rate plus8%.  The continuing personal guaranteeby the Company's President, of obligations of the Company, remains in force.

 

On March 16, 2001, theCompany received an additional equipment term loan of $100,000.  This financing is secured by a securityinterest in the Company's equipment and requires monthly payments of $4,166plus interest at Union Bank of California's prime rate plus 8%.  Principal payments of $4,166 plus interestcommenced on May 1, 2001, and will continue thereafter on the first day of eachmonth, and one final payment on May 20, 2003.

 

See "Business -Applicable to All Segments - Environmental protection regulation andlitigation" for a description of certain environmental matters relating tothe Company.

 

The Company has anaccumulated deficit of $7,212,000.  TheCompany’s past recurring losses and fiscal 2001 and 2000's nominal profits fromoperations and inability to generate sufficient cash flow from normaloperations to meet its obligations as they come due raise substantial doubtabout the Company’s ability to continue as a going concern.  The Company’s ability to continue inexistence is dependent upon future developments, including retaining currentfinancing and achieving a level of profitable operations sufficient to enableit to meet its obligations as they become due.

 

The Company does notbelieve that inflation had a significant impact on its operations during fiscalyears 2001 and 2000.

 

**ITEM 7.****                         ****FINANCIALSTATEMENTS.**

 
|                                                       |
|------------------------------------------------------------|
| **Index  to Financial Statements**                         |
|                                                       |
| Independent Auditor's  Report                              |
|                                                       |
| Financial  Statements:                                     |
|                                                       |
| Balance sheet as of September 30, 2001                     |
|                                                       |
| Statements  of operations for the years ended              |
| September  30, 2001 and September 30, 2000                 |
|                                                       |
| Statements of  stockholders' (deficit) for the years ended |
| September 30,  2001 and September 30, 2000                 |
|                                                       |
| Statements  of cash flows for the years ended              |
| September  30, 2001 and September 30, 2000                 |
|                                                       |
| Notes to financial  statements                             |

 

Allschedules not filed or included herein are omitted either because they are notapplicable or not required, or the required information is included in thefinancial statements or notes thereto.

 

 

 

***Caldwell, Becker, Dervin, Petrick &Co., L.L.P.***

***CERTIFIED PUBLIC ACCOUNTANTS***

 

 

 

 

INDEPENDENT AUDITOR'SREPORT

 

 

 

Tothe Board of Directors and Stockholders

ofLee Pharmaceuticals

 

Wehave audited the accompanying balance sheet of Lee Pharmaceuticals (aCalifornia corporation) as of September 30, 2001, and the related statements ofoperations, stockholders' (deficit), and cash flows for each of the years inthe two-year period then ended.  Thesefinancial statements are the responsibility of the Company's management.  Our responsibility is to express an opinionon these financial statements based on our audit.

 

Weconducted our audit in accordance with auditing standards generally accepted inthe United States of America.  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that our auditprovides a reasonable basis for our opinion.

 

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the financial position of Lee Pharmaceuticals as ofSeptember 30, 2001, and the results of its operations and its cash flows foreach of the years in the two-year period then ended, in conformity withaccounting principles generally accepted in the United States of America.

 

Theaccompanying financial statements have been prepared assuming that the Companywill continue as a going concern.  Asdiscussed in Note 1 to the financial statements, the Company has not shown atrend for generating sufficient net income and cash flow from normal operations.  Those conditions raise substantial doubtabout its ability to continue as a going concern.  Management's plans regarding those matters are also described inNote 1.  The financial statements do notinclude any adjustments that might result from the outcome of this uncertainty.

 

Asdiscussed in Note 11 to the financial statements, the Company is named inseveral environmental remediation actions. Although the Company has accrued a liability in the amount of $740,000,the total costs of these actions cannot be presently determined.

 

 

 

 

CALDWELL,BECKER, DERVIN, PETRICK & CO., L.L.P.

 

Caldwell,Becker, Dervin, Petrick & Co., L.L.P.

WoodlandHills, California

December7, 2001

 

 

 

 

20750Ventura Boulevard, Suite 140 **.** WoodlandHills, CA 91364

(818)704-1040 **.** (323) 873-1040 **.**FAX (818) 704-5536

 

**LEEPHARMACEUTICALS**

 

**BALANCE SHEET**

(roundedto thousands)

 

**SEPTEMBER30, 2001**

 

**ASSETS**

 

 
| **CURRENT ASSETS**:                                                                                            |   |       | ** ** |
|----------------------------------------------------------------------------------------------------------------|--------|------------|------------|
| Cash                                                                                                           |   | $          | 5,000      |   |
| Accounts receivable,  less allowance for doubtful accounts of $57,000 and sales returns allowance  of $271,000 |   | 749,000    |       |
| Inventories                                                                                                    |   | 2,409,000  |       |
| Deposits                                                                                                       |   | 279,000    |       |
| Other current assets                                                                                           |   | 43,000     |       |
| **Total current assets**                                                                                       |   | 3,485,000  |       |
|                                                                                                           |   |       | ** ** |
| **Property, plant and equipment,  at cost**:                                                                   |   |       | ** ** |
| Land                                                                                                           |   | 49,000     |       |
| Building                                                                                                       |   | 217,000    |       |
| Machinery and equipment                                                                                        |   | 5,092,000  |       |
| Leasehold improvements                                                                                         |   | 377,000    |       |
|                                                                                                           |   | 5,735,000  |       |
| Less accumulated  depreciation and amortization                                                                |   | (5,173,000 | )          |
| **Net property, plant and equipment**                                                                          |   | 562,000    |       |
| **Other assets:**                                                                                              |   |       |       |
| Intangible assets, net  of accumulated amortization of $2,838,000                                              |   | 2,958,000  |       |
| Non-current deposits                                                                                           |   | 46,000     |       |
| **Total other assets**                                                                                         |   | 3,004,000  |       |
|                                                                                                           |   |       |       |
| **Total**                                                                                                      |   | $          | 7,051,000  |   |
|                                                                                                           |   |       |       |
| **LIABILITIES  AND STOCKHOLDERS' (DEFICIT)**                                                                   |
|                                                                                                           |   |       |       |
| **Current liabilities:**                                                                                       |   |       |       |
| Bank overdraft                                                                                                 |   | $          | 85,000     |   |
| Notes payable - bank                                                                                           |   | 862,000    |       |
| Current portion -  notes payable, other                                                                        |   | 946,000    |       |
| Current portion - note  payable related party                                                                  |   | 670,000    |       |
| Accounts payable                                                                                               |   | 911,000    |       |
| Accrued  liabilities                                                                                           |   | 433,000    |       |
| Environmental cleanup  liability                                                                               |   | 366,000    |       |
| Due to related parties                                                                                         |   | 854,000    |       |
| Deferred income                                                                                                |   | 108,000    |       |
| **Total current liabilities**                                                                                  |   | 5,235,000  |       |
|                                                                                                           |   |       |       |
| **Long-term notes  payable - bank**                                                                            |   | 488,000    |       |
| **Long-term notes  payable to related parties**                                                                |   | 2,133,000  |       |
| **Long-term notes  payable, other**                                                                            |   | 1,201,000  |       |
| **Environmental cleanup liability -  casmalia site**                                                           |   | 374,000    |       |
| **Deferred income**                                                                                            |   | 197,000    |       |
| **Total liabilities**                                                                                          |   | 9,628,000  |       |
|                                                                                                           |   |       |       |
| **Commitments and  contingencies**                                                                             |   |       |       |
|                                                                                                           |   |       |       |
| **Stockholders' (deficit)****:**                                                                               |   |       |       |
| Common stock, $.10 par  value; authorized 7,500,000 shares; issued and outstanding, 4,135,162 shares           |   | 413,000    |       |
| Additional paid-in  capital                                                                                    |   | 4,222,000  |       |
| Accumulated (deficit)                                                                                          |   | (7,212,000 | )          |
| **Total stockholders' (deficit)**                                                                              |   | (2,577,000 | )          |
|                                                                                                           |   |       |       |
| **Total**                                                                                                      |   | $          | 7,051,000  |   |

 

 

Theaccompanying notes are an integral part of the financial statements.

 

**LEEPHARMACEUTICALS**

 

**STATEMENTS OF OPERATIONS**

(roundedto thousands)

 

**FOR THEYEARS ENDED SEPTEMBER 30,**

 

 
|                                                     |   | **2001**   |      | **2000**   |   |
|----------------------------------------------------------|--------|------------|-----------|------------|--------|
|                                                     |   |       |      |       |   |
| **GROSS  REVENUES**                                      |   | $          | 9,477,000 |       | $      | 9,862,000 |   |
| Less:  Sales returns, discounts and allowances      |   | (1,008,000 | )         | (1,061,000 | )      |
|                                                     |   |       |      |       |   |
| **Net revenues**                                         |   | 8,469,000  |      | 8,801,000  |   |
|                                                     |   |       |      |       |   |
| **Costs and expenses:**                                  |   |       |      |       |   |
| Cost of sales                                            |   | 4,386,000  |      | 4,205,000  |   |
| Selling and  advertising                                 |   | 2,312,000  |      | 2,672,000  |   |
| General and  administrative                              |   | 1,142,000  |      | 1,113,000  |   |
|                                                     |   |       |      |       |   |
| **Total costs and expenses**                             |   | 7,840,000  |      | 7,990,000  |   |
|                                                     |   |       |      |       |   |
| **Operating income**                                     |   | 629,000    |      | 811,000    |   |
| **Interest expense**                                     |   | (790,000   | )         | (859,000   | )      |
| **Gain****on sale of fixed assets**                      |   | 14,000     |      | 65,000     |   |
| **Ot****her income (loss)**                              |   | 70,000     |      | (1,000     | )      |
|                                                     |   |       |      |       |   |
| **Net (loss) income before  extraordinary item**         |   | (77,000    | )         | 16,000     |   |
| **Extraordinary iTEM**                                   |   | 124,000    |      | -          |   |
|                                                     |   |       |      |       |   |
| **Net income**                                           |   | $          | 47,000    |       | $      | 16,000 |   |
|                                                     |   |       |      |       |   |
| **Per  share:**                                     |   |       |      |       |   |
| Basic (loss) income  per share before extraordinary item |   | $          | (.02      | )          | $      | .00 |   |
| Extraordinary item                                       |   | .03        |      | -          |   |
| Basic  income per share                                  |   | $          | .01       |       | $      | .00 |   |
|                                                     |   |       |      |       |   |

 

 

Theaccompanying notes are an integral part of the financial statements.

 

**LEEPHARMACEUTICALS**

 

**STATEMENTSOF STOCKHOLDERS' (DEFICIT)**

(roundedto thousands)

 

**FOR THEYEARS ENDED SEPTEMBER 30,**

 

 
|                              |   |              |   |           |    |         |   | **Retained**     |   |       |       |
|-----------------------------------|--------|-------------------|--------|----------------|---------|--------------|--------|------------------|--------|------------|------------|
|                              |   | **Common  Stock** |   | **Additional** |    | **Earnings** |   |             |   |
|                              |   | **Number  of**    |   |           |    | **Paid-in**  |   | **(Accumulated** |   |       |       |
|                              |   | **Shares**        |   | **Amount**     |    | **Capital**  |   | **Deficit)**     |   | **Total**  |       |
|                              |   |              |   |           |    |         |   |             |   |       |       |
|                              |   |              |   |           |    |         |   |             |   |       |       |
| **Balance at September 30, 1999** |   | 4,135,162         |   | $              | 413,000 |         | $      | 4,222,000        |   | $          | (7,275,000 | ) | $ | (2,640,000 | ) |
|                              |   |              |   |           |    |         |   |             |   |       |       |
| Net  income                       |   |              |   |           |    |         |   | 16,000           |   | 16,000     |       |
|                              |   |              |   |           |    |         |   |             |   |       |       |
|                              |   |              |   |           |    |         |   |             |   |       |       |
| **Balance at September 30, 2000** |   | 4,135,162         |   | 413,000        |    | 4,222,000    |   | (7,259,000       | )      | (2,624,000 | )          |
|                              |   |              |   |           |    |         |   |             |   |       |       |
| Net  income                       |   |              |   |           |    |         |   | 47,000           |   | 47,000     |       |
|                              |   |              |   |           |    |         |   |             |   |       |       |
|                              |   |              |   |           |    |         |   |             |   |       |       |
| **Balance at September 30, 2001** |   | 4,135,162         |   | $              | 413,000 |         | $      | 4,222,000        |   | $          | (7,212,000 | ) | $ | (2,577,000 | ) |

 

 

Theaccompanying notes are an integral part of the financial statements.

 

**LEEPHARMACEUTICALS**

 

**STATEMENTS OF CASH FLOWS**

(roundedto thousands)

 

**FOR THEYEARS ENDED SEPTEMBER 30,**

 
|                                                                                     |   | **2001**   |    | **2000**   |   |
|------------------------------------------------------------------------------------------|--------|------------|---------|------------|--------|
| CASH FLOWS PROVIDED BY  OPERATING ACTIVITIES:                                            |   |       |    |       |   |
| Net income                                                                               |   | $          | 47,000  |       | $      | 16,000 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:       |   |       |    |       |   |
| Depreciation                                                                             |   | 170,000    |    | 157,000    |   |
| Amortization of  intangibles                                                             |   | 487,000    |    | 880,000    |   |
| (Gain) on sale of  fixed assets                                                          |   | (14,000    | )       | (65,000    | )      |
| Other loss                                                                               |   | 1,000      |    | 1,000      |   |
| Change in operating  assets and liabilities:                                             |   |       |    |       |   |
| Decrease (increase) in  accounts receivable                                              |   | 365,000    |    | (390,000   | )      |
| (Decrease) increase in  allowance for doubtful accounts and sales returns and allowances |   | (17,000    | )       | 186,000    |   |
| (Increase) decrease in  inventories                                                      |   | (122,000   | )       | 44,000     |   |
| Decrease (increase) in  deposits                                                         |   | 112,000    |    | (148,000   | )      |
| Decrease in other  current assets                                                        |   | 60,000     |    | 108,000    |   |
| Increase (decrease) in accounts payable and accrued liabilities                          |   | 25,000     |    | (418,000   | )      |
| Increase  in due to related parties-accrued interest                                     |   | 121,000    |    | 63,000     |   |
| (Decrease) increase in  accrued royalties                                                |   | (39,000    | )       | 13,000     |   |
| Increase in deferred  income                                                             |   | 294,000    |    | -          |   |
|                                                                                     |   |       |    |       |   |
| Net  cash provided by operating activities                                               |   | 1,490,000  |    | 447,000    |   |
|                                                                                     |   |       |    |       |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                   |   |       |    |       |   |
| Additions to property,  plant and equipment                                              |   | (201,000   | )       | (274,000   | )      |
| Proceeds from sale of  equipment                                                         |   | 7,000      |    | 1,000      |   |
| Acquisition of product  brands                                                           |   | (463,000   | )       | (249,000   | )      |
| Increase in  non-current deposit                                                         |   | (11,000    | )       | -          |   |
|                                                                                     |   |       |    |       |   |
| Net cash (used in)  investing activities                                                 |   | (668,000   | )       | (522,000   | )      |
|                                                                                     |   |       |    |       |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                   |   |       |    |       |   |
| Proceeds from notes  payable to related party                                            |   | 44,000     |    | 90,000     |   |
| (Payments on) notes  payable to related party                                            |   | (155,000   | )       | (10,000    | )      |
| Decrease (increase) in  due from related party                                           |   | 25,000     |    | (19,000    | )      |
| (Decrease) in notes payable                                                              |   | (74,000    | )       | (60,000    | )      |
| Proceeds from notes payable,  other                                                      |   | 1,070,000  |    | 1,050,000  |   |
| (Payments on)   notes payable, other                                                |   | (1,474,000 | )       | (1,226,000 | )      |
| (Decrease)  increase in bank overdraft                                                   |   | (265,000   | )       | 258,000    |   |
| Net cash (used in)  provided by financing activities                                     |   | (829,000   | )       | 83,000     |   |
|                                                                                     |   |       |    |       |   |
| NET (DECREASE)  INCREASE IN CASH                                                         |   | (7,000     | )       | 8,000      |   |
| Cash, beginning of  year                                                                 |   | 12,000     |    | 4,000      |   |
|                                                                                     |   |       |    |       |   |
| Cash, end of year                                                                        |   | $          | 5,000   |       | $      | 12,000 |   |
|                                                                                     |   |       |    |       |   |
| SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:                                      |   |       |    |       |   |
|                                                                                     |   |       |    |       |   |
| Cash paid during the  year for:                                                          |   |       |    |       |   |
| Interest                                                                                 |   | $          | 676,000 |       | $      | 747,000 |   |
| Taxes                                                                                    |   | $          | 1,000   |       | $      | 1,000 |   |
|                                                                                     |   |       |    |       |   |
| NON  CASH FINANCING AND INVESTING ACTIVITY:                                              |   |       |    |       |   |
| Acquisition of product  brands:                                                          |   |       |    |       |   |
| Fair value of assets  acquired                                                           |   | $          | -       |       | $      | 394,000 |   |
| Fair value of  liabilities incurred                                                      |   | -          |    | (145,000   | )      |
| Net cash payments                                                                        |   | $          | -       |       | $      | 249,000 |   |

 

 

Theaccompanying notes are an integral part of the financial statements.

 

**LEE PHARMACEUTICALS**

**NOTES TO FINANCIAL STATEMENTS**

 

 

**NOTE 1 -****                    ****SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

 

**Descriptionof business**

 

 

TheCompany is engaged in the development, purchase, manufacture, and marketing ofconsumer personal care products and professional dental products, all of whichare targeted for the improved well-being of the human body.  The Company's business is directed to twomain areas:  (a) the development andmarketing of a range of consumer products including over-the-counter items,health and beauty aids, cosmetics and prescription drug products containingcontrolled substances and (b) the manufacture and sale of materials andsupplies for use in the professional dental health field.  For all years presented, revenues, operatingresults and identifiable assets of the consumer products group were in excessof 93% of total Company operations.

 

**Continuedexistence**

 

Thefinancial statements have been prepared assuming the Company will continue as agoing concern.  The Company has anaccumulated deficit of $7,212,000.  TheCompany’s recurring losses from operations and inability to generate sufficientcash flow from normal operations to meet its obligations as they come due raisesubstantial doubt about the Company’s ability to continue as a goingconcern.  The Company’s ability tocontinue in existence is dependent upon future developments, includingretaining current financing and achieving a level of profitable operationssufficient to enable it to meet its obligations as they become due.  Management’s plans in regard to thesematters are to increase profitability by increasing sales, control expenses andseek additional financing from outside lenders.  The financial statements do not include any adjustments toreflect the possible future effects of the recoverability and classification ofassets or the amounts and classification of liabilities that may result fromthe possible inability of the Company to continue as a going concern.

 

**Reclassifications**

 

Certainreclassifications have been made to the prior year financial statements to beconsistent with the 2001 presentation.

 

**Cashand cash equivalents**

 

Forpurposes of the statements of cash flows, the Company considers cash and cashequivalents to include cash on hand, bank balances, money markets andshort-term investments with a maturity of three months or less.

 

**Accountsreceivable**

 

TheCompany provides an allowance for doubtful accounts and reserve for returnedmerchandise.  The Company's estimatesare based on historical collection and return experience and a review of thecurrent status of trade accounts receivable. It is reasonably possible that the Company's estimate of the allowancefor doubtful accounts will change.

 

**Inventories**

 

Inventoriesare stated at the lower of average cost or market using the first-in, first-outmethod.

 

**Depreciationand amortization**

 

Propertyand Equipment

 

Property and equipmentare recorded at cost.  Expenditures formajor additions and improvements are capitalized, and minor replacements,maintenance, and repairs are charged to expense as incurred.  When property and equipment are retired orotherwise disposed of, the cost and accumulated depreciation are removed fromthe accounts and any resulting gain or loss is included in the results ofoperations for the respective period. Amortization and depreciation are computed on the methods used forfederal income tax purposes using the following lives:

 
| Building                 |   | 31  years  |
|--------------------------|--------|------------|
| Machinery and  equipment |   | 5-7  years |
| Leasehold improvements   |   | 39  years  |

 

Depreciationexpense was $170,000 and $157,000 for the years ended September 30, 2001 and2000 respectively.

 

Intangibles

 

Intangible assets arebeing amortized under the straight-line method using the following lives:

 
| Goodwill                  |   | 120  months - 240 months |
|---------------------------|--------|--------------------------|
| Covenants not to  compete |   | 60  months- 120 months   |
| Other                     |   | 56  months               |

 

Amortizationexpense was $487,000 and $880,000 for the years ended September 30, 2001 and2000 respectively.

 

**Environmentalexpenditures**

 

Environmentalexpenditures that relate to an existing condition caused by past operations,and which do not contribute to current or future revenue generation, areexpensed.  The Company's proportionateshare of the liabilities are recorded when environmental remediation and/orcleanups are probable, and the costs can be reasonably estimated.  Management believes that the total amountprovided at September 30, 2001 for remedial cost studies is adequate based oncurrent information available.  See Note11 - "Assessment for environmental cleanup."

 

**Majorcustomer**

 

TheCompany had one major customer with sales volume approximating 10% and 16% ofthe Company's net revenues for the years ending September 30, 2001, and 2000,respectively.  The amount due from thecustomer was $102,000 and $332,000 at September 30, 2001, and 2000,respectively, and is included in accounts receivable in these financialstatements.  The Company has fivevendors that accounted for 24% of the total inventory purchased for the fiscalyear ended September 30, 2001.

 

**Revenuerecognition**

 

Incomeand expenses are recorded on the accrual basis of accounting.  The Company recognizes revenues from saleswhen goods have been shipped, there are no material uncertainties regardingcustomer acceptance, collection of the resulting receivable is deemed probable,and no other significant vendor obligations exist.  Expenses are recognized when services have been performed orinventory items have been used. Chemical items are recognized as inventory once Quality Control testingis in compliance with the Company specifications.  Adoption of SAB 101 has had no effect on the way the Companyrecognizes revenue.  The Company has nothad to change their accounting policies to comply with SAB 101.

 

**Concentrationof credit risk**

 

Financialinstruments which potentially subject the Company to concentrations of creditrisk consist of cash and trade receivables. The Company places its cash with high credit quality financialinstitutions.  At times such investmentsmay be in excess of the FDIC limit.  Inregards to trade receivables, the risk is limited due to the large number ofcustomers comprising the customer base, and the dispersion in differentindustries and geographies.  Generally,the Company does not require collateral for its trade receivables.

 

**Deferredincome tax accounts**

 

Deferredtax assets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases.  Deferred tax assets, including tax loss andcredit carryforwards, and liabilities are measured using enacted tax rates expectedto apply to taxable income in the years in which those temporary differencesare expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in taxrates is recognized in income in the period that includes the enactmentdate.  Deferred income tax expenserepresents the change during the period in the deferred tax assets and deferredtax liabilities.  The components of thedeferred tax assets and liabilities are individually classified as current andnon-current based on their characteristics. Deferred tax assets are reduced by a valuation allowance when, in theopinion of management, it is more likely than not that some portion or all ofthe deferred tax assets will not be realized.

 

**Use ofestimates**

 

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosures ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

**Fairvalue of financial instruments**

 

Basedon borrowing rates currently available to the Company for bank loans withsimilar terms and maturities, the fair value of the Company's long-term debtapproximates the carrying value. Furthermore, the carrying value of all other financial instrumentspotentially subject to valuation risk (principally consisting of accountsreceivable and accounts payable) also approximates fair value.

 

**Impairmentof long-lived assets and long-lived assets to be disposed of**

 

TheCompany evaluates its long-lived assets, including goodwill and certainidentifiable intangibles, for impairment whenever events or changes incircumstances indicate that the carrying amount of such assets or intangiblesmay not be recoverable.  Recoverabilityof assets to be held and used is measured by a comparison of the carryingamount of an asset to future undiscounted net cash flows expected to begenerated by the asset.  If such assetsare considered to be impaired, the impairment to be recognized is measured bythe amount by which the carrying amount of the assets exceed the fair value ofthe assets.  If an asset is to be disposedof, it is reported at the lower of the carrying amount or fair value less coststo sell.  To date, there has been noimpairment of long-lived assets.

 

**Advertisingcosts**

 

Advertisingcosts are expensed as incurred. Advertising costs for fiscal years ended September 30, 2001 and 2000were $194,000 and $279,000 respectively.

 

**Stockoption plan**

 

TheCompany applies the intrinsic value-based method of accounting prescribed byAccounting Principles Board ("ABP") Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations, inaccounting for its outstanding stock options. As such, deferred compensation expense would generally be recorded onthe date of grant only if the current market price of the underlying stockexceeded the exercise price.  Suchdeferred compensation is expensed pro-rata over the vesting period of the stockoption.  Repriced stock options areaccounted for using variable plan accounting which requires periodicre-measurement of the intrinsic value of the related stock option until itsexercise, forfeiture or cancellation. (See Note 12 - "StockOptions.")

 

**Segmentreporting**

 

InJune 1997, the FASB issued Statement of Financial Accounting Standards("SFAS") No. 131, *Disclosures about Segments of an Enterprise andRelated Information*.  SFASNo. 131 establishes standards for the manner in which public companies reportinformation about operating segments in annual and interim financialstatements.  It also establishesstandards for related disclosures about products and services, geographic areasand major customers.  The method fordetermining what information to report is based on the way management organizesthe operating segments within the Company for making operating decisions andassessing financial performance.  TheCompany's chief operating decision-maker is considered to be the Company'schief executive officer ("CEO").

 

Informationavailable on reportable segments is as follows:

 
|                                          |   | **For  Year Ended September 30** |      |
|-----------------------------------------------|--------|----------------------------------|-----------|
|                                          |   | **2001**                         |      | **2000** |   |
|                                          |   |                             |      |   |   |
| Revenue  from consumer personal care products |   | $                                | 9,183,489 |   | $ | 9,488,776 |   |
|                                          |   |                             |      |   |   |
| Revenue  from professional dental products    |   | $                                | 293,524   |   | $ | 373,714 |   |

 

TheCompany does not identify or allocate assets by operating segment and does notallocate cost of sales, operating profits, depreciation or other expenses byoperating segments.

 

**NOTE 2 -****                    ****NETINCOME PER SHARE**

 

Basicnet income per share is computed using the weighted-average number of shares ofcommon stock outstanding.  Diluted netincome per share is computed using the weighted-average number of shares ofcommon stock outstanding and, when dilutive, potentially dilutive shares fromrestricted stock and options to purchase common stock using the treasury stockmethod.

 

Thefollowing is a reconciliation of the shares used in the computation of basicand diluted net income per share:

 
|                                                                                   |   | **For  Year Ended September 30** |   |
|----------------------------------------------------------------------------------------|--------|----------------------------------|--------|
|                                                                                   |   | **2001**                         |   | **2000** |   |
|                                                                                   |   |                             |   |   |   |
| Basic  net income per share - weighted average number   of common shares outstanding   |   | 4,135,162                        |   | 4,135,162 |   |
|                                                                                   |   |                             |   |   |   |
| Effect  of potentially dilutive securities outstanding -  restricted stock and options |   | -                                |   | - |   |
|                                                                                   |   |                             |   |   |   |
| Shares  used in diluted net income per share computation                               |   | 4,135,162                        |   | 4,135,162 |   |

 

Options to purchaseshares of common stock at an average share price which is greater than theaverage market price of the shares are not included in the computation ofdiluted earnings per share, or EPS, because the effect of their inclusion wouldhave been anti-dilutive.  For the yearended September 30, 2001 and September 30, 2000,  1,059,334 options to purchase shares of common stock wereexcluded from the computation of diluted earnings per share.

 

**NOTE 3 -****                    ****INVENTORIES**

 

                                                Inventoriesconsist of the following at September 30, 2001:

 

| Raw materials               |   | $         | 2,278,000 |   |
|-----------------------------|--------|-----------|-----------|--------|
| Work-in-process             |   | 301,000   |      |
| Finished goods              |   | 416,000   |      |
|                        |   | 2,995,000 |      |
| Allowance for  obsolescence |   | (586,000  | )         |
| Total                       |   | $         | 2,409,000 |   |

 

**NOTE 4 -****                    ****INTANGIBLEASSETS**

 

TheCompany acquired certain product lines in 2001 (See Note 16) and prioryears.  Amounts related to theseacquisitions are allocated to intangible assets.  Included in intangible assets, which have not been fullyamortized at September 30, 2001, are the following:

|                            |   | **Cost**   |      |
|---------------------------------|--------|------------|-----------|
|                            |   |       |      |
| Goodwill                        |   | $          | 2,340,000 |   |
| Covenants not to  compete       |   | 3,386,000  |      |
| Distribution rights             |   | 70,000     |      |
| Total                           |   | 5,796,000  |      |
| Less: accumulated  amortization |   | (2,838,000 | )         |
| Intangibles  - net              |   | $          | 2,958,000 |   |

 

**NOTE 5-****                    ****NOTES PAYABLE - BANK**

 
| Note payable to bank  (accounts receivable financing), secured by accounts receivable, equipment,  inventories, and certain other assets, maximum revolving advance is  $1,400,000 (based on domestic accounts receivable as defined in the agreement  less amounts loaned on inventory, not to exceed $300,000, can be advanced),  requires minimum monthly interest of $3,000, interest rate is 8% above Union  Bank of California's prime rate.  The  agreement matures May 2003 and is renewable annually.  The continuing personal guarantee by the  Company's President, of the obligations of the Company, remains in force. |   | $         | 633,000 |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------|---------|--------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |   |      |    |
| Note payable to bank,  secured by inventory, maximum amount of term loan is the lessor of $300,000  or 25% of the amount of eligible inventory, requires monthly payments of  $5,000 plus interest at Union Bank of California's prime rate plus 8%,  maturing May 2003.                                                                                                                                                                                                                                                                                                                                                                      |   | 275,000   |    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |   |      |    |
| Note payable to bank,  maximum amount of term loan is $400,000, secured by the Company's machinery  and equipment, requires monthly payments of $10,000 plus interest at Union  Bank of California's prime rate plus 6%, maturing May 2003.                                                                                                                                                                                                                                                                                                                                                                                                   |   | 341,000   |    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |   |      |    |
| Note payable to bank,  maximum amount of term loan is $134,000, secured by the Company's machinery  and equipment, requires monthly payments of $5,166 plus interest at Union  Bank of California's prime rate plus 8%, maturing May 2003.                                                                                                                                                                                                                                                                                                                                                                                                    |   | 101,000   |    |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |   | 1,350,000 |    |
| Less  current portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |   | (862,000  | )       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |   | $         | 488,000 |   |

 

 

Interestexpense on the above notes was $226,000 for the year ended September 30,

2001.

 

**NOTE 6 -****                    ****ACCRUEDLIABILITIES**

 

Forthe year ended September 30, 2001, accrued liabilities consisted of thefollowing:

 

| Payroll taxes         |   | $       | 14,888  |   |
|-----------------------|--------|---------|---------|--------|
| Royalties             |   | 44,041  |    |
| Commissions           |   | 15,539  |    |
| Customer deposits     |   | 39,352  |    |
| Rental deposits       |   | 30,557  |    |
| Salaries and vacation |   | 71,448  |    |
| Professional fees     |   | 27,925  |    |
| Advertising           |   | 116,320 |    |
| Other                 |   | 72,930  |    |
| Total                 |   | $       | 433,000 |   |

 

**NOTE 7 -****                    ****RELATEDPARTY TRANSACTIONS**

 

In 1991 the Company soldand leased back two of its operating facilities in a transaction with itsformer Chairman.  An initial gain wasrecognized and a deferred gain was recorded which is being amortized over theterm of the two leases which expired November 2000.  The amount of deferred gain realized in 2001 was $11,000 and in2000 was $65,000.  (See Note 11 -"Lease commitments.")

 

The amounts of rentspaid to related parties were $139,000 for September 30, 2001 and $134,000 forSeptember 30, 2000.

 

During the fiscal yearending September 30, 2001, the total interest expensed to related parties (Note9) was $223,000 of which $109,000 was paid. Included in due to related parties, as of September 30, 2001, wasaccrued interest of $825,000.

 

During the fiscal yearending September 30, 2000, the total interest expensed to related parties was$269,000 of which $128,000 was paid.

**NOTE 8 -****                    ****NOTESPAYABLE - OTHER**
| Note payable, secured  by product brand, payable in monthly installments of $12,000, plus interest,  commencing July 25, 2001, until and including September 25, 2001.  Thereafter, monthly installment payments  will be $22,000.  The interest rate is  the highest prime rate published by Citibank, N.A., during the preceding  month.                        | $      | 488,000    |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------|--------|
|                                                                                                                                                                                                                                                                                                                                                                        |   |       |   |
| Notes payable to bank,  secured by a deed on land and building, requires monthly payments of $4,200,  including interest at the bank’s reference rate plus 4%, maturing January  2006.  The note is guaranteed by the  President and former Chairman of the Company.                                                                                              |   | 166,000    |   |
|                                                                                                                                                                                                                                                                                                                                                                        |   |       |   |
| Note payable to seller  on acquisition of product brand payable in monthly installments of $8,000,  plus interest, until January 1, 2002.   The interest rate is the highest prime rate in the Wall Street Journal  during the previous month.  The  interest rate at September 30, 2001, was 6.0%.  The note is guaranteed by the President of the Company. |   | 32,000     |   |
|                                                                                                                                                                                                                                                                                                                                                                        |   |       |   |
| The  following notes are due to two individuals.                                                                                                                                                                                                                                                                                                                            |   |       |   |
|                                                                                                                                                                                                                                                                                                                                                                        |   |       |   |
| Note payable, secured  by product brand, bearing interest at 20%.   The note, as renewed, matures December 1, 2002.  Interest only payments are made monthly.                                                                                                                                                                                                     |   | 50,000     |   |
|                                                                                                                                                                                                                                                                                                                                                                        |   |       |   |
| Note payable, secured  by product brand, payable in monthly installments of $10,000, plus interest,  at 20%, commencing February 20, 2000.                                                                                                                                                                                                                                  |   | 100,000    |   |
|                                                                                                                                                                                                                                                                                                                                                                        |   |       |   |
| Note payable,  unsecured, payable in monthly installments of $10,000, plus interest at 20%,  commencing June 20, 2000.                                                                                                                                                                                                                                                      |   | 140,000    |   |
|                                                                                                                                                                                                                                                                                                                                                                        |   |       |   |
| Note payable,  unsecured, payable in monthly installments of $10,000, plus interest at 20%,  commencing September 25, 2000.                                                                                                                                                                                                                                                 |   | 120,000    |   |
|                                                                                                                                                                                                                                                                                                                                                                        |   |       |   |
| Note payable,  unsecured, payable in monthly installments of $6,000, plus interest at 20%  commencing January 10, 2001.                                                                                                                                                                                                                                                     |   | 296,000    |   |
|                                                                                                                                                                                                                                                                                                                                                                        |   |       |   |
| Note payable, secured  by product brand, payable in monthly installments of $4,000, plus interest at  20%, commencing April 10, 2001.                                                                                                                                                                                                                                       |   | 176,000    |   |
|                                                                                                                                                                                                                                                                                                                                                                        |   |       |   |
| Note payable, secured  by product brand, payable in monthly installments of $5,000, plus interest at  20%, commencing August 1, 2001.                                                                                                                                                                                                                                       |   | 185,000    |   |
|                                                                                                                                                                                                                                                                                                                                                                        |   |       |   |
| Note payable, secured  by product brand, payable in monthly installments of $6,000, plus interest at  20%, commencing September 15, 2001.                                                                                                                                                                                                                                   |   | 394,000    |   |
|                                                                                                                                                                                                                                                                                                                                                                        |   | 2,147,000  |   |
| Less  current portion                                                                                                                                                                                                                                                                                                                                                       |   | (946,000   | )      |
|                                                                                                                                                                                                                                                                                                                                                                        |   | $1,201,000 |   |

 

Interestexpense on the above notes was $320,000 for the year ended September 30,

2001.

 

**NOTE 9 -****                    ****NOTESPAYABLE - RELATED PARTIES (LEE FAMILY MEMBERS)**
| Notes payable to  related parties, unsecured, bearing interest at bank's prime rate (6.0% at  September 30, 2001), maturing January 2005.   Payable interest only.                                                                                                        |   | $         | 50,000    |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------|-----------|--------|
|                                                                                                                                                                                                                                                                           |   |      |      |
| Note payable to  related party, unsecured, bearing interest at bank's prime rate (6.0% at  September 30, 2001), principal is maturing and accrued interest is payable in  January 2005.                                                                                        |   | 372,000   |      |
|                                                                                                                                                                                                                                                                           |   |      |      |
| Notes payable to  related party (Lee Foundation), secured by product brand, bearing interest at  bank's prime rate (6.0% at September 30, 2001), principal is maturing and  accrued interest is payable in January 2005.                                                       |   | 400,000   |      |
|                                                                                                                                                                                                                                                                           |   |      |      |
| Note payable to  related party, unsecured, bearing interest at bank's prime rate (6.0% at  September 30, 2001), and principal payable based on a twelve (12) year fully  amortized schedule commencing March 15, 1997.  Monthly payments are not being made on this note. |   | 1,440,000 |      |
|                                                                                                                                                                                                                                                                           |   |      |      |
| Notes payable to  related party, secured by product brand, bearing interest at bank's prime  rate (6.0% at September 30, 2001), principal is maturing and accrued interest  is payable in January 2005.                                                                        |   | 61,000    |      |
|                                                                                                                                                                                                                                                                           |   |      |      |
| Note payable to  related party, secured by product brand, bearing interest at bank's prime  rate (6.0% at September 30, 2001), principal is maturing and accrued interest  is payable in January 2005.                                                                         |   | 100,000   |      |
|                                                                                                                                                                                                                                                                           |   |      |      |
| Note payable to  related party, unsecured, bearing interest at bank's prime rate (6.0% at  September 30, 2001), principal is maturing and accrued interest is  payable in January 2005.                                                                                   |   | 250,000   |      |
|                                                                                                                                                                                                                                                                           |   |      |      |
| Note payable to  officer, unsecured, bearing interest at bank’s prime rate (6.0% at September  30, 2001), maturing January 2005.                                                                                                                                          |   | 10,000    |      |
|                                                                                                                                                                                                                                                                           |   |      |      |
| Note payable to  officer, unsecured, bearing interest at 5.9% on $68,000 and 6.99% on  $22,000.  Monthly payments are based  on credit card minimum, no due date stated.                                                                                                  |   | 89,000    |      |
|                                                                                                                                                                                                                                                                           |   |      |      |
| Note payable to  officer, unsecured, bearing interest at bank's prime rate (6.0% at September  30, 2001), due on demand.                                                                                                                                                       |   | 31,000    |      |
|                                                                                                                                                                                                                                                                           |   | 2,803,000 |      |
| Less  current portion ($615,000 in arrears)                                                                                                                                                                                                                                    |   | (670,000  | )         |
|                                                                                                                                                                                                                                                                           |   | $         | 2,133,000 |   |

 

Interestexpense on the above notes was $223,000 for the year ended September 30,

2001.

 

**NOTE 10 -****             ****LONG-TERMDEBT MATURITIES**

 

AtSeptember 30, 2001, the Company was committed to the following minimumprincipal payments.

 
| **Year  ending**   | ** ** | **Notes  payable** | ** ** | **Related** | ** ** |      | ** ** |
|--------------------|------------|--------------------|------------|-------------|------------|-----------|------------|
| **September  30,** | ** ** | **bank**           | ** ** | **parties** | ** ** | **Other** | ** ** |
|               |       |               |       |        |       |      |       |
| 2002               |       | $                  | 862,000    |        | $          | 670,000   |       | $ | 946,000 |   |
| 2003               |       | 488,000            |       | 120,000     |       | 536,000   |       |
| 2004               |       | -                  |       | 120,000     |       | 276,000   |       |
| 2005               |       | -                  |       | 120,000     |       | 205,000   |       |
| 2006               |       | -                  |       | 1,483,000   |       | 150,000   |       |
| Thereafter         |       | -                  |       | 290,000     |       | 34,000    |       |
| Total              |       | $                  | 1,350,000  |        | $          | 2,803,000 |       | $ | 2,147,000 |   |

 

**NOTE 11 -****             ****COMMITMENTSAND CONTINGENCIES**

 

**                                                                       ****Leasecommitments**

 

AtSeptember 30, 2001, the Company was committed to its Chairman and to othersunder noncancelable operating leases for land and buildings requiring minimumannual rentals as follows:

 

| **Year  ending**   |   |       |      |         |   |
|--------------------|--------|------------|-----------|--------------|--------|
| **September  30,** |   | **Others** |      | **Chairman** |   |
|               |   |       |      |         |   |
| 2002               |   | $          | 456,000   |         | $      | 143,000 |   |
| 2003               |   | 456,000    |      | 143,000      |   |
| 2004               |   | 456,000    |      | 143,000      |   |
| 2005               |   | 456,000    |      | 143,000      |   |
| 2006               |   | 76,000     |      | 24,000       |   |
| Total              |   | $          | 1,900,000 |         | $      | 596,000 |   |

 

 

Theleases, which expired November 30, 2000, have been renewed.  The new expiration date for these leases isNovember 30, 2005.  The renewal callsfor Consumer Price Index (based on Los Angeles - Riverside - Orange County: Allitems - All Urban Consumers) adjustments on December 1, 2000, December 1, 2002and December 1, 2004.  The lessee has anoption to renew at the end of all lease terms.

 

Generally,the leases provide that maintenance, insurance and a portion of property taxesare to be paid by the Company.  TheCompany also has a right of first refusal to acquire most of the buildingswhich it leases.  The Company's rentalexpense for the years ended September 30, 2001, and 2000, was $596,000 and$573,000 respectively.

 

Threeof the above leases are subleased to other companies.  Sublease income was $178,000 and $166,000 for fiscal years endedSeptember 30, 2001 and 2000 respectively. One sublease is month to month. Another sublease was renewed December 1, 2000 for $7,280 per month fortwenty four months.  The third subleasefor $4,116 per month was signed April 1, 2001. It will expire November 30, 2005.

 

| **Year  ending**   | ** ** | **Sublease** | ** ** |
|--------------------|------------|--------------|------------|
| **September  30,** | ** ** | **revenues** | ** ** |
|               |       |         |       |
| 2002               |       | $            | 136,752    |   |
| 2003               |       | $            | 63,952     |   |
| 2004               |       | $            | 49,392     |   |
| 2005               |       | $            | 49,392     |   |
| 2006               |       | $            | 8,232      |   |
|               |       |         |       |
| Total              |       | $            | 307,720    |   |

**                                                                       ****Assessmentfor environmental cleanup**

 

The Company owns amanufacturing facility located in South El Monte, California.  The California Regional Water QualityControl Board (The "RWQCB") ordered the Company in 1988 and 1989 toinvestigate the contamination on its property (relating to soil and groundwatercontamination).  The Company engaged aconsultant who performed tests and reported to the then Chairman of theCompany.  The Company resisted furtherwork on its property until the property upgradient was tested in greater detailsince two "apparent source" lots had not been tested.  On August 12, 1991, the RWQCB issued a"Cleanup and Abatement Order" directing the Company to conductfurther testing and cleanup the site. In October 1991, the Company received from an environmental consultingfirm an estimate of $465,200 for investigation and cleanup costs.  The Company believed that this estimatewas  inconclusive and overstated thecontamination levels.  The Company believesthat subsequent investigations will support the Company’s conclusions  about that estimate.  The Company did not complete the testing forthe reasons listed above as well as "financial constraints".  In June 1992, the RWQCB requested that theEPA evaluate the contamination and take appropriate action.  At the EPA's request, Ecology &Environment, Inc. conducted an investigation of soil and groundwater on theCompany's property.  Ecology &Environment Inc.'s Final Site Assessment Report, which was submitted to the EPAin June 1994, did not rule out the possibility that some of the contaminationoriginated on-site, and resulted from either past or current operations on theproperty.  The Company may be liable forall or part of the costs of remediating the contamination on its property.  The EPA has not taken any further action inthis matter, but may do so in the future.  

 

The Company and nearbyproperty owners, in consort with their comprehensive general liability (CGL)carriers , engaged a consultant to perform a site investigation with respect tosoil and shallow groundwater contamination over the entire city block.  The CGL carriers provided $290,000 infunding which paid for the $220,000 study, $20,000 in legal fees for projectoversight, and a $50,000 balance in the operating fund.  Earlier the Company had accrued $87,500 as itsproportionate share of the earlier quote of $175,000. Since that time, theoverall scope of the project was increased to $205,000 plus $15,000 for wastewater disposal, bringing the total to the above listed $220,000.  The $87,500 accrual was not spent on thisproject (as the entire cost was borne by the CGL carriers), but remains on thebooks as an accrual against the cost of remediation of the same site that wasincluded in the study.

 

The tenants of nearbyproperties upgradient have sued the Company alleging that hazardous materialsfrom the Company's property caused contamination on the properties leased bythe tenants.  The case name is DelRay Industrial Enterprises, Inc. v. Robert Malone, et al., LosAngeles County Superior Court, Northwest District, commenced August 21,1991.  In this action, the plaintiffalleges environmental contamination by defendants of its property, and seeks acourt order preventing further contamination and monetary damages.  The Company does not believe there is anybasis for the allegations and is vigorously defending the lawsuit.

 

The Company's South ElMonte manufacturing facility is also located over a large area of possiblycontaminated regional groundwater which is part of the San Gabriel ValleySuperfund Site.  The Company has beennotified that it is a potentially responsible party  ("PRP")  for thecontamination.   In 1995, the Companywas informed that the EPA estimated the cleanup costs for the South El Monte’sportion of the San Gabriel Valley Superfund Site to be $30 million.  The Company’s potential share of such amounthas not been determined.  Superfund PRPsare jointly and severally liable for superfund site costs, and are responsiblefor negotiating among themselves the allocation of the costs based on, amongother things, the outcome of environmental investigation.

 

In August 1995, theCompany was informed that the EPA entered into an Administrative Order ofConsent with Cardinal Industrial Finishes ("Cardinal") for a PRP leadremedial investigation and feasibility study (the "Study") which, theEPA states, will both characterize the extent of groundwater contamination inSouth El Monte and analyze alternatives to control the spread ofcontamination.  The Company and othersentered into the South El Monte Operable Unit Site Participation Agreement withCardinal pursuant to which, among other things, Cardinal contracted with anenvironmental firm to conduct the Study. The Study has been completed. The Company's share of the cost of the Study was $15,000 and was accruedfor in the financial statements as of September 30, 1995.  The South El Monte Operable Unit (SEMOU)participants developed four remedial alternatives.  The capital cost of the four alternatives range from $0 (noaction) up to $3.49 million.  Theestimated annual operating cost for the four alternatives range from $0 (noaction) to $770,300.  Over a 30-yearperiod, the total cost of the four alternatives range from $0 (no action) up to$13.05 million.  The EPA prefers analternative which estimates the capital cost up to $3.08 million, the annualoperating cost at $.48 million, and the 30-year period total cost up toapproximately $9.09 million.  Theselection of the actual alternative implemented is subject to public comment.  At the present time, the Company does notknow what its share of the cost may be, if any.  Therefore, no additional accrual has been recognized as aliability on the Company's books.  TheCompany requested that the EPA conduct an "ability-to-pay evaluation"to determine whether the Company is entitled to an early settlement of thismatter based upon a limited ability to pay costs associated with siteinvestigation and remediation.  InAugust 2000, the EPA informed the Company that it does not qualify for an earlysettlement at this time.

 

The EPA has informed theCompany that it has learned that the intermediate zone groundwatercontamination in the western portion of the SEMOU has migrated further west andhas now impacted the City of Monterey Park and Southern California WaterCompany production wells.  The EPA statedthat the City of Monterey Park Water Department, San Gabriel Valley WaterCompany and Southern California Water Company are planning to build treatmentfacilities for their wells.  The EPAstated that these three water purveyors contacted some of the SEMOU PRPs, otherthan the Company, to seek funding to develop groundwater treatment facilitiesfor the contaminated wells.  A group ofthese PRPs calling themselves the "South El Monte Cooperative Group"has been formed and purportedly has reached a general agreement with the waterpurveyors to fund the development of treatment facilities and use the waterpurveyors' wells in an attempt to contain the groundwater contamination to meetEPA's goals.  At this time, the EPA hasnot reviewed or approved any specific plan to address contamination at thepurveyor wells, nor has the EPA compromised its right to recover response costsfrom any person who is legally responsible for contamination within theSEMOU.  As of the date of this report,the Company has not been contacted by the South El Monte Cooperative Group inrespect to its participation in any proposed cleanup activity.  As a result, the Company is not able todetermine what contribution, if any, it may be assessed in connection with thiscleanup activity.

By letter dated November13, 2000, the Company was notified that the City of Monterey Park, San GabrielValley Water Company and Southern California Water Company intend to bring suitunder the Safe Drinking Water and Toxic Enforcement Act of 1986 alleging thatthe Company has knowingly released volatile organic compounds in the soil andshallow groundwater beneath the Company's property between at least on orbefore November 8, 1996 and the present and has failed to promptly clean up allof the contamination.  As of the date ofthis report, the Company has not been served with this lawsuit.

 

The City of South ElMonte, the city in which the Company has its manufacturing facility, is locatedin the San Gabriel Valley.  The SanGabriel Valley has been declared a Superfund site.  The 1995 Water Quality Control Plan issued by the CaliforniaRegional Water Quality Control Board states that the primary groundwater basinpollutants in the San Gabriel Valley are volatile organic compounds fromindustry, nitrates from subsurface sewage disposal and past agriculturalactivities.  In addition, the Plan notedthat hundreds of underground storage tanks leaking gasoline and other toxicchemicals have existed in the San Gabriel Valley.  The California Department of Toxic Substance Control has declaredlarge areas of the San Gabriel Valley to be environmentally hazardous andsubject to cleanup work.

 

The Company believes theCity of South El Monte does not appear to be located over any of the majorplumes.  However, the EPA has announcedit is studying the possibility that, although the vadose soil and groundwater,while presenting cleanup problems, there may be a contamination by DNAPs (densenon-aqueous phase liquids), i.e., "sinkers", usually chlorinatedorganic cleaning solvents.  The EPA hasproposed to drill six "deep wells" throughout the City of South ElMonte at an estimated cost of $1,400,000. The EPA is conferring with SEMPOA (South El Monte Property OwnersAssociation) as to cost sharing on this project.  SEMPOA has obtained much lower preliminary cost estimates.  The outcome cost and exact scope of this areunclear at this time.

 

The Company and otherproperty owners engaged Geomatrix Consultants, Inc., to do a survey of vadosesoil and shallow groundwater in the "hot spots" detected in theprevious studies.  Geomatrix issued areport dated December 1, 1997 (the “Report”), on the impact of volatile organiccompounds on the soil and groundwater at the Lidcombe and Santa Anita Avenuesite located in South El Monte, California (which includes the Company’sfacilities).  The Report indicatedgenerally low concentrations of tetrachloroethene, trichloaethene andtrichloroethane in the groundwater of the upgradient neighbor.  The Report was submitted to the RWQCB forits comments and response.  A meetingwith the parties and RWQCB was held on February 10, 1998.  The RWQCB had advised companies that vadosesoil contamination is minimal and requires no further action.  However, there is an area of shallowgroundwater which has a higher than desired level of chlorinated solvents, andthe RWQCB requested a proposed work plan be submitted by Geomatrix.  Geomatrix has submitted a "FocusedFeasibility Study" which concludes that there are five possible methodsfor cleanup.  The most expensive are fora pump and sewer remediation which would cost between $1,406,000 and$1,687,000.  The Company is activelyexploring the less expensive alternative remediation methods, of which the twoproposed alternatives range in cost between $985,000 and $1,284,000.  Since there are four economic entitiesinvolved, the Company's best estimate at this time, in their judgment, would bethat their forecasted share would be $287,000 less the liability already recognizedon the books of $165,000 thereby requiring an additional $122,000liability.  Accordingly, the Companyrecorded an additional accrual of $122,000 in the third quarter of fiscal1998.  The $122,000 accrual is inaddition to the $79,000 accrual for the Monterey Site as will be explained in thefollowing paragraph.  The $79,000accrual, in the third quarter of fiscal 1998, related to the Monterey Site isnot included in the $287,000 figure above. In April 2000, the Company received a Notice of Violation from theRWQCB.  The Notice of Violation statesthat the Company and other property owners were required to submit agroundwater remedial action plan by November 1, 1999, and that the RWQCB hasbeen advised that the Company and the other property owners were unable tosubmit the required remedial action plan because the Company and the otherproperty owners could not agree on the allocation of financial responsibilityto prepare the action plan.  The RWQCBstated that it will no longer encourage the cooperative approach among theCompany and the other property owners in completing the cleanup requirementsand will pursue appropriate measures, including when necessary, enforcementactions.  The RWQCB states that it mayimpose civil liability penalties of up to $1,000 per day from November 1, 1999 forfailure to file the action plan.  Inlight of these events, no assurances can be given that the cleanup costs andpossible penalties will not exceed the amount of the Company's current accrualsof $287,000 (which includes the $122,000 charge to income in the third quarterof fiscal 1998).

 

In July 2000, theproperty owners formed the Lidcombe & Santa Anita Avenue Work Group (LSAAW)in response to the RWQCB request for the preparation of an action plan.  The LSAAW submitted a Focused Feasibility Studyto the RWQCB for their review and approval of the selected remedial actionmethod for the site.  After receivingRWQCB approval, LSAAW obtained three cost proposals to implement the RWQCBapproved pump and treat remedial method. According to these cost proposals, the lowest estimated costs for anassumed five (5) years of pump and treat remediation is $600,000.  This cost is lower than the previous costproposed work plan, discussed above, from Geomatrix Consultants, Inc.  The capital costs including contingenciesare approximately $300,000.

 

The LSAAW is hopeful theWater Quality Authority (WQA) is willing and able to reauthorize its grant forone-half (1/2) of the capital costs of its remediation system construction notto exceed $150,000.  It is estimated atthis time that the reserves for the Company's share of this cost proposal areadequate since its prior accrual was based on the higher cost estimate fromGeomatrix.

Without any priorcorrespondence or inkling of the Company's potential liability, the EPAinformed the Company that the Company may have potential liability for theongoing remediation of Operating Industries, Inc. (as they have gone out ofbusiness) Landfill Superfund Site in Monterey Park, California (the"Monterey Site").  TheMonterey Site is a 190 acre landfill that operated from 1948 to 1984, in whichthe Company disposed of non toxic pH balanced waste water on six occasionsbetween 1974 and 1978.  Over 4,000companies have been identified as having contributed waste to the Monterey Site.  The EPA has offered to settle the Company'spotential liability with respect to the Monterey Site for a cost to the Companyof $79,233.  The Company accrued a$79,000 charge in the third quarter of fiscal 1998 with respect to thispossible liability.  The Company haselected to file for relief from these obligations under the financial hardshipoption in the EPA's response form.  OnJune 30, 2000, the EPA informed the Company that the EPA believed the Companyis able to pay the full settlement cost, but offered to reduce the amount ofthe settlement to $75,271.

 

The Company was notifiedby the EPA that the Company may have potential liability for waste material itdisposed of at the Casmalia Disposal Site ("Site") located on a252-acre parcel in Santa Barbara County, California.  The Site was operational from 1973 to 1989, and over 10,000separate parties disposed of waste there. The EPA stated that federal, state and local governmental agencies alongwith the numerous private entities that used the Site for waste disposal willbe expected to pay their share as part of this settlement.  The U.S. EPA is also pursuing theowner(s)/operator(s) of the Site to pay for Site remediation.  The EPA has a settlement offer to theCompany with respect to the Site for a cost of $373,950.  The Company accrued a $374,000 charge in thefirst quarter of fiscal 1999 with respect to this possible liability.  The Company has elected to file for relieffrom these obligations under the financial hardships option in the EPA's responseform.  The Company, the EPA and certainPRPs have entered into an agreement tolling the applicable statutes oflimitation.  The Company has beennotified by the EPA that their request for a waiver, due to financial hardship,was "partially granted." Improvements in the bidding process has lowered the Company's estimatedshare down to $245,000 (from $374,000) and of that, the EPA was requesting thatthe Company pay $113,000, as a result of their findings on the application forwaiver due to financial hardship.  TheCompany is considering the EPA's request.

 

The total amount ofenvironmental investigation and cleanup costs that the Company may incur withrespect to the foregoing is not known at this time.  However, based upon information available to the Company at thistime, the Company has expensed since 1988 a total of $860,000, of which $89,000were legal fees, exclusive of legal fees expended in connection with the SECenvironmental investigation.  The actualcosts could differ materially from the amounts expensed for environmentalinvestigation and cleanup costs to date.

 

As of September 30,2001, no additional amounts have been incurred and no settlements have beenreached.

 

**NOTE 12 -****             ****STOCKOPTIONS**

 

TheCompany has a Stock Option Plan adopted in 1987 for 50,000 common stockoptions.  No options were exercised andno additional options can be granted under this plan.  Options expire five years from the date of the grant.

 

The 1997 EmployeeIncentive Stock Option Plan was adopted by the Board of Directors on January20, 1997, and was approved by the Company’s shareholders on March 11,1997.  The Employee Incentive StockOption Plan provides for the granting of options to selected officers and keyemployees of the Company for the purchase of a total of 980,000 shares ofcommon stock of the Company at a price per share equal to the fair market valueon the date of the grant.  The optionsexpire five years from the date of the grant.

 

An additional 1997 StockOption Plan was adopted by the Board of Directors on January 20, 1997, and wasapproved by the Company's shareholders on March 11, 1997.  This Stock Option Plan provides for thegranting of options to the Company's outside directors for the purchase of150,000 shares of common stock of the Company at a price per share equal to thefair market value on the date of the grant. These options expire five years from the date of the grant.

 

Only incentive stockoptions may be granted under the Employee Incentive Stock Option Plan and onlynonqualified stock options may be granted under the 1997 Stock Option Plan.

 

Under both plans, theprice per share of the shares subject to each option shall not be less than100% of the fair market value of such stock on the date the stock option isgranted.  Stock options shall not beexercisable until one and one-half years from the date of the grant.  Commencing eighteen (18), thirty (30), andforty-two (42) months, respectively, after the date of the grant, an option maybe exercised to the extent of one third of the total number of shares to whichit relates.  Upon a change in control ofthe Company (as defined), all stock options granted to any optionee will becomefully exercisable.  Any stock optiongranted to an employee who at the time the option is granted, owns stockrepresenting more than ten percent (10%) of the total combined voting power ofall classes of stock of the Company, will be granted at a price equal to onehundred and ten percent (110%) of the fair market value determined as of thedate the stock option is granted.  Bothplans will expire on December 31, 2006.

 

Stock option activityunder the Plans is as follows:

 
| ** **                        | ** ** | **Shares**     | ** ** | ** **      | ** ** | **Weighted**        | ** ** | **Weighted**              | ** ** |
|-----------------------------------|------------|----------------|------------|-----------------|------------|---------------------|------------|---------------------------|------------|
| ** **                        | ** ** | **available**  | ** ** | **Options**     | ** ** | **average**         | ** ** | **average  grant date**   | ** ** |
| ** **                        | ** ** | **for  grant** | ** ** | **outstanding** | ** ** | **exercise  price** | ** ** | **fair  value per share** | ** ** |
|                              |       |           |       |            |       |                |       |                      |       |
| Balance  as of September 30, 2001 |       | 1,130,000      |       | 1,130,000       |       | $                   | 0.18       |                      | $          | 0.16  - $0.22 |   |
|                                   |            |                |            |                 |            |                     |            |                           |            |  |  |

 

 

Therehas been no activity under the stock option plans and no deferred stock-basedcompensation recorded with respect to options issued by the Company for theyear ended September 30, 2001.

The following tablesummarizes information about stock options outstanding at September 30, 2001:

 
|                |         | **Options  Outstanding** |       | **Options  Exercisable** |        |
|---------------------|--------------|--------------------------|------------|--------------------------|-------------|
|                |         |                     |       |                     |        |   |   |   |   |   |   |
| ** **          | ** **   | ** **               | ** ** | **Weighted**             | ** **  | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| **Range  of**       | ** **   | **Number**               | ** ** | **average  remaining**   | ** **  | **average** | ** ** | **Number** | ** ** | **average** | ** ** |
| **exercise prices** | ** **   | **of  shares**           | ** ** | **contractual  life**    | ** **  | **exercise  price** | ** ** | **of  shares** | ** ** | **exercise  price** |   |
|                |         |                     |       |                     |        |   |   |   |   |   |   |
| $                   | 0.16 - $0.18 |                     | 918,000    |                     | .50  years  |   | $ | 0.18 |   | 918,000 |   | $ | 0.18 |   |
| $                   | 0.22 - $0.00 |                     | 212,000    |                     | 1.33  years |   | $ | 0.18 |   | 212,000 |   | $ | 0.18 |   |
|                |         | 1,130,000                |       |                     |        |   |   |   |   |   |   |

 

Forpurposes of pro forma disclosures, we estimated fair value of each option grantand Employee Stock Option Plan grant on the date of the grant using theBlack-Scholes single option pricing model with the following assumptions:

 
|                      |   | **For  Year Ended September 30** |   |
|---------------------------|--------|----------------------------------|--------|
|                      |   | **2001**                         |   | **2000** |   |
|                      |   |                             |   |   |   |
| Expected  life of options |   | 5  years                         |   | 5  years |   |
| Volatility                |   | 35                               | %      | 75 | % |
| Risk  free interest rate  |   | 5                                | %      | 6 | % |
| Dividend  yield           |   | -0-                              |   | -0- |   |

 

The pro forma effect onnet income for 2001 and 2000 is not representative of the pro forma effect onnet income in future years because it does not take into consideration proforma compensation expense related to grants made prior to 1995.  Pro forma information in future years willreflect the amortization of a larger number of stock options granted in severalsucceeding years.  The Company's proforma information is as follows (in thousands except share data):

 
|                        |   | **For  Year Ended September 30** |   |
|-----------------------------|--------|----------------------------------|--------|
|                        |   | **2001**                         |   | **2000** |   |
|                        |   |                             |   |   |   |
| Pro  forma income           |   | $47                              |   | $16 |   |
| Pro  forma income per share |   | $0.01                            |   | $0.00 |   |

 

**NOTE 13-****             ****DEFERRED INCOME TAXES**

 

Thenet deferred tax amounts included in the accompanying balance sheet contain thefollowing amounts of deferred tax assets and liabilities:

 
| Deferred Tax Asset -  Current         |   | $          | 417,000   |   |
|---------------------------------------|--------|------------|-----------|--------|
| Deferred Tax Liability  - Current     |   | -          |      |
|                                  |   | 417,000    |      |
| Less Valuation  Allowance             |   | (417,000   | )         |
| Net Deferred Tax  Liability - Current |   | $          | -         |   |
|                                  |   |       |      |
| Deferred Tax Asset -  Non-Current     |   | $          | 3,880,000 |   |
| Deferred Tax Liability  - Non-Current |   | -          |      |
|                                  |   | 3,880,000  |      |
| Less Valuation  Allowance             |   | (3,880,000 | )         |
| Net Deferred Tax  Liability - Current |   | $          | -         |   |

 

Thedeferred tax asset - current, results from an allowance for bad debts andinventory reserves, for financial statement purposes not allowed for income taxpurposes.

 

Thedeferred tax asset - non-current, results from an estimated net operating losscarryforward for federal and state income tax purposes, and from bookdepreciation and amortization in excess of tax amounts.

 

TheCompany has recorded a valuation allowance to reflect the estimated amount ofdeferred asset, which may not be realized. For the year ended September 30, 2001, valuation allowance decreased by$433,000.

 

**NOTE 14-****             ****INCOME TAXES**

 

Asof September 30, 2001, the Company had net operating loss (NOL) carryforwardsof approximately $10,300,000 for Federal and $1,700,000 for California whichfor tax purposes can be used to offset future Federal and California incometaxes.  The differences in the statecarryforwards relate primarily to the treatment of loss carryforwards anddepreciation of property, plant and equipment. The Federal carryforwards expire from 2005 through 2020; Californiaexpires from 2001 through 2005.  TheCompany has provided an allowance for the entire amount of the deferred assetapplicable to the NOL.

 

**NOTE 15 -****             ****EMPLOYEEBENEFIT PLANS**

 

TheCompany has a 401(k) Profit Sharing Plan (the "Plan") available toall employees who meet the Plan's eligibility requirements.  Under the Plan, participating employees maydefer a percentage (not to exceed 20%) of their eligible pretax earnings up tothe Internal Revenue Service's annual contribution limit.  Company contributions are not required. To date,the Company has not made any contributions to the Plan.

 

**NOTE 16-****             ****ACQUISITIONS**

 

OnNovember 15, 1999, the Company purchased certain assets of the product linesfrom U.S. Dermatologics, Inc. which includes Cope®, a tensionheadache relief tablet, and Astring-o-Sol®, a concentrated mouthwash,for $400,000.  The Company has remitted$200,000 at closing and is required to make twenty-four equal monthlyinstallments of $8,000, plus interest at a rate equal to the highest prime ratein the Wall Street Journal during the preceding month, commencing January 25,2000 and ending on December 25, 2001, and a final payment of all remainingprincipal due on January 25, 2002. Included in the above purchase price were certain inventories valued atapproximately $60,000.

 

OnJanuary 31, 2000, the Company purchased certain assets of the product Serutan®,toasted granules, a bulk-forming laxative, for $60,000 cash.  Included in the purchase price were certaininventories valued at approximately $6,000. The balance of $54,000 is for an eight year covenant not to compete.

 

On October 30, 2000, theCompany purchased certain assets of the Sloans® liniment temporarypain relief product from C.B. Fleet Co., Inc. for $50,000 plus approximately$600 of inventory.  The Company remittedthe full $50,000 at closing.  Thebalance of $50,000 is for a five year covenant not to compete.

 

OnFebruary 12, 2001, the Company purchased certain assets of the Black Draught®laxative product line from The Monticello Companies, Inc. for $185,000.  This amount includes approximately $37,000of inventory and was remitted in full at closing.  The balance of $148,000 is for a five year covenant not tocompete.

 

OnAugust 22, 2001, the Company purchased certain assets of the DeWitt's®Pills product line from The Monticello Companies, Inc. for $265,000.  The DeWitt's® is an analgesicpill for backache and joint pain relief. The Company remitted the full $265,000 at closing.

 

**NOTE 17 -****             ****OTHERINCOME**

 

For the year endedSeptember 30, 2001, the Company realized a gain of $52,600 related to the saleof the Klutch® product line. This amount is included in other income on the statement of operations.

 

**NOTE 18 -****             ****EXTRAORDINARYITEM**

 

The Company reported$124,000 of extraordinary income related to the extinguishment of debtassociated with note payable - related party and renegotiation of two notespayable pertaining to prior product line acquisitions.  The extraordinary item has no income taxeffect.

 

**NOTE 19 -****             ****SUBSEQUENTEVENTS (UNAUDITED)**

 

On October 16, 2001, theCompany exercised their option to resell certain assets of DeWitt's®Pills product line back to The Monticello Companies, Inc.  The Company received $265,000 related to theresell of DeWitt's® Pills.

 

**ITEM 8.****                            ****CHANGES IN AND DISAGREEMENTSWITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.**

 

Not applicable.

**PART III**

 

**ITEM 9.****                            ****DIRECTORS,EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT.**

 

Directors are elected toserve until the next annual stockholders' meeting or until their respective successorshave been elected and qualified or as otherwise provided in the bylaws.  Set forth below for the current directorsand executive officers are their ages, principal occupations during the pastfive years, and the period during which they have served as a director orofficer of the Company.

 
|                    |       |       |       |                                               |       | **A  director** |       |                                                                                                                                              |   |
|-------------------------|------------|------------|------------|----------------------------------------------------|------------|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| ** **              | ** ** | ** ** | ** ** | **Positions  held**                                |       | **or  officer** |       | **Principal  occupation**                                                                                                                         |   |
| **Name**                | ** ** | **Age**    | ** ** | **with  Company**                                  | ** ** | **since**       | ** ** | **during  the past five years (1)**                                                                                                               |   |
|                    |       |       |       |                                               |       |            |       |                                                                                                                                              |   |
| Dr.  Henry L. Lee       |       | 75         |       | Director                                           |       | 1971            |       | Chairman  of the Board of Lee Pharmaceuticals through April 1995 when he retired,  available as a consultant, currently a Director of the Company |   |
|                    |       |       |       |                                               |       |            |       |                                                                                                                                              |   |
| Ronald  G. Lee          |       | 49         |       | President,  Chairman and Director                  |       | 1977            |       | President  and since April 1995, Chairman of the Board of the Company                                                                             |   |
|                    |       |       |       |                                               |       |            |       |                                                                                                                                              |   |
| Michael  L. Agresti     |       | 59         |       | Vice  President - Finance, Treasurer and Secretary |       | 1977            |       | Vice  President - Finance, Treasurer and Secretary of the Company                                                                                 |   |
|                    |       |       |       |                                               |       |            |       |                                                                                                                                              |   |
| William  M. Caldwell IV |       | 54         |       | Director                                           |       | 1987            |       | President  of CAIS Internet, an internet infra-structure solutions company, and  President of Union Jack Group, a merchant banking firm.          |   |
|                    |       |       |       |                                               |       |            |       |                                                                                                                                              |   |

                                                (1)None of the companies named, other than the Company, is a parent, subsidiary orother affiliate of the Company.

 

**FamilyRelationships**

 

                                                RonaldG. Lee is the son of Dr. Henry L. Lee.

 

**ITEM10.****                     ****EXECUTIVE COMPENSATION.**

 

The following table setsforth information with respect to remuneration paid by the Company to theexecutive officers of the Company with total annual salary and bonus of atleast $100,000 for services in all capacities while acting as officers anddirectors of the Company during the fiscal years ended September 30, 2001,2000, and 1999.

 
| **SUMMARY  COMPENSATION TABLE** |
|---------------------------------|
| ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Long  Term** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Compensation** | ** ** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Annual  Compensation** | ** ** | **Awards** | ** ** | ** ** | ** ** | ** ** |
| **Name  and**                   | ** ** | ** ** | ** ** | ** ** | ** ** | **Other  Annual** | ** ** | ** ** | ** ** | ** ** | ** ** | **All  Other** | ** ** |
| **Principal  Position**         | ** ** | **Year** | ** ** | **Salary  ($)** | ** ** | **Compensation** | **($1)** | ** ** | **Options  (#)** | ** ** | ** ** | **Compensation ($)  ** |
| Ronald  G. Lee        |   | 2001 |   | 221,777 |   | 4,634 | (1) |   | — | (2) |   | — |   |
| President,  Chairman            |   | 2000 |   | 230,241 |   | 9,098 | (1) |   | — | (2) |   | — |   |
| (since  April 26, 1995)         |   | 1999 |   | 228,854 |   | 3,985 | (1) |   | — | (2) |   | — |   |
| &  Director                 |   |   |   |   |   |   | (1) |   |   | (2) |   |   |   |

 

(1)                Includesreimbursement of medical and dental expenses not covered by the Company'sinsurance plan of $4,634, $9,098, and $3,985, respectively, in 2001, 2000, and1999.

 

(2)               Nostock options were granted during fiscal year's 2001, 2000 and 1999.

 

                             Eachof the directors of the Company who is not employed by the Company receives adirector's fee of $750 for each quarter and $500 for each meeting of the Boardof Directors attended, except Dr. Henry L. Lee.  As holder of the honorary title of Founder Chairman Dr. Leewaived his fees.

 

**AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR**

**AND FISCAL YEAR END OPTION VALUES**

 
| ** **     | ** ** | **Number  of Unexercised Options** | ** ** |
|----------------|------------|------------------------------------|------------|
| ** **     | ** ** | **at  Fiscal Year End (#)**        | ** ** |
| **Name**       | ** ** | **Exercisable/Unexercisable**      | ** ** |
| Ronald  G. Lee | ** ** | 780,000/0                          |       |

 

Thestock options were deemed not in the money since the market price was less thanthe option price at September 30, 2001.

 

**ITEM 11.****                     ****SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.**

 

The following table setsforth the persons who, as of November 30, 2001, were known to the Company to bebeneficial owner of more than five percent of the Company's Common Stock:

 
| ** **          | ** ** | **Name  and address**     | ** ** | **Amount  and nature**       | ** ** | **Percentage** | ** ** |
|---------------------|------------|---------------------------|------------|------------------------------|------------|----------------|------------|
| **Title  of class** | ** ** | **of  beneficial owner**  | ** ** | **of  beneficial ownership** | ** ** | **of  class**  | ** ** |
| ** **          | ** ** | ** **                |       | ** **                   |       | ** **     |       |
| Common  Stock       |       | Ronald G. Lee             |       | 2,320,782  shares  (1   | )          | 47             | %          |
|                |       | 1444  Santa Anita Avenue  |       |                         |       |           |       |
|                |       | South  El Monte, CA 91733 |       |                         |       |           |       |
|                |       |                      |       |                         |       |           |       |
| Common  Stock       |       | Dr. Henry L. Lee          |       | 247,334  shares  (1) (2 | )          | 6              | %          |
|                |       | 1444  Santa Anita Avenue  |       |                         |       |           |       |
|                |       | South  El Monte, CA 91733 |       |                         |       |           |       |

 

(1)                      Includesshares subject to options exercisable at or within 60 days after December 31,2001.

 

(2)                      Includes28,000 shares of the Company's common stock which Dr. Lee holds as trustee forthe benefit of certain family members. He has the right to vote such shares but otherwise disclaims beneficialownership.

 

 

                        Thefollowing table sets forth the ownership of the Company's Common Stock by itsdirectors and its named executive officers and all executive officers anddirectors as a group.

 
| ** **          | ** ** | **Name  of**                                       | ** ** | **Amount  and nature**         | ** ** | **Percentage** | ** ** |
|---------------------|------------|----------------------------------------------------|------------|--------------------------------|------------|----------------|------------|
| **Title  of class** | ** ** | **beneficial  owner**                              | ** ** | **of  beneficial ownership**   | ** ** | **of  class**  | ** ** |
| ** **          | ** ** | ** **                                         |       | ** **                     |       | ** **     |       |
| Common  Stock       |       | Ronald G. Lee                                      |       | 2,320,782  shares  (1     | )          | 47             | %          |
| Common  Stock       |       | Dr. Henry L. Lee                                   |       | 247,334  shares  (2       | )          | 6              | %          |
| Common  Stock       |       | William M. Caldwell IV                             |       | 75,000  shares  (1        | )          | 1              | %          |
| Common  Stock       |       | All  officers and directors as a group (4 persons) |       | 2,857,652  shares  (1) (2 | )          | 54             | %          |

 

(1)          Includesshares subject to options exercisable at or within 60 days after December 31,2001.

 

(2)          Includes28,000 shares of the Company's common stock which Dr. Lee holds as trustee forthe benefit of certain family members. He has the right to vote such shares but otherwise disclaims beneficialownership.

 

**ITEM12.****                     ****CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS.**

 

The informationregarding borrowings from and sale and leaseback transactions between theCompany and it's Chairman of the Board which is contained in Item 6 and Notes 3and 8 of Notes to Financial Statements is incorporated herein by thisreference.

 

**ITEM13.****                     ****EXHIBITS AND REPORTS ON FORM8-K.**

 

 (a)                               Exhibits.  The following exhibits have been or arebeing filed herewith, and are numbered in accordance

                                                withItem 601 of Regulation S-B:

 

                                                Thefollowing exhibits are filed herewith:

 

                                                                                                10.76               -              Restructuringand Offset Agreement dated July 23, 2001, between Lee Pharmaceuticals,

                                                                                                                                                            APPharma, Inc. (formerly Advanced Polymer Systems, Inc.) and Premier Consumer

                                                                                                                                                            Products,Inc., regarding a prior brand acquisition

 

                                                                                                10.77               -              Amendedand Restated Security Agreement dated July 23, 2001, between LeePharmaceuticals

                                                                                                                                                            (grantor)and AP Pharma, Inc. (formerly Advanced Polymer Systems, Inc.)  (Secured Party)

                                                                                                                                                            regardinga prior brand acquisition

 

                                                                                                10.78               -              Promissorynote dated July 23, 2001, between Lee Pharmaceuticals and AP Pharma, Inc.

                                                                                                                                                            (formerlyAdvanced Polymer Systems, Inc.)

 

                                                                                                10.79               -              Promissorynote evidencing advance made to the Registrant

 

                                                                                                10.80               -              Promissorynote which was amended (modified) in November, 2001, evidencing advance made

                                                                                                                                                            tothe Registrant

 

                                                                                                10.81               -              Securedpromissory note dated March 16, 2001, between Lee Pharmaceuticals and Preferred

                                                                                                                                                            BusinessCredit, Inc.

 

                                                                                                10.82               -              Modificationof secured promissory note dated March 16, 2001, between Lee Pharmaceuticals

                                                                                                                                                            andPreferred Business Credit, Inc.

 

                                                Thefollowing exhibits have previously been filed by the Company:

 

                                                                                                      3.1                     -              Articlesof Incorporation, as amended (1)

 

                                                                                                      3.4                     -              By-laws,as amended December 20, 1977 (2)

 

                                                                                                      3.5                     -              Amendmentof By-laws effective March 14, 1978 (2)

 

                                                                                                      3.6                     -              Amendmentto By-laws effective November 1, 1980 (3)

 

                                                                                                10.1                     -              QualifiedStock Option Plan  including forms ofgrant (4)

 

                                                                                                10.2                     -              1985Employee Incentive Stock Option Plan (5)

 

                                                                                                10.3                     -              Descriptionof bonus agreements between the Registrant and its officers (2)

 

                                                                                                10.4                     -              Leasedated December 1, 1990, for the premises located at 1470 Santa Anita Avenue, 

                                                                                                                                                            SouthEl Monte, California (6)

 

                                                                                                10.5                     -              Leasedated April 16, 1990, for the premises located at 1425 and 1427 LidcombeAvenue,

                                                                                                                                                            SouthEl Monte, California (6)

 

                                                                                                10.6                     -              Leasedated April 16, 1990, for the premises located at 1434 Santa Anita Avenue,

                                                                                                                                                            SouthEl Monte, California (6)

 

                                                                                                10.7                     -              Leasedated April 16, 1990, for the premises located at 1460 Santa Anita Avenue,

                                                                                                                                                            SouthEl Monte, California (6)

 

                                                                                                10.8                     -              Leasedated April 16, 1990, for the premises located at 1457 Lidcombe,

                                                                                                                                                            SouthEl Monte, California (6)

 

                                                                                                10.9                     -              Leasedated April 16, 1990, for the premises located at 1500 Santa Anita Avenue,

                                                                                                                                                            SouthEl Monte, California (6)

 

                                                                                                10.10               -              Leasedated April 16, 1990, for the premises located at 1516 Santa Anita Avenue,

                                                                                                                                                            SouthEl Monte, California (6)

 

                                                                                                10.11               -              Leasedated March 1, 1991, for the premises located at 1444 Santa Anita Avenue,

                                                                                                                                                            SouthEl Monte, California (6)

 

                                                                                                10.12               -              Leasedated March 1, 1991, for the premises located at 1445 Lidcombe Avenue,

                                                                                                                                                            SouthEl Monte, California (7)

                                                                                                10.13               -              Promissorynotes which were amended in September 1992 evidencing advances by the

                                                                                                                                                            Registrant'sofficers and directors (8)

 

                                                                                                10.14              -               Promissorynotes which were amended in September 1994 evidencing advances by the

                                                                                                                                                            Registrant'sofficers and directors (9)

 

                                                                                                10.15              -               Promissorynotes evidencing advances made to the Registrant's officers and directors (9)

 

                                                                                                10.16              -               Promissorynotes evidencing advances made to the Registrant (9)

 

                                                                                                10.17              -               Promissorynotes which were amended in January 1995 evidencing advances by the

                                                                                                                                                            Registrant'sofficers and directors (10)

 

                                                                                                10.18              -               Promissorynotes evidencing advances made by the Registrant's officers and directors (10)

 

                                                                                                10.19              -               Promissorynotes which were amended in July 1995 evidencing advances made to the

                                                                                                                                                            Registrant(10)

 

                                                                                                10.20              -               Royaltyagreement dated August 31, 1994, between Lee Pharmaceuticals and The Fleetwood

                                                                                                                                                            Company,regarding a brand acquisition (10)

 

                                                                                                10.21              -               Royaltyagreement dated October 4, 1988, between Lee Pharmaceuticals and Roberts

                                                                                                                                                            Proprietaries,Inc. regarding a brand acquisition (10)

 

                                                                                                10.22              -               Notepayable to bank dated April 26, 1996, between Lee Pharmaceuticals and San

                                                                                                                                                            GabrielValley Bank, secured by the deed on land and building (11)

 

                                                                                                10.23              -               Loanand security agreement dated May 21, 1996, between Lee Pharmaceuticals and

                                                                                                                                                            PreferredBusiness Credit, Inc. regarding a revolving credit facility financing (11)

 

                                                                                                10.24              -               Securedpromissory note dated September 17, 1996, between Lee Pharmaceuticals and

                                                                                                                                                            PreferredBusiness Credit, Inc. (12)

 

                                                                                                10.25              -               Promissorynotes evidencing advances made by the Registrant (12)

 

                                                                                                10.26              -               Promissorynotes which were amended in July 1996 evidencing advances made to theRegistrant (12)

 

                                                                                                10.27              -               Subleasedated November 22, 1995, for the premises located at 1460 Santa Anita Avenue,

                                                                                                                                                            SouthEl Monte, California (12)

 

                                                                                                10.28              -               Subleasedated June 11, 1996, for the premises located at 1470 Santa Anita Avenue,

                                                                                                                                                            SouthEl Monte, California (12)

 

                                                                                                10.29              -               Leasedated December 1, 1995, for the premises located at 1444 Santa Anita Avenue,

                                                                                                                                                            SouthEl Monte, California (12)

 

                                                                                                10.30              -               Leasedated December 1, 1995, for the premises located at 1445 Lidcombe Avenue,

                                                                                                                                                            SouthEl Monte, California (12)

 

                                                                                                10.31              -               1997Employee Incentive Stock Option Plan (13)

 

                                                                                                10.32              -               1997Stock Option Plan (13)

 

                                                                                                10.33               -              Promissorynote which was amended in October 1997 evidencing advances made to the

                                                                                                                                                            Registrant(14)

 

                                                                                                10.34               -              Promissorynotes which were amended (modified) in December 1997 evidencing advances

                                                                                                                                                            madeto the Registrant (14)

 

                                                                                                10.35               -              Modificationof loan and security agreement dated September 10, 1997, between

                                                                                                                                                            LeePharmaceuticals and Preferred Business Credit, Inc. (14)

 

                                                                                                10.36               -              Promissorynote which was amended in February 1997 evidencing advances made to the

                                                                                                                                                            Registrant(14)

 

                                                                                                10.37               -              Securedpromissory note dated October 21, 1996, between Lee Pharmaceuticals and

                                                                                                                                                            RobertsLaboratories, Inc. (14)

 

                                                                                                10.38              -               Promissorynote evidencing advance made to the Registrant (15)

 

                                                                                                10.39              -               Promissorynote evidencing advance made to the Registrant (15)

 

                                                                                                10.40              -               Modificationof loan and security agreement dated May 21, 1996, between Lee Pharmaceuticalsand 

                                                                                                                                                            PreferredBusiness Credit, Inc. regarding a revolving credit facility financing (16)

 

                                                                                                10.41              -               Modificationof secured promissory note dated August 29, 1997, between Lee Pharmaceuticalsand 

                                                                                                                                                            PreferredBusiness Credit, Inc. (16)

                                                                                                10.42              -               Securedpromissory note dated May 15, 1998, between Lee Pharmaceuticals and Preferred 

                                                                                                                                                            BusinessCredit, Inc. (16)

 

                                                                                                10.43              -               Continuingguaranty dated May 15, 1998, between Lee Pharmaceuticals and Preferred Business

                                                                                                                                                            Credit,Inc. (16)

 

                                                                                                10.44              -               AssetPurchase and Sale Agreement dated June 29, 1999, between Lee Pharmaceuticals(buyer) and

                                                                                                                                                            PremierConsumer Products, Inc. (seller) and Advanced Polymer Systems, Inc., regardinga brand

                                                                                                                                                            acquisition(17)

 

                                                                                                10.45              -               Promissorynote evidencing advance made to the Registrant (17)

 

                                                                                                10.46              -               Promissorynote evidencing advance made to the Registrant (18)

 

                                                                                                10.47              -               Promissorynote evidencing advance made to the Registrant (19)

 

                                                                                                10.48              -               Modificationof loan and security agreement dated October 29, 1999, between LeePharmaceuticals 

                                                                                                                                                            andFinova Capital Corporation (formerly Preferred Business Credit, Inc.) regardinga revolving 

                                                                                                                                                            creditfacility financing (19)

 

                                                                                                10.49              -               Modificationof secured (by inventory) promissory note dated October 29, 1999, between Lee

                                                                                                                                                            Pharmaceuticalsand Finova Capital Corporation (formerly Preferred Business Credit, Inc.) (19)

 

                                                                                                10.50              -               Modificationof secured (by equipment) promissory note dated October 29, 1999 ,between Lee

                                                                                                                                                            Pharmaceuticalsand Finova Capital Corporation (formerly Preferred Business Credit, Inc.) (19)

 

                                                                                                10.51              -               Promissorynote evidencing advance made to the Registrant (20)

 

                                                                                                10.52              -               Modificationof loan and security agreement dated May 19, 2000, between Lee Pharmaceuticalsand

                                                                                                                                                            FinovaCapital Corporation (formerly Preferred Business Credit, Inc.) regarding arevolving credit

                                                                                                                                                            facilityfinancing (21)

 

                                                                                                10.53              -               Modificationof secured (by inventory) promissory note dated May 19, 2000, between Lee

                                                                                                                                                            Pharmaceuticalsand Finova Capital Corporation (formerly Preferred Business Credit, Inc.) (21)

 

                                                                                                10.54              -               Modificationof secured (by equipment) promissory note dated May 19, 2000, between Lee

                                                                                                                                                            Pharmaceuticalsand Finova Capital Corporation (formerly Preferred Business Credit, Inc.) (21)

 

                                                                                                10.55              -               Modificationof secured (by Accutek equipment) promissory note dated May 19, 2000, betweenLee

                                                                                                                                                            Pharmaceuticalsand Finova Capital Corporation (formerly Preferred Business Credit, Inc.) (21)

 

                                                                                                10.56              -               Modificationof secured (by Accutek equipment) promissory note dated May 19, 2000 betweenLee

                                                                                                                                                            Pharmaceuticalsand Finova Capital Corporation (formerly Preferred Business Credit, Inc.) (21)

 

                                                                                                10.57              -               Promissorynote evidencing advance made to the Registrant (22) 

 

                                                                                                10.58              -               Promissorynote evidencing advance made to the Registrant (22) 

 

                                                                                                10.59              -               Leasedated May 25, 2000, for the premises located at 1470 Santa Anita Avenue, 

                                                                                                                                                            SouthEl Monte, California (22) 

 

                                                                                                10.60              -               Leasedated May 25, 2000, for the premises located at 1425 and 1427 Lidcombe Avenue, 

                                                                                                                                                            SouthEl Monte, California (22) 

 

                                                                                                10.61              -               Leasedated May 25, 2000, for the premises located at 1434 Santa Anita Avenue, 

                                                                                                                                                            SouthEl Monte, California (22) 

 

                                                                10.62              -               Leasedated May 25, 2000, for the premises located at 1460 Santa Anita Avenue, 

                                                                                                                                                            SouthEl Monte, California (22) 

 

                                                                                                10.63              -               Leasedated May 25, 2000, for the premises located at 1500 Santa Anita Avenue, 

                                                                                                                                                            SouthEl Monte, California (22) 

 

                                                                                                10.64              -               Leasedated May 25, 2000, for the premises located at 1516 Santa Anita Avenue, 

                                                                                                                                                            SouthEl Monte, California (22) 

 

                                                                                                10.65              -               Subleasedated September 14, 2000, for the premises located at 1460 Santa Anita Avenue, 

                                                                                                                                                            SouthEl Monte, California (23)

 

                                                                                                10.66              -               Subleaseguaranty dated September 14, 2000, for the premises located at 1460 Santa AnitaAvenue,

                                                                                                                                                            SouthEl Monte, California (23)

 

                                                                                                10.67              -               Promissorynote evidencing advance made to the Registrant (23) 

 

                                                                                                10.68              -               Promissorynote evidencing advance made to the Registrant (24) 

 

                                                                                                10.69              -               Loanand security agreement dated February 20, 2001, between Lee Pharmaceuticals andPreferred

                                                                                                                                                            BusinessCredit, Inc., regarding a revolving credit facility financing (24) 

                                                                                                10.70               -              Securedpromissory note dated February 20, 2001, regarding equipment, between Lee 

                                                                                                                                                            Pharmaceuticalsand Preferred Business Credit, Inc. (24)

 

                                                                                                10.71               -              Securedpromissory note dated February 20, 2001, regarding inventory, between LeePharmaceuticals

                                                                                                                                                            andPreferred Business Credit, Inc. (24)

 

                                                                                                10.72               -              Subleasedated March 9, 2001, for the premises located at 1470 Santa Anita Avenue,

                                                                                                                                                            SouthEl Monte, California (24)

 

                                                                                                10.73               -              Subleaseguaranty dated March 9, 2001, for the premises located at 1470 Santa AnitaAvenue,

                                                                                                                                                            SouthEl Monte, California between Jing Jing Long (guarantor) and LeePharmaceuticals, Inc.

                                                                                                                                                            (sublandlord)  (24)

 

                                                                                                10.74               -              Promissorynote evidencing advance made to the Registrant (25)

 

                                                                                                10.75               -              Subleasedated April 17, 2001, for the premises located at 1470 Santa Anita Avenue,

                                                                                                                                                            SouthEl Monte, California (25)

 

                                                                            (1)                  Filedas an Exhibit of the same number with the Company's Form S-1 RegistrationStatement filed with the Securities and Exchange Commission on February 5,1973, (Registrant No. 2-47005), and incorporated herein by reference.

 

                                                                            (2)                  Filedas Exhibits 3.4, 3.5 and 13.18 with the Company's Form 10-K Annual Report forthe fiscal year ended September 30, 1978, filed with the Securities andExchange Commission in December 1978 and incorporated herein by reference.

 

                                                                            (3)                  Filedas an Exhibit of the same number with the Company's Form 10-K Annual Report forthe fiscal year ended September 30, 1979, filed with the Securities andExchange Commission in December 1979 and incorporated herein by reference.

 

                                                                            (4)                  Filedas Exhibit 5.1 with the Company's Form 10-K Annual Report for the fiscal yearended September 30, 1973, filed with the Securities and Exchange Commission inDecember 1973 and incorporated herein by reference.

 

                                                                            (5)                  Filedas Exhibits 13.27 and 13.28 with the Company's Form 10-K Annual Report for thefiscal year ended  September 30, 1986,filed with the Securities and Exchange Commission in December 1986 andincorporated herein by reference.

 

                                                                            (6)                  Filedas Exhibit 13.31 with the Company's Form 10-K Annual Report for the fiscal yearended September 30, 1990, filed with the Securities and Exchange Commission inDecember 1990 and incorporated herein by reference.

 

                                                                            (7)                  Filedas Exhibit 13.32 with the Company's Form 10-K Annual Report for the fiscal yearended September 30, 1991, filed with the Securities and Exchange Commission inDecember 1991 and incorporated herein by reference.

 

                                                                            (8)                  Filedas Exhibit 13.33 with the Company's Form 10-K Annual Report for the fiscal yearended September 30, 1992, filed with the Securities and Exchange Commission inDecember 1992 and incorporated herein by reference.

 

                                                                            (9)                  Filedas Exhibits 10.14, 10.15 and 10.16 with the Company's Form 10-KSB Annual Reportfor the fiscal year ended September 30, 1994, filed with the Securities andExchange Commission in December 1994 and incorporated herein by reference.

 

                                                                      (10)                  Filedas Exhibits 10.17, 10.18, 10.19, 10.20 and 10.21 with the Company's Form 10-KSBAnnual Report for the fiscal year ended September 30, 1995, filed with theSecurities and Exchange Commission in December 1995 and incorporated herein byreference.

 

                                                                      (11)                  Filedas Exhibits 10.22 and 10.23 with the Company's Form 10-QSB Quarterly Report forthe nine months ended June 30, 1996, filed with the Securities and ExchangeCommission in August 1996 and incorporated herein by reference.

 

                                                                      (12)                  Filedas Exhibits 10.24, 10.25, 10.26, 10.27, 10.28, 10.29 and 10.30 with theCompany’s Form 10-KSB Annual Report for the fiscal year ended September 30,1996, filed with the Securities and Exchange Commission in December 1996 andincorporated herein by reference.

 

                                                                      (13)                  Includedas an attachment to the Company’s definitive Proxy Statement to shareholdersfor the meeting dated March 11, 1997 and incorporated herein by reference.

 

                                                                      (14)                  Filedas Exhibits 10.33, 10.34, 10.35, 10.36 and 10.37 with the Company’s Form 10-KSBAnnual Report for the fiscal year ended September 30, 1997, filed with theSecurities and Exchange Commission in December 1997 and incorporated herein byreference.

 

                                                                      (15)                  Filedas Exhibits 10.37 and 10.38 with the Company's Form 10-QSB Quarterly Report forthe three months ended December 31, 1997, filed with the Securities andExchange Commission in February 1998 and incorporated herein by reference.

                                                                      (16)                  Filedas Exhibits 10.1, 10.2, 10.3 and 10.4 with the Company's Form 10-QSB QuarterlyReport for the nine months ended June 30, 1998, filed with the Securities andExchange Commission in August 1998 and incorporated herein by reference.

 

                                                                      (17)                  Filedas Exhibits 10.1 and 10.2 with the Company's Form 10-QSB Quarterly Report forthe nine months ended June 30, 1999, filed with the Securities and ExchangeCommission in August 1999 and incorporated herein by reference.

 

                                                                      (18)                  Filedas Exhibit 10.46 with the Company's Form 10-KSB Annual Report for the fiscalyear ended September 30, 1999, filed with the Securities and ExchangeCommission in December 1999 and incorporated herein by reference.

 

                                                                      (19)                  Filedas Exhibits 10.1, 10.2, 10.3 and 10.4 with the Company's Form 10-QSB QuarterlyReport for the three months ended December 31, 1999, filed with the Securitiesand Exchange Commission in February 2000 and incorporated herein by reference.

 

                                                                      (20)                  Filedas Exhibit 10.1 with the Company's Form 10-QSB Quarterly Report for the sixmonths ended March 31, 2000, filed with the Securities and Exchange Commissionin May 2000 and incorporated herein by reference.

 

                                                                      (21)                  Filedas Exhibits 10.1, 10.2, 10.3, 10.4 and 10.5 with the Company's Form 10-QSBQuarterly Report for the nine months ended June 30, 2000, filed with theSecurities and Exchange Commission in August 2000 and incorporated herein byreference.

 

                                                                      (22)                  Filedas Exhibits 10.57, 10.58, 10.59, 10.60, 10.61, 10.62, 10.63 and 10.64 with theCompany's Form 10-KSB Annual Report for the fiscal year ended September 30,2000, filed with the Securities and Exchange Commission in December 2000 andincorporated herein by reference.

 

                                                                      (23)                  Filedas Exhibits 10.1, 10.2 and 10.3 with the Company's Form 10-QSB Quarterly Reportfor the three months ended December 31, 2000, filed with the Securities andExchange Commission in February 2001 and incorporated herein by reference.

 

                                                                      (24)                  Filedas Exhibit 10.1, 10.2, 10.3, 10.4 and 10.6 with the Company's Form 10-QSBQuarterly Report for the six months ended March 31, 2001, filed with theSecurities and Exchange Commission in May 2001 and incorporated herein byreference.

 

                                                                      (25)                  Filedas Exhibits 10.1 and 10.2 with the Company's Form 10-QSB Quarterly Report forthe nine months ended June 30, 2001, filed with the Securities and ExchangeCommission in August 2001 and incorporated herein by reference.

 

 (b)                              Reportson Form 8-K:

 

                                                None

 

**SIGNATURES**

 

                                    Inaccordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 

 ** LEEPHARMACEUTICALS**

 

 

 

| Date:  |   | DECEMBER 19, 2001 |   | RONALD G. LEE                        |
|--------|--------|-------------------|--------|--------------------------------------|
|   |   |              |   | Ronald  G. Lee                       |
|   |   |              |   | Chairman  of the Board and President |
|   |   |              |   |                                 |

 

                                    Inaccordance with the Securities Exchange Act of 1934, this report has beensigned by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 

 

|   |   |              |   |                                                                  |
|--------|--------|-------------------|--------|-----------------------------------------------------------------------|
| Date:  |   | DECEMBER 19, 2001 |   | RONALD G. LEE                                                         |
|   |   |              |   | Ronald  G. Lee                                                        |
|   |   |              |   | Chairman  of the Board & President                                |
|   |   |              |   | (Principal  Executive, Financial and Accounting Officer) and Director |
|   |   |              |   |                                                                  |
| Date:  |   | DECEMBER 19, 2001 |   | HENRY L. LEE, JR.                                                     |
|   |   |              |   | Henry  L. Lee, Jr.                                                    |
|   |   |              |   | Director                                                              |
|   |   |              |   |                                                                  |
| Date:  |   | DECEMBER 19, 2001 |   | WILLIAM M. CALDWELL IV                                                |
|   |   |              |   | William  M. Caldwell IV                                               |
|   |   |              |   | Director                                                              |
|   |   |              |   |                                                                  |