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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
 Form 10-K  þ
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2004  o
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________to _________ Commission File Number 0-21185 aaiPharma Inc. (Exact name of Registrant as specified in its charter)
 Delaware
    
    04 2687849(State or other jurisdiction of
    
    (I.R.S. employerincorporation or organization)
    
    identification no.)
 2320 Scientific Park Drive, Wilmington, NC 28405(Address of principal executive offices) (Zip code) (910) 254 7000(Registrants telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $0.001 PAR VALUE PER SHARE
(Title of class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. þ o
 Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is
not contained herein, and will not be contained, to the best of registrants knowledge, in
definitive proxy or information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. o Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) þ o
 The aggregate market value of the registrants common stock held by non-affiliates of the
registrant as of June 30, 2004, computed by reference to the closing price of the common stock on
that date was $ 59,666,943. The number of shares outstanding of registrants common stock as of April 1, 2005 was 28,585,582
shares.




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TABLE OF CONTENTS PagePART IItem 1.
    
    Business
    
    
    1Item 2.
    
    Properties
    
    
    22Item 3.
    
    Legal Proceedings
    
    
    23Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    30PART IIItem 5.
    
    Market for the Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
    
    
    34Item 6.
    
    Selected Consolidated Financial Data
    
    
    36Item 7.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    38Item 7A.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    99Item 8.
    
    Financial Statements and Supplementary Data
    
    
    100Item 9.
    
    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    169Item 9A.
    
    Controls and Procedures
    
    
    169PART IIIItem 10.
    
    Directors and Executive Officers of the Registrant
    
    
    174Item 11.
    
    Executive Compensation
    
    
    176Item 12.
    
    Security Ownership of Certain Beneficial Owners and Management
    
    
    184Item 13.
    
    Certain Relationships and Related Transactions
    
    
    187Item 14.
    
    Principal Accountant Fees and Services
    
    
    190Item 15.
    
    Exhibits and Financial Statement Schedules
    
    
    192




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PART I Item 1. Business The terms we, us, our or aaiPharma in this Form 10-K include aaiPharma Inc., its corporate
predecessors and its subsidiaries, except where the context may indicate otherwise. Our corporation
was incorporated in 1986, although its corporate predecessor was founded in 1979. Our principal executive offices are located at 2320 Scientific Park Drive, Wilmington, North
Carolina (telephone: 910-254-7000). Our Internet address is www.aaipharma.com. We make available through our internet website our
Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and
amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange
Act of 1934 as soon as reasonably practicable after we electronically file such material with, or
furnish it to, the Securities and Exchange Commission. Trademarks and Trade Names We own the following registered and unregistered trademarks: Darvocet®, Darvon®, Darvon-N®,
Darvocet-N®, Darvocet A500, Brethine®, ProSorb®, ProSorb-D, Lynxorb, ProSLO®, ProSLO II,
ProCore®, Oramorph® SR, ProLonic AQ, Roxanol, Roxicodone®, AzaSan®, aaiPharma®, AAI®, AAI
Development Services and Applied Analytical Industries®. AzaSan® is a registered trademark owned
by us and licensed to Salix Pharmaceuticals. Unless the context otherwise requires, references in
this document to Darvon are to Darvon® and Darvon-N® collectively and references to Darvocet are to
Darvocet-N® and Darvocet A500. We also reference trademarks owned by other companies. Prilosec® is
a registered trademark of AstraZeneca AB, Dolophine® is a registered trademark of Eli Lilly and
Company, Allegra-D® is a registered trademark of Aventis Pharmaceuticals Inc., Proventil® is a
registered trademark of Schering Corporation, Volmax® is a registered trademark of GlaxoSmithKline,
Imuran® is a registered trademark of Prometheus Laboratories Inc., M.V.I.® and Aquasol® are
registered trademarks owned by Mayne Pharma (USA) Inc., Duraclon® is a registered trademark owned
by Fujisawa Healthcare, Inc. and licensed to us, Avinza® is a registered trademark owned by Ligand
Pharmaceuticals, Inc., MS Contin® is a registered trademark owned by Purdue Pharma, L.P., and
Kadian® is a registered trademark owned by Alpharma Inc. All references in this document to any of
these terms lacking the ® or TM symbols are defined terms that reference the products,
technologies or businesses bearing the trademarks with these symbols. Overview Our company was founded in 1979 to provide laboratory services, such as analytical testing on
pharmaceutical compounds, to pharmaceutical companies. In the 1980s, we increased our service
offerings to include clinical trials material manufacturing, microbiological testing and regulatory
and quality consulting. We continued expanding our scientific base in the 1990s by adding
bioanalytical, biotechnical, commercial manufacturing and human clinical trials management
capabilities. We offer our clients scientific solutions to their pharmaceutical




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development needs. In our history, we have worked with large and small companies offering a wide
range of services across the drug development continuum. We also use our drug development capacity to work on our own internal product pipeline. In the
1990s, we helped establish two companies which received approvals for products we developed. We
also entered into various shared-risk arrangements with companies to bring pharmaceutical products
to the market based on development work we conducted. In 2001, we began pursuing a product acquisition strategy to expand our operations as a specialty
pharmaceutical company. Between August 2001 and April 2002, we acquired three lines of
pharmaceutical products. In late 2003, we completed the acquisition of a line of pain products
from Elan Corporation, plc (Elan). In April 2004, we sold the multivitamin infusion product line
that we had acquired in 2001. In 2004, we operated through the following businesses:  
    Product Sales (the Pharmaceuticals Division);
    Development Services (the AAI Development Services Division); and
    Product Development (Research and Development). For information about the net revenues, income (loss) from operations and total assets of each
segment of our business for each of the last three years, see Note 14 of Notes to Consolidated
Financial Statements included in Part II, Item 8 Financial Statements and Supplementary Data. In March 2005, we reorganized our operating structure to reflect our decision to curtail our
research and development activities in light of our financial condition. As a result of this
reorganization of our operating structure, we currently operate in only two business segments 
proprietary pharmaceutical product development and sales through our Pharmaceuticals Division and
development services offered to third parties through our AAI Development Services Division. Overview of Financial Condition We incurred a substantial net loss and loss from operations for 2004 and the quarter ended December
31, 2004. (See Part II, Item 7, Managements Discussion and Analysis of Financial Condition and
Results of Operations  Overview of Results of Operations.) In 2005, our results of operations
have continued to deteriorate as customer concerns regarding our financial condition have affected
sales of our pharmaceutical products and our ability to obtain and maintain development services
engagements. As a result of our substantial and recurring operating losses, we believe that we do
not have adequate sources of liquidity to fund our operations in the near term unless we obtain
additional sources of liquidity. We did not make the $10.5 million scheduled interest payment due
on our senior subordinated notes on April 1, 2005 and have discontinued payments under leases for
assets not used in operations. In light of our current financial condition, we believe that our operations can no longer support
our existing debt and that we must restructure our debt to levels that are more in line with our
operations. Thus, it is highly likely that we will seek relief under chapter 11 of Title 11 of the U.S. Code 2




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(the Bankruptcy Code) which would substantially dilute and may eliminate the interests of the
holders of our common stock. For additional discussion of our financial condition and liquidity,
see Part II, Item 7, Managements Discussion and Analysis of Financial Condition and Results of
Operations  Liquidity and Capital Resources. Pharmaceuticals Division  Our Product Sales Business The Pharmaceuticals Division markets and commercializes the pharmaceutical products that we have
acquired or developed. In addition, the Pharmaceuticals Division manages the development of our
pipeline products, see Research and Development  Our Internal Product Development Pipeline. We
commercialize products in the pain and critical care therapeutic areas. Our pain products include
Duraclon, Drug Enforcement Administration (DEA) Schedule IV products (Darvon/Darvocet) and DEA
Schedule II products (Methadone injectable, Roxicodone, Roxanol, and Oramorph SR). Our critical
care products are used to treat organ rejection in kidney transplants (azathioprine) and severe
asthma (Brethine). Potential Divestiture of Assets We have been exploring a potential sale of some or all of the assets of our Pharmaceuticals
Division, including the Darvon/Darvocet products, as well as other operating assets. On March 31, 2005, we entered into an exclusivity
agreement with a potential purchaser of the assets of our Pharmaceuticals Division to facilitate
continued due diligence and negotiation over a potential sale. This
written agreement expired on April 22,
2005, though we are continuing to negotiate with this potential
purchaser on an exclusive basis. We have not yet reached a definitive agreement with this potential purchaser for the sale
of any assets. In addition, we have not determined to sell any
material assets, and we plan to continue to operate our Pharmaceuticals Division if we do not
complete a sale of its assets. Any sale of some or all of the assets of our Pharmaceuticals
Division would likely occur as part of a bankruptcy proceeding, and thus would be subject to the
approval of the bankruptcy court and may be subject to the approval of the lenders under our senior
credit facilities, the holders of our notes and our stockholders. Distribution of Pharmaceutical Products We have contracted with a subsidiary of Cardinal Health, Inc. to provide warehousing, distribution,
inventory tracking, customer service, and financial administrative assistance related to our
pharmaceutical product distribution program, including management of applicable chargebacks, and
accounts receivable collection. On December 26, 2003, we entered into an agreement with a second subsidiary of Cardinal Health,
Inc., effective as of October 1, 2003, to act as our exclusive distributor for our Brethine
injectable product for a three-year period. Manufacturing Capability We currently manufacture a highly toxic drug product, along with DEA controlled substance products,
for ourselves in our manufacturing facility in Wilmington, North Carolina. Although our
manufacturing generally covers small volume products, our manufacturing capability has been
upgraded to allow commercial volume manufacture of a portion of the Darvon and Darvocet family of
products in our own facility. In addition, we operate a 48,000-square-foot 3




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sterile manufacturing facility in Charleston, South Carolina where we manufacture sterile,
injectable products, including our Methadone injectable product and the vial presentation of our
Brethine injectable product. Marketing and Sales We initially marketed our pharmaceutical product lines through a contract sales force. In late
2002, we created an internal sales and marketing capability to augment this contract sales force.
In connection with our launch of Darvocet A500, we entered into a Service Agreement with Athlon
Pharmaceuticals, Inc. pursuant to which representatives of Athlon would promote the sale of our
Darvocet A500 product to physicians. We terminated this agreement in June 2004, but it remains the
subject of litigation between the parties. (See Part I, Item 3, Legal Proceedings  Athlon
Litigation below). In the second quarter of 2004, we made a strategic decision to refocus our
sales force to the hospital and pain clinic markets following our acquisition of Duraclon, Oramorph
SR and a Methadone injectable product. Our sales force was redesigned to provide experienced and
knowledgeable professionals to sell our complex, highly technical specialty pharmaceutical products
to a sophisticated target market. We believed that this new, narrower focus would create greater
efficiencies for our sales team and allow us a forum to discuss the clinical benefits of our
products. In the fourth quarter of 2004, we made the decision to eliminate our sales force due to
our liquidity issues. We reached the conclusion that we could not afford to build our sales force
to a sufficient scale that would be effective in increasing product revenues sufficient to justify
the cost of our sales force. As of December 31, 2004, we no longer employed a pharmaceutical
products sales force. Instead, we rely on a small commercial group that works at maintaining
logistical supply, works with large wholesalers and hospital buying groups, and performs other
activities needed to maintain an ongoing pharmaceutical products commercial business. Our Pharmaceutical Products We commercialize products in two therapeutic areas: pain management and critical care. Pain Management Products Roxicodone, Oramorph SR, Roxanol and Duraclon Product Lines. On December 2, 2003, we acquired a
line of pain management products, which treat moderate-to-severe pain, and existing inventory from
subsidiaries of Elan. We acquired these product lines, inventory and related intangible assets for
$102.5 million, exclusive of transactional costs. These products consist of three brands of DEA
Schedule II (CII) pain products  Roxicodone (oxycodone hydrochloride) tablets and immediate
release oral solutions, Oramorph SR (morphine sulfate) sustained-release tablets, and Roxanol
(morphine sulfate) immediate release oral solutions. We also acquired a non-scheduled pain
management product, Duraclon (clonidine hydrochloride) injection, as part of the same transaction.
DEA Schedule II pain products are regulated as controlled substances by the U.S. Drug Enforcement
Administration. Each of these DEA Schedule II pain products, other than Oramorph SR, is subject to
generic competition. Oramorph SR is subject to therapeutic substitution by pharmacists in certain
states. 4




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Supply of Product. Roxicodone, Oramorph SR, Roxanol and Duraclon are manufactured and supplied by
third parties. Duraclon is currently purchased on a purchase order basis from American
Pharmaceutical Partners, Inc. Roxicodone, Oramorph SR, and Roxanol are purchased pursuant to a
manufacturing agreement between Roxane Laboratories, Inc. (Roxane) and Elan Pharma International
Limited dated September 28, 2001 (the Roxane Supply Agreement). We assumed Elan Pharma
International Limiteds rights and obligations under the Roxane Supply Agreement. The term of the
Roxane Supply Agreement expires on September 27, 2006. Roxane manufactures the applicable products
in its Columbus, Ohio facility. Darvon and Darvocet. On March 28, 2002, we acquired from Eli Lilly the U.S. rights to the Darvon
and Darvocet branded product lines in the U.S. (and the existing inventory of these products). The
Darvon and Darvocet products are prescribed for the treatment of mild-to-moderate pain. The
acquired products include Darvon (propoxyphene hydrochloride), Darvocet-N (propoxyphene napsylate
and acetaminophen), Darvon-N (propoxyphene napsylate) and Darvon Compound-65 (propoxyphene
hydrochloride, aspirin, and caffeine). These product lines have been sold in the U.S. for over 25 years, with the initial marketing of
Darvon beginning in 1957. Darvons patent exclusivity expired in 1973 and Darvon-N and Darvocet-Ns
patent exclusivity expired in 1985. The first generic version of Darvon was introduced in 1973, and
by 1985, numerous generic products were being marketed for substitution for Darvon and Darvocet. We paid $211.4 million in cash, exclusive of transactional costs, for the rights in the U.S. to
these products and Eli Lillys existing inventory of these products. In addition, we have agreed to
pay Eli Lilly royalties upon sales of our future developed improvements to the Darvon and Darvocet
products or other products containing the active ingredient propoxyphene and any other
pharmaceutical products sold under the name Darvon, Darvocet or certain other trademarks. We
agreed to pay royalties for future products during each calendar quarter for a ten-year period
beginning upon the products commercial introduction, provided that the total net sales of all of
these future products, combined with the total net sales of the current Darvon and Darvocet
products, exceed $15.0 million in the applicable calendar quarter. Darvocet A500 is the only
product we currently sell that could subject us to a royalty payment; however, no royalties were
payable for sales made in 2004. Under our agreement with Eli Lilly, we are not required to pay any
royalties on the sales of the Darvon and Darvocet products themselves that we acquired from Eli
Lilly. Supply of Product. Until the agreement expired on December 31, 2004, we were party to a
manufacturing agreement, as amended, that we entered into with Eli Lilly under which Eli Lilly
agreed to supply specified quantities of the acquired products and the bulk active ingredient from
and after closing for the then-existing twelve Darvon and Darvocet product presentations (form,
dosage and packaging). We purchased these products manufactured by Eli Lilly for a fixed unit
cost, subject to a percentage increase on each January 1 plus any increase in Eli Lillys cost of
raw materials during that year. However, the purchase price for these products was no less than Eli
Lillys standard cost of manufacturing, which included raw materials, direct labor, and plant
overhead attributable to the Darvon and Darvocet products. We are currently manufacturing in our
Wilmington, North Carolina facility all of the products previously manufactured by Eli Lilly, 5




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except for our Darvocet N 100 product. This product is manufactured by DSM Pharmaceuticals Inc.
pursuant to a supply agreement that expires in January 2009. Darvocet A500. We acquired a product which we subsequently branded as Darvocet A500 from Athlon
Pharmaceuticals in July 2003. Darvocet A500 contains 500 mg of acetaminophen, compared to 650 mg
in Darvocet-N 100. We received FDA approval of Darvocet A500 on September 10, 2003, launched the
product in September 2003 and initiated a national campaign in October 2003. Under the acquisition
agreement for this product, we owe Athlon royalties on a quarterly basis until 2023 in an amount
equal to 10% of net sales of our Darvocet A500 product and any other combination propoxyphene
napsylate and acetaminophen products we may sell in the future. In connection with the acquisition, we entered a three-year services agreement with Athlon
Pharmaceuticals to provide sales support in designated territories throughout the United States for
the Darvocet A500 product. After providing notice to Athlon of its material breach under this
agreement, we terminated this agreement on June 4, 2004 and initiated litigation. Athlon has
brought counterclaims seeking payment of unpaid monthly payments under the terminated contract and
additional litigation, now consolidated, with respect to the royalty provisions of the asset
purchase agreement pertaining to Darvocet A500. The litigation is continuing. See Part I, Item 3,
Legal Proceedings  Athlon Litigation below. Supply of Product. Darvocet A500 is manufactured and supplied by Mikart, Inc. (Mikart). Mikart
manufactures Darvocet A500 in its Atlanta, Georgia facility. We have entered into an agreement
with Mikart to supply us with our requirements for Darvocet A500 for an initial term ending 2013.
Thereafter, the agreement with Mikart will continue for successive one-year renewal terms unless
terminated by either party as set forth in the agreement. The agreement requires us to make a
payment to Mikart if we have not purchased a set amount of Darvocet A500 by September 2006. In the
fourth quarter of 2004, we incurred a purchase commitment charge of $11.7 million in connection
with the establishment of a reserve related to this minimum purchase requirement. We are currently
negotiating with Mikart to extend the term of the agreement by an additional multi-year period, and
to amend our obligation to purchase the minimum level of Darvocet A500 products to include
additional products to be manufactured by Mikart for us under this agreement and applied against
our minimum purchase requirement. If we are successful in amending the agreement on this basis,
the reserve and corresponding charge may be reversed in a subsequent period. We cannot provide any
assurance, however, that we will be successful in amending the agreement on any terms. Methadone Hydrochloride Injection. In April 2003, we acquired exclusive rights to a parenterally
administered methadone injectable product, formerly branded as Dolophine Hydrochloride Injection,
from Roxane. This product is indicated for the treatment of moderate-to-severe pain not responsive
to non-narcotic analgesics, and for use in temporary treatment of opioid dependence in patients
unable to take oral medication. We manufacture this product at our facility in Charleston, South Carolina. 6




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Critical Care Products Brethine. On December 13, 2001, we acquired the U.S. rights to the Brethine branded product line
from Novartis Pharmaceuticals Corporation and Novartis Corporation for $26.6 million in cash,
exclusive of transactional costs. On April 19, 2004, the FDA approved our Supplemental New Drug
Application for a vial presentation of the injectable form of this product, which replaced our
former ampul presentation. On November 1, 2004, we launched our Brethine vial presentation into
the U.S. market. IMPAX Laboratories has been marketing a generic version of the oral form of Brethine since July
2001. Multiple generic versions of the injectable form of this drug, including a vial presentation,
were approved starting in May 2004. Supply of Product. Until the agreement expired on December 13, 2004, we were party to an interim
supply agreement with Novartis providing for manufacture and packaging of the oral and injectable
form of Brethine for sale by us in the U.S. Under this supply agreement, we purchased the products
for a fixed unit cost that was subject to an annual price adjustment on January 1, 2003 and January
1, 2004 tied to the Consumer Price Index. We have transferred the Brethine vial manufacturing
processes to our Charleston, South Carolina facility. Azathioprine. In 2003, we received FDA approval to market three internally developed line
extensions of additional strengths to our current 50 mg generic azathioprine tablet product: 25 mg,
75 mg and 100 mg tablets. We began selling the 75 mg and 100 mg products in the first quarter of
2003. In November 2003, we granted Salix Pharmaceuticals an exclusive license to market the 25 mg,
75 mg, and 100 mg strengths of Azasan (azathioprine) and we licensed our Azasan trademark to Salix.
Under the agreement with Salix, we receive royalties on net sales. Salix has the right to
terminate this agreement at any time with six months written notice after October 31, 2006. We
entered into a three-year supply agreement with Salix to continue to manufacture these products and
supply all of Salixs needs. We continue to manufacture and sell our 50 mg azathioprine tablet
product as a generic product. Product Disposition and Discontinuance During 2004 M.V.I. and Aquasol. On August 17, 2001, we acquired the M.V.I. and Aquasol branded lines of
critical care injectable and oral nutritional products from AstraZeneca for $52.5 million,
exclusive of transactional costs, paid at closing, plus additional consideration described below.
Our M.V.I. and Aquasol product line acquisition agreement was amended on July 22, 2003. As
amended, it provided for two $1.0 million guaranteed payments, which were made in August 2002 and
2003, eliminated a contingent payment of $2.0 million that was potentially due in August 2003 under
the original agreement, and provided for a future contingent payment of $43.5 million potentially
due in August 2004, depending on the status of certain reformulation activities being carried out
by the seller and regulatory approval of the reformulation by the FDA. The amount of the $43.5
million contingent payment was to be reduced by $1 million per month if the conditions for the
contingent payment had not occurred by December 31, 2002. The conditions for the contingent
payment were not met by the required date, so the amount of the contingent payment had decreased by
$12.0 million by the end of December 2003. Such conditions were satisfied in January and February
2004, fixing the liability at $31.5 million, 7




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which was charged to operations and recorded as a liability on our consolidated financial
statements in the first quarter of 2004. Also on July 22, 2003, the M.V.I. supply agreement with
the seller was extended through 2008, subject to early termination rights by us on six months
notice given at any time, and by the supplier on twenty-four months notice given at any time on or
after August 17, 2004. The M.V.I. and Aquasol product lines did not have separable assets and
liabilities associated with them other than inventory; therefore, we allocated the remaining
purchase price to acquired identifiable intangible assets. On April 26, 2004, we sold our M.V.I. and Aquasol product lines to Mayne Pharma (USA) Inc. for $105
million, subject to adjustments based on inventory levels at closing and other post-closing
obligations. Of that amount, $10 million was held in escrow to satisfy our post-closing obligations
under the agreement. In September 2004, approximately $1.6 million of this escrowed amount was
paid to us. We do not anticipate receiving any additional payments out of this escrow. At the
closing of the transaction, we paid to AstraZeneca AB the $31.5 million payment due in August 2004,
which was discounted to approximately $31.0 million. This payment represented a payment upon FDA
approval of the reformulated product under the terms of the amended purchase agreement with
AstraZeneca. Calcitriol.In February 2002, we purchased a calcitriol product from Aesgen, Inc. for payments of
$1.0 million in cash and additional contingent milestone payments of up to $1.5 million.
Calcitriol is a drug used primarily to treat chronic kidney dialysis patients with abnormally low
levels of calcium in their blood. In 2003, the prerequisite for payment of $500,000 of such
contingent milestones occurred and such payment was made to Aesgen. The prerequisites for payment
of the remaining $1.0 million of such contingent milestones were not met. We also sold calcitriol under an exclusive manufacturing and co-promotion agreement with Sicor
Pharmaceuticals, Inc. pursuant to which we acquired U.S. marketing rights to, and sold, Sicor
Pharmaceuticals calcitriol product under their regulatory approval. We amended the 2002
calcitriol injection acquisition agreement with Aesgen in 2003 to provide for royalty payments to
Aesgen on the gross margin we realized from our sales of the calcitriol product marketed under
Sicors regulatory approval and to provide for potential payments to Aesgen in connection with a
reacquisition by Sicor or an assignment to a third party of the U.S. marketing rights to calcitriol
injection. On December 23, 2004, Sicor Pharmaceuticals reacquired its U.S. marketing rights to
calcitriol injection, pursuant to the termination of the manufacturing and co-promotion agreement
discussed above. In connection with such termination, Sicor paid us $3.5 million. We no longer
commercialize calcitriol. AAI Development Services  Our Development Services Business AAI Development Services offers a comprehensive range of pharmaceutical product development
services to our customers, who are located worldwide. These services include formulation
development, analytical, microbiological, bioanalytical and stability testing services, production
scale-up, biotechnology analysis, human clinical trials, regulatory and quality consulting, and
manufacturing. These services generally are provided on a fee-for-service basis. AAI Development Services provides its services, both individually and in an integrated fashion, to: 8




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
    our customers, to help them develop, optimize, control, and supply their drug products;
    our Pharmaceuticals Division, to support product life cycle management and commercial
manufacture of the acquired drug products; and
    our research and development activities, by executing on defined project plans and
managing our portfolio of patents and drug-delivery technologies.  Since our founding in 1979, we have contributed to the submission, approval or continued marketing
of many client products, encompassing a wide range of therapeutic categories and technologies. We
believe that our ability to offer an extensive portfolio of high quality drug development and
support services enables us to effectively compete as pharmaceutical and biotechnology companies
look for a mixture of stand-alone and integrated drug development solutions that offer
cost-effective results on an accelerated basis.We have a strong base of resources, expertise, and ideas that allows us to develop and improve drug
products and carry out product life cycle management activities both for our customers and
ourselves. Our expertise covers many therapeutic categories and types of pharmaceutical products.We focus on our customers individual needs when marketing our services, often placing our
technical personnel with our clients development teams to participate in planning meetings for the
development or improvement of a product. We assign our sales and technical personnel as contacts
for our larger clients, understanding that technical personnel may be better able to identify the
full scope of our clients needs and suggest innovative approaches.Generally, AAI Development Services fee-for-service contracts are terminable by the client upon
notice of 30 days or less. Although the contracts typically permit payment of certain fees for
winding down a project or for work incurred to date, the loss of a large contract or the loss of
multiple contracts could adversely affect our future revenue and profitability in our Development
Services business. Contracts may be terminated for a variety of reasons, including the clients
decision to stop a particular study, the failure of product prototypes to satisfy safety
requirements, and unexpected or undesired results of product testing.Pharmaceutical ServicesAAI Development Services provides a variety of pharmaceutical services to its customers, including
drug formulation development and small scale manufacturing, as well as storage and distribution of
clinical trial supplies. The services are organized to help clients from the pre-clinical to
post-marketing stages.Formulation Development Services. AAI Development Services provides integrated formulation
development services for customers pharmaceutical products to develop safe and stable products
with desired characteristics. AAI Development Services provides services during each phase of the
drug development process, from new compounds to modifications of existing products. These
formulation development projects may last for a short duration or for several years. 9




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The formulation development group also manages our portfolio of intellectual property assets,
including patents and technologies, which are available for licensing to third parties or
incorporation into our existing product pipeline, see Research and Development  Our Drug-Delivery
Technologies.Manufacture of Clinical Trial Supplies and Third Party Pharmaceutical Products. AAI Development
Services manufactures clinical trials materials for Phase I through IV drug-product clinical
trials. It has experience in manufacturing tablets, capsules, liquids, and suspensions. Outsourcing
of clinical supply manufacturing is particularly attractive to pharmaceutical companies that
maintain large, commercial-quantity, batch facilities, where clinical supply manufacturing would
divert resources from revenue-producing manufacturing. AAI Development Services has a dedicated
25,000 square foot facility in Wilmington, North Carolina and another facility in Neu-Ulm, Germany
to distribute and track clinical trial materials used in clinical studies. Additionally, it has
the capacity for controlled substance storage and handling. AAI Development Services provides its
clients with assistance in scaling up production of clinical supply quantities to commercial
quantity manufacturing and provides small batch commercial manufacturing capabilities.AAI Development Services also manufactures certain drugs for commercial sale by third-party
pharmaceutical company clients. These products range from small volume, high-potency or
high-toxicity drug products, to larger scale oral solid products. Oral products are manufactured
in our Wilmington, North Carolina facility, while sterile injectable products are manufactured in
our Charleston, South Carolina facility.Analytical ServicesAAI Development Services provides a wide variety of analytical services, as well as services
pertaining to method development and validation, drug product and active pharmaceutical ingredient
characterization and control, microbiological support, stability storage and studies, technical
support, and problem solving. Our analytical services include:  
    Method development and validation;
    Product characterization;
    Raw materials and product release testing; and
    Stability studies. Biopharmaceutical Services AAI Development Services integrates a Phase I clinical study capability with bioanalytical and
biotechnology expertise to provide biopharmaceutical services to its customers. The analysis of
drugs, metabolites, and endogenous compounds in biological samples is a core service. Our
biopharmaceutical services include:  
    Phase I clinical services from our 88-bed Phase I clinical trial facility located in
Research Triangle Park, North Carolina, and a 72-bed facility in Neu-Ulm, Germany;
    Microbiological testing;
    Bioanalytical testing; and 10




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
    Biotechnology analysis. Phase I to IV Clinical Services AAI Development Services provides a broad range of Phase I through IV clinical services to
customers in the pharmaceutical, biotechnology, and medical device industries for assistance in the
drug development and regulatory approval process in North America and Europe. The clinical services
include clinical protocol and program development, global clinical strategy consulting,
investigator/site management, clinical trial management and monitoring, Project Management, site
selection, medical affairs (including safety surveillance, pharmacovigilance and serious adverse
event management), data management, and biostatistics. Regulatory and Other Consulting Services AAI Development Services provides consulting services with respect to regulatory affairs, quality
compliance, and process validations. It assists in the preparation of regulatory submissions for
drugs, devices, and biologics, audits clients vendors and client operations, conducts seminars,
provides training courses, and advises clients on applicable regulatory requirements. AAI
Development Services also assists clients in designing development programs for new or existing
drugs intended to be marketed in the United States and Europe. Research and Development Our research and development expenditures for 2005 will be significantly below historical trends
due to our financial condition. In March 2005, we reorganized our research and development group
to maximize efficiency, given the limited resources available to us. Our research and development
efforts are currently focused on three products in development. The oversight of the development
efforts on our pipeline products is conducted by a group within our Pharmaceuticals Division to
ensure the proper alignment of development efforts and commercial opportunities. The management of
our intellectual property assets, including our drug delivery technologies and patents, is
conducted by the Formulations Development Services group in our AAI Development Services Division. Our Drug-Delivery Technologies Our portfolio of internally developed and in-licensed drug-delivery technologies includes:  
    ProCore a patented technology for controlled release of a drug incorporated into a
two-layer coated pellet. The first layer allows for control of the lag time before an
active agent begins its release while the second layer controls the rate of release, and
thus the duration of the sustained release effect for the product.
    ProSorb a technology designed to accelerate absorption rates and potentially minimize
inter- or intra-patient variability. It generally permits weakly acidic compounds to
exhibit a shorter onset of action relative to conventional dosage forms. The concept is
that acidic drugs with the benefit of the technology form a dispersion pattern upon release
in the stomach that allows for faster stomach clearance and more rapid absorption in the
intestinal tract. ProSorb is a broad-based technology primarily used with liquid or 11




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encapsulated drug products. The application of this technology to diclofenac, a
non-steroidal anti-inflammatory drug, has resulted in our proprietary Lynxorb product
candidate, which is discussed below.  
    ProLonic AQ a drug-delivery technology specifically designed to release an active
agent in the colon. This technology can be incorporated into a tablet, a pellet, or a
capsule dosage form and uses conventional manufacturing equipment and aqueous coating
processes. The advantage represented by this technology is the ability to control the
location and timing of release and eliminate the need for solvent-based safety concerns.
    ProSLO and ProSLO II an osmotic technology designed to produce controlled release
product therapy with either a single drug or a combination of drugs. Osmotic action is the
natural movement of an aqueous solution through a membrane and is used to make oral drug
administration more accurate, precise, and convenient. This technology allows for an
immediate release component in the outside layer of a laser drilled tablet. This
facilitates two release patterns for a single drug (i.e., bi-phasic) or a combination of
multiple active ingredients with different release requirements. The advantages over
existing technologies are its easy scalability, the ability to use it with numerous active
ingredients, the ability to create both a long- and short-acting drug combination, and its
ability to handle what normally are reasonably insoluble active ingredients. We own the ProCore, ProSorb, and Prolonic AQ technologies. The ProSLO and ProSLO II technologies
are available for use by us and our clients throughout the world, except Latin America, through an
agreement with Osmotica Corporation. We have entered into a Cooperative Venture Agreement with
Osmotica Corporation to develop, manufacture, and license various new drug products with third
party organizations. This agreement enables us to develop mutually acceptable new drug products or
improve the characteristics of mutually acceptable products and compounds utilizing patents, patent
applications, and know-how associated with pharmaceutical formulation technologies for such
products. On January 15, 2004, we announced that Aventis submitted an NDA to the FDA for Allegra-D 24-hour
tablets. This is a fexofenadine/pseudoephedrine formulation developed under our agreement with
Osmotica with a patented extended release drug-delivery technology, ProSLO II. This product was
approved by the FDA on October 19, 2004. We received a milestone payment from Aventis for that
approval and expect to receive royalties on sales of the product in 2005. Our Internal Product Development Pipeline In 2004, we worked on three development projects:  
    A modified release Darvocet product. We have discussed our development plan with the
FDA and, based on FDA input, we are implementing a development plan which we believe will
be appropriate for filing our regulatory submission. We hope to complete pivotal trials for
this product in early 2006.
    Lynxorb - a formulation of diclofenac that utilizes our proprietary ProSorb
technology to enhance the amount and speed of absorption of this potent inhibitor of COX1
and COX2 12




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enzymes. We have submitted our pivotal trial protocol to the FDA for comment. Pivotal
trials for this product may be delayed due to budget constraints and liquidity concerns.
    An aaiPharma formulation of a generic proton pump inhibitor has made significant
progress in achieving the desired pharmacokinetic profile. We believe further development
of this product will be delayed due to budget constraints and liquidity concerns. For fiscal years 2004, 2003 and 2002, our expenditures on research and development were $16.3
million, $21.8 million and $20.9 million, respectively. Due to liquidity constraints, we
anticipate that 2005 expenditures on research and development will significantly decline. We can
provide no assurances that we will be able to fund further research and development activities on
these or any other projects in 2005, or at all. The only product under active development is the
Darvocet line extension. Information Technology Significant upgrades to our core information systems were completed during 2004. These upgrades
will help improve on-going compliance with legal requirements and expand our capabilities to
automate data capture. New systems were placed into operational use in 2004 to handle increased
data volume and to ensure compliance with FDA regulations for the clinical trials work provided by
AAI Development Services. The end of 2004 marked the completion of a three-year information
technology cycle where all personal computers and core infrastructure were replaced. Our
customized data management system connects analytical instruments with multiple software
architectures permitting automated data capture. We believe that information technology enables us
to expedite the development process by designing innovative services for individual client needs,
providing project execution, monitoring and control capabilities that exceed a clients internal
capabilities, streamlining and enhancing data presentation to the FDA and improving our own
internal operational productivity, while helping to maintain quality. Customers The Pharmaceuticals Divisions customers are primarily large well-established pharmaceutical
wholesalers. Cardinal Health, Inc., AmerisourceBergen Corporation and McKesson Corporation
accounted for approximately 7.3%, 9.4% and 13.1% of our 2004 consolidated net revenues,
respectively, and 20.2%, 26.0% and 36.3%, respectively, of our Pharmaceuticals Division net
revenues. As is customary in the pharmaceutical industry, we accept returns of products we have
sold as the products near their expiration date. Significant research and development projects have a defined cycle, and accordingly, the customers
of our AAI Development Services Division and customers for our research and development activities
change from year to year. Because of the project nature of engagements in these business segments,
large customers may represent a significant portion of the business in one period but not
subsequent periods. We have experienced concentration in these areas of our business in the past,
and do not believe that this is unusual for companies which operate in this market. 13




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Backlog Our order backlog consists of anticipated net revenues from signed fee-for-service contracts for
which services have not been completed. Once contracted work begins, net revenues are recognized as
the service is performed. The order backlog does not include anticipated net revenues for work
performed for internal clients or for any variable-priced contracts. During the course of a
project, a client may substantially adjust the requested scope of services and corresponding
adjustments are made. Our order backlog also includes orders for pharmaceutical products that have
been ordered by our customers, but have not yet been shipped. We believe that our order backlog as of any date is not a complete predictor of future results due
to the variability and short duration of many of our development services contracts. The backlog
can also be affected by adjustments in the scope of contracted projects. At December 31, 2004 and
2003, our order backlog was approximately $47.8 million and $52.0 million, respectively. We do not
expect to fill approximately $11.2 million of the 2004 amount by December 31, 2005, which is
related to longer term clinical trials and stability projects. Included in the backlog total at
December 31, 2004 is $3.1 million for pharmaceutical products ordered but not yet shipped. Competition We compete with companies and organizations in multiple segments of the pharmaceutical industry.
The branded drug products of our Pharmaceuticals Division are subject to competition from the
branded and generic products of other pharmaceutical companies, ranging from small specialty
pharmaceutical companies to large pharmaceutical companies. The following tables illustrate the products that compete with the products we sell: Our Branded Products Our Products
    
    Competitors ProductsBrethine (tablet)
    
    VolmaxProventilBranded and generic forms of Albuterol sulfateGeneric terbutaline sulfateBrethine (injectable)
    
    Generic terbutaline injectableOramorph SR
    
    AvinzaKadianMS ContinGeneric MS ContinRoxicodone
    
    generic immediate release oral liquid and solid
forms of oxycodoneRoxanol
    
    Generic oral liquid morphine
 14




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Our Products
    
    Competitors ProductsDarvon/Darvocet
    
    Generic propoxyphene productsMethadone injection (1)
    
    injectable hydromorphoneinjectable oxymorphoneinjectable meperidineinjectable fentanyl
    Our Generic Product Our Product
    
    Competitors ProductsAzathioprine
    
    Imuranother generic azathioprine products
 We do not believe that there are any products that are competitive with our Duraclon product. In
addition to the competitive products listed above, additional competitive products may be
introduced in the future. Our AAI Development Services Division and research and development activities compete primarily
with in-house research, development, quality control, and other support service departments of
pharmaceutical and biotechnology companies, as well as university research laboratories and other
contract research organizations. Some of our competitors, however, may have significantly greater
resources than we do. Competitive factors generally include reliability, turn-around time,
reputation for innovative and quality science, capacity to perform numerous required services,
financial viability, and price. Government Regulation The services that we perform and the pharmaceutical products that we develop, manufacture, and sell
are subject to various rigorous regulatory requirements designed to ensure the safety,
effectiveness, quality, and integrity of pharmaceutical products, primarily under the Federal Food,
Drug, and Cosmetic Act, including current Good Manufacturing Practice regulations. These
regulations are commonly referred to as the cGMP regulations and are administered by the FDA in
accordance with current industry standards. Our services and development efforts performed outside
the U.S. and products intended to be sold outside the U.S. are also subject to additional foreign
regulatory requirements and government agencies. U.S. laws and federal regulations apply to all phases of investigational and commercial development
(i.e. manufacturing, testing, promotion and distribution of drugs, including with respect to our
personnel, record keeping, facilities, equipment, control of materials, processes, laboratories,
packaging, labeling, storage, and advertising). If we fail to comply with these laws and
regulations, our drugs, drug improvements, and product line extensions will not be approved by the
FDA or will be withdrawn from the market and the data we collect may be out of specification and
not acceptable to the FDA requirements, which may result in us not being 15




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permitted to market our products. Additionally, we could be subject to significant monetary fines,
recalls and seizures of products, closing of our facilities, revocation of drug approvals
previously granted to us, and criminal prosecution. Any of these regulatory actions could
materially and adversely affect our business, financial condition, and results of operations. To help assure our compliance with applicable laws and regulations, we have quality assurance
controls in place at our facilities and we use FDA regulations and guidelines, as well as
applicable international standards, as a basis for our quality policies and standard operating
procedures. We regularly audit test data, inspect our facilities, and revise our standard operating
procedures to meet current cGMPs. In addition, we maintain a system for monitoring product-related
complaints for all of our commercial products. The balance of adhering to FDA compliance while bringing products to market requires us to
continuously improve our operating standards in order to reduce the possible risk of FDA actions.
In the event of any such action of a material nature, the resulting restrictions on our business
could materially and adversely affect our business, financial condition, and operating results. All of our drugs, investigational and commercial, must be manufactured in conformity with
International Conference on Harmonization, or ICH, guidances, cGMP regulations, and FDA guidances
and guidelines. Drug products subject to an approved FDA-application must be manufactured,
processed, packaged, held, and labeled in accordance with information contained in the application.
Modifications, enhancements, or changes in manufacturing sites of approved products are in many
cases subject to additional FDA inspections and supplemental approvals to the existing application.
The circumstances requiring inspections and supplemental filings may require a lengthy application
process. Our facilities, including the facilities used in our development services business and
those of our third-party manufacturers, are periodically subject to inspection by the FDA and other
governmental agencies. If such inspections prove unsatisfactory, the operations at these facilities
could be interrupted or halted for lengthy periods of time. Failure to comply with FDA or other governmental regulations can result in warning letters. If
those warning letters are not adequately addressed, further actions may lead to fines,
unanticipated compliance expenditures, recall or seizure of products, or total or partial
suspension of production or distribution. For drugs under FDA review, failure to be compliant at
manufacturing facilities could stop the FDAs review of our drug approval applications that could,
in certain circumstances, extend to the termination of ongoing research, disqualification of data
for submission to regulatory authorities, enforcement actions, injunctions, and criminal
prosecution. Under certain circumstances, the FDA also has the authority to revoke previously
granted drug approvals. Although we have instituted internal compliance programs that consistently
comply with cGMPs through strong training and corporate quality oversight, we are cognizant that if
these programs do not meet regulatory agency standards or if compliance is deemed deficient in any
significant way, it could have a material adverse effect on us, our third party manufacturers, and
our vendors. Most of our vendors are subject to similar regulations and periodic inspections. 16




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Some of our development and testing activities for our customers, and the manufacture, development,
and testing of the line of pain management products (the New Pain Products) that we acquired from
subsidiaries of Elan, our Darvon and Darvocet products, and our methadone hydrochloride product,
are subject to the Controlled Substances Act, administered by the Drug Enforcement Administration,
which strictly regulates all narcotic and habit-forming substances. We maintain separate,
restricted-access facilities and heightened control procedures for projects involving such
substances due to the level of security and other controls required by the DEA. Our business also involves the controlled storage, use, and disposal of hazardous materials and
biological hazardous materials. We are subject to numerous federal, state, local, and foreign
environmental regulations governing the use, storage, handling, and disposal of these materials.
Although we believe that our safety procedures for handling and disposing of these hazardous
materials comply in all material respects with the standards prescribed by law and regulation in
each of our locations, the risk of accidental contamination or injury from hazardous materials
cannot be completely eliminated. We maintain liability insurance for some environmental risks that
our management believes to be appropriate and in accordance with industry practice. However, we may
not be able to maintain this insurance in the future on acceptable terms. In the event of an
accident, we could be held liable for damages that are in excess or outside of the scope of our
insurance coverage or that deplete all or a significant portion of our resources. We are also governed by federal, state and local laws of general applicability, such as laws
regulating intellectual property, including patents and trademarks, working conditions, equal
employment opportunity, and environmental protection. In connection with our activities outside the U.S., we also are subject to foreign regulatory
requirements governing the testing, approval, manufacture, labeling, marketing, and sale of
pharmaceutical products, which requirements vary from country to country. Whether or not FDA
approval has been obtained for a product, approval by comparable regulatory authorities of foreign
countries must be obtained prior to marketing the product in those countries. For example, some of
our foreign operations are subject to regulations by the European Medicines Evaluations Agency and
the U.K. Medicines and Healthcare products Regulatory Agency. The approval process may be more or
less rigorous from country to country, and the time required for approval may be longer or shorter
than that required in the U.S. Therefore pharmaceutical product approval and policies for pricing
required for marketing will vary from country to country due to different regulations and policies
required by each. The Drug Development Regulatory Process New Drug Approval Process. FDA approval is required before any new drug can be marketed and sold
in the U.S. This approval is obtained through the new drug application, or NDA, process, which
involves the submission to the FDA of complete pre-clinical data about new compounds and their
characteristics, clinical data obtained from studies in humans showing the safety and effectiveness
of the drug for the proposed therapeutic use, and chemistry, manufacturing, and controls data
documenting how the drug is made and manufacturing operations are controlled. 17




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Before introducing a new drug into humans, stringent government requirements for pre-clinical data
must be satisfied. The pre-clinical data is obtained from laboratory studies, and tests performed
on animals, which are submitted to the FDA in an investigational new drug application, or an IND.
The pre-clinical data must provide an adequate basis for evaluating both the safety and the
scientific rationale for the initiation of clinical trials of the new drug in humans. Pursuant to
the IND, the new drug is tested in humans for safety, adverse effects, dosage, tolerance
absorption, metabolism, excretion and other elements of clinical pharmacology, and for
effectiveness for the proposed therapeutic use. Clinical trials are conducted in three sequential phases (i.e., Phase I, Phase II, and Phase III).
The clinical development plan or the process of completing clinical trials during the
investigational period for a new drug may take several years and require the expenditure of
substantial operational and financial resources. Phase I clinical trials frequently begin with the
initial introduction of the investigational drug product into healthy humans and test primarily for
safety. Phase II clinical trials typically involve a small sample of the intended patient
population to assess the efficacy of the investigational drug product for a specific indication, to
determine dose tolerance and the optimal dose range, and to gather additional information relating
to safety and potential adverse effects. Phase III clinical trials are studies with a
statistically qualified larger study population that compares the active drug product against a
placebo. These studies, conducted in a randomized group where the drug and placebo are typically
blinded from the physician and patient, further evaluate clinical safety and efficacy at different
study sites to determine the overall risk-benefit ratio of the drug and provide an adequate basis
for product labeling. Each clinical trial is conducted in accordance with rules, or protocols, that are developed to
detail the objectives of the study, including methods to monitor safety and efficacy and the
precise criteria to be evaluated. These protocols must be submitted to the FDA as part of the IND.
In some cases, the FDA allows a company to rely on data developed in foreign countries, or
previously published data, which eliminates the need to independently repeat some or all of the
studies. Once sufficient data have been developed pursuant to the IND, the NDA is submitted to the FDA to
request approval to market the new drug. Preparing an NDA involves substantial data collection,
verification and analysis, and expense, and there is no assurance that FDA approval of an NDA can
be obtained on a timely basis, if at all. The approval process is affected by a number of factors,
primarily the risks and benefits demonstrated in clinical trials as well as the severity of the
disease and the availability of alternative treatments. The FDA might not approve an NDA if the
regulatory criteria are not satisfied or, alternatively, may require additional studies to enhance
the overall risk-benefit ratio prior to an approval action. Referencing and Relying on New Drug Applications. With respect to the branded pharmaceutical
products (e.g., Darvon and Darvocet) that we have acquired, we are often able to reference the
original NDA along with the marketing rights to the products. As a result, when improving these
products or developing product line extensions, we are permitted to file a supplemental NDA, or a
new drug application known as a 505(b)(2) NDA, that directly cross references all of the data in
the original application. This provision in the federal Food, Drug, and Cosmetic Act allows us to
shorten our development process for improvements and line extensions. For example, we may 18




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be able to reduce the number of clinical trials in a clinical development plan with less extensive,
less time-consuming, and less costly Phase II and Phase III testing, with respect to any new
products that we may select to develop. Similarly, a 505(b)(2) application allows us to cross reference NDAs, or information therein, that
we do not own and are not authorized to reference directly. The 505(b)(2) NDA may, in certain
cases, permit us to meet NDA approval requirements with less original scientific data than would
normally be required, and may allow us to begin drug development in a later phase, so as to reduce
the time and expense involved in any particular phase, for any new products we select to develop.
Applications under 505(b)(2) are subject to certain patent and non-patent exclusivity rights
applicable to the NDAs on which they rely, if such rights remain in effect when such applications
are submitted. If we are unable to proceed with anticipated 505(b)(2) applications for any of the
products that we are developing, our FDA approval costs will increase. Abbreviated New Drug Application Process for Generic Products. A generic drug contains the same
active ingredient as a specified brand name drug and usually can be substituted for the brand name
drug by the pharmacist. FDA approval is required before a generic drug can be marketed. Approval of
a generic drug is obtained through the filing of an abbreviated new drug application, or an ANDA,
under section 505(j) of the Food, Drug, and Cosmetic Act. Submission and approval of an ANDA is
subject to certain patent and non-patent exclusivity rights applicable to the brand name drug, if
such rights remain in effect when the ANDA is submitted. When processing an ANDA, the FDA waives
the requirement of conducting full clinical studies provided that the drug is proven bioequivalent
to the reference listed drug (i.e., usually the applicant of the NDA) in a Phase I study conducted
in a small number of healthy volunteers. Bioavailability relates to the rate and extent of
absorption and levels of concentration of a drug active ingredient in the blood stream needed to
produce a therapeutic effect. Bioequivalence compares the bioavailability of one drug with another
that contains the same active ingredient, and when established, indicates that the rate and extent
of absorption and levels of concentration of a generic drug in the body are the same as the
previously approved brand name drug. An ANDA may be submitted for a drug on the basis that it is
the equivalent to a previously approved drug or, in the case of a new dosage form or other close
variant, is suitable for use under the conditions specified. The timing of final FDA approval of ANDAs depends on a variety of factors, including whether the
applicant challenges any listed patents for the brand-name drug and whether the brand-name
manufacturer is entitled to one or more non-patent statutory exclusivity periods, during which the
FDA is prohibited from accepting or approving applications for generic drugs. Under section 505(j), the FDA may impose debarment and other penalties on individuals and companies
that commit certain illegal acts relating to the generic drug approval process. In some situations,
the FDA is required not to accept or review ANDAs for a period of up to three years from a company
or an individual that has committed certain violations. The FDA may temporarily deny approval of
ANDAs during the investigation of certain violations that could lead to debarment and also, in more
limited circumstances, suspend the marketing of approved generic drugs by the affected company. The
FDA also may impose civil penalties and withdraw previously approved ANDAs. Neither we nor any of
our employees have ever been the subject of debarment procedures. 19




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Manufacturing Requirements. Before approving a drug, the FDA also requires that our procedures and
operations conform to cGMP regulations, ICH guidances and manufacturing guidelines and guidances
published by the FDA. We must be in compliance with all of the regulatory and quality regulations
at all times during the manufacture of our products. To help insure compliance with the regulatory
and quality regulations, we must continue to spend time, money, and effort in the areas of
production and quality control to ensure full technical compliance. If the FDA believes a company
is not in compliance with its regulations, it may withhold new drug approvals, as well as approvals
for supplemental changes to existing approvals, preventing the company from exporting its products.
It may also classify the company as an unacceptable supplier, thereby disqualifying the company
from selling products to federal agencies. We believe we are currently in compliance with the cGMP
regulations. Post-approval Requirements. After initial FDA approval for the marketing of a drug has been
obtained, further studies, including Phase IV studies, typically regarded as post-marketing
studies, may be required to provide additional data on safety or effectiveness. Also, the FDA
requires post-marketing reporting to monitor the adverse effects of the drug. Results of
post-marketing programs may limit or expand the further marketing of the drug. Further, if there
are any modifications to the drug, including changes in indication, manufacturing process, or
manufacturing facility, a supplemental application seeking approval of the modifications must be
submitted to the FDA or other regulatory authority. Prospectively, the FDA regulates our
post-approval promotional labeling and advertising activities to assure that such activities are
being conducted in conformity with statutory and regulatory requirements. Health Care Fraud and Abuse Laws Federal and state health care fraud and abuse laws have been applied to restrict certain marketing
practices in the pharmaceutical industry in recent years. These laws include antikickback statutes
and false claims statutes. The federal health care program antikickback statute makes it illegal
for anyone to knowingly and willfully make or receive kickbacks in return for any health care
item or service reimbursed under any federally financed healthcare program. This statute applies
to arrangements between pharmaceutical companies and the persons to whom they market, promote,
sell, and distribute their products. In 2003, the Office of the Inspector General of the
Department of Health and Human Services issued a Compliance Program Guidance for Pharmaceutical
Manufacturers describing pharmaceutical companies activities that may violate the statute. There
are a number of exemptions and safe harbors protecting certain common marketing activities from
prosecution. These include exemptions or safe harbors for product discounts, payments to employees,
personal services contracts, warranties, and administrative fees paid to group purchasing
organizations. These exemptions and safe harbors, however, are drawn narrowly. Federal false claims laws prohibit any person from knowingly making a false claim to the federal
government for payment. Recently, several pharmaceutical companies have been investigated or
prosecuted under these laws, even though they did not submit claims to government healthcare
programs. The prosecutors alleged that they were inflating drug prices they report to pricing
services, which are in turn used by the government to set Medicare and Medicaid reimbursement
rates. Pharmaceutical companies also have been prosecuted under these laws for allegedly 20




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providing free products to customers with the expectation that the customers would seek
reimbursement under federal programs for the products. Additionally, the majority of states have laws similar to the federal antikickback law and false
claims laws. Sanctions under these federal and state laws include monetary penalties, exclusion
from reimbursement for products under government programs, criminal fines, and imprisonment. We have internal policies and practices requiring compliance with the health care fraud and abuse
laws and false claims laws. Because of the breadth of these laws and the narrowness of the safe
harbors, however, it is possible that some of our business practices could be subject to challenge
under one or more of these laws, which could have a material adverse effect on our business,
financial condition, and results of operations. Employees At December 31, 2004, we had 924 full-time equivalent employees,
a material reduction from the approximate 1,300 employees at December 31, 2003. At March 31, 2005, we had 855 full time
equivalent employees. The decline in the number of employees resulted both from reductions in
force and voluntary attrition of employees who were not replaced. While we believe that our
relations with our employees are good, our uncertain financial condition has resulted in the loss
of a significant number of employees at all levels, including management. None of our employees in
the U.S. are represented by a union. European laws provide certain representative rights to our
employees in those jurisdictions. Our continued performance depends on our ability to attract and retain qualified professional,
scientific, and technical staff. The level of competition among employers for these skilled
personnel is high. We have experienced difficulty in attracting and retaining qualified staff for
certain positions in our Phase II and III U.S. operations, where high turnover is an industry-wide
problem, and in other skilled positions. It is possible that as competition for skilled employees
increases at our other operations or locations, we could experience similar problems there as well.
Our liquidity issues and uncertain financial condition, our potential bankruptcy filing, our
potential sale of material assets, declines in our stock price, and reductions in force have also
decreased, and may continue to decrease, our ability to attract and retain employees. Intellectual Property Our ability to successfully commercialize new branded products or technologies is significantly
enhanced by our ability to secure and enforce strong intellectual property rights  generally
patents  covering these products and technologies, and to avoid infringement of valid third-party
patents. We intend to seek patent protection in the United States and selected foreign countries
and to vigorously prosecute patent infringements, as we deem appropriate. We currently own patents
issued by the U.S. Patent and Trademark Office, and have additional patent applications filed and
pending with the U.S. Patent and Trademark Office. Additionally, we have assigned or transferred
six of our U.S. patents, one Canadian patent and three of our invention disclosure memoranda to
third parties for value. 21




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Our patents cover proprietary processes and techniques, or formulation technologies, that may be
applied to both new and existing products and chemical compounds. Our patents also cover new
chemical entities or compounds, pharmaceutical formulations, and methods of using certain
compounds. We are actively pursuing patent infringement against Kremers Urban Development Co., Schwarz Pharma
Inc. and their related companies to protect our rights under two of our patents with respect to
omeprazole. During the first twenty-two months of sales, the defendants in this action have
publicly confirmed approximately $1.3 billion in sales from the product that we believe is
infringing our patents. Litigation involves a high degree of uncertainty as to outcomes, and we
cannot predict the outcome of our infringement claims. The defendants have also asserted various
counter claims against us, including violations of antitrust laws. See Item 3. Legal Proceedings
 Patent Litigation for more information on this proceeding. We have a license in the U.S. and some other countries to use the patents, patent applications, and
know-how associated with certain pharmaceutical formulation technologies for mutually acceptable
drug candidates. The ProSLO and ProSLO II technologies are licensed from Osmotica Corporation.
Like our own formulation technologies mentioned above, these technologies may be used to develop
mutually acceptable new drug products or improve the characteristics of mutually acceptable
existing products and compounds. In addition to our patents, we rely upon trade secrets and unpatented proprietary know-how where we
believe public disclosures would not be in our best strategic interest. We seek to protect these
assets as permitted under state or federal law and by requiring our employees, consultants,
licensees, and other companies to enter into confidentiality and nondisclosure agreements and, when
appropriate, assignment of invention agreements. In the case of strategic partnerships or collaborative arrangements requiring the sharing of data,
our policy is to disclose to our partner only such data as is relevant to the partnership or as
required under the arrangement during its term. Item 2. Properties Our principal executive offices are located in Wilmington, North Carolina, in a 73,000 square foot
owned facility. Our primary U.S. facilities are located in Wilmington, North Carolina; Research
Triangle Park, North Carolina; Natick, Massachusetts; Charleston, South Carolina; and Shawnee,
Kansas. These facilities provide approximately 358,000 square feet of total operational and
administrative space. Our primary European facility is located in Neu-Ulm, Germany and includes
approximately 112,400 square feet of operational and administrative space. We also have U.S. sales
representatives for our Development Services business based throughout the United States and
foreign sales representatives for such business based in Japan, Sweden, Germany, and the U.K. We
believe that our facilities are adequate for our current operations and that suitable additional
space will be available when needed. 22




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Primary Operating Facilities ApproximateSquareLocation
    
    Primary Use
    
    Footage
    
    Leased/OwnedWilmington, N.C.
    
    Corporate Headquarters
    
    
    73,000
    
    
    OwnedWilmington, N.C.
    
    Manufacturing/Warehouse/
Office
    
    
    45,200
    
    
    OwnedWilmington, N.C.
    
    Laboratory/Office
    
    
    20,000
    
    
    Leased; lease
expires October
2006Wilmington, N.C.
    
    Laboratory/Office
    
    
    33,000
    
    
    OwnedWilmington, N.C.
    
    Clinical Distribution
Warehouse and Storage for
Stability Studies
    
    
    25,600
    
    
    Leased; lease
expires September
2008Chapel Hill, N.C.
    
    Laboratory/Clinic
    
    
    31,000
    
    
    OwnedShawnee, Kansas
    
    Laboratory/Office/Warehouse
    
    
    31,500
    
    
    Leased; lease
expires December
2005Natick, Mass.
    
    Office
    
    
    44,800
    
    
    Leased; lease
expires March 2007Charleston, S.C.
    
    Sterile Manufacturing/Office
    
    
    48,000
    
    
    Leased; lease
expires July 2011Neu-Ulm, Germany
    
    European Headquarters/
Laboratory/Clinic
    
    
    112,400
    
    
    Leased; lease
expires December
2008Mississauga, Ontario
    
    Office
    
    
    5,100
    
    
    Leased; lease
expires January,
2006
 We have been notified by the landlords of our leased facilities in New Jersey and California, as
well as one leased facility in North Carolina, that we are in default for failure to make the April
2005 lease payments for these facilities. We are not using any of these leased facilities. Item 3. Legal Proceedings We are party to lawsuits and administrative proceedings incidental to the normal course of our
business. Our material legal proceedings are described below. We cannot predict the outcomes of
these matters. As noted below, we believe that any liabilities related to such lawsuits or
proceedings, if adversely determined, could have a material adverse effect on our consolidated
financial condition, results of operations and cash flows. Prosecuting and defending these
material legal proceedings, including responding to governmental inquiries, has resulted, and is 23




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expected to continue to result, in a significant diversion of managements attention and resources
and an increase in professional fees. Government Investigations In April 2004, in connection with an investigation conducted by the United States Attorneys Office
for the Western District of North Carolina (the U.S. Attorneys Office), we received five federal
grand jury subpoenas for document production and potential testimony related to, among other
things, certain transactions regarding our 2002 and 2003 financial information, the terms,
conditions of employment, and compensation arrangements of certain of our senior management
personnel, compensation and incentive arrangements for employees responsible for the sale of our
Brethine, Darvocet, calcitriol, azathioprine and Darvon Compound products, quantities of the
foregoing products in distribution channels, financial benefits with respect to specified corporate
transactions to our senior management and others, certain loans obtained by us, extensions of
credit, if any, by us to officers or directors, accounting for sales and returns of our foregoing
products, our analysts conference calls on financial results, internal and external investigations
of pharmaceutical product sales activities, and related matters. The SEC has also commenced an
investigation and we have received a subpoena from the SEC covering similar matters. In addition,
both the U.S. Attorneys Office and the SEC have made informal requests for documents and other
information related to these matters. Certain of our current and former officers, directors, and
employees have received subpoenas to appear before the federal grand jury or requests to provide
information to the U.S. Attorneys Office. A former officer of our company, David M. Hurley, has
been advised by the U.S. Attorneys Office that he is a target of its investigation. We and a special committee of our Board of Directors established in February 2004 (the Special
Committee) have agreed to cooperate fully with the government investigations, and the Special
Committee has shared information regarding its investigation with the SEC and the U.S. Attorneys
Office. The U.S. Attorneys Office, SEC, and other government agencies that are investigating or might
commence an investigation of our company could impose, based on a claim of fraud, material
misstatements, violation of false claims law, or otherwise, civil and/or criminal sanctions,
including fines, penalties, and/or administrative remedies. If any government sanctions are
imposed, which we cannot predict or reasonably estimate at this time, our business and financial
condition, results of operations, or cash flows could be materially adversely affected. These
matters have resulted, and are expected to continue to result, in a significant diversion of
managements attention and resources and in significant professional fees. We have agreed to
advance expenses reasonably incurred by certain of our current directors and current and former
officers in connection with these investigations. This advancement of expenses was conditioned
upon the execution by such persons of undertakings to assist and cooperate with us in connection
with the investigations and to repay to us any advanced funds in the event that (i) we determine
that certain representations made by such directors and officers are inaccurate, (ii) we are
prohibited from providing indemnification to such directors or officers pursuant to Delaware law or
our organizational documents, or (iii) such directors or officers stop cooperating with us on the
investigations. For a description of the amount of expenses advanced in 2004 and the first 24




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part of 2005 to our current executive officers and directors, see Part III, Item 13, Certain
Relationships and Related Transactions. On January 2, 2004, we received separate letters from the Kentucky Office of Attorney General and
the Florida Office of Attorney General advising that each was currently investigating allegations
regarding our pricing practices related to our average manufacturer price and best price
calculations that are used by the government to set Medicaid reimbursement rates. Neither letter
requested that we provide any information, and each letter merely requested that we retain all
documents with respect to these calculations pursuant to a newly adopted federal regulation that
would have permitted the destruction of these documents three years after the applicable prices
were reported, except to the extent we were aware of an ongoing investigation. It is our
understanding that many other pharmaceutical companies received similar letters at that time from
attorneys general in a number of states and that such letters may have been in response to the new
federal regulation that would have otherwise allowed the destruction of documents reflecting these
pricing calculations. A number of attorneys general, including the Florida and Kentucky attorneys
general, petitioned the U.S. Secretary of Health and Human Services to withdraw the new regulation.
We are not aware of any further developments in these investigations. Federal Securities, Derivative and ERISA Litigation We, certain of our current and former officers and directors, and our independent registered public
accountants have been named as defendants in purported stockholder class action lawsuits alleging
violations of federal securities laws. The securities lawsuits were filed beginning in February
2004 and are pending in the U.S. District Court for the Eastern District of North Carolina. By
order dated April 16, 2004, the district court consolidated the securities lawsuits into one
consolidated action, and on February 11, 2005, the plaintiffs filed a consolidated amended
complaint. The amended securities complaint asserts claims arising under Sections 10(b) and 20(a)
of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder on behalf of a class of purchasers
of our common stock during the period from April 24, 2002 through and including June 15, 2004. The
securities complaints allege generally that the defendants knowingly or recklessly made false or
misleading statements during the Class Period concerning our financial condition and that our
financial statements did not present our true financial condition and were not prepared in
accordance with generally accepted accounting principles. The amended securities complaint seeks
certification as a class action, unspecified compensatory damages, attorneys fees and costs, and
other relief. A stockholder derivative suit was filed in the United States District Court for the Eastern
District of North Carolina on August 26, 2004 by two putative shareholders against current and
former members of the Companys Board of Directors and senior management. Our company is named as
a nominal defendant. The complaint alleges that the individual director and officer defendants
breached fiduciary and contractual obligations to our company by implementing an inadequate system
of internal control over financial reporting and causing our company to issue false and misleading
statements exposing our company to securities fraud liability, and that certain defendants engaged
in insider trading. The complaint seeks unspecified compensatory damages, attorneys fees and
costs, and other relief. 25




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In addition, we and certain of our current and former directors, officers and employees have been
named in a purported class action brought by an aaiPharma pension plan participant and beneficiary
asserting claims under ERISA on behalf of a class of all persons who are or were participants in or
beneficiaries of the aaiPharma Inc. Retirement and Savings Plan during the period from April 24,
2002 to June 15, 2004. An amended complaint was filed on March 14, 2005 which alleges generally
that the defendants breached fiduciary duties owed under ERISA with respect to the prudence and
lack of diversification of investment of Plan assets in our common stock, by misleading
participants and beneficiaries of the Plan regarding our earnings, prospects and business
condition, by failing to act in the sole interest of Plan participants, and by failing to monitor
the actions of other Plan fiduciaries. The complaint seeks certification as a class action,
unspecified compensatory damages, attorneys fees and costs, and other equitable relief. This
ERISA lawsuit is pending in U.S. District Court for the Eastern District of North Carolina. The
proceedings in this matter will be coordinated with the securities lawsuits described above. These lawsuits are at an early stage. Our response to the amended securities complaint is not due
until May 26, 2005, and our response to the amended ERISA complaint is not due until June 30, 2005
at the earliest. By agreement, no response to the derivative suit is due until 60 days after the
plaintiffs file their amended complaint, and no discovery has yet occurred in either the securities
or derivative litigation. Only limited discovery has occurred in the ERISA litigation. By, and subject to, the terms of our bylaws, we have certain obligations to indemnify our current
and former officers, directors and employees who have been named as defendants in these lawsuits.
We have purchased directors and officers liability insurance (D&O insurance) that may provide
coverage for some or all of these lawsuits and governmental investigations. We have given notice
to our D&O insurance carriers of the securities and derivative suits described above, and the
insurers have responded by requesting additional information and by reserving their rights under
the policies, including the rights to deny coverage under various policy exclusions or to rescind
the policies. There is a risk, however, that the D&O insurance carriers will rescind the policies
or that some or all of the claims or expenses will not be covered by such policies; or that, even
if covered, our ultimate liability will exceed the available insurance. Our fiduciary liability
insurance carrier has denied coverage of claims made in connection with the original ERISA
litigation complaint; the amended ERISA complaint is under review by us for potential fiduciary
policy coverage. Although we intend to vigorously pursue all defenses available in these lawsuits,
an adverse determination in these lawsuits or an inability to obtain payment under our insurance
policies for litigation and indemnification costs and any damages ultimately borne by us as a
result of these lawsuits and investigations could have a material adverse effect on our business,
financial condition, results of operations or cash flows. Patent Litigation We are a party to a number of legal actions with generic drug companies. We are involved in two
lawsuits centered on our omeprazole-related patents, including one lawsuit brought by us against an
alleged infringer of our patents and another lawsuit which was brought by a third party against us
and is currently essentially inactive. Both lawsuits are described in more detail below.
Omeprazole is the active ingredient found in Prilosec, a drug sold by AstraZeneca PLC. An 26




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additional lawsuit brought against us by Andrx Pharmaceuticals, Inc. involving omeprazole was
dismissed without prejudice in December 2004. An omeprazole-related case has been filed against us by Dr. Reddys Laboratories Ltd. and
Reddy-Cheminor Inc. in the U.S. District Court for the Southern District of New York in November
2001. The plaintiffs in this case have challenged the validity of five patents that we have
obtained relating to omeprazole and are seeking a declaratory judgment that their generic form of
Prilosec does not infringe these patents. Additionally, they have alleged misappropriation of trade
secrets, tortious interference, unfair competition and violations of the North Carolina Unfair
Trade Practice Act. We have denied the substantive allegations made in these cases. A second
lawsuit brought by the plaintiffs involving omeprazole was filed in July 2001 and was dismissed
without prejudice in March 2005. The case is in the early stages of litigation. However, while these plaintiffs have sought
approval from the FDA to market a generic form of Prilosec, to the best of our knowledge as of
April 18, 2005, no such FDA approval has been granted to them. In addition, these plaintiffs
omeprazole product has been found in separate litigation to infringe certain patents of AstraZeneca
and the infringement findings have been upheld on appeal. The lawsuit is essentially inactive at
this time. Only limited discovery has occurred in this lawsuit and no additional discovery is
currently being sought. No date has been set for the trial. In the event that the lawsuit again
becomes active, we intend to vigorously defend the patents validity and to determine whether or
not the plaintiffs product infringes any of our relevant patents. The other lawsuit involving our omeprazole patents was brought in December 2002 by us against
Kremers Urban Development Co., Schwarz Pharma Inc. and Schwarz Pharma AG (collectively, together
with the other named defendants, KUDCO) in the U.S. District Court for the Southern District of
New York. KUDCO has a generic omeprazole product with final FDA marketing approval, was found not
to infringe the AstraZeneca patents in the separate AstraZeneca patent litigation, and is currently
selling its generic substitute for Prilosec in the U.S. marketplace. We initially brought the lawsuit alleging infringement of our U.S. Patent No. 6,268,385. Following
the collection of additional information concerning KUDCOs commercially marketed product, we
sought leave of the court to file an amended complaint, adding additional claims of infringement
and contributory infringement under our U.S. Patent No. 6,326,384 and joining as defendants Schwarz
Pharma Manufacturing Inc. and Schwarz Pharma USA Holdings Inc. These two patents include, among
other claims, claims directed to compositions and methods wherein certain characteristics of solid
state omeprazole are essentially the same in formulated drug product as in its active ingredient. In September 2003, the judge granted us leave to file the first amended complaint adding our second
patent and the additional KUDCO affiliates to the lawsuit. Following initial discovery, we sought
leave of the court to file a second amended complaint, adding Kremers Urban Inc., another KUDCO
affiliate, to the lawsuit. On February 26, 2004, the judge granted us leave to file the second
amended complaint, adding Kremers Urban Inc. to the lawsuit. KUDCO has filed its answer to our complaint, denying our claims, asserting various affirmative
defenses to our claims (including patent invalidity and product non-infringement), and asserting 27




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counterclaims and antitrust violations under federal and state antitrust laws. KUDCO is also
contesting the personal jurisdiction of the court over all of the defendants in this lawsuit other
than Kremers Urban Development Co., Kremers Urban Inc. and Schwarz Pharma Inc. Motions on the
jurisdictional issues are pending before the court. We have denied the substantive allegations
made by KUDCO in its counterclaims, and the court has granted our motion to stay antitrust
discovery. Substantial discovery of both sides documents and of defendants product samples has occurred in
the lawsuit, although both sides asserted numerous discovery deficiencies against the other. On
February 26, 2004, the judge assigned the discovery disputes to a federal magistrate for
resolution. Discovery is continuing at this time. No trial date has been set. We have previously indicated to KUDCO a willingness to grant a license under our omeprazole patents
for an appropriate royalty. In the absence of KUDCO taking a royalty-bearing license, we are
seeking damages equal to a reasonable royalty on all infringing sales by the KUDCO defendants since
commercial launch of their generic substitute for Prilosec on December 9, 2002 through the date of
a judicial decision in the litigation, and a permanent injunction on subsequent sales thereafter
(unless KUDCO takes a license), among other remedies, in the event that we ultimately prevail in
the litigation. The KUDCO defendants have publicly confirmed sales of their generic omeprazole
product during the first twenty-two months after launch of their product of approximately $1.3
billion. In the absence of a license or settlement, we intend to vigorously prosecute the case,
defend our patent rights and defend against the foregoing defenses and counterclaims asserted by
KUDCO. It is possible that the omeprazole-related patents subject to the foregoing four lawsuits
will be found invalid, unenforceable or not infringed and, while currently stayed by the court, it
is possible that the defendants antitrust counterclaims in the KUDCO litigation will ultimately be
allowed to proceed and be litigated. If adverse findings were to occur, they could have a material
adverse effect on our consolidated financial statements, results of operations and cash flow. In cases where we have initiated an action, we intend to prosecute our claims to the full extent of
our rights under the law. In cases where we are named defendants, we intend to vigorously pursue
all defenses available. Athlon Litigation On April 15, 2004, we filed a lawsuit against Athlon Pharmaceuticals, Inc. in the U.S. District
Court for the Northern District of Georgia seeking a declaratory judgment that we were entitled to
terminate the Service Agreement (the Athlon Service Agreement) dated July 16, 2003, as amended,
between us and Athlon as well as damages and injunctive relief for material breaches of the Athlon
Service Agreement by Athlon. The Athlon Service Agreement incorporated the terms and conditions
pursuant to which representatives of Athlon would promote the sale of our Darvocet A500 product to
physicians. We initially paid Athlon $3,350,000 to build its sales force to promote the sale of our
Darvocet A500, and the terms of the Athlon Service Agreement would require us to pay Athlon an
additional $1,200,000 each month for such services for the contract period of 36 months, commencing
in October 2003, subject to Athlons compliance with certain representations, warranties and
covenants, some of which are described below. 28




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The lawsuit asserts that Athlon has materially breached the Athlon Service Agreement in several
ways, including failure to: (i) provide the required number of sales representatives during our
launch of Darvocet A500 commencing in October 2003, (ii) use its best efforts to promote Darvocet
A500 at the targeted levels of first and second pharmaceutical details to physicians, (iii) perform
the services to the best of its ability, as contractually required, and (iv) require its sales
representatives to perform the contracted services, as required, in a professional manner
consistent with industry standards and in conformance with that level of care and skill ordinarily
exercised by professional contract sales organizations in similar circumstances. The lawsuit also
asserts that Athlon breached its representation and warranty that it would perform, and would
require its sales representatives to perform, the contracted services in substantially the same
manner that it would promote Athlons own products. Athlon has asserted several counterclaims, including breach of an implied covenant of good faith in
fair dealing and anticipatory breach of the contract. We have filed a reply denying these
allegations. In May 2004, we ceased making payments under the Athlon Service Agreement, and on June 4, 2004, we
sent a notice of termination of the agreement to Athlon. On July 7, 2004, we amended the lawsuit
to assert claims of fraud and breaches of contract and implied covenants, seeking to recover
compensatory and punitive damages and attorneys fees. Athlon has amended its counterclaim to
assert fraud claims and to seek punitive damages. On August 11, 2004, Athlon filed a lawsuit against us, also in the U.S. District Court for the
Northern District of Georgia, alleging that we breached the Asset Purchase Agreement (the Purchase
Agreement) dated July 16, 2003 pursuant to which we acquired Darvocet A500 from Athlon. Athlon is
seeking royalties it alleges we failed properly to calculate and pay under the Purchase Agreement,
as well as attorneys fees. We have denied the substantive allegations in this case and filed
counterclaims seeking to recover an overpayment in the royalties owed to Athlon. The two cases have been consolidated and are currently in discovery. No trial date has been set.
We intend to prosecute our claims and counterclaims, and defend against the claims and
counterclaims made by Athlon, in these lawsuits to the fullest extent permitted by law. CIMA Litigation CIMA Labs, Inc. commenced an action against us in the Fourth Judicial District, State of Minnesota,
Hennepin County, on August 11, 2004. In its complaint, CIMA alleges that we are liable for
fraudulent inducement, negligent fraudulent misrepresentation, fraudulent concealment, breach of
contract, and attorneys fees and interest, all arising out of an Agreement and Plan of Merger dated
as of August 5, 2003, between CIMA and aaiPharma (the Merger Agreement). CIMA alleges that in
the negotiations leading up to the Merger Agreement, we engaged in misrepresentations and
concealments relating to our financial condition, and that in the Merger Agreement, we made false
representations and warranties concerning our financial statements, regulatory filings, and absence
of material adverse effects, among other things. Much of CIMAs claims are based on disclosures
made by us in our Amended Form 10-Q, which we filed with the SEC on June 24, 2004, for the period
ended June 30, 2003. CIMA seeks 29




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to recover the amount of $11.5 million, which it paid to us as a termination fee under the Merger
Agreement, plus additional sums it spent for professional fees and due diligence activities (which
it claims are in excess of $5 million), attorneys fees, litigation expenses, and interest. We
answered CIMAs complaint on September 17, 2004, denying all liability and raising a number of
affirmative defenses. Among other things, we assert that CIMAs termination of the Merger
Agreement barred any claims except those based on our willful breach of its representations,
warranties, covenants, or other agreements as set forth in that Agreement. In addition, we
affirmatively allege that CIMA terminated the Merger Agreement and paid the termination fee not as
the result of any alleged breach by us, but rather as part of CIMAs plan to secure and act on a
Superior Proposal from another bidder, which allowed it to consummate a transaction with that
other bidder on terms that it believed were more favorable to it than those set forth in the Merger
Agreement. The case is scheduled for trial in the fall of 2005, and the parties are currently
involved in document productions and written discovery. On January 14, 2005, the Minnesota court
rejected a relevance objection made by us in response to CIMAs discovery requests and ordered us
to produce voluminous documents to CIMA. On March 21, 2005, the Minnesota court approved a motion
to compel made by CIMA against us to produce documents by April 5, 2005 and an extensive privilege
log by April 20, 2005 with respect to documents generated by our legal counsel in the internal
investigation. We have produced the documents and have moved to delay the production of the
privilege log. The Court may deny our motion for additional time to produce the privilege log and
may sanction us, including holding us in contempt or entering a default judgment against us. We
intend to contest the action as vigorously as our limited resources permit. Leased Properties and Assets We have discontinued operations at our New Jersey facility, which constitutes approximately 75,000
square feet of laboratory and office space, but continue to be obligated under the lease for this
facility, which expires in 2010. On April 5, 2005, we received a written notice from the landlord
for this facility indicating that we are in default under the lease for this facility due to our
failure to timely pay rent, and that the landlord has filed a landlord/tenant eviction action
against us. We have not been served with formal notice of this proceeding or a formal complaint.
We also have stopped paying rent for certain other leased properties that we no longer use, and
have received notices of default from the landlords of these properties due to our failure to make
the required rent payments. In addition, we have been advised that we are in default of the lease
documents related to an airplane that we no longer use and that the lessor has terminated our
rights under these lease documents. Item 4. Submission of Matters to a Vote of Security Holders On December 15, 2004, we held our 2004 annual meeting of stockholders. The total number of shares
outstanding as of the record date, October 29, 2004, was 28,585,582. The matters voted on at the
meeting and the results are as follows: 30




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Election of Directors: Ludo J. Reynders, Ph.D.
    
    
    James G. Martin, Ph.D.
    
    
    Kurt M. LandgrafVotes For
    
    
    25,907,870
    
    
    
    25,010,535
    
    
    
    25,353,056Votes Withheld
    
    
    310,349
    
    
    
    1,207,684
    
    
    
    866,163
 Proposal to amend the 1997 Stock Option Plan by authorizing the issuance of an additional 1,500,000
shares of our common stock under the Plan: Votes For
    
    
    15,239,704Votes Against
    
    
    1,981,217Abstentions
    
    
    210,450
 Proposal to ratify the appointment of Ernst & Young as independent auditors of the Company for the
fiscal year ended December 31, 2004: Votes For
    
    
    25,732,470Votes Against
    
    
    53,156Abstentions
    
    
    432,593
 No other matters were voted on at the meeting. 31




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Executive Officers The following table contains information concerning our executive officers as of April 1, 2005: Name
    
    Age
    
    PositionLudo J. Reynders, Ph.D.
    
    
    51
    
    
    Chief Executive Officer and PresidentTimothy R. Wright
    
    
    47
    
    
    President, Pharmaceuticals DivisionMichael W. George
    
    
    56
    
    
    Executive Vice PresidentMatthew E. Czajkowski
    
    
    55
    
    
    Executive Vice President, Chief Financial
Officer and Chief Administrative OfficerWilliam H. Underwood
    
    
    57
    
    
    Executive Vice President, Corporate
DevelopmentGregory F. Rayburn
    
    
    45
    
    
    Interim Chief Operating OfficerGregory S. Bentley
    
    
    55
    
    
    Executive Vice President and General CounselJohn Harrington
    
    
    55
    
    
    Executive Vice President, Human Resources
 Ludo Reynders, Ph.D.joined the Company in September 2004 as the Chief Executive Officer and
President. Prior to joining the Company, Dr. Reynders served from 2003 to September 2004 as
managing member of Bronzewood LLC, a private company focused on improving productivity in drug
development. Dr. Reynders was managing director of the PharmaBio group of Quintiles Transnational
Corporation from 2002 to 2003. Dr. Reynders also held the position of Chief Executive Officer of
Quintiles Clinical Development Services and Product Development Services groups from 2000 to 2002
and 1996 to 2000, respectively. He began his career with Quintiles in 1988. Timothy R. Wrightjoined the Company in April 2004 as President of the Pharmaceuticals Division and
was appointed a director in May 2004. Prior to joining the Company, Mr. Wright served as the
President, Global Commercial Operations for Elan Bio-pharmaceuticals from February 2001 to December
2003. Before that, Mr. Wright served as a Senior Vice President of Healthcare Product Services
with Cardinal Health, Inc. from May 1999 to January 2001. Mr. Wright also held senior management
positions with DuPont Merck Pharmaceutical Company from 1984 to 1999. Michael W. Georgejoined the Company as Chief Administrative Officer, a position he relinquished in
March 2005, and as Executive Vice President in July 2004. Prior to joining aaiPharma, Mr. George
was President and Chief Executive Officer of Michael George and Associates, a
pharmaceutical-oriented consulting firm, from April 2002 to July 2004. Mr. George was also
President, North America for Elan Pharmaceuticals from November 2001 to April 2002 and President
and Chief Executive Officer of UROCOR INC., a company that specializes in oncology products and
services, from August 1998 to November 2001. Matthew E. Czajkowskijoined the Company in December 2004 having previously worked with POZEN Inc.,
where he served as Senior Vice President Finance and Administration and Chief Financial Officer
from 2000 to 2004. Prior to his service with POZEN, he was a private consultant from 1998 to 2000
and Managing Director of Societe Generale from 1997 to 1998. 32




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Additionally, Mr. Czajkowski has held senior management positions with Goldman, Sachs & Co. and
Wheat First Butcher Singer, Inc. William H. Underwoodis a director and Executive Vice President  Corporate Development of
aaiPharma. He has served as a director since 1996, as Chief Operating Officer from 1995 to 1997, as
Executive Vice President since 1992, and as Vice President from 1986 to 1992. Mr. Underwood held
various positions in the pharmaceutical and cosmetic industries prior to joining aaiPharma in 1986,
including Director of Quality Assurance and Director of Manufacturing at Mary Kay Cosmetics, Inc.
and Group Leader of Bacteriological Quality Control at Burroughs-Wellcome Co. Gregory F. Rayburnjoined the Company as interim Chief Operating Officer in March 2004. Mr. Rayburn
is also a senior managing director and the Interim Management practice leader with FTI Palladium
Partners, the interim management practice of FTI Consulting, Inc. (FTI), a leading provider of
turnaround, performance improvement, financial and operational restructuring services. Mr. Rayburn
provides services to us through a contract between the Company and FTI Palladium Partners. Mr.
Rayburn joined FTI Palladium Partners in 2003. Prior to FTI Palladium Partners, Mr. Rayburn served
a principal with AlixPartners from 2000 to 2003. While at AlixPartners, Mr. Rayburn served as the
Chief Restructuring Officer of WorldCom. Before that, Mr. Rayburn served from 1998 to 2000 as the
president of The Capstone Group LLC, a private investment partnership. Prior to serving as
president of Capstone, Mr. Rayburn was a partner in the Corporate Recovery Services Group of Arthur
Andersen LLP. Gregory S. Bentleyhas served as Executive Vice President and General Counsel of aaiPharma since
June 1999. Mr. Bentley served as Secretary of aaiPharma from June 1999 to April 2002. Prior to
joining aaiPharma, Mr. Bentley served from 1994 to 1999 as Vice President, Regulatory and Quality
for Siemens Medical Systems, Inc., a leading medical device company and a subsidiary of Siemens
Corporation. Prior to joining Siemens Corporation as Associate General Counsel in 1986, Mr. Bentley
practiced law with the law firm of Shearman & Sterling in New York. John Harringtonjoined the Company in July 2004 as Executive Vice President of Human Resources.
Mr. Harrington served as Senior Vice President of Human Resources for Quintiles Transnational
Corporation from January 2000 through March 2004 and head of Worldwide Human Resources for
Quintiles from 1997 through December 1999. Mr. Harrington was previously European Director of HR
for Syntex, a Palo Alto based pharmaceutical company subsequently acquired by Quintiles. Prior to
joining the pharmaceutical industry, Mr. Harrington held a number of increasingly senior HR posts
with British Petroleum over a 20-year period. 33




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##### 



PART II Item 5. Market for the Registrants Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities Prior to April 18, 2005, our common stock was traded on the NASDAQ National Market System under the
symbol AAII. Our common stock was delisted from the NASDAQ National Market System at the open of
trading on April 18, 2005, and began trading on the Pink Sheets under the symbol AAII.PK on that
day. The price range of our common stock is listed below by quarter for the years ended December
31, 2004 and 2003: QuarterFirst
    
    
    Second
    
    
    Third
    
    
    Fourth2004High
    
    $
    31.50
    
    
    $
    8.35
    
    
    $
    5.55
    
    
    $
    4.05Low
    
    $
    6.63
    
    
    $
    4.06
    
    
    $
    1.35
    
    
    $
    1.272003High
    
    $
    21.90
    
    
    $
    20.10
    
    
    $
    22.22
    
    
    $
    25.85Low
    
    $
    8.15
    
    
    $
    9.25
    
    
    $
    15.99
    
    
    $
    16.68
 The price ranges for the first quarter of 2003 have been adjusted for the three-for-two common
stock split, affected through a stock dividend, paid on March 10, 2003. We estimate there were approximately 5,180 holders of record for our common stock as of October
2004. No cash dividends were declared during 2004 or 2003, and our senior secured credit
facilities prohibit us from paying cash dividends. The background of the delisting of our common stock is as follows: in 2004, we did not timely file
our Annual Report on Form 10-K for the year ended December 31, 2003 and our Quarterly Report on
Form 10-Q for the period ended March 31, 2004. We received notices from the NASDAQ Stock Market
(NASDAQ) that, due to the delay in filing these reports, we were not in compliance with certain
NASDAQ marketplace rules and that our common stock would be subject to delisting. We requested and
participated in a hearing before a NASDAQ listing qualifications panel on April 29, 2004. On June
21, 2004, NASDAQ notified us that the listing qualifications panel had determined to continue the
listing of our common stock if we met certain conditions, including the prospective condition that
we file with the SEC and NASDAQ all periodic reports for reporting periods ending on or before June
30, 2005 on or before the deadline for the filing of those periodic reports. In its notification,
NASDAQ advised that the filing of a Notification of Late Filing on Form 12b-25 would not
automatically extend the deadline for the filing of a periodic report for the purpose of this
condition, and further that a failure to satisfy this condition could result in the delisting of
our common stock without the right to a hearing. On March 16, 2005, we provided notice to NASDAQ and the listing qualifications panel of our failure
to satisfy this condition, as a result of the failure to file this Annual Report on Form 10-K for
the fiscal year ended December 31, 2004 by March 16, 2005, and requested that the listing 34




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##### 



qualifications panel permit the continued listing of our common stock on NASDAQ if we filed this
Form 10-K by April 30, 2005. As a result, the listing qualifications panel held a hearing with us
on April 7, 2005. At the hearing, we again requested that NASDAQ continue the listing of our
common stock on the condition that we file this Form 10-K by April 30, 2005. On April 14, 2005, we
received notice from NASDAQ that our common stock would be delisted from NASDAQ effective with the
open of business on Monday, April 18, 2005 as a result of our failure to timely file this Form 10-K
as required by NASDAQ Marketplace Rule 4310(c)(14) and by the continued listing condition discussed
above. NASDAQs April 14, 2005 notice stated that the listing qualifications panel had rejected
our request. Our common stock was delisted from NASDAQ at the open of business on Monday, April
18, 2005 and now trades on the Pink Sheets under the symbol AAII.PK. PURCHASES OF EQUITY SECURITIES We made the following purchases of our common stock during the fourth quarter of 2004: Total Number of SharesTotal Number
    
    
    Average
    
    
    Purchased as Part of
    
    
    Maximum Number of Shares thatof Shares
    
    
    Price Paid
    
    
    Publicly Announced Plans
    
    
    May Yet Be Purchased Under thePeriod
    
    Purchased (1)
    
    
    per Share
    
    
    or Programs
    
    
    Plans or ProgramsOctober
    
    
    29,830
    
    
    $
    1.82
    
    
    
    0
    
    
    No publicly announced repurchaseprogram in placeNo publicly announced repurchaseNovember
    
    
    20,603
    
    
    
    3.51
    
    
    
    0
    
    
    program in placeNo publicly announced repurchaseDecember
    
    
    12,973
    
    
    
    2.97
    
    
    
    0
    
    
    program in placeNo publicly announced repurchaseTOTAL
    
    
    63,406
    
    
    $
    2.60
    
    
    
    0
    
    
    program in place
    In conjunction with the hiring of three executive officers in 2004, we granted such executive
officers a total of 104,817 shares of restricted stock. The shares become vested if the executives
are employed by us on the anniversary dates, either six months or one year, from their respective
hire date. 35




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##### 



Item 6. Selected Consolidated Financial Data. The selected historical financial data set forth below are not necessarily indicative of the
results of future operations and should be read in conjunction with Managements Discussion and
Analysis of Financial Condition and Results of Operations and our consolidated financial
statements and related notes and other financial information appearing elsewhere in this report. SELECTED FINANCIAL DATA Years Ended December 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(in thousands, except per share amounts)Statement of Operations Data:Net revenues
    
    $
    215,330
    
    
    $
    236,927
    
    
    $
    241,198
    
    
    $
    156,768
    
    
    $
    114,506Direct costs (excluding depreciation
and royalty expense)
    
    
    120,893
    
    
    
    126,787
    
    
    
    101,385
    
    
    
    82,892
    
    
    
    57,903Selling expenses
    
    
    34,983
    
    
    
    39,534
    
    
    
    23,077
    
    
    
    13,749
    
    
    
    11,652General and administrative expenses
    
    
    45,875
    
    
    
    40,463
    
    
    
    40,109
    
    
    
    26,538
    
    
    
    23,773Research and development
    
    
    16,319
    
    
    
    21,788
    
    
    
    20,853
    
    
    
    10,482
    
    
    
    11,891Depreciation
    
    
    8,665
    
    
    
    7,973
    
    
    
    7,156
    
    
    
    7,755
    
    
    
    7,253Professional fees - internal inquiry
    
    
    11,042
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    M.V.I. contingent payment/(gain on
sale)
    
    
    (8,112
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Guaranteed purchase commitments
    
    
    11,695
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Restructuring charges
    
    
    22,392
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Royalty expense
    
    
    1,727
    
    
    
    1,095
    
    
    
    
    
    
    
    
    
    
    
    Intangible asset impairment
    
    
    93,972
    
    
    
    20,600
    
    
    
    
    
    
    
    
    
    
    
    (Loss) income from operations
    
    
    (144,121
    )
    
    
    (21,313
    )
    
    
    48,618
    
    
    
    13,229
    
    
    
    2,034Other expense, net
    
    
    (43,360
    )
    
    
    (15,892
    )
    
    
    (26,958
    )
    
    
    (4,090
    )
    
    
    (1,916
    )(Loss) income before income taxes
and cumulative effect of accounting
change
    
    
    (187,481
    )
    
    
    (37,205
    )
    
    
    21,660
    
    
    
    9,139
    
    
    
    118Provision for (benefit from) income
taxes
    
    
    3,690
    
    
    
    (4,502
    )
    
    
    8,542
    
    
    
    3,199
    
    
    
    (441
    )(Loss) income before cumulative
effect of accounting change
    
    
    (191,171
    )
    
    
    (32,703
    )
    
    
    13,118
    
    
    
    5,940
    
    
    
    559Cumulative effect of a change in
accounting principle, net of a tax
benefit of $495
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (961
    )Net (loss) income
    
    $
    (191,171
    )
    
    $
    (32,703
    )
    
    $
    13,118
    
    
    $
    5,940
    
    
    $
    402Basic (loss) earnings per share (1)
    
    $
    (6.69
    )
    
    $
    (1.18
    )
    
    $
    0.48
    
    
    $
    0.22
    
    
    $
    (0.02
    )Weighted average shares outstanding
    
    
    28,565
    
    
    
    27,730
    
    
    
    27,348
    
    
    
    26,691
    
    
    
    26,232Diluted (loss) earnings per share (1)
    
    $
    (6.69
    )
    
    $
    (1.18
    )
    
    $
    0.46
    
    
    $
    0.22
    
    
    $
    (0.02
    )Weighted average shares outstanding
 assuming dilution
    
    
    28,565
    
    
    
    27,730
    
    
    
    28,359
    
    
    
    27,462
    
    
    
    26,657
 36




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##### 



As of December 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(in thousands)Balance Sheet Data:Cash and cash equivalents
    
    $
    7,130
    
    
    $
    8,785
    
    
    $
    6,532
    
    
    $
    6,371
    
    
    $
    1,225Working capital (deficiency)
    
    
    (385,246
    )
    
    
    (12,960
    )
    
    
    15,357
    
    
    
    20,493
    
    
    
    10,558Property and equipment, net
    
    
    52,942
    
    
    
    57,236
    
    
    
    53,125
    
    
    
    37,035
    
    
    
    42,161Total assets
    
    
    339,070
    
    
    
    534,597
    
    
    
    433,502
    
    
    
    196,286
    
    
    
    112,151Long-term debt, less current portion
    
    
    
    
    
    
    338,844
    
    
    
    277,899
    
    
    
    78,878
    
    
    
    509Redeemable warrants
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,855
    
    
    
    Total stockholders equity (deficit)
    
    
    (111,890
    )
    
    
    74,723
    
    
    
    95,254
    
    
    
    76,364
    
    
    
    65,721
   (1)
    
    All share and per share amounts have been restated to reflect the March 2003 three-for-two
stock split for each period presented as if it had occurred at the beginning of the period. 37




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##### 



Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis of our financial condition and results of
operations together with our consolidated financial statements and related notes included elsewhere
in this report. The notes to our consolidated financial statements set forth our critical
accounting policies, including policies relating to revenue recognition, intangible assets,
inventories and income taxes. These policies are summarized below under Critical Accounting
Policies. On January 30, 2003, our Board of Directors approved a three-for-two stock split of our common
shares. On March 10, 2003, each stockholder received one additional share of common stock for
every two shares such stockholder owned on the record date of February 19, 2003. All share and per
share amounts have been restated to reflect the stock split for each period presented as if it had
occurred at the beginning of the period. In the fourth quarter of 2004, we began reporting revenues and expenses under the guidelines of the
Emerging Issues Task Force Issue No. (EITF) 01-14, Income Statement Characterization of
Reimbursements Received for Out-of-Pocket Expenses Incurred.EITF 01-14 requires that
reimbursements received for out-of-pocket expenses be characterized as revenue. All prior period
amounts have been reclassified to comply with this release. The adoption of this rule resulted
only in the gross up of revenues and expenses and had no impact on earnings. Overview of Results of Operations Our financial results significantly deteriorated in 2004. Our net revenues declined to $215.3
million in 2004, compared to net revenues of $236.9 million in 2003. We incurred a net loss of
$191.2 million in 2004, compared to a net loss of $32.7 million in 2003. Our net revenues for 2004 decreased from 2003 as a result of a significant reduction in
pharmaceutical product sales. The reduction resulted from decreased sales volumes in our
Darvon/Darvocet and Brethine product lines, which were affected by the amount of inventory
previously sold into the wholesale channel, as well as the divestiture of our M.V.I. and Aquasol
product lines in the second quarter of 2004, as partially offset by contributions from our
Roxicodone and Oramorph product lines, which we acquired in December 2003. The wholesalers that we deal with have recently limited, and may continue to limit, their purchases
of pharmaceutical products from us. We believe these wholesalers have reduced their purchases in
order to minimize any exposure that could result from our liquidity position. In addition, we are
seeing an emerging trend of weakness in our development services business that we believe is a
result of customers being less willing to engage us for long-term development services projects due
to our liquidity issues. This weakness in our long-term development services business has been
partially offset by continued strength in short-term analytical development services projects. In addition to a decline in net revenues, the primary factors that contributed to our substantial
net loss in 2004 include: 38




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##### 




    Impairment charges that we recorded in 2004 due to the impairment of the intangible
assets associated with our Darvon/Darvocet ($87.1 million) and Brethine ($6.4 million)
products.
    $11.0 million in professional fees that we incurred in connection with the Special
Committees investigation described below under    Special Committee Investigation;
    $22.4 million in charges recorded in connection with work force reductions and facility
closures resulting from the implementation of several restructuring plans in 2004; and
    An $11.7 million charge, and corresponding reserve, related to a pharmaceutical product
manufacturing supply agreement entered into in 2003 requiring us, subject to the terms and
conditions of the agreement, to purchase a minimum level of certain products on a
take-or-pay basis by September 2006. As a result of our substantial and recurring operating losses, we believe that we will not have
adequate sources of liquidity to fund our operations in the near term unless we obtain additional
sources of liquidity. In March 2005, we received a tax refund of approximately $11.3 million, all
or substantially all of which was required to be paid down under our senior credit facilities.
Events of default had also occurred under our senior credit facilities that would prohibit
borrowings thereunder absent a waiver from our senior lenders. On March 31, 2005, we entered into
a waiver agreement pursuant to which our senior lenders agreed to forbear in exercising remedies
with respect to these existing events of default until the earlier of April 30, 2005 or the
occurrence of another default under the waiver agreement or our senior credit facilities. Upon any
such forbearance termination, our senior lenders could accelerate the debt then outstanding under
our senior credit facilities unless all events of default have been cured. This waiver agreement
also permitted us to immediately use approximately $5.7 million of the tax refund to meet budgeted
liquidity needs and required us to temporarily paydown revolving loans under the senior credit
facilities with the remaining $5.6 million of the tax refund. Despite the existing events of
default, the waiver permitted us to reborrow this $5.6 million, in weekly draws, to meet budgeted
liquidity needs. We have fully borrowed this $5.6 million, and no other borrowings are permitted
under our senior credit facilities absent a consent from our senior lenders. In light of our current financial condition, we believe that our operations can no longer support
our existing debt and that we must restructure our debt to levels that are more in line with our
operations. Thus, it is highly likely that we will seek relief under chapter 11 of the U.S. Bankruptcy Code
which would substantially dilute and may eliminate the interests of the holders of our common
stock. For additional discussion of our financial condition and liquidity, see    Liquidity and
Capital Resources. Business Overview Management and Operational Changes Since January 1, 2004, we have experienced substantial management changes. In February 2004, David
Hurley, our Chief Operating Officer and President of our Pharmaceuticals Division resigned. In
March 2004, Dr. Philip Tabbiner was replaced as our Chief Executive Officer by 39




---



##### 



Dr. Frederick D. Sancilio, and Gregory F. Rayburn, a senior managing director with FTI Palladium
Partners, was named to the position of interim Chief Operating Officer. In April 2004, Timothy R.
Wright was hired as the President of our Pharmaceuticals Division. In May 2004, William L. Ginna
stepped down from his position as Executive Vice President and Chief Financial Officer and Gina
Gutzeit, a senior managing director with FTI Palladium Partners, was named as interim Chief
Financial Officer. In July 2004, we hired Michael W. George as our Chief Administrative Officer, a
position he relinquished in March 2005, and as an Executive Vice President, and John Harrington
joined the Company as Executive Vice President of Human Resources. In September 2004, Dr.
Frederick D. Sancilio stepped down from his positions as our President, Chief Executive Officer and
Chief Scientific Officer and Dr. Ludo Reynders was appointed President and Chief Executive Officer.
Also in September, 2004, Dr. Vijay Aggarwal resigned as President, AAI Development Services, and
was replaced by Michael George as Executive Vice President in charge of AAI Development Services.
Due to Dr. Reynders hospitalization for suspected pneumonia from November 9, 2004 through November
22, 2004, Timothy R. Wright was appointed interim President and Chief Executive Officer during such
period. In December 2004, Matthew E. Czajkowski joined our company as Executive Vice President and
Chief Financial Officer, replacing Gina Gutzeit. In addition to serving as Executive Vice
President and Chief Financial Officer, Mr. Czajkowski was appointed Chief Administrative Officer in
March 2005. In March 2005, Michael George joined the Pharmaceuticals Division and Dr. Reynders
took direct operational control over AAI Development Services. In 2004, we operated three business units  a pharmaceutical product sales business operated
through our Pharmaceuticals Division, a development services business operated through our AAI
Development Services Division and a product development business operated through our Research and
Development Division. In March 2005, we reorganized our operating structure to reflect our
decision to curtail our research and development activities in light of our financial condition.
At that time, our Research and Development Division was no longer actively engaged in any
shared-risk development projects. Personnel involved in the development of proprietary products
were assigned to our Pharmaceuticals Division, while personnel that had focused on independent
research or shared-risk development projects were assigned to fee-for-service development projects
in our AAI Development Services Division. As a result of this reorganization of our operating
structure, we currently operate in only two business segments  proprietary pharmaceutical product
development and sales through our Pharmaceuticals Division and development services offered to
third parties through our AAI Development Services Division. Pharmaceuticals Division  Our Product Sales Business Our product sales business unit commercializes pharmaceutical products. We currently market
products under our various brand names as well as certain generic products. The principal costs of
this business in 2004 included manufacturing costs, either internally or under agreements with
third party manufacturers, selling expense of our sales force (which we terminated in the fourth
quarter of 2004), payments in connection with a contract sales force (which we ceased paying in May
2004 in connection with the termination of the Athlon Services Agreement) and general and
administrative costs of our business unit management team. During 2004, net revenues from product
sales were $77.8 million, or 36% of our consolidated net revenues. 40




---



##### 



Our results of operations can be influenced by the timing of purchases made by our customers and
the magnitude of the inventories of our products that our customers desire to maintain. These
customers are wholesalers and may increase their purchases if they anticipate a price increase.
Wholesalers may anticipate a price increase due to the timing of prior increases, the acquisition
of a product by a new supplier or other reasons. Any increase in revenues during one period due to
an anticipated price increase may likely be offset by decreased revenues in subsequent periods.
Thus, as described in more detail below, there may be some volatility of our pharmaceutical product
revenues in future periods due to the timing of our customers purchasing decisions. We believe that there is a significant shift occurring in the business model of wholesale
distributors of pharmaceutical products. Historically, wholesalers have made a significant portion
of their revenue by negotiating discounts on purchases and by purchasing product prior to
anticipated price increases in order to sell product at the new, higher price. Wholesalers are now
demanding that sellers of pharmaceutical products execute distribution services agreements that
require the payment of a service fee related to the purchase and distribution of product. These
fees may vary according to the size of the purchase and according to whether the products are
branded or generic. Except for our exclusive distribution agreement with a subsidiary of Cardinal
Health for our Brethine product, we have not entered into distribution services agreements with our
wholesaler customers. However, we anticipate that we may be required to do so in the near future. We have been exploring a potential sale of some or all of the assets of our Pharmaceuticals
Division, as well as other operating assets. On March 31, 2005, we entered into a limited
exclusivity agreement with a potential purchaser of certain of the assets of our Pharmaceuticals
Division to facilitate continued due diligence and negotiation over a potential sale. This
written exclusivity agreement expired by its terms on April 22, 2005,
though we are continuing to negotiate with this potential purchaser
on an exclusive basis. We have not reached a definitive
agreement with this potential purchaser regarding a sale and we cannot provide any assurance that
any material asset sale will be agreed upon or completed. In addition, we have not determined to
sell any material assets, and we plan to continue to operate our Pharmaceuticals Division if we do
not complete such a sale of its assets. AAI Development Services  Our Development Services Business Our development services business unit, AAI Development Services, provides a comprehensive range of
development services through two primary groups, a nonclinical group and a clinical group. The
nonclinical group develops and validates methods, analyzes and tests various chemical compounds,
and provides small scale manufacturing of chemical compounds to be used for human clinical trials
as well as for commercial distribution. The services performed by the nonclinical group also
include chemical analysis, chemical synthesis, drug formulation, bioanalytical testing, product
life cycle management services, and regulatory and compliance consulting. All of these nonclinical
services involve either laboratory work, small scale manufacturing or consulting services. The
clinical group performs testing for customers of new pharmaceutical products in humans under
controlled conditions as part of the regulatory approval process for pharmaceutical products. These
clinical services involve conducting human clinical studies, and the statistical analysis relating
to these studies. 41




---



##### 



Both the nonclinical and clinical groups receive requests for services from customers, often on a
competitive basis. These projects vary in length from one month to several years. In general, our
customers may cancel a project upon 30 days notice. The principal expenses of this business are
labor costs, including employee benefits, and equipment and facility-related costs. During 2004,
net revenues of our development services business unit were $94.9 million, or 44% of our
consolidated net revenues. Research and Development In 2004 and early 2005, our product development business unit used our research and development
expertise and capabilities to enhance and develop new drug delivery technologies and improve
existing pharmaceutical products. In March 2005, we reorganized our research and development
activities. Our Pharmaceuticals Division is now tasked with the oversight of our development
efforts on our product pipeline, while our AAI Development Services Division now manages our
intellectual property portfolio of patents and drug delivery technologies. We apply our drug development expertise to internally develop our own new products, develop our
customers products and improve our acquired products. We license the developed technologies and
products to customers, in some cases before the development is complete. With respect to our
customers products, we generally receive payments for our efforts and innovations upon the
occurrence of defined events, known as milestones, which are intended to help cover the costs of
development. These milestone payments are not refundable. We also may receive royalties on the
eventual sales of the product. Because of the long term nature of these projects, we may recognize
revenues from milestone payments or royalties in one period and the associated expenses in prior
periods. The principal expense of this business is research and development expense, which
consists primarily of labor costs, raw material expenses, third-party consulting and testing costs
and costs for clinical trials. In some cases, these costs may be directly reimbursed by our
customers. For fiscal years 2004, 2003 and 2002, our expenditures on research and development were
$16.4 million, $21.8 million and $20.9 million, respectively. Due to liquidity constraints, we
anticipate that 2005 expenditures on research and development will significantly decline. During
2004, net revenues of our product development business unit were $24.0 million, or 11% of our
consolidated net revenues, of which $17.7 million was attributable to our significant development
agreement discussed below. Product Acquisitions Since August 2001, we have acquired the M.V.I. and Aquasol product lines from AstraZeneca, our
Brethine product line from Novartis, our Darvon and Darvocet product lines from Eli Lilly, our
Darvocet A500 product from Athlon Pharmaceuticals and our Roxicodone, Oramorph SR, Roxanol and
Duraclon pain management products from Elan Corporation, plc. Each of these acquisitions were made
with cash consideration largely financed by the incurrence of debt. For a description of these
acquisitions, including more detailed information on the issuance of debt in connection with these
acquisitions, see Note 2 of Notes to Consolidated Financial Statements included elsewhere in this
report. 42




---



##### 



Significant Product Disposition On April 26, 2004, we sold our M.V.I. and Aquasol product lines to Mayne Pharma (USA) Inc. for $105
million, subject to adjustments based on inventory levels at closing and other post-closing
obligations. Of that amount, $10 million was held in escrow to satisfy our post-closing
obligations under the agreement. In September 2004, approximately $1.6 million of this escrowed
amount was paid to us. We do not anticipate receiving any additional payments out of this escrow.
In addition, we are entitled to royalties on sales levels, above specified thresholds, of the
M.V.I. line extension product that does not contain vitamin K, which we developed. At the closing
of the transaction, we paid to AstraZeneca AB a $31.5 million payment due in August 2004 that was
required to be paid upon FDA approval of a reformulated MVI Product pursuant to the terms of the
agreement pursuant to which we acquired MVI and Aquasol. The payment was discounted to
approximately $31.0 million. The sale resulted in a gain of $39.1 million that we recorded in the
second and third quarters of 2004. The gain was partially offset by the $31.0 million expense we
recorded in the first quarter of 2004 for the contingent payment to AstraZeneca AB. Special Committee Investigation On February 27, 2004, our Board of Directors appointed a committee consisting of all of the
non-employee members of our Board of Directors (the Special Committee) to conduct an inquiry into
unusual sales in our Brethine and Darvocet product lines. King & Spalding LLP, an independent law
firm, and Deloitte & Touche USA LLP, as independent forensic accountants, were engaged to assist
the Special Committee in this inquiry. In connection with the Special Committees inquiry, we determined that certain matters required
material adjustments to the 2003 financial information included in our February 5, 2004 press
release and the financial information for the periods ended March 31, June 30, and September 30,
2003. In addition to the accounting treatment adjustments identified in connection with the Special
Committees investigation, we identified several other adjustments that affected the 2003 financial
information that we had included in our February 5, 2004 press release. These adjustments
included:  
    a charge of $15.9 million due to the impairment of our Brethine intangible asset
recorded in the fourth quarter of 2003;
    a $4.7 million impairment charge in the fourth quarter of 2003 which represents the
entire intangible asset recorded in the third quarter of 2003 relating to the acquisition
of Darvocet A500;
    a $7.3 million increase in our returns reserve for sales of Brethine and Darvon/Darvocet
products in the fourth quarter of 2003;
    a $2.7 million increase in our inventory obsolescence reserve in the fourth quarter of
2003;
    a $3.2 million increase in our chargeback reserve for sales in the fourth quarter of
2003 for our Oramorph product and other products; and 43




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
    a valuation allowance of $10.0 million as an offset against our deferred tax asset as of
December 31, 2003. In addition to the 2003 adjustments arising in connection with the Special Committees
investigation and the additional adjustments identified above, as previously reported, we restated
our financial statements for the year ended December 31, 2002 and for the periods ended March 31,
June 30, and September 30, 2002 and 2003 to treat each of our major product line acquisitions as
acquisitions of assets that do not constitute a business. As a result of the foregoing, in our Annual Report on Form 10-K for the year ended December 31,
2003, we reduced our 2003 net revenues and diluted earnings per share by $57.7 million and $2.35,
respectively, from the results we reported in our February 2004 press release. In addition, we
reduced our 2002 diluted earnings per share by $0.15 from the results reported in our Annual Report
on Form 10-K for the year ended December 31, 2002. Significant Development Agreement We have a development agreement with a customer that provides for us to receive contingent periodic
royalties based on sales of the customers product and obligates the customer to use us on a
fee-for-service basis for a product life cycle management project related to the product. The
customer is a major pharmaceutical company with net assets in excess of $2.0 billion. The
development agreement relates to a product with respect to which we have licensed intellectual
property that we developed in the past. We have recognized product development revenues under this
agreement for the periodic payments based on our customers sales of the product and have
recognized development services revenue related to the product life cycle management project. In
April 2004, we entered into an agreement to receive a prepayment of the remaining product
development amounts under this agreement which would otherwise be paid to us quarterly through the
second quarter of 2005. These payments would have aggregated $15.4 million. Our agreement to
receive a prepayment of these amounts applied a 5% per annum discount from the date the payment
would otherwise be due to the date paid. In April 2004, we received approximately $15.0 million in
gross proceeds from prepayments made pursuant to this agreement. Product development revenues from this agreement were $17.7 million in 2004, $13.0 million in 2003
and $16.9 million in 2002. We recognized no research and development expense in 2004, 2003 and
2002 associated with the payments we received in those years. The expense of our work associated
with these revenues was recognized primarily in 1997 through 1999. We do not anticipate that we
will receive any further product development payments in connection with this significant
development agreement in the future. Our obligations under the significant development agreement
with respect to the prepaid amounts continue through the second quarter of 2005, and we will
recognize approximately $7.0 million of revenue in the first half of 2005 associated with the
prepayment received in April 2004 as we satisfy these contractual obligations through the second
quarter of 2005. The development agreement also required the customer to use a minimum amount of our development
services at standard rates on the product life cycle management project. In 2004, 2003 and 2002,
the project was at the minimum contractual levels. Development services 44




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revenues associated with this agreement were $0.7 million in 2004, $2.7 million in 2003 and $4.7
million in 2002. We have recorded our costs incurred in this project as research and development
expensezero in 2004, $1.0 million in 2003 and $0.7 million in 2002. Accordingly, for our
development services business unit, we have recognized no expense associated with the development
services revenue arising under this agreement, as this expense was recognized by our product
development business unit. The customer is not obligated to continue the project after December
2004, and we do not anticipate any further development services revenue from this project. 2004 Financial Summary In 2004, we recorded net revenues of $215.3 million and a net loss of $191.2 million or $(6.69) per
share. Our consolidated net revenues for 2004 decreased from 2003 as a result of a significant
decrease in pharmaceutical product sales. The decrease resulted from decreased sales volumes in
our Darvon/Darvocet and Brethine product lines, which were affected by the amount of inventory
previously sold into the wholesale channel, as well as the divestiture of our M.V.I. and Aquasol
product lines in the second quarter of 2004, as partially offset by contributions from our
Roxicodone and Oramorph product lines, which were acquired in December 2003. The following table presents the net revenues for each of our major pharmaceutical product lines: 2004
    
    
    2003
    
    
    2002Darvon/Darvocet
    
    $
    17,291
    
    
    $
    46,797
    
    
    $
    47,256Brethine
    
    
    3,654
    
    
    
    16,206
    
    
    
    33,472MVI/Aquasol
    
    
    6,882
    
    
    
    34,956
    
    
    
    40,985Elan products
    
    
    38,796
    
    
    
    14,480
    
    
    
    All Other
    
    
    11,153
    
    
    
    6,784
    
    
    
    2,671Total net revenues
    
    $
    77,776
    
    
    $
    119,223
    
    
    $
    124,384
 Several events occurred which had a material impact on our financial results. We recorded an $87.1
million charge in December 2004 due to the impairment of intangible assets associated with our
Darvon/Darvocet products and we recorded charges of $6.4 million in the second half of 2004 due to
the impairment of an intangible asset associated with our Brethine product. These impairment
charges will not result in future cash expenditures. In 2004, we announced and implemented several restructuring plans, and recorded charges of $22.4
million related to work force reductions and facility closures. These charges included severance
costs and related employee-benefit expenses, separation payments to our former chief executive
officer and costs for leased facilities which are no longer in use. We recorded $11.0 million of
legal, financial and consulting professional fees in 2004 associated with a previously disclosed
internal investigation conducted by a Special Committee of our Board of Directors. In April 2004, we sold our M.V.I. product lines to Mayne Pharma (USA) Inc. The sale resulted in a
gain of $39.1 million that we recorded in the second and third quarters of 2004. The gain was
partially offset by a $31.0 million expense we recorded in the first quarter of 2004 for a 45




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contingent payment to AstraZeneca AB based on the regulatory approval of the reformulation of our
M.V.I.-12 product. In addition, in the fourth quarter of 2004, we recorded a charge of $11.7 million, and established
a corresponding reserve, related to a pharmaceutical product manufacturing supply agreement entered
into in 2003 requiring us, subject to the terms and conditions of the agreement, to purchase a
minimum level of certain products on a take-or-pay basis by September 2006. We are negotiating
with the manufacturer under this agreement to extend the term of our obligation to purchase the
minimum level of products by an additional multi-year period and to include additional products to
be manufactured for us under this agreement and applied against our minimum purchase requirement.
If we are successful in amending the agreement on this basis, the reserve and corresponding charge
may be reversed in a subsequent period. We cannot provide any assurance, however, that we will be
successful in amending the agreement on any terms. Operating results for our product sales business continued to be affected by the amount of
inventory previously sold into the wholesale channel. Our revenues from sales to wholesalers in
2004 were significantly reduced from prior periods due to the levels of Brethine and
Darvon/Darvocet products on hand at wholesalers at the beginning of the year. During 2004, we
reduced the aggregate amount of units of our products at the wholesalers and chain pharmacies by
approximately 73%. This inventory comparison excludes M.V.I. and Aquasol product (which we sold in
April 2004) at all relevant times. As part of
our effort to reduce inventories in the distribution channel, we stopped offering negotiated
discounts to our wholesalers with respect to sales of pharmaceutical products, which we believe
lowered wholesale demand. We believe that wholesalers have recently limited, and may continue to
limit, their purchases of pharmaceutical products from us to minimize any exposure that could
result from our liquidity position. We recognized $77.8 million in pharmaceutical product revenues
in 2004. Of that amount, we recognized $10.5 million in revenues recorded under the consignment
method. For these revenues, we had received cash for the products from the wholesalers,
principally in late 2003 or in the first quarter of 2004. The introduction of generic competition
to our Brethine injectable and Roxicodone products also had a negative impact on sales. During 2004, one of our major pharmaceutical product customers ceased making cash payments to us
for pharmaceutical products that it purchased as a set-off for amounts that we currently owe under
separate agreements with its affiliates and for amounts we may owe related to chargebacks and
returns exposure to such customer and its affiliates. We continue to conduct business with this
customer and its affiliates. Our AAI Development Services Division recorded $94.9 million in net revenues during 2004. In 2004,
we continued to experience strong demand for Phase I services in both the United States and Europe,
as well as for analytical services. The AAI Development Services Division was able to dedicate more
capacity to outside clients during 2004 due to reduced utilization of resources on internally
driven research and development projects. Notwithstanding increased demand in 2004 in the
development services business, customer concerns with respect to our uncertain financial condition
are adversely affecting our ability to obtain new development service projects, particularly
long-term projects. This trend, if it were to continue, could adversely affect 46




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future period net revenues of our AAI Development Services Division. The manufacturing capacity
for the Charleston facility was planned to cover the manufacturing needs of our Brethine injectable
product. The introduction of a generic competitor eliminated the near-term need for manufacturing
additional Brethine injectable products and created for us an excess in sterile manufacturing
capacity which we were not able to sell to third parties. During 2004, we recorded $16.3 million in research and development expenses. However,
due to liquidity constraints, we do not believe we will be able to fund additional research and
development activities in 2005 at this level, we have significantly reduced research and
development expenditures in 2005 and we may not be able to fund additional research and development
activities at all. Results of Operations The following table presents the net revenues for each business unit we operated in 2004 and our
consolidated expenses and net (loss) income and each item expressed as a percentage of consolidated
net revenues: Years Ended December 31,2004
    
    
    2003
    
    
    2002Net revenues:Product sales
    
    $
    77,776
    
    
    
    36
    %
    
    $
    119,223
    
    
    
    50
    %
    
    $
    124,384
    
    
    
    52
    %Product development
    
    
    23,987
    
    
    
    11
    
    
    
    16,468
    
    
    
    7
    
    
    
    19,610
    
    
    
    8Development services
    
    
    94,883
    
    
    
    44
    
    
    
    89,286
    
    
    
    38
    
    
    
    86,516
    
    
    
    36Reimbursed out-of-pocket
    
    
    18,684
    
    
    
    9
    
    
    
    11,950
    
    
    
    5
    
    
    
    10,688
    
    
    
    4$
    215,330
    
    
    
    100
    %
    
    $
    236,927
    
    
    
    100
    %
    
    $
    241,198
    
    
    
    100
    %Direct costs (excluding
depreciation and royalty expense)
    
    $
    120,893
    
    
    
    56
    %
    
    $
    126,787
    
    
    
    54
    %
    
    $
    101,385
    
    
    
    42
    %Selling expenses
    
    
    34,983
    
    
    
    16
    
    
    
    39,534
    
    
    
    17
    
    
    
    23,077
    
    
    
    10General and administrative expenses
    
    
    45,875
    
    
    
    21
    
    
    
    40,463
    
    
    
    17
    
    
    
    40,109
    
    
    
    17Research and development
    
    
    16,319
    
    
    
    8
    
    
    
    21,788
    

    
    
    9
    
    
    
    20,853
    
    
    
    9Depreciation
    
    
    8,665
    
    
    
    4
    
    
    
    7,973
    
    
    
    3
    
    
    
    7,156
    
    
    
    3Professional fees- internal inquiry
    
    
    11,042
    
    
    
    5
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    M.V.I. contingent payment/(gain on
sale)
    
    
    (8,112
    )
    
    
    (4
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Guaranteed purchase commitments
    
    
    11,695
    
    
    
    5
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Restructuring charges
    
    
    22,392
    
    
    
    10
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Royalty expense
    
    
    1,727
    
    
    
    1
    
    
    
    1,095
    
    
    
    
    
    
    
    Intangible asset impairment
    
    
    93,972
    
    
    
    44
    
    
    
    20,600
    
    
    
    9
    
    
    
    
    
    
    
    (Loss) income from operations
    
    
    (144,121
    )
    
    
    (67
    )
    
    
    (21,313
    )
    
    
    (9
    )
    
    
    48,618
    
    
    
    20Interest expense, net
    
    
    34,989
    
    
    
    16
    
    
    
    21,078
    
    
    
    9
    
    
    
    19,366
    
    
    
    8Loss from extinguishment of debt
    
    
    (6,229
    )
    
    
    (3
    )
    
    
    (1,511
    )
    
    
    (1
    )
    
    
    (8,053
    )
    
    
    (3
    )Other (expense) income, net
    
    
    (2,142
    )
    
    
    (1
    )
    
    
    6,697
    
    
    
    3
    
    
    
    461
    
    
    
    Provision for (benefit from)
income taxes
    
    
    3,690
    
    
    
    2
    
    
    
    (4,502
    )
    
    
    (2
    )
    
    
    8,542
    
    
    
    4Net (loss) income
    
    
    (191,171
    )
    
    
    (89
    )
    
    
    (32,703
    )
    
    
    (14
    )
    
    
    13,118
    
    
    
    5
 47




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Year Ended December 31, 2004 Compared to Year Ended December 31, 2003 Our consolidated net revenues for the year ended December 31, 2004 decreased 9% to $215.3 million,
from $236.9 million in 2003. Net revenues from product sales decreased 35% in 2004 to $77.8
million, from $119.2 million in 2003. The decrease resulted from decreased sales volumes in our
Darvon/Darvocet and Brethine product lines, as discussed above, as well as the divestiture of our
M.V.I. and Aquasol product lines in the second quarter of 2004, which was partially offset by
contributions from our Roxicodone and Oramorph product lines. Roxicodone and Oramorph were
acquired in December 2003. In addition, the price of our Brethine product decreased
significantly in 2004 due to the introduction of generic competition.
In June 2004, we exchanged products that were nearing expiration with products with improved
expiry dating at one wholesaler which reduced our returns reserve requirements by $3.9 million.
This reduction is reflected as an increase in net revenues in 2004. Our net revenues for the year
ended December 31, 2004 and 2003 included $10.5 million and $13.9 million, respectively, recognized
under the consignment sales method. Net revenues from product development increased 46% in 2004 to $24.0 million, or 11% of net
revenues, from $16.5 million, or 7% of net revenues, in 2003 period, primarily due to product
development revenues under our significant development agreement, a milestone payment related to
FDA approval of a new drug application for Aventis new Allegra-D 24 hour tablets, and a payment
from SICOR Pharmaceuticals Inc. to reacquire their U.S. marketing rights for calcitriol. We expect
to record net revenues of $7.0 million under our significant development agreement in 2005,
although we received the cash associated with this revenue in April 2004, and we do not expect any
further cash receipts or revenues under this agreement. Net revenues from our development services business increased 6% in 2004 to $94.9 million, from
$89.3 million in 2003. The increase was principally attributable to higher demand for our Phase I
clinical capabilities in both the United States and Europe, as well as for Phase II-IV and
bioanalytical services, partially offset by lower fee-for-service revenues under our significant
development agreement. Reimbursed out-of-pocket revenues represent out-of-pocket expenses we incur that are reimbursed to
us by our clients. Reimbursed out-of-pocket revenues increased to $18.7 million in 2004, from
$12.0 million in 2003. This increase is primarily related to projects in our clinical trials
operations and is expected to fluctuate from one period to another as a result of changes in the
clinical trials conducted during any period of time. Direct costs (excluding depreciation and royalty expense) decreased $5.9 million, or 5%, to $120.9
million in the year ended December 31, 2004, from $126.8 million in the same period in 2003. This
decrease in direct costs resulted primarily from lower unit sales of our pharmaceutical products,
partially offset by an increase in reimbursable out-of-pocket expenses. Direct costs as a
percentage of net revenues were 56% in 2004 as compared to 54% in 2003. 48




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Selling expenses decreased 12% in 2004 to $35.0 million, or 16% of net revenues, from $39.5
million, or 17% of net revenues, in 2003. This decrease is primarily due to reduced personnel
and marketing and promotional costs related to our product sales business partially offset by
increases associated with sales force related expenses under an agreement with Athlon
Pharmaceuticals. We terminated the contract with Athlon for our outside sales force in the second
quarter of 2004 and we terminated our entire internal sales force in the fourth quarter of 2004.
As of December 31, 2003, our pharmaceutical sales force was approximately 200, including 105
outside sales professionals provided under the contract with Athlon. General and administrative costs increased $5.4 million in 2004 to $45.9 million, or 21% of net
revenues, from $40.5 million, or 17% of net revenues, in 2003. This increase was primarily due to
additional product liability insurance expense for the products we acquired in December 2003 and
litigation-related expenses. During 2004, we incurred legal fees and expenses in our ongoing
omeprazole patent litigation against Schwarz Pharma Inc., Schwarz Pharma AG, Kremers Urban
Development Co., and certain of their affiliates. We anticipate that we will continue to incur
legal fees and expenses in connection with this litigation in 2005, as well as other litigation and
investigations. See Part I, Item 3 Legal Proceedings for additional information regarding this
litigation and other pending litigation that may significantly increase our legal expenses in 2005. Research and development expenses were $16.3 million, or 8% of net revenues, in 2004, compared to
$21.8 million, or 9% of net revenues, in 2003. The decrease in research and development expenses
was primarily attributable to the liquidity issues we faced in 2004. Significant project spending
in 2004 was related to our Lynxorb (formerly referred to as ProSorb-D) pain management product and
our proton pump inhibitor development program. In 2004, we recorded $11.0 million of legal, financial and consulting professional fees associated
with the investigation conducted by the Special Committee. We will continue to incur significant
legal, financial and consulting professional fees in 2005 associated with debt restructuring
activities, including costs related to a potential filing under Chapter 11 of the U.S. Bankruptcy
Code. In April 2004, we sold our M.V.I. and Aquasol product lines to Mayne Pharma (USA) Inc. for $105
million, subject to certain adjustments and an escrow of part of the purchase price. The sale
resulted in a gain of $39.1 million that we recorded in the second and third quarters of 2004. The
gain was partially offset by a $31.0 million expense we recorded in the first quarter of 2004 for a
contingent payment to AstraZeneca AB based on the status of the reformulation of our M.V.I.-12
product. The FDAs approval in the first quarter of the reformulation of this product created an
obligation under our product line acquisition agreement for us to make this contingent payment. In the fourth quarter of 2004, we recorded a charge of $11.7 million, and established a
corresponding reserve, related to a pharmaceutical product manufacturing supply agreement entered
into in 2003 requiring us, subject to the terms and conditions of the agreement, to purchase a
minimum level of products on a take-or-pay basis by September 2006. We do not expect to be able to
fulfill our purchase obligations under this agreement within that period. We are negotiating with
the manufacturer under this agreement to extend the term of our obligation 49




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##### 



to purchase the minimum
level of products by an additional multi-year period and to include additional products to be
manufactured for us under this agreement and applied against our
minimum purchase requirement. If we are successful in amending the agreement on this basis, the
reserve and corresponding charge may be reversed in a subsequent period. We cannot provide any
assurance, however, that we will be successful in amending the agreement on these, or any other,
terms. In 2004, we announced and implemented several restructuring plans, which included work force
reductions and facility closures. We recorded a $22.4 million expense in 2004, primarily
representing severance costs and related employee-benefit expenses of $5.5 million, separation
payments of $1.9 million to our former chief executive officer and costs of $15.0 million for
assets and leased facilities which are no longer in use. These leased facilities include our New
Jersey lab facility, smaller facilities in North Carolina, Florida and California, and aircraft
leased by us. We are currently seeking to sub-lease these facilities, and have entered a
short-term sublease for one aircraft and the California facility. Royalty expenses for the year ended December 31, 2004 were $1.7 million. We accrued royalties
based on revenues generated by certain acquired products, including calcitriol injectable, which we
divested in December 2004. We will continue to incur royalty expenses on other products in 2005.
Royalty expenses were $1.1 million for 2003. In September and December 2004, we recorded charges of $5.3 million and $1.2 million, respectively,
due to the impairment of an intangible asset associated with our acquired Brethine product. The
introduction of generic competition for our Brethine injectable product affected our future
anticipated revenues, which negatively impacted the carrying value of the acquired intangible
assets. In December 2004, we also recorded an $87.1 million charge due to the impairment of
intangible assets associated with our Darvon/Darvocet products. This charge resulted from the
impact on our impairment analysis of our experience in the process we undertook to sell the
Darvon/Darvocet products. Our consolidated loss from operations was $144.1 million in 2004, as compared to $21.3 million in
2003. This decrease is primarily attributable to the intangible asset impairment charges and the
other items discussed above, including the decrease in product sales revenue, higher general and
administrative expenses, professional fees related to the Special Committee investigation, and the
restructuring charges, partially offset by the higher development services and product development
revenues, lower selling expenses and the gain on the sale of the M.V.I. and Aquasol product lines,
net of the expenses associated with the M.V.I. Contingent Payment. The loss from operations for our product sales business was $108.6 million in 2004, compared to
income from operations of $1.7 million in 2003. This decrease is attributable to a decrease in
revenue due to the divestiture of our M.V.I. and Aquasol product lines, the reduction in sales
volumes of our Darvocet and Brethine products, the introduction of generic competition for our
Brethine and Roxicodone products, the intangible asset impairment and guaranteed purchase
commitment charges, both as discussed above, and restructuring charges of $3.1 million. 50




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Income from operations for our product development business was $24.0 million in 2004, compared to
income from operations of $16.5 million in 2003. This change resulted from the increased revenues
from our significant development agreement, as discussed above. The loss from operations for our development services business was $3.6 million in 2004, compared
to income from operations of $1.7 million in 2003. This change is primarily due to restructuring
charges of $10.8 million, as discussed above, partially offset by the higher revenues. Unallocated corporate expenses increased in 2004 to $38.7 million, from $19.0 million in 2003.
This increase is primarily related to restructuring charges of $8.0 million and the $11.0 million
of professional fees related to the Special Committee investigation. Net interest expense increased to $35.0 million in 2004 from $21.1 million in 2003 due to charges
related to the refinancing of our senior credit facilities (see Liquidity and Capital Resources
for additional information on changes to our debt). In addition, we recorded a $6.2 million
expense for the extinguishment of debt related to our previous senior credit facilities. Other expense in 2004 includes $1.6 million representing the fee we paid to terminate an agreement
we had entered into to purchase a product awaiting regulatory approval that we subsequently
concluded was no longer commercially viable. Terminating the agreement eliminated a contingent
payment obligation of $13.8 million. No future obligations remain under this terminated agreement. Other income in 2003 included $5.6 million related to the termination fee, net of expenses,
received from CIMA Labs Inc. in connection with CIMAs termination of a merger agreement with us,
and the $1.8 million gain from the sale of our investment in Endeavor Pharmaceuticals Inc., a
pharmaceutical development company which we helped organize in 1994. We recorded income tax expense of $3.7 million in 2004. We currently believe that it is more
likely than not that any deferred tax assets generated during 2004 will not be utilized; therefore
no tax benefit was recorded. Included in this tax expense is an additional valuation allowance for
previously unreserved deferred tax assets for which it is now more likely than not that the benefit
will not be realized. The need for this additional valuation allowance resulted from changes in
the projected recoverability of these deferred tax assets. Our effective tax rate for 2004 was 2%.
Our effective tax rate for 2003 was 12%. Year Ended December 31, 2003 Compared to Year Ended December 31, 2002 Our consolidated net revenues for the year ended December 31, 2003 decreased 2% to $236.9 million,
from $241.2 million in 2002. The decrease was attributable to lower net revenues recorded from the
sale of our pharmaceutical products and, to a lesser extent, a reduction in product development
revenues associated with our significant development contract. Net revenues from product sales decreased to $119.2 million in 2003, from $124.4 million in 2002.
The decrease in net revenue was attributable to reduced net sales of our Brethine line and, to a
lesser extent, reduced net sales of our M.V.I. line. 51




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##### 



These reduced sales were mitigated in 2003 by the introduction of several new products, including
the New Pain Products acquired from Elan in December 2003, our Darvocet A500 line extension
introduced in September 2003 and our calcitriol injection product introduced in March 2003. These
new product offerings contributed an aggregate of $17.4 million to 2003 net
revenue, of which $14.5 million was attributable to sales of the New Pain Products. In addition,
price increases, primarily related to our Brethine injectable product and Darvon and Darvocet
product lines, accounted for $9.5 million of our 2003 net revenue. Net revenues from product development decreased 16% in 2003 to $16.5 million, or 7% of net
revenues, from $19.6 million, or 8% of net revenues, in 2002, primarily due to lower revenues
related to our significant development agreement in 2003 and to third-party licensing payments
which we had previously deferred and were amortized into revenue in 2002 and prior years. No
previously deferred revenues were recognized in 2003. Net revenues from our development services business increased 3% in 2003 to $89.3 million, from
$86.5 million in 2002. This increase was principally attributable to higher demand for our
European bioanalytical and clinical services and our U.S. analytical capabilities, partially offset
by lower fee-for-service revenues from lower demand for our clinical manufacturing and formulations
services and under our significant development agreement. Direct costs (excluding depreciation and royalty expense) increased $25.4 million, or 25%, to
$126.8 million in 2003, from $101.4 million in 2002. This increase in direct cost dollars resulted
from higher product costs of $8.8 million, increased inventory reserves of $11.2 million related to
estimated reserves for excess wholesaler inventories in excess of anticipated demand in 2003 and
increased amortization expense of $3.0 million related to product rights for acquired products.
Direct costs as a percentage of net revenues increased to 54% in 2003 from 42% in 2002. Selling expenses increased 71% in 2003 to $39.5 million, or 17% of net revenues, from $23.1
million, or 10% of net revenues, in 2002. This increase is primarily due to expenses incurred by
our product sales business associated with developing our product sales force and marketing and
promoting our new products. As of December 31, 2003, our pharmaceutical sales force was
approximately 200, including 105 outside sales professionals added in October 2003 under an
agreement with Athlon Pharmaceuticals, from whom we acquired our Darvocet A500 product, as compared
to 50 sales professionals at December 31, 2002. General and administrative costs increased 1% in 2003 to $40.5 million, or 17% of net revenues,
from $40.1 million, or 17% of net revenues, in 2002. This increase was primarily due to additions
to our corporate infrastructure to accommodate the expansion of our overall business, expenses
related to the management build-up for our product sales business and increased product related
insurance costs, partially offset by lower legal fees and employee benefit related expenses. Research and development expenses increased 4% in 2003 to $21.8 million from $20.9 million in 2002.
These amounts represented 9% of net revenues in 2003 and 2002. We incurred significant project
spending in 2003 related to our ProSorb-D pain management product and development work on line
extensions for our pain management and critical care products. 52




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Royalty expenses in 2003 were $1.1 million. We accrue royalties based on revenues generated by
certain acquired products, including our Darvocet A500 product and our calcitriol product. No
similar royalty expenses were incurred in 2002. In December 2003, we recorded a $15.9 million charge due to the impairment of an intangible asset
associated with our acquired Brethine product. The then-anticipated introduction of generic
competition for this product (which subsequently occurred in May 2004) affected our future
anticipated revenues, which negatively impacted the carrying value of the acquired intangible
assets. We also recorded a $4.7 million write down of the full amount of the intangibles assets
related to the Darvocet A500 product we acquired in 2003. In March and April of 2004, we
experienced significant requests for returns of Darvocet A500. We re-evaluated our sales forecast
for Darvocet A500 and identified a potential impairment of the asset. As a result of the
impairment analysis, we determined that the asset needed to be written-off. The consolidated loss from operations was $21.3 million in 2003, compared to consolidated income
from operations of $48.6 million in 2002. This decrease was primarily due to the lower product
sales and product development revenues in 2003, increased product-related costs and the intangible
asset impairment charges. Income from operations for our product sales business in 2003 was $1.7 million, compared to $66.4
million in 2002. This decrease resulted from the combination of reduced net sales, increases in our
reserves for product returns, increased sales costs associated with the launch of Darvocet A500,
and the intangible asset impairment recorded in the fourth quarter. Income from operations for our product development business was $16.5 million in 2003, compared to
income from operations of $19.6 million in 2002. This change resulted from the decreased revenues
from our significant development agreement. Income from operations for our development services business was $1.7 million in 2003, compared to
$1.0 million in 2002. This increase is primarily due to increased margins in our bioanalytical and
analytical businesses in 2003. The increase in revenues was the primary reason for the higher
operating margins achieved in 2003. Unallocated corporate expenses increased in 2003 to $19.0 million, or 8% of net revenues, from
$17.2 million, or 7% of net revenues, in 2002. This higher level was due to additions to our
corporate infrastructure to accommodate the expansion of our overall business. Net interest expense increased to $21.1 million in 2003, from $19.4 million in 2002. This $1.7
million increase is primarily attributable to the borrowings that funded our product line
acquisitions in December 2003 and March 2002, partially offset by debt repayments and lower
interest rates on our variable rate debt. Losses from the extinguishment of debt of $1.5 million and $8.1 million were recorded in 2003 and
2002, respectively. These losses resulted from the write-off of deferred financing and other costs
due to the refinancing of our term loan facility in December 2003 in connection with our New Pain
Products acquisition and the refinancing of our prior debt facilities in March 2002 related to our
Darvon and Darvocet acquisition. 53




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Other income in 2003 included $5.6 million related to the termination fee, net of expenses,
received from CIMA Labs Inc. in connection with CIMAs termination of a merger agreement with us,
and the $1.8 million gain from the sale of our investment in Endeavor Pharmaceuticals Inc., a
pharmaceutical development company which we helped organize in 1994. We recorded a tax benefit of $4.5 million in 2003, based on an effective tax rate of 39%, offset by
a valuation allowance of $10.0 million because it is more likely than not that some portion of the
deferred tax asset will not be realized. Our effective tax rate for 2002 was 39%. Liquidity and Capital Resources Liquidity was a major focus of management attention throughout 2004. We replaced our senior credit
facilities in April 2004 and increased the size of such facilities from $140 million to $180
million through a series of amendments during 2004 to meet liquidity needs, including the payment
of the interest due on our senior subordinated notes. We also amended our senior subordinated
notes and received consents of the holders thereof to waive certain defaults and facilitate the
senior debt facility amendments. See Senior Credit Facilities and Subordinated Notes
due 2010 below. In addition, we implemented reductions in workforce and facility closure plans to
rationalize our expense base as it relates to revenues, resulting in $22.4 million of restructuring
plan charges, and we disposed of certain investments and non-core assets for liquidity purposes in
addition to the sale of our M.V.I. and Aquasol product lines described below. Because of the potential for defaults under our senior credit facilities and notes at December 31,
2004, including failure to pay the interest on our Notes due April 1, 2005, all $350.5 million of
debt outstanding at December 31, 2004 under our senior credit facilities and notes is classified as
current liabilities on our consolidated balance sheet at December 31, 2004. Due in part to this
classification, our current liabilities at December 31, 2004 exceed our current assets by $385.2
million. In light of our current financial condition, we believe that our operations cannot support our
existing debt and that we must restructure our debt to levels that are more in line with our
operations. Thus, it is highly likely that we will seek relief in bankruptcy under chapter 11 of the Bankruptcy
Code. See Analysis of Liquidity below. Historically, we have funded our businesses with cash flows provided by operations and proceeds
from borrowings. Cash flow used in operations in 2004 was $93.1 million, compared to cash flow
provided by operations of $38.4 million in 2003. This decrease was primarily due to a significant
decrease in cash receipts from the sale of our pharmaceutical products, a significant increase in
cash expenditures for professional fees, and a decrease in deferred revenues on products accounted
for under the consignment model, partially offset by a significant decrease in the gross amount of
our accounts receivable. In the second half of 2004, we also reclassified $12.4 million from
deferred product revenue to other accrued liabilities, recognizing the potential return of certain
products accounted for under the consignment model resulting from reduced demand and related
expiration issues. 54




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The gross amount of our accounts receivable decreased by $45.8 million, or 53%, in 2004 due to
significant collections in 2004 for pharmaceutical products shipped during the fourth quarter of
2003 and a significant decrease in the amount of pharmaceutical products shipped during 2004. This
decrease in our accounts receivable was partially offset by the effect of the decision of one of
our major pharmaceutical products customers to setoff cash payments due to us for certain
pharmaceutical products that it purchased from us against amounts due from us for services
under separate agreements with affiliates of such customer. This customer also has setoff cash
payments due to us against amounts that we may owe it for product returns and chargebacks related
to certain pharmaceutical products that it has already purchased from us. We are in on-going
negotiations with this customer regarding these payments and setoffs. Additionally, as of December 31, 2004, our $39.9 million in gross accounts receivable were offset
by $24.6 million in allowances for customer credits, which primarily consist of reserves we
established to cover estimated future chargebacks and estimated future product returns. These
reserves are necessary because we must either issue a credit on future sales or make a cash payment
when a chargeback is issued or when wholesalers exercise their rights of return for our
pharmaceutical products as the products near expiration. Cash provided by investing activities was $87.2 million in 2004, primarily related to the cash
proceeds from the sale of our M.V.I. and Aquasol product lines, partially offset by $5.4 million of
capital spending. Cash used in investing activities was $114.3 million in 2003, which included
$102.5 million related to our pain product acquisition in December 2003 and $11.9 million related
to capital spending. Net cash provided by financing activities during 2004 was $4.4 million, primarily representing
$177.5 million of borrowings under our senior credit facilities and $3.4 million in proceeds from
the issuance of common stock primarily related to the exercise of stock options, partially offset
by debt repayments of $166.0 million under the previous debt agreements and a termination payment
of $9.4 million under our previous interest rate hedging agreement. Net cash provided by financing activities during 2003 was $78.0 million, primarily representing net
proceeds of $160.0 million in additional borrowings under the term loan facility we entered into in
December 2003, as described below, $8.8 million of cash proceeds from the exercise of stock options
and $1.7 million related to the unamortized proceeds from the sales of our interest rate swap,
partially offset by the repayment of $93.5 million of borrowings under the then-existing revolving
credit facility and the prior term loan credit facility. These repayments included $50.0 million
from the proceeds of the term loan we entered into in December 2003. The additional repayments
were funded by cash from operations as part of our program to aggressively pay down our
then-existing credit facility. These prepayments of our term loan indebtedness reduced our
liquidity. M.V.I. and Aquasol Product Line Sale and Contingent Payment The agreement under which we acquired our M.V.I. and Aquasol product line was amended in July 2003.
As amended, it provided for two $1.0 million guaranteed payments, which were made in August 2002
and 2003, eliminated a contingent payment of $2.0 million that was potentially due in August 2003
under the original agreement, and provided for a future 55




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contingent payment of $43.5 million, which
we refer to as the M.V.I. Contingent Payment, potentially due in August 2004, depending on the
status of certain reformulation activities being carried out by the seller and regulatory approval
of the reformulations by the U.S. Food and Drug Administration (FDA). The amount of the M.V.I.
Contingent Payment was to be reduced by $1 million per month if the conditions for the contingent
payment had not occurred by December 31, 2002. The amount of the M.V.I. Contingent Payment had
decreased by $12.0 million by
December 31, 2003. Such conditions were satisfied in January and February 2004, fixing the
previously contingent liability under the amendment at $31.5 million. As a result of an amendment
to the original acquisition agreement, we were precluded from recognizing this obligation as
additional purchase price for the M.V.I. and Aquasol product line; therefore, we expensed this
obligation in the first quarter of 2004. We sold the M.V.I. and Aquasol product lines on April 26,
2004. Because the $31.5 million contingent payment was not included in the basis of the assets
sold, we recorded a gain from the sale transaction in the second quarter of 2004 of $37.5 million,
which was partially offset by the expense for the M.V.I. Contingent Payment in the first quarter of
2004. We made the M.V.I. Contingent Payment, discounted to approximately $31.0 million, in April
2004. In the third quarter of 2004, we recorded an additional gain of $1.6 million related to a
reduction in our post-closing obligations under the purchase agreement. Senior Credit Facilities On April 23, 2004, we entered into $140 million of senior credit facilities with a syndicate of
lenders, Silver Point Finance LLC (Silver Point) as collateral agent, and Bank of America, N.A.,
as administrative agent. We entered into amendments to these credit facilities on August 9, 2004
and August 13, 2004 to, among other things, increase the amount of the term loan by up to $10
million, extend the maturity date of the facilities by one year, increase the interest rate on the
loans by an additional 1.5% subject to potential incremental reduction, adjust certain covenants
under the facilities and waive certain defaults and events of default. As amended, our new senior
credit facilities consisted of a $135 million senior secured term loan facility (of which $125
million was fully drawn at the initial closing in April and the remaining $10 million was drawn on
August 13, 2004) and a $15 million senior secured revolving credit facility. Our senior credit
facilities included a covenant requiring us to maintain combined availability under the revolving
credit facility and cash and cash equivalents in the aggregate amount of $5.0 million plus certain
other amounts related to payables, bank overdrafts and interest payments on the loans paid in the
form of additional notes. The outstanding loans under our new senior credit facilities are payable
in full on April 21, 2007. The August amendments also required us to retain FTI Consulting, Inc.
during the term of the senior credit facilities unless certain available cash and annualized cost
reduction thresholds were satisfied by a specific date, at which time our retention of FTI could be
terminated. These thresholds were not met. Our senior credit facilities are secured by a security interest on substantially all domestic
assets, all of the stock of domestic subsidiaries and 65% of the stock of material foreign
subsidiaries. As part of the initial borrowing under these senior credit facilities, we recorded a
$6.2 million loss for the early extinguishment of debt related to the write-off of financing fees
related to our previous senior credit facilities. Subject to exceptions set forth in the definitive
documentation, loans under our new senior credit facilities are also required to be prepaid with a
negotiated percentage of: 56




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
    excess cash flow, as defined;
    non-ordinary course assets sales;
    net proceeds from the sale of subordinated indebtedness;
    net proceeds from equity issuances; and
    extraordinary receipts, as defined. Optional reductions in revolving credit commitments and optional prepayments of term loans, as well
as mandatory reductions in revolving credit commitments and mandatory prepayments of term loans
from the net proceeds of asset sales, subject to defined exceptions, are subject to a prepayment
fee equal to 3.5% until August 9, 2005, 2.5% for the subsequent 12 months, and 1.5% for the next 6
months (with no prepayment penalty payable for the remainder of the term). Prior to the August 9,
2004 amendment, outstanding loans under the facilities bore interest at a rate per annum equal to a
defined LIBOR rate (with a floor of 2%), plus 6.25%, or a defined reference rate (with a floor of
4%), plus 5.25%, in each case payable monthly in arrears. As a result of, and effective with, the
August amendments to these credit facilities, the applicable interest rate on outstanding loans was
increased by an incremental amount, which was initially 1.5%, subject to incremental reductions
based on our financial performance. An additional 1% per annum unused line fee is payable on unused
revolving credit commitments, payable quarterly in arrears. The proceeds of the initial borrowings under these facilities were used, together with the net cash
proceeds from the sale of our M.V.I. and Aquasol product lines, to (i) fund payment of termination
obligations with respect to our interest rate hedging agreement (discussed below), (ii) refinance
our then-existing senior credit facilities, (iii) fund the April 2004 interest payment due on our
senior subordinated notes due 2010, (iv) provide for ongoing working capital and general corporate
needs, and (v) pay fees, costs and expenses in connection with the new senior credit facilities and
other corporate transactions. Effective as of October 8, 2004, we amended our senior secured credit facilities to, among other
things, adjust financial covenants. The senior secured lenders also waived compliance with certain
financial covenants in the senior secured credit facility for the quarter ended September 30, 2004
and the quarter ended December 31, 2004 provided that we met minimum consolidated EBITDA thresholds
(as defined in the senior secured credit facility). The amendment also added a minimum gross
revenue requirement of $40 million for the quarter ended December 31, 2004 and consented to certain
asset disposition transactions and receipt of a deferred purchase price payment pursuant to which
we received approximately $4.2 million in the aggregate. These transactions related to the sale of
our investment in Aesgen and our M.V.I. and Aquasol product lines. The amendment also waived any
requirement to prepay the senior secured loans with the net proceeds of these transactions. As a
result of changes to certain financial covenants affected by this amendment, we were in compliance
with the adjusted covenants under our senior credit facilities at and for the applicable periods
ended December 31, 2004. On October 22, 2004, we entered into another amendment to our senior secured credit facility that
increased the existing term loan facility under our senior secured credit facility by $30 million
(the Supplemental Term Loan), subject to certain specified conditions which were satisfied on
October 29, 2004. The Supplemental Term Loan was made available in up to three draws to be made on
or prior to January 15, 2005. We borrowed $20 million of such term loans 57




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on October 29, 2004 and
the remaining $10 million of such loans in increments on November 5, 2004, November 12, 2004,
November 24, 2004 and December 9, 2004. Following effectiveness of the amendment and these
borrowings, our senior secured credit facility consisted of a term loan of $165 million and a
revolving credit facility of up to $15 million. The amendment also modified the interest rate on the entire senior secured credit facility,
including the Supplemental Term Loan, to equal a defined LIBOR rate (with a floor of 2%) plus 8.25%
per annum or a defined reference rate (with a floor of 4%) plus 7.25% per annum. The amendment
also provided for a commitment fee equal to 0.75% per annum on any undrawn portion of the
Supplemental Term Loan, payable monthly in arrears. At December 31, 2004, 30-day LIBOR was 2.4%. The amendment retained the April 21, 2007 maturity date of the senior secured credit facility and
the optional and mandatory prepayment requirements and premiums described above. The proceeds of the loans under the Supplemental Term Loan were used (i) to fund payment of the
October 1, 2004 interest payment due on our senior subordinated notes, (ii) to pay for fees, costs
and expenses in connection with the amendment and the October 2004 consent solicitation for our
senior subordinated notes, and (iii) for working capital and other general corporate purposes. The amendment retained substantially the same representations, warranties and affirmative and
negative covenants as are provided in the existing senior secured credit facility, including
limitations on liens, indebtedness, fundamental transactions, dispositions of assets, changes in
the nature of our business, investments, acquisitions, capital and operating leases, capital
expenditures, dividends, redemptions or other acquisitions of capital stock, redemptions or
prepayments of other debt, transactions with affiliates, issuances of capital stock, modifications
of indebtedness, organizational documents and other agreements, and retention of excess cash. The
amendment also added a covenant requiring us to retain Rothschild Inc. or another financial advisor
to assist with our exploration of the potential sale of some or all of the assets comprising our
Pharmaceuticals Division. The amendment also maintained the existing financial covenants under the senior secured credit
facilities, including a minimum fixed charge coverage ratio, and a maximum total debt to trailing
twelve-month EBITDA leverage ratio, but eliminated a minimum gross revenue covenant for the quarter
ended December 31, 2004. Compliance with the fixed charge coverage ratio and the leverage ratio
was also waived through the first quarter of 2005 so long as defined minimum EBITDA thresholds are
satisfied. In addition, the amendment retained a covenant requiring certain levels of cash or
revolver availability and increased the level of cash or revolver availability required for the
period from March 31, 2005 through May 15, 2005 to $15,000,000. The amendment also substantially retained the existing events of default under the senior secured
credit facility, including, among others, nonpayment of principal, interest or fees, violations of
covenants, inaccuracy of representations and warranties, a cross-default to our senior subordinated
notes and other material indebtedness, bankruptcy events, and a change in control and added an
event of default if we fail to pursue in good faith the exploration of the potential sale of some
or all of the assets comprising our Pharmaceutical Division or other non-core assets. 58




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No events of default existed under our senior credit facilities at December 31, 2004. However,
since that date, events of default have occurred under our senior credit facilities that would
prohibit borrowings thereunder absent a waiver from our senior lenders. These events of default
included the violation of the cash/revolver availability covenant described above and the failure
to timely file this Form 10-K. On March 31, 2005, we entered into a waiver agreement pursuant to
which our senior lenders agreed to forbear in exercising remedies with respect to the defaults and
events of default existing on that date until the earlier of April 30, 2005 or the occurrence of
another default under the waiver agreement or our senior credit facilities. Upon any such
forbearance termination, our senior lenders could accelerate the debt then outstanding under our
senior credit facilities unless all events of default have been cured prior to such termination. The waiver agreement also permitted us to immediately use approximately $5.7 million of our $11.3
million tax refund received in March 2005 to meet budgeted liquidity needs and required us to
temporarily paydown revolving loans under the senior credit facilities with the remaining $5.6
million of the tax refund. Despite the existing events of default, the waiver permitted us to
reborrow this $5.6 million, in weekly draws, to meet budgeted liquidity needs. No other borrowings
are permitted under our senior credit facilities absent a consent of our senior lenders. Because
of the potential for defaults under our senior credit facilities, all $175.5 million of debt
outstanding at December 31, 2004 under our senior credit facilities is classified as a current
liability on our consolidated balance sheet at December 31, 2004. Subordinated Notes Due 2010 In March 2002, we issued $175 million of senior subordinated unsecured notes due 2010. The
proceeds from the issuance of these notes were $173.9 million, which was net of the original issue
discount. This discount will be charged to interest expense over the term of the notes. These
notes originally had a fixed interest rate of 11% per annum and are guaranteed on a subordinated
basis by all of our existing domestic subsidiaries and all of our future domestic subsidiaries of
which we own 80% or more of the equity interests. Prior to March 28, 2005, up to 35% of the notes
were redeemable with the proceeds of qualified sales of equity at 111% of par value. The terms of
our senior credit facilities require us to repay all of the indebtedness under those facilities
before we may repurchase any of the notes. On or after March 28, 2006, all or any portion of the
notes are redeemable at declining premiums to par value, beginning at 105.5%. Under the terms of
the indenture for the notes, we are required to comply with various covenants including, but not
limited to, a covenant relating to incurrence of additional indebtedness. On March 31, 2004, the lenders under our then-existing credit agreement, which was then in default,
exercised their right to block us from making the interest payment to holders of our senior
subordinated notes due on April 1, 2004. Accordingly, we did not make that interest payment on
April 1, 2004. In addition, our failure to timely file our 2003 Form 10-K constituted a default
under the indenture governing the senior subordinated notes. On April 20, 2004, we completed a solicitation seeking the consent from holders of our senior
subordinated notes to approve a refinancing or replacement of our then existing credit facilities
with our current senior credit facilities and certain amendments to, and waivers under, the
indenture governing the senior subordinated notes to, among other things: 59




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
    grant a lien to secure our obligations under the senior subordinated notes, which lien
is junior to the liens securing our new senior credit facilities but covers the same
collateral;
    increase the interest rate of the senior subordinated from 11% per annum to 11.5% per
annum effective April 1, 2004;
    suspend our obligation under the indenture to file periodic reports with the SEC until
the earlier of the date that our 2003 Form 10-K was filed with the SEC or September 30,
2004, and suspend our obligation under the indenture to furnish annual written statements
of our accountants until the fifth day after the earlier of the date that our 2003 Form
10-K was filed with the SEC and September 30, 2004;
    further limit our ability to grant liens to secure certain obligations unless the liens
are subordinate to the liens securing the senior subordinated notes or are otherwise
permitted under the indenture; and
    limit our ability to incur up to $10 million of indebtedness, and to grant liens to
secure that amount of indebtedness, not otherwise specifically permitted by the indenture,
until our 2003 10-K was filed with the SEC or unless the indebtedness is incurred to fund
an interest payment with respect to the senior subordinated debt. Following the completion of this consent solicitation, we entered into a supplemental indenture to
effect these amendments and waivers and made the interest payments that had been due on April 1,
2004, together with default interest. On October 1, 2004, we failed to make the interest payment then due on our senior subordinated
notes. The failure to make the October 1, 2004 interest payment constituted a default under our
notes, subject to a 30-day cure period. On October 29, 2004, we made the interest payment, curing
the default under the notes. On October 29, 2004, we also completed a solicitation seeking the consent from the holders of our
senior subordinated notes to certain amendments to, and waivers under, the indenture governing our
senior subordinated notes to, among other things:  
    permit us to incur up to $30 million of additional indebtedness under credit facilities;
    permit us to incur additional senior debt in order to maintain $40 million (subject to
an increase up to $50 million in order to allow us to make interest payments on the senior
subordinated notes) in senior debt under credit facilities in the event we are required to
pay down senior debt with the proceeds of asset sales;
    require that debt permitted to be incurred under a fixed charge coverage ratio test set
forth in the Indenture must rank on parity with or be subordinated in right of payment to
the senior subordinated notes and any liens granted to secure any such parity debt shall
rank pari passu with the liens securing our senior subordinated notes;
    require proceeds of asset sales to be used to reduce senior debt under credit facilities
to $40 million;
    provide that the liens on assets that secure obligations under our senior subordinated
notes will continue if all senior debt is repaid, but will resume as junior liens if we
thereafter incur any new senior debt;
    prohibit the payment in cash in excess of an aggregate of $5 million to settle pending
litigation, excluding payments funded or reimbursed under insurance policies, until we 60




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make the interest payments due on our senior subordinated notes on April 1, 2005 and October
1, 2005;
    prohibit the payment of dividends on our common stock and other restricted payments (as
defined in the Indenture) until the interest payments due on our senior subordinated notes
on April 1, 2005 and October 1, 2005 are paid; and
    temporarily increase the interest rate on our senior subordinated notes by 0.5% per
annum (to 12% per annum), beginning on October 1, 2004 and ending on March 31, 2005. The completion of the consent solicitation satisfied a condition of an amendment to our senior
credit facilities (described above) that, among other matters, made available a supplemental term
loan under the senior credit facilities that was used in part to make the October 1, 2004 interest
payment on our senior subordinated notes, together with default interest thereon, on October 29,
2004 and to pay the consent fee described below. The October 29, 2004 interest payment cured the
existing default under the senior subordinated notes. In connection with the October 2004 consent solicitation, we paid a consent fee to the holders of
senior subordinated notes who had submitted valid and unrevoked consents by the expiration date of
the consent solicitation of $20 for each $1,000 in principal amount of senior subordinated notes
for which a consent was submitted. Following discussions with representatives of an ad hoc
committee of holders of the senior subordinated notes, we offered to pay the same consent fee with
respect to senior subordinated notes for which a valid and unrevoked consent had not been properly
submitted by the expiration of the consent solicitation, if the holder of such senior subordinated
notes completed a consent and release for payment by February 7, 2005 that consented to the
proposed amendments and waivers described above and waived all claims it may have against us, the
trustee under the indenture governing the senior subordinated notes, the payment agent in the
consent solicitation, and our and their respective directors, officers, employees, agents,
attorneys, affiliates and advisors with respect to matters related to the consent solicitation. On
February 9, 2005, we paid approximately $1.0 million in additional consent fees pursuant to
properly submitted consents and releases for payment. At December 31, 2004, we were not in default under the covenants under the senior subordinated
notes. Our failure to timely file this Annual Report on Form 10-K for the fiscal year ended
December 31, 2004 (accompanied by a certificate of our independent accountants) constituted a
default under the notes on March 17, 2005. In addition, we have not paid the $10.5 million of
scheduled interest due on April 1, 2005 on our notes. An event of default will occur under the
indenture governing the notes if the interest payment is not made within 30 days after April 1.
Such an event of default would entitle the trustee under the indenture for the notes or the holders
of 25% of the principal amount of the notes to accelerate the notes. Any event of default
entitling the trustee or the holders of the notes to accelerate the notes would also constitute an
event of default under our senior credit facilities entitling our senior lenders to accelerate the
debt thereunder. Because of the potential for defaults under our notes at December 31, 2004, all $175.0 million of
debt outstanding at December 31, 2004 under our notes is classified as a current liability on our
consolidated balance sheet at December 31, 2004. 61




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Interest Rate Hedging Agreement Concurrently with the issuance of our senior subordinated notes, we entered into an interest rate
hedging agreement to effectively convert interest expense on a portion of the senior subordinated
notes for the term of the notes from an 11% fixed annual rate to a floating annual rate equal to
6-month LIBOR plus a base rate. In 2003, we sold the then outstanding hedging agreement, and
replaced it with a similar interest rate hedging agreement. The amounts we received, less the
termination payment and the interest benefits earned through the dates of sale, have been recorded
as premiums to the carrying amount of the notes and are being amortized into interest income over
their remaining life. Our obligations under the interest rate hedging agreement were secured by collateral under our
then-existing senior credit facilities. As a condition to establishing our new senior credit facilities, we terminated the interest rate
hedging agreement in April 2004. Our termination obligations under the interest rate hedging
agreement were approximately $9.4 million, which amount was paid upon termination of that
agreement. Income Tax Refunds Income tax refund proceeds are serving as a source of near term liquidity. In March 2005, we
received a tax refund of approximately $11.3 million, all or substantially all of which was
required to be paid down under our senior credit facilities. On March 31, 2005, we entered into a
waiver agreement pursuant to which our senior lenders permitted us to immediately use approximately
$5.7 million of the tax refund to meet budgeted liquidity needs and required us to temporarily
paydown revolving loans under the senior credit facilities with the remaining $5.6 million of the
tax refund. Despite existing events of default under our senior credit facilities, the waiver
permitted us to reborrow this $5.6 million, in weekly draws, to meet budgeted liquidity needs. Commitments and Contingencies We may have to make contingent payments of $4.7 million over three years in connection with the
purchase of our Charleston, South Carolina manufacturing facility, based on the level of
manufacturing revenues at this facility. At December 31, 2004 these contingent payment obligations
are not liabilities and have not been recorded on our consolidated balance sheet. We made interest payments on the senior subordinated notes of $9.7 million in April 2004 and $10.2
million in October 2004. An interest payment of $10.5 million was due on our senior subordinated
notes on April 1, 2005 and was not paid. An additional $10.1 million interest payment is due on
such notes on October 1, 2005. We are a party to several significant lawsuits and are being investigated by the SEC and the U.S.
Attorneys Office for the Western District of North Carolina. Any damages or litigation costs
(including any indemnification of, or payment of litigation expenses for, our current and former
officers, directors and employees who have been named as defendants in these lawsuits or are
subject to these investigations) that are not covered by applicable insurance policies that we 62




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have, including our D&O policy, and thus are ultimately borne by us as a result of an adverse
determination in these lawsuits, are significant contingent liabilities that are not recorded as
liabilities on our balance sheet but could result in significant cash payment obligations in the
future. In addition, the U.S. Attorneys Office, SEC and other government agencies that are
investigating or might commence an investigation of aaiPharma could impose, based on a claim of
fraud, material misstatements, violation of false claims law or otherwise, civil and/or criminal
sanctions, including fines, penalties, and/or administrative remedies. The potential for
government sanctions also represents a significant contingent liability that is not recorded as a
liability on our balance sheet but could result in significant cash payment obligations in the
future. We expect to incur significant legal and related costs and expenses in connection with
these lawsuits and investigations in 2005. For more information on these lawsuits and
investigations, see Note 13 of Notes to Consolidated Financial Statements included elsewhere in
this report. The following schedule summarizes contractual obligations and commitments at December 31, 2004 (in
thousands): Over One
    
    
    Over ThreeOne Year
    
    
    Through
    
    
    Through
    
    
    Over FiveOr Less
    
    
    Three Years
    
    
    Five Years
    
    
    Years
    
    
    TotalSenior credit facilities
    
    $
    175,500
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    175,500Senior subordinated notes
    
    
    175,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    175,000Operating leases
    
    
    7,839
    
    
    
    10,831
    
    
    
    7,350
    
    
    
    4,642
    
    
    
    30,662Capital lease obligations
    
    
    239
    
    
    
    172
    
    
    
    
    
    
    
    
    
    
    
    411Purchase commitments
    
    
    34,218
    
    
    
    5,848
    
    
    
    
    
    
    
    
    
    
    
    40,066$
    392,796
    
    
    $
    16,851
    
    
    $
    7,350
    
    
    $
    4,642
    
    
    $
    421,639
 The scheduled maturity for our senior credit facilities is April 21, 2007 and the scheduled
maturity for our senior subordinated notes is April 1, 2010. However, due to the potential for
defaults under our senior credit facilities and notes, the debt outstanding thereunder is
classified as a current liability on our consolidated balance sheet at December 31, 2004. Our
purchase commitments are primarily related to outstanding orders and commitments with suppliers to
purchase finished goods related to our pharmaceutical products. In the fourth quarter of 2004, we
recorded a charge of $11.7 million, and established a corresponding reserve, related to a
pharmaceutical product manufacturing supply agreement entered into in 2003 requiring us, subject to
the terms and conditions of the agreement, to purchase a minimum level of products on a take-or-pay
basis by September 2006. We do not expect to be able to fulfill our purchase obligations under
this agreement during this period. This purchase commitment is reflected in the table above. We
are negotiating with the manufacturer under this agreement to extend the term of our obligation to
purchase the minimum level of products by an additional multi-year period and to include additional
products to be manufactured for us under this agreement and applied against our minimum purchase
requirement. If we are successful in amending the agreement on this basis, the reserve and
corresponding charge may be reversed in a subsequent period. We cannot provide any assurance,
however, that we will be successful in amending the agreement on these, or any other, terms. 63




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Our liquidity needs increased during 2004, and our annual net interest expense may exceed $46
million in 2005. We failed to make an interest payment on our senior subordinated notes of $10.5
million due on April 1, 2005, and we have another interest payment on such notes of approximately
$10.1 million due on October 1, 2005. We will incur substantial cash expenses in 2005, resulting from the cost of advisors, such as legal
counsel (including legal counsel to the ad hoc committee of holders of our senior subordinated
notes and legal counsel for our senior lenders), FTI Palladium Partners, the ad hoc committees
financial advisor, our senior lenders financial advisor, and our financial advisor in connection
with potential asset sales. In addition, we will continue to incur significant severance and
restructuring costs in connection with the restructuring plans implemented in 2004. On March 31, 2004, each of Moodys Investors Service and Standard & Poors Ratings Services
announced that it had lowered our corporate credit rating: Moodys to Caa2 from B2 and Standard &
Poors to CCC from B+. At the same time, Moodys lowered its rating of our senior subordinated
notes to Ca from Caa1 and our senior unsecured issuer rating to Caa3 from B3. Standard & Poors
lowered its senior secured debt rating to CCC+ from BB-, and its subordinated debt rating to CC
from B-. On December 31, 2004, Moodys confirmed the Caa2 corporate credit rating, lowered its
rating of our senior subordinated notes to C from Ca and our senior unsecured issuer rating to Ca
from Caa3. On March 17, 2005, Standard & Poors Ratings Services announced that it had lowered our
corporate credit rating from CCC to CC and our subordinated debt rating from CC to C, and on April
4, 2005, it lowered both ratings to D, the lowest rating possible, following our failure to pay the
$10.5 million interest payment due on April 1, 2005, on our senior subordinated notes. These
actions may negatively affect our ability to raise any necessary capital through issuances of debt
securities or other debt instruments on acceptable terms, or at all. Analysis of Liquidity We incurred a substantial net loss and loss from operations for 2004 and the quarter ended December
31, 2004. As a result of our recurring substantial operating losses, we did not have available
sufficient cash on hand, or the ability to borrow under our senior credit facilities, to pay the
approximately $10.5 million of scheduled interest due on April 1, 2005 on our $175 million of
senior subordinated notes due 2010. In March 2005, we received a tax refund of approximately $11.3 million, all or substantially all of
which was required to be paid down under our senior credit facilities. Events of default had also
occurred under our senior credit facilities that would prohibit borrowings thereunder absent a
waiver from our senior lenders. On March 31, 2005, we entered into a waiver agreement pursuant to
which our senior lenders agreed to forbear in exercising remedies with respect to these existing
events of default until the earlier of April 30, 2005 or the occurrence of another default under
the waiver agreement or our senior credit facilities. Upon any such forbearance termination, our
senior lenders could accelerate the debt then outstanding under our senior credit facilities unless
all events of default have been cured. This waiver agreement also permitted us to immediately use
approximately $5.7 million of the tax refund to meet budgeted liquidity needs and required us to
temporarily paydown revolving loans under the senior credit facilities with the remaining $5.6
million of the tax refund. Despite the existing events of default, the waiver 64




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permitted us to reborrow this $5.6 million, in weekly draws, to meet budgeted liquidity needs.
These tax refund proceeds and borrowings have permitted us to meet near term liquidity needs. However, no other borrowings are permitted under our senior credit facilities absent a consent of
our senior lenders. Our failure to make the $10.5 million interest payment due on our senior
subordinated notes on April 1, 2005 will also be an event of default under the indenture governing
such notes if the interest payment is not made within 30 days after April 1. Such an event of
default would permit the acceleration of the notes. We have been exploring a potential sale of some or all of the assets of our Pharmaceuticals
Division, as well as other operating assets. In October 2004, we engaged Rothschild Inc. to assist
us, and in November 2004 Rothschild began a process to gauge the interest in any asset sale
transaction by contacting potential strategic and financial purchasers. Potential purchasers
expressing an interest were provided an opportunity to examine detailed information regarding our
Pharmaceuticals Division, its business, products and products in development. On March 31, 2005,
we entered into a limited exclusivity agreement with a potential purchaser of certain of the assets
of our Pharmaceuticals Division to facilitate continued due diligence and negotiation over a
potential sale. This written exclusivity agreement expired by its
terms on April 22, 2005, though we are continuing to negotiate
with this potential purchaser on an exclusive basis. We have not
reached a definitive agreement with this potential purchaser regarding a sale and we cannot provide
any assurance that any material asset sale will be agreed upon or completed. In addition, we have
not determined to sell any material assets, and we plan to continue to operate our Pharmaceuticals
Division if we do not complete such a sale of its assets. Pursuant to the terms of our senior credit facilities, the net proceeds of any material asset sale
are required to be applied to permanently reduce our outstanding indebtedness under our senior
credit facilities. Similarly, the indenture governing our notes requires that the net proceeds of
material asset sales be applied to permanently reduce indebtedness under the senior credit
facilities to $40 million, at which point we would be permitted under the indenture to incur an
additional $10 million of indebtedness solely to fund payments of interest on the notes.
Accordingly, such a sale would not provide liquidity unless the amount of the net proceeds was in
excess of the amount needed to discharge our indebtedness under the senior credit facilities or our
senior lenders and holders of our notes consented to permit a portion of the net proceeds to be
used for a purpose other than repayment of our senior debt. Based on our exploration of a possible
sale of some or all of the assets of our Pharmaceuticals Division, we believe that, the sale of all
of the assets of our Pharmaceuticals Division at this time, given our financial condition and other
circumstances, may not yield net proceeds in excess of the amount needed to discharge the
indebtedness under our senior credit facilities. A sale of some or all of the assets of the
Pharmaceutical Division would require the consent of the Lenders under our senior credit
facilities, and such a sale may require the consent of the holders of our notes and our
stockholders. In light of our current financial condition, we believe that our operations can no longer support
our existing debt and that we must restructure our debt to levels that are more in line with our
operations. Thus, it is highly likely that we will seek relief under chapter 11 of the U.S. Bankruptcy Code
which would substantially dilute and may eliminate the interests of the holders of our common
stock. 65




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We have continued our engagement of FTI as our financial advisor to assist us in exploring our
alternatives. With FTI, we have held discussions with Lenders under our senior credit facilities
and advisors to an ad hoc committee of holders of our notes in an effort to negotiate a consensual
restructuring of our debt. In addition, we have engaged in
discussions and negotiations with prospective lenders to obtain financing sufficient to refinance indebtedness
outstanding under the senior credit facilities and/or to provide additional credit facilities in
order to fund our operations while in a chapter 11 proceeding under the Bankruptcy Code if we were
to commence such a proceeding. Our independent registered public accountants have advised our management and the Audit Committee
of our Board of Directors that our recurring losses from operations raise substantial doubt
regarding our ability to continue to operate as a going concern. Therefore, our independent
registered public accountants have included in their report on our consolidated financial
statements an explanatory paragraph addressing the substantial doubt regarding our ability to
continue to operate as a going concern. Critical Accounting Policies Our management has concluded that our internal control over financial reporting is not effective
due to the existence of several material weaknesses. Several of these material weaknesses relate
to the critical accounting policies discussed below and further complicate the judgments necessary
in those accounting areas. Our managements report on internal control over financial reporting is
included with the financial statements reflected in Item 8 of this Annual Report on Form 10-K. Revenue Recognition We recognize revenue in accordance with the Securities and Exchange Commissions Staff Accounting
Bulletin No. 101, Revenue Recognition in Financial Statements as amended by Staff Accounting
Bulletin No. 104 (together, SAB 101) and Statement of Financial Accounting Standards No. 48
Revenue Recognition When Right of Return Exists (FAS 48). SAB 101 states that revenue should
not be recognized until it is realized or realizable and earned. Revenue is realized or realizable
and earned when all of the following criteria are met: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred or services have been rendered; (3) the sellers price to the
buyer is fixed and determinable; and (4) collectibility is reasonably assured. FAS 48 states that
revenue from sales transactions where the buyer has the right to return the product shall be
recognized at the time of sale only if (1) the sellers price to the buyer is substantially fixed
or determinable at the date of sale, (2) the buyer has paid the seller, or the buyer is obligated
to pay the seller and the obligation is not contingent on resale of the product, (3) the buyers
obligation to the seller would not be changed in the event of theft or physical destruction or
damage of the product, (4) the buyer acquiring the product for resale has economic substance apart
from that provided by the seller, (5) the seller does not have significant obligations for future
performance to directly bring about resale of the product by the buyer, and (6) the amount of
future returns can be reasonably estimated. 66




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Net Revenues. Our consolidated net revenues represent our total revenues less allowances for
customer credits, including estimated discounts, rebates, chargebacks, product returns and non
research and development expenses reimbursed by customers. As is customary in the pharmaceutical
industry, we accept returns of products we have sold as the products near their expiration date.
At the time we recognize revenue from product sales, we record an adjustment, or decrease, to
revenue for estimated chargebacks, rebates, discounts and returns. The following table sets forth our consolidated gross revenues and the amount of dilution to
consolidated revenues resulting from allowances for customer credits, including discounts, rebates,
chargebacks, product returns and other allowances for each of 2004, 2003 and 2002: Years Ended December 31,2004
    
    
    2003
    
    
    2002(in thousands)Gross revenues
    
    $
    273,227
    
    
    $
    339,232
    
    
    $
    294,602Less allowances for customer credits
    
    
    57,897
    
    
    
    102,305
    
    
    
    53,404Net revenues
    
    $
    215,330
    
    
    $
    236,927
    
    
    $
    241,198
 Allowances for customer credits as a percentage of consolidated gross revenues were 21.2% for 2004
as compared to 30.2% for 2003. This change is primarily related to lower pharmaceutical returns
and chargeback reserve needs based on changes in sales mix, primarily due to lower Brethine sales
and the sale of our MVI product line. Net revenues are reported for our three operating segments in 2004, which were product sales,
development services and product development. Product Sales. We recognize revenues for product sales at the time title and risk of loss are
transferred to the customer, and the other criteria of SAB 101 and FAS 48 are satisfied, which is
generally at the time products are received by our customers. Product shipping and handling costs
are included in cost of sales. We accept returns of products near their expiration date. At the time we recognize revenue from product sales, we record an adjustment, or decrease, to
revenue for estimated chargebacks, rebates, discounts and returns. Revenue reserves are
established on a product-by-product basis. These revenue reductions are established by management
as its best estimate at the time of sale based on each products historical experience adjusted to
reflect known changes in the factors that impact such reserves. Reserves for chargebacks, rebates
and discounts are established based on the contractual terms with our customers; analysis of
historical levels of discounts, chargebacks and rebates; communications with customers and
purchased information about the rate of prescriptions being written and the levels of inventory
remaining in the distribution channel, as well as our expectations about the market for each
product and anticipated introduction of competitive products. The reserves for chargebacks and
returns are the most significant estimates used in the recognition of our revenue from product
sales. We have established contract prices for certain indirect customers that are supplied by our
wholesale customers. A chargeback represents the difference between the current published
wholesale acquisition cost and the indirect customers contract prices. 67




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Prior to 2003, the amount of actual product returns experienced by the Company had not been
significant. As a result, actual returns were charged against revenue in the period they occurred
and aggregate revenue reserves were evaluated to determine if they were sufficient to cover
estimated chargebacks, rebates and related allowances, as well as the expected rate of returns, and
adjusted as deemed necessary. In 2003, we began segregating our products return reserve, which
prior thereto we believed was adequately covered by our aggregate revenue reserves for chargebacks,
rebates and related allowances. We increased the level of detail included in our analyses to
include analyzing inventory in the channel to determine remaining shelf life. Our returns reserve
needs are primarily related to the number of months of inventory estimated to be in the
distribution channel. Levels of inventory in the distribution channel are monitored and estimated
based on information we purchase from the wholesalers, combined with active discussions between our
sales personnel and the wholesalers we supply. In addition, our actual sales, returns and
chargeback history are used to assess the reasonableness of the estimated number of months of
inventory on hand at our wholesalers. The shelf life of products remaining in the distribution
channel is estimated based on an analysis of the lots sold. Each batch has a specific expiration
date. A review of the actual returns history is performed and the run rate of sales out of the
distribution channel is estimated. Estimated product returns reserves are adjusted based on these
reviews. Reserves may also be adjusted to reflect any significant changes in trends or based upon
new information that we believe may affect the reserve needs. Allowances for new product
introductions are estimated based on our experiences for similar products that we currently market
and are adjusted as deemed necessary based on our experience with each product. Our reserve
analysis also includes a review for the potential introduction of generic competition and the
resulting impact on pricing and returns reserves. Existing reserves may be adjusted accordingly to
reflect our estimate for any impact these factors may have. We continually monitor our assumptions
with respect to our revenue reserves for product sales and modify them if necessary. Revenues from new product launches and the sale of Brethine to a specialty wholesaler have been
recorded under the consignment model. Under the consignment model, we do not recognize revenue
upon receipt of product by wholesalers, but instead invoice the wholesaler, record deferred revenue
at gross invoice sales price and classify the inventory held by the wholesaler as consignment
inventory at our cost of such inventory. We recognize revenue when such inventory is sold through
to the wholesalers customers, on a first-in first-out (FIFO) basis. Product Development. Product development revenues consist of royalty revenues and licensing fees.
We recognize royalty revenues as earned based on sales of the underlying products. Each of our
licensing agreements is reviewed to determine the appropriate revenue recognition treatment under
SAB 101. Revenues from upfront licensing fees are deferred and amortized over the term of the
associated agreement or as ongoing services are performed. Revenues resulting from achieving
certain milestones stipulated in our agreements are recognized when the specific milestone is
achieved. Milestones are based upon the occurrence of a substantive element specified in the
contract or as a measure of substantive progress towards completion under the contract. Development Services. We recognize the majority of our development services revenues from
fee-for-service contracts on a proportional performance basis as the work is performed. This is
based on the ratio of actual direct costs incurred to total estimated direct contract costs, which
is 68




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the best indicator of performance of these contract obligations. This ratio is multiplied by the
estimated contract value to determine the revenue to be recognized. The proportional performance
method requires us to estimate total expected revenue, costs and profitability of the contract.
These estimates are reviewed periodically and, if these estimates change or actual results differ
from expected results, an adjustment is recorded in the period in which they become reasonably
estimable. These adjustments could have a material effect on our results of operations.
Historically, there have not been significant variations between contract estimates and actual
costs incurred which were not recoverable from clients. Changes in the scope of work generally
result in an amendment to contract pricing terms. Amended contract amounts are not included in net
revenues until earned and realization is assured. We also recognize revenue on a time and
materials basis in accordance with the specific contract terms. Revenues recognized prior to
contract billing terms are recorded as work in progress. Provisions for losses on contracts, if
any, are recognized when identified. Clients generally may terminate services at any time, however
the majority of our contracts contain provisions that require payment for all services rendered to
date, even those services that have not yet been billed. We perform ongoing credit evaluations of
our customers and maintain reserves for potential uncollectible accounts. Intangible Assets When we acquire the rights to manufacture and sell a product, we record the aggregate purchase
price, along with the value of the product related liabilities we assume, as intangible assets. We
use the assistance of valuation consultants to help us allocate the purchase price to the fair
value of the various intangible assets we have acquired. Then, we must estimate the economic useful
life of each of these intangible assets in order to amortize their cost as an expense in our
statement of operations over the estimated economic useful life of the related asset. The factors
that drive the actual economic useful life of a pharmaceutical product are inherently uncertain,
and include physician loyalty and prescribing patterns, competition by products prescribed for
similar indications, future introductions of competing products not yet FDA approved, the impact of
promotional efforts and many other issues. We use all of these factors in initially estimating the
economic useful lives of our products, and we also continuously monitor these factors for
indications of appropriate revisions. In assessing the recoverability of our intangible assets, we must make assumptions regarding
estimated undiscounted future cash flows and other factors. If the estimated undiscounted future
cash flows do not exceed the carrying value of the intangible assets we must determine the fair
value of the intangible assets. If the fair value of the intangible assets is less than its
carrying value, an impairment loss will be recognized in an amount equal to the difference. If
these estimates or their related assumptions change in the future, we may be required to record
impairment changes for these assets. In addition, material adjustments to our forecasted revenues
from the sales of any of our acquired product lines including Brethine and Darvocet may require us
to employ different assumptions with respect to our estimated cash flows. We review intangible
assets for impairment at least annually and whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. If we determine that an intangible
asset is impaired, a non-cash impairment charge would be recognized. 69




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For the year ended December 31, 2001, goodwill, defined as the excess of the purchase price over
the fair value of the net assets of acquired businesses, was amortized over 20 years. In
accordance with SFAS 141, we ceased amortization of goodwill as of January 1, 2002. For purchase
business combinations consummated subsequent to June 30, 2001, goodwill and indefinite-lived
intangible assets are not amortized, but are evaluated for impairment on an annual basis or as
impairment indicators are identified. Other identifiable intangible assets are amortized, if
applicable, on a straight line basis over their estimated useful lives, which range from 3 to 20
years. Our goodwill and intangible assets consist of the following: December 31,
    
    
    December 31,2004
    
    
    2003(in thousands)Goodwill, net
    
    $
    14,350
    
    
    $
    13,361Intangible assets, net:Definite-lived
    
    $
    196,769
    
    
    $
    320,530Indefinite-lived
    
    
    
    
    
    
    51,017196,769
    
    
    
    371,547Less accumulated amortization
    
    
    (6,670
    )
    
    
    (20,232
    )$
    190,099
    
    
    $
    351,315
 On a periodic basis, or as otherwise required, we assess the value of our goodwill, intangibles and
other assets by determining their ability to recover the unamortized balances over the remaining
useful lives. Goodwill, intangibles and other long lived assets determined to be unrecoverable are
written off in the period in which such determination is made. Set forth in the table below are the details of the purchase price allocations for of all our major
product line acquisitions since the beginning of 2001. The table lists the assets, the value
allocated to each asset, how the value was determined, and the useful life assigned to each asset.
In these acquisitions, the only tangible assets acquired were inventory and marketing/promotional
materials, which were valued based on internal analyses and data provided by the sellers.
Inventory obtained at time of acquisition was valued at the estimated selling price less the cost
of disposal and a reasonable selling profit. Marketing/promotional materials received were
generally outdated and in limited quantities, so no material value was assigned to them in the
purchase price allocations. We engaged third-party valuation consultants to assist in purchase
price allocations, including identification of intangible assets, recommendations of fair value of
intangible assets, and determination of expected lives of those assets. Intangible assets that
arose from contractual or legal rights and other intangible assets that were separable, as provided
in paragraph 39 of SFAS 141, were identified. Among the assets that were considered for
recognition were trademarks, Internet domain names, non-competition agreements, customer lists,
backlogs, customer contracts and non-contractual relationships, licensing and royalty agreements,
supply contracts, employment contracts, patented and unpatented technology, and trade secrets. 70




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The third-party valuation consultants reviewed pertinent facts and recommended for each asset the
appropriate generally accepted valuation approach and methodology from among the cost, market, and
income approaches. Where possible, a valuation derived using an alternative valuation approach or
methodology was presented and used by management to evaluate the reasonableness of the recommended
fair value. We recorded an $87.1 million charge in December 2004 due to the impairment of intangible assets
associated with our Darvon/Darvocet products. In 2003 and 2004, we recorded charges of $15.9
million and $6.4 million, respectively, due to the impairment of an intangible asset associated
with our Brethine product. These impairments are not reflected in the following table. Value atAcquisitionIdentifiable Assets
    
    (in millions)
    
    
    How Valued
    
    Useful LifeM.V.I. and AquasolTotal purchase price,
including transaction fees
    
    $
    54.7Allocation of purchase price:Inventory
    
    $
    3.7
    
    
    Estimated Selling Price Less Cost of  Disposal and a
    
    N/AReasonable Selling ProfitTrademarks
    
    
    27.3
    
    
    Income Approach Discounted Cash Flow Method
    
    IndefiniteDeveloped Technology
    
    
    23.7
    
    
    Income Approach Discounted Cash Flow Method
    
    IndefiniteTotal
    
    $
    54.7The M.V.I.
and Aquasol product lines were divested in April 2004.BrethineTotal purchase price,
including transaction fees
    
    $
    26.6Allocation of purchase price:Trademarks-Existing
    
    $
    11.3
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsTrademarks-Reformulated
    
    
    9.4
    
    
    Income Approach Discounted Cash Discounted Cash
    
    20 years
 71




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Value atAcquisitionIdentifiable Assets
    
    (in millions)
    
    
    How Valued
    
    Useful LifeDeveloped Technology
    
    
    5.9
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsTotal
    
    $
    26.6Darvon/DarvocetTotal purchase price,
including transaction fees
    
    $
    212.6Allocation of purchase price:Inventory
    
    $
    1.7
    
    
    Estimated Selling Price Less Cost of Disposal
    
    N/Aand a Reasonable Selling ProfitTrademarks-Existing
    
    
    80.3
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsTrademarks-Reformulated
    
    
    50.3
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsDeveloped Technology
    
    
    80.3
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsTotal
    
    $
    212.6Elan Pain PortfolioTotal purchase price,
including transaction fees
    
    $
    103.4Allocation of purchase price:Inventory
    
    $
    5.1
    
    
    Estimated Selling Price Less Cost of Disposal
    
    N/Aand a Reasonable Selling ProfitTrademarks
    
    
    49.1
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsDeveloped Technology
    
    
    49.2
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsTotal
    
    $
    103.4
 72




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Inventories Our inventories are valued at the lower of cost (determined on a first-in, first-out basis) or
market. We review our inventory for short-dated or slow-moving product and inventory commitments
under supply agreements based on projections of future demand and market conditions. For inventory
so identified, we estimate market value or net sales value based on current realization trends. If
the projected net realizable value is less than cost, on a product basis, we provide a reserve to
reflect the lower value of that inventory. We recognize inventory losses at the time such losses
are evident rather than at the time products are actually sold. We also maintain supply agreements
with some of our vendors which contain minimum purchase requirements. We estimate future inventory
requirements based on current trends. If our estimated future inventory requirements exceed
estimated shipments to our customers, we record a charge in direct costs. If we over- or
under-estimate the amount of inventory that will not be sold prior to expiration, there may be a
material adverse impact on our consolidated financial condition and results of operations. Income Taxes Income taxes are accounted for under the liability method. This approach requires the recognition
of deferred tax assets and liabilities for the expected future tax consequences of differences
between the tax basis of assets or liabilities and their carrying amounts in the consolidated
financial statements. A valuation allowance is provided for deferred tax assets if it is more
likely than not that these items will either expire before we are able to realize their benefit or
if future deductibility is uncertain. Developing the provision for income taxes requires
significant judgment and expertise in federal and state income tax laws, regulations and
strategies, including the determination of deferred tax assets and liabilities and, if necessary,
any valuation allowances that may be required for deferred tax assets. Our judgments and tax
strategies are subject to audit by various taxing authorities. While we believe we have provided
adequately for our income tax liabilities in our consolidated financial statements, adverse
determinations by these taxing authorities could have a material adverse effect on our consolidated
financial condition and results of operations. Research and Development Arrangements Research and development expense was 8% of our consolidated net revenues in 2004. However, due to
liquidity constraints, we do not believe we will be able to fund additional research and
development activities in 2005 at this level, and we may not be able to fund additional research
and development activities at all. The only product under active development is the Darvocet line
extension. The following product development table identifies, for each of our major development
programs in 2004, the stage of development at December 31, 2004 of the lead product or products in
each program, research and development spending on each program in 73




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2004, cumulative research and development spending on each program from inception through December
31, 2004, an estimate of the additional research and development expense to complete the
development of the lead product in the program, and the year in which we anticipate completing the
lead product in the program. The estimated additional expense to complete the lead product and the
timing of completion represent our estimates. As we continue to evaluate our liquidity position
and the viability of these development programs, including an evaluation of our interim results and
other information, we may decide to cease research and development activities on some or all of
these products, or to change the scope and direction of a program as well as how we allocate our
research and development spending. In addition, our actual costs in developing these products may
be materially different from our estimates due to uncertainties inherent in product development.
Moreover, even if we are able to fund additional research and development of these products, we may
not be able to successfully develop, commercialize or license the products or technologies included
in the table. Stage of
    
    
    
    
    
    
    Cumulative
    
    
    EstimatedMajor
    
    Development
    
    
    2004
    
    
    Program R&D
    
    
    Additional R&DDevelopment
    
    for Lead
    
    
    Program
    
    
    Spending Through
    
    
    Spending toProgram (and
    
    Products in
    
    
    R&D
    
    
    December 31,
    
    
    Complete LeadLead Products)
    
    Program
    
    
    Spending (1)
    
    
    2004
    
    
    Products (2)(3)(dollars in millions)Products:Pain Management
    
    
    
    
    
    $
    6.6
    
    
    $
    34.2(Darvocet line
extension)
    
    Pre-clinical
    
    
    
    
    
    
    
    
    
    $
    8.5(Lynxorb)
    
    Phase III
    
    
    
    
    
    
    
    
    
    
    4.8Gastrointestinal
    
    
    
    
    
    
    6.9
    
    
    
    23.2(GI-1)
    
    Phase I
    
    
    
    
    
    
    
    
    
    
    10.0Critical Care
    
    
    
    
    
    
    1.0
    
    
    
    6.2(Brethine line
extension)
    
    Approved in 2004
    
    
    
    
    
    
    
    
    
    
    n/aOther
    
    
    n/a
    
    
    
    2.3
    
    
    
    n/a
    
    
    
    n/a$
    16.8
   (1)
    Includes an allocation of $4.6 million of indirect costs, primarily management and
administrative overhead and facilities costs, based on direct research and development costs
in 2004. In addition, this includes an allocation of $0.4 million reported as depreciation in
our consolidated statements of operations.(2)
    The estimated additional research and development spending to complete the lead product
represent our estimates of the amount required to complete the product if we are able to fund
the necessary research and development activities. The only product under active development
is the Darvocet line extension. However, due to liquidity constraints, we do not believe we
will be able to fund additional research and development activities in 2005 at the same level
as 2004, and we may not be able to fund additional research and development activities at all.(3)
    Based on an evaluation from a scientific perspective, we believe we could complete each of
the lead projects in 2006 if we are able to fully fund the required research and development
activities. However, due to liquidity constraints, we do not believe we will be able to fund
additional research 74




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and development activities in 2005 at the same level as 2004, and we may not be able to fund
additional research and development activities at all. The only product under active
development is the Darvocet line extension. Thus, we are unable to estimate actual completion
dates for these products, or whether we will be able to complete these programs at all, due to
our liquidity position. In addition to the specifically identified programs named in the table, we have targeted
additional product development programs or projects. These other programs or projects may require
significant research and development spending in future periods. However, due to liquidity
constraints, we do not believe we will be able to fund additional research and development
activities in 2005 at the same level as 2004, and we may not be able to fund additional research
and development activities at all. There is a risk that any specific research and development program or project may not produce
revenues. We believe that the potential profit margins from successful development programs or
projects will compensate for costs incurred for unsuccessful projects. See Risk Factors and
Forward-Looking Statements. Related Party Transactions For a description of our related party transactions, see Note 10 to our Consolidated Financial
Statements included elsewhere in this report. Inflation We believe that the effects of inflation generally do not have a material adverse effect on our
consolidated results of operations or financial condition. New Accounting Standards In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting
Standards No. 123 (revised 2004), Share-Based Payment, (SFAS No. 123(R)), which amends SFAS No.
123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for
Stock Issued to Employees. SFAS No. 123(R) requires compensation expense to be recognized for all
share-based payments made to employees based on the fair value of the award at the date of grant,
eliminating the intrinsic value alternative allowed by SFAS No. 123. Statement 123(R) requires all

share-based payments to employees, including grants of employee stock options, to be recognized in
the financial statements based on their fair values (i.e., pro forma disclosure is no longer an
alternative to financial statement recognition). SFAS No. 123(R) must be adopted in the first
annual period beginning after June 15, 2005. We currently plan to adopt SFAS No. 123(R) on January 1, 2006. This change in accounting is not
expected to materially impact our financial position. However, because we currently account for
share-based payments to our employees under APB No. 25, our results of operations have not included
the recognition of compensation expense for the issuance of stock option awards. Had we applied
the fair-value criteria established by SFAS No. 123(R) to previous stock option grants, the impact
to our results of operations would have approximated the impact of applying 75




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SFAS No. 123, which was a reduction to net income of approximately $6.0 million in 2004, $9.7
million in 2003 and $6.5 million in 2002. We do not believe that any other recently issued, but not yet effective, accounting standards will
have a material impact on the company Risk Factors and Forward Looking Statements Forward-Looking Statements and Safe Harbor Language This report contains forward-looking statements within the meaning of the safe harbor provisions
of the Private Securities Litigation Reform Act of 1995. Words such as estimate, project,
intend, anticipate, believe and similar expressions are intended to identify forward-looking
statements. The forward-looking statements contained in this report include statements about
future financial and operating results, including the anticipated financial condition, results of
operations, business strategies, operating efficiencies, competitive positions, growth
opportunities for existing products and businesses, and markets for our common stock.
Forward-looking statements also include statements about potential events of default, or
acceleration of the debt, under our senior credit facilities and the notes, proposed financial
restructuring transactions, the need to seek protection under the Bankruptcy Code, potential asset
sales, our internal control over financial reporting, and plans and objectives of our management.
These statements are based on the current expectations and beliefs of our management and are
subject to a number of factors and uncertainties, including the matters noted above, that could
cause actual outcomes to differ materially from those described in the forward-looking statements.
These statements are not guarantees of future outcomes, involve certain risks, uncertainties and
assumptions that are difficult to predict, and are based upon assumptions as to future events that
may not prove accurate. Therefore, actual outcomes may differ materially from what is expressed in
the forward-looking statement. Additional risks and uncertainties pertaining to the following
factors, among others, could cause actual results to differ materially from those described in the
forward-looking statements:  
    our ability to obtain an agreement with our senior lenders and an ad hoc
committee of holders of our notes to a plan to restructure our debt and to effect such
an agreement,
    our ability to comply with, or receive further or continued waivers, consents
or forbearances of our lenders with respect to, financial covenants under our senior
credit agreement or other indebtedness or receive waivers of any defaults under such
agreements,
    our ability to generate sufficient cash from operations, asset sales and other
transactions to fund our cash needs, and our inability to do so has resulted in our
plan to file a voluntary petition for bankruptcy,
    our ability to continue to operate in the ordinary course and to manage our
relationships with our lenders, bondholders, customers, vendors and suppliers and
employees, 76




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
    our ability to attract, retain and complete product development projects and
other customer relationships,
    our ability to obtain critical supplies,
    our ability to effect the sale of some or all of the assets comprising our
Pharmaceuticals Division and other assets, if we choose to do so, on attractive terms
or at all and to obtain necessary consents and waivers from our Lenders and the holders
of the notes to permit such sales and the application of the net proceeds of such sales
for working capital purposes,
    our ability to obtain additional credit facilities in order to fund our
operations while in a chapter 11 proceeding under the U.S. Bankruptcy Code if we were
to commence such a proceeding,
    the impact of material weaknesses in internal control over financial reporting
on our ability to timely prepare accurate financial statements and to avoid material
adverse effects on our financial and operational results,
    our ability to timely remediate identified material weaknesses in internal
control over financial reporting,
    the investigations by the U.S. Attorneys office and the SEC into our financial
reporting and related activity,
    the outcome of pending litigation filed against us,
    the outcome of pending litigations we have filed against others,
    significant changes in our management team and the loss of critical personnel,
    our ability to attract critical personnel,
    demand for our products and services and the products we produce for others,
    the prices that we or our customers can obtain for our products and services,
    the level of competition we face,
    distributors and wholesalers inventory levels and ordering and payment
patterns,
    the amounts and timing of product returns and chargebacks,
    timely success in product development and regulatory approvals for new products
and line extensions, both for our proprietary products and products we develop for our
customers,
    market acceptance of new products and line extensions at levels that justify
our cost of developing or acquiring these products, 77




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
    actions by the United States Food and Drug Administration (FDA) in connection
with submissions related to our products or those of our competitors or customers,
    other governmental regulations and actions affecting our products and services
or those of our competitors,
    third-party payer decisions and actions affecting our products or those of our
competitors or customers,
    our ability to participate in federal health care programs, including the
Medicare and Medicaid programs,
    developments in patent or other proprietary rights owned by us or others, and
    general conditions in the economy and capital markets. Some of these factors and additional factors that may cause our actual results to differ materially
are discussed below. Whenever you read or hear any subsequent written or oral forward-looking
statements attributable to us or any person acting on our behalf, you should keep in mind the
cautionary statements contained or referred to in this report. We do not undertake, and expressly disclaim, any obligation to update or alter our forward-looking
statements, whether as a result of new information, future events or otherwise. Risk Factors The risks and uncertainties described below are intended to highlight risks and uncertainties that
are specific to us but are not the only risks and uncertainties that we face. Additional risks and
uncertainties, including those generally affecting the industry in which we operate and risks and
uncertainties that we currently deem immaterial, also may impair our business and the value of any
investment in us. Risks Relating to a Potential Bankruptcy Proceeding and Our Financial Condition It is highly likely
that we will seek relief under chapter 11 of the U.S. Bankruptcy Code which would
substantially dilute and may eliminate the interests of the holders of our common stock. In light of our current financial condition, we believe that our operations can no longer support
our existing debt and that we must restructure our debt to levels that are more in line with our
operations. Moreover, we do not have a source of liquidity to fund near term operations and
believe that we will be able to secure necessary liquidity sources only in the context of a Chapter
11 bankruptcy proceeding. Accordingly, it is highly likely that we
will seek relief under chapter 11 of the
Bankruptcy Code which would substantially dilute and may eliminate the interests of the holders of
our common stock. We reported a consolidated net loss of $191.2 million and $32.7 million for the years ended
December 31, 2004 and 2003, respectively. As a result of our substantial and recurring operating 78




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losses, we do not have adequate sources of liquidity to fund our operations in the near term.
Events of default have occurred under our senior credit facilities that would permit the lenders to
accelerate the debt thereunder absent a forbearance or waiver. While we have obtained a temporary
forbearance with respect to such events of default, such forbearance will expire no later than
April 30, 2005 absent a further consent from our senior lenders. In addition, we did not pay the
$10.5 million interest payment due on April 1, 2005 under our senior subordinated notes. The
failure to pay such interest payment within 30 days after April 1 would constitute an event of
default under such notes, permitting acceleration thereunder. We received an $11.3 million tax refund in March 2005 and a waiver agreement from our senior
lenders that permitted immediate use of approximately $5.7 million of such tax proceeds for
liquidity purposes and required the remaining $5.6 million to pay down revolving loans under our
senior credit facilities. While this $5.6 million can be reborrowed to meet budget working capital
expenses under the terms of this waiver agreement, no additional loans are available under our
senior credit facilities absent consent from our senior lenders. We have reborrowed the entire
$5.6 million. We have been exploring a potential sale of some or all of the assets of our Pharmaceuticals
Division, as well as other operating assets, for liquidity purposes. We executed an exclusivity
agreement with a potential purchaser of certain of the assets of our Pharmaceuticals Division.
This written agreement expired on April 22, 2005, though we are
continuing to negotiate with this potential purchaser on an exclusive
basis. We have not reached a definitive agreement with this
potential purchaser and cannot provide any assurance that any material asset sale will be agreed
upon or completed. If we are able to reach a definitive agreement with this potential purchaser,
it is highly likely that the sale would be completed as part of a bankruptcy proceeding because the
potential purchaser is seeking to require that any such sale be completed as part of a bankruptcy
proceeding. In addition, even if such sale were not part of a bankruptcy proceeding, substantially
all of the proceeds of any material asset sale are required under our debt documents to be used to
pay down senior debt and we would need consents of our senior lenders and noteholders to waive this
requirement. We would also require the consent of our senior lenders, and may require the consent
of our stockholders and noteholders, to approve the consummation of any asset sale not completed as
part of a bankruptcy proceeding. In the event of a bankruptcy proceeding, we may be unable to secure debtor-in-possession financing
necessary to fund our continued operation. We have engaged in
discussions and negotiations with prospective lenders to obtain
financing sufficient to refinance indebtedness outstanding under our senior credit facilities
and/or to provide additional credit facilities in order to fund our operations while in a chapter
11 proceeding under the Bankruptcy Code (DIP Financing) if we were to commence such a proceeding.
If we are able to obtain DIP Financing, any
DIP Financing will be subject to approval by the bankruptcy court
in any bankruptcy proceeding and we may be unable to obtain that approval. If we are unable to
secure adequate debtor-in-possession financing in a bankruptcy proceeding, we will be unable to
fund the continued operations of our company. We believe the failure to continue to operate our
company as a going concern would substantially reduce the value of our enterprise. 79




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If we seek relief under chapter 11 of the Bankruptcy Code we may be unable to develop a plan of
reorganization acceptable to our creditors and may be required to liquidate our assets and cease to
operate as a going concern. If we seek relief under chapter 11 of the Bankruptcy Code, we do not
anticipate that at the time we file for relief we will have a plan of reorganization or any
understanding with our creditors with respect to a plan of reorganization. Our future results are
dependent upon our developing, confirming and implementing, on a timely basis, a plan of
reorganization. Moreover, we may be unable to develop, confirm and implement a plan of
reorganization in bankruptcy proceedings. If we cannot develop, confirm and implement a plan of
reorganization, we may be required to liquidate our assets and cease to operate as a going concern. In a bankruptcy proceeding, we may be unable to operate under the terms of the DIP Financing which
may preclude our access to a source of liquidity necessary to fund the continued operation of our
business. If we seek relief under chapter 11 of the Bankruptcy Code and secure DIP Financing, we may be
unable to operate under the terms of the DIP Financing or may otherwise violate the terms of the
DIP Financing. Based on our preliminary discussions with lenders, the definitive agreements
establishing any DIP Financing that we are able to obtain may require us to complete a sale of the
assets of the Pharmaceutical Division on terms and conditions reasonably satisfactory to the
lenders under the DIP Financing by a certain date, with the further requirement that milestones in
the sale process be completed by specified dates. If we are unable to complete a sale of the
Pharmaceutical Division on acceptable terms on a timely basis, we may be in default of any DIP
Financing that we are able to obtain and, as a result, we may not have access to a source of
liquidity necessary to continue to operate our business and may be required to cease operations and
liquidate our assets. Our substantial indebtedness severely limits cash flow available for our operations and impairs our
ability to service debt or obtain additional financing if necessary. We are highly leveraged. We currently have $165.0 million in senior term loans outstanding. We
cannot borrow additional amounts under the senior term loans. We also have a senior revolving
credit facility in the amount of $15.0 million, of which loans aggregating $10.8 million are
outstanding as of April 25, 2005. We may not borrow additional funds under this revolving credit
facility without the consent of our senior lenders. In addition, we have $175.0 million of our
senior subordinated notes outstanding. We have granted the lenders under our senior credit
facilities a lien on substantially all of our current and future property, including our
intellectual property, and we have granted a second-priority lien on these assets to secure our
senior subordinated notes and the guarantees of the notes by certain of our subsidiaries. The
terms of our senior secured credit facilities and the indenture governing our senior subordinated
notes severely restrict our ability to obtain funds by incurring further indebtedness. Among other things, the substantial amount of payments on our outstanding debt and other payment
obligations: 80




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
    limits our ability to obtain additional financing,
    limits our flexibility in planning for, or reacting to, changes in our business
and the industry,
    places us at a competitive disadvantage relative to our competitors with less
debt,
    renders us more vulnerable to general adverse economic and industry conditions,
and
    requires us to dedicate a substantial portion of our cash flow to service our
debt. Our ability to make future payments on, and, if necessary, to refinance our debt, will depend on
our ability to restructure our debt and generate cash in the future, which may be influenced by
general economic, business, financial, competitive, legislative, regulatory and other factors
beyond our control. We cannot assure you that we will be able to restructure our debt or that our
business will generate sufficient cash flow from operations or that future borrowings will be
available in an amount sufficient to enable us to make scheduled interest payments on our debt or
repay our debt on or before maturity. As noted above, our failure to pay the $10.5 million of
scheduled interest due on April 1, 2005 on our notes could result in an acceleration of our notes. Our near-term liquidity and cash flow may be significantly affected by pharmaceutical product
chargebacks and returns. Each of our pharmaceutical products may be returned to us near the expiration date of the product.
We also have established contract prices for certain indirect customers that are supplied by our
wholesale customers. A chargeback represents the difference between the cash payments we have
received from our wholesale customers, which is the current published wholesale acquisition cost,
and the indirect customers contract prices. At December 31, 2004, we had $24.6 million in
allowances for customer credits, which primarily consist of reserves we established to cover
estimated future chargebacks and estimated future product returns. These reserves are necessary
because we must either issue a credit on future sales or make a cash payment when a chargeback is
issued or when wholesalers exercise their rights of return for our pharmaceutical products as the
products near expiration. In addition, a specialty wholesaler had $11.1 million of our Brethine
injectable product in inventory as of December 31, 2004. We are accounting for the shipment of
this product under the consignment method. We expect that this specialty wholesaler will return a
significant portion of this product to us, and this wholesaler is currently setting off payments
owed to us for other purchases of our pharmaceutical products against this return exposure. If our
customers exercise their rights of return for products we have previously sold or request us to
issue a chargeback for products that are sold to our indirect customers, the issuance of either a
credit on future sales or cash payment resulting from such returns and chargebacks could have a
material effect on our liquidity in 2005. In March 2005, we received a return request for
approximately $2.8 million of our Darvon and Darvocet products. 81




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Pharmaceutical product customers concerns with respect to our liquidity and potential bankruptcy
filing may continue to have an adverse effect on our near-term liquidity and cash flow. Concern by wholesalers with respect to our liquidity, potential bankruptcy filing and ability to
make payments with respect to product returns or chargebacks may continue to have an adverse effect
on our near-term liquidity and cash flow. Our wholesalers are under no contractual obligation to
purchase our pharmaceutical products. We have seen a recent downturn in purchases of our
pharmaceutical products that we believe to be the result of wholesalers limiting their exposure to
us due to our liquidity position and potential bankruptcy filing. In addition, a significant
wholesale customer has indicated to us that it will not pay for current purchases of pharmaceutical
products until its exposure for potential product return and chargeback payments is reduced below a
specified level. Accordingly, current sales to this significant wholesaler have not resulted in
corresponding cash payments to us. Finally, to the extent that wholesaler channel inventories of
our products exceed appropriate levels, our sales of those products in subsequent periods, and thus
our cash flow, may be adversely affected. Customers concerns with respect to our liquidity and potential bankruptcy filing and pending
governmental investigations and litigation could make it difficult for us to obtain and retain
fee-for-service projects. Some customers and potential customers of our AAI Development Services Division have expressed
concern with respect to issues regarding our liquidity and potential bankruptcy filing and pending
governmental investigations and litigation in deciding whether to place, or continue, product
development projects with us. Customer concerns regarding our uncertain financial condition have
adversely affected our ability to obtain new engagements in our AAI Development Services Division,
particularly long-term product development engagements. In the event of any filing under chapter
11 of the Bankruptcy Code, customer concerns about our ability to continue to perform product
development projects may be significantly heightened. If we are unsuccessful in overcoming these
customer concerns, we may fail to obtain new product development projects or retain existing
product development projects, which would have a material adverse effect on our results of
operations, financial condition and cash flow. We are incurring significant professional fees, including in connection with governmental
investigations and pending litigation, that are depleting our cash resources. We have incurred, and in the near term likely will continue to incur, significant professional fees
in connection with the pending governmental investigations and litigation described in Part I, Item
3, Legal Proceedings of this Annual Report on Form 10-K and in connection with a bankruptcy
proceeding assuming we seek relief under chapter 11 of the bankruptcy Code. We are paying
significant professional fees to FTI Palladium Partners for help in addressing our financial and
liquidity concerns and other administrative services. We have also agreed to pay the fees and
expenses of the legal counsel to the ad hoc committee of holders of our senior subordinated notes
and the committees financial advisor and in connection with our discussions with that committee.
We will also incur fees payable to our financial advisor in connection with potential asset sales.
Further, we have incurred, and may continue to incur, significant professional fees in connection
with our debt restructuring process and in connection with 82




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evaluating and improving our internal controls over financial reporting, including in connection
with our efforts to document our internal controls as required by Section 404 of the Sarbanes-Oxley
Act of 2002. Professional fees on a number of the matters described in this report, including
securities, stockholder derivative and ERISA litigation and governmental investigations, may extend
for several years. These professional fees have substantially increased, and in the near term may
continue to substantially increase, our cash needs to an extent that cash from our operations may
be insufficient to fund all of our cash needs. Risks Relating to Pending Governmental Investigations and Lawsuits An adverse judgment in litigation in which we and certain current and former executive officers,
employees and directors are defendants could have a material adverse effect on our results of
operations and liquidity. We, certain of our current and former officers and directors, and our independent registered public
accountants have been named as defendants in purported stockholder class action lawsuits alleging
violations of federal securities laws. The securities lawsuits were filed beginning in February
2004 and are pending in the U.S. District Court for the Eastern District of North Carolina. By
order dated April 16, 2004, the district court consolidated the securities lawsuits into one
consolidated action, and on February 11, 2005 the plaintiffs filed a consolidated amended
complaint. The amended securities complaint asserts claims arising under Sections 10(b) and 20(a)
of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder on behalf of a class of purchasers
of our common stock during the period from April 24, 2002 through and including June 15, 2004. The
securities complaints allege generally that the defendants knowingly or recklessly made false or
misleading statements during the Class Period concerning our financial condition and that our
financial statements did not present our true financial condition and were not prepared in
accordance with generally accepted accounting principles. The amended securities complaint seeks
certification as a class action, unspecified compensatory damages, attorneys fees and costs, and
other relief. A stockholder derivative suit was filed in the United States District Court for the Eastern
District of North Carolina on August 26, 2004 by two putative shareholders against current and
former members of our Board of Directors and senior management. Our company is named as a nominal
defendant. The complaint alleges that the individual director and officer defendants breached
fiduciary and contractual obligations to our company by implementing an inadequate system of
internal controls, and causing our company to issue false and misleading statements exposing our
company to securities fraud liability, and that certain defendants engaged in insider trading. The
complaint seeks unspecified compensatory damages, attorneys fees and costs, and other relief. In addition, we, certain of our current and former directors, officers and employees and others
have been named in a purported class action brought by an aaiPharma pension plan participant and
beneficiary asserting claims under ERISA on behalf of a class of all persons who are or were
participants or beneficiaries of the aaiPharma Inc. Retirement and Savings Plan during the period
from April 24, 2002 to June 15, 2004. An amended complaint was filed on March 14, 2005 which
alleges generally that the defendants breached fiduciary duties owed under ERISA with respect to
the prudence and lack of diversification of investment of Plan assets in our common 83




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stock, by misleading participants and beneficiaries of the Plan regarding our earnings, prospects,
and business condition, by failing to act in the sole interest of Plan participants, and by failing
to monitor the actions of other Plan fiduciaries. The complaint seeks certification as a class
action, unspecified compensatory damages, attorneys fees and costs, and other equitable relief.
This ERISA lawsuit is pending in U.S. District Court for the Eastern District of North Carolina.
The proceedings in this matter will be coordinated with the securities lawsuits described above. These lawsuits are at an early stage. Our response to the amended securities complaint is not due
until May 26, 2005, and our response to the amended ERISA complaint is not due until June 30, 2005
at the earliest. By agreement, no response to the derivative suit is due until 60 days after the
plaintiffs file their amended complaint, and no discovery has yet occurred in either the securities
or derivative litigation. Only limited discovery has occurred in the ERISA litigation. In addition to the foregoing matters, we are also a party to several other lawsuits. We are
involved in two lawsuits centered on our omeprazole-related patents, including one lawsuit brought
by us against an alleged infringer of our patents and another lawsuit which was brought by a third
party against us and is currently essentially inactive. Omeprazole is the active ingredient found
in Prilosec, a drug sold by AstraZeneca PLC. In August 2004, CIMA Labs, Inc. initiated a lawsuit
against us in Minnesota state court seeking to recover the $11.5 million break-up fee paid to us
pursuant to the merger agreement that we had entered into with CIMA on August 5, 2003, as well as
$5 million in other costs. In addition, we are a party to a lawsuit pending in federal court in
Georgia against Athlon Pharmaceuticals, Inc. regarding an agreement pursuant to which Athlon was to
provide a contract sales force. Athlon is seeking to recover damages in connection with the
termination of this agreement. Athlon has also filed a separate action against us in the same
court alleging a breach of the purchase agreement pursuant to which we purchased Darvocet A500 from
Athlon. Although we intend to vigorously pursue all of our claims and defenses available in these lawsuits,
an adverse determination in these lawsuits or an inability to obtain payment under our directors
and officers liability insurance (D&O insurance) policies for litigation and indemnification
costs in the securities matters and derivative action and any damages ultimately borne by us as a
result of these lawsuits could have a material adverse effect on our business, financial condition,
results of operations or cash flows. See Note 13 of Notes to Consolidated Financial Statements
included in Part II, Item 8 Financial Statements and Supplementary Data. An adverse outcome with respect to investigations of aaiPharma that are being conducted by the SEC
and the U.S. Attorneys Office could have a material adverse effect on our results of operations
and liquidity. In April 2004, in connection with an investigation conducted by the U.S. Attorneys Office for the
Western District of North Carolina (the U.S. Attorneys Office), we received federal grand jury
subpoenas for document production and potential testimony related to, among other things, certain
transactions regarding our 2002 and 2003 financial information, the terms, conditions of employment
and compensation arrangements of certain of our senior management personnel, compensation and
incentive arrangements for employees responsible for the sale of our Brethine, Darvocet,
calcitriol, azathioprine and Darvon Compound products, quantities of the foregoing products in
distribution channels, financial benefits with respect to specified corporate 84




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transactions to our senior management and others, certain loans obtained by us, extensions of
credit, if any, by us to officers or directors, accounting for sales and returns of our foregoing
products, our analysts conference calls on financial results, internal and external investigations
of pharmaceutical product sales activities, and related matters. The SEC has also commenced an
investigation and we have received a subpoena from the SEC covering similar matters. We have agreed to cooperate fully with the government investigations and share with the SEC and the
U.S. Attorneys Office all results of the Special Committees investigation of unusual sales of
certain of our products and other matters. The U.S. Attorneys Office, SEC and other government
agencies that are investigating or might commence an investigation of aaiPharma could impose, based
on a claim of fraud, material misstatements, violation of false claims law or otherwise, civil
and/or criminal sanctions, including fines, penalties, and/or administrative remedies. If any
government sanctions are imposed, which we cannot predict or reasonably estimate at this time, our
business, and financial condition, results of operations or cash flows could be materially
adversely affected. These matters have resulted, and are expected to continue to result, in a
significant diversion of managements attention and resources and in significant professional fees. In addition, there may be additional governmental investigations pending of which we are not yet
aware. We have certain obligations to indemnify our officers and directors and to advance expenses to such
officers and directors , and we may not have sufficient insurance coverage available for this
purpose. We may be forced to pay these indemnification costs directly, and we may not be able to
maintain existing levels of coverage, which could make it difficult to attract or retain qualified
directors and officers. Our bylaws require that we indemnify our directors and officers under specified circumstances. We
have also agreed to advance expenses to certain of our directors and current and former officers in
connection with investigations by the SEC and the U.S. Attorneys office. Although we have
purchased D&O liability insurance for our directors and officers to fund a portion of these
obligations, if our insurance carriers should deny coverage, or if the indemnification costs exceed
the insurance coverage, we may be forced to bear some or all of these indemnification costs
directly, which could be substantial and may have an adverse effect on our business, financial
condition, results of operations and cash flows. Our insurance carrier has initially denied
coverage with respect to claims made in connection with the pending ERISA litigation, though we
have made a new demand for coverage under this policy based on the claims contained in the amended
complaint. If the cost of this insurance increases significantly, or if this insurance becomes
unavailable, we may not be able to maintain or increase our levels of insurance coverage for our
directors and officers, which could make it difficult to attract or retain qualified directors and
officers. 85




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Concerns with respect to our liquidity, and the circumstances surrounding our pending litigation
and governmental investigations and recent management changes and reductions in force could make it
difficult for us to retain and hire critical personnel. Concerns with respect to our liquidity and the investigations by the SEC and/or the U.S. Attorneys
Office and pending securities and ERISA class actions and other litigation, and recent changes to
our management team and reductions in force, have created substantial uncertainty regarding our
ability to focus on our business operations and remain competitive with other companies in our
industry. Because of this uncertainty, we may have difficulty retaining critical personnel or
replacing personnel who leave aaiPharma. In addition, due to the recent substantial declines in
the price of our common stock, the exercise price of outstanding employee stock options
substantially exceeds the trading price of our common stock. We also have made matching
contributions to our 401(k) plan that were invested in our common stock. The loss in value of
these stock options and 401(k) investments may affect our ability to retain our critical employees,
which could seriously harm our ability to generate revenue, manage day-to-day operations, and
deliver our products and services. A substantial number of employees have voluntarily left
aaiPharma in 2004 and we may continue to lose critical personnel. Risks Related to Our Business Our internal control over financial reporting has been inadequate and may continue to be inadequate
and could adversely affect our financial condition and ability to carry out our business plan. In connection with the preparation of our 2003 Form 10-K, our then Chief Executive Officer and then
interim Chief Financial Officer concluded that, as of December 31, 2003, our disclosure controls
and procedures were not adequate. In addition, management has recently completed the process of
assessing the effectiveness of our internal control over financial reporting, as required by
Section 404 of the Sarbanes-Oxley Act. Based on their assessment, our Chief Executive Officer and
Chief Financial Officer have concluded that our internal control over financial reporting was not
effective as of December 31, 2004 due to the existence of numerous material weaknesses. A detailed
description of these material weaknesses is included in Part I, Item 8  Management Report on
Internal Control Over Financial Reporting. In order to remediate the numerous material weaknesses in our internal control over financial
reporting, we have devoted, and will be required to continue to devote, significant financial
resources and management attention to our remediation efforts. Due to our liquidity constraints,
we may not be able to devote sufficient financial resources to successfully remediate the material
weaknesses in our internal controls that we have identified. In addition, our management is
currently focused on dealing with our liquidity issues while continuing to operate our business,
and thus may not be able to devote sufficient time and attention to our remediation efforts. If we are not successful in addressing these material weaknesses, we may be unable to produce
accurate and reliable financial reports on a timely basis or at all. In addition, if we do not
have effective internal control over financial reporting, we may be exposed to an increased
likelihood of financial fraud. If we cannot provide accurate and reliable financial reports and do
not have internal controls that provide reasonable assurance that financial fraud will be
prevented, 86




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investors, lenders, customers or suppliers could lose confidence in our reported financial
information and our liquidity, access to capital markets, business and operating results could be
harmed. We may have overpaid for our branded product lines, which may not produce sufficient cash flow to
repay indebtedness incurred in connection with the acquisition or to provide an acceptable rate of
return on our investment. Beginning in 2001, we increased our net revenues through a series of acquisitions of branded
products. The acquisition prices that we paid were based upon many factors, including our analysis
of sales history, forecasted sales, competition, and our judgment with respect to marketing
potential, brand strength and product improvement opportunities. The revenues we derive from any
of these product lines may be lower than amounts we expected when we acquired these product lines.
We funded our significant product acquisitions, including Brethine, Darvon, Darvocet, Oramorph SR,
Roxanol, and Roxicodone, with borrowings under predecessor senior credit facilities, and the net
proceeds from our sale of the Notes. We may have overpaid for our branded product lines, and they
may not produce sufficient cash flow to repay indebtedness incurred in connection with the
acquisition or to provide an acceptable rate of return on our investment. Our branded products are subject to generic competition and increased generic substitution for our
branded products may result in a decrease in our revenues and materially affect our liquidity. Our branded products are subject to generic competition. In early 2004, the Food and Drug
Administration approved generic versions of our Roxicodone and Brethine injectable products. There
is no proprietary protection for most of the branded pharmaceutical products that we sell, and as a
result our branded pharmaceutical products are or may become subject to competition from generic
substitutes. In May 2004, a generic version of injectable Brethine was introduced, which has
significantly adversely affected our sales of that product (both as a result of a reduction in
volume and pricing) and is expected to continue to do so and may result in the return of product
sold in prior periods as the products shelf life nears expiration. In the second half of 2004, we
recorded charges of $6.4 million due to the impairment of an intangible asset associated with our
Brethine product because the introduction of generic competition adversely affected our future
anticipated revenues, which negatively impacted the carrying value of such intangible asset. In
addition, given levels of inventory of this product in the distribution channel, our cash flows
from sales of this product may be negatively affected and we may experience significant returns of
this product which could materially adversely affect our liquidity. Generic substitutes for our
branded products, which may be identical to our branded products, are sold by competitors at
significantly lower prices. If consumers and physicians do not believe that our branded products
have greater benefits than their generic equivalents, they may elect generic equivalents or other
substitute products in lieu of our branded products, which may result in decreased revenues for our
branded products. Any further increase in the amount of generic and other competition against any
one or more of our products could further lower prices and unit sales. In addition, pressures to
reduce pharmaceutical costs, including from third-party payers such as health maintenance
organizations, or HMOs, and health insurers, may result in physicians or pharmacies increasingly
using generic substitutes. State and federal legislation, 87




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and decisions by state and federal government agencies with the power to determine or influence
purchasing decisions on products sold to government agencies or through government-funded programs,
may be enacted or made that would adversely affect purchases of branded pharmaceutical products.
Such legislation or government agency decisions may more broadly mandate substitution of generic
products for prescriptions written for branded products, establish preferred or exclusionary
product lists that favor generic products, or otherwise establish or influence product purchases.
Competition from generic products or additional legislation or regulatory developments favoring
generic products, creating preferred or exclusionary product lists, or establishing or influencing
purchasing decisions, could cause our sales of branded products to decrease and could have a
material adverse effect on our business, financial condition, and results of operations. A small number of customers account for a large portion of our sales and the loss of one of them,
or changes in their purchasing or payment patterns or inventories, could result in reduced sales or
adversely impact our financial performance. We are heavily dependent on sales of our products to three large national wholesalers, McKesson
Corporation, Cardinal Health Inc., and AmerisourceBergen Corporation, which then resell our
products out of their inventories to pharmacies and other indirect customers for use in meeting
ultimate prescription demand. Our results of operations, including, in particular, product sales
revenue, may vary from quarter to quarter due to buying and payment patterns and inventories of our
wholesalers. A significant wholesale customer has indicated to us that it will not pay for current
purchases until its exposure for potential product return and chargeback payments is reduced below
a specified level. Accordingly, current sales to this significant wholesaler have not resulted in
corresponding cash payments to us. In the event wholesalers with whom we do business determine to
limit their purchases of our inventory or withhold payments from us, sales of our products or our
cash flows could be materially adversely affected. In addition, we believe that excess sales of
our Brethine injectable and Darvocet N-100 products during the second half of 2003 significantly
reduced our sales of these products in 2004. The small number of wholesale drug distributors,
consolidation in this industry, changes in the business model of such wholesale drug distributors
or financial difficulties of these distributors could result in the combination or elimination of
warehouses, which could temporarily increase returns of our products or, as a result of
distributors reducing inventory levels, delay the purchase of our products. We do not anticipate receiving further material payments in connection with our significant
development agreement in the future, and we may be unable to replace this revenue stream. We have a significant development agreement under which we received product development revenues of
$17.7 million in 2004, $13.0 million in 2003 and $16.9 million in 2002 and development services
revenues of $0.7 million in 2004, $2.7 million in 2003 and $4.7 million in 2002. During this time
period, we recorded research and development expenses of zero in 2004, $1.0 million in 2003 and
$0.7 million in 2002 related to this agreement. In April 2004, we entered into an agreement to
receive a prepayment of amounts that would otherwise be paid to us quarterly through the second
quarter of 2005 under this significant development agreement. These payments would have aggregated
$15.4 million, and in April 2004 we received approximately $15.0 million in gross proceeds from the
prepayment. We do not anticipate that 88




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we will receive any further payments in connection with this significant development agreement in
the future. If we are unable to replace this revenue stream, our results of operations and cash
flows may be materially adversely affected. We are dependent on third parties for the manufacture of our products and for critical raw
materials and services. We are dependent on third parties for certain essential business functions, and problems with these
third-party arrangements could materially adversely affect our ability to manufacture and sell
products and our business, financial condition, and results of operations. We are dependent on third parties for the manufacture of certain of our pharmaceutical products.
Our manufacturing dependence upon third parties may adversely affect our profit margins and our
ability to deliver our products on a timely and competitive basis. We have entered into supply
agreements with our third-party manufacturers that obligate them to supply us with products.
However, if we are unable to timely pay for such products, our third party manufacturers may be
able to terminate their obligations to supply our needs. If we are unable to retain or replace
third-party manufacturers on commercially acceptable terms and on a timely basis, we may not be
able to distribute our products as planned. If we encounter delays or difficulties with contract
manufacturers in producing or packaging our products, the distribution, marketing and subsequent
sales of these products will be adversely affected, and we may have to seek alternative sources of
supply, lose sales or abandon or divest a product line on unsatisfactory terms. We may be unable
to enter into alternative supply arrangements at commercially acceptable rates on a timely basis,
if at all. The manufacturers that we use may not be able to provide us with sufficient quantities
of our products, and the products supplied to us may not meet our specifications. Moreover,
failure of our contract manufacturers to follow good manufacturing practices as mandated by the
FDA, could suspend or halt manufacturing at these sites. Additionally, modifications,
enhancements, or changes in manufacturing sites of approved products are subject to FDA approval
that we may not be able to obtain and that may be subject to a lengthy application process. After expiration of our existing third-party supply contracts, our manufacturing costs for those
products supplied under these contracts could be higher and any transfer of manufacturing of these
products, including any transfer to our own or new third-party manufacturing facilities, may cause
us to incur significant manufacturing start-up costs. Our third-party supply contracts are
scheduled to expire beginning over the next few years, and we may be unable to renew agreements
with our current suppliers because in a number of cases our suppliers are companies from whom we
acquired our branded products and the supply agreements were entered into in connection with the
purchase of the branded product line. Additionally, any change of the manufacturing site of any of
these products would require FDA approval of the new manufacturing facility. FDA approval,
however, is not within our control, and we may not receive the necessary approval within our
anticipated time schedule, if at all. We are also dependent on third parties for the supply of critical raw materials and packaging
supplies. Sales of our products will be dependent on our ability to obtain FDA-approved supplies
of raw materials, including active and inactive pharmaceutical ingredients, and packaging
materials, at commercially acceptable prices and terms, in time to satisfy critical 89




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product development, testing, analytical and manufacturing activities, customer contracts, or our
development plans. The FDA must approve the supply source of many ingredients for our products.
The qualification of a new supply source could delay the manufacture of the drug involved.
Arrangements with our foreign suppliers are subject to certain additional risks, including the
availability of governmental clearances, export duties, political instability, currency
fluctuations, and restrictions on the transfer of funds. Any constraints on the supply of raw
materials could materially and adversely affect our business, financial condition, and results of
operations. We use, and are dependent on, a contract distribution program for warehousing of our branded
products. We have contracted with a national pharmaceutical product distribution company to
provide warehousing, product distribution, inventory tracking, customer service and financial
administrative assistance related to our product distribution program. We have extended our time
of payments of our obligations under this agreement and continue to negotiate with the distributor
with respect to payment plans related thereto. The distribution company may terminate this
agreement for any reason with 180 days written notice and upon an uncured default thereunder. We
are dependent on the capabilities of this third party to distribute our products effectively. We
do not have extensive experience performing these functions ourselves and may suffer significant
disruption if in the future we have to perform these functions or find alternative providers. Our new products and line extensions, including Darvocet A500, may not produce revenues sufficient
to justify the cost of acquiring or developing these products or our related direct costs and
selling expenses. Our business plan for our Darvocet line extensions, including Darvocet A500, was based on the
belief that these products would not be subject to immediate competition from generic products,
although they would be subject to potential generic competition. In some jurisdictions, however,
pharmacists may fill prescriptions written for Darvocet A500 and similar Darvocet line extension
products with generic products that, though not recognized by the FDA as therapeutically equivalent
to the Darvocet products, may be deemed by the pharmacist to be therapeutically equivalent to those
products. It is our understanding that a pharmacists profit margin on these generic products
generally exceeds the pharmacists profit margin on our branded Darvocet line extension products.
These factors may result in lower revenues from these Darvocet line extensions than we had
internally estimated. We have written off the full amount of the Darvocet A500 assets we acquired
in July 2003 because we do not anticipate additional material income from this product. Our new
products and line extensions may not produce revenues sufficient to justify our cost of acquiring
or developing these products or our direct costs and selling expenses. If we cannot sell our Darvocet A500 and other products in amounts greater than our minimum purchase
requirements under our supply agreement, our results of operations and cash flows may be adversely
affected. Our original supply agreement for Darvocet A500 requires us to purchase certain minimum levels of
this product over the initial three-year period of this agreement, subject to specified terms and
conditions. If sales of our Darvocet A500 product do not significantly increase from 90




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current rates, we will likely incur losses in connection with the purchase commitments under the
supply agreement. We have booked an $11.7 million charge with respect to this purchase commitment
in 2004, however, we will have to make a cash payment to this supplier in 2006 if we do not meet
this minimum purchase commitment. In the event we incur losses in connection with the purchase
commitments under the supply agreements, there may be a material adverse effect upon our cash
flows. Because we have a limited number of product lines, a material adverse change in any one of our
product lines could materially adversely affect our results of operations and cash flows. Our success is largely dependent upon a limited number of key product lines, which means that any
unfavorable developments with respect to any one product line could materially adversely affect us.
Sales of our branded product lines, particularly Darvon and Darvocet, represent a significant
portion of our total revenues. The divestiture of our M.V.I. business reduced the number of key
product lines that we sell. Accordingly, any factor adversely affecting sales of any of these
products, such as the introduction in 2004 of generic competitors of our injectable Brethine and
Roxicodone products, could have a material adverse effect on our business, financial condition, and
results of operations. In addition, any perceived problems with these products, such as any
problem with their safety or efficacy, could have a similar material adverse effect. We may incur substantial expense to develop products that we never successfully commercialize. We incur substantial research and development expenses, and other expenses, attempting to develop
new or improved products or product line extensions. The products or line extensions to which we
devote operational and financial resources could be commercial failures. Successful
commercialization of products and product line extensions requires accurate anticipation of market
and customer acceptance of particular products, customers needs, the sale of competitive products,
and emerging technological trends, among other things. Additionally, for successful product
development, we must complete many complex formulation and analytical testing requirements and
timely obtain regulatory approvals from the FDA and other regulatory agencies. When developed, new
or reformulated drugs may not exhibit desired characteristics or may not be accepted by the
marketplace. Complications can also arise during production scale-up. Our products and line
extensions may encounter unexpected, irresolvable patent conflicts, or may not have enforceable
intellectual property rights. Delays or problems also may arise from internal conflicts for
resource availability, personnel errors or equipment failures. In addition, development of
products and product line extensions may be delayed due to budget constraints and liquidity
concerns. If we incur significant expenses for a product or line extension that we do not
successfully develop and commercialize, there could be a material adverse effect on our business,
financial condition and results of operations. Delays in development of pipeline pharmaceutical products due to liquidity concerns may result in
reduced benefits if we later successfully complete development. Due to liquidity constraints, we do not believe we will be able to fund additional research and
development activities in 2005 at historical levels, and we may not be able to fund additional 91




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research and development activities at all. As of the date of this Annual Report, the only product
under active development is the Darvocet line extension. Our inability to fund research and
development at this time will delay the development of our pipeline products if we subsequently
actively pursue development of these products. Delays in development may jeopardize the likelihood
that the products we may subsequently develop would be commercially successful. For example, the
commercial success of products we are developing as generic pharmaceutical products depends upon
our products being the first or second such generic product approved by the FDA. Any delay in
development may result in competitors generic products being approved before we complete
development of our product. We may terminate a development project due to delays if we believe
that the likelihood of obtaining an advantageous competitive position for our product candidate no
longer justifies continued development expense, in which case we may not have the ability to recoup
any of our research and development expense on that project. There is a risk that we may incur additional charges for intangible asset impairment. When we acquire the rights to manufacture and sell a product, we record the aggregate purchase
price, along with the value of the product related liabilities we assume, as intangible assets. We
use the assistance of valuation consultants to help us allocate the purchase price to the fair
value of the various intangible assets we have acquired. Then, we must determine if each asset has
an indefinite life or a definite life and estimate the economic useful life of each of the
definite-lived intangible assets in order to amortize their cost as an expense in our statement of
operations over the estimated economic useful life of the related asset. The factors that drive
the actual economic useful life of a pharmaceutical product are inherently uncertain, and include
physician loyalty and prescribing patterns, competition by products prescribed for similar
indications, future introductions of competing products not yet FDA approved, the impact of
promotional efforts and many other issues. We use all of these factors in initially estimating the
economic useful lives of our products, and we also routinely monitor these factors for indications
of appropriate revisions. In assessing the recoverability of our intangible assets, we must make assumptions regarding
estimated undiscounted future cash flows and other factors. If the estimated undiscounted future
cash flows do not exceed the carrying value of the intangible assets, we must determine the fair
value of the intangible assets. If the fair value of the intangible assets is less than their
carrying value, an impairment loss will be recognized in an amount equal to the difference. If
these estimates or their related assumptions change in the future, we may be required to record
impairment charges for our intangible assets. In addition, material adjustments to our forecasted
revenues from the sales of any of our acquired product lines, including Darvocet, may require us to
employ different assumptions with respect to our estimated cash flows. We review intangible assets
for impairment at least annually and whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. If we determine that an intangible asset is
impaired, a non-cash impairment charge is recognized. In 2004, we recorded impairment charges of
$87.1 million due to the impairment of intangible assets associated with our Darvon/Darvocet
products and $6.4 million due to the impairment of intangible assets associated with our Brethine
products. Because circumstances after an acquisition can change, we may not realize the value of intangible
assets. If we were to determine that impairment of our intangible assets has occurred, 92




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we would be required to write-off the impaired portion of the unamortized intangible assets, which
could have a material adverse effect on our results of operations in the period in which the
write-off occurs. In addition, in the event of a sale of any of our assets, we cannot be certain
that our recorded value of such intangible assets would be recovered. We may be unable to secure or enforce adequate intellectual property rights to protect the new
products or technologies we develop, and our existing intellectual property rights may not be
adequate to protect us or provide us with a competitive advantage. Our ability to successfully commercialize new products or technologies is dependent upon our
ability to secure and enforce strong intellectual property rights, generally patents, and we may be
unable to do so. To obtain patent protection, we must be able to successfully persuade the U.S.
Patent and Trademark Office and its foreign counterparts to issue patents on a timely basis and
possibly in the face of third-party challenges. Even if we are granted a patent, our rights may
later be challenged or circumvented by third parties. The issuance of a patent is not conclusive
as to its validity or enforceability. Litigation to enforce our patents generally will involve
substantial professional fees and costs and may ultimately prove to be unsuccessful. In addition,
we may receive notices from third parties regarding patent claims against us or our subsidiaries.
Any such claims, with or without merit, could be time-consuming to defend, result in costly
litigation, divert our managements attention and resources, and cause us to incur significant
expenses or, in the event of adverse decisions, significant damages owed to the patent owner. In
addition, any potential intellectual property litigation could require that we stop selling our
products, obtain a license from the owner to sell or use the relevant intellectual property, which
we may not be able to obtain on favorable terms, if at all, or modify our products to avoid using
the relevant intellectual property. In the event of a successful claim of infringement against us,
our business, financial condition and results of operations could be materially and adversely
affected. Additionally, we also rely on trade secrets and other unprotected proprietary knowledge, which we
generally seek to protect by confidentiality, non-disclosure and assignment of invention agreements
with our employees, consultants, licensees and other companies. These agreements, however, may be
breached or may not be enforceable, or we may not have adequate remedies for a breach by the other
party. Additionally, our trade secrets may become known by our competitors. Parties to those
agreements may claim rights to intellectual property arising out of their work. The disclosure or
misappropriation of our intellectual property for any of these reasons could materially and
adversely affect our business, financial condition or results of operations. We may be unable to obtain government approval for our products or comply with government
regulations relating to our business. The commercialization of pharmaceutical products is subject to extensive federal, state and local
regulation in the United States and similar foreign regulation. We do not know the extent to which
we may be affected by legislative and other regulatory actions and developments concerning various
aspects of our operations, our products and the health care field generally. We do not know what
effect changes in governmental regulation and other actions or decisions by governmental agencies
may have on our business in the future. Any changes could require 93




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changes to manufacturing methods or facilities, pharmaceutical importation, expanded or different
labeling, new approvals, the recall, replacement or discontinuance of certain products, additional
record keeping, price or purchase controls or limitations, and expanded documentation of the
properties of certain products and scientific substantiation. Any regulatory changes could have a
material adverse effect on our business, financial condition and results of operations or our
competitive position. The manufacturing, processing, formulation, packaging, labeling,
distribution, importation, pricing, reimbursement and advertising of our products, and disposal of
waste products arising from these activities, are also subject to regulation by the U.S. Drug
Enforcement Administration, the Federal Trade Commission, the U.S. Consumer Product Safety
Commission, the U.S. Department of Agriculture, the Occupational Safety and Health Administration,
the U.S. Environmental Protection Agency, the U.S. Customs Service and the Centers for Medicare and
Medicaid Services, as well as state, local and foreign governments. Before marketing most drug products, we are required to obtain approval from the FDA based upon
pre-clinical testing, clinical trials showing safety and effectiveness, chemistry and manufacturing
control data, and other data and information. The generation of the required data is regulated by
the FDA and can be time-consuming and expensive, and the results might not justify approval. Our
FDA product filings may not be approved in a timely manner, if at all, and we may be unable to meet
other regulatory requirements for our products. Pharmaceutical products also must be distributed,
sampled, advertised and promoted in accordance with FDA requirements. Even if we are successful in
obtaining all required pre-marketing approvals, post-marketing requirements and any failure on our
part to comply with other regulations could result in suspension or limitation of approvals or
commercial activities pertaining to affected products. The FDA could also require reformulation of
products during the post-marketing stage. All of our drugs must be manufactured in conformity with current Good Manufacturing Practice
regulations, as interpreted and enforced by the FDA, and drug products subject to an FDA-approved
application must be manufactured, processed, packaged, held and labeled in accordance with
information contained in the application. Additionally, modifications, enhancements or changes in
manufacturing sites of approved products are, in many circumstances, subject to FDA approval, which
may be subject to a lengthy application process or which we may be unable to obtain. Our
facilities, including the facilities used in our development services business and those of our
third-party manufacturers, are periodically subject to inspection by the FDA and other governmental
agencies, and operations at these facilities could be interrupted or halted if such inspections are
unsatisfactory. Failure to comply with FDA or other governmental regulations can result in fines, unanticipated
compliance expenditures, recall or seizure of products, total or partial suspension of production
or distribution, suspension of the FDAs review of our product applications, termination of ongoing
research, disqualification of data for submission to regulatory authorities, enforcement actions,
injunctions and criminal prosecution. Under certain circumstances, the FDA also has the authority
to revoke previously granted drug approvals. Although we have instituted internal compliance
programs, if compliance is deficient in any significant way, it could have a material adverse
effect on us. Most of our suppliers are subject to similar regulations and periodic inspections. 94




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The federal health care program anti-kickback statute makes it illegal for anyone to knowingly and
willfully make or receive kickbacks in return for any health care item or service reimbursed
under any federally financed healthcare program. This statute applies to arrangements between
pharmaceutical companies and the persons to whom they market, promote, sell and distribute their
products. Federal false claims laws prohibit any person from knowingly making a false claim to the
federal government for payment. Recently, several pharmaceutical companies have been prosecuted
under these laws, even though they did not submit claims to government healthcare programs. The
prosecutors alleged that they were inflating drug prices they report to pricing services, which are
in turn used by the government to set Medicare and Medicaid reimbursement rates. Pharmaceutical
companies also have been prosecuted under these laws for allegedly providing free products to
customers with the expectation that the customers would bill federal programs for the products.
Additionally, the majority of states have laws similar to the federal anti-kickback law and false
claims laws. Sanctions under these federal and state laws include monetary penalties, exclusion
from reimbursement for products under government programs, criminal fines and imprisonment. While
we have internal policies and practices requiring compliance with the health care fraud and abuse
laws and false claims laws, it is possible that some business practices could be subject to
challenge under one or more of these laws, which could have a material adverse effect on our
business, financial condition and results of operations. On January 2, 2004, we received separate letters from the Kentucky Office of Attorney General and
the Florida Office of Attorney General advising that each was currently investigating allegations
regarding our pricing practices related to our average manufacturer price and best price
calculations that are used by the government to set Medicaid reimbursement rates. Neither letter
requested that we provide any information, and each letter merely requested that we retain all
documents with respect to these calculations pursuant to a newly adopted federal regulation that
would have permitted the destruction of these documents three years after the applicable prices
were reported, except to the extent we were aware of an ongoing investigation. It is our
understanding that many other pharmaceutical companies received similar letters at that time from
attorneys general in a number of states and that such letters may have been in response to the new
federal regulation that would have otherwise allowed the destruction of documents reflecting these
pricing calculations. A number of attorneys general, including the Florida and Kentucky attorneys
general, petitioned the U.S. Secretary of Health and Human Services to withdraw the new regulation.
We are not aware of any further developments in these investigations. Additionally, our business involves the controlled storage, use and disposal of hazardous or highly
potent materials. We are subject to numerous environmental laws and regulations in the
jurisdictions in which we operate. Although we believe that our safety procedures for handling and
disposing of these hazardous materials comply in all material respects with the standards
prescribed by law and regulation in each of our locations, the risk of accidental contamination or
injury from hazardous materials cannot be completely eliminated. In the event of an accident, we
could be held liable to governmental authorities or private parties for any damages that result,
and the liability could exceed our resources. In addition, we could be held liable for costs
associated with contamination of properties currently or formerly occupied by us, or at other
parties disposal sites where we dispose or have disposed of hazardous wastes, even though this
contamination may have been caused by third parties or the disposal may have complied with the 95




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regulatory requirements then in place. Current or future environmental laws and regulations, or
adverse changes in the way current laws and regulations are interpreted or enforced, may materially
adversely affect our business, financial condition and results of operations. We maintain
liability insurance for some environmental risks that our management believes to be appropriate and
in accordance with industry practice. However, we may incur liabilities beyond the limits or
outside the coverage of our insurance and may not be able to maintain insurance on acceptable
terms. In connection with our activities outside the U.S., we are subject to foreign regulatory
requirements governing the testing, approval, manufacture, labeling, marketing and sale of
pharmaceutical products. These requirements vary from country to country. Even if FDA approval
has been obtained for a product, approval by comparable regulatory authorities of foreign countries
must be obtained prior to marketing the product in those countries. For example, some of our
foreign operations are subject to regulations by the European Medicines Evaluations Agency and the
U.K. Medicines Control Agency. The approval process may be more or less rigorous from country to
country, and the time required for approval may be longer or shorter than that required in the U.S.
Clinical studies conducted outside of any particular country may not be accepted by that country,
and the approval of a pharmaceutical product in one country does not assure that the product will
be approved in another country. In addition, regulatory agency approval of pricing is required in
many countries and may be required for our marketing of any drug in those countries. Product liability claims or product recalls could harm our business, financial condition and
results of operations. We face an inherent business risk of exposure to product liability claims in the event that the use
of our products or products that we manufacture for others is alleged to have resulted in adverse
effects. Such risks will exist even with respect to those products that receive regulatory
approval for commercial sale. While we will take what we believe are appropriate precautions, we
may not be able to avoid significant product liability exposure. Although we maintain product
liability insurance, this insurance may not be sufficient to cover all potential claims against us
or involving our products or products manufactured for others. Also, adequate insurance coverage
for existing and future products may not be available in the future at acceptable costs, if at all.
The assertion of this type of claim could have a material adverse affect on our business,
financial condition and results of operations. Product recalls may be issued at our discretion or
at the discretion of government agencies or others having regulatory authority for pharmaceutical
product sales. Recalls also could have a material adverse effect on our business, financial
condition and results of operations. We are vulnerable to pressures from third-party payers. Our commercial success in product sales will depend on patients being reimbursed by third-party
health care payers, such as government and private health insurers and managed care organizations.
Third-party payers are increasingly challenging the pricing of medical products and services. For
example, third-party payers strenuously discourage use of branded products when generic substitutes
are available. As a result, reimbursement may not be available to enable us to maintain price
levels sufficient to realize an appropriate return on our investment in product 96




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acquisition and development. If adequate reimbursement levels are not provided, our business,
financial condition and results of operations could be materially and adversely affected. The market for our products may also be limited by other actions of third-party payers. For
example, many managed health care organizations are now limiting the pharmaceutical products that
are on their lists of approved drugs. The resulting competition among pharmaceutical companies to
place their products on these formulary lists has created a trend of downward pricing pressure in
the industry. In addition, many managed care organizations are pursuing various ways to reduce
pharmaceutical costs and are considering formulary contracts primarily with those pharmaceutical
companies that can offer a broad line of products for a given class of therapy or disease, which we
cannot do. Our products may not be included on the approved drug list of managed care
organizations, and downward pricing pressures in the industry generally could materially and
adversely impact our business, financial condition and results of operations. New legislation or regulatory proposals or actions may adversely affect our revenues and prospects. A number of legislative proposals aimed at reducing the costs of medical products and services have
been enacted or proposed. For example, certain state governments have enacted legislation that
seeks to reduce the price paid by the Medicaid program for prescription drugs. In Florida and
Michigan, pharmaceutical companies that sell drugs reimbursed under state Medicaid programs are now
required to offer rebates in addition to the existing rebates mandated by Federal law in order for
their prescription drugs to be placed on the states preferred list of drugs eligible for Medicaid
reimbursement. A number of states are considering additional legislation and other measures that
would, if enacted, further adversely affect revenues from the sale of branded drugs, for example,
through limits on the purchase of branded drugs by state institutions and restrictions on
reimbursement for branded drugs in programs subject to state jurisdiction. In addition, in 2000, Congress directed the FDA to adopt regulations allowing the reimportation of
approved drugs originally manufactured in the United States back into the United States from other
countries where the drugs were sold at a lower price. Although the Secretary of Health and Human
Services has refused to implement this directive, in July 2003 the House of Representatives passed
a similar bill that does not require the Secretary of Health and Human Services to act. The
reimportation bills have not yet resulted in any new laws or regulations; however, these and other
initiatives could decrease the price we receive for our products. For most of our branded
products, we own only the U.S. distribution rights, while others own the rights to distribute these
products outside the United States. Accordingly, sales of our products in the United States could
be adversely affected by the importation of equivalent products that are manufactured by others and
are available outside the United States. The FDA has recently taken action requiring a broad class of painkillers known as nonsteroidal
anti-inflammatory drugs or NSAIDs to carry a black box label warning consumers of an increased
risk of heart attack and stroke from using these products. A black box warning is the strongest
possible warning required by the FDA. The Lynxorb product that we have been developing is an NSAID
and would be required to carry this black box label if we complete development of this product
and it is approved by the FDA. A black box warning label could reduce the commercial prospects
for Lynxorb. 97




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Changes in the Medicare, Medicaid or similar governmental programs or the amounts paid by those
programs for our services may adversely affect our earnings. These programs are highly regulated
and subject to frequent and substantial changes and cost containment measures. In recent years,
changes in these programs have limited and reduced reimbursement to providers. The Medicare
Prescription Drug, Improvement and Modernization Act of 2003, creates a new, voluntary prescription
drug benefit under the Social Security Act, which we refer to as Medicare Drug Benefit.
Beginning in 2006, Medicare beneficiaries entitled to Part A or enrolled in Part B, as well as
certain other Medicare enrollees, will be eligible for the Medicare Drug Benefit. Regulations
implementing the Medicare Drug Benefit have not yet been published, and the Medicare Drug Act
requires that the Federal Trade Commission conduct a study and make recommendations regarding
additional legislation that may be needed concerning the Medicare Drug Benefit. We are unable at
this time to predict or estimate the financial impact of this new legislation. Additionally, several large pharmaceutical companies have recently adopted discount plans for the
elderly. Our business, financial condition and results of operations could be materially and
adversely affected if recently established or future legislative or regulatory programs that are
designed to reduce the costs of medical products and services are effective or require consumers to
use generic substitutes or other alternatives for our branded products. Our business is subject to changing regulation of corporate governance and public disclosure that
has increased both our costs and the risk of noncompliance. Because our common stock is publicly traded, we are subject to certain rules and regulations of
federal, state and financial market exchange entities charged with the protection of investors and
the oversight of companies whose securities are publicly traded. These entities, including the
Public Company Accounting Oversight Board and the SEC, have recently issued new requirements and
regulations and continue developing additional regulations and requirements in response to recent
corporate scandals and laws enacted by Congress, most notably the Sarbanes-Oxley Act of 2002. Our
efforts to comply with these new regulations have resulted in, and are likely to continue resulting
in, increased general and administrative expenses and diversion of management time and attention
from revenue-generating activities to compliance activities. In particular, our efforts to prepare to comply with Section 404 of the Sarbanes-Oxley Act and
related regulations regarding our managements required assessment of our internal control over
financial reporting and our independent auditors attestation of that assessment have required, and
continue to require, the commitment of significant financial and managerial resources, including
the commitment of significant financial and managerial resources to remediate the material
weaknesses in our internal control over financial reporting that we have identified. Moreover, because the new and changed laws, regulations and standards are subject to varying
interpretations in many cases due to their lack of specificity, their application in practice may
evolve over time as new guidance is provided by regulatory and governing bodies. This evolution
may result in continuing uncertainty regarding compliance matters and additional costs necessitated
by ongoing revisions to our disclosure and governance practices. 98




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Item 7A. Quantitative and Qualitative Disclosures About Market Risk As a result of global operating activities, we are exposed to risks associated with changes in
foreign exchange rates. As foreign exchange rates change, the U. S. dollar equivalent of revenues
and expenses denominated in foreign currencies change and can have an adverse impact on our
operating results. To seek to minimize our risk from foreign exchange movement, we may use local
debt to fund our foreign operations. If foreign exchange rates were to increase by 10%, our
operating results would have been lower by $0.1 million in 2004 due to the reduction in reported
results from European operations. We are also exposed to fluctuations in interest rates on variable rate debt instruments tied to
LIBOR, as discussed in Managements Discussion and Analysis of Financial Condition  Liquidity and
Capital Resources. If interest rates were to increase by 1%, annual interest expense on variable
rate debt tied to interest rates would increase by approximately $1.5 million based on our average
variable rate debt balance in 2004. 99




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Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements PageManagements Report on Internal Control Over Financial Reporting
    
    
    101Report of Independent Registered Public Accounting Firm on Financial
Statements
    
    
    104Report of Independent Registered Public Accounting Firm on Internal
Control
    
    
    106Consolidated Statements of Operations
    
    
    109Consolidated Balance Sheets
    
    
    111Consolidated Statements of Cash Flows
    
    
    113Consolidated Statements of Stockholders Equity (Deficit)
    
    
    115Consolidated Statements of Comprehensive (Loss) Income
    
    
    116Notes to Consolidated Financial Statements
    
    
    117
 100




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Managements Report on Internal Control Over Financial Reporting Management of aaiPharma Inc. (the Company) is responsible for establishing and maintaining
adequate internal control over financial reporting as defined in Rule 13a-15(f) under the
Securities Exchange Act of 1934. Internal control over financial reporting is a process designed
to provide reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with accounting principles
generally accepted in the United States of America. Internal control over financial reporting
includes policies and procedures that: 1) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the Companys assets; 2)
provide reasonable assurance that transactions are recorded as necessary to permit preparation of
financial statements in accordance with accounting principles generally accepted in the United
States of America, and that receipts and expenditures are being made only in accordance with
authorizations of management and directors of the Company; and 3) provide reasonable assurance
regarding prevention or timely detection of unauthorized acquisition, use or disposition of the
Companys assets that could have a material effect on the financial statements. Management conducted an assessment of the effectiveness of the Companys internal control over
financial reporting as of December 31, 2004, based on the framework set forth in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission. Based on this assessment, management has concluded that the Companys internal control
over financial reporting was not effective as of December 31, 2004 because of the material
weaknesses outlined below. A material weakness in internal controls is a significant deficiency, or combination of significant
deficiencies, that results in more than a remote likelihood that a material misstatement of the
financial statements would not be prevented or detected on a timely basis by the Company. Management has identified the following material weaknesses in connection with its assessment of
the effectiveness of the Companys internal control over financial reporting as of December 31,
2004: 1. The Company did not maintain effective controls over revenue recognition from Development
Services activities. The Companys independent registered public accountants discovered in their
audit of the Companys financial statements at and for the year ended December 31, 2004 a
Development Services project for which revenue had been recorded in 2004 in excess of the amount
stated in a purchase order issued by the client. Management believes that the controls in place
over revenue recognition from Development Services activities during 2004 were not sufficient to
provide reasonable assurance that a similar material misstatement would be prevented or detected in
a timely fashion. 2. The Company did not maintain effective controls over the accounting for inventory of certain
supplies used in the non-clinical portion of the Development Services business. Management
determined that employees failed to follow policies and procedures related to the consumption of
this inventory. In addition, this inventory was not included in year-end physical inventory
counts. The inventory process lacked adequate control processes to ensure that timely 101




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adjustments were made to the recorded amount of inventory as the asset was consumed. This
ineffective control resulted in an untimely recording of a decrease in inventory value. 3. The Company lacked effective controls over the period-end financial closing process due to three
specific deficiencies. First, management determined that ineffective controls existed due to
insufficient review processes that resulted in a number of adjustments identified by the Companys
independent registered public accountants and subsequently made to the Companys financial
statements for the period ended December 31, 2004 that were not initially identified and recorded
by the Company. Second, there was a lack of timely closing of the Companys financial books and records. This
precluded the timely review by operations management of monthly financial reports against budgets
or forecasts and the timely reporting of quarterly results to the Board of Directors in sufficient
detail, including a budget/forecast-to-actual comparison. Third, within the accounting functions involved in the closing process, there existed a number of
segregation of duties conflicts. Although a process was initiated in the third and fourth quarters
of 2004 to segregate these duties where possible and implement independent review procedures, the
process had not been completed as of December 31, 2004. 4. The Company lacked effective controls over the processes and procedures involved in the
accounting for income taxes in connection with the preparation of consolidated financial
statements. Specifically, the control deficiency related to the Companys review of the work
prepared by an independent third party firm that was retained in the third and fourth quarters of
2004 to assist in the accounting for income tax. The Companys review of this work failed to
identify adjustments related to an inaccurate valuation allowance and an inaccurate calculation of
the appropriate deduction for stock options exercised and did not include a reconciliation between
the Companys tax return as filed and the income tax provision recorded. These adjustments were
identified by the Companys independent registered public accountants as part of the year-end
audit. As a result, the Company reflected adjustments to the provision for income taxes, deferred
tax assets, and interest payable in the 2004 financial statements. 5. The Company lacked effective controls over the process for reviewing its intangible assets for
impairment in connection with the preparation of the Companys 2004 consolidated financial
statements. The Companys independent registered public accountants determined in connection with
the year end audit that the methodology used by the Company for determining impairment was not
adequate. Management determined this to be a material weakness because the Companys use of the
revised methodology led to its recognition of write downs of intangible pharmaceutical products
assets that had not been initially identified and recorded by the Company. 6. The Company lacked effective controls over the process for determining appropriate product
returns reserves for product sales. Specifically, the weakness related to the Companys review of
wholesalers reports of their respective inventory levels. In March 2005, a major wholesaler
notified the Company of its intent to return product for credit. In reviewing the notification,
the Company determined that the specific inventory to be returned was omitted from that
wholesalers most recent quarterly reports to the Company, and that the Company did not 102




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perform sufficient reconciliations to provide reasonable assurance that this type of error would be
detected on a timely basis. As a result of this error, the Company made adjustments to increase
its reserve for product returns, which affected the amount of net revenues from product sales
initially recorded by the Company in the third and fourth quarters of 2004, and is restating the
reported results for its third quarter of 2004. The Companys independent registered public accountants, Ernst & Young LLP, have audited
managements assessment and have issued an unqualified attestation report on managements
assessment of the Companys internal control over financial reporting and an adverse opinion on the
Companys internal control over financial reporting, which appears, together with their report on
the Companys consolidated financial statements, on pages 104 through 108. /s/ Ludo J. Reynders
Ludo J. Reynders, Ph. D.
President and Chief Executive Officer /s/ Matthew E. Czajkowski
Matthew E. Czajkowski
Executive Vice President, Chief Financial Officer and
Chief Administrative Officer April 26, 2005 103




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Report of Independent Registered Public Accounting Firm on Financial Statements Board of Directors and Stockholders
aaiPharma Inc. We have audited the accompanying consolidated balance sheets of aaiPharma Inc. and subsidiaries as
of December 31, 2004 and 2003, and the related consolidated statements of operations, cash flows,
stockholders equity (deficit), and comprehensive (loss) income for each of the three years in the
period ended December 31, 2004. Our audits also included the financial statement schedule listed in
the index at Item 15(c). These financial statements and schedule are the responsibility of the
Companys management. Our responsibility is to express an opinion on these financial statements and
schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material
respects, the consolidated financial position of aaiPharma Inc. and subsidiaries at December 31,
2004 and 2003, and the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted
accounting principles. Also in our opinion, the related financial statement schedule, when
considered in relation to the basic financial statements taken as a whole, presents fairly in all
material respects the information set forth therein. The accompanying financial statements have been prepared assuming that aaiPharma Inc. will continue
as a going concern. As more fully described in Note 1, the Company has incurred recurring
operating losses and has a significant working capital deficiency. In addition, the Company has
not complied with certain covenants of loan agreements with banks and other lenders. These
conditions raise substantial doubt about the Companys ability to continue as a going concern.
Managements plans as to these matters are also described in Note 1. The 2004 financial statements
do not include any adjustments to reflect the possible future effects on the recoverability and
classification of assets or the amounts and classifications of liabilities that may result from the outcome of this uncertainty. 104




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We also have audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the effectiveness of aaiPharma Inc.s internal control over financial
reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our
report dated April 26, 2005 expressed an unqualified opinion on managements assessment and an
adverse opinion on the effectiveness of internal control over financial reporting. /s/ Ernst & Young
 Raleigh, North Carolina April 26, 2005 105




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Report of Independent Registered Public Accounting Firm on Internal Control The Board of Directors and Shareholders of aaiPharma Inc. We have audited managements assessment, included in the accompanying Managements Report on
Internal Control over Financial Reporting, that aaiPharma Inc. did not maintain effective internal
control over financial reporting as of December 31, 2004, because of the effect of material
weaknesses in internal controls over recognizing developmental services revenue, accounting for
inventory, the financial statement close process, accounting for income taxes, the product revenue
adjustment process, and analyzing intangible assets for impairment based on criteria established in
Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (the COSO criteria). aaiPharma Inc.s management is responsible for
maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility is to express an
opinion on managements assessment and an opinion on the effectiveness of aaiPharma Inc.s internal
control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating managements assessment, testing and evaluating the
design and operating effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audit provides a reasonable basis
for our opinion. A companys internal control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles. A
companys internal control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of aaiPharma Inc.; (2) provide reasonable assurance
that transactions are recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts and expenditures of
aaiPharma Inc. are being made only in accordance with authorizations of management and directors of
aaiPharma Inc.; and (3) provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use, or disposition of aaiPharma Inc.s assets that could have a material
effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or
detect misstatements. Also, projections of any evaluation of effectiveness to future periods are
subject to the risk that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate. A material weakness is a control deficiency, or combination of control deficiencies, that results
in more than a remote likelihood that a material misstatement of the annual or interim financial 106




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statements will not be prevented or detected. The following material weaknesses have been
identified and included in managements assessment:  -
    Insufficient controls with respect to recognition of revenue from developmental
services contracts for its development services business. The accounts affected by this
material weakness are development services revenue and work-in-process receivables as
adjustments were recorded to aaiPharma Inc.s 2004 annual financial statements as a
result of our audit;-
    Insufficient controls with respect to accounting for inventory of certain
supplies used in its development services business. The accounts affected by this
material weakness are inventory and direct costs as adjustments were recorded to
aaiPharma Inc.s 2004 annual financial statements as a result of our audit;-
    A combination of control deficiencies relating to aaiPharma Inc.s period end
financial statement close process. All accounts are affected by this material weakness
as numerous adjustments were recorded to aaiPharma Inc.s 2004 annual financial
statements as a result of our audit;-
    A combination of control deficiencies relating to aaiPharma Inc.s accounting
for income taxes. This material weakness affected the following tax accounts: income
tax expense, the related income tax accruals and current and non-current deferred tax
assets and liabilities, as adjustments were recorded to aaiPharma Inc.s 2004 annual
financial statements as a result of our audit;-
    Insufficient controls related to aaiPharma Inc.s pharmaceutical divisions
process of recording adjustments to revenue, including reserving for product returns.
This material weakness affects accounts receivable reserve accounts and product sales
revenue, as adjustments were recorded to aaiPharma Inc.s 2004 annual financial
statements and September 30, 2004 interim financial results as a result of our audit;
and-
    Insufficient controls related to aaiPharma Inc.s analysis for impairment of
intangible assets. This material weakness affects intangible assets and amortization
expense, as adjustments were recorded to aaiPharma Inc.s 2004 annual financial
statements as a result of our audit. These material weaknesses were considered in determining the nature, timing and extent of audit
tests applied in our audit of the December 31, 2004 financial statements, and this report does not
affect our report dated April 26, 2005 on those financial statements. In our opinion, managements assessment that aaiPharma Inc. did not maintain effective internal
control over financial reporting as of December 31, 2004, is fairly stated, in all material
respects, based on the COSO control criteria. Also, in our opinion, because of the effect of the
material weaknesses described above on the achievement of the objectives of the control criteria,
aaiPharma Inc. has not maintained effective internal control over financial reporting as of
December 31, 2004, based on the COSO control criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the consolidated balance sheets of aaiPharma Inc. and subsidiaries as of
December 31, 2004 and 2003, and the related consolidated statements of 107




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operations, cash flows, stockholders equity (deficit), and comprehensive (loss) income for each of
the three years in the period ended December 31, 2004 and our report dated April 26, 2005 expressed
an unqualified opinion thereon (which contains an explanatory paragraph describing conditions that
raise substantial doubt about the Companys ability to continue as a going concern as described in
Note 1 to the consolidated financial statements). /s/ Ernst & Young LLP
 Raleigh, North Carolina April 26, 2005 108




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aaiPharma Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts) Years Ended December 31,2004
    
    
    2003
    
    
    2002Net revenues:Product sales
    
    $
    77,776
    
    
    $
    119,223
    
    
    $
    124,384Product development
    
    
    23,987
    
    
    
    16,468
    
    
    
    19,610Development services (includes related
party net revenues of $0, $630, and
$1,556)
    
    
    94,883
    
    
    
    89,286
    
    
    
    86,516Reimbursed out-of-pocket
    
    
    18,684
    
    
    
    11,950
    
    
    
    10,688215,330
    
    
    
    236,927
    
    
    
    241,198Operating costs and expenses:Direct costs (excluding depreciation
and royalty expense):Product sales (includes product
related amortization of $15,811,
$12,273 and $9,239)
    
    
    46,248
    
    
    
    61,763
    
    
    
    39,487Development services
    
    
    55,961
    
    
    
    53,074
    
    
    
    51,210Reimbursable out-of-pocket
    
    
    18,684
    
    
    
    11,950
    
    
    
    10,688Total direct costs
    
    
    120,893
    
    
    
    126,787
    
    
    
    101,385Selling expenses
    
    
    34,983
    
    
    
    39,534
    
    
    
    23,077General and administrative expenses
    
    
    45,875
    
    
    
    40,463
    
    
    
    40,109Research and development
    
    
    16,319
    
    
    
    21,788
    
    
    
    20,853Depreciation
    
    
    8,665
    
    
    
    7,973
    
    
    
    7,156Professional
fees - internal inquiry
    
    
    11,042
    
    
    
    
    
    
    
    M.V.I. contingent payment/(gain on sale)
    
    
    (8,112
    )
    
    
    
    
    
    
    Guaranteed purchase commitments
    
    
    11,695
    
    
    
    
    
    
    
    Restructuring charges
    
    
    22,392
    
    
    
    
    
    
    
    Royalty expenses
    
    
    1,727
    
    
    
    1,095
    
    
    
    Intangible asset impairment
    
    
    93,972
    
    
    
    20,600
    
    
    
    Total operating costs and expenses
    
    
    359,451
    
    
    
    258,240
    
    
    
    192,580(Loss) income from operations
    
    
    (144,121
    )
    
    
    (21,313
    )
    
    
    48,618Other income (expense):Interest expense, net
    
    
    (34,989
    )
    
    
    (21,078
    )
    
    
    (19,366
    )Loss from extinguishment of debt
    
    
    (6,229
    )
    
    
    (1,511
    )
    
    
    (8,053
    )Other
    
    
    (2,142
    )
    
    
    6,697
    
    
    
    461(43,360
    )
    
    
    (15,892
    )
    
    
    (26,958
    )(Loss) income before income taxes
    
    
    (187,481
    )
    
    
    (37,205
    )
    
    
    21,660Provision for (benefit from) income taxes
    
    
    3,690
    
    
    
    (4,502
    )
    
    
    8,542
 109




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Years Ended December 31,2004
    
    
    2003
    
    
    2002Net (loss) income
    
    $
    (191,171
    )
    
    $
    (32,703
    )
    
    $
    13,118Basic (loss) earnings per share
    
    $
    (6.69
    )
    
    $
    (1.18
    )
    
    $
    0.48Weighted average shares outstanding
    
    
    28,565
    
    
    
    27,730
    
    
    
    27,348Diluted (loss) earnings per share
    
    $
    (6.69
    )
    
    $
    (1.18
    )
    
    $
    0.46Weighted average shares outstanding
    
    
    28,565
    
    
    
    27,730
    
    
    
    28,359
 The accompanying notes are an integral part of these financial statements. 110




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aaiPharma Inc.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data) December 31,2004
    
    
    2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    7,130
    
    
    $
    8,785Accounts receivable, net
    
    
    12,756
    
    
    
    32,614Work-in-progress
    
    
    10,172
    
    
    
    12,503Inventories, net
    
    
    10,722
    
    
    
    14,693Deferred tax assets
    
    
    
    
    
    
    19,184Income taxes recoverable
    
    
    11,110
    
    
    
    Prepaid and other current assets
    
    
    13,810
    
    
    
    10,398Total current assets
    
    
    65,700
    
    
    
    98,177Property and equipment, net
    
    
    52,942
    
    
    
    57,236Goodwill, net
    
    
    14,350
    
    
    
    13,361Intangible assets, net
    
    
    190,099
    
    
    
    351,315Other assets
    
    
    15,979
    
    
    
    14,508Total assets
    
    $
    339,070
    
    
    $
    534,597LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)Current liabilities:Current maturities of long-term debt
    
    $
    351,645
    
    
    $
    4,000Accounts payable
    
    
    22,031
    
    
    
    21,879Customer advances
    
    
    11,043
    
    
    
    17,630Accrued wages and benefits
    
    
    4,881
    
    
    
    5,320Interest payable
    
    
    5,738
    
    
    
    5,511Deferred product revenue
    
    
    4,127
    
    
    
    45,664Other accrued liabilities
    
    
    51,481
    
    
    
    11,133Total current liabilities
    
    
    450,946
    
    
    
    111,137Long-term debt, less current portion
    
    
    
    
    
    
    338,844Deferred tax liability
    
    
    
    
    
    
    2,246Other liabilities
    
    
    14
    
    
    
    7,647Commitments and contingenciesStockholders equity (deficit):Preferred stock, $.001 par value; 5 million shares
authorized, none outstanding in 2004 or 2003
    
    
    
    
    
    
    Common stock, $.001 par value; 100 million shares
authorized, 28,585,582 outstanding - 2004; 28,221,983
outstanding - 2003
    
    
    29
    
    
    
    28
 111




---



##### 



December 31,2004
    
    
    2003Paid-in capital
    
    
    91,425
    
    
    
    88,049Accumulated deficit
    
    
    (207,478
    )
    
    
    (16,307
    )Accumulated other comprehensive income
    
    
    4,398
    
    
    
    3,197Deferred compensation
    
    
    (264
    )
    
    
    (244
    )Total stockholders equity (deficit)
    
    
    (111,890
    )
    
    
    74,723Total liabilities and stockholders equity (deficit)
    
    $
    339,070
    
    
    $
    534,597
 The accompanying notes are an integral part of these financial statements. 112




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##### 



aaiPharma Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands) Years Ended December 31,2004
    
    
    2003
    
    
    2002Cash flows from operating activities:Net (loss) income
    
    $
    (191,171
    )
    
    $
    (32,703
    )
    
    $
    13,118Adjustments to reconcile net (loss) income to net
cash (used in) provided by operating activities:Depreciation and amortization
    
    
    24,476
    
    
    
    20,246
    
    
    
    16,395Intangible asset impairment, net of tax
    
    
    93,972
    
    
    
    20,600
    
    
    
    Write-off of deferred financing and other costs
    
    
    6,229
    
    
    
    1,511
    
    
    
    8,053Gain on sale of M.V.I. product line
    
    
    (39,113
    )
    
    
    
    
    
    
    Noncash stock based compensation
    
    
    225
    
    
    
    
    
    
    
    Loss on
disposal of assets and other
    
    
    2,008
    
    
    
    434
    
    
    
    145Changes in operating assets and liabilities:Accounts receivable, net
    
    
    20,256
    
    
    
    (2,632
    )
    
    
    (2,380
    )Work-in-progress
    
    
    3,007
    
    
    
    (1,085
    )
    
    
    643Inventories
    
    
    1,088
    
    
    
    2,449
    
    
    
    (7,853
    )Deferred tax assets and income taxes
recoverable
    
    
    8,074
    
    
    
    (17,913
    )
    
    
    (352
    )Prepaid and other assets
    
    
    (11,083
    )
    
    
    (5,687
    )
    
    
    (10,409
    )Accounts payable
    
    
    (65
    )
    
    
    3,849
    
    
    
    1,937Customer advances
    
    
    (7,004
    )
    
    
    2,062
    
    
    
    1,227Interest payable
    
    
    226
    
    
    
    279
    
    
    
    4,861Deferred product revenue
    
    
    (41,537
    )
    
    
    45,664
    
    
    
    Accrued wages and benefits and other accrued
liabilities
    
    
    37,327
    
    
    
    1,278
    
    
    
    5,580Net cash (used in) provided by operating activities
    
    
    (93,085
    )
    
    
    38,352
    
    
    
    30,965Cash flows from investing activities:Purchases of property and equipment
    
    
    (5,427
    )
    
    
    (11,910
    )
    
    
    (8,529
    )Purchase of property and equipment previously
leased
    
    
    
    
    
    
    
    
    
    
    (14,145
    )Proceeds from sales of property and equipment
    
    
    97
    
    
    
    606
    
    
    
    131Product line disposals
    
    
    92,918
    
    
    
    
    
    
    
    Product line acquisitions
    
    
    
    
    
    
    (102,464
    )
    
    
    (211,997
    )Other
    
    
    (340
    )
    
    
    (502
    )
    
    
    (593
    )Net cash provided by (used in) investing activities
    
    
    87,248
    
    
    
    (114,270
    )
    
    
    (235,133
    )Cash flows from financing activities:Proceeds from long-term borrowings
    
    
    177,500
    
    
    
    160,000
    
    
    
    244,486Payments on long-term borrowings
    
    
    (166,000
    )
    
    
    (93,500
    )
    
    
    (51,900
    )(Payments on) proceeds from interest rate swaps,
net
    
    
    (10,293
    )
    
    
    1,703
    
    
    
    10,486Proceeds from stock option exercises
    
    
    3,132
    
    
    
    8,757
    
    
    
    3,243Other
    
    
    (193
    )
    
    
    1,086
    
    
    
    (2,153
    )
 113




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##### 



Years Ended December 31,2004
    
    
    2003
    
    
    2002Net cash provided by financing activities
    
    
    4,146
    
    
    
    78,046
    
    
    
    204,162Net (decrease) increase in cash and cash equivalents
    
    
    (1,691
    )
    
    
    2,128
    
    
    
    (6
    )Effect of exchange rate changes on cash
    
    
    36
    
    
    
    125
    
    
    
    167Cash and cash equivalents, beginning of year
    
    
    8,785
    
    
    
    6,532
    
    
    
    6,371Cash and cash equivalents, end of year
    
    $
    7,130
    
    
    $
    8,785
    
    
    $
    6,532Supplemental information, cash paid for:Interest
    
    $
    32,183
    
    
    $
    24,012
    
    
    $
    16,835Income taxes
    
    $
    6,124
    
    
    $
    7,248
    
    
    $
    1,346
 The accompanying notes are an integral part of these financial statements. 114




---



##### 



aaiPharma Inc.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT)
(In thousands) Retained Earnings
    
    
    AccumulatedCommon Stock
    
    
    Paid-in
    
    
    (Accumulated
    
    
    Other Comprehensive
    
    
    DeferredShares
    
    
    Amount
    
    
    Capital
    
    
    Deficit)
    
    
    Income (Loss)
    
    
    Compensation
    
    
    TotalBalance, December 31,
2001
    
    
    26,996
    
    
    $
    27
    
    
    $
    75,224
    
    
    $
    3,278
    
    
    $
    (2,165
    )
    
    $
    
    
    
    $
    76,364Stock options exercised
    
    
    507
    
    
    
    
    
    
    
    3,825
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,825Currency translation
adjustments, net of
tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,837
    
    
    
    
    
    
    
    1,837Realized loss on
investments
reclassified into
earnings
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    110
    
    
    
    
    
    
    
    110Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,118
    
    
    
    
    
    
    
    
    
    
    
    13,118Balance, December 31,
2002
    
    
    27,503
    
    
    
    27
    
    
    
    79,049
    
    
    
    16,396
    
    
    
    (218
    )
    
    
    
    
    
    
    95,254Stock options exercised
    
    
    719
    
    
    
    1
    
    
    
    8,582
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,583Currency translation
adjustments, net of
tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,415
    
    
    
    
    
    
    
    3,415Issuance of restricted
stock award
    
    
    
    
    
    
    
    
    
    
    418
    
    
    
    
    
    
    
    
    
    
    
    (418
    )
    
    
    Deferred compensation
amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    174
    
    
    
    174Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (32,703
    )
    
    
    
    
    
    
    
    
    
    
    (32,703
    )Balance, December 31,
2003
    
    
    28,222
    
    
    
    28
    
    
    
    88,049
    
    
    
    (16,307
    )
    
    
    3,197
    
    
    
    (244
    )
    
    
    74,723Stock options exercised
    
    
    364
    
    
    
    1
    
    
    
    3,131
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,132Currency translation
adjustments, net of
tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,201
    
    
    
    
    
    
    
    1,201Issuance of restricted
stock award
    
    
    
    
    
    
    
    
    
    
    245
    
    
    
    
    
    
    
    
    
    
    
    (245
    )
    
    
    Deferred compensation
amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    225
    
    
    
    225Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (191,171
    )
    
    
    
    
    
    
    
    
    
    
    (191,171
    )Balance, December 31,
2004
    
    
    28,586
    
    
    $
    29
    
    
    $
    91,425
    
    
    $
    (207,478
    )
    
    $
    4,398
    
    
    $
    (264
    )
    
    $
    (111,890
    )
 The accompanying notes are an integral part of these financial statements. 115




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##### 



aaiPharma Inc.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME
(In thousands) Years Ended December 31,2004
    
    
    2003
    
    
    2002Net (loss) income
    
    $
    (191,171
    )
    
    $
    (32,703
    )
    
    $
    13,118Currency translation adjustments, net of tax
    
    
    1,201
    
    
    
    3,415
    
    
    
    1,837Realized loss on investments reclassified
into earnings from other comprehensive
income
    
    
    
    
    
    
    
    
    
    
    110Comprehensive (loss) income
    
    $
    (189,970
    )
    
    $
    (29,288
    )
    
    $
    15,065
 The accompanying notes are an integral part of these financial statements. 116




---



##### 



aaiPharma Inc. Notes to Consolidated Financial Statements
December 31, 2004 1. Significant Accounting Policies and Other Matters Organization aaiPharma Inc. (aaiPharma or the Company) is a science-based pharmaceutical company. The
Company has a comprehensive range of pharmaceutical development capabilities primarily in the
United States and Europe. In 2004, the majority of the Companys consolidated net revenues were
earned in its development services business. In 2003 and 2002, the majority of the Companys
consolidated net revenues came from the sale of commercial pharmaceutical products in its product
sales business. Major customers for the development services and product development businesses
are large and small pharmaceutical and biotechnology companies. Major customers for the Companys
pharmaceutical products are large, well established pharmaceutical wholesalers and distributors. Basis of Presentation and Consolidation The consolidated financial statements include the accounts of aaiPharma Inc. and its wholly owned
subsidiaries. All material intercompany transactions have been eliminated. Certain balances in the
prior years consolidated financial statements have been reclassified to conform to the December
31, 2004 presentation. These reclassifications had no impact on previously reported net income
(loss) or stockholders equity (deficit). On January 30, 2003, aaiPharmas Board of Directors approved a three-for-two stock split of the
Companys common shares. On March 10, 2003, each stockholder received one additional share of
common stock for every two shares they owned on the record date of February 19, 2003. All share
and per share amounts have been restated to reflect the stock split for each period presented as if
it had occurred at the beginning of the period. Going Concern The Company incurred a substantial net loss and loss from operations for 2004 and the quarter ended
December 31, 2004. The Companys results of operations have continued to deteriorate as customer
concerns regarding its financial condition have affected sales of the Companys pharmaceutical
products as well as the Companys ability to obtain and maintain development services engagements. As a result of the Companys substantial and recurring operating losses, the Company believes that
it does not have adequate sources of liquidity to fund operations in the near term unless the
Company obtains additional sources of liquidity. The Company did not make the $10.5 million
scheduled interest payment due on its senior subordinated notes on April 1, 2005. In light of its current financial condition, the Company believes that its operations can no longer
support its existing debt and that the Company must restructure its debt to levels that are more in 117




---



##### 



line with its operations.
Thus, it is highly likely that the Company will seek relief under chapter 11 of Title
11 of the U.S. Code (the Bankruptcy Code) which would substantially dilute and may eliminate the
interests of the holders of the Companys common stock. These conditions raise substantial doubt about the Companys ability to continue as a going
concern. The accompanying consolidated financial statements do not include any adjustments to
reflect the possible future effects on the recoverability and
classification of assets or the amounts and classifications of liabilities that
may result from the outcome of this uncertainty. Because of the potential for defaults under the Companys senior credit facilities and the senior
subordinated notes at December 31, 2004, all $350.5 million of debt under the Companys senior
credit facilities and the notes was classified as current liabilities on the Companys consolidated
balance sheet at December 31, 2004. Revenue Recognition The Company recognizes revenue in accordance with the SECs Staff Accounting Bulletin No. 101,
Revenue Recognition in Financial Statements as amended by Staff Accounting Bulletin No. 104
(together, SAB 101), and FASB Statement No. 48 Revenue Recognition When Right of Return Exists
(SFAS 48). SAB 101 states that revenue should not be recognized until it is realized or
realizable and earned. Revenue is realized or realizable and earned when all of the following
criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or
services have been rendered; (3) the sellers price to the buyer is fixed and determinable; and (4)
collectibility is reasonably assured. SFAS 48 states that revenue from sales transactions where
the buyer has the right to return the product shall be recognized at the time of sale only if (1)
the sellers price to the buyer is substantially fixed or determinable at the date of sale, (2) the
buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not
contingent on resale of the product, (3) the buyers obligation to the seller would not be changed
in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the
product for resale has economic substance apart from that provided by the seller, (5) the seller
does not have significant obligations for future performance to directly bring about resale of the
product by the buyer, and (6) the amount of future returns can be reasonably estimated. Net Revenues The Companys consolidated net revenues represent the Companys total revenues less allowances for
customer credits, including estimated discounts, rebates, chargebacks, product returns and non
research and development expenses reimbursed by customers. Net revenues are reported for the Companys three operating segments, which are product sales,
development services and product development. The following table sets forth the Companys gross revenues and the amount of dilution to revenues
resulting from revenue reserves such as allowances for customer credits, including discounts,
rebates, chargebacks, product returns and other allowances for each of 2004, 2003 and 2002: 118




---



##### 



Years Ended December 31,2004
    
    
    2003
    
    
    2002(dollars in thousands)Gross revenues
    
    $
    273,227
    
    
    $

    339,232
    
    
    $
    294,602Less allowance for customer credits
    
    
    57,897
    
    
    
    102,305
    
    
    
    53,404Net revenues
    
    $
    215,330
    
    
    $
    236,927
    
    
    $
    241,198
 Allowances for customer credits as a percentage of gross revenues were 21.2% for 2004 as compared
to 30.2% for 2003 and 18.1% for 2002. This change is primarily related to lower pharmaceutical
returns and chargeback reserve needs based on changes in sales mix, primarily due to lower Brethine
sales and the sale of the Companys MVI product line. In the fourth quarter of 2004, the Company began reporting revenues and expenses under the
guidelines of the Emerging Issues Task Force Issue No. (EITF) 01-14, Income Statement
Characterization of Reimbursements Received for Out-of-Pocket Expenses Incurred.EITF 01-14
requires that reimbursements received for out-of-pocket expenses should be characterized as
revenue. All prior period amounts have been reclassified to comply with this release. The
adoption of this rule resulted only in the gross up of revenues and expenses and had no impact on
earnings. Product Sales The Company recognizes revenues for product sales at the time title and risk of loss are
transferred to the customer, and the other criteria of SAB 101 and SFAS 48 are satisfied, which is
generally at the time products are received by our customers. Product shipping and handling costs
are included in product cost of goods sold. Products are sold to pharmaceutical wholesalers, the
largest three of which account for approximately 83%, 81% and 88% of the Companys product sales
net revenues for the years ended December 31, 2004, 2003 and 2002, respectively. At the time gross
revenue is recognized from product sales, an adjustment, or decrease, to revenue for estimated
chargebacks, rebates, discounts and returns is also recorded. These revenue reserves are
determined on a product-by-product basis. Revenue reserves are established by management as its
best estimate at the time of sale based on each products historical experience adjusted to reflect
known changes in the factors that impact such reserves. Reserves for chargebacks, rebates and
related allowances are established based on the contractual terms with customers; analysis of
historical levels of discounts, chargebacks and rebates; communications with customers and
purchased information about the rate of prescriptions being written and the levels of inventory
remaining in the distribution channel as well as expectations about the market for each product and
anticipated introduction of competitive products. The reserves for chargebacks and returns are the
most significant estimates used in the recognition of our revenue from product sales. Contract
prices are established for certain indirect customers that are supplied by the Companys wholesale
customers. A chargeback represents the difference between the current published wholesale
acquisition cost and the indirect customers contract price. If the actual amount of cash
discounts taken, chargebacks, rebates and expired product returns differ from the amounts estimated
by 119




---



##### 



management, material differences may result from the amount of revenue the Company recognizes from
product sales. In the case of shipments made to wholesalers that do not meet the revenue recognition criteria of
SFAS 48 and SAB 101, such shipments are accounted for using the consignment model. Product
shipments accounted for under the consignment model currently include the Companys new product
launches in 2003 and product shipments through a specialty distributor, which began in the third
quarter of 2003. Under the consignment model, the Company does not recognize revenue upon shipment
of product. For these product sales, the Company invoices the wholesaler, records deferred revenue
at gross invoice sales price, and classifies the inventory held by the wholesaler as consigned
inventory at the Companys cost of goods for such inventory. The Company recognizes revenue on
consigned inventory when such inventory is sold through to the wholesalers customers, on a
first-in first-out (FIFO) basis. The Companys estimates of inventory at the wholesalers and
deferred revenue on consigned inventory are based on (1) the projected prescription demand-based
sales for its products, (2) the Companys analysis of third-party information, including
information obtained from certain wholesalers with respect to their inventory levels and
sell-through to customers and third-party market research data, and (3) the Companys internal
product sales information. The Companys estimates are subject to the inherent limitations of
estimates that rely on third-party data, as certain third-party information was itself in the form
of estimates, and reflect other limitations. The Companys sales and revenue recognition for such
consigned inventory reflect the Companys estimates of actual product sold through to the wholesale
customer. Deferred product revenues under the consignment model were $4.1 million and $45.7 million
as of December 31, 2004 and 2003, respectively. Prior to 2003, the amount of actual product returns experienced by the Company had not been
significant. As a result, actual returns were charged against revenue in the period they occurred
and aggregate revenue reserves were evaluated to determine if they were sufficient to cover
estimated chargebacks, rebates and related allowances, as well as the expected rate of returns, and
adjusted as deemed necessary. In 2003, the Company began segregating the Companys products return
reserve, which prior thereto the Company believed was adequately covered by the Companys aggregate
revenue reserves for chargebacks, rebates and related allowances. The Company increased the level
of detail included in the Companys analyses to include analyzing inventory in the channel to
determine remaining shelf life. The Companys returns reserve needs are primarily related to the
number of months of inventory estimated to be in the distribution channel. Levels of inventory in
the distribution channel are monitored and estimated based on information the Company purchases
from the wholesalers, combined with active discussions between the Companys sales personnel and
the wholesalers to which the Company supplies. In addition, the Companys actual sales, returns
and chargeback history are used to assess the reasonableness of the estimated number of months of
inventory on hand at the Companys wholesalers. The shelf life of products remaining in the
distribution channel is estimated based on an analysis of the lots sold. Each batch has a specific
expiration date. A review of the actual returns history is performed and the run rate of sales out
of the distribution channel is estimated. Estimated product returns reserves are adjusted based on
these reviews. Reserves may also be adjusted to reflect any significant changes in trends or based
upon new information that the Company believes may affect the reserve needs. Allowances for new
product introductions are estimated based on the Companys experiences for similar products that
the Company currently 120




---



##### 



markets and are adjusted as deemed necessary based on the Companys experience with each product.
The Companys reserve analysis also includes a review for the potential introduction of generic
competition and the resulting impact on pricing and returns reserves. Existing reserves may be
adjusted accordingly to reflect the Companys estimate for any impact these factors may have.
aaiPharma continually monitors its assumptions with respect to the Companys revenue reserves for
product sales and modifies them if necessary. Product Development The majority of the product development segments revenues consist of licensing, milestone and
royalty payments from the Companys proprietary technology. The provisions for licensing, milestone
and royalty payments included in contracts are related to the occurrence of specific identifiable
events. Each of the licensing agreements is reviewed to determine the appropriate revenue
recognition treatment under SAB 101 and EITF 00-21 Revenue Arrangements with Multiple Deliverable
Arrangements. The Company recognizes revenues from licensing fees over the estimated life of the
agreement to which the licensing fees relate or when the commitment to perform services under the
agreement has been fulfilled. Milestone payments are recognized as revenue when the milestone has
been achieved, the performance obligation has been met and collection of the milestone-related
revenue to be recognized is probable. The Company recognizes recurring royalties revenue in the
period in which the related product sales occur or, in the case of the development agreement
discussed below, in the period the matching contractual obligation is performed. The Company has a development agreement with a customer that provides for it to receive contingent
periodic royalties based on sales of the customers product and obligates the customer to use the
Company on a fee for service basis for a product life cycle management project related to the
product. The customer is a major pharmaceutical company with net assets in excess of $2.0 billion.
The development agreement relates to a product with respect to which the Company has licensed
intellectual property that it developed in the past. The Company has recognized product
development revenues under this agreement for the periodic payments based on its customers sales
of the product and recognized development services revenue related to the product life cycle
management project. In April 2004, the Company entered into an agreement to receive a prepayment
of amounts that would otherwise be paid to the Company quarterly through the second quarter of
2005. These payments would have aggregated $15.4 million. The Companys agreement to receive a
prepayment of these amounts applied a 5% per annum discount from the date the payment would
otherwise be due to the date paid. In April 2004, the Company received approximately $15.0 million
in gross proceeds from prepayments made pursuant to this agreement. Product development net revenues from the development agreement were $17.7 million in 2004, $13.0
million in 2003 and $16.9 million in 2002. The Company recognized no research and development
expense in 2004, 2003 and 2002 associated with the related revenues it recorded in those years. The
expense of its work associated with these revenues was recognized primarily in 1997 through 1999.
The Company does not anticipate that it will receive any additional payments in connection with the
development agreement. The Companys contractual obligations under the development agreement with
respect to the prepaid amounts continue through the second quarter of 2005. The development
agreement also required the customer to 121




---



##### 



use a minimum amount of the Companys development services at standard rates on the product life
cycle management project in specified calendar quarters. In 2004, 2003 and 2002, the customer
acquired services from the Company at the minimum contractual levels. Development services
revenues associated with this agreement were $0.7 million in 2004, $2.7 million in 2003 and $4.7
million in 2002. The Company has recorded its costs incurred in this project as research and
development expenses in the consolidated statements of operations of zero in 2004, $1.0 million in
2003 and $0.7 million in 2002. Accordingly, for its development services business unit, the Company
has recognized no expense associated with the development services revenue arising under this
agreement, as this expense was recognized by its product development business unit. The customer
is not obligated to continue the project after December 2004. Development Services The Company recognizes the majority of its development services revenues from fee-for-service
contracts on a proportional performance basis as the work is performed. To measure performance,
the Company compares actual direct costs incurred to estimated total contract direct costs, which
is the best indicator of performance of the contract obligations as the costs directly relate to
the labor hours incurred to perform the service. This ratio is multiplied by the estimated
contract value to determine the revenue to be recognized. The proportional performance method
requires an estimate of total expected revenue and at no time under this method are costs deferred.
These estimates are reviewed periodically and, if these estimates change or actual results differ
from expected results, an adjustment is recorded in the period in which they become reasonably
estimable. These adjustments could have a material effect on the Companys results of operations.
Historically, there have not been significant variations between contract estimates and actual
costs incurred. Changes in the scope of work generally result in an amendment to contract pricing
terms. Amended contract amounts are not included in net revenues until signed change orders are
executed, revenue is earned and realization is assured. The Company also recognizes revenue on a
time and materials basis in accordance with the specific contract terms. Revenues recognized prior
to contract billing terms are recorded as work in progress. The majority of the Companys arrangements with customers are not multiple-element arrangements.
However, due to the proprietary nature of product formulations, the Company has entered into a
limited number of multiple-element arrangements related to product development activity. During
2003, the Company adopted EITF 00-21 and has applied its criteria to such arrangements in
determining the separability of elements and timing of revenue recognition under SAB 101. Provisions for losses on contracts, if any, are recognized when identified. Clients generally may
terminate services at any time. However, the majority of contracts contain provisions that require
payment for all services rendered to date, even those services that had not yet been billed. In
the specific cases where these termination provisions are not specifically defined in the contract,
the Company ensures that the future billing milestones are achievable and within the Companys
control prior to recognition of revenue under such arrangements 122




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Income Taxes Income taxes have been accounted for using the liability method in accordance with Financial
Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 109 Accounting
for Income Taxes. This approach requires the recognition of deferred tax assets and liabilities
for the expected future tax consequences of differences between the tax basis of assets or
liabilities and their carrying amounts in the consolidated financial statements. A valuation
allowance is provided for deferred tax assets if it is more likely than not that these items will
either expire before the Company is able to realize their benefit or if future deductibility is
uncertain. Developing the provision for income taxes requires significant judgment and expertise
in federal and state income tax laws, regulations and strategies, including the determination of
deferred tax assets and liabilities and, if necessary, any valuation allowances that may be
required for deferred tax assets. The Companys judgments and tax strategies are subject to audit
by various taxing authorities. While the Company believes that it has provided adequately for its
income tax liabilities in its consolidated financial statements, adverse determinations by these
taxing authorities could have a material adverse effect on the Companys consolidated financial
condition and results of operations. Research and Development Costs The Company engages in numerous research and development (R&D) projects with the objective of
growth and utilization of its portfolio of proprietary technologies and patent and intellectual
property rights to bring products to market or to license or sell these technologies to others. R&D
expenses represent direct salaries of R&D personnel, raw material expenses, third party consulting
and testing costs, along with an allocation of indirect costs such as management and administrative
overhead costs and facilities costs. R&D costs are charged to expense as incurred. Advertising The Company expenses advertising costs as incurred, and these costs are included in selling
expenses. Advertising costs were $3.5 million, $8.0 million and $4.5 million for the years ended
December 31, 2004, 2003 and 2002, respectively. (Loss) Earnings per Share Basic (loss) earnings per share are based on the weighted average number of common shares
outstanding during the year. Diluted (loss) earnings per share is computed assuming that the
actual weighted average number of common shares outstanding was increased by the exercise of stock
options issued to employees and members of the Companys Board of Directors under the treasury
stock method. The diluted per share amounts reflect a change in the number of shares outstanding
(the denominator) to include the options as if they were exercised and converted to shares and
issued, unless their inclusion would be anti-dilutive. In 2004, 2003 and 2002, 4.7 million, 1.9
million and 2.3 million options were excluded as they were anti-dilutive. In each year presented,
the net (loss) income (the numerator) is the same for both basic and diluted per share
computations. 123




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The following table provides a reconciliation of the denominators for the basic and diluted (loss)
earnings per share computations: Years Ended December 31,2004
    
    
    2003
    
    
    2002(In thousands)Basic (loss) earnings per share:Weighted average number of shares
    
    
    28,565
    
    
    
    27,730
    
    
    
    27,348Effect of dilutive securities:Stock options
    
    
    
    
    
    
    
    
    
    
    1,011Diluted (loss) earnings per share:Adjusted weighted average number
of shares and assumed
conversions
    
    
    28,565
    
    
    
    27,730
    
    
    
    28,359
 Concentration of Credit Risk The Company is subject to a concentration of credit risk with respect to its accounts receivable
balance, all of which is due from wholesalers, distributors and large and small pharmaceutical and
biotechnology companies. At December 31, 2004, no customer represented more than 10% of the net
accounts receivable balance. At December 31, 2003, approximately 29% of the accounts receivable
balance represented amounts due from one customer. The Company performs ongoing credit evaluations
of its customers and maintains reserves for potential uncollectible accounts. Actual losses from
uncollectible accounts have been minimal. In 2004, one customer accounted for approximately 13% of the Companys consolidated net revenues.
In 2003, three customers accounted for approximately 17%, 15% and 12%, respectively, of the
Companys consolidated net revenues. In 2002, three customers accounted for approximately 19%, 18%
and 12%, respectively, of the Companys consolidated net revenues. Cash and Cash Equivalents The Company considers all highly liquid investments purchased with a maturity of three months or
less to be cash equivalents. Work in Progress Work in progress represents development services revenues recognized prior to contract billing
terms. Inventories Inventories are stated at
the lower of cost (determined on a first-in, first-out basis) or market.
Provisions are made to reduce inventories to their net realizable
value, based on, among other things, the amount of inventory on hand
and estimated to be in the distribution channel, the estimated time
required to sell such inventory, the remaining shelf life and market
conditions. 124




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Property and Equipment Property and equipment is recorded at cost. Depreciation is recognized using the straight line
method over the estimated useful lives of the assets. Depreciable lives are 31.5 years for
buildings and improvements and 3 to 15 years for equipment. Leasehold improvements are amortized
over the lesser of the asset life or the lease term. Goodwill and Other Intangibles, Net In accordance with the Statement of Financial Accounting Standards No. 141, Business Combinations
(SFAS 141), for purchase business combinations consummated subsequent to June 30, 2001, goodwill
and indefinite-lived intangible assets are not amortized, but are evaluated for impairment on an
annual basis or as impairment indicators are identified. At December 31, 2004 and 2003, the
amounts for accumulated amortization of goodwill were approximately $4.4 million and $4.0 million,
respectively. The change in accumulated goodwill amortization from December 31, 2003 to December
31, 2004 is due to foreign currency exchange rate changes. Other identifiable intangible assets
are amortized, if applicable (see Note 2), on a straight line basis over their estimated useful
lives, which range from 3 to 20 years. At December 31, 2004 and 2003, the amounts of accumulated
amortization of identifiable intangibles were approximately $6.7 million and $20.2 million,
respectively. The change in accumulated intangible amortization from December 31, 2003 to December
31, 2004 is due to amortization expense in 2004, reduced by the impairment charges for Brethine and
Darvon/Darvocet and the divestiture of the M.V.I. and Aquasol product lines. The changes in the carrying value of goodwill which is entirely in the Development Services
operating segment for the year ended December 31, 2004 are as follows: Balance at
    
    
    
    
    
    
    Foreign Currency
    
    
    Balance at DecemberJanuary 1, 2004
    
    
    Additions
    
    
    Translation
    
    
    31, 2004(in thousands)Development services
    
    $
    13,361
    
    
    $
    
    
    
    $
    989
    
    
    $
    14,350
 The changes in identifiable intangible assets for the years ended December 31, 2004 and 2003 are as
follows: Balance at
    
    
    
    
    
    
    
    
    
    
    Asset
    
    
    Balance at DecemberJanuary 1, 2004
    
    
    Additions
    
    
    Amortization Expense
    
    
    Write-down/ Sale
    
    
    31, 2004
    
    
    Amortizable Life(in thousands)Indefinite-lived
intangibles
    
    $
    51,017
    
    
    $
    
    
    
    $
    
    
    
    $
    (51,017
    )
    
    $
    
    
    
    IndefiniteTrademarks,
technology and
license agreements
    
    
    300,298
    
    
    
    435
    
    
    
    (16,316
    )
    
    
    (94,318
    )
    
    
    190,099
    
    
    3  20 years$
    351,315
    
    
    $
    435
    
    
    $
    (16,316
    )
    
    $
    (145,335
    )
    
    $
    190,099
 125




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Balance at
    
    
    
    
    
    
    
    
    
    
    Asset
    
    
    Balance at DecemberJanuary 1, 2003
    
    
    Additions
    
    
    Amortization Expense
    
    
    Write-downs
    
    
    31, 2003
    
    
    Amortizable Life(in thousands)Indefinite-lived
intangibles
    
    $
    51,017
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    51,017
    
    
    IndefiniteTrademarks,
technology and
license agreements
    
    
    230,652
    
    
    
    103,670
    
    
    
    (12,620
    )
    
    
    (21,404
    )
    
    
    300,298
    
    
    3  20 years$
    281,669
    
    
    $
    103,670
    
    
    $
    (12,620
    )
    
    $
    (21,404
    )
    
    $
    351,315
 The total intangible asset amortization expense for the year ended December 31, 2004 was $16.3
million, of which $15.8 million is pharmaceutical product related and is included in direct costs
and $0.5 million is included in depreciation and amortization expenses. Amortization expense for
the next five years is estimated to be approximately $10.5 million per year. In March 2002, the Company acquired the Darvon and Darvocet branded product lines, as further
discussed in Note 2. In December 2004, the Company performed an analysis of the carrying value of
the intangible assets associated with these products, based on discounted cash flows using updated
assumptions, and determined they were impaired. The Company recorded an impairment charge of $87.1
million in 2004. In December 2001, the Company acquired the Brethine product line, as further discussed in Note 2.
In early 2004, generic versions of this product were approved by the FDA. In 2003 and 2004, the
Company performed analyses of the carrying value of the intangible
assets associated with these
products, based on discounted cash flows using its updated assumptions, and determined that they
were impaired. The Company recorded impairment charges of $15.9 million in 2003 and $6.4 million
in 2004. In July 2003, the Company acquired the rights to a product marketed under the Darvocet A500 brand
name. The Company valued these rights at $4.7 million in its financial statements for the third
quarter of 2003, and recorded such value as an intangible asset to be amortized over its estimated
useful life. As a result of a delay in market acceptance of the Darvocet A500 product and other
changes in market condition for these products, the Company evaluated the intangible asset carrying
value at December 31, 2003. Based on a discounted cash flows analysis of this intangible as of
December 31, 2003, the Company determined that the value was fully impaired and wrote off the
unamortized balance of $4.7 million as intangible asset impairment on the consolidated statements
of operations. 126




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On a periodic basis, or as otherwise required, the Company assesses the value of its goodwill,
intangibles and other long-lived assets by determining their ability to recover the unamortized
balances over the remaining useful lives. Goodwill, intangibles and other long-lived assets
determined to be unrecoverable are written off in the period in which such determination is made.
The Company tests goodwill for impairment as of October 1st of each fiscal year, or more frequently
should circumstances change or events occur that would represent an impairment indicator and it is
believed that such an indicator may reduce the fair value of a reporting unit below its carrying
amount. Foreign Currency Translation The financial statements of foreign subsidiaries have been translated into U.S. dollars in
accordance with Statement of Financial Accounting Standards No. 52, Foreign Currency Translation.
All balance sheet accounts have been translated using the exchange rates in effect at the balance
sheet dates. Income statement amounts have been translated using the average exchange rates for the
respective years. The gains and losses resulting from the changes in exchange rates from year to
year have been reported in accumulated other comprehensive income (loss) included in the
consolidated statements of stockholders equity (deficit). Derivative Financial Instruments aaiPharma used an interest rate hedging agreement to modify its fixed rate obligation under the
Companys senior subordinated notes to a variable rate obligation, thereby adjusting the interest
rate to the current market rate and ensuring that the hedged notional amount of the debt instrument
is always reflected at fair value. The Company follows Statement of Financial Accounting Standards
No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended (SFAS 133),
to account for its interest rate swap using hedge accounting treatment. As of December 31, 2003,
the Company had outstanding one interest rate hedging agreement to convert a portion of fixed rate
debt to a floating rate basis, thus hedging for changes in the fair value of the fixed rate debt
being hedged. The Company had determined that this interest rate hedging agreement, designated as
a fair value hedge, qualified for treatment under the short-cut method of measuring effectiveness.
Under the provisions of SFAS 133, this hedge was determined to be perfectly effective, and there
was no requirement to periodically evaluate effectiveness. This interest rate hedging agreement
was terminated in April 2004 for a cash payment by the Company of $9.4 million. At December 31,
2004, no interest rate hedging agreements were outstanding. The amounts received, less the
termination payment and the interest benefits earned through the dates of sale, have been recorded
as premiums to the carrying amount of the notes and are being amortized into interest income over
the remaining life. Impact of Recently Issued Accounting Standards In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting

Standards No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R)), which amends Statement of
Financial Accounting Standards No. 123 Accounting for Stock Based Compensation (SFAS 123), and
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123(R) requires
compensation expense to be recognized for all share-based payments made to employees based on the
fair value of the award at the date of 127




---



##### 



grant, eliminating the intrinsic value alternative allowed by SFAS 123. SFAS 123(R) requires all
share-based payments to employees, including grants of employee stock options, to be recognized in
the financial statements based on their fair values (i.e., pro forma disclosure is no longer an
alternative to financial statement recognition). SFAS 123(R) must be adopted in the first annual
period beginning after June 15, 2005. The Company currently plans to adopt SFAS 123(R) on January 1, 2006. This change in accounting is
not expected to materially impact the Companys financial position. However, because the Company
currently accounts for share-based payments to its employees under APB No. 25, the results of
operations have not included the recognition of compensation expense for the issuance of stock
option awards. Had the Company applied the fair-value criteria established by SFAS 123(R) to
previous stock option grants, the impact to its results of operations would have approximated the
impact of applying SFAS 123, which was a reduction to net income of approximately $6.0 million in
2004, $9.7 million in 2003 and $6.5 million in 2002. The impact of applying SFAS 123 to previous
stock option grants is further summarized below. No other recently issued, but not yet effective, accounting standards are believed to have a
material impact on the Company. Employee Stock Based Compensation The Company follows Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees (APB 25)and related Interpretations in accounting for its employee stock options as
permitted by SFAS 123 and makes the pro forma disclosures required by SFAS 123, as amended by SFAS
148, Accounting for Stock-Based Compensation-Transition and Disclosure. The fair value for stock options was estimated at the date of grant using a Black Scholes pricing
model with the following weighted average assumptions: Years Ended December 31,2004
    
    
    2003
    
    
    2002Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %Risk free interest rate
    
    
    3.4
    %
    
    
    3.0
    %
    
    
    3.8
    %Expected volatility
    
    
    116.0
    %
    
    
    116.0
    %
    
    
    113.0
    %Expected life (in years from vesting)
    
    
    5
    
    
    
    5
    
    
    
    5
 For purposes of pro forma disclosures, the estimated fair value of the stock options is amortized
to expense on a straight-line basis over the vesting period. The grant date Black Scholes weighted
average fair value of options issued at market price was $3.42, $13.19 and $11.49 per share for
2004, 2003 and 2002, respectively, and the weighted average fair value of options issued in excess
of market price was $9.94 per share in 2002. No options were issued in excess of market price in
2004 or 2003. The Company applies APB 25 and related Interpretations in accounting for its stock option plans and
restricted stock awards; therefore, compensation expense has not been recognized for 128




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##### 



options granted at fair value. If compensation cost for the Companys stock option plans and
restricted stock awards had been determined based on the fair value at the grant dates for awards
under those plans consistent with the fair value method of SFAS 123, the Companys net (loss)
income and earnings (loss) per share would have been changed to the pro forma amounts indicated
below. Pro forma compensation expense under SFAS 123 is based on the single award method recorded
on a straight-line basis. Years Ended December 31,2004
    
    
    2003
    
    
    2002(In thousands, except per share data)Net (loss) income, as reported
    
    $
    (191,171
    )
    
    $
    (32,703
    )
    
    $
    13,118Add back deferred compensation expense, net of tax
    
    
    135
    
    
    
    104
    
    
    
    Less pro forma stock-based compensation cost, net
of tax
    
    
    6,121
    
    
    
    9,764
    
    
    
    6,520Pro forma net (loss) income
    
    
    (197,157
    )
    
    
    (42,363
    )
    
    
    6,598(Loss) earnings per share:As reported -Basic
    
    ($
    6.69
    )
    
    ($
    1.18
    )
    
    $
    0.48Diluted
    
    ($
    6.69
    )
    
    ($
    1.18
    )
    
    $
    0.46Pro forma -Basic
    
    ($
    6.90
    )
    
    ($
    1.53
    )
    
    $
    0.24Diluted
    
    ($
    6.90
    )
    
    ($
    1.53
    )
    
    $
    0.23
 Fair Value of Financial Instruments The carrying values of cash and cash equivalents, accounts receivable, work in progress and current
liabilities approximate fair values as of December 31, 2004 and 2003. Based on borrowing rates
currently available to the Company, the carrying value of the variable rate debt approximated fair
value. The fair market value of the Companys fixed rate debt is based on market quotations. At
December 31, 2004 and 2003, the fair market value of the Companys fixed rate debt was
approximately the carrying value. Use of Estimates The preparation of consolidated financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates and assumptions that
affect the amounts reported in the consolidated financial statements and accompanying notes. The
most significant estimates relate to revenue reserves and sales allowances, including reserves for
chargebacks, product returns, rebates and related allowances, an allowance for doubtful accounts,
inventory reserves and useful lives for intangible assets. Actual results could differ from such
estimates and changes in such estimates may have a material affect on amounts reported in future
periods. 2. Asset Acquisitions/Dispositions On December 2, 2003, the Company acquired a line of pain management products, which treat moderate
to severe pain (the New Pain Products), and existing inventory from subsidiaries of Elan
Corporation, plc in an asset purchase. The product lines acquired are marketed under the 129




---



##### 



Roxicodone, Oramorph SR, Roxanol and Duraclon brand names. The Company acquired these product
lines and related intangible assets for $102.5 million, exclusive of transactional costs. To
finance this acquisition, which included $5.1 million of inventory, the Company used the proceeds
from its then-existing senior term loan credit facility (which was refinanced by the Companys
existing senior credit facilities described in Note 6). Revenues from the sales of these products
are included in the Companys results of operations beginning on the acquisition date. The New
Pain Products did not have separable assets and liabilities associated with them, other than
inventory. Therefore the Company allocated the purchase price, including acquisition related
expenses, to acquired identifiable tangible and intangible assets. Based on this allocation, $98
million of intangible assets have been identified and will be amortized over 20 years. The following unaudited pro forma consolidated financial information reflects the results of
operations for the years ended December 31, 2003 and 2002 as if the acquisition of the New Pain
Products had occurred at the beginning of the periods presented. Years Ended December 31,2003
    
    
    2002(In thousands, exceptper share data)Net revenues
    
    $
    294,895
    
    
    $
    295,592Direct costs
    
    
    120,498
    
    
    
    98,152
 These pro forma results have been prepared for comparative purposes only and do not purport to be
indicative of what operating results would have been had the acquisition taken place at the
beginning of the period presented. In addition, these results are not intended to be a projection
of future results. On August 5, 2003, aaiPharma and CIMA LABS INC., (CIMA) entered into a merger agreement. The
completion of the merger was subject to several conditions, including the approval of the merger by
the stockholders of CIMA and aaiPharma and the expiration or termination of the applicable waiting
period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, and contained customary
termination rights by each party in the event of higher unsolicited offers by a third party.
During the fourth quarter of 2003, the Company announced the termination of the merger agreement by
CIMA in light of a competing offer for CIMA by a third party. As a result, the Company received an
$11.5 million termination fee from CIMA, as provided in the terminated merger agreement, against
which $5.9 million of merger-related fees and expenses were applied. The net amount of $5.6
million is included in other income on the 2003 consolidated statements of operations. As
described in Note 11, CIMA has sued the Company and seeks to recover the $11.5 million termination
fee, plus other fees and expenses exceeding $5 million. On March 28, 2002, the Company acquired the U.S. rights to the Darvon and Darvocet branded product
lines, which treat mild-to-moderate pain, and existing inventory from Eli Lilly and Company, in an
asset purchase. The Company acquired these product lines and related intangible assets for $211.4
million, exclusive of transactional costs. To finance this acquisition, which included $1.8
million of inventory, the Company used the proceeds from the then existing senior secured credit
facilities (which were refinanced in April 2004 by the Companys existing 130




---



##### 



senior credit facilities described in Note 6) and its senior subordinated notes as described in
Note 6. Revenues from the sales of these products are included in the Companys results of
operations beginning on the acquisition date. The Darvon and Darvocet product lines did not have
separable assets and liabilities associated with them, other than inventory, therefore the Company
allocated the purchase price, including acquisition related expenses, to acquired identifiable
tangible and intangible assets. The identified intangible assets are amortized over 20 years. In December 2001, the Company acquired from Novartis Pharmaceutical Corporation and Novartis
Corporation a line of asthma products used in the prevention and reversal of bronchospasm in
patients age 12 and older with asthma and reversible bronchospasm associated with bronchitis and
emphysema, in an asset purchase. The product line acquired is marketed under the Brethine brand
name. The Company acquired this product line and related intangible assets for $26.6 million,
exclusive of transactional costs. To finance this acquisition, the Company used the proceeds from a
$25 million term loan (which was refinanced in March 2002 by a senior secured credit facility,
which was again refinanced in April 2004 by the Companys existing senior credit facilities
described in Note 6), and used working capital to pay the remainder of the purchase price. Revenues
from the sales of these products are included in the Companys results of operations beginning on
the acquisition date. The Brethine product line did not have separable assets and liabilities
associated with it, therefore the Company allocated the purchase price, including acquisition
related expenses, to acquired identifiable intangible assets, which are being amortized over 20
years. In August 2001, the Company completed the acquisition of a line of critical care injectable and
oral nutrition products from AstraZeneca AB, an affiliate of AstraZeneca PLC, in an asset purchase.
The product lines acquired are marketed under the M.V.I. and Aquasol brand names. The Company
acquired these product lines and related intangible assets for $52.5 million, exclusive of
transactional costs, paid at closing, plus additional consideration described below. To finance
the initial payment for this acquisition, which included $3.7 million for inventory, the Company
used the proceeds from a term loan, which has since been refinanced. The product line acquisition
agreement was amended in July 2003. As amended, it provided for two $1.0 million guaranteed
payments, which were made in August 2002 and 2003, eliminated a contingent payment of $2.0 million
that was potentially due in August 2003 under the original agreement, and provided for a future
contingent payment of $43.5 million potentially due in August 2004, depending on the status of
certain reformulation activities being carried out by the seller and regulatory approval of the
reformulations by the U.S. Food and Drug Administration (FDA). The amount of the $43.5 million
contingent payment was to be reduced by $1 million per month if the conditions for the contingent
payment had not occurred by December 31, 2002. The amount of the contingent payment had decreased
by $12.0 million by December 31, 2003. Such conditions were satisfied in January and February
2004, fixing the previously contingent liability under the amendment at $31.5 million. As a result
of the July 2003 amendment to the original purchase agreement, the Company was precluded from
recognizing this obligation as additional purchase price for the M.V.I. and Aquasol product line.
As of December 31, 2003, this contingent obligation had not been recorded as a liability on the
Companys consolidated balance sheet and was recorded as a liability and as an expense in the first
quarter of 2004. Also in July 2003, the M.V.I. supply agreement with the seller was extended
through 2008, subject to early termination rights by the Company on six months notice given at any
time, and by the supplier on twenty-four months notice given at any time on or after August 17,
2004. Revenues from the 131




---



##### 



sales of these products are included in the Companys results of operations beginning on the
acquisition date. The M.V.I. and Aquasol product lines did not have separable assets and
liabilities associated with them, other than inventory; therefore the Company allocated the
purchase price, including acquisition related expenses, to acquired identifiable tangible and
intangible assets. In connection with the M.V.I. and Aquasol acquisition, the Company recorded intangible assets which
meet the criteria for having an indefinite life. In accordance with Statement of Financial
Accounting Standards No. 142 Goodwill and Other Intangible Assets, these intangible assets were
not being amortized but were evaluated for impairment on at least an annual basis. The intangible
assets recorded in connection with this acquisition represent the trademarks, technology and know
how associated with the product lines. On April 26, 2004, the Company sold the M.V.I. and Aquasol product lines to Mayne Pharma (USA)
Inc., for $105 million subject to certain adjustments based on inventory levels at closing and
other post-closing obligations. A portion of the closing payment was held in escrow to satisfy the
Companys post-closing obligations under the agreement. The Company received approximately $1.6
million from this escrow in 2004 and does not anticipate receiving any additional payments out of
this escrow. At the closing of the transaction, aaiPharma paid to AstraZeneca AB the $31.5 million
payment due in August 2004, which was discounted to approximately $31.0 million. Mayne Pharma (USA)
Inc. is obligated to pay the Company royalties on sales levels of the new M.V.I. product
formulation above specified thresholds as part of this agreement. During July 2001, the Company made an initial payment of $0.9 million to acquire the assets of a
sterile manufacturing facility located in Charleston, South Carolina. In 2002, a $0.2 million
payment was made based on the level of manufacturing revenues at this facility. No payment was
made in 2003. Additional contingent payments of up to $4.7 million plus additional royalties may
become due in increments through June 30, 2006 based on the level of manufacturing revenues during
this period. These contingent payment obligations have not yet been recorded as a liability on the
Companys consolidated balance sheets. Set forth in the table below are the details of the purchase price allocations for each of the
Companys major product line acquisitions since the beginning of 2001. The table lists the assets
acquired, the value allocated to each asset, how the value was determined, and the estimated useful
life assigned to each asset. In these acquisitions, the only tangible assets acquired were
inventory and marketing/promotional materials, which were valued based on internal analyses and
data provided by the sellers. Inventory obtained at time of acquisition was valued at the
estimated selling price less the cost of disposal and a reasonable selling profit.
Marketing/promotional materials received were generally outdated and in limited quantities;
therefore no material value was assigned in the purchase price allocations. The Company engaged
third-party valuation consultants to assist the Company with its purchase price allocations,
including identification of intangible assets, recommendations of fair value of intangible assets,
and determination of expected lives of those assets. Intangible assets that arose from contractual
or legal rights and other intangible assets that were separable, as discussed in SFAS 141, were
identified. Among the assets that were considered for recognition were trademarks, Internet domain
names, non-competition agreements, customer lists, backlogs, 132




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customer contracts and non-contractual relationships, licensing and royalty agreements, supply
contracts, employment contracts, patented and unpatented technology, and trade secrets. The third-party valuation consultants reviewed pertinent facts and recommended for each asset the
appropriate generally accepted valuation approach and methodology from among the cost, market, and
income approaches. Where possible, a valuation derived using an alternative valuation approach or
methodology was presented and used by management to evaluate the reasonableness of the recommended
fair value. The Company recorded an $87.1 million charge in December 2004 due to the impairment of intangible
assets associated with its Darvon/Darvocet products. This charge
resulted from the impact on the Companys impairment analysis of
its experience
in the process it undertook to sell the Darvon/Darvocet products. The impairment was identified in the course
of the Companys fourth quarter review of the fair value of our
intangible assets. In 2003 and 2004, the Company recorded charges of
$15.9 million and $6.4 million, respectively, due to the impairment of an intangible asset
associated with its Brethine product line. The introduction of generic competition affected future
anticipated revenues of the Brethine products, which negatively impacted the carrying value of the
acquired intangible assets. These impairment charges are not reflected in the following table. AcquisitionIdentifiable Assets
    
    Value (millions)
    
    
    How Valued
    
    Useful LifeM.V.I. and Aquasol:Total purchase price, including
transaction fees
    
    $
    54.7Allocation of purchase price:Inventory
    
    $
    3.7
    
    
    Estimated Selling Price Less Cost of Disposal and a Reasonable Selling  Profit
    
    
    N/ATrademarks
    
    
    27.3
    
    
    Income Approach Discounted Cash Flow Method
    
    IndefiniteDeveloped Technology
    
    
    23.7
    
    
    Income Approach Discounted Cash Flow Method
    
    IndefiniteTotal
    
    $
    54.7The M.V.I. and Aquasol product lines were divested in April 2004.Brethine:Total
purchase price, including transaction fees
    
    $
    26.6Allocation of purchase price:Trademarks-Existing
    
    $
    11.3
    
    
    Income Approach Discounted Cash Flow Method
    
    20 years
 133




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##### 



AcquisitionIdentifiable Assets
    
    Value (millions)
    
    
    How Valued
    
    Useful LifeTrademarks-Reformulated
    
    
    9.4
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsDeveloped Technology
    
    
    5.9
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsTotal
    
    $
    26.6Darvon/Darvocet:Total purchase price, including transaction fees
    
    $
    212.6Allocation of purchase price:Inventory
    
    $
    1.7
    
    
    Estimated Selling Price Less Cost of Disposal and a Reasonable Selling Profit
    
    
    N/ATrademarks-Existing
    
    
    80.3
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsTrademarks-Reformulated
    
    
    50.3
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsDeveloped Technology
    
    
    80.3
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsTotal
    
    $
    212.6Elan Pain Portfolio:Total purchase price, including transaction fees
    
    $
    103.4Allocation of purchase price:Inventory
    
    $
    5.1
    
    
    Estimated Selling Price Less Cost of Disposal and a Reasonable Selling Profit
    
    
    N/ATrademarks
    
    
    49.1
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsDeveloped Technology
    
    
    49.2
    
    
    Income Approach Discounted Cash Flow Method
    
    20 yearsTotal
    
    $
    103.4
 134




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##### 



3.
    Accounts Receivable, Net The following table presents the components of accounts receivable: December 31,2004
    
    
    2003(In thousands)Gross accounts receivable
    
    $
    39,885
    
    
    $
    85,726Allowance for uncollectible accounts
    
    
    (2,564
    )
    
    
    (1,130
    )Allowance for customer credits
    
    
    (24,565
    )
    
    
    (51,982
    )Total accounts receivable, net
    
    $
    12,756
    
    
    $
    32,614
  4.
    Inventories, Net The following table presents the components of inventories: December 31,2004
    
    
    2003(In thousands)Finished goods
    
    $
    11,492
    
    
    $
    18,579Work-in-process
    
    
    920
    
    
    
    1,865Raw materials and supplies
    
    
    5,747
    
    
    
    5,007Inventory reserves
    
    
    (7,437
    )
    
    
    (10,758
    )Total inventories, net
    
    $
    10,722
    
    
    $
    14,693
  5.
    Property and Equipment, Net The following table presents the components of property and equipment: December 31,2004
    
    
    2003(In thousands)Land
    
    $
    2,786
    
    
    $
    2,784Buildings and improvements
    
    
    32,267
    
    
    
    31,446Machinery and equipment
    
    
    74,388
    
    
    
    69,593Construction-in-progress
    
    
    4,798
    
    
    
    8,154Total cost of property and equipment
    
    
    114,239
    
    
    
    111,977Less, accumulated depreciation
    
    
    (61,297
    )
    
    
    (54,741
    )Property and equipment, net
    
    $
    52,942
    
    
    $
    57,236
 Depreciation expense was approximately $8.7 million, $8.0 million and $7.2 million for the years
ended December 31, 2004, 2003 and 2002, respectively. 135




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##### 



6.
    Debt and Credit Line The following table presents the components of current maturities of long term debt: December 31,2004
    
    
    2003(In thousands)Current maturities of long-term debt
    
    $
    351,645
    
    
    $
    4,000
 The following table presents the components of long-term debt: December 31,2004
    
    
    2003(In thousands)Term loan
    
    $
    165,000
    
    
    $
    156,000Revolving credit facility
    
    
    10,500
    
    
    
    8,00011% senior subordinated notes due 2010, net of
original issue discount
    
    
    174,249
    
    
    
    174,106Interest rate swap monetization deferred income, net
    
    
    1,896
    
    
    
    12,189Fair value of interest rate swap
    
    
    
    
    
    
    (7,451
    )Less current maturities of long-term debt
    
    
    (351,645
    )
    
    
    (4,000
    )Total long-term debt due after one year
    
    $
    
    
    
    $
    338,844
 In March 2002, the Company issued $175 million of senior subordinated notes due April 1, 2010. The
proceeds from the issuance of these notes were $173.9 million, which was net of the original issue
discount. This discount will be charged to interest expense over the term of the notes. These
notes initially had a fixed interest rate of 11% per annum and are guaranteed on a subordinated
basis by all existing domestic subsidiaries and all future domestic subsidiaries that are owned 80%
or more by the Company. When issued, the notes were not secured. Prior to the third anniversary
of the date of issuance of the notes, up to 35% of the notes are redeemable with the proceeds of
qualified sales of equity at 111% of par value. On or after the fourth anniversary of the date of
issuance of the notes, all or any portion of the notes are redeemable at declining premiums to par
value, beginning at 105.5%. Concurrently with the issuance of the senior subordinated notes, the Company entered into an
interest rate hedging agreement to effectively convert interest expense on a portion of the senior
subordinated notes for the term of the notes from an 11% fixed annual rate to a floating annual
rate equal to 6-month LIBOR plus a base rate. In 2003, the Company sold the then outstanding
interest rate hedging agreement and replaced it with a similar interest rate hedging agreement. In
April 2004, the Company paid $9.4 million to terminate the interest rate hedging agreement. The
amounts received, less the termination payment and the interest benefits earned through the dates
of sale, have been recorded as premiums to the carrying amount of the notes and are being amortized
into interest income over their remaining life. 136




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On March 31, 2004, the lenders under the Companys then-existing credit agreement, which was then
in default, exercised their right to block the Company from making the interest payment due on
April 1, 2004 to holders of the Companys senior subordinated notes. Accordingly, aaiPharma did
not make that interest payment on April 1, 2004. In addition, the Companys failure to timely file
its Annual Report on Form 10-K for the year ended December 31, 2003 constituted a default under the
indenture governing the senior subordinated notes. On April 20, 2004, aaiPharma completed a solicitation seeking the consent from holders of the
Companys current senior subordinated notes to approve a refinancing or replacement of the
Companys then-existing credit facilities with the Companys senior credit facilities (described
below) and certain amendments to, and waivers under, the indenture governing the senior
subordinated notes to, among other things:  
    grant a lien to secure the Companys obligations under the senior subordinated notes, which
lien is junior to the liens securing the Companys new senior credit facilities but covers the
same collateral;  
    increase the interest rate of the senior subordinated notes from 11% per annum to 11.5% per
annum effective April 1, 2004;  
    suspend the Companys obligation under the indenture to file periodic reports with the SEC
until the earlier of the date that the Companys 2003 Form 10-K was filed with the SEC or
September 30, 2004 and suspend the Companys obligation to furnish annual written statements
of the Companys accountants until the fifth day after the earlier of the date that the
Companys 2003 Form 10-K was filed with the SEC and September 30, 2004;  
    further limit the Companys ability to grant liens to secure certain obligations unless the
liens are subordinate to the liens securing the senior subordinated notes or are otherwise
permitted under the indenture; and  
    limit the Companys ability to incur up to $10 million of indebtedness, and to grant liens
to secure that amount of indebtedness, not otherwise specifically permitted by the indenture,
until the Companys 2003 Form 10-K was filed with the SEC or unless the indebtedness is
incurred to fund an interest payment with respect to the senior subordinated notes. Following the completion of the consent solicitation, aaiPharma entered into a supplemental
indenture to effect these amendments and waivers and made the interest payments that had been due
on April 1, 2004, together with default interest. On October 1, 2004, the Company failed to make the interest payment then due on its senior
subordinated notes. The failure to make the October 1, 2004 interest payment constituted a default
under the notes, subject to a 30-day cure period. On October 29, 2004, the Company made the
interest payment, curing the default under the notes. On October 29, 2004, the Company also completed a solicitation seeking the consent from the holders
of its senior subordinated notes to certain amendments to, and waivers under, the indenture
governing the senior subordinated notes to, among other things: 137




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
    permit the Company to incur up to $30 million of additional indebtedness under credit
facilities;  
    permit the Company to incur additional senior debt in order to maintain $40 million
(subject to an increase up to $50 million in order to allow the Company to make interest
payments on the senior subordinated notes) in senior debt under credit facilities in the event
the Company is required to pay down senior debt with the proceeds of asset sales;  
    require that debt permitted to be incurred under a fixed charge coverage ratio test set
forth in the Indenture must rank on parity with or be subordinated in right of payment to the
senior subordinated notes and any liens granted to secure any such parity debt shall rank pari
passu with the liens securing the senior subordinated notes;  
    require proceeds of asset sales to be used to reduce senior debt under credit facilities to
$40 million;  
    provide that the liens on assets that secure obligations under the senior subordinated
notes will continue if all senior debt is repaid, but will resume as junior liens if the
Company thereafter incurs any new senior debt;  
    prohibit the payment in cash in excess of an aggregate of $5 million to settle pending
litigation, excluding payments funded or reimbursed under insurance policies, until the
Company makes the interest payments due on the senior subordinated notes on April 1, 2005 and
October 1, 2005;  
    prohibit the payment of dividends on the Companys common stock and other restricted
payments (as defined in the Indenture) until the interest payments due on the senior
subordinated notes on April 1, 2005 and October 1, 2005 are paid; and  
    temporarily increase the interest rate on the senior subordinated notes by 0.5% per annum
(to 12% per annum), commencing to accrue on October 1, 2004 and ending on March 31, 2005. The completion of the consent solicitation satisfied a condition of an amendment to the Companys
senior credit facilities (described below) that, among other matters, made available a supplemental
term loan under the senior credit facilities. This supplemental term loan was used in part to make
the October 1, 2004 interest payment on the senior subordinated notes, together with default
interest thereon, on October 29, 2004 and to pay the consent fee described below. The interest
payment made on October 29, 2004 cured the existing default under the senior subordinated notes. In connection with the October 2004 consent solicitation, the Company paid a consent fee to the
holders of senior subordinated notes who had submitted valid and unrevoked consents by the
expiration date of the consent solicitation of $20 for each $1,000 in principal amount of senior
subordinated notes for which a consent was submitted. Following discussions with representatives
of an ad hoc committee of holders of the senior subordinated notes, the Company offered to pay the
same consent fee with respect to senior subordinated notes for which a valid and unrevoked consent
had not been properly submitted by the expiration of the consent solicitation, if the holder of
such senior subordinated notes completed a consent and release for payment by February 7, 2005 that
consented to the proposed amendments and waivers described above and waived all claims it may have
against the Company, the trustee under the indenture governing the senior subordinated notes,
Global Bondholder Services Corporation, and their 138




---



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respective directors, officers, employees, agents, attorneys, affiliates and advisors with respect
to matters related to the consent solicitation. In 2004, the Company paid approximately $4.2 million in consent fees in connection with the consent
solicitations discussed above. On February 9, 2005, the Company paid approximately $1.0 million in
additional consent fees. At December 31, 2004, the Company was not in default under the covenants under the senior
subordinated notes. However, the Company failed to pay the $10.5 million of scheduled interest due
on April 1, 2005 on the notes. An event of default will occur under the indenture governing the
notes if the interest payment is not made within 30 days after April 1. Such an event of default
would entitle the trustee under the indenture for the notes or the holders of 25% of the principal
amount of the notes to accelerate the notes. The Companys failure to timely file its 2004 Annual
Report on Form 10-K and provide certain required annual certificates for 2004 to the trustee under
the indenture for the notes also constituted defaults. Any event of default entitling the trustee
or the holders of the notes to accelerate the notes would also constitute an event of default under
our senior credit facilities entitling the Companys senior lenders to accelerate the debt
thereunder. On April 23, 2004, aaiPharma entered into $140 million of senior credit facilities with a syndicate
of lenders, Silver Point Finance LLC (Silver Point) as collateral agent, and Bank of America,
N.A., as administrative agent. These senior credit facilities consisted of a two-year, $125
million senior secured term loan facility (which was fully drawn at closing) and a two-year, $15
million senior secured revolving credit facility, of which the entire amount was available for
borrowing at closing. The outstanding loans under the Companys senior credit facilities were
payable in full on the two-year anniversary date of the closing of the facilities. The Companys
senior credit facilities are secured by a security interest on substantially all domestic assets,
all of the stock of domestic subsidiaries and 65% of the stock of material foreign subsidiaries.
As part of this transaction, the Company recorded a $6.2 million loss for the early extinguishment
of debt related to the write-off of financing fees related to its previous senior credit
facilities. Subject to exceptions set forth in the definitive documentation, loans under the
Companys senior credit facilities are also required to be prepaid with a negotiated percentage of:  
    excess cash flow, as defined;  
    non-ordinary course assets sales;  
    net proceeds from the sale of subordinated indebtedness;  
    net proceeds from equity issuances; and  
    extraordinary receipts, as defined. Optional reductions in revolving credit commitments and optional prepayments of term loans were
initially subject to a prepayment fee equal to 3% for the first nine months of the term of the
facilities, 1.5% for the subsequent nine months of such term, and 0.75% for the next three months
of such term (with no prepayment penalty payable for the last three months of the term).
Outstanding loans under the facilities bore interest at a rate per annum equal to a defined LIBOR
rate (with a floor of 2%), plus 6.25%, or a defined reference rate (with a floor of 4%), plus
5.25%, in each case payable monthly in arrears. An additional 1% per annum unused line fee is
payable on unused revolving credit commitments, payable quarterly in arrears. 139




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The proceeds of the loans were used, together with the net cash proceeds from the sale of the
M.V.I. and Aquasol product lines, to (i) fund payment of termination obligations with respect to
the Companys interest rate hedging agreement (discussed above), (ii) refinance the Companys
then-existing senior credit facilities, (iii) fund the April 2004 interest payment due on the
Companys senior subordinated notes due 2010, (iv) provide for ongoing working capital and general
corporate needs, and (v) pay for fees, costs and expenses in connection with the new senior credit
facilities and other corporate transactions. On August 9, 2004 and August 13, 2004, the Company entered into amendments to its senior secured
credit facility to, among other things, increase the amount of the term loans by up to $10 million,
extend the maturity date of the facilities by one year to April 21, 2007, increase the interest
rate on the loans by an additional 1.5% subject to potential incremental reduction based on the
Companys financial performance, adjust certain covenants under the facilities and waive certain
defaults and events of default. Under the amended credit facility, the Company borrowed an
additional $10 million in term loans on August 13, 2004. The amendment adjusted both the
percentages of proceeds of certain transactions that are required to be applied to prepay the loans
and the fees to be paid upon optional reductions of the credit facility. As amended, optional
reductions in revolving credit commitments and optional prepayments of term loans, as well as
mandatory reductions in revolving credit commitments and mandatory prepayments of term loans from
the net cash proceeds of asset sales, subject to defined exceptions, are subject to a prepayment
fee equal to 3.5% until August 9, 2005, 2.5% for the subsequent 12 months, and 1.5% for the next 6
months (with no prepayment penalty payable for the remainder of the term). Effective as of October 8, 2004, the Company amended its senior secured credit facility to, among
other things, adjust financial covenants. The senior secured lenders also waived compliance with
certain financial covenants in the senior secured credit facility for the quarters ended September
30, 2004 and December 31, 2004 provided that the Company met minimum consolidated EBITDA thresholds
(as defined in the senior secured credit facility). The amendment also added a minimum gross
revenue requirement of $40 million for the quarter ended December 31, 2004 and consented to certain
asset disposition transactions and receipt of a deferred purchase price payment pursuant to which
the Company received approximately $4.2 million in the aggregate. These transactions related to
the sale of the Companys investment in Aesgen (see Note 10) and its sale of the M.V.I. and Aquasol
product lines (see Note 2), respectively. The amendment also waived any requirement to prepay the
senior secured loans with the net proceeds of these transactions. On October 22, 2004, the Company entered into another amendment to its senior secured credit
facility that increased the existing term loan facility under the senior secured credit facility by
$30 million, subject to certain specified conditions which were satisfied on October 29, 2004. The
Supplemental Term Loan was made available in up to three draws to be made on or prior to January
15, 2005, and the Company borrowed $20 million of such term loans on October 29, 2004. The
remaining $10 million of such term loans was borrowed in increments by the Company on November 5,
2004, November 12, 2004, November 24, 2004 and December 9, 2004. Following effectiveness of the
amendment and these borrowings, the senior secured credit facility consisted of a term loan of $165
million and a revolving credit facility of up to $15 million. 140




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The amendment also modified the interest rate on the entire senior secured credit facility,
including the Supplemental Term Loan, to equal a defined LIBOR rate (with a floor of 2%) plus 8.25%
per annum or a defined reference rate (with a floor of 4%) plus 7.25% per annum. The amendment
also provided for a commitment fee equal to 0.75% per annum on any undrawn portion of the
Supplemental Term Loan, payable monthly in arrears. The amendment retained the April 21, 2007 maturity date of the senior secured credit facility and
the optional and mandatory prepayment requirements and premiums described above. The proceeds of the loans under the Supplemental Term Loan were used (i) to fund payment of the
October 1, 2004 interest payment due on the Companys senior subordinated notes, (ii) to pay for
fees, costs and expenses in connection with the amendment and the October 2004 consent solicitation
for the Companys senior subordinated notes, and (iii) for working capital and other general
corporate purposes. The amendment retained substantially the same representations, warranties and affirmative and
negative covenants as are provided in the existing senior secured credit facility, including
limitations on liens, indebtedness, fundamental transactions, dispositions of assets, changes in
the nature of the Companys business, investments, acquisitions, capital and operating leases,
capital expenditures, dividends, redemptions or other acquisitions of capital stock, redemptions or
prepayments of other debt, transactions with affiliates, issuances of capital stock, modifications
of indebtedness, organizational documents and other agreements, and retention of excess cash. The
amendment also added a covenant requiring the Company to retain Rothschild Inc. or another
financial advisor to assist with its exploration of the potential sale of some or all of the assets
comprising the Companys Product Sales business (Pharmaceuticals Division). The amendment also maintained the existing financial covenants under the senior secured credit
facilities, including a minimum fixed charge coverage ratio and a maximum total debt to trailing
twelve-month EBITDA leverage ratio, but eliminated a minimum gross revenue covenant for the quarter
ended December 31, 2004. Compliance with the fixed charge coverage ratio and the leverage ratio
was also waived through the first quarter of 2005 so long as defined minimum EBITDA thresholds are
satisfied. In addition, the amendment retained a covenant requiring certain levels of cash or
revolver availability and increased the level of cash or revolver availability required for the
period from March 31, 2005 through May 15, 2005 to $15.0 million. The amendment added a covenant
requiring the Company to retain Rothschild Inc. or another financial advisor to assist with its
exploration of the potential sale of some or all of the assets of the Companys Pharmaceuticals
Division. The amendment also substantially retained the existing events of default under the senior secured
credit facility, including, among others, nonpayment of principal, interest or fees, violations of
covenants, inaccuracy of representations and warranties, a cross-default to the Companys senior
subordinated notes and other material indebtedness, bankruptcy events, and a change in control and
added an event of default if the Company fails to pursue in good faith the exploration of the
potential sale of some or all of the assets comprising its Pharmaceutical Division or other
non-core assets. 141




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##### 



No event of default existed under the Companys senior credit facilities at December 31, 2004.
However, since that date, events of default have occurred under the Companys senior credit
facilities that would prohibit borrowings thereunder absent a waiver from its senior lenders.
These events of default included the violation of the cash/revolver availability covenant described
above and the failure to timely file the Companys Form 10-K for the fiscal year ended December 31,
2004. On March 31, 2005, the Company entered into a waiver agreement pursuant to which its senior
lenders agreed to forbear in exercising remedies with respect to the defaults and events of default
existing on that date until the earlier of April 30, 2005 or the occurrence of another default
under the waiver agreement or the Companys senior credit facilities. Upon any such forbearance
termination, the Companys senior lenders could accelerate the debt then outstanding under the
Companys senior credit facilities unless all events of default have been cured prior to such
termination. The waiver agreement also permitted the Company to immediately use approximately $5.7 million of
its $11.3 million tax refund received in March 2005 to meet budgeted liquidity needs and required
the Company to temporarily pay down revolving loans under the senior credit facilities with the
remaining $5.6 million of the tax refund. Despite the existing events of default, the waiver
permitted the Company to reborrow this $5.6 million, in weekly draws, to meet budgeted liquidity
needs. No other borrowings are permitted under the Companys senior credit facilities absent a
consent of the Companys senior lenders. Because of the potential for defaults under the Companys senior credit facilities and the notes at
December 31, 2004, all $350.5 million of debt under the Companys senior credit facilities and the
notes was classified as a current liability on the Companys consolidated balance sheet at December
31, 2004.  7.
    Other Accrued Liabilities The following table presents the components of other accrued liabilities: December 31,2004
    
    
    2003(In thousands)Reserve for restructuring (see Note 8)
    
    $
    14,953
    
    
    $
    Consignment inventory returns reserve
    
    
    12,412
    
    
    
    Guaranteed purchase commitments
    
    
    11,695
    
    
    
    Advance royalty payments
    
    
    7,209
    
    
    
    Income taxes payable
    
    
    
    
    
    
    8,044Other
    
    
    5,212
    
    
    
    3,089Total other accrued liabilities, net
    
    $
    51,481
    
    
    $
    11,133
  8.
    Restructuring Charges In 2004, the Company announced and implemented several restructuring plans intended to rationalize
its expense base in relation to its revenue. These plans included work force 142




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##### 



reductions and facility closures. The Company recorded a $22.4 million expense in 2004, including
$5.3 million in the fourth quarter, primarily representing severance costs and related
employee-benefit expenses of $5.5 million, separation payments of $1.9 million to the Companys
former chief executive officer and costs of $15.0 million for leased facilities which are no longer
in use. These leased facilities include the Companys New Jersey lab facility, smaller facilities
in North Carolina and California, and aircraft leased by the Company. The Company is currently
seeking to sub-lease these facilities, and has entered a short-term sublease for one aircraft and
the California facility. These charges have been allocated to the related segments: $10.8 million
to the development services business (including $7.4 million for the New Jersey lab facility), $8.0
million to corporate operations, $3.1 million to the product sales business and $0.5 million to
research and development. The liabilities are included in other accrued liabilities on the
Companys consolidated balance sheet. The following table represents the components of the restructuring reserve (in thousands): December 31,
    
    
    
    
    
    
    Less
    
    
    December 31,2003
    
    
    
    
    
    
    Payments/
    
    
    2004Balance
    
    
    Charges
    
    
    Write-downs
    
    
    BalanceLease costs, net of
estimated sub-lease
income
    
    $
    
    
    
    $
    12,227
    
    
    $
    (1,950
    )
    
    $
    10,277Severance costs
    
    
    
    
    
    
    7,404
    
    
    
    (3,322
    )
    
    
    4,082Other costs
    
    
    
    
    
    
    2,761
    
    
    
    (2,167
    )
    
    
    594Total
    
    $
    
    
    
    $
    22,392
    
    
    $
    (7,439
    )
    
    $
    14,953
 In accordance with Statement of Financial Accounting Standard No. 146, Accounting for Costs
Associated with Exit or Disposal Activities, the Company recorded facility closure costs at
estimated fair value, net of estimated sub-lease income.  9.
    Stockholders Equity The authorized capital stock of the Company at December 31, 2004 and 2003 was 100 million shares of
voting common stock, $0.001 par value per share, and 5 million shares of preferred stock, $0.001
par value per share. The preferred stock is issuable in one or more series by the Companys Board
of Directors without further stockholder approval. No preferred stock was outstanding at December
31, 2004 or 2003. The Company has reserved 1.8 million shares of common stock for issuance under
the stock option plans at December 31, 2004. Stock Option and Award Plans The Company has five stock option plans: the 2000 Stock Option Plan for Non Employee Directors (the
2000 Plan), the 1997 Stock Option Plan (the 1997 Plan), the 1996 Stock Option Plan (the 1996
Plan), the 1995 Stock Option Plan (the 1995 Plan) and the 1996 Incentive and Non Qualified Stock
Option Plan (the MTRA Plan). Under the 1995 Plan, the Board of Directors initially could grant
options to purchase up to 363,807 shares of common stock. However, the Company has no obligation to
issue the shares upon exercise of such options until it has purchased an equal number of shares
from certain existing stockholders. Under the 2000 Plan, the 1997 Plan and the 1996 Plan, the Board
of Directors initially could grant options 143




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to purchase up to 615,000, 3,966,000 and 743,441, respectively, of newly issued shares of common
stock. The 1997 Plan has been amended to allow the issuance of options to purchase a total of
8,091,000 shares of common stock. The Board of Directors reserved 776,250 shares to cover the
exercise of the options under the MTRA Plan. The plans require that the exercise price of options
cannot be less than either 100% (2000 Plan, 1997 Plan and MTRA Plan) or 75% (1996 and 1995 Plans)
of the estimated fair market value of the Companys shares of common stock on the date of grant.
In conjunction with the hiring of three executive officers in 2004, the Company granted such
executive officers a total of 104,817 shares of restricted stock. The shares become vested if the
executives are employed by the Company on the anniversary dates, either six months or one year,
from their respective hire date. No shares of restricted stock were granted by the Company in
2003. The combined activity from all plans is presented in the following table: WeightedAverageShares
    
    
    Exercise PriceOutstanding, December 31, 2001
    
    
    3,495,978
    
    
    $
    7.65Granted
    
    
    3,387,798
    
    
    
    14.24Exercised
    
    
    (512,423
    )
    
    
    6.33Forfeited
    
    
    (962,380
    )
    
    
    14.13Outstanding, December 31, 2002
    
    
    5,408,973
    
    
    
    10.79Granted
    
    
    1,884,755
    
    
    
    15.37Exercised
    
    
    (618,723
    )
    
    
    8.36Forfeited
    
    
    (247,401
    )
    
    
    12.83Outstanding, December 31, 2003
    
    
    6,427,604
    
    
    
    12.28Granted
    
    
    3,412,918
    
    
    
    4.15Exercised
    
    
    (359,999
    )
    
    
    9.93Forfeited
    
    
    (2,686,281
    )
    
    
    13.61Outstanding, December 31, 2004
    
    
    6,794,242
    
    
    $
    8.06
 Information regarding stock options outstanding and options exercisable at December 31, 2004 is
summarized in the table below: Options Outstanding
    
    
    Options ExercisableWeightedAverage
    
    
    Weighted
    
    
    
    
    
    
    WeightedRemaining
    
    
    Average
    
    
    
    
    
    
    AverageShares
    
    
    Life
    
    
    Exercise
    
    
    Shares
    
    
    ExerciseRange of Exercise prices
    
    Outstanding
    
    
    (Years)
    
    
    price
    
    
    Exercisable
    
    
    Price$1.41   - $2.97
    
    
    2,388,918
    
    
    
    9.79
    
    
    $
    2.26
    
    
    
    
    
    
    $
    $3.00   - $8.54
    
    
    1,708,806
    
    
    
    6.71
    
    
    $
    5.72
    
    
    
    1,106,806
    
    
    $
    6.03$8.57   - $14.80
    
    
    1,908,986
    
    
    
    7.00
    
    
    $
    12.20
    
    
    
    1,398,182
    
    
    $
    12.02$14.96 - $28.72
    
    
    787,532
    
    
    
    8.32
    
    
    $
    18.54
    
    
    
    333,862
    
    
    $
    17.28$1.41   - $28.72
    
    
    6,794,242
    
    
    
    8.06
    
    
    $
    7.81
    
    
    
    2,838,850
    
    
    $
    10.30
 144




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##### 



At December 31, 2004, 2003 and 2002, exercisable options representing 2.8 million, 2.8 million and
1.8 million shares, respectively, were outstanding.  10.
    Related Party Transactions Endeavor Pharmaceuticals, Inc. In 1994, aaiPharma organized Endeavor Pharmaceuticals, Inc. (Endeavor) with several investors to
fund the development of hormone pharmaceutical products, initially focusing on several generic
hormone products already under development by the Company. The Company also agreed to permit
Endeavor, under certain circumstances, the first right to purchase additional proprietary hormone
pharmaceutical products developed by aaiPharma. aaiPharma obtained a 47% equity interest in
Endeavor through the contribution of its accumulated product research and development and technical
know-how. The other investors contributed cash in exchange for their interests which, for all
investors, was in the form of convertible preferred stock. Based on subsequent investments by
other investors, the Companys interest, assuming conversion, had been reduced to approximately 10%
of the fully diluted common equity of Endeavor. Subsequent to the reduction in ownership percentage
and its reduced influence over the Endeavor operations, the Company ceased accounting for this as
an equity method investment and began to account for it under the cost method. Endeavor
accumulated significant losses since inception and this investment had been recorded at zero value
since 1995. In the fourth quarter of 2003, Endeavor sold substantially all of its assets to a
third party. As part of this transaction, the Company recorded a pretax gain of $1.8 million for
the sale of its investment in Endeavor. This gain is included in other income on the 2003
consolidated statements of operations. As of December 31, 2003, the Company no longer had any
investment in Endeavor. The Company had net sales to Endeavor of zero in 2004 and approximately $0.6 million and $1.1
million for the years ended December 31, 2003 and 2002, respectively. At December 31, 2004 and
2003, the Company had no related accounts receivable from Endeavor. Aesgen, Inc. Aesgen, Inc. (Aesgen) was formally organized with an affiliate of the Mayo Clinic and MOVA
Pharmaceutical Corporation and funded in 1995 through the issuance of approximately $11 million of
nonconvertible, nonvoting, mandatorily redeemable, preferred stock. The Company made a cash
investment of $1.6 million in such preferred stock, which is carried at cost, and is included in
other noncurrent assets on the consolidated balance sheets. In January 2001, the terms of the
preferred stock owned by the Company were amended to make that class of stock convertible into
Aesgen common stock. In October 2001, the Company entered into a Service Agreement and a Subscription Agreement with
Aesgen, whereby the Company agreed to perform certain clinical work for Aesgen and to receive
Aesgen preferred stock in lieu of cash for the services performed. The Company subscribed to $1.1
million of preferred stock. Through December 31, 2004, the Company performed services under the
agreement of $580,000. At September 30, 2004, the Company held 145




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##### 



convertible preferred shares of Aesgen that represented 10.0% of Aesgens fully diluted common
equity, which included shares earned for services performed under this agreement. Aesgen merged
into a subsidiary of MGI Pharma, Inc. in October 2004. The Companys investment was converted into
common stock immediately prior to the merger and the common stock was converted into a right to
receive approximately 10% of the cash paid as merger consideration. The Company received $2.7
million in October 2004 on the effective date of the merger. The Company is entitled to 10% of the
residual portion of the $3.2 million of merger consideration that is held in a one-year escrow. In
addition, the Company is entitled to receive 10% of any future contingent payments that may be
payable under the merger agreement. In February 2002, the Company purchased a calcitriol product from Aesgen for payments of $1.0
million in cash and additional contingent milestone payments of up to $1.5 million. In 2003, the
prerequisite for payment of $500,000 of such contingent milestones occurred and such payment was
made to Aesgen. The prerequisites for payment of the remaining $1.0 million of such contingent
milestones were not met and no further contingent milestone payments are owed by the Company.
Under the purchase agreement with Aesgen, the Company was obligated to pay royalty payments for the
eight year period following the first commercial sale of the product. In 2004, the Company
expensed royalties related to Aesgen of $0.4 million. Of this amount, none was payable at December
31, 2004. The Company also sold calcitriol under an exclusive manufacturing and co-promotion agreement with
Sicor Pharmaceuticals, Inc. pursuant to which the Company acquired U.S. marketing rights to, and
sold, Sicor Pharmaceuticals calcitriol product under their regulatory approval. The Company
amended the 2002 calcitriol injection acquisition agreement with Aesgen in 2003 to provide for
royalty payments to Aesgen on the gross margin it realized from sales of the calcitriol product
marketed under Sicors regulatory approval and to provide for potential payments to Aesgen in
connection with Sicors reacquisition of the U.S. marketing rights to calcitriol injection. On
December 23, 2004, Sicor Pharmaceuticals reacquired its U.S. marketing rights to calcitriol
injection, pursuant to the termination of the manufacturing and co-promotion agreement discussed
above. In connection with such termination, Sicor paid the Company $3.5 million. The Company no
longer commercializes calcitriol. In December 2001, the Company acquired right, title and interest to some of the products being
developed by Aesgen. These products include five products for which abbreviated new drug
applications have been approved by the FDA, and two other products under development. As
consideration for the purchase of these products, the Company waived all claims to amounts due from
Aesgen. At December 31, 2004, the book value of these assets was zero. In 1996, the Company sold to Aesgen marketing rights to a product under development by the Company.
Under the agreement, Aesgen paid a license fee and would have paid additional royalties upon
marketing the product. aaiPharma had the right, under its development agreement with Aesgen, to
provide certain product development and support services to Aesgen with respect to some generic
drugs currently being developed by Aesgen, provided that aaiPharmas fees for such services were
comparable to those of a competitor. In addition, under such development agreement, the Company had
agreed not to develop, for its own account or any other person, a formulation of any of the generic
products currently under development for Aesgen and any additional drugs that aaiPharma agrees to
develop in the future for Aesgen. 146




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##### 



aaiPharma recognized net revenues of zero, zero and $494,000 from Aesgen for the years ended
December 31, 2004, 2003 and 2002 respectively. The Company had no related accounts receivable from
Aesgen or work in progress at December 31, 2004 or 2003. Employment Agreement In 1995, the Company entered into an employment agreement with Dr. Frederick D. Sancilio. The
employment agreement was amended in 2003 and in September 2004. The employment agreement renewed
automatically for successive two-year periods unless either party notified the other party of an
intention not to extend the term. Dr. Sancilio served as aaiPharmas Executive Chairman of the
Board and Chief Scientific Officer as well as Chief Executive Officer from March  September 2004.
Prior to July 2002, he served as Chairman of the Board of Directors and Chief Executive Officer. The Board of Directors increased Dr. Sancilios annual salary from $400,000 to $422,000 effective
January 1, 2003. Dr. Sancilio resumed his previous role as Chief Executive Officer on March 29,
2004. His salary was not adjusted to reflect his increased responsibilities. Pursuant to the
employment agreement, Dr. Sancilio received a bonus when aaiPharma received certain regulatory
approvals. This bonus was in the amount of $250,000 for each new drug application and $50,000 for
each supplemental new drug application or abbreviated new drug application. Dr. Sancilio was
awarded a bonus of $100,000 in May 2003 upon regulatory approval and commercialization of two
products. Dr. Sancilio earned a bonus of approximately $500,000 in 2004 in connection with the
regulatory approval and commercialization of certain products in 2004. Dr. Sancilio and the
Company are negotiating the form of payment. The employment agreement permitted the Company to terminate Dr. Sancilios employment at any time,
with or without cause. The Company terminated Dr. Sancilios employment under his employment
agreement on September 27, 2004. Under the terms of the employment agreement, Dr. Sancilio will
receive payments aggregating three times his then current annual salary plus a target bonus which
equaled $422,000. Pursuant to an amendment to the employment agreement entered into in connection
with the termination of Dr. Sancilios employment, these payments will be made in monthly
installments over two years, during which time Dr. Sancilio would continue to receive his medical
and life insurance benefits. The employment agreement requires Dr. Sancilio to refrain from certain
activities in competition with aaiPharma for a period of two years after the termination of his
employment for any reason. The bonus and severance payments due to Dr. Sancilio are recorded in
other accrued liabilities.  11.
    Income Taxes The following table presents the components of the provision for (benefit from) income taxes: Years Ended December 31,2004
    
    
    2003
    
    
    2002(In thousands)(Loss) income before income taxes:United States
    
    $
    (189,313
    )
    
    $
    (38,600
    )
    
    $
    21,758Non-U.S.
    
    
    1,832
    
    
    
    1,395
    
    
    
    (98
    )
 147




---



##### 



Years Ended December 31,2004
    
    
    2003
    
    
    2002(In thousands)(Loss) income before taxes
    
    $
    (187,481
    )
    
    $
    (37,205
    )
    
    $
    21,660Provision for (benefit from) income taxes:Current:Federal
    
    $
    (11,110
    )
    
    $
    14,824
    
    
    $
    1,842State
    
    
    58
    
    
    
    67
    
    
    
    219Non-U.S.
    
    
    319
    
    
    
    113
    
    
    
    355Total current taxes
    
    
    (10,733
    )
    
    
    15,004
    
    
    
    2,416Deferred:Federal
    
    
    14,131
    
    
    
    (18,398
    )
    
    
    4,517State
    
    
    1,118
    
    
    
    (1,108
    )
    
    
    1,609Foreign
    
    
    (826
    )
    
    
    
    
    
    
    Total deferred taxes
    
    
    14,423
    
    
    
    (19,506
    )
    
    
    6,126Provision for (benefit from) income taxes
    
    $
    3,690
    
    
    $
    (4,502
    )
    
    $
    8,542
 The following table presents the reconciliation of the provision for (benefit from) income taxes to
the amount computed by applying the U.S. federal statutory income tax rate: Years Ended December 31,2004
    
    
    2003
    
    
    2002(In thousands)(Loss) income before income taxes
    
    $
    (187,481
    )
    
    $
    (37,205
    )
    
    $
    21,660Tax (benefit) expense using U.S. statutory
income tax rate of 35% for 2004, 2003 and
2002
    
    $
    (65,618
    )
    
    $
    (13,022
    )
    
    $
    7,581State income taxes, net
    
    
    (5,024
    )
    
    
    (1,972
    )
    
    
    1,141Permanent items, net
    
    
    1,525
    
    
    
    1,299
    
    
    
    329Non-U.S. operations, net
    
    
    402
    
    
    
    (1,542
    )
    
    
    (194
    )Tax credits
    
    
    
    
    
    
    (450
    )
    
    
    (677
    )Change in valuation allowance for deferred
tax assets
    
    
    72,405
    
    
    
    11,185
    
    
    
    362Provision for (benefit from) income taxes
    
    $
    3,690
    
    
    $
    (4,502
    )
    
    $
    8,542
 Deferred income taxes arise from temporary differences between the tax bases of assets and
liabilities and their reported amounts in the financial statements. Deferred taxes are included in
prepaid and other current assets, other accrued liabilities and other long-term liabilities. The
following table presents the Companys deferred tax assets and liabilities: 148




---



##### 



December 31,2004
    
    
    2003(In thousands)Deferred tax assets, resulting from:Accrued liabilities
    
    $
    1,031
    
    
    $
    1,069Accounts receivable
    
    
    979
    
    
    
    332Deferred revenue
    
    
    2,642
    
    
    
    17,371U.S. net operating loss carryforwards
    
    
    32,322
    
    
    
    359Non-U.S. net operating losses
    
    
    3,370
    
    
    
    4,196Accrued reserves and other
    
    
    7,573
    
    
    
    18,426Interest
    
    
    3,592
    
    
    
    Intangible assets
    
    
    37,641
    
    
    
    Restructuring
    
    
    5,637
    
    
    
    Total deferred tax assets
    
    
    94,787
    
    
    
    41,753Deferred tax liabilities, resulting from:Amortization
    
    
    
    
    
    
    (6,064
    )Property and equipment
    
    
    (6,275
    )
    
    
    (4,555
    )Valuation allowances on tax assets
    
    
    (88,512
    )
    
    
    (14,196
    )Net deferred tax assets (liabilities)
    
    $
    
    
    
    $
    16,938
 Valuation allowances have been provided for certain assets resulting from accumulated net operating
losses from foreign entities and other deferred tax assets because Statement of Financial
Accounting Standards No. 109, Accounting for Income Taxes requires that deferred tax assets be
reduced by a valuation allowance if it is more likely than not that some portion of the deferred
tax asset will not be realized. `Of the total valuation allowance, approximately $23 million
relates to the net benefit from stock options. This amount will be a direct credit to equity if
and when realized. As of December 31, 2004, the Company had approximately $78 million of federal
net operating losses that will expire in 2005 and $100 million of state net operating loss
carryforwards that began to expire in 2005. The use of existing net
operating losses, tax credit carryovers, and certain asset basis to offset future income may be limited if an
ownership change occurs (or has occurred) as defined by Internal Revenue Code section 382. Undistributed earnings of certain consolidated foreign subsidiaries at December 31, 2004, amounted
to approximately $2.5 million. No provision for deferred U.S. income taxes has been made for these
subsidiaries because aaiPharma intends to permanently reinvest such earnings in those foreign
operations. If such earnings were not permanently reinvested, a deferred tax liability may be
required.  12.
    Employee Benefit Plan The Company provides retirement benefits for all domestic aaiPharma employees with one year of
service through a defined contribution plan qualified under section 401(k) of the Internal Revenue
Code of 1986, as amended. Participants may elect to contribute a portion of their annual
compensation, subject to limitations. The Company makes matching contributions equal to 50% of a
participants contribution up to a certain amount, which matching contributions were invested in
aaiPharma common stock. Additionally, the Company may make profit sharing contributions at the
discretion of the Board of Directors. The Company expensed $1.2 million, $1.1 million and $1.0
million for the years ended December 31, 2004, 2003 and 2002, 149




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##### 



respectively, for this benefit plan, all related to the matching contributions. In March 2005, the
Company changed the plan to permit the matching contributions described above to be invested in
assets other than aaiPharma stock and permitted participants to liquidate aaiPharma stock allocated
in the 401(k) plan to their accounts and reinvest the proceeds in other investment alternatives
under the 401(k) plan.  13.
    Commitments and Contingencies The Company leases land, buildings and equipment under renewable lease agreements classified as
operating leases. Rent expense under these agreements for the years ended December 31, 2004, 2003
and 2002 was $7.9 million, $7.1 million and $7.0 million, respectively. As of December 31, 2004,
future minimum rentals due under non-cancelable operating lease agreements with initial terms of
one year or more were: $8.0 million2005; $6.1 million2006; $5.0 million2007; $4.5
million2008; $2.9 million2009 and $4.6 millionthereafter. As of December 31, 2004, future
minimum rentals due under non-cancelable capital lease agreements with initial terms of one year or
more were: $0.2 million2005; $0.2 million2006; and zerothereafter. In 2003, the Company entered a three-year services agreement with Athlon Pharmaceuticals, Inc.
(Athlon) to provide sales support in designated territories throughout the United States for the
Darvocet A500 product. The Company has commenced litigation against Athlon with respect to this
agreement, and terminated this agreement, as described below. The Company also entered into a
multi-year supply agreement for Darvocet A500 with a separate third party. In the fourth quarter
of 2004, the Company recorded a charge of $11.7 million and established a corresponding reserve
related to the minimum guaranteed purchase requirement remaining under this supply agreement. The
Company is negotiating with the manufacturer under this agreement to extend the term of its
obligation to purchase the minimum level of products by an additional multi-year period and to
include additional products to be manufactured for the Company under this agreement and applied
against the minimum guaranteed purchase requirement. If the Company is successful in amending the
agreement on this basis, the reserve and corresponding charge may be reversed in a subsequent
period. In April 2004, in connection with an investigation conducted by the United States Attorneys Office
for the Western District of North Carolina (the U.S. Attorneys Office), the Company received
five federal grand jury subpoenas for document production and potential testimony related to, among
other things, certain transactions regarding its 2002 and 2003 financial information, the terms,
conditions of employment and compensation arrangements of certain of its senior management
personnel, compensation and incentive arrangements for employees responsible for the sale of its
Brethine, Darvocet, calcitriol, azathioprine and Darvon Compound products, quantities of the
foregoing products in distribution channels, financial benefits with respect to specified corporate
transactions to its senior management and others, certain loans obtained by the Company, extensions
of credit, if any, by aaiPharma to officers or directors, accounting for sales and returns of the
Companys foregoing products, its analysts conference calls on financial results, internal and
external investigations of pharmaceutical product sales activities, and related matters. The SEC
has also commenced an investigation and the Company has received a subpoena from the SEC covering
similar matters. In addition, both the U.S. Attorneys Office and the SEC have made informal
requests for documents and other 150




---



##### 



information related to these matters. Certain of the Companys current and former officers,
directors and employees have received subpoenas to appear before the federal grand jury or requests
to provide information to the U.S. Attorneys Office. A former officer of the Company, David M.
Hurley, has been advised by the U.S. Attorneys Office that he is a target of its investigation.
The Company and a special committee of its Board of Directors established in February 2004 (the
Special Committee) have agreed to cooperate fully with the government investigations, and the
Special Committee has shared information regarding its investigation with the SEC and the U.S.
Attorneys Office. The U.S. Attorneys Office, SEC and other government agencies that are
investigating or might commence an investigation of the Company could impose, based on a claim of
fraud, material misstatements, violation of false claims law or otherwise, civil and/or criminal
sanctions, including fines, penalties, and/or administrative remedies. If any government sanctions
are imposed, which the Company cannot predict or reasonably estimate at this time, aaiPharmas
business and financial condition, results of operations or cash flows could be materially adversely
affected. These matters have resulted, and are expected to continue to result, in a significant
diversion of managements attention and resources and in significant professional fees. The
Company has agreed to advance expenses reasonably incurred by certain of its current directors and
current and former officers in connection with these investigations. This advancement of expenses
was conditioned upon the execution by such persons of undertakings to assist and cooperate with the
Company in connection with the investigations and to repay to the Company any advanced funds in the
event that (i) aaiPharma determines that certain representations made by such directors and
officers are inaccurate, (ii) aaiPharma is prohibited from providing indemnification to such
directors or officers pursuant to Delaware law or its organizational documents, or (iii) such
directors or officers stop cooperating with aaiPharma on the investigations. The Company, certain of its current and former officers and directors, and its independent
registered public accountants have been named as defendants in purported stockholder class action
lawsuits alleging violations of federal securities laws and a stockholder derivative action
alleging violations of state law fiduciary responsibilities. The securities lawsuits were filed
beginning in February 2004 and are pending in the U.S. District Court for the Eastern District of
North Carolina. By order dated April 16, 2004, the district court consolidated the securities
lawsuits into one consolidated action, and on February 11, 2005 the plaintiffs filed a consolidated
amended complaint. The amended securities complaint asserts claims arising under Sections 10(b) and
20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 there under on behalf of a class of
purchasers of the Companys common stock during the period from April 24, 2002 through and
including June 15, 2004. The securities complaints allege generally that the defendants knowingly
or recklessly made false or misleading statements during the Class Period concerning the Companys
financial condition and that the Companys financial statements did not present its true financial
condition and were not prepared in accordance with generally accepted accounting principles. The
amended securities complaint seeks certification as a class action, unspecified compensatory
damages, attorneys fees and costs, and other relief. A stockholder derivative suit was filed in
the United States District Court for the Eastern District of North Carolina on August 26, 2004 by
two putative shareholders against current and former members of the Companys Board of Directors
and senior management. aaiPharma is named as a nominal defendant. The complaint alleges that
the individual director and officer defendants breached fiduciary and contractual obligations to
the Company by implementing an inadequate system of internal controls, and causing the Company to
issue false and misleading statements 151




---



##### 



exposing it to securities fraud liability, and that certain defendants engaged in insider trading.
The complaint seeks unspecified compensatory damages, attorneys fees and costs, and other relief. In addition, the Company and certain of its current and former directors, officers and employees
have been named in a purported class action brought by an aaiPharma pension plan participant and
beneficiary asserting claims under ERISA on behalf of a class of all persons who are or were
participants or beneficiaries of the aaiPharma Inc. Retirement and Savings Plan during the period
from April 24, 2002 to June 15, 2004. An amended complaint was filed on March 14, 2005 which
alleges generally that the defendants breached fiduciary duties owed under ERISA with respect to
the prudence and lack of diversification of investment of Plan assets in the Companys common
stock, by misleading participants and beneficiaries of the Plan regarding the Companys earnings,
prospects, and business condition, by failing to act in the sole interest of Plan participants, and
by failing to monitor the actions of other Plan fiduciaries. The complaint seeks certification as
a class action, unspecified compensatory damages, attorneys fees and costs, and other equitable
relief. This ERISA lawsuit is pending in U.S. District Court for the Eastern District of North
Carolina. The proceedings in this matter will be coordinated with the securities lawsuits
described above. These lawsuits are at an early stage. The Companys response to the amended securities complaint
is not due until May 26, 2005, and its response to the amended ERISA complaint is not due until
June 30, 2005 at the earliest. By agreement, no response to the derivative suit is due until 60
days after the plaintiffs file their amended complaint, and no discovery has yet occurred in either
the securities or derivative litigation. Only limited discovery has occurred in the ERISA
litigation. By, and subject to, the terms of the Companys bylaws, the Company has certain obligations to
indemnify its current and former officers, directors and employees who have been named as
defendants in these lawsuits. The Company has purchased directors and officers liability insurance
(D&O insurance) that may provide coverage for some or all of these lawsuits and governmental
investigations. The Company has given notice to its D&O insurance carriers of the securities and
derivative suits described above, and the insurers have responded by requesting additional
information and by reserving their rights under the policies, including the rights to deny coverage
under various policy exclusions or to rescind the policies. There is a risk, however, that the D&O
insurance carriers will rescind the policies or that some or all of the claims or expenses will not
be covered by such policies; or that, even if covered, the Companys ultimate liability will exceed
the available insurance. The Companys fiduciary liability insurance carrier has denied coverage
of claims made in connection with the original ERISA litigation complaint; the amended ERISA
complaint is under review by us for potential fiduciary policy coverage. Although the Company
intends to vigorously pursue all defenses available in these lawsuits, an adverse determination in
these lawsuits or an inability to obtain payment under the Companys insurance policies for
litigation and indemnification costs and any damages ultimately borne by us as a result of these
lawsuits and investigations could have a material adverse effect on the Companys business,
financial condition, results of operations or cash flows. 152




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The Company is a party to a number of legal actions with generic drug companies. The Company is
involved in two lawsuits centered on its omeprazole-related patents, including one lawsuit brought
by it against an alleged infringer of its patents and another lawsuit which was brought by a third
party against the Company and is currently essentially inactive. Omeprazole is the active
ingredient found in Prilosec, a drug sold by AstraZeneca PLC. An additional lawsuit brought against
the Company by Andrx Pharmaceuticals, Inc. involving omeprazole was dismissed without prejudice in
December 2004. An omeprazole-related case has been filed against the Company by Dr. Reddys Laboratories Ltd. and
Reddy-Cheminor Inc. in the U.S. District Court for the Southern District of New York in November
2001. The plaintiffs in this case have challenged the validity of five patents that aaiPharma has
obtained relating to omeprazole and are seeking a declaratory judgment that their generic form of
Prilosec does not infringe these patents. Additionally, they have alleged misappropriation of trade
secrets, tortious interference, unfair competition and violations of the North Carolina Unfair
Trade Practice Act. The Company has denied the substantive allegations made in these cases. A
second lawsuit brought by the plaintiffs involving omeprazole was filed in July 2001 and was
dismissed without prejudice in March 2005. The case is in the early stages of litigation. However, while these plaintiffs have sought
approval from the FDA to market a generic form of Prilosec, to the best of the Companys knowledge
as of April 18, 2005, no such FDA approval has been granted to them. In addition, these
plaintiffs omeprazole product has been found in separate litigation to infringe certain patents of
AstraZeneca and the infringement findings have been upheld on appeal. The lawsuit is essentially
inactive at this time. Only limited discovery has occurred in this lawsuit and no additional
discovery is currently being sought. No date has been set for the trial. In the event that the
lawsuit again becomes active, the Company intends to vigorously defend the patents validity and to
determine whether or not the plaintiffs product infringes any of its relevant patents. The other lawsuit involving the Companys omeprazole patents was brought in December 2002 by it
against Kremers Urban Development Co., Schwarz Pharma Inc. and Schwarz Pharma AG (collectively,
together with the other named defendants, KUDCO) in the U.S. District Court for the Southern
District of New York. KUDCO has a generic omeprazole product with final FDA marketing approval,
was found not to infringe the AstraZeneca patents in the separate AstraZeneca patent litigation,
and is currently selling its generic substitute for Prilosec in the U.S. marketplace. The Company initially brought the lawsuit alleging infringement of the Companys U.S. Patent No.
6,268,385. Following the collection of additional information concerning KUDCOs commercially
marketed product, the Company sought leave of the court to file an amended complaint, adding
additional claims of infringement and contributory infringement under the Companys U.S. Patent No.
6,326,384 and joining as defendants Schwarz Pharma Manufacturing Inc. and Schwarz Pharma USA
Holdings Inc. These two patents include, among other claims, claims directed to compositions and
methods wherein certain characteristics of solid state omeprazole are essentially the same in
formulated drug product as in its active ingredient. 153




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In September 2003, the judge granted aaiPharma leave to file the first amended complaint adding the
Companys second patent and the additional KUDCO affiliates to the lawsuit. Following initial
discovery, the Company sought leave of the court to file a second amended complaint, adding Kremers
Urban Inc., another KUDCO affiliate, to the lawsuit. On February 26, 2004, the judge granted the
Company leave to file the second amended complaint, adding Kremers Urban Inc. to the lawsuit. KUDCO has filed its answer to aaiPharmas complaint, denying its claims, asserting various
affirmative defenses to its claims (including patent invalidity and product non-infringement), and
asserting counterclaims and antitrust violations under federal and state antitrust laws. KUDCO is
also contesting the personal jurisdiction of the court over all of the defendants in this lawsuit
other than Kremers Urban Development Co., Kremers Urban Inc. and Schwarz Pharma Inc. Motions on
the jurisdictional issues are pending before the court. The Company has denied the substantive
allegations made by KUDCO in its counterclaims, and the court has granted aaiPharmas motion to
stay antitrust discovery. Substantial discovery of both sides documents and of defendants product samples has occurred in
the lawsuit, although both sides asserted numerous discovery deficiencies against the other. On
February 26, 2004, the judge assigned the discovery disputes to a federal magistrate for
resolution. Discovery is continuing at this time. No trial date has been set. The Company has previously indicated to KUDCO a willingness to grant a license under its omeprazole
patents for an appropriate royalty. In the absence of KUDCO taking a royalty-bearing license,
aaiPharma is seeking damages equal to a reasonable royalty on all infringing sales by the KUDCO
defendants since commercial launch of their generic substitute for Prilosec on December 9, 2002
through the date of a judicial decision in the litigation, and a permanent injunction on subsequent
sales thereafter (unless KUDCO takes a license), among other remedies, in the event that the
Company ultimately prevails in the litigation. The KUDCO defendants have publicly confirmed sales
of their generic omeprazole product during the first twenty-two months after launch of their
product of approximately $1.3 billion. In the absence of a license or settlement, the Company
intends to vigorously prosecute the case, defend its patent rights and defend against the foregoing
defenses and counterclaims asserted by KUDCO. It is possible that the omeprazole-related patents
subject to the foregoing four lawsuits will be found invalid, unenforceable or not infringed and,
while currently stayed by the court, it is possible that the defendants antitrust counterclaims in
the KUDCO litigation will ultimately be allowed to proceed and be litigated. If adverse findings
were to occur, they could have a material adverse effect on aaiPharmas consolidated financial
statements, results of operations and cash flow. In cases where the Company has initiated an action, it intends to prosecute its claims to the full
extent of its rights under the law. In cases where the Company is a named defendant, the Company
intends to vigorously pursue all defenses available. On April 15, 2004, the Company filed a lawsuit against Athlon Pharmaceuticals, Inc. in the U.S.
District Court for the Northern District of Georgia seeking a declaratory judgment that it was
entitled to terminate the Service Agreement (the Athlon Service Agreement) dated July 16, 2003,
as amended, between the Company and Athlon as well as damages and injunctive relief for material
breaches of the Athlon Service Agreement by Athlon. The Athlon Service Agreement 154




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incorporated the terms and conditions pursuant to which representatives of Athlon would promote the
sale of the Companys Darvocet A500 product to physicians. The Company initially paid Athlon
$3,350,000 to build its sales force to promote the sale of the Companys Darvocet A500, and the
terms of the Athlon Service Agreement would require the Company to pay Athlon an additional
$1,200,000 each month for such services for the contract period of 36 months, commencing in October
2003, subject to Athlons compliance with certain representations, warranties and covenants, some
of which are described below. The lawsuit asserts that Athlon has materially breached the Athlon Service Agreement in several
ways, including failure to: (i) provide the required number of sales representatives during the
Companys launch of Darvocet A500 commencing in October 2003, (ii) use its best efforts to promote
Darvocet A500 at the targeted levels of first and second pharmaceutical details to physicians,
(iii) perform the services to the best of its ability, as contractually required, and (iv) require
its sales representatives to perform the contracted services, as required, in a professional manner
consistent with industry standards and in conformance with that level of care and skill ordinarily
exercised by professional contract sales organizations in similar circumstances. The lawsuit also
asserts that Athlon breached its representation and warranty that it would perform, and would
require its sales representatives to perform, the contracted services in substantially the same
manner that it would promote Athlons own products. Athlon has asserted several counterclaims, including breach of an implied covenant of good faith in
fair dealing and anticipatory breach of the contract. The Company has filed a reply denying these
allegations. In May 2004, the Company ceased making payments under the Athlon Service Agreement, and on June 4,
2004, it sent a notice of termination of the agreement to Athlon. On July 7, 2004, the Company
amended the lawsuit to assert claims of fraud and breaches of contract and implied covenants,
seeking to recover compensatory and punitive damages and attorneys fees. Athlon has amended its
counterclaim to assert fraud claims and to seek punitive damages. On August 11, 2004, Athlon filed a lawsuit against the Company, also in the U.S. District Court for
the Northern District of Georgia, alleging that the Company breached the Asset Purchase Agreement
(the Purchase Agreement) dated July 16, 2003 pursuant to which the Company acquired Darvocet A500
from Athlon. Athlon is seeking royalties it alleges the Company failed properly to calculate and
pay under the Purchase Agreement, as well as attorneys fees. The Company has denied the
substantive allegations in this case and filed counterclaims seeking to recover an overpayment in
the royalties owed to Athlon. The two cases have been consolidated and are currently in discovery. No trial date has been set.
The Company intends to prosecute its claims and counterclaims, and defend against the claims and
counterclaims made by Athlon, in these lawsuits to the full extent permitted by law. CIMA Labs, Inc. (CIMA) commenced an action against the Company in the Fourth Judicial District,
State of Minnesota, Hennepin County, on August 11, 2004. In its complaint, CIMA alleges that the
Company is liable for fraudulent inducement, negligent fraudulent misrepresentation, fraudulent
concealment, breach of contract, and attorneys fees and interest, all arising out of an Agreement
and Plan of Merger dated as of August 5, 2003, between CIMA and 155




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aaiPharma (Merger Agreement). CIMA alleges that in the negotiations leading up to the Merger
Agreement, the Company engaged in misrepresentations and concealments relating to its financial
condition, and that in the Merger Agreement, the Company made false representations and warranties
concerning its financial statements, regulatory filings, and absence of material adverse effects,
among other things. Much of CIMAs claims are based on disclosures made by the Company in its
Amended Form 10-Q, filed with the SEC on June 24, 2004, for the period ended June 30, 2003. CIMA
seeks to recover the amount of $11.5 million, which it paid to aaiPharma as a termination fee under
the Merger Agreement, plus additional sums it spent for professional fees and due diligence
activities (which it claims are in excess of $5 million), attorneys fees, litigation expenses, and
interest. The Company answered CIMAs complaint on September 17, 2004, denying all liability and
raising a number of affirmative defenses. Among other things, the Company asserted that CIMAs
termination of the Merger Agreement barred any claims except those based on the Companys willful
breach of its representations, warranties, covenants, or other agreements as set forth in that
Agreement. In addition, the Company affirmatively alleged that CIMA terminated the Merger
Agreement and paid the termination fee not as the result of any alleged breach by aaiPharma, but
rather as part of CIMAs plan to secure and act on a Superior Proposal from another bidder, which
allowed it to consummate a transaction with that other bidder on terms that it believed were more
favorable to it than those set forth in the Merger Agreement. The case is scheduled for trial in
the fall of 2005, and the parties are currently involved in document productions and written
discovery. On January 14, 2005, the Minnesota court rejected a relevance objection made by the
Company in response to CIMAs discovery requests and ordered the Company to produce voluminous
documents to CIMA. On March 21, 2005, the Minnesota court approved a motion to compel made by CIMA
against the Company to produce documents by April 5, 2005 and an extensive privilege log by April
20, 2005 with respect to documents generated by the Companys legal counsel in the internal
investigation. The Company has produced the documents and has moved to delay the production of the
privilege log due to its liquidity situation. The Companys legal counsel in the case has
withdrawn from representing the Company and the Company is in the process of retaining new counsel.
The Court may deny the Companys motion for additional time to produce the privilege log and may
sanction the Company, including holding the Company in contempt or entering a default judgment
against the Company. The Company intends to contest the action as vigorously as its limited
resources permit. The Company cannot predict the outcomes of these lawsuits. Future adverse findings in the above
described lawsuits could have a material adverse effect on its consolidated financial condition,
results of operations or cash flows.  14.
    Financial Information by Business Segment and Geographic Area The Company operates in three business segments consisting of a product sales business, primarily
comprised of the pharmaceuticals division, a product development business, primarily the research
and development business unit, and a development services business, primarily the AAI Development
Services business unit. The product sales business provides for the sales of the Companys
pharmaceutical product lines and for the commercial manufacturing of small quantity products
outsourced by other pharmaceutical companies. In the product development segment, the Company
internally develops drugs and technologies for future sales by the product sales business or with
the objective of licensing marketing rights to third parties in exchange for 156




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##### 



license fees and royalties. The core services provided by the development services business on a
fee-for-service basis to pharmaceutical and biotechnology industries worldwide include
comprehensive formulation, testing and manufacturing expertise, in addition to the ability to take
investigational products into and through human clinical trials. The majority of the Companys
non-U.S. operations are located in Germany. Corporate income (loss) from operations includes general corporate overhead costs which are not
directly attributable to a business segment. Financial data by segment and geographic region are as
follows: Years Ended December 31,2004
    
    
    2003
    
    
    2002(in thousands)Net revenues:Product sales
    
    $
    77,776
    
    
    $
    119,223
    
    
    $
    124,384Product development
    
    
    23,987
    
    
    
    16,468
    
    
    
    19,610Development services
    
    
    94,883
    
    
    
    89,286
    
    
    
    86,516Reimbursed out-of-pockets
    
    
    18,684
    
    
    
    11,950
    
    
    
    10,688$
    215,330
    
    
    $
    236,927
    
    
    $
    241,198United States
    
    $
    191,858
    
    
    $
    216,610
    
    
    $
    239,515Germany
    
    
    23,693
    
    
    
    20,623
    
    
    
    15,520Other
    
    
    1,533
    
    
    
    1,665
    
    
    
    962Less intercompany
    
    
    (1,754
    )
    
    
    (1,971
    )
    
    
    (14,799
    )$
    215,330
    
    
    $
    236,927
    
    
    $
    241,198(Loss) income from operations:Product sales
    
    $
    (108,610
    )
    
    $
    1,740
    
    
    $
    66,426Product development
    
    
    23,987
    
    
    
    16,468
    
    
    
    19,610Development services
    
    
    (3,578
    )
    
    
    1,722
    
    
    
    1,012(88,201
    )
    
    
    19,930
    
    
    
    87,048Research and development expense
    
    
    (17,234
    )
    
    
    (22,205
    )
    
    
    (21,279
    )Corporate
    
    
    (38,686
    )
    
    
    (19,038
    )
    
    
    (17,151
    )$
    (144,121
    )
    
    $
    (21,313
    )
    
    $
    48,618United States
    
    $
    (145,792
    )
    
    $
    (22,420
    )
    
    $
    49,020Germany
    
    
    1,738
    
    
    
    1,150
    
    
    
    (58
    )Other
    
    
    (67
    )
    
    
    (43
    )
    
    
    (344
    )$
    (144,121
    )
    
    $
    (21,313
    )
    
    $
    48,618Depreciation and amortization:Product sales
    
    $
    16,540
    
    
    $
    12,787
    
    
    $
    9,430Development services
    
    
    5,148
    
    
    
    4,889
    
    
    
    4,418Research and development expense
    
    
    447
    
    
    
    416
    
    
    
    425Corporate
    
    
    2,341
    
    
    
    2,154
    
    
    
    2,122
 157




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##### 



Years Ended December 31,2004
    
    
    2003
    
    
    2002(in thousands)$
    24,476
    
    
    $
    20,246
    
    
    $
    16,395Total assets:Product sales
    
    $
    233,682
    
    
    $
    423,366
    
    
    $
    340,302Product development
    
    
    14,777
    
    
    
    13,062
    
    
    
    5,966Research revenues
    
    
    51,939
    
    
    
    56,877
    
    
    
    50,481Corporate
    
    
    38,672
    
    
    
    41,292
    
    
    
    36,753$
    339,070
    
    
    $
    534,597
    
    
    $
    433,502United States
    
    $
    308,018
    
    
    $
    504,574
    
    
    $
    411,174Germany
    
    
    29,077
    
    
    
    28,243
    
    
    
    21,167Other
    
    
    1,975
    
    
    
    1,780
    
    
    
    1,161$
    339,070
    
    
    $
    534,597
    
    
    $
    433,502Goodwill, net:Development services
    
    $
    14,350
    
    
    $
    13,361
    
    
    $
    11,378
 15. Financial Results by Quarter (Unaudited) QuarterThirdFirst
    
    
    Second
    
    
    (as restated)
    
    
    Fourth(In thousands, except per share amounts)2004Net revenues
    
    $
    58,487
    
    
    $
    55,984
    
    
    $
    45,686
    
    
    $
    55,173Net (loss) income
    
    
    (49,572
    )
    
    
    7,218
    
    
    
    (35,954
    )
    
    
    (112,864
    )Basic (loss) earnings per share
    
    $
    (1.74
    )
    
    $
    0.25
    
    
    $
    (1.26
    )
    
    $
    (3.95
    )Diluted (loss) earnings per share
    
    
    (1.74
    )
    
    
    0.25
    
    
    
    (1.26
    )
    
    
    (3.95
    )
 QuarterFirst
    
    
    Second
    
    
    Third
    
    
    Fourth(In thousands, except per share amounts)2003Net revenues
    
    $
    51,729
    
    
    $
    69,008
    
    
    $
    42,576
    
    
    $
    73,614Net (loss) income
    
    
    (2,468
    )
    
    
    3,492
    
    
    
    (9,392
    )
    
    
    (24,335
    )Basic (loss) earnings per share
    
    $
    (0.09
    )
    
    $
    0.13
    
    
    $
    (0.34
    )
    
    $
    (0.87
    )Diluted (loss) earnings per share
    
    
    (0.09
    )
    
    
    0.12
    
    
    
    (0.34
    )
    
    
    (0.87
    )
 The Company has restated its consolidated statements of operations, cash flows, and comprehensive
(loss) income for the three and nine months ended September 30, 2004 and its consolidated balance
sheet as of September 30, 2004. The restatement does not affect periods prior to the three months
ended September 30, 2004. The restatement adjusts the Companys estimated reserve for
pharmaceutical product returns. Set forth below is the adjustment included 158




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in the restatement of the previously issued financial statements for the three and nine months
ended September 30, 2004. The following table presents the impact of the restatement adjustment described below on net loss
for the three and nine months ended September 30, 2004. Net Loss
    
    
    Net Lossfor the Three
    
    
    for the NineMonths Ended
    
    
    Months EndedSeptember 30,
    
    
    September 30,2004
    
    
    2004(In thousands)As previously reported
    
    $
    (33,790
    )
    
    $
    (76,144
    )Additional
returns reserves (allowances for
customer credits)
    
    
    (2,164
    )
    
    
    (2,164
    )As restated
    
    $
    (35,954
    )
    
    $
    (78,308
    )
 The restatement for the three and nine months ended September 30, 2004 reflects a correction to
increase the Companys allowance for customer credits, which includes estimated product returns,
and thus reduces net revenues. The allowances for customer credits impact the Companys net
revenues because net revenues represent total gross revenues less the allowances for customer
credits. The need for this correction came to the Companys attention after it received a return
request in late March 2005 from one of its major wholesale customers that related to pharmaceutical
product inventory that the customer was holding as of September 30, 2004 and December 31, 2004 but
which the customer failed to report to the Company in the customers September 30, 2004 and
December 31, 2004 inventory reports. The wholesaler inventory information is used to help the
Company estimate product return reserves. The following table presents the impact of the restatement adjustment on the Companys previously
reported consolidated statements of operations for the three and nine months ended September 30,
2004 on a condensed basis: Three Months Ended
    
    
    Nine Months EndedSeptember 30, 2004
    
    
    September 30, 2004As
    
    
    
    
    
    
    AsPreviously
    
    
    As
    
    
    Previously
    
    
    AsReported
    
    
    Restated
    
    
    Reported
    
    
    Restated(In thousands, except per share data)Net revenues
    
    $
    47,850
    
    
    $
    45,686
    
    
    $
    162,321
    
    
    $
    160,157Total costs and expenses
    
    
    81,640
    
    
    
    81,640
    
    
    
    238,465
    
    
    
    238,465Net loss
    
    $
    (33,790
    )
    
    $
    (35,954
    )
    
    $
    (76,144
    )
    
    $
    (78,308
    )Basic loss per share
    
    $
    (1.18
    )
    
    $
    (1.26
    )
    
    $
    (2.67
    )
    
    $
    (2.74
    )Diluted loss per share
    
    $
    (1.18
    )
    
    $
    (1.26
    )
    
    $
    (2.67
    )
    
    $
    (2.74
    )
 159




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The following table presents the impact of the restatement adjustment on the Companys previously
reported consolidated balance sheet as of September 30, 2004 on a condensed basis: September 30, 2004AsPreviously
    
    
    AsReported
    
    
    Restated(In thousands)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    7,143
    
    
    $
    7,143Accounts receivable, net
    
    
    6,799
    
    
    
    4,635Other current assets
    
    
    45,579
    
    
    
    45,579Total current assets
    
    
    59,521
    
    
    
    57,357Other assets
    
    
    366,348
    
    
    
    366,348Total assets
    
    $
    425,869
    
    
    $
    423,705LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)Current liabilities
    
    $
    100,557
    
    
    $
    100,557Long-term debt, less current portion
    
    
    323,700
    
    
    
    323,700Other liabilities
    
    
    18
    
    
    
    18Stockholders equity (deficit)
    
    
    1,594
    
    
    
    (570
    )Total liabilities and stockholders equity (deficit)
    
    $
    425,869
    
    
    $
    423,705
 16. Financial Information for Subsidiary Guarantors and Non Guarantors In the first quarter of 2002, the Company issued senior subordinated notes which are guaranteed by
certain of the Companys subsidiaries. The following presents condensed consolidating financial information for the Company, segregating:
(1) aaiPharma Inc., which issued the notes (the Issuer); (2) the domestic subsidiaries, which
guarantee the notes (the Guarantor Subsidiaries); and (3) all other subsidiaries (the
Non-Guarantor Subsidiaries). The Guarantor Subsidiaries are wholly-owned direct subsidiaries of
the Company and their guarantees are full, unconditional and joint and 160




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several. Wholly-owned subsidiaries are presented on the equity basis of accounting. Certain
reclassifications have been made to conform all of the financial information to the financial
presentation on a consolidated basis. The principal adjusting entries eliminate investments in
subsidiaries and intercompany balances and transactions. The following information presents consolidating statements of operations, balance sheets and cash
flows for the periods and as of the dates indicated: aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands) Year Ended December 31, 2004Non-Guarantor
    
    
    GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedNet revenues
    
    $
    52,963
    
    
    $
    138,848
    
    
    $
    25,272
    
    
    $
    (1,753
    )
    
    $
    215,330Equity earnings from subsidiaries
    
    
    (124,252
    )
    
    
    
    
    
    
    
    
    
    
    124,252
    
    
    
    Total net revenues
    
    
    (71,289
    )
    
    
    138,848
    
    
    
    25,272
    
    
    
    122,499
    
    
    
    215,330Operating costs and expenses:Direct costs (excluding depreciation
and royalty expense)
    
    
    36,888
    
    
    
    69,661
    
    
    
    15,459
    
    
    
    (1,115
    )
    
    
    120,893Selling expenses
    
    
    6,213
    
    
    
    26,414
    
    
    
    2,356
    
    
    
    
    
    
    
    34,983General and administrative expenses
    
    
    41,348
    
    
    
    96
    
    
    
    4,431
    
    
    
    
    
    
    
    45,875Research and development
    
    
    5
    
    
    
    16,314
    
    
    
    
    
    
    
    
    
    
    
    16,319Depreciation
    
    
    5,710
    
    
    
    1,600
    
    
    
    1,355
    
    
    
    
    
    
    
    8,665Professional
fees - internal inquiry
    
    
    
    
    
    
    11,042
    
    
    
    
    
    
    
    
    
    
    
    11,042M.V.I. contingent payment/(gain on sale)
    
    
    
    
    
    
    (8,112
    )
    
    
    
    
    
    
    
    
    
    
    (8,112
    )Guaranteed purchase commitments
    
    
    
    
    
    
    11,695
    
    
    
    
    
    
    
    
    
    
    
    11,695Restructuring charges
    
    
    
    
    
    
    22,392
    
    
    
    
    
    
    
    
    
    
    
    22,392Royalty expenses
    
    
    
    
    
    
    1,727
    
    
    
    
    
    
    
    
    
    
    
    1,727Intangible asset impairment
    
    
    
    
    
    
    93,972
    
    
    
    
    
    
    
    
    
    
    
    93,97290,164
    
    
    
    246,801
    
    
    
    23,601
    
    
    
    (1,115
    )
    
    
    359,451(Loss) income from operations
    
    
    (161,453
    )
    
    
    (107,953
    )
    
    
    1,671
    
    
    
    123,614
    
    
    
    (144,121
    )Other income (expense):Interest, net
    
    
    (648
    )
    
    
    (34,606
    )
    
    
    265
    
    
    
    
    
    
    
    (34,989
    )Net intercompany interest
    
    
    (2,050
    )
    
    
    2,322
    
    
    
    (272
    )
    
    
    
    
    
    
    Other (expense) income, net
    
    
    (23,646
    )
    
    
    15,534
    
    
    
    (259
    )
    
    
    
    
    
    
    (8,371
    )(26,344
    )
    
    
    (16,750
    )
    
    
    (266
    )
    
    
    
    
    
    
    (43,360
    )(Loss) income before income taxes
    
    
    (187,797
    )
    
    
    (124,703
    )
    
    
    1,405
    
    
    
    123,614
    
    
    
    (187,481
    )Provision for income taxes
    
    
    3,374
    
    
    
    288
    
    
    
    28
    
    
    
    
    
    
    
    3,690Net (loss) income
    
    $
    (191,171
    )
    
    $
    (124,991
    )
    
    $
    1,377
    
    
    $
    123,614
    
    
    $
    (191,171
    )
 161




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands) Year Ended December 31, 2003Non-Guarantor
    
    
    GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedNet revenues
    
    $
    52,238
    
    
    $
    164,372
    
    
    $
    22,288
    
    
    $
    (1,971
    )
    
    $
    236,927Equity earnings from subsidiaries
    
    
    (17,069
    )
    
    
    
    
    
    
    
    
    
    
    17,069
    
    
    
    Total net revenues
    
    
    35,169
    
    
    
    164,372
    
    
    
    22,288
    
    
    
    15,098
    
    
    
    236,927Operating costs and expenses:Direct costs (excluding depreciation
and royalty expense)
    
    
    34,953
    
    
    
    79,636
    
    
    
    13,680
    
    
    
    (1,482
    )
    
    
    126,787Selling expenses
    
    
    6,465
    
    
    
    30,861
    
    
    
    2,208
    
    
    
    
    
    
    
    39,534General and administrative expenses
    
    
    28,464
    
    
    
    7,877
    
    
    
    4,122
    
    
    
    
    
    
    
    40,463Research and development
    
    
    
    
    
    
    21,777
    
    
    
    
    
    
    
    11
    
    
    
    21,788Depreciation
    
    
    5,466
    
    
    
    1,334
    
    
    
    1,173
    
    
    
    
    
    
    
    7,973Royalty expenses
    
    
    
    
    
    
    1,095
    
    
    
    
    
    
    
    
    
    
    
    1,095Intangible asset impairment
    
    
    
    
    
    
    20,600
    
    
    
    
    
    
    
    
    
    
    
    20,60075,348
    
    
    
    163,180
    
    
    
    21,183
    
    
    
    (1,471
    )
    
    
    258,240(Loss) income from operations
    
    
    (40,179
    )
    
    
    1,192
    
    
    
    1,105
    
    
    
    16,569
    
    
    
    (21,313
    )Other income (expense):Interest, net
    
    
    (1,654
    )
    
    
    (19,598
    )
    
    
    174
    
    
    
    
    
    
    
    (21,078
    )Net intercompany interest
    
    
    (2,027
    )
    
    
    2,199
    
    
    
    (172
    )
    
    
    
    
    
    
    Other income (expense), net
    
    
    6,636
    
    
    
    (1,468
    )
    
    
    18
    
    
    
    
    
    
    
    5,1862,955
    
    
    
    (18,867
    )
    
    
    20
    
    
    
    
    
    
    
    (15,892
    )(Loss) income before income taxes
    
    
    (37,224
    )
    
    
    (17,675
    )
    
    
    1,125
    
    
    
    16,569
    
    
    
    (37,205
    )(Benefit from) provision for income taxes
    
    
    (4,532
    )
    
    
    30
    
    
    
    
    
    
    
    
    
    
    
    (4,502
    )Net (loss) income
    
    $
    (32,692
    )
    
    $
    (17,705
    )
    
    $
    1,125
    
    
    $
    16,569
    
    
    $
    (32,703
    )
 162




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands) Year Ended December 31, 2002Non-Guarantor
    
    
    GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedNet revenues
    
    $
    62,678
    
    
    $
    176,837
    
    
    $
    16,483
    
    
    $
    (14,800
    )
    
    $
    241,198Equity earnings from subsidiaries
    
    
    48,465
    
    
    
    
    
    
    
    
    
    
    
    (48,465
    )
    
    
    Total net revenues
    
    
    111,143
    
    
    
    176,837
    
    
    
    16,483
    
    
    
    (63,265
    )
    
    
    241,198Operating costs and expenses:Direct costs (excluding
depreciation and royalty expense)
    
    
    41,241
    
    
    
    64,195
    
    
    
    10,438
    
    
    
    (14,489
    )
    
    
    101,385Selling expenses
    
    
    6,348
    
    
    
    14,954
    
    
    
    1,775
    
    
    
    
    
    
    
    23,077General and administrative expenses
    
    
    27,532
    
    
    
    8,900
    
    
    
    3,677
    
    
    
    
    
    
    
    40,109Research and development
    
    
    732
    
    
    
    20,121
    
    
    
    
    
    
    
    
    
    
    
    20,853Depreciation
    
    
    5,153
    
    
    
    1,005
    
    
    
    998
    
    
    
    
    
    
    
    7,15681,006
    
    
    
    109,175
    
    
    
    16,888
    
    
    
    (14,489
    )
    
    
    192,580Income (loss) from operations
    
    
    30,137
    
    
    
    67,662
    
    
    
    (405
    )
    
    
    (48,776
    )
    
    
    48,618Other income (expense):Interest, net
    
    
    (1,774
    )
    
    
    (17,602
    )
    
    
    10
    
    
    
    
    
    
    
    (19,366
    )Net intercompany interest
    
    
    (2,292
    )
    
    
    2,494
    
    
    
    (202
    )
    
    
    
    
    
    
    Other
    
    
    (4,215
    )
    
    
    (3,678
    )
    
    
    301
    
    
    
    
    
    
    
    (7,592
    )(8,281
    )
    
    
    (18,786
    )
    
    
    109
    
    
    
    
    
    
    
    (26,958
    )Income (loss) before income taxes
    
    
    21,856
    
    
    
    48,876
    
    
    
    (296
    )
    
    
    (48,776
    )
    
    
    21,660Provision for (benefit from) income
taxes
    
    
    8,738
    
    
    
    
    
    
    
    (196
    )
    
    
    
    
    
    
    8,542Net income (loss)
    
    $
    13,118
    
    
    $
    48,876
    
    
    $
    (100
    )
    
    $
    (48,776
    )
    
    $
    13,118
 163




---



##### 



aaiPharma Inc.
CONSOLIDATING BALANCE SHEET
(In thousands) December 31, 2004Non-Guarantor
    
    
    GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedASSETSCurrent assets:Cash and cash equivalents
    
    $
    6,696
    
    
    $
    276
    
    
    $
    158
    
    
    $
    
    
    
    $
    7,130Accounts receivable, net
    
    
    10,831
    
    
    
    (756
    )
    
    
    2,681
    
    
    
    
    
    
    
    12,756Work-in-progress
    
    
    2,079
    
    
    
    4,830
    
    
    
    9,745
    
    
    
    (6,482
    )
    
    
    10,172Inventories, net
    
    
    1,871
    
    
    
    7,449
    
    
    
    1,402
    
    
    
    
    
    
    
    10,722Income taxes recoverable
    
    
    11,110
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,110Prepaid and other current assets
    
    
    4,600
    
    
    
    8,999
    
    
    
    211
    
    
    
    
    
    
    
    13,810Total current assets
    
    
    37,187
    
    
    
    20,798
    
    
    
    14,197
    
    
    
    (6,482
    )
    
    
    65,700Investments in and advances to subsidiaries
    
    
    66,099
    
    
    
    (46,240
    )
    
    
    
    
    
    
    (19,859
    )
    
    
    Property and equipment, net
    
    
    36,108
    
    
    
    12,501
    
    
    
    4,333
    
    
    
    
    
    
    
    52,942Goodwill, net
    
    
    725
    
    
    
    1,229
    
    
    
    12,396
    
    
    
    
    
    
    
    14,350Intangible assets, net
    
    
    1,159
    
    
    
    188,940
    
    
    
    
    
    
    
    
    
    
    
    190,099Other assets
    
    
    155
    
    
    
    15,698
    
    
    
    126
    
    
    
    
    
    
    
    15,979Total assets
    
    $
    141,433
    
    
    $
    192,926
    
    
    $
    31,052
    
    
    $
    (26,341
    )
    
    $
    339,070LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)Current liabilities:Current maturities of long-term debt
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    351,645
    
    
    $
    351,645Accounts payable
    
    
    7,057
    
    
    
    13,093
    
    
    
    1,881
    
    
    
    
    
    
    
    22,031Customer advances
    
    
    5,208
    
    
    
    4,327
    
    
    
    6,154
    
    
    
    (4,646
    )
    
    
    11,043Accrued wages and benefits
    
    
    2,553
    
    
    
    993
    
    
    
    1,335
    
    
    
    
    
    
    
    4,881Interest payable
    
    
    160
    
    
    
    5,578
    
    
    
    
    
    
    
    
    
    
    
    5,738Deferred product revenue
    
    
    
    
    
    
    4,127
    
    
    
    
    
    
    
    
    
    
    
    4,127Other accrued liabilities
    
    
    18,939
    
    
    
    33,699
    
    
    
    (408
    )
    
    
    (749
    )
    
    
    51,481Total current liabilities
    
    
    33,917
    
    
    
    61,817
    
    
    
    8,962
    
    
    
    346,250
    
    
    
    450,946Long-term debt, less current portion
    
    
    10,500
    
    
    
    341,145
    
    
    
    
    
    
    
    (351,645
    )
    
    
    Deferred tax liability
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Other liabilities
    
    
    14
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    14Investments in and advances to subsidiaries
    
    
    162,822
    
    
    
    (166,642
    )
    
    
    3,457
    
    
    
    363
    
    
    
    Total stockholders equity (deficit)
    
    
    (65,820
    )
    
    
    (43,394
    )
    
    
    18,633
    
    
    
    (21,309
    )
    
    
    (111,890
    )Total liabilities and stockholders
equity
(deficit)
    
    $
    141,433
    
    
    $
    192,926
    
    
    $
    31,052
    
    
    $
    (26,341
    )
    
    $
    339,070
 164




---



##### 



aaiPharma Inc.
CONSOLIDATING BALANCE SHEET
(In thousands) December 31, 2003Non-Guarantor
    
    
    GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedASSETSCurrent assets:Cash and cash equivalents
    
    $
    8,161
    
    
    $
    192
    
    
    $
    432
    
    
    $
    
    
    
    $
    8,785Accounts receivable, net
    
    
    11,242
    
    
    
    16,785
    
    
    
    4,587
    
    
    
    
    
    
    
    32,614Work-in-progress
    
    
    3,688
    
    
    
    5,337
    
    
    
    7,793
    
    
    
    (4,315
    )
    
    
    12,503Inventories, net
    
    
    4,588
    
    
    
    8,909
    
    
    
    1,196
    
    
    
    
    
    
    
    14,693Deferred tax assets
    
    
    19,184
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,184Prepaid and other current assets
    
    
    1,872
    
    
    
    8,304
    
    
    
    222
    
    
    
    
    
    
    
    10,398Total current assets
    
    
    48,735
    
    
    
    39,527
    
    
    
    14,230
    
    
    
    (4,315
    )
    
    
    98,177Investments in and advances to subsidiaries
    
    
    66,061
    
    
    
    (46,202
    )
    
    
    
    
    
    
    (19,859
    )
    
    
    Property and equipment, net
    
    
    39,011
    
    
    
    13,954
    
    
    
    4,271
    
    
    
    
    
    
    
    57,236Goodwill, net
    
    
    725
    
    
    
    1,229
    
    
    
    11,407
    
    
    
    
    
    
    
    13,361Intangible assets, net
    
    
    1,209
    
    
    
    350,106
    
    
    
    
    
    
    
    
    
    
    
    351,315Other assets
    
    
    2,419
    
    
    
    11,974
    
    
    
    115
    
    
    
    
    
    
    
    14,508Total assets
    
    $
    158,160
    
    
    $
    370,588
    
    
    $
    30,023
    
    
    $
    (24,174
    )
    
    $
    534,597LIABILITIES AND STOCKHOLDERS EQUITY (DEFICIT)Current liabilities:Current maturities of long-term debt
    
    $
    
    
    
    $
    4,000
    
    
    $
    
    
    
    $
    
    
    
    $
    4,000Accounts payable
    
    
    5,082
    
    
    
    14,292
    
    
    
    2,505
    
    
    
    
    
    
    
    21,879Customer advances
    
    
    6,441
    
    
    
    8,101
    
    
    
    4,807
    
    
    
    (1,719
    )
    
    
    17,630Accrued wages and benefits
    
    
    2,575
    
    
    
    1,517
    
    
    
    1,228
    
    
    
    
    
    
    
    5,320Interest payable
    
    
    7
    
    
    
    5,504
    
    
    
    
    
    
    
    
    
    
    
    5,511Deferred product revenue
    
    
    
    
    
    
    45,664
    
    
    
    
    
    
    
    
    
    
    
    45,664Other accrued liabilities
    
    
    8,640
    
    
    
    4,332
    
    
    
    (448
    )
    
    
    (1,391
    )
    
    
    11,133Total current liabilities
    
    
    22,745
    
    
    
    83,410
    
    
    
    8,092
    
    
    
    (3,110
    )
    
    
    111,137Long-term debt, less current portion
    
    
    8,000
    
    
    
    330,844
    
    
    
    
    
    
    
    
    
    
    
    338,844Deferred tax liability
    
    
    2,246
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,246Other liabilities
    
    
    196
    
    
    
    7,451
    
    
    
    
    
    
    
    
    
    
    
    7,647Investments in and advances to subsidiaries
    
    
    127,232
    
    
    
    (133,051
    )
    
    
    6,212
    
    
    
    (393
    )
    
    
    Total
stockholders equity (deficit)
    
    
    (2,259
    )
    
    
    81,934
    
    
    
    15,719
    
    
    
    (20,671
    )
    
    
    74,723Total liabilities and stockholders equity
(deficit)
    
    $
    158,160
    
    
    $
    370,588
    
    
    $
    30,023
    
    
    $
    (24,174
    )
    
    $
    534,597
 165




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF CASH FLOWS
(In thousands) Year Ended December 31, 2004Non-Guarantor
    
    
    GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedCash flows from operating activities:Net (loss) income
    
    $
    (191,171
    )
    
    $
    (124,991
    )
    
    $
    1,377
    
    
    $
    123,614
    
    
    $
    (191,171
    )Adjustments to reconcile net (loss) income to net
cash
(used in) provided by operating activities:Depreciation and amortization
    
    
    5,368
    
    
    
    17,753
    
    
    
    1,355
    
    
    
    
    
    
    
    24,476Intangible asset impairment, net of tax
    
    
    
    
    
    
    93,972
    
    
    
    
    
    
    
    
    
    
    
    93,972Write-off of deferred financing and other costs
    
    
    
    
    
    
    6,229
    
    
    
    
    
    
    
    
    
    
    
    6,229Gain on sale of M.V.I. product line
    
    
    
    
    
    
    (39,113
    )
    
    
    
    
    
    
    
    
    
    
    (39,113
    )Noncash stock based compensation
    
    
    225
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    225Other
    
    
    574
    
    
    
    995
    
    
    
    439
    
    
    
    
    
    
    
    2,008Changes in operating assets and liabilities:Accounts receivable, net
    
    
    412
    
    
    
    17,541
    
    
    
    2,303
    
    
    
    
    
    
    
    20,256Work-in-progress
    
    
    1,609
    
    
    
    506
    
    
    
    (1,276
    )
    
    
    2,168
    
    
    
    3,007Inventories
    
    
    2,717
    
    
    
    (1,528
    )
    
    
    (101
    )
    
    
    
    
    
    
    1,088Deferred tax assets and income taxes
recoverable
    
    
    8,074
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,074Prepaid and other assets
    
    
    (465
    )
    
    
    (10,648
    )
    
    
    30
    
    
    
    
    
    
    
    (11,083
    )Accounts payable
    
    
    1,975
    
    
    
    (1,199
    )
    
    
    (841
    )
    
    
    
    
    
    
    (65
    )Customer advances
    
    
    (1,232
    )
    
    
    (3,774
    )
    
    
    929
    
    
    
    (2,927
    )
    
    
    (7,004
    )Interest payable
    
    
    152
    
    
    
    74
    
    
    
    
    
    
    
    
    
    
    
    226Deferred product revenue
    
    
    
    
    
    
    (41,537
    )
    
    
    
    
    
    
    
    
    
    
    (41,537
    )Accrued wages and benefits and other accrued
liabilities
    
    
    7,852
    
    
    
    29,293
    
    
    
    (459
    )
    
    
    641
    
    
    
    37,327Intercompany receivables and payables
    
    
    159,842
    
    
    
    (33,592
    )
    
    
    (2,754
    )
    
    
    (123,496
    )
    
    
    Net cash (used in) provided by operating activities
    
    
    (4,068
    )
    
    
    (90,019
    )
    
    
    1,002
    
    
    
    
    
    
    
    (93,085
    )Cash flows from investing activities:Purchases of property and equipment
    
    
    (2,659
    )
    
    
    (1,456
    )
    
    
    (1,312
    )
    
    
    
    
    
    
    (5,427
    )Proceeds from sales of property and equipment
    
    
    8
    
    
    
    89
    
    
    
    
    
    
    
    
    
    
    
    97Product line disposals
    
    
    
    
    
    
    92,918
    
    
    
    
    
    
    
    
    
    
    
    92,918Other
    
    
    (378
    )
    
    
    38
    
    
    
    
    
    
    
    
    
    
    
    (340
    )Net cash (used in) provided by investing activities
    
    
    (3,029
    )
    
    
    91,589
    
    
    
    (1,312
    )
    
    
    
    
    
    
    87,248Cash flows from financing activities:Proceeds from long-term borrowings
    
    
    12,500
    
    
    
    165,000
    
    
    
    
    
    
    
    
    
    
    
    177,500Payments on long-term borrowings
    
    
    (10,000
    )
    
    
    (156,000
    )
    
    
    
    
    
    
    
    
    
    
    (166,000
    )Proceeds from interest rate swaps, net
    
    
    
    
    
    
    (10,293
    )
    
    
    
    
    
    
    
    
    
    
    (10,293
    )Proceeds from stock option exercises
    
    
    3,132
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,132Other
    
    
    
    
    
    
    (193
    )
    
    
    
    
    
    
    
    
    
    
    (193
    )Net cash provided by (used in) financing activities
    
    
    5,632
    
    
    
    (1,486
    )
    
    
    
    
    
    
    
    
    
    
    4,146Net (decrease) increase in cash and cash equivalents
    
    
    (1,465
    )
    
    
    84
    
    
    
    (310
    )
    
    
    
    
    
    
    (1,691
    )Effect of exchange rate changes on cash
    
    
    
    
    
    
    
    
    
    
    36
    
    
    
    
    
    
    
    36Cash and cash equivalents, beginning of year
    
    
    8,161
    
    
    
    192
    
    
    
    432
    
    
    
    
    
    
    
    8,785Cash and cash equivalents, end of year
    
    
    6,696
    
    
    $
    276
    
    
    $
    158
    
    
    $
    
    
    
    $
    7,130
 166




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF CASH FLOWS
(In thousands) Year Ended December 31, 2003Non-Guarantor
    
    
    GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedCash flows from operating activities:Net (loss) income
    
    $
    (32,703
    )
    
    $
    (17,574
    )
    
    $
    1,125
    
    
    $
    16,449
    
    
    $
    (32,703
    )Adjustments to reconcile net (loss) income to
net cash provided by operating activities:Depreciation and amortization
    
    
    5,039
    
    
    
    14,034
    
    
    
    1,173
    
    
    
    
    
    
    
    20,246Intangible asset impairment, net of tax
    
    
    
    
    
    
    20,600
    
    
    
    
    
    
    
    
    
    
    
    20,600Write-off of deferred financing and other
costs, net of tax
    
    
    1,511
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,511Other
    
    
    (151
    )
    
    
    (13
    )
    
    
    598
    
    
    
    
    
    
    
    434Changes in operating assets and liabilities:Accounts receivable, net
    
    
    (1,138
    )
    
    
    (27
    )
    
    
    (1,467
    )
    
    
    
    
    
    
    (2,632
    )Work-in-progress
    
    
    47
    
    
    
    (2,386
    )
    
    
    (2,322
    )
    
    
    3,176
    
    
    
    (1,085
    )Inventories
    
    
    916
    
    
    
    2,205
    
    
    
    (361
    )
    
    
    (311
    )
    
    
    2,449Deferred tax assets and income taxes
recoverable
    
    
    (17,913
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (17,913
    )Prepaid and other assets
    
    
    1,224
    
    
    
    (6,939
    )
    
    
    28
    
    
    
    
    
    
    
    (5,687
    )Accounts payable
    
    
    673
    
    
    
    2,844
    
    
    
    332
    
    
    
    
    
    
    
    3,849Customer advances
    
    
    (1,399
    )
    
    
    2,370
    
    
    
    1,671
    
    
    
    (580
    )
    
    
    2,062Interest payable
    
    
    (277
    )
    
    
    556
    
    
    
    
    
    
    
    
    
    
    
    279Deferred product revenue
    
    
    
    
    
    
    45,664
    
    
    
    
    
    
    
    
    
    
    
    45,664Accrued wages and benefits and other accrued
liabilities
    
    
    2,935
    
    
    
    1,540
    
    
    
    (1,150
    )
    
    
    (2,047
    )
    
    
    1,278Intercompany receivables and payables
    
    
    76,218
    
    
    
    (60,758
    )
    
    
    1,227
    
    
    
    (16,687
    )
    
    
    Net cash provided by operating activities
    
    
    35,382
    
    
    
    2,116
    
    
    
    854
    
    
    
    
    
    
    
    38,352Cash flows from investing activities:Purchases of property and equipment
    
    
    (2,082
    )
    
    
    (8,654
    )
    
    
    (1,174
    )
    
    
    
    
    
    
    (11,910
    )Proceeds from sales of property and equipment
    
    
    381
    
    
    
    225
    
    
    
    
    
    
    
    
    
    
    
    606Product line acquisition
    
    
    
    
    
    
    (102,464
    )
    
    
    
    
    
    
    
    
    
    
    (102,464
    )Other
    
    
    (502
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (502
    )Net cash used in investing activities
    
    
    (2,203
    )
    
    
    (110,893
    )
    
    
    (1,174
    )
    
    
    
    
    
    
    (114,270
    )Cash flows from financing activities:Proceeds from long-term borrowings
    
    
    
    
    
    
    160,000
    
    
    
    
    
    
    
    
    
    
    
    160,000Payments on long-term borrowings
    
    
    (39,500
    )
    
    
    (54,000
    )
    
    
    
    
    
    
    
    
    
    
    (93,500
    )Proceeds from interest rate swaps, net
    
    
    
    
    
    
    1,703
    
    
    
    
    
    
    
    
    
    
    
    1,703Proceeds from stock option exercises
    
    
    8,757
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,757Other
    
    
    
    
    
    
    1,086
    
    
    
    
    
    
    
    
    
    
    
    1,086Net cash (used in) provided by financing activities
    
    
    (30,743
    )
    
    
    108,789
    
    
    
    
    
    
    
    
    
    
    
    78,046Net increase (decrease) in cash and cash equivalents
    
    
    2,436
    
    
    
    12
    
    
    
    (320
    )
    
    
    
    
    
    
    2,128Effect of exchange rate changes on cash
    
    
    
    
    
    
    
    
    
    
    125
    
    
    
    
    
    
    
    125Cash and cash equivalents, beginning of year
    
    
    5,725
    
    
    
    180
    
    
    
    627
    
    
    
    
    
    
    
    6,532Cash and cash equivalents, end of year
    
    $
    8,161
    
    
    $
    192
    
    
    $
    432
    
    
    $
    
    
    
    $
    8,785
 167




---



##### 



aaiPharma Inc.
CONSOLIDATING STATEMENT OF CASH FLOWS
(In thousands) Year Ended December 31, 2002Non-Guarantor
    
    
    GuarantorIssuer
    
    
    Subsidiaries
    
    
    Subsidiaries
    
    
    Eliminations
    
    
    ConsolidatedCash flows from operating activities:Net income (loss)
    
    $
    13,118
    
    
    $
    48,876
    
    
    $
    (100
    )
    
    $
    (48,776
    )
    
    $
    13,118Adjustments to reconcile net income (loss) to
net cash (used in) provided by operating
activities:Depreciation and amortization
    
    
    4,743
    
    
    
    10,654
    
    
    
    998
    
    
    
    
    
    
    
    16,395Write-off of deferred financing and other
costs, net of tax
    
    
    
    
    
    
    8,053
    
    
    
    
    
    
    
    
    
    
    
    8,053Other
    
    
    (9
    )
    
    
    (432
    )
    
    
    586
    
    
    
    
    
    
    
    145Changes in operating assets and liabilities:Accounts receivable, net
    
    
    3,085
    
    
    
    (8,342
    )
    
    
    577
    
    
    
    2,300
    
    
    
    (2,380
    )Work-in-progress
    
    
    (264
    )
    
    
    2,148
    
    
    
    (80
    )
    
    
    (1,161
    )
    
    
    643Inventories
    
    
    (2,549
    )
    
    
    (5,530
    )
    
    
    (85
    )
    
    
    311
    
    
    
    (7,853
    )Deferred tax assets and income taxes
recoverable
    
    
    (352
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (352
    )Prepaid and other assets
    
    
    2,510
    
    
    
    (13,007
    )
    
    
    88
    
    
    
    
    
    
    
    (10,409
    )Accounts payable
    
    
    783
    
    
    
    1,211
    
    
    
    (57
    )
    
    
    
    
    
    
    1,937Customer advances
    
    
    3,957
    
    
    
    (1,143
    )
    
    
    (449
    )
    
    
    (1,138
    )
    
    
    1,227Interest payable
    
    
    284
    
    
    
    4,577
    
    
    
    
    
    
    
    
    
    
    
    4,861Accrued wages and benefits and other accrued
liabilities
    
    
    5,634
    
    
    
    238
    
    
    
    (1,348
    )
    
    
    1,056
    
    
    
    5,580Intercompany receivables and payables
    
    
    (59,528
    )
    
    
    11,199
    
    
    
    935
    
    
    
    47,394
    
    
    
    Net cash (used in) provided by operating activities
    
    
    (28,588
    )
    
    
    58,502
    
    
    
    1,065
    
    
    
    (14
    )
    
    
    30,965Cash flows from investing activities:Purchases of property and equipment
    
    
    (4,909
    )
    
    
    (2,070
    )
    
    
    (1,550
    )
    
    
    
    
    
    
    (8,529
    )Purchases of property and equipment previously
leased
    
    
    (14,145
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (14,145
    )Proceeds from sales of property and equipment
    
    
    127
    
    
    
    4
    
    
    
    
    
    
    
    
    
    
    
    131Acquisitions of product rights and other
intangibles
    
    
    
    
    
    
    (211,997
    )
    
    
    
    
    
    
    
    
    
    
    (211,997
    )Other
    
    
    (642
    )
    
    
    49
    
    
    
    
    
    
    
    
    
    
    
    (593
    )Net cash used in investing activities
    
    
    (19,569
    )
    
    
    (214,014
    )
    
    
    (1,550
    )
    
    
    
    
    
    
    (235,133
    )Cash flows from financing activities:Proceeds from long-term borrowings
    
    
    49,401
    
    
    
    195,085
    
    
    
    
    
    
    
    
    
    
    
    244,486Payments on long-term borrowings
    
    
    (1,900
    )
    
    
    (50,014
    )
    
    
    
    
    
    
    14
    
    
    
    (51,900
    )Proceeds from interest rate swaps, net
    
    
    
    
    
    
    10,486
    
    
    
    
    
    
    
    
    
    
    
    10,486Proceeds from stock option exercises
    
    
    3,243
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,243Other
    
    
    (2,163
    )
    
    
    (19
    )
    
    
    29
    
    
    
    
    
    
    
    (2,153
    )Net cash provided by financing activities
    
    
    48,581
    
    
    
    155,538
    
    
    
    29
    
    
    
    14
    
    
    
    204,162Net increase (decrease) in cash and cash equivalents
    
    
    424
    
    
    
    26
    
    
    
    (456
    )
    
    
    
    
    
    
    (6
    )Effect of exchange rate changes on cash
    
    
    
    
    
    
    
    
    
    
    167
    
    
    
    
    
    
    
    167Cash and cash equivalents, beginning of year
    
    
    5,301
    
    
    
    154
    
    
    
    916
    
    
    
    
    
    
    
    6,371Cash and cash equivalents, end of year
    
    $
    5,725
    
    
    $
    180
    
    
    $
    627
    
    
    $
    
    
    
    $
    6,532
 168




---



##### 



Item 9.
    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None.  Item 9A.
    Controls and Procedures Evaluation of Disclosure Controls and Procedures We have carried out an evaluation, under the supervision and with the participation of our Chief
Executive Officer and Chief Financial Officer, each of whom joined us in the latter part of 2004,
pursuant to Rule 13a-15 promulgated under the Securities Exchange Act of 1934, as amended, of the
effectiveness of the design and operation of our disclosure controls and procedures as of December
31, 2004, the end of the period covered by this Annual Report on Form 10-K. Disclosure controls
and procedures are to be designed to reasonably assure that material information we must disclose
in our reports filed or submitted under the Securities Exchange Act of 1934, such as this Annual
Report on Form 10-K, is (i) recorded, processed, summarized and reported on a timely basis and (ii)
accumulated and communicated to our management, including the Chief Executive Officer and Chief
Financial Officer, as appropriate to allow timely decisions regarding disclosure. As a result of
that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our
disclosure controls and procedures were not effective as of December 31, 2004 due to the material
weaknesses outlined in our managements report on internal control over financial reporting
included in Item 8 of this Annual Report on Form 10-K. Management Report on Internal Control Over Financial Reporting Our managements report on internal control over financial reporting is included with the financial
statements set forth in Item 8 of this Annual Report on Form 10-K and is incorporated herein by
reference. Explanation of Previous Disclosure of Material Weaknesses In our Current Report on Form 8-K filed with the SEC on March 16, 2005, we had indicated that,
although managements assessment of our internal control over financial reporting was then still
underway, our management or independent registered public accountants had identified four material
weaknesses in internal control over financial reporting as of December 31, 2004, including a lack
of effective control at the entity level with respect to the internal audit function due to
inadequate staffing. Subsequent to the filing of the March 16, 2005 Form 8-K and in the course of
completing its assessment of internal control over financial reporting as of December 31, 2004, our
management re-evaluated its initial conclusion and concluded that the identified deficiencies in
the internal audit function did not constitute a material weakness in the Companys entity level
controls because the internal audit function was not a critical function to the Companys entity
level controls because the internal audit department was primarily responsible for testing internal
controls in connection with managements assessment of internal control over financial reporting.
As a result of the deficiencies previously identified by management, our management directed a
review, and, where warranted, a retesting supervised by personnel independent of the internal audit
function of internal controls that had previously been 169




---



##### 



tested by the internal audit function as part of its assessment of internal control over financial
reporting. Changes in Internal Controls We made the following changes in our internal control over financial reporting during the fourth
quarter of 2004 that materially affected or are reasonably likely to materially affect our internal
control over financial reporting:  
    We made process enhancements to the customer credit approval process, which we began to
develop during the third quarter of 2004 and fully implemented in the fourth quarter.
    We completed the training of our finance, sales and marketing, and legal personnel, as
well as management, regarding the formal revenue recognition protocols pursuant to the
training programs that we developed during the third quarter of 2004. In addition to a
more rigorous examination of revenue recognition under generally accepted accounting
principles and applicable SEC regulations, these protocols provide that the level of
channel inventory and demand trends for products be considered in the analysis of revenue
reserves for product sales. Key members of management and the finance department were
involved in the development of these protocols.
    We implemented improvements to the budgeting and forecasting process within the
Pharmaceutical Products Division, which we began during the third quarter of 2004.
    We have implemented quarterly internal audits of invoice preparation in the Development
Services Division. These audits will continue on a quarterly basis during 2005.
    We implemented improved procedures for analyzing, reviewing, and documenting the support
for managements accounting entries and significant transactions. Documentation for all
complex accounting transactions is maintained by the Corporate Controller. This
implemented procedure provides additional controls over the period-end closing process.
    We implemented a procedure to require management to perform reviews of all monthly bank
reconciliations to ensure they are performed timely and accurately. This procedure
provides additional controls over the period-end closing process.
    We developed new period end closing checklists to ensure that all required closing
entries are posted. Any unusual or non-routine entries not appearing on the checklist
require the approval of the Corporate Controller or Assistant Controller prior to posting.
This implemented procedure provides additional controls over the period-end closing
process. Although many of these remediation processes, procedures, and controls were in place prior to
December 31, 2004, they were not operating for an adequate period of time to conclude they were
operating effectively as of December 31, 2004. 170




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##### 



In addition to the changes described above that we implemented in 2004, since then we have
implemented or are in the process of implementing the following specific enhancements to our
internal control over financial reporting related to the material weaknesses described in our
report of our assessment of internal control over financial reporting, which is included with the
financial statements set forth in Item 8 of this Annual Report on Form 10-K:  
    During the fourth quarter we commenced a process for documenting and communicating to
our employees information about our required policies and procedures.
    During the first quarter of 2005 we completed our initial review all finance associates
security authorizations for the financial reporting system and, where appropriate,
eliminated security authorizations in order to prevent segregation of duties conflicts.
    We have implemented increased controls relating to Letters of Authorizations obtained
from clients for any development services work performed outside of a signed contract or
binding purchase order. These procedures provide additional controls in maintaining
effective control over revenue recognition from Development Services activities.
    Management is currently reviewing the invoicing processes for our Development Services
Division and determining areas where more control and review processes should be added. We
do not expect these new processes to be in place until the fourth quarter of 2005.
    We have improved control processes around approvals and documentation of changes made to
signed contracts or purchase orders by the Development Services segment.
    We now require periodic cycle counts for all inventory balances. The results of these
cycle counts are reviewed by management within the finance department. Appropriate
adjustments are made on a timely basis and unusual items are investigated. This new
procedure provides additional controls over the accounting for inventory of certain
supplies used in the non-clinical portion of the Development Services business.
    A review of the process used for accounting for the issuance of supplies inventory is
currently being performed by a task force identified to address this issue and determine
the appropriate control procedure to implement in this process. These new processes will
be implemented during the second quarter of 2005. These procedures will provide additional
control over the accounting for inventory of certain supplies used in the non-clinical
portion of the Development Services business.
    Management has determined that quarterly reviews of divisional financial statements will
be performed by the Corporate Controller in conjunction with the divisional financial
managers beginning with the first quarter of 2005. Significant variances between actual
results and budgeted (forecast) amounts and variances from prior years identified during
these reviews will be discussed with each division. This new procedure will provide
additional controls over the period-end closing process. 171




---



##### 




    Management has implemented enhanced Corporate Finance oversight and controls for key
financial activities. During late 2004 and early 2005 many accounting activities were
relocated to Corporate Finance, such as the ability to post manual journal entries. This
process is continuing to be reviewed and will be revised as needed. The improved oversight
of these accounting functions provides additional controls over the period-end closing
process.
    A detailed review is performed by a senior level financial executive of all contingency
reserves and valuation allowances with documentation maintained to support all conclusions.
This implemented procedure provides additional controls over the period-end closing
process.
    The income tax function was outsourced in the third quarter of 2004 to a qualified
independent tax firm. We have implemented a procedure requiring detailed, documented
reviews to be performed by management of all work performed by the independent tax firm.
This new implemented procedure provides additional controls over the processes and
procedures involved in the accounting for income taxes in connection with the preparation
of consolidated financial statements.
    A tax procedures checklist was implemented to provide a standard process to follow and
serve as a review document to ensure that all appropriate steps have been performed. This
implemented procedure provides additional controls over the processes and procedures
involved in the accounting for income taxes in connection with the preparation of
consolidated financial statements.
    A review is performed quarterly by the Corporate Controller to determine if any changes
have occurred that significantly affect the current or deferred portion of the tax
provision. This implemented procedure provides additional controls over the processes and
procedures involved in the accounting for income taxes in connection with the preparation
of consolidated financial statements.
    A Goodwill/Intangible Amortization Policy was implemented to set forth, among other
things, a process for required reviews of asset values. This implemented procedure
provides additional controls over the process for reviewing intangible assets for
impairment.
    We have implemented a roll forward analytic procedure for analyzing the information
provided by our major wholesalers with respect to inventory levels of our products in
wholesalers inventory channel. This quarterly control procedure is intended to enable us
to identify any future misstatements or omissions in the reports provided by wholesalers.
This new procedure provides additional controls over the process for determining
appropriate product returns reserves for product sales. In light of the remediation actions listed above that were still in the process of being
implemented as of the end of the first quarter, we are performing the following additional
procedures in order to gain assurance as to the accuracy of the financial statements: 172




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##### 




    The invoicing process for Development Services is being reviewed and we expect changes
to be made to the process to provide for more controls around the recognition of revenue.
We are currently in the process of developing these new procedures, however, we do not
expect these to be in place until the fourth quarter of 2005. In order to provide
assurance on the financials as they relate to the invoicing function, management is
performing quarterly internal audits of the Development Services invoicing function.
    A review of the process used for accounting for the issuance of supplies inventory is
currently being performed by a task force identified to address this issue and determine
the appropriate control procedure to implement in this process. A remediation plan has
been developed and will be in place for the second quarter of 2005. In order to gain
assurance as to the reported inventory amounts for the 2004 year end as well as the first
quarter of 2005, management performed a physical inventory count of this supplies inventory
and recorded needed adjustments for the 2004 year end and will also perform a count for the
first quarter of 2005.
    Management has determined that quarterly reviews of divisional financial statements will
be performed by the Corporate Controller in conjunction with the divisional financial
managers beginning with the first quarter of 2005. Significant variances between actual
results and budgeted (forecast) amounts and variances from prior years identified during
these reviews will be reviewed with each division. Management is still considering additional control implementations that will be needed to
adequately address the identified material weaknesses and is also monitoring the controls
implemented in 2004 to ensure they are performed properly. In order to remediate the numerous
material weaknesses in our internal control over financial reporting, we will be required to devote
significant financial resources and management attention to our remediation efforts. Due to our
liquidity and human resources constraints, we may not be able to devote sufficient financial
resources to successfully remediate the material weaknesses in our internal controls that we have
identified. In addition, our management is currently focused on dealing with our liquidity issues
while continuing to operate our business, and thus may not be able to devote sufficient time and
attention to our remediation efforts. 173




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##### 



PART III Item 10. Directors and Executive Officers of the Registrant Directors The business and affairs of the Company are managed under the direction of its Board of Directors,
which is presently comprised of ten members. The Board of Directors is classified, with the
directors serving staggered three-year terms. The following sets forth certain information with
respect to our directors as of March 1, 2005. John E. Avery(age 76) joined the Companys Board of Directors in 2000. Mr. Avery is a retired
senior executive of Johnson & Johnson, a leading multinational healthcare products company, having
served as Company Group Chairman of all operations in Latin America and the Caribbean. Mr. Avery
served from 1993 to 1996 as Chairman of each of the Americas Society and the Council of the
Americas, each a non-profit organization. Robert J. Brown(age 70) became a director in December 2004. Mr. Brown founded B&C Associates,
Inc., High Point, North Carolina, in 1960, served as its President from 1960 until 1968 and has
been its Chairman and CEO since 1973. He also is a director of Wachovia Corporation, Sonoco
Products Company, Duke Energy Corp. and AutoNation, Inc. Joseph H. Gleberman(age 46) joined the Companys Board of Directors in 1995. Mr. Gleberman has
been employed by Goldman, Sachs & Co., an investment-banking firm, since 1982 and has been a
Partner of Goldman, Sachs & Co. since 1990 and Managing Director since 1996. Mr. Gleberman also
serves as a director of Berry Plastics Corporation, IPC Acquisition Corp. and MCG Capital
Corporation. Pursuant to a stockholders agreement entered into in connection with a 1995
investment in the Company, certain Goldman Sachs investment partnerships have the right to
designate one member of the Companys Board of Directors for as long as the investment partnerships
collectively own at least 10% of the Companys outstanding common stock. Mr. Gleberman is their
nominee. Kurt M. Landgraf(age 58) joined the Companys Board of Directors in 2001. Mr. Landgraf has served
since August 2000 as the President and Chief Executive Officer of the Educational and Testing
Service in Princeton, New Jersey, the worlds largest private educational testing and measurement
organization. He served in various positions at E.I. DuPont de Nemours Company and its affiliates
from 1980 until 2000, including Chairman and Chief Executive Officer of DuPont Pharmaceuticals
Company from January 2000 to May 2000, Executive Vice President and Chief Operating Officer from
April 1998 to August 2000, Executive Vice President from November 1997 to April 1998, and Chief
Financial Officer from December 1996 to October 1997 of E.I. DuPont de Nemours and Company. Mr.
Landgraf also serves as director of IKON Office Solutions, Inc., and NDC Health Corporation. James G. Martin, Ph.D.(age 69) joined the Companys Board of Directors in 1999 and was elected
Chairman of the Board in September 2004. Dr. Martin has served since 1995 as Corporate Vice
President and since 1993 as Chairman of the Research Development Board of Carolinas HealthCare
System, a regional healthcare system. Prior to joining Carolinas HealthCare, Dr. Martin served as
Governor of the State of North Carolina from 1984 to 1992. 174




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##### 



Dr. Martin also serves as a director of Duke Energy Corporation, Palomar Medical Technologies,
Inc., and Family Dollar Stores, Inc. Richard G. Morrison, Ph.D.(age 68) joined the Companys Board of Directors in 1999. Prior to his
retirement in May 2001, Dr. Morrison was an Adjunct Professor of Business at the Cameron School of
Business, University of North Carolina at Wilmington for over six years. Dr. Morrison also has
more than 30 years of pharmaceutical industry experience, recently acting as a private consultant
for medium-sized international pharmaceutical businesses, and having served as General Manager and
President of Eli Lillys operations in Venezuela, Mexico and Brazil. Ludo J. Reynders, Ph.D.(age 51) joined the Company in September 2004 as the Chief Executive
Officer and President and became a director in December 2004. Prior to joining the Company, Dr.
Reynders served from 2003 to September 2004 as managing member of Bronzewood LLC, a private company
focused on improving productivity in drug development. Dr. Reynders was managing director of the
PharmaBio group of Quintiles Transnational Corporation from 2002 to 2003. Dr. Reynders also held
the position of Chief Executive Officer of Quintiles Clinical Development Services and Product
Development Services groups from 2000 to 2002 and 1996 to 2000, respectively. He began his career
with Quintiles in 1988. Frederick D. Sancilio, Ph.D.(age 54) is a director and served as Executive Chairman of the Board
of Directors from July 2002 to September 2004. Dr. Sancilio also served as Chief Executive Officer
from 1979 to July 2002 and from March 2004 to September 2004 and as Chief Scientific Officer of the
Company from July 2002 to September 2004. With more than 25 years experience in the pharmaceutical
industry, Dr. Sancilio worked with Burroughs-Wellcome Co., Schering-Plough Corporation, and
Hoffmann-LaRoche, Inc. before founding the Company in 1979. William H. Underwood(age 57) is Executive Vice President, Corporate Development of the Company,
and has served as Chief Operating Officer from 1995 to 1997, as Executive Vice President since
1992, as Vice President from 1986 to 1992, and as a director since 1996. He has held positions in
the pharmaceutical and cosmetic industries for more than 17 years, in positions including Director
of Quality Assurance and Director of Manufacturing at Mary Kay Cosmetics, Inc. and Group Leader of
Bacteriological Quality Control at Burroughs-Wellcome Co. Timothy R. Wright(age 47) joined the Company in April 2004 as President of the Pharmaceuticals
Division and was appointed a director in May 2004. Prior to joining the Company, Mr. Wright served
as the President, Global Commercial Operations for Elan Bio-pharmaceuticals from February 2001 to
December 2003. Before that, Mr. Wright served as a Senior Vice President of Healthcare Product
Services with Cardinal Health, Inc. from May 1999 to January 2001. Mr. Wright also held senior
management positions with DuPont Merck Pharmaceutical Company from 1984 to 1999. 175




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##### 



Executive Officers Information about the Companys executive officers is contained at the end of Part I of this Annual
Report on Form 10-K. Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Securities Exchange Act of 1934 requires the Companys officers and directors,
as well as any holders of more than 10% of the Companys common stock, to file with the SEC certain
reports of ownership and changes in ownership of common stock and other equity securities of the
Company. Based solely on review of such reports and certain representations furnished to it, the
Company believes that all such reports required to be filed during the fiscal year ended December
31, 2004 were timely filed. Audit Committee The Board of Directors has determined that the members of the Audit Committee are independent as
defined in Rule 4200(a)(15) of NASDAQs listing standards and Rule 10A-3(b)(1) under the 1934 Act.
The audit committee is composed of James G. Martin, Ph.D., Richard G. Morrison, Ph.D., and Kurt M.
Landgraf. The Board of Directors has also determined that Mr. Landgraf is an audit committee
financial expert as defined in Item 401(h) of Regulation S-K under the Exchange Act. Code of Ethics In addition to a code of conduct that applies to all of our employees, our Board of Directors has
adopted a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer,
Chief Accounting Officer and Controller. We will provide copies of our code of ethics without
charge upon request. To obtain a copy of the code of ethics free of charge, please send your
written request to our General Counsel, aaiPharma Inc., 2320 Scientific Park Drive, Wilmington,
North Carolina 28405. Item 11. Executive Compensation Compensation of Directors All non-employee directors receive $3,000 per meeting for attending in-person meetings of the Board
of Directors and meetings of Board committees not held in connection with a regular Board meeting.
Non-employee directors also receive $1,000 per meeting lasting longer than one hour for
participating in telephonic meetings of the Board of Directors and $500 for Board committee
telephonic meetings. In addition, non-employee directors who serve on the Audit Committee receive
an annual retainer of $15,000 and those who serve on the Executive and Corporate Governance
Committees receive an annual retainer of $10,000. The non-employee chair of the Audit, the
Executive and Corporate Governance, and the Compensation Committees receives an annual retainer of
$30,000, $15,000 and $10,000, respectively. The non-employee chair of the Board of Directors
receives an annual retainer of $100,000, which is paid in quarterly installments. Directors are
also reimbursed for expenses incurred in connection with attending meetings. 176




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##### 



One director, Dr. Sancilio, uses office space in Jupiter, Florida that the Company has leased from
a third party. The Company paid $92,000 per year for this office space, but ceased paying rent in
April 2005. Executive Compensation The following Summary Compensation Table sets forth all compensation awarded to, earned by or paid
for services rendered to the Company in all capacities in 2004 by: (i) all individuals serving as
the Companys chief executive officer during 2004, (ii) the Companys next four most highly
compensated employees who were serving as executive officers on December 31, 2004 and (iii) two
former executive officers who left the Company before December 31, 2004 but whose salary and bonus
exceeded the salary and bonus of certain of the persons set forth below who were serving as
executive officers on December 31, 2004 (collectively, the Named Executive Officers). The
Companys Chief Operating Officer, Gregory F. Rayburn, is not included in the Summary Compensation
Table because the Company neither controls nor participates in decisions regarding his
compensation, which is paid to him by FTI Palladium Partners. 177




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##### 



Summary Compensation Table Annual Compensation
    
    
    Long-Term Compensation AwardsSecuritiesRestricted
    
    
    Underlying
    
    
    All OtherOther Annual
    
    
    Stock
    
    
    Options/SARs(#)
    
    
    Compensation($)Name and Principal Position
    
    Year
    
    
    Salary ($)(1)
    
    
    Bonus ($)(2)
    
    
    Compensation
    
    
    Awards(#)(3)
    
    
    (4)
    
    
    (5)Ludo J. Reynders, Ph.D.(6)
    
    
    2004
    
    
    
    103,846
    
    
    
    0
    
    
    
    
    (7)
    
    
    50,000
    
    
    
    782,918
    
    
    
    0Chief Executive OfficerFrederick D. Sancilio, Ph.D.(8)
    
    
    2004
    
    
    
    354,176
    
    
    
    500,000
    (9)
    
    
    72,313
    (10)
    
    
    0
    
    
    
    0
    
    
    
    234,442
    (11)Former
    
    
    2003
    
    
    
    438,193
    
    
    
    100,000
    
    
    
    73,125
    (10)
    
    
    0
    
    
    
    0
    
    
    
    0Chief Executive Officer
    
    
    2002
    
    
    
    407,115
    
    
    
    427,000
    
    
    
    58,499
    (10)
    
    
    0
    
    
    
    82,500
    
    
    
    0Philip S. Tabbiner, D.B.A.(12)
    
    
    2004
    
    
    
    629,993
    (13)
    
    
    0
    
    
    
    
    (7)
    
    
    0
    
    
    
    0
    
    
    
    3,000Former
    
    
    2003
    
    
    
    527,500
    
    
    
    26,375
    
    
    
    
    (7)
    
    
    0
    
    
    
    329,500
    
    
    
    3,000Chief Executive Officer
    
    
    2002
    
    
    
    397,942
    
    
    
    360,500
    
    
    
    
    (7)
    
    
    37,500
    
    
    
    168,000
    
    
    
    0Timothy R. Wright (14)
    
    
    2004
    
    
    
    315,692
    
    
    
    3,808
    
    
    
    
    (7)
    
    
    0
    
    
    
    180,000
    
    
    
    0President, Pharmaceuticals
Division and Former Interim
Chief Executive OfficerWilliam H. Underwood
    
    
    2004
    
    
    
    227,897
    
    
    
    0
    
    
    
    
    (7)
    
    
    0
    
    
    
    100,000
    
    
    
    2,279Executive Vice President
    
    
    2003
    
    
    
    213,953
    
    
    
    71,538
    
    
    
    38,415
    (15)
    
    
    0
    
    
    
    42,500
    
    
    
    2,9142002
    
    
    
    202,800
    
    
    
    95,840
    
    
    
    
    (7)
    
    
    0
    
    
    
    37,500
    
    
    
    2,438Gregory S. Bentley
    
    
    2004
    
    
    
    252,686
    
    
    
    0
    
    
    
    
    (7)
    
    
    0
    
    
    
    60,000
    
    
    
    3,000Executive Vice President
    
    
    2003
    
    
    
    237,375
    
    
    
    11,869
    
    
    
    
    (7)
    
    
    0
    
    
    
    27,500
    
    
    
    3,000& General Counsel
    
    
    2002
    
    
    
    225,000
    
    
    
    219,250
    
    
    
    
    (7)
    
    
    0
    
    
    
    75,000
    
    
    
    3,000Michael W. George(16)
    
    
    2004
    
    
    
    100,961
    
    
    
    0
    
    
    
    
    (7)
    
    
    0
    
    
    
    145,000
    
    
    
    0Executive Vice PresidentVijay Aggarwal, Ph.D.(17)
    
    
    2004
    
    
    
    322,081
    
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    3,000Former
    
    
    2003
    
    
    
    356,645
    
    
    
    17,832
    
    
    
    
    (7)
    
    
    0
    
    
    
    142,750
    
    
    
    2,675Executive Vice President
    
    
    2002
    
    
    
    232,212
    
    
    
    59,875
    (18)
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0William L. Ginna
    
    
    2004
    
    
    
    359,114
    (19)
    
    
    0
    
    
    
    
    (7)
    
    
    0
    
    
    
    0
    
    
    
    3,000Former
    
    
    2003
    
    
    
    274,301
    
    
    
    13,175
    
    
    
    
    (7)
    
    
    0
    
    
    
    157,750
    
    
    
    3,000Chief Financial Officer
    
    
    2002
    
    
    
    260,000
    
    
    
    197,300
    
    
    
    30,000
    (20)
    
    
    0
    
    
    
    187,500
    
    
    
    3,000
   (1)
    
    Includes salary amounts deferred pursuant to the Companys 401(k) plan.(2)
    
    Includes discretionary bonuses granted in March 2002 that were paid in 2003 and 2004;
performance bonuses for 2002 that were paid in 2003; and bonuses paid in 2003 for regulatory
approval of Company products. Discretionary bonuses were granted in March 2002 and were
payable in April 2002, unless the executive elected to defer receipt of the bonus until the
future. If the deferral election was made, the executive received 100% of the bonus in
January 2003 and received an additional 100% of the bonus in January 2004, unless the
deferring executive voluntarily left our employment prior to the payment date. The following
Named Executive Officers elected to defer their bonus payments and received the following
amounts in each of 2003 and 2004, and the aggregate of the bonuses received in 2003 and 2004
is reflected in the executives 2002 bonus line: Dr. Sancilio, $140,000; Dr. Tabbiner,
$99,750; Mr. Bentley, $66,500; and Mr. Ginna, $75,250. In addition, Mr. Bentley received a
$30,000 bonus in 2002 and an equal amount that was deferred until 2003. Both bonus payments
are reflected in Mr. Bentleys 2002 bonus. The Named Executive Officers received bonuses for
2002 performance in the following amounts, which are also included in the 2002 bonus line: Dr.
Sancilio, $147,000; Dr. Tabbiner, $161,000; Mr. Bentley, $56,250; Dr. Aggarwal, $25,875; and
Mr. Ginna, $46,800. The 2003 bonuses were for the commercialization of certain 178




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##### 



products that received regulatory approval in 2003. No bonuses were paid to executives as a
result of their individual or collective performance during 2003 or 2004.(3)
    
    The market value of the restricted stock granted to Dr. Reynders was $162,500 and the market
value of the restricted stock granted to Dr. Tabbiner was $121,875 at December 31, 2004.(4)
    
    All options vest in one-third increments at each of the first, second, and third
anniversaries of the grant date and have 10-year terms. A portion of the options granted on
October 29, 2004 will have their vesting accelerated if the employee is terminated for cause.(5)
    
    For 2004, these amounts represent the Companys match to the executives 401K account and for
Dr. Sancilio, severance payments made pursuant to his employment agreement.(6)
    
    Dr. Reynders joined the Company as Chief Executive Officer on September 27, 2004.(7)
    
    Amounts received did not exceed the lesser of $50,000 or 10% of salary.(8)
    
    Dr. Sancilio served as Chief Executive Officer from March 29 through September 27, 2004.(9)
    
    Under Dr. Sancilios employment agreement, he became entitled to this bonus as a result of
the regulatory approval and commercialization of certain products in 2004. Dr. Sancilio and
the Company are negotiating the form and timing of payment.(10)
    
    For 2004, this amount includes $27,126 for non-business use of the Companys aircraft and
$14,054 for reimbursement for accounting fees pursuant to Dr. Sancilios employment agreement
with the Company. In addition, Dr. Sancilio received $12,104 for reimbursement for tuition
for his children pursuant to a benefit accorded members of senior management. For 2003, this
amount includes $62,230 for non-business use of the Companys aircraft and $10,895 for
reimbursement for accounting fees and club memberships pursuant to Dr. Sancilios employment
agreement with the Company. For 2002, it includes $24,414 for non-business use of the
Companys aircraft and $20,946 for reimbursement for accounting fees and club memberships
pursuant to Dr. Sancilios employment agreement.(11)
    
    This amount represents severance payments to which Dr. Sancilio is entitled under the
employment agreement. The amount will be paid in 24 monthly increments of $78,147 each, which
began in October 2004.(12)
    
    Dr. Tabbiner left the Company on March 29, 2004.(13)
    
    This amount includes $412,422 paid to Dr. Tabbiner in 2004 pursuant to his consulting
agreement.(14)
    
    Mr. Wright joined the Company in April 2004 and served as interim Chief Executive Officer
from November 9, 2004 to November 22, 2004 during the temporary incapacity of Dr. Reynders as
Chief Executive Officer.(15)
    
    This amount includes $32,415 for reimbursement for tuition for his children pursuant to a
benefit accorded members of senior management.(16)
    
    Mr. George joined the Company in July 2004.(17)
    
    Dr. Aggarwal joined the Company in April 2002 and left the Company in September 2004.(18)
    
    This amount includes a signing bonus of $34,000.(19)
    
    This amount includes $203,150 paid to Mr. Ginna in 2004 pursuant to his consulting agreement.(20)
    
    This amount includes $24,000 for a country club membership. 179




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##### 



The following table sets forth certain information with respect to options granted during 2004 to
the Named Executive Officers. Stock Option Grants in 2004 Potential RealizableNumber of
    
    
    Percent of Total
    
    
    
    
    
    
    
    
    
    
    Value at Assumed AnnualSecurities
    
    
    Options/SARs
    
    
    
    
    
    
    
    
    
    
    Rates of Stock PriceUnderlying
    
    
    Granted to
    
    
    Exercise
    
    
    
    
    
    
    Appreciation for OptionOptions Granted
    
    
    Employees in
    
    
    Price
    
    
    Expiration
    
    
    Term (1)Name and Principal Position
    
    (#) (2)
    
    
    Fiscal Year
    
    
    ($/Sh)
    
    
    Date
    
    
    5%($)
    
    
    10%($)Ludo J. Reynders, Ph.D.
    
    
    782,918
    
    
    
    23.8
    %
    
    
    1.41
    
    
    27-Sep-14
    
    
    691,784
    
    
    
    1,753,116Frederick D. Sancilio, Ph.D.
    
    
    0
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Philip S.
Tabbiner, D.B.A.
    
    
    0
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Timothy R. Wright
    
    
    120,000
    
    
    
    3.6
    %
    
    
    7.95
    
    
    21-Apr-14
    
    
    599,966
    
    
    
    1,520,43060,000
    (3)
    
    
    1.8
    %
    
    
    2.96
    
    
    29-Oct-14
    
    
    111,880
    
    
    
    283,527William H. Underwood
    
    
    100,000
    
    
    
    3.0
    %
    
    
    1.61
    
    
    30-Sep-14
    
    
    100,938
    
    
    
    255,796Gregory S. Bentley
    
    
    60,000
    (3)
    
    
    1.8
    %
    
    
    3.00
    
    
    29-Oct-14
    
    
    111,880
    
    
    
    283,527Michael W. George
    
    
    85,000
    
    
    
    2.6
    %
    
    
    1.81
    
    
    15-Oct-14
    
    
    96,488
    
    
    
    244,52060,000
    (3)
    
    
    1.8
    %
    
    
    2.97
    
    
    29-Oct-14
    
    
    111,880
    
    
    
    283,527Vijay Aggarwal, Ph.D.
    
    
    0
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    William L. Ginna
    
    
    0
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
   (1)
    
    Potential realizable value is based on an assumption that the price of the Companys
common stock will appreciate at the annual rate shown (compounded annually) from the date of
grant until the end of the ten-year option term. The numbers are calculated based on
requirements promulgated by the SEC and do not reflect the Companys estimate of future stock
price growth.(2)
    
    The options vest in one-third increments at each of the first, second, and third
anniversaries of the grant date.(3)
    
    In the event an optionee is terminated without cause, options granted to that employee will
become vested as if the employee was employed with the Company on the next vesting date. The following table sets forth certain information with respect to the number of shares of common
stock underlying unexercised options and the value of unexercised options held at fiscal year-end
by the Named Executive Officers: 180




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##### 



Aggregated 2004 Year-End Option Values Number of SecuritiesUnderlying
    
    Value of Unexercised In-the-Unexercised Options at
    
    Money Options AtFiscal Year End(#)
    
    Fiscal Year-End($)(1)Name and Principal Position
    
    Exercisable/Unexercisable
    
    Exercisable/UnexercisableLudo J. Reynders, Ph.D.
    
    0/782,918
    
    0/1,050,536Frederick D. Sancilio, Ph.D.
    
    0/0
    
    0/0Philip S. Tabbiner, D.B.A.
    
    245,376/0
    
    0/0Timothy R. Wright
    
    0/180,000
    
    0/17,100William H. Underwood
    
    178,163/140,859
    
    0/164,500Gregory S. Bentley
    
    164,112/103,388
    
    0/17,100Michael W. George
    
    0/145,000
    
    0/139,925John Harrington
    
    0/190,000
    
    0/99,350Vijay Aggarwal, Ph.D.
    
    0/0
    
    0/0William L. Ginna
    
    217,526/0
    
    0/0
   (1)
    
    Market value of underlying securities at fiscal year-end minus the exercise price of
in-the-money options. No Named Executive Officers exercised options in 2004. Employment and Compensation Agreements On November 17, 1995, the Company entered into an employment agreement with Dr. Frederick D.
Sancilio. The employment agreement, which was amended in 2003 and in September 2004, renewed
automatically for successive two-year periods unless either party notified the other party of an
intention not to extend the term. Dr. Sancilio served as aaiPharmas Executive Chairman of the
Board and Chief Scientific Officer from July 2002 until September 2004, as well as Chief Executive
Officer from March 2004 until September 2004. Prior to July 2002, he served as Chairman of the
Board of Directors and Chief Executive Officer. The Company was required under this agreement to
use best efforts to cause Dr. Sancilio to be elected to the Companys Board of Directors, the
Boards of Directors of any affiliated corporations on which Dr. Sancilio served on November 17,
1995, and the Board of Directors of any majority-owned subsidiary of aaiPharma acquired after
November 17, 1995. In July 2002, Dr. Sancilios salary was adjusted downward to $400,000 to reflect his new role as
Executive Chairman and Chief Scientific Officer. The Board of Directors increased Dr. Sancilios
annual salary from $400,000 to $422,000 effective January 1, 2003. Dr. Sancilio resumed his
previous role as Chief Executive Officer on March 29, 2004. His salary was not adjusted to reflect
his increased responsibilities. Pursuant to the employment agreement, Dr. Sancilio was entitled to
a bonus when aaiPharma received certain regulatory approvals. This bonus was in the amount of
$250,000 for each new drug application and $50,000 for each supplemental new drug application or
abbreviated new drug application. Dr. Sancilio was awarded a bonus of $100,000 in May 2003 upon
regulatory approval and commercialization of two products. Dr. Sancilio earned a bonus of
approximately $500,000 in 2004 in connection 181




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##### 



with the regulatory approval of certain products that were commercialized in 2004. Dr. Sancilio
and the Company are negotiating the form and timing of payment. The employment agreement permitted the Company to terminate Dr. Sancilios employment at any time,
with or without cause. The Company terminated Dr. Sancilios employment under his employment
agreement on September 27, 2004. Under the terms of the employment agreement, Dr. Sancilio will
receive payments aggregating three times his then-current annual salary of $422,000 plus a target
bonus which equaled $422,000. Pursuant to an amendment to the employment agreement entered into in
connection with the termination of Dr. Sancilios employment, these payments will be made in
monthly installments over two years, during which time Dr. Sancilio will continue to receive his
medical and life insurance benefits. The employment agreement requires Dr. Sancilio to refrain
from certain activities in competition with aaiPharma for a period of two years after the
termination of his employment. On March 29, 2004, the Company announced that Dr. Philip S. Tabbiner had resigned as Chief
Executive Officer to take a consulting position with the Company. Dr. Tabbiner entered into a
consulting agreement with aaiPharma for a period of fifteen months. Under this agreement, Dr.
Tabbiner agreed to provide such services as may be reasonably requested by the Company. Dr.
Tabbiner is receiving $10,615 per week during the term of the agreement. The consulting agreement
ends in June 2005, or earlier if it is determined that Dr. Tabbiner committed an act of willful
misconduct while serving as an employee of the Company. On May 11, 2004, the Companys Chief Financial Officer, William L. Ginna, Jr., left the Company.
Mr. Ginna also agreed to enter into a consulting agreement with the Company, for a twelve-month
period. Mr. Ginna is receiving $6,173 per week during the term of the agreement. The consulting
agreement ends in May 2005, or earlier if it is determined that Mr. Ginna committed an act of
willful misconduct or gross negligence in the performance of his duties as an employee of the
Company. On September 27, 2004, the Company entered into an employment agreement with Dr. Ludo Reynders.
The employment agreement has an initial two-year term and is renewed automatically for successive
one-year periods unless either party notifies the other party of an intention not to extend the
term. Dr. Reynders serves as the Companys President and Chief Executive Officer. Under the
employment agreement, Dr. Reynders annual base salary is to be no less than $550,000. In
addition, Dr. Reynders is eligible to participate in cash and bonus programs that the Board or
Compensation Committee may establish, and is entitled to reimbursement of up to $10,000 per
calendar year for tax preparation and financial planning services and repayment of certain excise
tax payments that may be owed by Dr. Reynders following a change of control. The employment agreement permits the Company to terminate Dr. Reynders employment at any time,
with or without cause. However, if the Company terminates Dr. Reynders employment without cause
or if Dr. Reynders terminates his employment within 12 months following a Change of Control which
creates Good Reason, Dr. Reynders would be entitled to receive payments aggregating one times his
then current annual salary. These payments would be made in either bi-weekly installments over a
one-year period or in a single payment made within 60 days after the date of termination. Under
the employment agreement, a Good Reason includes, among other things, a reduction in Dr.
Reynders responsibilities or the relocation of 182




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Dr. Reynders worksite by more than 50 miles from its current location. The definition of Change
of Control includes, among other things, the acquisition of Company common stock in which a person
would thereby own 50% or more of the Companys outstanding common stock and a change in the
membership of the Board of Directors such that the directors at September 27, 2004 (or their
elected successors) no longer constitute at least two-thirds of the Board. The employment
agreement requires Dr. Reynders to refrain from certain activities in competition with aaiPharma
for a period of one year after the termination of his employment for any reason. The Company has entered into a letter agreement with Timothy R. Wright, President of the
Pharmaceuticals Division and a member of the Companys Board of Directors. Under this letter
agreement, which is modeled after agreements executed in the fourth quarter of 2004 with employees
who are not executive officers, the Company agreed to provide Mr. Wright with bonus and severance
benefits in the event the Company sold some or all of the assets of its Pharmaceuticals Division.
Specifically, if the Company sold some or all of such assets (excluding the sale of products to
customers in the ordinary course of business) by March 31, 2005, the letter agreement provided that
Mr. Wright would have been entitled to receive a bonus amount based on the cash proceeds from the
sale. Such a sale did not occur. The letter agreement also provides that Mr. Wright will be eligible to receive a standard severance
benefit from the Company if the Company terminates his employment as a result of the sale of the
assets and he is not hired by, nor his employment transferred to, the purchaser of the assets. The Company entered into an offer letter agreement, effective as of November 30, 2004, with Matthew
E. Czajkowski. Under the offer letter agreement, Mr. Czajkowski serves as Executive Vice President
and Chief Financial Officer of the Company, and is employed at a base salary of not less than
$255,000 and received a grant of options to purchase 145,000 shares of the registrants common
stock and a grant of 50,000 restricted shares of the registrants common stock as of the date of
hire. Of the 50,000 shares of restricted stock, 25,000 vest six months after the date of hire and
the other 25,000 vest on the first anniversary of the date of hire. The parties intend to enter
into an employment contract that will set out additional terms of
Mr. Czajkowskis employment.  Mr. Czajkowskis base
salary was increased to $325,000 in March 2005 in connection with his
appointment as Chief Administrative Officer. On June 19, 2004, the Company entered into an employment agreement with John Harrington. The
employment agreement has an initial one-year term and is renewed automatically for successive
one-year periods unless either party notifies the other party of an intention not to extend the
term. Mr. Harrington serves as the Companys Executive Vice President of Human Resources. Under
the employment agreement, Mr. Harringtons annual base salary is to be no less than $225,000. In
addition, Mr. Harrington is eligible to participate in cash and bonus programs that the Board or
Compensation Committee may establish. The employment agreement permits the Company to terminate Mr. Harringtons employment at any time,
with or without cause. However, if the Company were to terminate Mr. Harringtons employment
without cause or if Mr. Harrington terminates his employment within 12 months following a Change
of Control which creates Good Reason, Mr. Harrington would be entitled to receive payments
aggregating his base salary, less applicable withholding for taxes, 183




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##### 



until the end of the then applicable one-year term of the agreement. These payments would be made
in either bi-weekly installments over the remainder of the one-year period or in a single payment
made within 60 days after the date of termination. Under the employment agreement, a Good Reason
includes, among other things, a reduction in Mr. Harringtons responsibilities or the relocation of
Mr. Harringtons worksite by more than 50 miles from its current location. The definition of
Change of Control includes, among other things, the acquisition of Company common stock after
which a person would thereby own 50% or more of the Companys outstanding common stock or a change
in the membership of the Board of Directors such that the directors at June 19, 2004 (or their
elected successors) no longer constitute at least two-thirds of the Board. The employment
agreement requires Mr. Harrington to refrain from certain activities in competition with aaiPharma
for a period of one year after the termination of his employment for any reason. Item 12. Security Ownership of Certain Beneficial Owners and Management Security Ownership The following table sets forth certain information known to aaiPharma with respect to beneficial
ownership of aaiPharmas common stock as of March 1, 2005 by (i) each stockholder known by
aaiPharma to be the beneficial owner of more than 5% of aaiPharmas common stock, (ii) each
director, (iii) each Named Executive Officer and (iv) all current executive officers and directors
as a group. Number of Shares
    
    
    Percent ofName of Beneficial Owner
    
    Beneficially Owned (1)
    
    
    Shares (2)Frederick D. Sancilio, Ph.D. (3)(4)
    
    
    6,123,167
    
    
    
    21.4
    %Brown Capital Management, Inc. (5)
    
    
    4,495,150
    
    
    
    15.7
    %The Goldman Sachs Group, Inc. (6)
    
    
    3,415,249
    
    
    
    11.9
    %James Waters (7)
    
    
    3,341,244
    
    
    
    11.7
    %Royce Associates, LLC (8)
    
    
    1,440,600
    
    
    
    5.0
    %William H. Underwood (9)
    
    
    315,273
    
    
    
    1.1
    %Phillip S. Tabbiner, D.B.A.
    
    
    286,629
    
    
    
    1.0
    %Gregory S. Bentley
    
    
    201,141
    
    
    
    *John E. Avery
    
    
    169,985
    
    
    
    *Kurt M. Landgraf
    
    
    161,985
    
    
    
    *James G. Martin, Ph.D.
    
    
    130,734
    
    
    
    *Richard Morrison, Ph.D.
    
    
    122,484
    
    
    
    *Ludo Reynders, Ph.D.
    
    
    50,000
    
    
    
    *Timothy Wright
    
    
    39,960
    
    
    
    *Joseph H. Gleberman (10)
    
    
    19,985
    
    
    
    *Robert J. Brown
    
    
    0
    
    
    
    Michael George
    
    
    0
    
    
    
    Vijay Aggarwal
    
    
    0
    
    
    
    William L. Ginna
    
    
    217,526
    
    
    
    *All executive officers and
directors as a group (16 persons)
    
    
    7,893,683
    
    
    
    25.8
    %
 184




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##### 



*
    
    Less than 1%(1)
    
    Unless otherwise indicated below, the persons and entities named in the table have
sole voting and sole investment power with respect to all shares beneficially owned,
subject to community property laws where applicable. Information in the table reflects
options granted under aaiPharmas 1995 Stock Option Plan, 1996 Stock Option Plan, 1997
Stock Option Plan and the 2000 Non-Employee Director Stock Option Plan to the extent such
options are exercisable or will become exercisable within 60 days after March 1, 2005.
Accordingly, the totals for the following executive officers and directors and all
executive officers and directors as a group includes the following shares represented by
options: Dr. Sancilio, 0 shares; Mr. Underwood, 188,177 shares; Dr. Tabbiner, 245,376
shares; Mr. Bentley, 181,641 shares; Mr. Avery, 139,985 shares; Mr. Landgraf, 159,985
shares; Dr. Martin, 128,484 shares; Dr. Morrison, 122,484 shares; Dr. Reynders, 0 shares;
Mr. Wright, 39,960 shares; Mr. Gleberman, 19,985 shares; Mr. Brown, 0 shares; Mr. George,
0 shares; Mr. Ginna, 217,526 shares and all executive
officers and directors as a group, 1,760,673 shares.(2)
    
    These calculations are based on an aggregate of 28,585,582 shares issued and
outstanding as of March 1, 2005. Options to purchase shares held by a person that are
exercisable or become exercisable within the 60-day period after March 1, 2005 are deemed
to be outstanding for the purpose of calculating the percentage of outstanding shares
owned by that person but are not deemed to be outstanding for the purpose of calculating
the percentage owned by any other person.(3)
    
    Dr. Sancilios address is 5395 Pennock Point Road, Jupiter, Florida 33458.(4)
    
    Includes 2,325 shares owned by Dr. Sancilios children.(5)
    
    Based on the Schedule 13G/A filed by Brown Capital Management, Inc. with the SEC on
February 11, 2004. The address of Brown Capital Management, Inc. is 1201 N. Calvert
Street, Baltimore, Maryland 21202. This Schedule 13G/A indicates that Brown Capital
Management, Inc. has sole dispositive power for 4,495,150 shares and sole voting power for
2,516,145 shares.(6)
    
    Goldman, Sachs & Co. is a wholly owned, direct and indirect, subsidiary of The
Goldman Sachs Group, Inc. Goldman, Sachs, an NASD member, is an investment banking firm
that regularly performs services such as acting as a financial advisor and serving as
principal or agent in the purchase and sale of securities. The Goldman Sachs Group and
Goldman, Sachs may be deemed to own beneficially and indirectly in the aggregate 3,415,249
shares of aaiPharmas common stock through certain investment partnerships of which
affiliates of Goldman, Sachs and The Goldman Sachs Group are the general partner, managing
general partner or managing partner. Each investment partnership shares voting and
dispositive power with respect to its shares with The Goldman Sachs Group, Goldman, Sachs
and certain of their affiliates. Goldman, Sachs is the investment manager of one or more
of the 185




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##### 



investment partnerships. The address of Goldman, Sachs is 85 Broad Street, New York,
New York 10004.(7)
    
    Includes 659,207 shares of common stock beneficially owned by Mr. Waters spouse,
46,275 shares owned by the Waters Foundation and 19,985 shares issuable upon exercise of
options that are exercisable or will become exercisable within 60 days after March 1,
2005. Mr. Waters address is 260 Cedar Hill Street, Marlborough, MA 01752-3017(8)
    
    Based on the Schedule 13G filed by Royce & Associates, LLC with the Securities and
Exchange Commission dated January 31, 2003. The address of Royce & Associates, LLC is 1414
Avenue of Americas, New York, NY 10019. This Schedule 13G indicates that Royce &
Associates, LLC has sole dispositive power for 1,440,600 shares and sole voting power for
1,440,600 shares.(9)
    
    Includes 1,387 shares owned by Mr. Underwoods children.(10)
    
    Mr. Gleberman, a managing director of Goldman, Sachs, disclaims beneficial ownership
of the 3,415,249 shares that may be deemed beneficially owned by The Goldman Sachs Group
as described in note (6) above. Mr. Gleberman, a managing director of Goldman, Sachs,
disclaims beneficial ownership of the securities reported herein except to the extent of
his pecuniary interest therein, if any. 186




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Equity Compensation Plan Information The following table sets forth the aggregate number of shares of common stock to be issued and
available for issuance as of December 31, 2004 and the weighted average exercise price of the
outstanding options under our equity compensation plans. WeightedNumber of Securities
    
    
    average exercise
    
    
    Number ofto be issued upon
    
    
    price of
    
    
    securitiesexercise of
    
    
    outstanding
    
    
    remainingoutstanding options,
    
    
    options, warrants
    
    
    available forPlan Category
    warrants and rights
    
    and rights
    
    
    future issuanceEquity compensation
plans approved by
security holders
    
    
    6,794,242
    
    
    $
    7.80
    
    
    
    1,775,470Equity compensation
plans not approved
by security holders
    
    
    0
    
    
    
    0
    
    
    
    0TOTAL
    
    
    6,794,242
    
    
    $
    7.80
    
    
    
    1,775,470
 Item 13. Certain Relationships and Related Transactions We have certain relationships, and have engaged in transactions, with related parties. These
transactions may raise conflicts of interest. Our Audit Committee evaluates relationships and
transactions involving conflicts of interest on a case by case basis. Two brothers of Dr. Sancilio, who is currently a director and served as Chief Executive Officer and
Chief Scientific Officer during part of 2004, were employed by us until September 16, 2004. Their
compensation, including severance, paid between January 1, 2004 and March 31, 2005 was $316,915 and
$141,985. In November 1995, GS Capital Partners II, L.P., G.S. Capital Partners II Offshore, L.P., Bridge
Street Fund 1995, L.P., Stone Street Fund, L.P., and Goldman Sachs & Co. Verwaltungs GmbH, each an
investment partnership managed by an affiliate of The Goldman Sachs Group Ltd., purchased shares of
preferred stock of aaiPharma. All outstanding shares of preferred stock were converted into
aaiPharma common stock in conjunction with our public offering of common stock in September 1996.
These Goldman Sachs investment partnerships own 3,415,249 shares of our common stock. Pursuant to
a stockholder agreement entered into in connection with their 1995 investment, the Goldman Sachs
investment partnerships have the right to designate one member of our Board of Directors for so
long as they and their affiliates (which include Goldman, Sachs & Co.) beneficially own 10% or more
of the outstanding shares of our common stock. Pursuant to the stockholders agreement, Joseph
Gleberman, a managing director of Goldman, Sachs & Co., serves as one of our directors. In connection with the 1995 investment, we agreed that so long as the Goldman Sachs investment
partnerships beneficially own 5% or more of the outstanding shares of our common stock, we will
retain Goldman, Sachs & Co. or an affiliate to perform all investment banking 187




---



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services for us for which an investment banking firm is retained, and to serve as managing
underwriter of any offering of our capital stock on customary terms, consistent with an arms
length transaction. If we cannot agree to the terms of an engagement with Goldman, Sachs & Co. or
their affiliates after good faith discussions, the agreement permits us to engage any other
investment banking firm. However, Goldman, Sachs & Co. would be entitled to serve as co-managing
underwriter in any underwritten offering of our capital stock. In addition, in that 1995 investment transaction, we granted to the Goldman Sachs investment
partnerships, and other stockholders including Frederick Sancilio, James Waters and William
Underwood, rights to cause us to register for sale the shares of common stock they beneficially
owned at that time. Dr. Sancilio and Mr. Underwood are directors of aaiPharma. We organized Aesgen, Inc. with an affiliate of the Mayo Clinic in 1994 and funded it in 1995 with
an affiliate of the Mayo Clinic, MOVA Pharmaceutical Corporation and certain other investors. Our
initial common stock investment in Aesgen was distributed to our shareholders prior to our initial
public offering in 1996. As a result, some of our directors and executive officers received common
equity of Aesgen. In January 2001, the terms of the nonconvertible, redeemable preferred stock we
received in connection with our 1995 investment in Aesgen were amended to make that class of stock
convertible into Aesgen common stock. In October 2001, we agreed to provide development services
to Aesgen, through AAI Development Services, in exchange for up to $1.1 million of Aesgen
convertible preferred stock. Through December 31, 2004, the Company had performed $580,000 of
services under the agreement. As of December 31, 2003, we owned 10.0% of the common equity of
Aesgen on a fully diluted basis. Aesgen merged into a subsidiary of MGI Pharma, Inc. in October
2004. The Companys investment was converted into common stock immediately prior to the merger and
the common stock was converted into a right to receive approximately 10% of the cash paid as merger
consideration. The Company received $2.7 million in October 2004 on the effective date of the
merger. The Company is entitled to 10% of the residual portion of the $3.2 million of merger
consideration that is held in a one-year escrow. In addition, the Company will receive 10% of any
future contingent payments that may be payable under the merger agreement. At the time of our 1995 investment in Aesgen, we entered into a development agreement with Aesgen.
Under this agreement, we had the right to provide product development and support services to
Aesgen with respect to the generic drugs being developed by Aesgen, provided that our fees for such
services were comparable to those of a competitor. In addition, we were obligated not to develop
for our own account or for any other person, any formulation of the generic products then under
development by Aesgen. In 1996, we sold to Aesgen marketing rights to a pharmaceutical product
that we were developing. Under the agreement, Aesgen paid a license fee and agreed to pay
additional royalties upon marketing the product. In December 2001, we agreed to purchase from
Aesgen a number of generic product development projects including the rights to associated
abbreviated new drug applications that have been filed with or approved by the FDA. In exchange
for the rights to these products, we agreed to terminate the 1995 development agreement and the
1996 license agreement with Aesgen described above, and to release Aesgen from any and all
liabilities owed to us under these contracts, including approximately $0.7 million of work in
progress and accounts receivable. Furthermore, as a result of this transaction, we have the right
to receive royalties that were formerly payable to Aesgen by MOVA Pharmaceutical Corporation with
respect to the abbreviated new drug 188




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##### 



applications we acquired from Aesgen. The terms of this transaction resulted from negotiations
between Aesgen and us. We believe this transaction was fair to us. In February 2002, we purchased a calcitriol product from Aesgen for payments of $1.0 million in
cash and additional contingent milestone payments of up to $1.5 million. Calcitriol is a drug used
primarily to treat chronic kidney dialysis patients with abnormally low levels of calcium in their
blood. In 2003, the prerequisite for payment of $500,000 of such contingent milestones occurred
and such payment was made to Aesgen. The prerequisites for payment of the remaining $1.0 million
of such contingent milestones were not met and we do not owe any further contingent milestone
payments to Aesgen. The purchase agreement with Aesgen obligated us to pay royalty payments for
the eight-year period following the first commercial sale of this product. We expensed royalties
related to this agreement of $0.4 million in 2004 and $0.6 million in 2003. Of this amount, none
was payable at December 31, 2004. We also sold calcitriol under an exclusive manufacturing and co-promotion agreement with Sicor
Pharmaceuticals, Inc. pursuant to which we acquired U.S. marketing rights to, and sold, Sicor
Pharmaceuticals calcitriol product under their regulatory approval. We amended the 2002
calcitriol injection acquisition agreement with Aesgen in 2003 to provide for royalty payments to
Aesgen on the gross margin we realized from our sales of the calcitriol product marketed under
Sicors regulatory approval and to provide for potential payments to Aesgen in connection with
Sicors reacquisition of the U.S. marketing rights to calcitriol injection. On December 23, 2004,
Sicor Pharmaceuticals reacquired its U.S. marketing rights to calcitriol injection, pursuant to the
termination of the manufacturing and co-promotion agreement. In connection with such termination,
Sicor paid us $3.5 million. We no longer commercialize calcitriol. We recognized net revenues of $494,000 from Aesgen in 2002. We recognized no net revenues from
Aesgen in 2003 or 2004 and had no accounts receivable or work in progress at December 31, 2004 and
2003. Mr. Waters and Dr. Sancilio have agreed to sell us up to a total of 363,807 shares of our common
stock to provide the shares for issuance pursuant to our 1995 Stock Option Plan. Upon the exercise
of a stock option awarded under the 1995 plan, we are entitled to purchase from them the same
number of shares at the exercise price of the option, $5.57 per share. As of December 31, 2004, no
options were outstanding to acquire shares of our common stock under our 1995 Stock Option Plan.
We acquired 4,202 shares in 2003 for $23,388 from Mr. Waters, no shares in 2004 or 2002, and we
acquired 5,715 shares in 2003 for $28,590 from Dr. Sancilio, no shares in 2004 or 2002. By, and subject to, the terms of our bylaws, we have certain obligations to indemnify the current
and former officers, directors and employees of the Company in connection with the governmental
investigations and lawsuits described in Part I, Item 3, Legal Proceedings. As of March 22,
2005, we had advanced a total of approximately $180,000 to current executive officers and directors
in connection with these matters. 189




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Item 14. Principal Accountant Fees and Services Fees Paid to Independent Auditors Audit Fees The Company has been billed fees of $1,905,870 and $2,096,758 for 2003 and 2004, respectively,
for services rendered for the audits of the Companys consolidated financial statements and
managements assessment of internal control over financial reporting for 2004, including
restatement of previously issued financial statements, the audit of the Companys internal control
over financial reporting, the audit of managements assessment of the effectiveness of internal
control over financial reporting, timely reviews of Forms 10Q, consents, assistance with review of
documents filed with the SEC and statutory audits of various international subsidiaries. The
increase in the amount of audit fees from 2003 to 2004 primarily relates to fees for testing of the
Companys internal control over financial reporting under Section 404 of the Sarbanes Oxley Act of
2002. Audit-Related Fees The Company has been billed $451,873 and $306,870 for audit-related services rendered for 2003
and 2004, respectively, for accounting consultations and due diligence related to acquisitions,
consulting services relating to Section 404 of the Sarbanes-Oxley Act of 2002, audit services
concerning the Companys 401(k) plan, and various audit related consultations concerning financial
accounting and reporting standards. Tax Fees Aggregate fees billed for all tax compliance, tax advice and tax planning services rendered
for 2003 and 2004, respectively, are $722,795 and $377,989. These fees are primarily for services
rendered in the areas of international tax planning, transfer pricing consultation, research and
development tax credits, state and local tax preparation assistance, tax compliance and general tax
consulting. All Other Fees No other fees were paid to our independent auditors for 2003 and 2004. Pre-approval Policy On January 29, 2003, the Audit Committee of our Board of Directors adopted the policy described
below regarding the pre-approval of all audit and permissible non-audit services provided by the
independent auditor after such date. Prior to engagement of the independent auditor for the next
years audit, management is required to submit an aggregate of services expected to be rendered
during that year for each of the four categories of services listed below to the audit committee
for approval.  
    Audit services, which include audit work performed in the preparation of
financial statements, as well as work that generally only the independent auditor can 190




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reasonably be expected to provide, including comfort letters, statutory audits, and
attest services and consultation regarding financial accounting and/or reporting
standards.
    Audit-related services for assurance and related services that are
traditionally performed by the independent auditor, such as due diligence related to
mergers and acquisitions, employee benefit plan audits, and special procedures required
to meet certain regulatory requirements.
    Tax services, which include services performed by the independent auditors tax
personnel other than services specifically related to the audit of the financial
statements, such as tax compliance, tax planning, and tax advice.
    Other services, which include services not captured in the other categories. Prior to engagement, the Audit Committee pre-approves these services by category of service. The
fees are budgeted and the Audit Committee requires the independent auditor and management to report
actual fees versus the budget periodically throughout the year by category of service. During the
year, circumstances may arise that make it necessary to engage the independent auditor for
additional services not contemplated in the original pre-approval. In those instances, the Audit
Committee requires specific pre-approval of the services before engaging the independent auditor. The audit committee may delegate pre-approval authority to one or more of its members. The member
to whom such authority is delegated must report, for informational purposes only, any pre-approval
decisions to the Audit Committee at its next scheduled meeting. 191




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Item 15. Exhibits and Financial Statement Schedules (a)(1) and (2)The response to this portion of Item 15 is submitted as a separate section of this
Report on Form 10-K and reference is hereby made to Item 8. (a) (3) The response to this portion of Item 15 is incorporated by reference to the Exhibit Index
of this Report on Form 10-K. (b) ExhibitsA list of the exhibits required to be filed as part of this Report on Form 10-K is
set forth in the Exhibit Index, which immediately precedes such exhibits, and is incorporated
herein by reference. (c) FINANCIAL STATEMENT SCHEDULE Schedules not included herein have been omitted because they are not applicable or the required
information is shown in the consolidated financial statements or notes thereto. 192




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SCHEDULE II aaiPharma Inc. VALUATION AND QUALIFYING ACCOUNTS (In thousands) Balance at
    
    
    Charged to
    
    
    Charged to
    
    
    
    
    
    
    Balance atBeginning
    
    
    Costs and
    
    
    Other
    
    
    
    
    
    
    End ofDescription
    
    of Period
    
    
    Expenses
    
    
    Accounts
    
    
    Deductions
    
    
    PeriodAllowances for
doubtful accounts2002
    
    $
    1,044
    
    
    $
    1,294
    
    
    $
    
    
    
    $
    (670
    )(1)
    
    $
    1,6682003
    
    
    1,668
    
    
    
    1,181
    
    
    
    
    
    
    
    (1,871
    )(1)
    
    
    9782004
    
    
    978
    
    
    
    1,792
    
    
    
    
    
    
    
    (206
    )(1)
    
    
    2,564Product inventory
obsolescence
reserves2002
    
    
    200
    
    
    
    526
    
    
    
    
    
    
    
    (5
    )(2)
    
    
    7212003
    
    
    721
    
    
    
    11,687
    
    
    
    
    
    
    
    (1,650
    )(2)
    
    
    10,7582004
    
    
    10,758
    
    
    
    3,402
    
    
    
    
    
    
    
    (6,723
    )(2)
    
    
    7,437Tax asset valuation
allowances2002
    
    
    2,649
    
    
    
    362
    
    
    
    
    
    
    
    
    
    
    
    3,0112003
    
    
    3,011
    
    
    
    11,185
    
    
    
    
    
    
    
    
    
    
    
    14,1962004
    
    
    14,196
    
    
    
    98,518
    
    
    
    
    
    
    
    
    
    
    
    112,714
   (1)
    
    Represents amounts written off as uncollectible accounts receivable(2)
    
    Represents amounts disposed 193




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##### 



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly
authorized. /s/ Ludo J. Reynders, Ph.D.
    
    Chief Executive Officer
    
    April 27, 2005Ludo J. Reynders, Ph.D.
 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed
below by the following persons, or in their behalf by their duly appointed attorney in fact, on
behalf of the Registrant in the capacities and on the date indicated. Signatures
    
    Title
    
    Date/s/ Ludo J. Reynders , Ph.D.
    
    Chief Executive Officer and Director
    
    April 27, 2005Ludo J. Reynders, Ph.D./s/ Matthew E. Czajkowski
    
    Chief Financial Officer
    
    April 27, 2005Matthew E. Czajkowski/s/ John D. Hogan
    
    Vice President and Controller
    
    April 27, 2005(Principal Accounting Officer)John D. Hogan/s/ William H. Underwood
    
    Executive Vice President and Director
    
    April 27, 2005William H. Underwood/s/ Timothy R. Wright
    
    Executive Vice President and Director
    
    April 27, 2005Timothy R. Wright/s/ John E. Avery
    
    Director
    
    April 27, 2005John E. Avery/s/Robert J. Brown
    
    Director
    
    April 27, 2005Robert J. Brown/s/ Joseph H. Gleberman
    
    Director
    
    April 27, 2005Joseph H. Gleberman/s/ Kurt M. Landgraf
    
    Director
    
    April 27, 2005Kurt M. Landgraf/s/ James G. Martin
    
    Director
    
    April 27, 2005James G. Martin, Ph.D.
 194




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##### 



Signatures
    
    Title
    
    Date/s/ Richard G. Morrison
    
    Director
    
    April 27, 2005Richard G. Morrison, Ph.D./s/ Frederick D. Sancilio, Ph.D.
    
    Director
    
    April 27, 2005Frederick D. Sancilio, Ph.D.
 195




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##### 



aaiPharma Inc.
Exhibit Index ExhibitNumber
    
    Description3.1
    
    Amended and Restated Certificate of Incorporation of the Company, and amendments thereto
(incorporated by reference to Exhibit 3.1 to the Companys Quarterly Report on Form 10-Q for
the quarter ended June 30, 2003)3.2
    
    Amended and Restated By-laws of the Company (incorporated by reference to Exhibit 3.1 to the
Companys Current Report on Form 8-K filed with the SEC on November 10, 2004)4.1
    
    Articles Fourth, Seventh, Eleventh and Twelfth of the Amended and Restated Certificate of
Incorporation of the Company (included in Exhibit 3.1)4.2
    
    Articles II and IX and Section 7.1 of the Amended and Restated By-laws of the Company
(included in Exhibit 3.2)4.3
    
    Specimen Certificate for shares of Common Stock, $.001 par value, of the Company
(incorporated by reference to Exhibit 4.3 to the Companys Registration Statement on Form S-1
(Registration No. 333-5535))4.4
    
    Indenture (which includes the form of 11% Senior Subordinated Note due 2010) dated as of
March 28, 2002 between the Company, certain of its subsidiaries as guarantors and Wachovia
Bank, National Association (formerly, First Union National Bank), as Trustee (incorporated by
reference to Exhibit 10.8 to the Companys Registration Statement on Form S-1 (Registration
No. 333-85602))4.5
    
    First Supplemental Indenture, dated as of April 20, 2004, among the Company, certain of its
subsidiaries as guarantor parties thereto and Wachovia Bank, National Association (formerly,
First Union National Bank), as Trustee (incorporated by reference to Exhibit 99.4 to the
Companys Current Report on Form 8-K filed with the SEC on April 27, 2004)4.6
    
    Security Agreement, dated as of April 23, 2004, made by the Company and certain subsidiaries
of the Company as grantors in favor of Wachovia Bank, National Association, in its capacity as
collateral agent for the holders of the Companys 11% Senior Subordinated Notes due 2010
(incorporated by reference to Exhibit 99.5 to the Companys Current Report on Form 8-K filed
with the SEC on April 27, 2004)4.7
    
    Pledge and Security Agreement, dated as of April 23, 2004, made by the Company and certain
subsidiaries of the Company as pledgors in favor of Wachovia Bank, National Association, in
its capacity as collateral agent for the holders of the Companys 11% Senior Subordinated
Notes due 2010 (incorporated
 196




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##### 



ExhibitNumber
    
    Descriptionby reference to Exhibit 99.6 to the Companys Current Report on Form 8-K filed with
the SEC on April 27, 2004)4.8
    
    Second Supplemental Indenture, dated as of October 29, 2004, among the Company, certain of
its subsidiaries as guarantor parties thereto and Wachovia Bank, National Association
(formerly, First Union National Bank), as Trustee (incorporated by reference to Exhibit 10.1
to the Companys Current Report on Form 8-K filed with the SEC on November 4, 2004)10.1
    
    Amended and Restated Employment Agreement dated January 1, 2003 between the Company and
Frederick D. Sancilio (incorporated by reference to Exhibit 10.1 to the Companys Quarterly
Report on Form 10-Q for the period ended June 30, 2003)*10.2
    
    Amendment to Employment Agreement, dated as of September 27, 2004, between the Company and
Frederick D. Sancilio (incorporated by reference to Exhibit 10.1 to the Companys Current
Report on Form 8-K filed with the SEC on September 29, 2004)*10.3
    
    Employment Agreement, dated as of September 27, 2004, between the Company and Ludo J.
Reynders (incorporated by reference to Exhibit 10.2 to the Companys Current Report on Form
8-K filed with the SEC on September 29, 2004)*10.4
    
    Consulting Agreement dated March 27, 2004 between the Company and Philip S. Tabbiner*, **10.5
    
    Consulting Agreement dated May 10, 2004 between the Company and William L. Ginna, Jr.*, **10.6
    
    Director and Named Executive Officer Compensation Arrangements*, **10.7
    
    Offer letter agreement, effective as of November 30, 2004, between the Company and Matthew E.
Czajkowski*, **10.8
    
    Applied Analytical Industries, Inc. 1995 Stock Option Plan (incorporated by reference to
Exhibit 10.3 to the Companys Registration Statement on Form S-1 (Registration No. 333-5535))*10.9
    
    Applied Analytical Industries, Inc. 1996 Stock Option Plan, as amended on March 27, 2000
(incorporated by reference to Exhibit 10.17 to the Companys Annual Report on Form 10-K for
the year ended December 31, 1999)*10.10
    
    Applied Analytical Industries, Inc. 1997 Stock Option Plan, as amended, including the form
of award agreement thereunder (incorporated by reference to Exhibit 10.2 to the Companys
Quarterly Report on Form 10-Q for the quarter ended June 30, 2003)*
 197




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##### 



ExhibitNumber
    
    Description10.11
    
    aaiPharma Inc. 2000 Stock Option Plan for Non-Employee Directors, as amended (incorporated
by reference to Exhibit 10.6 to the Companys Registration Statement on Form S-1 (Registration
No. 333-85602))*10.12
    
    Stockholder Agreement dated as of November 17, 1995 among the Company, GS Capital Partners
II, L.P., GS Capital Partners II Offshore, L.P., Goldman, Sachs & Co. Verwaltungs GmbH, Stone
Street Fund 1995, L.P., Bridge Street Fund 1995, L.P., Noro-Moseley Partners III, L.P.,
Wakefield Group Limited Partnership, James L. Waters, Frederick D. Sancilio and the parties
listed on Schedule 1 thereto (incorporated by reference to Exhibit 10.5 to the Companys
Registration Statement on Form S-1 (Registration No. 333-5535))10.13
    
    Registration Rights Agreement dated as of November 17, 1995 among the Company, GS Capital
Partners II, L.P., GS Capital Partners II Offshore, L.P., Goldman, Sachs & Co. Verwaltungs
GmbH, Stone Street Fund 1995, L.P., Bridge Street Fund 1995, L.P., Noro-Moseley Partners III,
L.P., Wakefield Group Limited Partnership, James L. Waters, Frederick D. Sancilio and the
parties listed on Schedule 1 thereto (incorporated by reference to Exhibit 10.16 to the
Companys Registration Statement on Form S-1 (Registration No. 333-5535))10.14
    
    Underwriting Agreement dated September 19, 1996 between the Company and Goldman Sachs & Co.,
Cowen & Company and Lehman Brothers, Inc., as representatives of the underwriters listed on
Schedule 1 thereto (incorporated by reference to Exhibit 10.17 to the Companys Quarterly
Report on Form 10-Q for the quarter ended September 30, 1996)10.15
    
    Asset Purchase Agreement dated as of December 13, 2001 between NeoSan Pharmaceuticals Inc.,
Novartis Pharmaceuticals Corporation and Novartis Corporation (incorporated by reference to
Exhibit 2.3 to the Companys Current Report on Form 8-K filed with the SEC on January 24,
2002)10.16
    
    Assignment, Transfer and Assumption Agreement dated as of February 18, 2002 between NeoSan
Pharmaceuticals, Inc. and Eli Lilly and Company (incorporated by reference to Exhibit 2.1 to
the Companys Amendment No. 1 to Current Report on Form 8-K/A filed with the SEC on April 12,
2002)10.17
    
    Asset Purchase Agreement dated as of October 22, 2003 by and among aaiPharma Inc., Elan
Pharma International Limited and Elan Pharmaceuticals, Inc. (incorporated by reference to
Exhibit 2.1 to the Companys Current Report on Form 8-K filed with the SEC on December 15,
2003)10.18
    
    Roxanne Assignment and Assumption Agreement dated as of October 22, 2003 by and among
aaiPharma Inc., Elan Pharma International Limited, Elan Pharmaceuticals, Inc., Elan
Corporation, plc, Roxane Laboratories, Inc. and Boehringer Ingelheim Corporation (incorporated
by reference to Exhibit 2.2 to the Companys Current Report on Form 8-K filed with the SEC on
December 15, 2003)
 198




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##### 



ExhibitNumber
    
    Description10.19
    
    First Amendment to Manufacturing Agreement dated as of December 2, 2003 by and between Elan
Pharma International Limited and Roxane Laboratories, Inc. (incorporated by reference to
Exhibit 2.3 to the Companys Current Report on Form 8-K filed with the SEC on December 15,
2003)10.20
    
    Asset Purchase Agreement dated as of July 16, 2003 by and among aaiPharma Inc. and Athlon
Pharmaceuticals, Inc. (incorporated by reference to Exhibit 10.20 to the Companys Annual
Report on Form 10-K for the year ended December 31, 2003)10.21
    
    Service Agreement dated as of July 16, 2003 by and among aaiPharma Inc. and Athlon
Pharmaceuticals, Inc. (incorporated by reference to Exhibit 10.21 to the Companys Annual
Report on Form 10-K for the year ended December 31, 2003)10.22
    
    Manufacturing and Supply Agreement dated as of July 16, 2003 by and between aaiPharma Inc.
and Mikart, Inc. (incorporated by reference to Exhibit 10.22 to the Companys Annual Report on
Form 10-K for the year ended December 31, 2003)10.23
    
    First Amendment to Manufacturing and Supply Agreement dated as of May 13, 2004 between
aaiPharma Inc. and Mikart, Inc. (incorporated by reference to Exhibit 10.23 to the Companys
Annual Report on Form 10-K for the year ended December 31, 2003)10.24
    
    Product Sales Agreement dated as of December 21, 2001 between the Company and Aesgen, Inc.
(incorporated by reference to Exhibit 10.23 to the Companys Annual Report on Form 10-K for
the year ended December 31, 2001)10.25
    
    Asset Purchase Agreement dated as of February 27, 2004, among the Company, aaiPharma LLC,
AAI Properties, Inc. and Mayne Pharma (USA) Inc. (incorporated by reference to Exhibit 2.1 to
the Companys Current Report on Form 8-K filed with the SEC on May 7, 2004)10.26
    
    Amendment No. 1 to Asset Purchase Agreement dated as of April 22, 2004, among the Company,
aaiPharma LLC, AAI Properties, Inc. and Mayne Pharma (USA) Inc. (incorporated by reference to
Exhibit 2.2 to the Companys Current Report on Form 8-K filed with the SEC on May 7, 2004)10.27
    
    Financing Agreement, dated as of April 23, 2004, by and among the Company and certain
subsidiaries of the Company as borrowers, the financial institutions from time to time party
thereto as lenders, Silver Point Finance, LLC, as collateral agent, and Bank of America, N.A.,
as administrative agent (incorporated by reference to Exhibit 99.1 to the Companys Current
Report on Form 8-K filed with the SEC on April 27, 2004)10.28
    
    Security Agreement, dated April 23, 2004, made by the Company and certain subsidiaries of
the Company as grantors in favor of Silver Point Finance, LLC, as collateral agent
(incorporated by reference to Exhibit 99.2 to the Companys Current Report on Form 8-K filed
with the SEC on April 27, 2004)
 199




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##### 



ExhibitNumber
    
    Description10.29
    
    Pledge and Security Agreement, dated April 23, 2004, made by the Company and certain
subsidiaries of the Company as pledgors in favor of Silver Point Finance, LLC, as collateral
agent (incorporated by reference to Exhibit 99.3 to the Companys Current Report on Form 8-K
filed with the SEC on April 27, 2004)10.30
    
    Intercreditor Agreement, dated as of April 23, 2004, among Silver Point Finance, LLC, as
senior collateral agent, Wachovia Bank, National Association, as noteholder collateral agent,
and the Company (incorporated by reference to Exhibit 99.7 to the Companys Current Report on
Form 8-K filed with the SEC on April 27, 2004)10.31
    
    First Amendment to Financing Agreement and to Security Agreement, dated as of August 9,
2004, by and among the Company and certain subsidiaries of the Company as borrowers, the
financial institutions from time to time party thereto as lenders, Silver Point Finance, LLC,
as collateral agent, and Bank of America, N.A., as administrative agent (incorporated by
reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed with the SEC on
August 11, 2004)10.32
    
    Second Amendment to Financing Agreement, dated as of August 13, 2004, by and among the
Company and certain subsidiaries of the Company as borrowers, the financial institutions from
time to time party thereto as lenders, Silver Point Finance, LLC, as collateral agent, and
Bank of America, N.A., as administrative agent (incorporated by reference to Exhibit 10.2 to
the Companys Quarterly Report on Form 10-Q for the quarter ended September 30, 2004)10.33
    
    Third Amendment to Financing Agreement, dated as of October 8, 2004, by and among the
Company and certain subsidiaries of the Company as borrowers, the financial institutions from
time to time party thereto as lenders, Silver Point Finance, LLC, as collateral agent, and
Bank of America, N.A., as administrative agent (incorporated by reference to Exhibit 10.1 to
the Companys Current Report on Form 8-K filed with the SEC on October 13, 2004)10.34
    
    Fourth Amendment to Financing Agreement, dated as of October 22, 2004, by and among the
Company and certain subsidiaries of the Company as borrowers, the financial institutions from
time to time party thereto as lenders, Silver Point Finance, LLC, as collateral agent, and
Bank of America, N.A., as administrative agent (incorporated by reference to Exhibit 10.1 to
the Companys Current Report on Form 8-K filed with the SEC on October 22, 2004)21
    
    Subsidiaries of aaiPharma Inc. (incorporated by reference to Exhibit 21 to the Companys
Annual Report on Form 10-K for the year ended December 31, 2002)23
    
    Consent of Ernst & Young LLP**31.1
    
    Certification pursuant to Exchange Act Rule 13a  14(a) of Ludo J. Reynders, Ph.D.**
 200




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##### 



ExhibitNumber
    
    Description31.2
    
    Certification pursuant to Exchange Act Rule 13a  14(a) of Matthew E. Czajkowski**32
    
    Certification Pursuant to 18 U.S.C. Section 1350**
   *
    
    Management contract or compensatory plan required to be filed under Item 15(c) of this report
and Item 601 of Regulation S-K of the SEC.**
    
    Filed herewith. 201