XFRA:S6UN Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

 

FORM 10-Q

 

 

(Mark One)

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

For the quarterly period ended June 30, 2012

OR

 

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

For the transition period from              to             .

Commission File Number: 000-51665

 

 

Somaxon Pharmaceuticals, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   20-0161599
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)

10935 Vista Sorrento Parkway,

Suite 250, San Diego CA

  92130
(Address of principal executive offices)   (Zip Code)

(858) 876-6500

(Registrant’s telephone number, including area code)

 

 

(Former name, former address and formal fiscal year, if changed since last report)

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  Yes    ¨  No

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

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

 

Large accelerated filer   ¨    Accelerated filer   þ
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

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

The number of outstanding shares of the registrant’s common stock, par value $0.0001 per share, as of July 13, 2012 was 48,108,251.

 

 

 


Table of Contents

SOMAXON PHARMACEUTICALS, INC.

QUARTERLY REPORT ON FORM 10-Q

For the Quarter Ended June 30, 2012

TABLE OF CONTENTS

 

     Page  
PART I — FINANCIAL INFORMATION   

Item 1. Financial Statements (Unaudited)

  

Condensed Balance Sheets

     F-1   

Condensed Statements of Operations and Comprehensive Loss

     F-2   

Condensed Statements of Cash Flows

     F-3   

Condensed Statements of Stockholders’ Equity

     F-4   

Notes to Condensed Financial Statements

     F-5   

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     1   

Item 3. Quantitative and Qualitative Disclosures about Market Risk

     13   

Item 4. Controls and Procedures

     14   
PART II – OTHER INFORMATION   

Item 1. Legal Proceedings

     14   

Item 1A. Risk Factors

     15   

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

     31   

Item 3. Defaults Upon Senior Securities

     31   

Item 4. Mine Safety Disclosures

     31   

Item 5. Other Information

     31   

Item 6. Exhibits

     32   

SIGNATURES

     34   


Table of Contents

PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements

SOMAXON PHARMACEUTICALS

CONDENSED BALANCE SHEETS

(Unaudited)

(In thousands, except par value)

 

     June 30,
2012
    December 31,
2011
 

ASSETS

    

Current assets

    

Cash and cash equivalents

   $ 7,084      $ 10,668   

Current portion of restricted cash

     50        50   

Accounts receivable, net

     2,000        1,950   

Inventory

     239        264   

Other current assets

     855        1,003   
  

 

 

   

 

 

 

Total current assets

     10,228        13,935   

Long-term portion of restricted cash

     201        201   

Property and equipment, net

     519        634   

Intangible assets, net

     989        1,089   
  

 

 

   

 

 

 

Total assets

   $ 11,937      $ 15,859   
  

 

 

   

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current liabilities

    

Accounts payable

   $ 1,572      $ 1,774   

Accrued liabilities

     6,044        7,054   
  

 

 

   

 

 

 

Total current liabilities

     7,616        8,828   

Other long-term liabilities

     626        490   
  

 

 

   

 

 

 

Total liabilities

     8,242        9,318   
  

 

 

   

 

 

 

Commitments and contingencies (see Note 5)

    

Stockholders’ equity

    

Preferred stock, $0.0001 par value; 10,000 shares authorized, none issued and outstanding

     —          —     

Common stock, $0.0001 par value; 100,000 shares authorized; 48,108 and 48,063 shares outstanding at June 30, 2012 and December 31, 2011, respectively

     5        5   

Additional paid-in capital

     284,138        282,668   

Accumulated deficit

     (280,448     (276,132
  

 

 

   

 

 

 

Total stockholders’ equity

     3,695        6,541   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 11,937      $ 15,859   
  

 

 

   

 

 

 

The Accompanying Notes are an Integral Part of these Unaudited Condensed Financial Statements

 

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SOMAXON PHARMACEUTICALS, INC.

CONDENSED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(Unaudited)

(In thousands, except per share amounts)

 

     Three months ended
June 30,
    Six months ended
June 30,
 
     2012     2011     2012     2011  

Revenue

        

Net product sales

   $ 2,930      $ 6,242      $ 5,671      $ 8,564   

License fee revenue

     420        —          420        —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenue

     3,350        6,242        6,091        8,564   

Operating costs and expenses

        

Cost of product sales

   $ 265      $ 661      $ 539      $ 1,024   

Selling, general and administrative

     5,299        20,073        9,899        38,666   

Research and development

     —          457        —          876   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating costs and expenses

     5,564        21,191        10,438        40,566   
  

 

 

   

 

 

   

 

 

   

 

 

 

Loss from operations

     (2,214     (14,949     (4,347     (32,002

Other income and expense

     15        —          31        15   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

   $ (2,199   $ (14,949   $ (4,316   $ (31,987
  

 

 

   

 

 

   

 

 

   

 

 

 

Basic and diluted net loss per share

   $ (0.05   $ (0.33   $ (0.09   $ (0.71
  

 

 

   

 

 

   

 

 

   

 

 

 

Shares used to calculate net loss per share

     48,108        45,492        48,108        45,250   
  

 

 

   

 

 

   

 

 

   

 

 

 
Comprehensive loss         

Net loss

   $ (2,199   $ (14,949   $ (4,316   $ (31,987

Unrealized gain/(loss) in short-term investments

     —          (3     —          1   
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive loss

   $ (2,199   $ (14,952   $ (4,316   $ (31,986
  

 

 

   

 

 

   

 

 

   

 

 

 

The Accompanying Notes are an Integral Part of these Unaudited Condensed Financial Statements

 

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SOMAXON PHARMACEUTICALS, INC.

CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

 

     Six Months Ended June 30,  
     2012     2011  

Cash flows from operating activities

    

Net loss

   $ (4,316   $ (31,987

Adjustments to reconcile net loss to net cash used in operating activities:

    

Share-based compensation expense

     1,370        2,588   

Depreciation and amortization of property and equipment

     115        116   

Amortization of intangible assets

     100        74   

Amortization of investment discount

     —          145   

Realized gain on sale of short-term investments

     —          1   

Changes in operating assets and liabilities:

    

Accounts receivable

     (50     3,631   

Inventory

     25        (108

Other current assets

     148        (1,230

Accounts payable

     (202     (34

Accrued liabilities

     (910     1,362   

Deferred revenue and other liabilities

     136        (2,962
  

 

 

   

 

 

 

Net cash used in operating activities

     (3,584     (28,404
  

 

 

   

 

 

 

Cash flows from investing activities

    

Purchases of property and equipment

     —          (318

Payments for intangible assets

     —          (161

Purchases of marketable securities

     —          (3,508

Sales and maturities of marketable securities

     —          34,777   
  

 

 

   

 

 

 

Net cash provided by investing activities

     —          30,790   
  

 

 

   

 

 

 

Cash flows from financing activities

    

Issuance of common stock, net of costs

     —          5,000   

Exercise of stock options

     —          1   
  

 

 

   

 

 

 

Net cash provided by financing activities

     —          5,001   
  

 

 

   

 

 

 

(Decrease) increase in cash and cash equivalents

     (3,584     7,387   

Cash and cash equivalents at beginning of the period

     10,668        21,008   
  

 

 

   

 

 

 

Cash and cash equivalents at end of the period

   $ 7,084      $ 28,395   
  

 

 

   

 

 

 

Supplemental cash flow information

    

Issuance of restricted stock units to settle obligations

   $ 100      $ —     
  

 

 

   

 

 

 

The Accompanying Notes are an Integral Part of these Unaudited Condensed Financial Statements

 

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SOMAXON PHARMACEUTICALS, INC.

CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY

(Unaudited)

(In thousands, except per share amounts)

 

     Common Stock      Additional
Paid-in
     Accumulated        
     Shares      Amount      Capital      Deficit     Total  

Balance at December 31, 2011

     48,063       $ 5       $ 282,668       $ (276,132   $ 6,541   

Net loss

     —           —           —           (4,316     (4,316

Issuance of common stock pursuant to vesting of restricted stock units

     45         —           —           —          —     

Issuance of restricted stock units to settle obligations

     —           —           100         —          100   

Share-based compensation expense

     —           —           1,370         —          1,370   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Balance at June 30, 2012

     48,108       $ 5       $ 284,138       $ (280,448   $ 3,695   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

The Accompanying Notes are an Integral Part of these Unaudited Condensed Financial Statements

 

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Note 1. Organization

Business

Somaxon Pharmaceuticals, Inc. (“Somaxon”, “the Company”, “we”, “us” or “our”) is a specialty pharmaceutical company focused on the in-licensing, development and commercialization of proprietary branded products and product candidates to treat important medical conditions where there is an unmet medical need and/or high-level of patient dissatisfaction, currently in the central nervous system therapeutic area. In March 2010, the U.S. Food and Drug Administration (“FDA”) approved our New Drug Application (“NDA”) for Silenor® 3 mg and 6 mg tablets for the treatment of insomnia characterized by difficulty with sleep maintenance. Silenor was made commercially available by prescription in the United States in September 2010. We operate in one reportable segment, which is the development and commercialization of pharmaceutical products.

Basis of Presentation

The accompanying condensed balance sheet as of December 31, 2011, which has been derived from our audited financial statements, and the unaudited interim condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission (“SEC”) related to a quarterly report on Form 10-Q. Certain information and note disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to those rules and regulations, although we believe that the disclosures made are adequate to make the information presented not misleading. The unaudited interim condensed financial statements reflect all adjustments which, in the opinion of our management, are necessary for a fair statement of the results for the periods presented. All such adjustments are of a normal and recurring nature. These unaudited condensed financial statements should be read in conjunction with the financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2011. The operating results presented in these unaudited condensed financial statements are not necessarily indicative of the results that may be expected for any future periods.

Capital Resources

Since inception, our operations have been financed primarily through the sale of equity securities and the proceeds from the exercise of warrants and stock options. We have incurred losses from operations and negative operating cash flows since our inception, and we expect to continue to incur substantial losses for the foreseeable future as we continue our commercial activities for Silenor, commercialize any other products to which we obtain rights and potentially pursue the development of other product candidates. Based on our recurring losses, negative cash flows from operations and working capital levels, we will need to raise substantial additional funds to finance our operations. If we are unable to maintain sufficient financial resources, including by raising additional funds when needed, our business, financial condition and results of operations will be materially and adversely affected.

We commercially launched Silenor in September 2010 with 110 sales representatives provided to us on an exclusive basis under our contract sales agreement with Publicis Touchpoint Solutions, Inc. (“Publicis”), managed by our sales management personnel, and an additional 105 sales representatives provided to us under our co-promotion agreement with The Procter & Gamble Distributing Company LLC (“P&G”). In February 2011, we amended our agreement with Publicis to have Publicis deploy for us an additional 35 sales representatives. Because we did not believe that the growth of Silenor revenues throughout 2011 was sufficient to support sales and marketing expenses at then-current levels, we terminated our agreements with Publicis and P&G in December 2011. At the conclusion of the contract term with Publicis, we were contractually obligated to assume financial responsibility for the remaining vehicle lease payments associated with our Publicis sales representatives. All of our obligations associated with our contract sales agreement with Publicis were settled in full in February 2012. Effective January 3, 2012, we hired a reduced sales force to cover 25 sales territories to promote Silenor. The remainder of the Publicis sales force ceased promoting Silenor as of November 2, 2011. In addition, we terminated the employment of 28 employees in the fourth quarter of 2011. In June 2012, we began reallocating our commercial resources relating to Silenor, including by eliminating 10 vacant and/or unprofitable field sales territories and focusing greater resources on other activities to better support our in-person promotional efforts.

 

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As described more fully in Note 8, “Subsequent Events,” on July 24, 2012, we raised net proceeds of approximately $2.7 million through the sale of approximately 9.4 million shares of our common stock and five-year warrants to purchase up to approximately 4.7 million additional shares of our common stock. In August 2011, we entered into an at-the-market equity sales agreement with Citadel Securities LLC (“Citadel”). However, there can be no assurance that we can or will consummate sales based on prevailing market conditions or in the quantities or at the prices that we deem appropriate. Citadel or the Company is permitted to terminate the sales agreement at any time. Sales of shares pursuant to the sales agreement will have a dilutive effect on the holdings of our existing stockholders, and may result in downward pressure on the price of our common stock.

We have two effective shelf registration statements on Form S-3 filed with the SEC under which we may offer from time to time any combination of debt securities, common and preferred stock and warrants. However, the rules and regulations of the SEC or other regulatory agencies may restrict our ability to conduct certain types of financing activities, or may affect the timing of and the amounts we can raise by undertaking such activities. For example, under current SEC regulations, because the aggregate market value of our common stock held by non-affiliates (“public float”), is less than $75 million, the amount that we can raise through primary public offerings of securities in any twelve-month period using one or more registration statements on Form S-3 is limited to an aggregate of one-third of our public float. Our July 2012 offering of stock and warrants was a primary offering using one of our effective shelf registration statements on Form S-3 and was subject to this limitation.

We will need to obtain additional funds to finance our operations. Until we can generate significant cash from our operations, we intend to obtain any additional funding we require through public or private equity or debt financings, strategic relationships, assigning receivables or royalty rights, or other arrangements and we cannot assure such funding will be available on reasonable terms, or at all. Additional equity financing will be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants.

In December 2011 we hired Stifel Nicolaus Weisel as a strategic advisor to assist us in identifying and evaluating strategies to maximize stockholder value by leveraging our rights in Silenor. The exploration of strategic alternatives may not result in any agreement or transaction and, if completed, any agreement or transaction may not be successful or on attractive terms. The inability to enter into a strategic transaction, or a strategic transaction that is not successful or on attractive terms, could accelerate our need for cash and make securing funding on reasonable terms more difficult. In addition, if we raise additional funds through collaborations or other strategic transactions, it may be necessary to relinquish potentially valuable rights to our potential products or proprietary technologies, or grant licenses on terms that are not favorable to us.

If our efforts in raising additional funds when needed are unsuccessful, we may be required to delay, scale-back or eliminate plans or programs relating to our business, relinquish some or all rights to Silenor or renegotiate less favorable terms with respect to such rights than we would otherwise choose or cease operating as a going concern. In addition, if we do not meet our payment obligations to third parties as they come due, we may be subject to litigation claims. Even if we were successful in defending against these potential claims, litigation could result in substantial costs and be a distraction to management, and may result in unfavorable results that could further adversely impact our financial condition.

If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our financial statements, and it is likely that investors will lose all or a part of their investments. These financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Note 2. Summary of Significant Accounting Policies

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Cash and Cash Equivalents

All highly liquid investments with maturities of three months or less at the time of purchase are considered to be cash

 

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equivalents. Investments with maturities at the date of purchase greater than three months are classified as marketable securities. At June 30, 2012 and December 31, 2011, our cash and cash equivalents consisted of cash on deposit at financial institutions, which included funds invested in money market accounts.

Fair Value of Financial Instruments

Cash equivalents, accounts receivable, accounts payable and accrued liabilities are presented in the financial statements at their carrying amounts, which are reasonable estimates of fair value due to their short maturities.

Concentration of Credit Risk, Significant Customers and Sources of Supply

Financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. We maintain accounts in federally insured financial institutions in excess of federally insured limits. Some of these funds are invested in money market funds that are not federally insured. However, management believes we are not exposed to significant credit risk due to the financial positions of the depository institutions in which these deposits are held and of the money market funds and other entities in which these investments are made. Additionally, we have established guidelines regarding the diversification of our investments and their maturities that are designed to maintain safety and liquidity.

We sell our product primarily to established wholesale distributors in the pharmaceutical industry. The following table sets forth customers who represented 10% or more of our product sales:

 

     Three Months Ended
June  30,
    Six Months Ended
June  30,
 
     2012     2011     2012     2011  

Cardinal Health

     28     42     36     45

McKesson

     47     41     43     37

AmerisourceBergen

     22     11     18     11

The majority of our accounts receivable balance as of June 30, 2012 and December 31, 2011 represents amounts due from these three wholesale distributors. Credit is extended based on an evaluation of the customer’s financial condition. Based upon the review of these factors, we did not record an allowance for doubtful accounts at June 30, 2012 or December 31, 2011.

We rely on third-party manufacturers for the production of Silenor and single source third-party suppliers to manufacture key components of Silenor. If our third-party manufacturers are unable to continue manufacturing Silenor, or if we lost our single source suppliers used in the manufacturing process, we may not be able to meet market demand for our product.

Inventory

Our inventories are valued at the lower of weighted average cost or net realizable value. We analyze our inventory levels quarterly and write down inventory that has become obsolete or has a cost basis in excess of its expected net realizable value, as well as any inventory quantities in excess of expected requirements. We did not record any significant write-downs for potentially obsolete or excess inventory during the three or six months ended June 30, 2012 or 2011.

Intangible Assets

Our intangible assets consist of the costs incurred to in-license our product and technology development costs relating to our websites. Prior to the FDA approval of our NDA for Silenor, we had expensed all license fees and milestone payments for acquired development and commercialization rights to operations as incurred since the underlying technology associated with these expenditures related to our research and development efforts and had no alternative future use at the time. Costs related to our intellectual property are capitalized once technological feasibility has been established. Capitalized amounts are amortized on a straight line basis over the expected life of the intellectual property. License fees began being amortized upon the first sale of Silenor to our wholesaler in August 2010 and are being amortized over approximately ten years. Costs incurred in the planning stage of a website are expensed, while costs incurred in the

 

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development stage are capitalized and will be amortized over the expected life of the product associated with the website once the asset is placed in service, which we estimate to be approximately 10 years. Costs incurred for other intangible assets to be used primarily on our website are capitalized and amortized over the expected useful life, which we estimate to be two years. The carrying values of our intangible assets are periodically reviewed to determine if the facts and circumstances suggest that a potential impairment may have occurred. Our results of operations for the three and six months ended June 30, 2012 and 2011 do not reflect any write-downs associated with the potential impairment of our intangible assets.

Revenue Recognition

Product Sales

We sell Silenor to wholesale pharmaceutical distributors. Our returned goods policy generally permits our customers to return products beginning six months before and up to twelve months after the expiration date of the product. We authorize returns for expired products in accordance with our returned goods policy and issue credit to our customers for expired returned product. We do not exchange product from inventory for returned product. Through June 30, 2012, the dollar amount of returns received since we commenced commercial shipments of Silenor (in August 2010) has been negligible.

We recognize product revenue from product sales when 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) our price to the buyer is fixed or determinable; and (4) collectability is reasonably assured. Revenue from sales transactions where the buyer has the right to return the product is recognized at the time of sale only if (1) our price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid us, or the buyer is obligated to pay us and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to us 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 us, (5) we do 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.

Prior to the second quarter of 2011, we were unable to reasonably estimate returns. We therefore deferred revenue recognition until the right of return no longer existed, which was the earlier of Silenor being dispensed through patient prescriptions or the expiration of the right of return. We estimated patient prescriptions dispensed using an analysis of third-party information. In order to develop a methodology to reliably estimate product returns and provide a basis for recognizing revenue on sales to customers at the time of product shipment, we analyzed many factors, including, without limitation, industry data regarding product return rates, and tracked the Silenor product return history, taking into account product expiration dating at the time of shipment and levels of inventory in the wholesale channel compared to prescription units dispensed and the sell-down of our launch inventory. During the second quarter of 2011, the sell-down of our launch inventory was completed, which we believe demonstrates sufficient market acceptance of our product for purposes of our revenue recognition analysis. In addition, since product launch, we have sold product to wholesale pharmaceutical distributors at standard commercial terms utilized in the industry. As a result, we believe we can analogize to industry data regarding product return rates. Based on the sell-down of our launch inventory and the industry and internal data gathered, we believe we have the information needed to reasonably estimate product returns. As a result, in the second quarter of 2011, we began recognizing revenue for Silenor sales at the time of delivery of the product to wholesale pharmaceutical distributors and our other customers.

License and Royalty Revenue

We consider a variety of factors in determining the appropriate method of accounting for our license agreements, including whether the various deliverables within the agreement can be separated and accounted for as separate units of accounting. Where there are multiple deliverables identified within an agreement that are combined into a single unit of accounting, revenues are deferred and recognized on a straight-line basis over the expected period of performance. Where a license agreement includes multiple deliverables that are determined to have stand-alone values, we allocate arrangement consideration based on their estimated relative fair value. Revenue is recognized for each individual deliverable after there are no further performance obligations, the related consideration is fixed and determinable and collectability is reasonably assured. For deliverables with continuing performance obligations, we recognize revenue over the expected performance period using either a proportional performance or straight-line method depending on whether we can reasonably estimate the level of effort required to complete our performance obligations under the arrangement.

 

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We are entitled to sales-based milestone payments and royalty revenues under the terms of our license agreements. We will recognize these revenues once the earnings process is complete and payment is reasonably assured.

Product Sales Discounts and Allowances

We record product sales discounts and allowances at the time of sale and report revenue net of such amounts in the same period that product sales are recorded. In determining the amount of product sales discounts and allowances, we must make significant judgments and estimates. If actual results vary from our estimates, we may need to adjust these estimates, which could have an effect on product revenue in the period of adjustment. Our product sales discounts and allowances and the specific considerations we use in estimating these amounts include:

Prompt Pay Discounts. As an incentive for prompt payment, we offer a 2% cash discount to customers. We calculate the discount based on the gross amount of each invoice as we expect that all customers will comply with the contractual terms to earn the discount. We record the discount as an allowance against accounts receivable and a corresponding reduction of revenue. At June 30, 2012 and December 31, 2011, the allowance for prompt pay discounts was $41,000 and $39,000, respectively.

 

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Patient Discount Programs. We offer discount programs to patients of Silenor under which the patient receives a discount on his or her prescription. We reimburse pharmacies for these discounts through third-party vendors. We estimate the total amount that will be redeemed based on the dollar amount of the discounts, the timing and quantity of distribution and historical redemption rates. We accrue the discounts and recognize a corresponding reduction of revenue. At June 30, 2012 and December 31, 2011, the accrual for patient discount programs was $392,000 and $414,000, respectively.

Distribution Service Fees. We pay distribution services fees to each wholesaler for distribution and inventory management services. We accrue for these fees based on contractually defined terms with each wholesaler and recognize a corresponding reduction of revenue. At June 30, 2012 and December 31, 2011, the accrual for distribution service fees was $224,000 and $319,000, respectively.

Chargebacks. We provide discounts to federal government qualified entities with whom we have contracted. These federal entities purchase products from the wholesalers at a discounted price, and the wholesalers then charge back to us the difference between the current retail price and the contracted price the federal entity paid for the product. We accrue chargebacks based on contract prices and sell-through sales data obtained from third-party information. At June 30, 2012 and December 31, 2011, the accrual for chargebacks was $47,000 and $24,000, respectively.

Rebates. We participate in certain rebate programs, which provide discounted prescriptions to qualified insured patients. Under these rebate programs, we pay a rebate to the third-party administrator of the program. We accrue rebates based on contract prices, estimated percentages of product sold to qualified patients and estimated levels of inventory in the distribution channel. Our accrual consists of: (1) the amount expected to be incurred based on the current quarter's product sold, (2) an accrual for unpaid rebates relating to prior quarters, and (3) an accrual for rebates relating to estimated inventory in the distribution channel. Our estimate of utilization is based on partial claims history data received, third-party data, and information about our expected patient population. At June 30, 2012 and December 31, 2011, the accrual for rebates was $1,886,000 and $1,896,000, respectively.

Product Returns. We estimate future product returns based upon actual returns history, product expiration dating analysis, estimated inventory levels in the distribution channel, and industry data regarding product return rates for similar products. There may be a significant time lag between the date we determine the estimated allowance and when we receive product returns and issue credits to customers. Due to this time lag, we may record adjustments to our estimated allowance over several periods, which would impact our operating results in those periods. At June 30, 2012 and December 31, 2011, the allowance for product returns was $594,000 and $255,000, respectively.

Cost of Product Sales

Cost of product sales includes the costs to manufacture, package, and ship Silenor, including personnel costs associated with manufacturing oversight, as well as royalties and amortization of capitalized license fees associated with our license agreement with ProCom One, Inc. (“ProCom”).

Share-Based Compensation Expense

Share-based compensation expense for employees and directors is recognized in the statement of operations based on estimated amounts, including the grant date fair value, the probability of achieving performance conditions and the expected service period for awards with conditional vesting provisions. We estimate the grant date fair value for our stock option awards using the Black-Scholes valuation model which requires the use of multiple subjective inputs including estimated future volatility and the expected terms of the stock option awards. Our stock did not have a readily available market prior to our initial public offering in December 2005, creating a relatively short history from which to obtain data to estimate the volatility of our stock price. Consequently, we estimate expected future volatility based on a combination of both comparable companies and our own stock price volatility to the extent such history is available. The expected term for stock options is estimated using guidance provided by the SEC in Staff Accounting Bulletin (“SAB”) No. 107 and SAB No. 110. This guidance provides a formula-driven approach for determining the expected term. Share-based compensation is based on awards expected to ultimately vest and has been reduced for estimated forfeitures. The estimated forfeiture rates may differ from actual forfeiture rates which would affect the amount of expense recognized during the period. Estimated forfeitures are adjusted to actual amounts as they become known.

 

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We recognize the value of the portion of the awards that are ultimately expected to vest on a straight-line basis over the award’s requisite service period. The requisite service period is generally the time over which our share-based awards vest. Some of our share-based awards have vested and may vest upon achieving certain performance conditions, generally pertaining to the commercial performance of Silenor or the achievement of other strategic objectives. Share-based compensation expense for awards with performance conditions is recognized over the period from the date the performance condition is determined to be probable of occurring through the time the applicable condition is met. If the performance condition is not considered probable of being achieved, no expense is recognized until such time as the meeting of the performance condition is considered probable.

Income Taxes

Our income tax expense would consist of current and deferred income tax expense or benefit. Current income tax expense or benefit is the amount of income taxes expected to be payable or refundable for the current year. A deferred income tax asset or liability is recognized for the future tax consequences attributable to tax credits and loss carryforwards and to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. As of June 30, 2012, we have established a valuation allowance to fully reserve our net deferred tax assets. Tax rate changes are reflected in income during the period such changes are enacted. Changes in ownership may limit the amount of net operating loss carryforwards that can be utilized in the future to offset taxable income. In addition, the state of California has currently suspended the use of net operating loss carryforwards to offset taxable income

Net Loss per Share

Basic earnings per share (“EPS”) excludes the effects of common stock equivalents. EPS is calculated by dividing net income or loss applicable to common stockholders by the weighted average number of common shares outstanding for the period, reduced by the weighted average number of unvested common shares outstanding subject to repurchase. Diluted EPS is computed in the same manner as basic EPS, but includes the effects of common stock equivalents to the extent they are dilutive, using the treasury-stock method. For us, basic and diluted net loss per share are equivalent because we have incurred a net loss in all periods presented, causing any potentially dilutive securities to be anti-dilutive.

 

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Net loss per share was determined as follows (in thousands, except per share amounts):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2012     2011     2012     2011  

Numerator:

        

Net loss

   $ (2,199   $ (14,949   $ (4,316   $ (31,987
  

 

 

   

 

 

   

 

 

   

 

 

 

Denominator:

        

Weighted average common shares outstanding

     48,108        45,492        48,108        45,250   
  

 

 

   

 

 

   

 

 

   

 

 

 

Per share calculation:

        

Basic and diluted net loss per share

   $ (0.05   $ (0.33   $ (0.09   $ (0.71
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average anti-dilutive securities not included in diluted net loss per share calculation:

        

Weighted average stock options outstanding

     5,026        4,645        5,123        4,207   

Weighted average restricted stock units outstanding

     717        563        453        404   

Weighted average warrants outstanding

     3,151        2,418        3,151        2,418   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total weighted average anti-dilutive securities not included in diluted net loss per share

     8,894        7,626        8,727        7,029   
  

 

 

   

 

 

   

 

 

   

 

 

 

Recent Accounting Pronouncements

In June 2011, the Financial Accounting Standards Board issued an Accounting Standards Update which requires entities to present reclassification adjustments included in other comprehensive income on the face of the financial statements and allows entities to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate consecutive statements. It also eliminated the option for entities to present components of other comprehensive income as part of the statement of changes to stockholders equity. We adopted this guidance on January 1, 2012.

 

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Note 3. Composition of Certain Balance Sheet Items

Accounts Receivable

Accounts receivable, net consisted of the following (in thousands):

 

     June 30,
2012
    December 31,
2011
 

Accounts receivable for product sales, gross

   $ 2,041      $ 1,989   

Allowances for discounts

     (41     (39
  

 

 

   

 

 

 

Total accounts receivable

   $ 2,000      $ 1,950   
  

 

 

   

 

 

 

Inventory

Inventory consisted of the following (in thousands):

 

     June 30,
2012
     December 31,
2011
 

Work in process

   $ 45       $ 124   

Finished goods inventory

     194         140   
  

 

 

    

 

 

 

Total inventory

   $ 239       $ 264   
  

 

 

    

 

 

 

Other Current Assets

Other current assets consisted of the following (in thousands):

 

     June 30,
2012
     December 31,
2011
 

Prepaid expenses

   $ 489       $ 622   

Prepaid sales and marketing costs

     87         91   

Deposits and other current assets

     279         290   
  

 

 

    

 

 

 

Total other current assets

   $ 855       $ 1,003   
  

 

 

    

 

 

 

Property and Equipment

Property and equipment consisted of the following (in thousands):

 

     June 30,
2012
    December 31,
2011
 

Tooling

   $ 867      $ 867   

Computer equipment

     481        481   

Furniture and equipment

     241        241   

Leasehold improvements

     76        76   
  

 

 

   

 

 

 

Property and equipment, at cost

     1,665        1,665   

Less: accumulated depreciation and amortization

     (1,146     (1,031
  

 

 

   

 

 

 

Property and equipment, net

   $ 519      $ 634   
  

 

 

   

 

 

 

 

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Depreciation and amortization expense of our property and equipment was $55,000 and $64,000 for the three months ended June 30, 2012 and 2011, respectively, and $115,000 and $116,000 for the six months ended June 30, 2012 and 2011, respectively.

Intangible Assets

Intangible assets consisted of the following (in thousands):

 

     June 30,
2012
    December 31,
2011
 

License fees

   $ 1,000      $ 1,000   

Technology development costs relating to websites

     147        147   

Other intangible assets

     161        161   
  

 

 

   

 

 

 

Intangible assets, at cost

     1,308        1,308   

Less: accumulated amortization

     (319     (219
  

 

 

   

 

 

 

Total intangible assets, net

   $ 989      $ 1,089   
  

 

 

   

 

 

 

Amortization expense of our intangible assets was $50,000 and $44,000 for the three months ended June 30, 2012 and 2011, respectively, and $100,000 and $74,000 for the six months ended June 30, 2012 and 2011, respectively.

Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):

 

     June 30,
2012
     December 31,
2011
 

Accrued product discounts, allowances and returns

   $ 3,143       $ 2,908   

Accrued fees and royalties

     1,102         1,904   

Accrued legal fees

     923         507   

Accrued compensation and benefits

     299         427   

Accrued liability to third party sales organization

     —           614   

Other accrued expenses

     577         694   
  

 

 

    

 

 

 

Total accrued liabilities

   $ 6,044       $ 7,054   
  

 

 

    

 

 

 

Other Long-Term Liabilities

Other long-term liabilities consisted of the following (in thousands):

 

     June 30,
2012
     December 31,
2011
 

Deferred revenue

   $ 497       $ 447   

Deferred rent

     129         43   
  

 

 

    

 

 

 

Total other long-term liabilities

   $ 626       $ 490   
  

 

 

    

 

 

 

Note 4. Collaboration and License Agreements

CJ CheilJedang Corporation. In April 2012, we entered into a license agreement and a supply agreement with CJ CheilJedang Corporation (“CJ”). Under the license agreement, CJ has the exclusive right to commercialize Silenor in South Korea, subject to the receipt of marketing approval. We received an upfront license fee of $600,000 (net of applicable Korean withholding taxes of $99,000) in connection with the execution of the agreements. If Silenor is commercialized in South Korea, we will also be eligible to receive sales-based milestone payments as well as a royalty based on net sales in South Korea. CJ will be responsible for regulatory submissions for Silenor in South Korea, and governance of the collaboration will occur through a joint committee. We have also granted to CJ a right of first negotiation with respect to doxepin isomer or metabolite products we may develop in South Korea. The term of the license agreement runs through the later of the expiration of the term of our amended and restated license agreement with ProCom or 10 years from the first commercial sale of Silenor in South Korea. Either party may terminate the license agreement upon

 

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an uncured material breach by the other party, upon the bankruptcy or insolvency of the other party, or upon a force majeure event that lasts for at least 120 days. We may also terminate the license agreement upon 60 days’ prior written notice if we are unable to license rights to a third party’s intellectual property and such failure would reasonably be expected to result in a claim from such third party alleging intellectual property infringement or misappropriation.

For accounting purposes, we have determined that our agreement with CJ includes the granting of a license and the delivery of a specified level of regulatory support services over the term of the license arrangement. We believe that each of these elements has a standalone value and should therefore be treated for as a separate unit of accounting. In accordance with the accounting guidance regarding revenue recognition for multiple-element agreements, we have allocated the contract value between these two deliverables based on our estimated relative future cash flows associated with each element. Revenue allocated to each unit of accounting is recognized as the service is provided or as otherwise earned. Our statement of operations for the three and six months ended June 30, 2012 includes license fee revenues of $420,000 associated with this transaction. The remainder of the upfront payment has been included in deferred revenue and is being amortized over the period of our significant involvement under the agreement, which we are estimating to be 10 years.

In connection with the license agreement, we also entered into a supply agreement, under which we will supply CJ with all of its requirements for Silenor for a per-unit transfer price during the term of the license agreement or until CJ procures its own supply of Silenor. CJ may terminate the supply agreement upon 10 business days’ notice if we are materially unable to supply Silenor to CJ’s requirements as defined in the supply agreement, and upon 10 business days’ notice in the event that the per-unit transfer price under the agreement exceeds a price specified in the supply agreement. We and CJ will mutually agree to terminate the supply agreement at any time if CJ enters into a direct contractual relationship with our manufacturer of Silenor. We may terminate the supply agreement upon 90 days prior written notice if there is a regulatory change or safety consideration that would have a material adverse effect on the global supply chain and at any time on six months’ prior notice after final FDA approval of a generic competing product for Silenor in the U.S.

Paladin. In June 2011, we entered into a license agreement, a supply agreement and a stock purchase agreement with Paladin Labs Inc. (“Paladin”). Under the license agreement, Paladin has the exclusive right to commercialize Silenor in Canada, South America, the Caribbean and Africa, subject to the receipt of marketing approval in each such territory. Paladin will be responsible for regulatory submissions for Silenor in the licensed territories, and governance of the collaboration will occur through a joint committee. We have also granted to Paladin a right of first negotiation with respect to additional doxepin products we may develop in the licensed territories and a right of first negotiation relating to rights to develop and market Silenor as an over-the-counter medication in the licensed territories.

The term of the license agreement runs through the later of the last date on which Silenor is sold by Paladin in the licensed territories or 15 years from the first commercial sale of Silenor in the licensed territories. If Silenor is commercialized in the licensed territories, we would also be eligible to receive sales-based milestone payments of up to $128.5 million as well as a tiered double-digit percentage of net sales in the licensed territories. We may terminate the license agreement on a country-by-country basis in specified key countries upon 60 days’ prior written notice if the first commercial sale has not occurred in such country within 12 months of the date on which marketing approval was obtained in such country. We may also terminate the license agreement upon 60 days’ prior written notice if marketing approval in Canada has not been received by December 7, 2013. Either party may terminate the license agreement upon an uncured material breach by the other party, upon the bankruptcy or insolvency of the other party, or upon a force majeure event that lasts for at least 120 days. We may also terminate the license agreement upon 60 days’ prior written notice and payment of a termination fee if we are unable to license rights to a third party’s intellectual property and such failure would reasonably be expected to result in a claim from such third party alleging intellectual property infringement or misappropriation.

 

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In connection with the license agreement, we also entered into a supply agreement, under which we will supply Paladin all of its requirements for Silenor during the term of the license agreement or until Paladin procures its own supply of Silenor. Paladin may terminate the supply agreement upon 10 business days’ notice if we are materially unable to supply Silenor to Paladin’s requirements as defined in the supply agreement, and at any time if Paladin enters into a direct contractual relationship with our manufacturer of Silenor. We may terminate the supply agreement upon 180 days prior written notice if there is a regulatory change or safety consideration that would have a material adverse effect on the global supply chain and at any time on six months’ prior notice after April 30, 2013.

ProCom. In August 2003, we entered into an exclusive worldwide in-license agreement with ProCom to develop and commercialize Silenor for the treatment of insomnia. This agreement was amended and restated in September 2010. The term of the license extends until the last licensed patent expires, which is expected to occur no earlier than 2020. The license agreement is terminable by us at any time with 30 days’ notice if we believe that the use of the product poses an unacceptable safety risk or if it fails to achieve a satisfactory level of efficacy. Either party may terminate the agreement with 30 days’ notice if the other party commits a material breach of its obligations and fails to remedy the breach within 90 days, or upon the filing of bankruptcy, reorganization, liquidation, or receivership proceedings. Costs related to the licensed intellectual property incurred after approval of the Silenor NDA by the FDA in March 2010 have been capitalized and included in intangibles in our balance sheet as of June 30, 2012 and December 31, 2011. Capitalized amounts are being amortized on a straight line basis over approximately ten years. Royalty payments due under the terms of the agreement are recorded in accrued liabilities as of June 30, 2012 and December 31, 2011. The royalty payments are recognized as an expense in cost of sales when the related shipments of product are recognized as revenue.

Other Agreements. In October 2006, we entered into a supply agreement with JRS Pharma L.P. (“JRS”), under which we purchase from JRS all of our requirements for ProSolv®HD90, an ingredient used in the formulation for Silenor. In August 2008, this supply agreement was amended to provide us with the exclusive right to use this ingredient in combination with doxepin. Pursuant to the amendment, we are obligated to pay a royalty on worldwide net sales of Silenor beginning as of the expiration of the statutory exclusivity period for Silenor in each country in which Silenor is marketed. Such royalty is only payable if one or more patents under the license agreement continue to be valid in each such country and a patent relating to our formulation for Silenor has not issued in such country.

As described more fully in Note 8, “Subsequent Events,” in July 2012 we entered into separate settlement and license agreements with Mylan, Par and Zydus to resolve the pending patent litigation between the parties involving the applications made by such other parties seeking approval to market generic versions of Silenor 3 mg and 6 mg tablets. Each of Mylan, Par and Zydus was granted the right to commercialize a generic version of Silenor in the United States on future dates that may vary depending on circumstances. In connection with the settlement and license agreement with Mylan, we entered into a manufacturing services agreement with Mylan for the supply of Silenor 3 mg and 6 mg tablets for commercial use.

Note 5. Commitments and Contingencies

Commitments

Procter & Gamble. In August 2010, we entered into a co-promotion agreement with P&G under which P&G provided sales support to promote Silenor in the U.S. We recognized the revenue from Silenor product sales generated by the promotional efforts of P&G, and in return, were required to pay P&G a fixed fee and a royalty fee as a percentage of U.S. net sales on a quarterly basis during the term of the agreement. The fees due to P&G under this agreement were recognized as part of sales, general, and administrative expense. Each party was responsible for the costs of training, maintaining and operating its own sales force, and we were responsible for all other costs pertaining to the commercialization of Silenor. We terminated this agreement effective as of December 31, 2011. As a result of such termination, P&G is entitled to a low single digit royalty on net sales of Silenor for the 2012 fiscal year.

 

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In May 2012, we entered into an amendment to the agreement with P&G to modify the timing of payment of approximately $1.7 million owed to P&G as of December 31, 2011. Under this amendment, we made an initial payment to P&G of $750,000, and agreed to pay the remainder based on net sales of Silenor in the U.S. The payment will be 3% of net sales from April 1, 2012 through December 31, 2012, and 6% of such net sales thereafter. Such payment will continue until the remaining $0.9 million owed to P&G has been paid in full, subject to acceleration under certain circumstances as set forth in the amendment. Such payment is in addition to the royalty currently payable to P&G by us relating to net sales of Silenor, which continues through December 31, 2012.

Facility Lease. In May 2011, we entered into a lease arrangement to rent approximately 12,100 square feet of office space, which we use as our corporate headquarters. The lease commenced on August 25, 2011. The lease will expire on December 24, 2016, and we will have the option to extend the term for an additional five years at the then-current fair market rental rate (as defined in the lease). We have paid the first month’s rent of approximately $30,000 and the monthly rent is approximately $30,000. However, the second through thirteenth month’s rent will be abated by one-half, provided that we are not in default of the lease. After the first year, the monthly rent will increase by 3.5% per year. We recognize rent expense on a straight line basis over the lease term. The difference between rent expense recorded and amounts paid under lease agreements is recorded as deferred rent and included in other long-term liabilities in the accompanying balance sheet. We have opened a letter of credit in the amount of $200,000 in favor of our landlord to secure our obligations under the lease. The funds securing the letter of credit have been recorded as restricted cash in the accompanying balance sheet.

Citadel Securities LLC. In August 2011, we entered into an at-the-market equity sales agreement with Citadel (the “Sales Agreement”) pursuant to which we may sell, at our option, up to an aggregate of $30.0 million in shares of our common stock through Citadel, as sales agent. Sales of the common stock made pursuant to the Sales Agreement, if any, will be made on the Nasdaq Stock Market (“Nasdaq”) under our currently-effective Registration Statements on Form S-3 by means of ordinary brokers’ transactions at then-prevailing market prices. Additionally, under the terms of the Sales Agreement, we may also sell shares of our common stock through Citadel, on the Nasdaq or otherwise, at negotiated prices or at prices related to the prevailing market price. Under the terms of the Sales Agreement, we may also sell shares to Citadel as principal for Citadel’s own account at a price agreed upon at the time of sale pursuant to a separate terms agreement to be entered into with Citadel at such time. We will pay Citadel a commission equal to 3% of the gross proceeds from the sale of shares of our common stock under the Sales Agreement. The offering of common stock pursuant to the Sales Agreement will terminate upon the earlier of (a) the sale of all of the common stock subject to the Sales Agreement or (b) the termination of the Sales Agreement by us or Citadel. Either party may terminate the Sales Agreement in its sole discretion at any time upon written notice to the other party. There can be no assurance that we can or will consummate sales based on prevailing market conditions or in the quantities or at the prices that we deem appropriate.

We will not be able to make sales of our common stock pursuant to the sales agreement unless certain conditions are met, which include the accuracy of representations and warranties made to Citadel under the sales agreement; compliance with laws; and the continued listing of our stock on the Nasdaq Capital Market. On December 13, 2011, we received a letter from the Listing Qualifications Department of Nasdaq , informing us that because the closing bid price of our common stock listed on Nasdaq was below $1.00 for 30 consecutive trading days, we did not comply with the minimum closing bid price requirement for continued listing on the Nasdaq Capital Market under Nasdaq Marketplace Rule 5550(a)(2). In June 2012, we received a second letter from Nasdaq notifying us that we had been granted an additional 180-day compliance period, or until December 10, 2012, to regain compliance with the $1.00 per share minimum closing bid price requirement under Nasdaq Marketplace Rule 5550(a)(2). Nasdaq’s determination was based on us meeting the continued listing requirement for market value of publicly held shares and all other applicable requirements for initial listing on the Nasdaq Capital Market, with the exception of the bid price requirement, and our written notice of our intention to cure the deficiency during the second compliance period by effecting a reverse stock split, if necessary.

We may regain listing compliance by maintaining a closing bid price of our common stock of at least $1.00 per share for a minimum of 10 consecutive business days at any time before December 10, 2012. If, pursuant to Nasdaq Marketplace Rule 5810(c)(3)(A), we meet the outlined requirements, Nasdaq will provide written confirmation to us that we comply with Nasdaq Marketplace Rule 5550(a)(2), unless Nasdaq exercises its discretion to extend this 10-day period pursuant to its Listing Rule 5810(c)(3)(F). If compliance is not demonstrated within the applicable compliance period, Nasdaq will notify us that our securities will be delisted from the Nasdaq Capital Market. However, we may appeal Nasdaq’s determination to delist our securities to a Hearings Panel.

 

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In addition, the rules and regulations of the SEC or other regulatory agencies may restrict our ability to make sales under the sales agreement, or may affect the timing of and the amounts we can raise by making such sales. For example, under current SEC regulations, because the aggregate market value of our public float is less than $75 million, the amount that we can raise through primary public offerings of securities in any twelve-month period using one or more registration statements on Form S-3 is limited to an aggregate of one-third of our public float.

Other Commitments. We have contracted with various consultants, drug manufacturers, wholesalers, and other vendors to assist in regulatory and compliance matters, data analysis, and commercialization activities for Silenor. The contracts are terminable at any time, but obligate us to reimburse the providers for any time or costs incurred through the date of termination. We have employment agreements with certain of our current employees that provide for severance payments and accelerated vesting for certain share-based awards if their employment is terminated under specified circumstances.

Litigation

We received notices from each of Actavis Elizabeth LLC and Actavis Inc. (collectively, “Actavis”), Mylan, Par and Zydus that each had filed with the FDA an Abbreviated New Drug Application (“ANDA”) for a generic version of Silenor 3 mg and 6 mg tablets. The notices included “paragraph IV certifications” with respect to eight of the nine patents listed in the FDA’s Approved Drug Products with Therapeutic Equivalence Evaluations, commonly known as the Orange Book, for Silenor. A paragraph IV certification is a certification by a generic applicant that in the opinion of that applicant, the patent(s) listed in the Orange Book for a branded product are invalid, unenforceable, and/or will not be infringed by the manufacture, use or sale of the generic product.

We, together with ProCom, filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that each of Actavis, Mylan, Par and Zydus infringed U.S. Patent No. 6,211,229 (the “’229 patent”) by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties have infringed U.S. Patent No. 7,915,307 (the “’307 patent”) by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

As described more fully in Note 8, “Subsequent Events,” in July 2012 we and ProCom One entered into separate settlement agreements with each of Mylan, Par and Zydus to resolve the pending patent litigation between the parties. In July 2012, the U.S. District Court for the District of Delaware entered an order dismissing the litigation with respect to each of Mylan, Par and Zydus.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action.

We intend to vigorously enforce our intellectual property rights relating to Silenor, but cannot predict the outcome of ongoing or any future actions.

We may from time-to-time become subject to other litigation matters. Regardless of how these litigation matters are ultimately resolved, litigation could reasonably be expected to be costly, time-consuming and distracting to management, which could have a material adverse effect on our business.

Note 6. Share-based Compensation and Equity

We have issued and intend to continue to issue stock options, restricted stock units (“RSUs”) and restricted stock awards under our equity incentive award plans. We have equity awards outstanding under both our 2004 Equity Incentive Award Plan (the “2004 Plan”) and our 2005 Equity Incentive Award Plan (the “2005 Plan”). During 2012, we had the following types of equity awards outstanding:

 

   

Stock Options: Stock options generally have ten-year terms and vest over a period of between one and four years and are service-based. The exercise price for our stock options is generally equal to the closing stock price at the date of grant.

 

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Restricted Stock Units: RSUs, which are convertible into an equivalent number of shares of common stock upon vesting, have been granted to employees and members of our board of directors.

Certain of our share-based awards will vest upon the achievement of performance conditions. Compensation expense for share-based awards granted to employees and directors is recognized based on the grant date fair value for the portion of the awards for which performance conditions are considered probable of being achieved. Such expense is recorded over the period the performance condition is expected to be performed. No expense is recognized for awards with performance conditions that are considered improbable of being achieved.

The following table summarizes non-cash share-based compensation expense (in thousands).

 

     Three Months Ended
June  30,
     Six Months Ended
June 30,
 
     2012      2011      2012      2011  

Included in selling, general and administrative expense

   $ 682       $ 1,245       $ 1,370       $ 2,294   

Included in research and development expense

     —           148         —           294   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total share-based compensation expense

   $ 682       $ 1,393       $ 1,370       $ 2,588   
  

 

 

    

 

 

    

 

 

    

 

 

 

Included in these tables for 2012 is the effect of a modification of the option agreements with certain terminated employees as a result of an extension of the term of their post-employment consulting agreements. We recognized $78,000 of share-based compensation expense during 2012 as a result of these modifications.

In March 2012, our board of directors amended our Director Compensation Policy retroactively to October 1, 2011 to provide that non-employee directors receive restricted stock units in lieu of other forms of compensation for their service on our board of directors. Stock based compensation for the three and six months ended June 30, 2012 includes $164,000 and $303,000, respectively, associated with compensation of our non-employee board members. As a result of this retroactive change, $100,000 that had been included in accrued liabilities at December 31, 2011 was reclassified to additional paid-in capital during 2012.

In March 2012, the compensation committee of our board of directors determined that, in order to reduce costs, the base salaries of our executive officers would be reduced effective April 2012. The amount of such salary reduction for each executive officer will be paid to them on a quarterly basis in arrears in the form of restricted stock units. Stock based compensation for the three and six months ended June 30, 2012 includes $35,000 associated with compensation of our executive officers.

Note 7. Related Party Transaction

We have in-licensed certain intellectual property from ProCom (see Note 4, “Collaboration and License Agreements”). Royalty expense associated with this agreement is included in cost of sales and totaled $165,000 and $349,000 for the three months ended June 30, 2012 and 2011, respectively, and $300,000 and $470,000 for the six months ended June 30, 2012 and 2011, respectively.

At June 30, 2012 and December 31, 2011, $165,000 and $239,000, respectively, is recorded in accrued liabilities for ProCom royalty payments.

As part of the in-license agreement, ProCom has the right to designate one nominee for election to our board of directors (Terrell Cobb, a principal of ProCom).

 

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Note 8. Subsequent Events

Settlement and License Agreements

On July 17, 2012, we and ProCom entered into a Settlement and License Agreement (the “Mylan Agreement”) with Mylan to resolve the pending patent litigation between the parties involving Mylan’s application seeking approval to market a generic version of Silenor 3 mg and 6 mg tablets. Pursuant to the Mylan Agreement, we entered into a Manufacturing Services Agreement (the “Mylan Supply Agreement” and collectively with the Mylan Agreement, the “Mylan Agreements”) with Mylan Pharmaceuticals, Inc. for the supply of Silenor 3 mg and 6 mg tablets for commercial use. Under the Mylan Agreement, we agreed to grant Mylan an exclusive, royalty-bearing license under the patents that are the subject of the litigation, U.S. Patent Nos. 6,211,229 and 7,915,307 (the “Litigated Patents”), to sell an authorized generic version of Silenor under our NDA in the United States for a limited period beginning January 1, 2020, or earlier under certain circumstances. Such circumstances include the sale in the United States of a generic equivalent version of Silenor by a third party, and a substantial decline in Silenor prescription volume that is not within our sole control, subject to a formula included in the Mylan Agreement. After Mylan’s license to sell such authorized generic product expires, Mylan will have a non-exclusive, royalty-bearing license to sell a generic version of Silenor under Mylan’s ANDA in the United States.

The Mylan Agreement provides that we and Mylan will not pursue litigation activities related to the pending litigation, and we jointly filed a stipulated consent judgment and joint motion to dismiss the pending litigation with respect to Mylan. Under the Mylan Agreement, we will make payments to Mylan in recognition of the savings inuring to us in terms of the avoidance of costs and burden associated with prosecuting the litigation. This obligation, which will be paid over a period of time, will result in a one-time expense in the third quarter of 2012. The Mylan Agreement required us and Mylan to submit the Mylan Agreements to the U.S. Federal Trade Commission and the U.S. Department of Justice within ten business days following the date of execution.

Under the Mylan Supply Agreement, we agreed to purchase from Mylan certain minimum amounts of our commercial requirements of Silenor 3 mg and 6 mg tablets. We also granted to Mylan a right of first negotiation with respect to the manufacture of commercial quantities of any additional branded pharmaceutical product containing doxepin as the sole active pharmaceutical ingredient, to the extent such product is to be manufactured by a third party. The initial term of the Mylan Supply Agreement is as specified in the Mylan Supply Agreement and will automatically be renewed unless terminated by either party upon prior written notice prior to the expiration of the initial term or any renewal term. We have the right to terminate the Mylan Supply Agreement upon prior written notice if a generic form of Silenor is launched in the United States or in the event that any governmental agency takes any action, or raises any objection, that prevents us from importing, exporting, purchasing or selling Silenor. Mylan has the right to terminate the Mylan Supply Agreement upon prior written notice if a generic form of Silenor is launched in the United States (other than by Mylan in breach of the Mylan Agreement). Either party may terminate the Mylan Supply Agreement in the event of a material breach of the Mylan Supply Agreement by the other party, unless the material breach is cured within a specified period after written notice, in the event of a breach of the Mylan Agreement by the other party, or in the event of a force majeure event that prevents the other party’s performance for a specified period. In addition, either party may immediately terminate the Mylan Supply Agreement upon written notice if (1) the other party is declared insolvent or bankrupt by a court of competent jurisdiction, (2) a voluntary petition of bankruptcy is filed in any court of competent jurisdiction by the other party or (3) the Mylan Supply Agreement is assigned by such other party for the benefit of creditors.

The Mylan Agreements also contain provisions regarding indemnification, confidentiality, dispute resolution and other customary provisions for agreements of these kinds.

On July 17, 2012, we and ProCom entered into a Settlement and License Agreement (the “Par Agreement”) with Par to resolve the pending patent litigation between the parties involving Par’s application seeking approval to market a generic version of Silenor 3 mg and 6 mg tablets. Under the Par Agreement, we agreed to grant Par a non-exclusive license under the Litigated Patents to sell a generic version of Silenor in the United States 180 days after the earlier of the date that a third party’s generic version of Silenor is first sold in the United States under a license from us or a final court decision that the Litigated Patents are not infringed, invalid or unenforceable, or earlier under certain circumstances. Par will be required to pay us royalties on its net sales of such generic product until a date specified in the Par Agreement. The Par Agreement provides that we and Par will not pursue litigation activities related to the pending litigation, and we jointly filed a stipulated consent judgment and joint motion to dismiss the pending litigation with respect to Par. The Par Agreement required us and Par to submit the Par Agreement to the U.S. Federal Trade Commission and the U.S. Department of Justice within ten business days following the date of execution. The Par Agreement also contains provisions regarding indemnification, confidentiality, dispute resolution and other customary provisions for an agreement of this kind.

 

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On July 18, 2012, we and ProCom entered into a Settlement and License Agreement (the “Zydus Agreement”) with Zydus to resolve the pending patent litigation between the parties involving Zydus Pharmaceuticals (USA), Inc.’s application seeking approval to market a generic version of Silenor 3 mg and 6 mg tablets. Under the Zydus Agreement, we agreed to grant Zydus a non-exclusive license under the Litigated Patents to sell a generic version of Silenor in the United States 180 days after the earlier of the date that a third party’s generic version of Silenor is first sold in the United States under a license from us or a final court decision that the Litigated Patents are not infringed, invalid or unenforceable, or earlier under certain circumstances. Zydus will be required to pay us royalties on its net sales of such generic product until a date specified in the Zydus Agreement. Zydus will also be required to pay to us liquidated damages specified in the Zydus Agreement under certain circumstances. The Zydus Agreement provides that we and Zydus will not pursue litigation activities related to the pending litigation, and we jointly filed a stipulated consent judgment and joint motion to dismiss the pending litigation with respect to Zydus. The Zydus Agreement required us and Zydus to submit the Zydus Agreement to the U.S. Federal Trade Commission and the U.S. Department of Justice within ten business days following the date of execution. The Zydus Agreement also contains provisions regarding indemnification, confidentiality, dispute resolution and other customary provisions for an agreement of this kind.

In July 2012, the U.S. District Court for the District of Delaware entered an order dismissing the litigation with respect to each of Mylan, Par and Zydus.

Sale of Common Stock and Warrants

On July 24, 2012, we sold to institutional investors an aggregate of 9,422,496 shares of our common stock (the “Shares”) and warrants to purchase up to an additional 4,711,248 shares of our common stock (the “Warrants”) at a combined purchase price of $0.32 per Share and per Warrant. The Warrants have an exercise price of $0.46 per share, will be exercisable beginning six months and one day from the date of issuance and will expire on the fifth anniversary of the date they first become exercisable. The total gross proceeds from the offering were approximately $3.0 million, before deducting anticipated selling commissions and expenses of approximately $0.3 million.

Litigation with Classen Immunotherapies, Inc.

On August 1, 2012, a complaint for patent infringement was filed against us by Classen Immunotherapies, Inc. in the United States District Court for the Central District of California. The complaint alleges that we infringed one or more claims of two of plaintiff’s patents by conducting one or more clinical studies relating to Silenor and seeking FDA approval for Silenor. The plaintiff seeks damages, including for willful infringement, and attorneys’ fees. We have not yet been served with the complaint. We believe that none of our activities has infringed plaintiff’s patents, and we will defend the action vigorously.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The interim financial statements and this Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2011, and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our Annual Report on Form 10-K for the year ended December 31, 2011. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to those set forth under the caption “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011 and the caption “Risk Factors” in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2012.

Overview

Background

We are a specialty pharmaceutical company focused on the in-licensing, development and commercialization of proprietary branded products and product candidates to treat important medical conditions where there is an unmet medical need and/or high-level of patient dissatisfaction, currently in the central nervous system therapeutic area. In March 2010, the U.S. Food and Drug Administration, or FDA, approved our New Drug Application, or NDA, for Silenor 3 mg and 6 mg tablets for the treatment of insomnia characterized by difficulty with sleep maintenance. Silenor was made commercially available by prescription in the United States in September 2010.

Our principal focus is on commercial activities relating to Silenor. We commercially launched Silenor in September 2010 with 110 sales representatives provided to us on an exclusive basis under our contract sales agreement with Publicis, managed by our sales management personnel, and an additional 105 sales representatives provided to us under our co-promotion agreement with The Procter & Gamble Distributing Company LLC, or P&G. In February 2011, we amended our agreement with Publicis Touchpoint Solutions, Inc., or Publicis, to have Publicis deploy for us an additional 35 sales representatives. Because we did not believe that the growth of Silenor revenues throughout 2011 was sufficient to support sales and marketing expenses at then-current levels, we terminated our agreements with Publicis and P&G in December 2011 in an effort to conserve cash, and effective January 3, 2012, we hired a reduced sales force to cover 25 sales territories to promote Silenor. The remainder of the Publicis sales force ceased promoting Silenor as of November 2, 2011. Our financial statements as of December 31, 2011 reflect all remaining contractual obligations owed to Publicis. In June 2012, we began reallocating our commercial resources relating to Silenor, including by eliminating 10 vacant and/or unprofitable field sales territories and focusing greater resources on other activities to better support our in-person promotional efforts.

In June 2011, we entered into agreements with Paladin Labs Inc., or Paladin, under which Paladin has the right to commercialize Silenor in Canada, South America, the Caribbean and Africa, subject to the receipt of marketing approval in each such territory. In April 2012, we entered into agreements with CJ CheilJedang Corporation, or CJ , under which CJ has the right to commercialize Silenor in South Korea, subject to the receipt of marketing approval in South Korea.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of our financial condition and results of operations is based on our condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, expenses and related disclosures. Actual results could differ from those estimates. We believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our condensed financial statements.

 

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Revenue Recognition

Product Sales

We sell Silenor to wholesale pharmaceutical distributors. Our returned goods policy generally permits our customers to return products beginning six months before and up to twelve months after the expiration date of the product. We authorize returns for expired products in accordance with our returned goods policy and issue credit to our customers for expired returned product. We do not exchange product from inventory for returned product. Through June 30, 2012, the dollar amount of returns received since we commenced commercial shipments of Silenor (in August 2010) has been negligible.

We recognize product revenue from product sales when 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) our price to the buyer is fixed or determinable; and (4) collectability is reasonably assured. Revenue from sales transactions where the buyer has the right to return the product is recognized at the time of sale only if (1) our price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid us, or the buyer is obligated to pay us and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to us 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 us, (5) we do 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.

Prior to the second quarter of 2011, we were unable to reasonably estimate returns. We therefore deferred revenue recognition until the right of return no longer existed, which was the earlier of Silenor being dispensed through patient prescriptions or the expiration of the right of return. We estimated patient prescriptions dispensed using an analysis of third-party information. In order to develop a methodology to reliably estimate product returns and provide a basis for recognizing revenue on sales to customers at the time of product shipment, we analyzed many factors, including, without limitation, industry data regarding product return rates, and tracked the Silenor product return history, taking into account product expiration dating at the time of shipment and levels of inventory in the wholesale channel compared to prescription units dispensed and the sell-down of our launch inventory. During the second quarter of 2011, the sell-down of our launch inventory was completed, which we believe demonstrates sufficient market acceptance of our product for purposes of our revenue recognition analysis. In addition, since product launch, we have sold product to wholesale pharmaceutical distributors at standard commercial terms utilized in the industry. As a result, we believe we can analogize to industry data regarding product return rates. Based on the sell-down of our launch inventory and the industry and internal data gathered, we believe we have the information needed to reasonably estimate product returns. As a result, in the second quarter of 2011, we began recognizing revenue for Silenor sales at the time of delivery of the product to wholesale pharmaceutical distributors and our other customers.

License and Royalty Revenue

We consider a variety of factors in determining the appropriate method of accounting for our license agreements, including whether the various deliverables within the agreement can be separated and accounted for as separate units of accounting. Where there are multiple deliverables identified within an agreement that are combined into a single unit of accounting, revenues are deferred and recognized on a straight-line basis over the expected period of performance. Where a license agreement includes multiple deliverables that are determined to have stand-alone values, we allocate arrangement consideration based on their estimated relative fair value. Revenue is recognized for each individual deliverable after there are no further performance obligations, the related consideration is fixed and determinable and collectability is reasonably assured. For deliverables with continuing performance obligations, we recognize revenue over the expected performance period using either a proportional performance or straight-line method depending on whether we can reasonably estimate the level of effort required to complete our performance obligations under the arrangement.

We are entitled to sales-based milestone payments and royalty revenues under the terms of our license agreements. We will recognize these revenues once the earnings process is complete and payment is reasonably assured.

 

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Product Sales Discounts and Allowances

We record product sales discounts and allowances at the time of sale and report revenue net of such amounts in the same period that product sales are recorded. In determining the amount of product sales discounts and allowances, we must make significant judgments and estimates. If actual results vary from our estimates, we may need to adjust these estimates, which could have an effect on product revenue in the period of adjustment. Our product sales discounts and allowances and the specific considerations we use in estimating these amounts include:

Prompt Pay Discounts. As an incentive for prompt payment, we offer a 2% cash discount to customers. We calculate the discount based on the gross amount of each invoice as we expect that all customers will comply with the contractual terms to earn the discount. We record the discount as an allowance against accounts receivable and a corresponding reduction of revenue. At June 30, 2012 and December 31, 2011, the allowance for prompt pay discounts was $41,000 and $39,000, respectively.

Patient Discount Programs. We offer discount programs to patients of Silenor under which the patient receives a discount on his or her prescription. We reimburse pharmacies for these discounts through third-party vendors. We estimate the total amount that will be redeemed based on the dollar amount of the discounts, the timing and quantity of distribution and historical redemption rates. We accrue the discounts and recognize a corresponding reduction of revenue. At June 30, 2012 and December 31, 2011, the accrual for patient discount programs was $392,000 and $414,000, respectively.

Distribution Service Fees. We pay distribution services fees to each wholesaler for distribution and inventory management services. We accrue for these fees based on contractually defined terms with each wholesaler and recognize a corresponding reduction of revenue. At June 30, 2012 and December 31, 2011, the accrual for distribution service fees was $224,000 and $319,000, respectively.

 

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Chargebacks. We provide discounts to federal government qualified entities with whom we have contracted. These federal entities purchase products from the wholesalers at a discounted price, and the wholesalers then charge back to us the difference between the current retail price and the contracted price the federal entity paid for the product. We accrue chargebacks based on contract prices and sell-through sales data obtained from third party information. At June 30, 2012 and December 31, 2011, the accrual for chargebacks was $47,000 and $24,000, respectively.

Rebates. We participate in certain rebate programs, which provide discounted prescriptions to qualified insured patients. Under these rebate programs, we pay a rebate to the third-party administrator of the program. We accrue rebates based on contract prices, estimated percentages of product sold to qualified patients and estimated levels of inventory in the distribution channel. Our accrual consists of: (1) the amount expected to be incurred based on the current quarter's product sold, (2) an accrual for unpaid rebates relating to prior quarters, and (3) an accrual for rebates relating to estimated inventory in the distribution channel. Our estimate of utilization is based on partial claims history data received, third-party data, and information about our expected patient population. At June 30, 2012 and December 31, 2011, the accrual for rebates was $1,886,000 and $1,896,000, respectively.

Product Returns. We estimate future product returns based upon actual returns history, product expiration dating analysis, estimated inventory levels in the distribution channel, and industry data regarding product return rates for similar products. There may be a significant time lag between the date we determine the estimated allowance and when we receive product returns and issue credits to customers. Due to this time lag, we may record adjustments to our estimated allowance over several periods, which would impact our operating results in those periods. At June 30, 2012 and December 31, 2011, the allowance for product returns was $594,000 and $255,000, respectively.

To the extent that we expand our managed care rebate programs and discount programs to offset patients’ out of pocket costs, we would expect product sales discounts and allowances to increase.

The following table summarizes the activity for the three months ended June 30, 2012 associated with product sales discounts and allowances, with amounts shown in thousands:

 

     Prompt
Pay
Discounts
    Patient
Discount
Fees
    Distribution
Service
Fees
    Charge-
backs and
Rebates
    Product
Returns
    Total  

Balance at January 1, 2012

   $ 39      $ 414      $ 319      $ 1,920      $ 255      $ 2,947   

Current period provision

     189        519        623        1,925        345        3,601   

Payments and other credits

     (187     (541     (718     (1,912     (6     (3,364
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at June 30, 2012

   $ 41      $ 392      $ 224      $ 1,933      $ 594      $ 3,184   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cost of Product Sales

Cost of product sales includes the costs to manufacture, package, and ship Silenor, including personnel costs associated with manufacturing oversight, as well as royalties and amortization of capitalized license fees associated with our license agreement with ProCom One, Inc., or ProCom.

Inventory

Our inventories are valued at the lower of weighted average cost or net realizable value. We analyze our inventory levels quarterly and write down inventory that has become obsolete, or has a cost basis in excess of its expected net realizable value, as well as any inventory quantities in excess of expected requirements. Expired inventory is disposed of and the related costs are written off. We did not record any significant write-downs of obsolete or excess inventory during the three or six months ended June 30, 2012.

 

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Capitalized License Fees

License fees related to our intellectual property are capitalized once technological feasibility has been established. Determining when technological feasibility has been achieved, and determining the related amortization period for capitalized intellectual property, requires the use of estimates and subjective judgment. Costs incurred to in-license our product candidates subsequent to FDA approval of our NDA for Silenor have been capitalized and recorded as an intangible asset. Capitalized amounts are amortized on a straight line basis over approximately ten years.

Share-based Compensation

Share-based compensation expense for employees and directors is recognized in the statement of operations based on estimated amounts, including the grant date fair value, the probability of achieving performance conditions and the expected service period for awards with conditional vesting provisions. For stock options, we estimate the grant date fair value using the Black-Scholes valuation model which requires the use of multiple subjective inputs including an estimate of future volatility and the expected terms of the awards. Our stock did not have a readily available market prior to our initial public offering in December 2005, creating a relatively short history from which to obtain data to estimate volatility for our stock price. Consequently, we estimate our expected future volatility based on a combination of both comparable companies and our own stock price volatility to the extent such history is available. Our future volatility may differ from our estimated volatility at the grant date. We estimate the expected term of our options using guidance provided by the Securities and Exchange Commission, or SEC, in Staff Accounting Bulletin, or SAB, No. 107 and SAB No. 110. This guidance provides a formula-driven approach for determining the expected term. Share-based compensation recorded in our statement of operations is based on awards expected to ultimately vest and has been reduced for estimated forfeitures. Our estimated forfeiture rates may differ from actual forfeiture rates which would affect the amount of expense recognized during the period. Estimated forfeitures are adjusted to actual amounts as they become known.

We recognize the value of the portion of the awards that are expected to vest on a straight-line basis over the awards’ requisite service periods. The requisite service period is generally the time over which our share-based awards vest. Some of our share-based awards vested upon achieving certain performance conditions, generally pertaining to the commercial performance of Silenor or the achievement of other strategic objectives. Share-based compensation expense for awards with performance conditions is recognized over the period from the date the performance condition is determined to be probable of occurring through the time the applicable condition is met. If the performance condition is not considered probable of being achieved, then no expense is recognized until such time the performance condition is considered probable of being met. At that time, expense is recognized over the period during which the performance condition is likely to be achieved. Determining the likelihood and timing of achieving performance conditions is a subjective judgment made by management which may affect the amount and timing of expense related to these share-based awards. Share-based compensation is adjusted to reflect the value of options which ultimately vest as such amounts become known in future periods. As a result of these subjective and forward-looking estimates, the actual value of our stock options realized upon exercise could differ significantly from those amounts recorded in our financial statements.

Results of Operations

Comparisons of the Three Months Ended June 30, 2012 and 2011

Product Sales. Net product sales represent sales of Silenor for which we have recognized revenue, and are summarized in the following table (in thousands).

 

     Three Months Ended
June 30,
    Change  
     2012     2011     Dollar     Percent  

Gross product sales

   $ 4,879      $ 8,234      $ (3,355     (41 %) 

Sales discounts and allowances

        

Prompt pay discount

     (101     (164     63        (38 %) 

Patient discount programs

     (242     (497     255        (51 %) 

Distribution service fees

     (326     (534     208        (39 %) 

Rebates and chargebacks

     (1,060     (634     (426     67

Product returns and other discounts

     (220     (163     (57     35
  

 

 

   

 

 

   

 

 

   

 

 

 

Total discounts and allowances

     (1,949     (1,992     43        (2 %) 
  

 

 

   

 

 

   

 

 

   

 

 

 

Total net product sales

   $ 2,930      $ 6,242      $ (3,312     (53 %) 
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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We recognized net product sales of $2.9 million and $6.2 million for the three months ended June 30, 2012 and 2011, respectively. In the second quarter of 2011, we began recognizing revenue for sales of Silenor at the time of delivery of the product to our wholesale pharmaceutical distributors and our other customers resulting in a one-time increase in net product sales of $3.2 million from the recognition of previously deferred product sales revenue.

Sales discounts and allowances totaled $1.9 million for the three months ended June 30, 2012, compared to $2.0 million for the same period in 2011. As a percentage of gross sales, the discounts and allowances were 39.9% and 24.2% for the three months ended June 30, 2012 and 2011, respectively. The increase in sales discounts as a percentage of gross product sales is primarily due to the expansion of our participation in rebate programs with managed care organizations.

License Fee Revenue. License fee revenue represents revenues associated with our agreements with CJ. There were no similar revenues in the comparable prior year period.

Cost of Product Sales. Cost of product sales includes the costs to manufacture, package, and ship Silenor, including personnel costs associated with manufacturing oversight, as well as royalties and amortization of capitalized license fees associated with our license agreement. Cost of product sales is summarized in the following table (in thousands).

 

     Three Months Ended
June  30,
     Change  
     2012      2011      Dollar     Percent  

Cost of product sales

   $ 265       $ 661       $ (396     (60 %) 
  

 

 

    

 

 

    

 

 

   

 

 

 

We recognized cost of product sales of $0.3 million and $0.7 million for the three months ended June 30, 2012 and 2011, respectively, relating to product sales with respect to which revenue was recognized. The decrease in cost of product sales expense was due to the decline in product sales as well as a reduction in personnel and related costs resulting from cost reduction initiatives we implemented in the fourth quarter of 2011. Gross profit was $2.7 million and $5.6 million for the three months ended June 30, 2012 and 2011, respectively. Expressed as a percentage of net product sales, gross margin was 91.0% and 89.4% for the three months ended June 30, 2012 and 2011, respectively.

Selling, General and Administrative Expenses. Our selling, general and administrative expenses consist primarily of salaries, benefits, share-based compensation expense, the costs of our sales representatives, royalties paid to our former co-promotion partner, personnel costs and other promotional spending and consulting costs, advertising and market research costs, insurance and facility costs, and professional fees related to our marketing, administrative, finance, human resources, legal and internal systems support functions.

Selling, general and administrative expenses are summarized in the following table (in thousands, except percentages).

 

     Three Months Ended
June 30,
     Change  
     2012      2011      Dollar     Percent  

Sales and marketing

   $ 1,659       $ 14,849       $ (13,190     (89 %) 

General and administrative

     3,640         5,224         (1,584     (30 %) 
  

 

 

    

 

 

    

 

 

   

 

 

 

Total selling, general and administrative expense

   $ 5,299       $ 20,073       $ (14,774     (74 %) 
  

 

 

    

 

 

    

 

 

   

 

 

 

Selling and marketing expenses totaled $1.7 million and $14.8 million for the three months ended June 30, 2012 and 2011, respectively. Of this, share-based compensation expense totaled $19,000 and $0.4 million for the three months ended June 30, 2012 and 2011, respectively. The decrease in our selling and marketing expenses of $13.2 million in comparison to the prior year was primarily due to the reduction in the scope of our commercial operations and marketing activities which we implemented during the fourth quarter of 2011.

General and administrative expenses totaled $3.6 million and $5.2 million for the three months ended June 30, 2012 and 2011, respectively. Of this, share-based compensation expense totaled $0.7 million and $0.8 million for the three months ended June 30, 2012 and 2011, respectively. The decrease in our general and administrative expenses of $1.6 million in comparison to the prior year was primarily due to the reduction in our headcount and other cost savings initiatives implemented by us during the fourth quarter of 2011.

 

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Research and Development Expense. Research and development expenses are summarized in the following table (in thousands, except percentages).

 

     Three Months Ended
June  30,
     Change  
     2012      2011      Dollar     Percent  

Personnel and other costs

   $ —         $ 309       $ (309     (100 )% 

Share-based compensation expense

     —           148         (148     (100 )% 
  

 

 

    

 

 

    

 

 

   

 

 

 

Total research and development expense

   $ —         $ 457       $ (457     (100 )% 
  

 

 

    

 

 

    

 

 

   

 

 

 

Our most significant research and development expenses have typically consisted of salaries, benefits and share-based compensation expense related to our research and development personnel. In connection with our other cost reduction initiatives implemented during the fourth quarter of 2011, we discontinued all of our ongoing research and development activities. Previously, research and development costs were incurred in connection with ongoing process validation associated with Silenor.

Comparisons of the Six Months Ended June 30, 2012 and 2011

Product Sales. Net product sales are summarized in the following table (in thousands).

 

     Six Months Ended
June 30,
    Change  
     2012     2011     Dollar     Percent  

Gross product sales

   $ 9,272      $ 11,112      $ (1,840     (17 %) 

Sales discounts and allowances

        

Prompt pay discount

     (189     (219     30        (14 %) 

Patient discount programs

     (519     (592     73        (12 %) 

Distribution service fees

     (623     (738     115        (16 %) 

Rebates and chargebacks

     (1,925     (649     (1,276     197

Product returns and other discounts

     (345     (350     5        (1 %) 
  

 

 

   

 

 

   

 

 

   

 

 

 

Total discounts and allowances

     (3,601     (2,548     (1,053     41
  

 

 

   

 

 

   

 

 

   

 

 

 

Total net product sales

   $ 5,671      $ 8,564      $ (2,893     (34 %) 
  

 

 

   

 

 

   

 

 

   

 

 

 

We recognized net product sales of $5.7 million and $8.6 million for the six months ended June 30, 2012 and 2011, respectively. In the second quarter of 2011, we began recognizing revenue for sales of Silenor at the time of delivery of the product to our wholesale pharmaceutical distributors and our other customers resulting in a one-time increase in net product sales of $3.2 million from the recognition of previously deferred product sales revenue.

Sales discounts and allowances totaled $3.6 million for the six months ended June 30, 2012, compared to $2.5 million for the same period in 2011. As a percentage of gross sales, the discounts and allowances were 38.8% and 22.9% for the six months ended June 30, 2012 and 2011, respectively. The increase in sales discounts as a percentage of gross product sales is primarily due to the expansion of our participation in rebate programs with managed care organizations.

License Fee Revenue. License fee revenue represents revenues associated with our agreements with CJ. There were no similar revenues in the comparable prior year period.

 

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Cost of Product Sales. Cost of sales is summarized in the following table (in thousands).

 

                                                               
     Six Months Ended
June  30,
     Change  
     2012      2011      Dollar     Percent  

Cost of product sales

   $ 539       $ 1,024       $ (485     (47 %) 
  

 

 

    

 

 

    

 

 

   

 

 

 

We recognized cost of product sales of $0.5 million and $1.0 million for the six months ended June 30, 2012 and 2011, respectively, relating to product sales with respect to which revenue was recognized. The decrease in cost of product sales expense was due to the decline in product sales as well as a reduction in personnel and related costs resulting from cost reduction initiatives we implemented in the fourth quarter of 2011. Gross profit was $5.1 million and $7.5 million for the six months ended June 30, 2012 and 2011, respectively. Expressed as a percentage of net product sales, gross margin was 90.5% and 88.0% for the six months ended June 30, 2012 and 2011, respectively.

Selling, General and Administrative Expenses. Selling, general and administrative expenses are summarized in the following table (in thousands, except percentages).

 

                                                               
     Six Months Ended
June 30,
     Change  
     2012      2011      Dollar     Percent  

Sales and marketing

   $ 3,471       $ 28,358       $ (24,887     (88 %) 

General and administrative

     6,428         10,308         (3,880     (38 %) 
  

 

 

    

 

 

    

 

 

   

 

 

 

Total selling, general and administrative expense

   $ 9,899       $ 38,666       $ (28,767     (74 %) 
  

 

 

    

 

 

    

 

 

   

 

 

 

Selling and marketing expenses totaled $3.5 million and $28.4 million for the six months ended June 30, 2012 and 2011, respectively. Of this, share-based compensation expense totaled $48,000 and $0.7 million for the six months ended June 30, 2012 and 2011, respectively. The decrease in our selling and marketing expenses of $24.9 million in comparison to the prior year was primarily due to the reduction in the scope of our commercial operations and marketing activities which we implemented during the fourth quarter of 2011. During the first quarter of 2012, we also negotiated reductions in amounts included in accounts payable at December 31, 2011 resulting in a $0.3 million reduction of selling and marketing expenses for the first quarter of 2012.

General and administrative expenses totaled $6.4 million and $10.3 million for the six months ended June 30, 2012 and 2011, respectively. Of this, share-based compensation expense totaled $1.3 million and $1.6 million for the six months ended June 30, 2012 and 2011, respectively. The decrease in our general and administrative expenses of $3.9 million in comparison to the prior year was primarily due to the reduction in our headcount and other cost savings initiatives implemented by us during the fourth quarter of 2011.

Research and Development Expense. Research and development expenses are summarized in the following table (in thousands, except percentages).

 

                                                               
     Six Months Ended
June  30,
     Change  
     2012      2011      Dollar     Percent  

Personnel and other costs

   $ —         $ 582       $ (582     (100 )% 

Share-based compensation expense

     —           294         (294     (100 )% 
  

 

 

    

 

 

    

 

 

   

 

 

 

Total research and development expense

   $ —         $ 876       $ (876     (100 )% 
  

 

 

    

 

 

    

 

 

   

 

 

 

In connection with our other cost reduction initiatives implemented during the fourth quarter of 2011, we discontinued all of our ongoing research and development activities. Previously, research and development costs were incurred in connection with ongoing process validation associated with Silenor.

 

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Liquidity and Capital Resources

As of June 30, 2012, we had $7.1 million in cash and cash equivalents which consisted of cash on deposit at financial institutions, including funds invested in money market accounts. On July 24, 2012, we sold to institutional investors an aggregate of 9,422,496 shares of our common stock and warrants to purchase up to an additional 4,711,248 shares of our common stock at a combined purchase price of $0.32 per share and per warrant. The warrants have an exercise price of $0.46 per share, will be exercisable beginning six months and one day from the date of issuance and will expire on the fifth anniversary of the date they first become exercisable. The total gross proceeds from the offering were approximately $3.0 million, before deducting anticipated selling commissions and expenses of approximately $300,000. We will need to obtain additional funds to finance our operations. Actual financial results for the period of time through which our financial resources will be adequate to support our operations could vary based upon many factors, including but not limited to Silenor sales performance, the actual cost of commercial activities and any potential litigation expenses we may incur.

Since inception, our operations have been financed primarily through the sale of equity securities and the proceeds from the exercise of warrants and stock options. We have incurred losses from operations and negative cash flows since our inception, and we expect to continue to incur losses and have negative cash flows from operations in the foreseeable future as we continue our commercial activities for Silenor, commercialize any other products to which we obtain rights and potentially pursue the development of other product candidates. Based on our recurring losses, negative cash flows from operations and working capital levels, we will need to raise substantial additional funds to finance our operations. If we are unable to maintain sufficient financial resources, including by raising additional funds when needed, our business, financial condition and results of operations will be materially and adversely affected. The report of our independent registered public accounting firm on our financial statements for the year ended December 31, 2011 contained an explanatory paragraph stating that our recurring losses raise substantial doubt about our ability to continue as a going concern.

We are responsible for the costs relating to the sales and marketing of Silenor in the United States, which include the costs associated with our field-based sales force. The efforts of our sales force are complemented by on-line and other non-personal promotional initiatives that target both physicians and patients. We are also focused on ensuring broad patient access to Silenor by negotiating agreements with leading commercial managed care organizations and with government payors. Our commercial activities relating to Silenor are likely to result in the need for substantial additional funds. Our future capital uses and requirements depend on numerous forward-looking factors. These factors include but are not limited to the following:

 

   

our success in generating cash flows from sales of Silenor;

 

   

the costs of establishing or contracting for commercial programs and resources, and the scope of the commercial programs and resources we pursue;

 

   

the terms and timing of any future collaborative, licensing and other arrangements that we may establish;

 

   

the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights;

 

   

the extent to which we acquire or in-license new products, technologies or businesses;

 

   

the rate of progress and cost of any future non-clinical studies, any future clinical trials and other development activities;

 

   

the scope, prioritization and number of development programs we pursue; and

 

   

the effect of competing technological and market developments.

In August 2011, we entered into an at-the-market equity sales agreement, or sales agreement, with Citadel Securities LLC, or Citadel. However, there can be no assurance that we can or will consummate sales based on prevailing market conditions or in the quantities or at the prices that we deem appropriate. We or Citadel may terminate the sales agreement at any time. Sales of shares pursuant to the sales agreement will have a dilutive effective on the holdings of our existing stockholders, and may result in downward pressure on the price of our common stock. We have two effective shelf registration statements on Form S-3 filed with the SEC under which we may offer from time to time any combination of debt securities, common and preferred stock and warrants. However, the rules and regulations of the SEC or other regulatory agencies may restrict our ability to conduct certain types of financing activities, or may affect the timing of and the amounts we can raise by undertaking such activities. For example, under current SEC regulations, because the aggregate market value of our common stock held by non-affiliates, or our public float, is less than $75 million, the amount

 

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that we can raise through primary public offerings of securities in any twelve-month period using one or more registration statements on Form S-3 is limited to an aggregate of one-third of our public float. Our July 2012 offering of stock and warrants was a primary offering using one of our effective shelf registration statements on Form S-3 and was subject to this limitation. Additional equity financing will be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants. There can be no assurance that we would be successful in selling securities under our shelf registration statements based on prevailing market conditions or in the quantities or at the prices that we deem appropriate.

We will not be able to make sales of our common stock pursuant to the sales agreement unless certain conditions are met, which include the accuracy of representations and warranties made to Citadel under the sales agreement; compliance with laws; and the continued listing of our stock on the Nasdaq Capital Market.

In December 2011, we received a letter from the Listing Qualifications Department of the Nasdaq Stock Market, or Nasdaq, informing us that because the closing bid price of our common stock listed on Nasdaq was below $1.00 for 30 consecutive trading days, we did not comply with the minimum closing bid price requirement for continued listing on the Nasdaq Capital Market under Nasdaq Marketplace Rule 5550(a)(2). In June 2012, we received a second letter from the Listing Qualifications Department of the Nasdaq Stock Market notifying us that we had been granted an additional 180-day compliance period, or until December 10, 2012, to regain compliance with the $1.00 per share minimum closing bid price requirement under Nasdaq Marketplace Rule 5550(a)(2). Nasdaq’s determination was based on us meeting the continued listing requirement for market value of publicly held shares and all other applicable requirements for initial listing on the Nasdaq Capital Market, with the exception of the bid price requirement, and our written notice of our intention to cure the deficiency during the second compliance period by effecting a reverse stock split, if necessary.

We may regain listing compliance by maintaining a closing bid price of our common stock of at least $1.00 per share for a minimum of 10 consecutive business days at any time before December 10, 2012. If, pursuant to Nasdaq Marketplace Rule 5810(c)(3)(A), we meet the outlined requirements, Nasdaq will provide written confirmation to us that we comply with Nasdaq Marketplace Rule 5550(a)(2), unless Nasdaq exercises its discretion to extend this 10-day period pursuant to its Listing Rule 5810(c)(3)(F). If compliance is not demonstrated within the applicable compliance period, Nasdaq will notify us that our securities will be delisted from the Nasdaq Capital Market. However, we may appeal Nasdaq’s determination to delist our securities to a Hearings Panel.

In December 2011 we hired Stifel Nicolaus Weisel as a strategic advisor to assist us in identifying and evaluating strategies to maximize stockholder value by leveraging our rights in Silenor. The exploration of strategic alternatives may not result in any agreement or transaction and, if completed, any agreement or transaction may not be successful or on attractive terms. The inability to enter into a strategic transaction, or a strategic transaction that is not successful or on attractive terms, could accelerate our needs for cash and make securing funding on reasonable terms more difficult. In addition, if we raise additional funds through collaborations or other strategic transactions, it may be necessary to relinquish potentially valuable rights to our potential products or proprietary technologies, or grant licenses on terms that are not favorable to us.

We intend to obtain any additional funding we require through public or private equity or debt financings, strategic relationships, assigning receivables or royalty rights, or other arrangements and we cannot assure such funding will be available on reasonable terms, or at all. Additional equity financing will be dilutive to stockholders, and debt financing, if available, may involve restrictive covenants.

If our efforts in raising additional funds when needed are unsuccessful, we may be required to delay, scale-back or eliminate plans or programs relating to our business, relinquish some or all rights to Silenor or renegotiate less favorable terms with respect to such rights than we would otherwise choose or cease operating as a going concern. In addition, if we do not meet our payment obligations to third parties as they come due, we may be subject to litigation claims. Even if we were successful in defending against these claims, litigation could result in substantial costs and be a distraction to management, and may result in unfavorable results that could further adversely impact our financial condition.

If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our financial statements, and it is likely that investors will lose all or a part of their investments. Our financial statements do not include any adjustments that might result from the outcome of this uncertainty.

 

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Cash Flows

Net cash used in operating activities totaled $3.6 million for the six months ended June 30, 2012 compared to $28.4 million in the comparable prior year period. The decrease in net cash used in operating activities was primarily due to the decrease in our net loss in 2012 as compared to 2011 as a result of the reduction in our headcount and other cost savings initiatives implemented by us during the fourth quarter of 2011. There was no cash flow provided or consumed by investing or financing activities during the six months ended June 30, 2012. Investing activities, principally the net maturities of our marketable securities portfolio, provided $30.8 million during the six months ended June 30, 2011. Financing activities, principally the net proceeds from the issuance of common stock, generated proceeds of $5.0 million during the same timeframe.

Litigation

We received notices from Actavis LLC and Actavis Inc., or collectively, Actavis, Mylan, Par and Zydus that each had filed with the FDA an Abbreviated New Product Application, or ANDA, for a generic version of Silenor 3 mg and 6 mg tablets. The notices included paragraph IV certifications with respect to eight of the nine patents listed in the Orange Book for Silenor.

We, together with ProCom, filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that each of Actavis, Mylan, Par and Zydus infringed U.S. Patent No. 6,211,229, or the ‘229 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties have infringed U.S. Patent No. 7,915,307, or the ’307 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In July 2012 we and ProCom One entered into separate settlement agreements with each of Mylan, Par and Zydus to resolve the pending patent litigation between the parties. Mylan has the exclusive right under the ‘229 patent and the ‘307 patent to sell an authorized generic version of Silenor under our NDA in the United States for a limited period beginning January 1, 2020, or earlier under certain circumstances. After Mylan’s license to sell such authorized generic product expires, Mylan will have a non-exclusive license to sell a generic version of Silenor under Mylan’s ANDA in the United States. Par and Zydus each have a non-exclusive license under the ‘229 patent and the ‘307 patent to sell a generic version of Silenor in the United States 180 days after the earlier of the date that a third party’s generic version of Silenor is first sold in the United States under a license from us or a final court decision that the ’229 patent and the ’307 patent are not infringed, invalid or unenforceable, or earlier under certain circumstances. In July 2012, the U.S. District Court for the District of Delaware entered an order dismissing the litigation with respect to each of Mylan, Par and Zydus.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action. We intend to vigorously enforce our intellectual property rights relating to Silenor, but we cannot predict the outcome of ongoing or any future actions.

The continued prosecution of the lawsuit will increase our cash expenditures. Any adverse outcome in this litigation could result in one or more generic versions of Silenor being launched before the expiration of the listed patents, which could adversely affect our ability to successfully execute our business strategy to generate sales of Silenor and would negatively impact our financial condition and results of operations, including causing a significant decrease in our revenues and cash flows, such events could also significantly impact our ability to continue as a going concern.

 

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Contractual Obligations

We have entered into a license agreement with ProCom to acquire the rights to develop and commercialize Silenor under which we are obligated to pay royalties on sales of Silenor until the expiration of the applicable patents. We have also entered into other agreements, including the lease arrangement for our corporate headquarters and purchase orders with suppliers, and we have contracted with various third parties, consultants and other vendors to assist in clinical trial work, pre-clinical studies, data analysis, and activities to support the marketing of Silenor. The contracts are generally terminable at any time, but obligate us to reimburse the providers for any time or costs incurred through the date of termination. We also have employment agreements with each of our current executive officers that provide for severance payments and accelerated vesting for certain share-based awards if their employment with us is terminated under specified circumstances. A summary of our minimum contractual obligations related to our major outstanding contractual commitments is included in our Annual Report on Form 10-K for the year ended December 31, 2011.

Off-Balance Sheet Arrangements

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

Recent Accounting Pronouncements

In June 2011, the Financial Accounting Standards Board issued an Accounting Standards Update which requires entities to present reclassification adjustments included in other comprehensive income on the face of the financial statements and allows entities to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate consecutive statements. It also eliminated the option for entities to present components of other comprehensive income as part of the statement of changes to stockholders equity. We adopted this guidance on January 1, 2012.

Caution on Forward-Looking Statements 

Any statements in this report about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements. You can identify these forward-looking statements by the use of words or phrases such as “believe,” “may,” “could,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “seek,” “plan,” “expect,” “should” or “would.” Among the factors that could cause actual results to differ materially from those indicated in the forward-looking statements are risks and uncertainties inherent in our business including, without limitation: our ability to successfully commercialize Silenor; the market potential for insomnia treatments, and our ability

 

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to compete within that market; risks related to our settlement agreements with Mylan, Par and Zydus, including any legal or regulatory challenges to the settlement agreements by the U.S. Department of Justice and/or the U.S. Federal Trade Commission, and the outcome of any such challenges; the potential to enter into an agreement with any third party relating to over-the-counter, or OTC, rights for Silenor; our ability, together with any partner, to receive FDA approval for an OTC version of Silenor; our ability, together with our strategic advisor Stifel Nicolaus Weisel, to successfully enter into one or more transactions to enhance stockholder value; our ability to successfully hire, manage and utilize a sales force to market Silenor; our ability to successfully enforce our intellectual property rights and defend our patents, including any developments relating to the submission of ANDAs for generic versions of Silenor 3 mg and 6 mg tablets and related patent litigation; the scope, validity and duration of patent protection and other intellectual property rights for Silenor; whether the approved label for Silenor is sufficiently consistent with such patent protection to provide exclusivity for Silenor; the possible introduction of generic competition of Silenor; our ability to ensure adequate and continued supply of Silenor to successfully meet anticipated market demand; our ability to raise sufficient capital to fund our operations, including patent infringement litigation, and the impact of any financing activity on the level of our stock price; the impact of any inability to raise sufficient capital to fund ongoing operations, including any patent infringement litigation; our ability to fully utilize the sales agreement with Citadel as a source of future financings, whether due to market conditions, legal or regulatory constraints or our ability to satisfy various conditions required to sell shares under the agreement; Citadel’s performance of its obligations under the agreement or otherwise; the impact on the level of our stock price, which may decline, in connection with the implementation of the sales agreement or the occurrence of any sales under the agreement; changes in healthcare regulation and reimbursement policies; our ability to operate our business without infringing the intellectual property rights of others; our reliance on our licensees, Paladin and CJ, for critical aspects of the commercial sales process for Silenor outside of the United States; the performance of Paladin and CJ and their adherence to the terms of their contracts with us; inadequate therapeutic efficacy or unexpected adverse side effects relating to Silenor that could result in recalls or product liability claims; other difficulties or delays in development, testing, manufacturing and marketing of Silenor; the timing and results of post-approval regulatory requirements for Silenor, and the FDA’s agreement with our interpretation of such results; and other risks detailed in this report under Part II – Item 1A – Risk Factors below and previously disclosed in our Annual Report on Form 10-K.

Although we believe that the expectations reflected in our forward-looking statements are reasonable, we cannot guarantee future results, events, levels of activity, performance or achievement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law. This caution is made under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

While our cash and cash equivalents at June 30, 2012 consisted primarily of cash, the primary objective of our investment activities, if any, is to preserve principal while maximizing the income we receive from our investments without significantly increasing risk. Historically, our primary exposure to market risk has been interest rate sensitivity. This means that a change in prevailing interest rates may cause the value of the investment to fluctuate. For example, if we purchase a security that was issued with a fixed interest rate and the prevailing interest rate later rises, the value of our investment will probably decline. Currently, our holdings are in cash, and therefore this interest rate risk is minimal. To minimize our interest rate risk going forward, we intend to continue to maintain our holdings in cash. If our cash balance increases significantly relative to our cash needs, we may also invest in cash equivalents and marketable securities such as money market funds and United States government debt securities, all with various maturities. In general, money market funds are not subject to market risk because the interest paid on such funds fluctuates with the prevailing interest rate. We also generally time the maturities of our investments to correspond with our expected cash needs, allowing us to avoid realizing any potential losses from having to sell securities prior to their maturities.

When our cash is invested, it is invested in accordance with a policy approved by our board of directors which specifies the categories, allocations and ratings of securities we may consider for investment. We do not believe our cash and cash equivalents will have significant risk of default or illiquidity. While we intend that any future portfolio of cash, cash equivalents and short-term investments will be well diversified, we cannot provide absolute assurance that our investments, if any, will not be subject to future adverse changes in market value.

 

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Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports made under the Securities Exchange Act of 1934, as amended, or the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of June 30, 2012.

Changes in Internal Control Over Financial Reporting

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

PART II — OTHER INFORMATION

 

Item 1. Legal Proceedings

We received notices from Actavis, Mylan, Par, and Zydus that each had filed with the FDA an ANDA for a generic version of Silenor 3 mg and 6 mg tablets. The notices included “paragraph IV certifications” with respect to eight of the nine patents listed in the Orange Book for Silenor.

We, together with ProCom, filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that each of Actavis, Mylan, Par and Zydus infringed the ’229 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties infringed the ’307 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In July 2012 we and ProCom One entered into separate settlement agreements with each of Mylan, Par and Zydus to resolve the pending patent litigation between the parties. Mylan has the exclusive right under the ‘229 patent and the ‘307 patent to sell an authorized generic version of Silenor under our NDA in the United States for a limited period beginning January 1, 2020, or earlier under certain circumstances. After Mylan’s license to sell such authorized generic product expires, Mylan will have a non-exclusive license to sell a generic version of Silenor under Mylan’s ANDA in the United States. Par and Zydus each have a non-exclusive license under the ‘229 patent and the ‘307 patent to sell a generic version of Silenor in the United States 180 days after the earlier of the date that a third party’s generic version of Silenor is first sold in the United States under a license from us or a final court decision that the ’229 patent and the ’307 patent are not infringed, invalid or unenforceable, or earlier under certain circumstances. In July 2012, the U.S. District Court for the District of Delaware entered an order dismissing the litigation with respect to each of Mylan, Par and Zydus.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action. We do not know when there will be a court decision on the merits in any of these cases. We intend to vigorously enforce our intellectual property rights relating to Silenor, but we cannot predict the outcome of ongoing or any future actions.

 

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Item 1A. Risk Factors

Investing in our common stock involves a high degree of risk. Our Annual Report on Form 10-K for the year ended December 31, 2011 includes a detailed discussion of our risk factors under the heading “Part I, Item 1A—Risk Factors.” Set forth below are certain changes from the risk factors previously disclosed in our Annual Report on Form 10-K. You should carefully consider the risk factors discussed in our Annual Report on Form 10-K and in this report, as well as the other information in this report, before deciding whether to invest in shares of our common stock. The occurrence of any of the risks discussed in the Annual Report on Form 10-K or this report could harm our business, financial condition, results of operations or growth prospects. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment. Except with respect to our trademarks, the trademarks, trade names and service marks appearing in this report are the property of their respective owners.

Risks Related to Our Business

We will require substantial additional funding and may be unable to raise capital when needed, which could force us to delay, reduce or eliminate planned activities or result in our inability to continue as a going concern.

We began generating revenues from the commercialization of Silenor late in the third quarter of 2010, and our operations to date have generated substantial needs for cash. We expect our negative cash flows from operations to continue until we are able to generate significant cash flows from sales of Silenor. Based on our recurring losses, negative cash flows from operations and working capital levels, we will need to raise substantial additional funds to finance our operations. If we are unable to maintain sufficient financial resources, including by raising additional funds when needed, our business, financial condition and results of operations will be materially and adversely affected. The report of our independent registered public accounting firm on our financial statements for the year ended December 31, 2011 contains an explanatory paragraph stating that our recurring losses raise substantial doubt about our ability to continue as a going concern.

We are responsible for the costs relating to the sales and marketing of Silenor in the United States. As a result, commercial activities relating to Silenor are likely to result in the need for substantial additional funds. Our future capital requirements will depend on, and could increase significantly as a result of, many factors, including:

 

   

our success in generating cash flows from sales of Silenor;

 

   

the costs of establishing or contracting for commercial programs and resources, and the scope of the commercial programs and resources we pursue;

 

   

the terms and timing of any future collaborative, licensing and other arrangements that we may establish;

 

   

the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights;

 

   

the extent to which we acquire or in-license new products, technologies or businesses;

 

   

the rate of progress and cost of any future non-clinical studies, any future clinical trials and other development activities;

 

   

the scope, prioritization and number of development programs we pursue; and

 

   

the effect of competing technological and market developments.

On July 24, 2012, we sold to institutional investors an aggregate of 9,422,496 shares of our common stock and warrants to purchase up to an additional 4,711,248 shares of our common stock at a combined purchase price of $0.32 per share and per warrant. The warrants have an exercise price of $0.46 per share, will be exercisable beginning six months and one day from the date of issuance and will expire on the fifth anniversary of the date they first become exercisable. The total gross proceeds from the offering were approximately $3.0 million, before deducting anticipated selling commissions and expenses of approximately $300,000. In August 2011, we entered into an at-the-market equity sales agreement with Citadel Securities LLC, or Citadel. However, there can be no assurance that we can or will consummate sales under the agreement based on prevailing market conditions or in the quantities or at the prices that we deem appropriate. Citadel or we are permitted to terminate the sales agreement at any time.

We have two effective shelf registration statements on Form S-3 filed with the SEC under which we may offer from time to time any combination of debt securities, common and preferred stock and warrants. However, the rules and regulations of the SEC or other regulatory agencies may restrict our ability to conduct certain types of financing activities,

 

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or may affect the timing of and the amounts we can raise by undertaking such activities. For example, under current SEC regulations, because the aggregate market value of our public float, is less than $75 million, the amount that we can raise through primary public offerings of securities in any twelve-month period using one or more registration statements on Form S-3 is limited to an aggregate of one-third of our public float. Our July 2012 offering of stock and warrants was a primary offering using one of our effective shelf registration statements on Form S-3 and was subject to this limitation.

At June 30, 2012 we had cash and cash equivalents totaling $7.1 million. We will need to obtain additional funds to finance our operations. Actual financial results for the period of time through which our financial resources will be adequate to support our operations could vary based upon many factors, including but not limited to Silenor sales performance, the actual cost of commercial activities and any litigation expenses we may incur.

In December 2011 we hired Stifel Nicolaus Weisel as a strategic advisor to assist us in identifying and evaluating strategies to maximize stockholder value by leveraging our rights in Silenor. The exploration of strategic alternatives may not result in any agreement or transaction and, if completed, any agreement or transaction may not be successful or on attractive terms. The inability to enter into a strategic transaction, or a strategic transaction that is not successful or on attractive terms, could accelerate our needs for cash and make securing funding on reasonable terms more difficult. In addition, if we raise additional funds through collaborations or other strategic transactions, it may be necessary to relinquish potentially valuable rights to our products, potential products or proprietary technologies, or grant licenses on terms that are not favorable to us.

We intend to obtain any additional funding we require through public or private equity or debt financings, strategic relationships, assigning receivables or royalty rights, or other arrangements and cannot assure that such funding will be available on reasonable terms, or at all. If we are unsuccessful in raising additional required funds, we may be required to delay, scale-back or eliminate plans or programs relating to our business, relinquish some or all rights to Silenor, or renegotiate less favorable terms with respect to such rights than we would otherwise choose or cease operating as a going concern. In addition, if we do not meet our payment obligations to third parties as they come due, we may be subject to litigation claims. Even if we are successful in defending against these claims, litigation could result in substantial costs and distract management, and may result in unfavorable outcomes that could further adversely impact our financial condition.

If we raise additional funds by issuing equity securities, substantial dilution to existing stockholders would result. If we raise additional funds by incurring debt financing, the terms of the debt may involve significant cash payment obligations as well as covenants and specific financial ratios that may restrict our ability to operate our business. If we are unable to continue as a going concern, we may have to liquidate our assets and may receive less than the value at which those assets are carried on our financial statements, and it is likely that investors will lose all or a part of their investments.

We will need to retain qualified sales and marketing personnel and successfully manage our sales and marketing programs and resources in order to successfully generate sales of Silenor.

Prior to December 31, 2011, revenues we received from sales of Silenor largely depended upon the efforts of sales representatives employed by P&G, and Publicis. Because we did not believe that the growth of Silenor revenues throughout 2011 was sufficient to support sales and marketing expenses at then-current levels, we terminated our agreements with Publicis and P&G in December 2011 in an effort to conserve cash, and effective January 3, 2012, we hired a reduced sales force of 25 field-based sales representatives from Publicis as our employees to promote Silenor. In June 2012, we began reallocating our commercial resources relating to Silenor, including by eliminating 10 vacant and/or unprofitable field sales territories, and focusing greater resources on other activities to better support our in-person promotional efforts. We are now solely relying on our limited number of sales representatives to market and sell Silenor, and our sales in the short term may suffer as we make this transition and may continue to suffer in the long term if such transition is not successful. In addition, our strategy of focusing on an overall smaller, but more concentrated, geography may not be successful.

The efforts of our sales force are complemented by on-line and other non-personal promotional initiatives that target both physicians and patients. We are also focused on ensuring broad patient access to Silenor by negotiating agreements with leading commercial managed care organizations and with government payors. Although our goal is to achieve Silenor sales through the efficient execution of our sales and marketing plans and programs, we may not be able to effectively generate prescriptions and achieve broad market acceptance for Silenor on a timely basis, or at all.

 

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Restrictions on or challenges to our patent rights relating to our products and limitations on or challenges to our other intellectual property rights may limit our ability to prevent third parties from competing against us.

Our success will depend on our ability to obtain and maintain patent protection for Silenor and any other product candidate we develop or commercialize, preserve our trade secrets, prevent third parties from infringing upon our proprietary rights and operate without infringing upon the proprietary rights of others. The patent rights that we have in-licensed relating to Silenor are limited in ways that may affect our ability to exclude third parties from competing against us. In particular, we do not hold composition of matter patents covering the active pharmaceutical ingredient, or API, of Silenor. Composition of matter patents on APIs are a particularly effective form of intellectual property protection for pharmaceutical products, as they apply without regard to any method of use or other type of limitation. As a result, competitors who obtain the requisite regulatory approval can offer products with the same APIs as our products so long as the competitors do not infringe any method of use or formulation patents that we may hold.

The principal patent protection that covers, or that we expect will cover, Silenor consists of method of use patents. This type of patent protects the product only when used or sold for the specified method. However, this type of patent does not limit a competitor from making and marketing a product that is identical or similar to our product for an indication that is outside of the patented method. Moreover, physicians may prescribe such a competitive or similar identical product for off-label indications that are covered by the applicable patents. Some physicians are prescribing generic 10 mg doxepin capsules and generic oral solution doxepin for insomnia on such an off-label basis. In addition, some managed health care plans are requiring the substitution of these generic doxepin products for Silenor, and some pharmacies are suggesting such substitution. Although such off-label prescriptions may induce or contribute to the infringement of method of use patents, the practice is common and such infringement is difficult to prevent or prosecute.

Because products with active ingredients identical to ours have been on the market for many years, there can be no assurance that these other products were never used off-label or studied in such a manner that such prior usage would not affect the validity of our method of use patents. Due to some prior art that we identified, we initiated a reexamination of one of the patents we have in-licensed covering Silenor, (specifically, U.S. Patent No. 5,502,047, “Treatment for Insomnia”) which claims the treatment of chronic insomnia using doxepin in a daily dosage of 0.5 mg to 20 mg and expires in March 2013. The reexamination proceedings terminated and the U.S. Patent and Trademark Office, or USPTO, issued a reexamination certificate narrowing certain claims, so that the broadest dosage ranges claimed by us are 0.5 mg to 20 mg for otherwise healthy patients with chronic insomnia and for patients with chronic insomnia resulting from depression, and 0.5 mg to 4 mg for all other chronic insomnia patients. We also requested reissue of this same patent to consider some additional prior art and to add intermediate dosage ranges below 10 mg. In two office actions relating to this reissue request, the USPTO raised no prior art objections to 32 of the 34 claims we were seeking and raised a prior art objection to the other two, as well as some technical objections. Each of the claims objected to by the USPTO related to dosages above 10 mg. After further review of the prior art submitted, the USPTO withdrew all of its prior art objections. We then determined that the proposed addition of the intermediate dosage ranges and the resolution of the technical objections no longer warranted continuation of the reissue proceeding. As a result, we elected not to continue that proceeding.

We also have multiple internally developed pending patent applications. No assurance can be given that the USPTO or other applicable regulatory authorities will allow pending applications to result in issued patents with the claims we are seeking, or at all.

Patent applications in the United States are confidential for a period of time until they are published, and publication of discoveries in scientific or patent literature typically lags actual discoveries by several months. As a result, we cannot be certain that the inventors of issued patents to which we hold rights were the first to conceive of inventions covered by pending patent applications or that the inventors were the first to file patent applications for such inventions.

In addition, third parties may challenge issued patents to which we hold rights and any additional patents that we may obtain, which could result in the invalidation or unenforceability of some or all of the relevant patent claims, or could attempt to develop products utilizing the same APIs as our products that do not infringe the claims of our in-licensed patents or patents that we may obtain.

 

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When a third party files an ANDA for a product containing doxepin for the treatment of insomnia at any time during which we have patents listed for Silenor in the FDA’s Orange Book publication, the applicant will be required to certify to the FDA concerning the listed patents. Specifically, the applicant must certify that: (1) the required patent information relating to the listed patent has not been filed in the NDA for the approved product; (2) the listed patent has expired; (3) the listed patent has not expired, but will expire on a particular date and approval is sought after patent expiration; or (4) the listed patent is invalid or will not be infringed by the manufacture, use or sale of the new product. A certification that the new product will not infringe the Orange Book-listed patents for Silenor or that such patents are invalid is called a paragraph IV certification.

We received notices from each of Actavis, Mylan, Par, and Zydus, that each has filed with the FDA an ANDA for a generic version of Silenor 3 mg and 6 mg tablets. The notices included paragraph IV certifications with respect to eight of the nine patents listed in the Orange Book for Silenor.

We, together with ProCom, filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that each of Actavis, Mylan, Par and Zydus infringed the ’229 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties infringed the ’307 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In July 2012 we and our licensor for the ‘229 patent, ProCom, entered into separate settlement agreements with each of Mylan, Par and Zydus to resolve the pending patent litigation between the parties. Mylan has the exclusive right under the ‘229 patent and the ‘307 patent to sell an authorized generic version of Silenor under our NDA in the United States for a limited period beginning January 1, 2020, or earlier under certain circumstances. After Mylan’s license to sell such authorized generic product expires, Mylan will have a non-exclusive license to sell a generic version of Silenor under Mylan’s ANDA in the United States. Par and Zydus each have a non-exclusive license under the ‘229 patent and the ‘307 patent to sell a generic version of Silenor in the United States 180 days after the earlier of the date that a third party’s generic version of Silenor is first sold in the United States under a license from us or a final court decision that the ’229 patent and the ’307 patent are not infringed, invalid or unenforceable, or earlier under certain circumstances. In July 2012, the U.S. District Court for the District of Delaware entered an order dismissing the litigation with respect to each of Mylan, Par and Zydus.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action.

We intend to vigorously enforce our intellectual property rights relating to Silenor, but we cannot predict the outcome of ongoing or any future actions. Any adverse outcome in ongoing or any future actions could result in one or more generic versions of Silenor being launched before the expiration of the listed patents, which could adversely affect our ability to successfully execute our business strategy and would negatively impact our financial condition and results of operations, including causing a significant decrease in our revenues and cash flows. Such events could also significantly impact our ability to continue as a going concern.

Certain pharmaceutical companies’ patent settlement agreements with generic pharmaceutical companies have been challenged by the U.S. Federal Trade Commission alleging a violation of Section 5(a) of the Federal Trade Commission Act. Our settlement agreements with Mylan, Par and Zydus, or any other patent settlement agreement that we may enter into with any generic pharmaceutical company, may be subject to similar challenges, which will be both expensive and time consuming and may render such settlement agreements unenforceable. In addition, legislation has been proposed by Congress that, if passed, would subject patent settlement agreements to further restrictions.

 

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We also rely upon unpatented trade secrets and improvements, unpatented know-how and continuing technological innovation to develop and maintain our competitive position, which we seek to protect, in part, by confidentiality agreements with our collaborators, employees and consultants. We also have invention or patent assignment agreements with our employees and certain consultants. There can be no assurance that inventions relevant to us will not be developed by a person not bound by an invention assignment agreement with us. There can be no assurance that binding agreements will not be breached, that we would have adequate remedies for any breach, or that our trade secrets will not otherwise become known or be independently discovered by our competitors.

Litigation or other proceedings to enforce or defend intellectual property rights is often very complex in nature, expensive and time-consuming, may divert our management’s attention from our core business and may result in unfavorable results that could adversely impact our ability to prevent third parties from competing with us.

We are subject to uncertainty relating to healthcare reform measures, reimbursement policies and regulatory proposals which, if not favorable to Silenor or any other product that we commercialize, could hinder or prevent our commercial success.

Our ability to successfully commercialize Silenor and any other product to which we obtain rights will depend in part on the extent to which governmental authorities, private health insurers and other organizations establish appropriate coverage and reimbursement levels for the cost of our products and related treatments. Based on third party formulary data, we believe that 76% of patients in commercial health plans have coverage for Silenor.

The continuing efforts of the government, insurance companies, managed care organizations and other payors of healthcare services to contain or reduce costs of healthcare may adversely affect:

 

   

the ability to obtain a price we believe is fair for our products;

 

   

the ability to generate revenues and achieve or maintain profitability;

 

   

the future revenues and profitability of our potential customers, suppliers and collaborators; and

 

   

the availability of capital.

The U.S. Congress has enacted legislation to reform the healthcare system. A major goal of this healthcare reform law was to provide greater access to healthcare coverage for more Americans. Accordingly, the healthcare reform law required individual U.S. citizens and legal residents to maintain qualifying health coverage, imposed certain requirements on employers with respect to offering health coverage to employees, amended insurance regulations regarding when coverage can be provided and denied to individuals, and expanded existing government healthcare coverage programs to more individuals in more situations. Among other things, the healthcare reform law specifically:

 

   

established annual, non-deductible fees on any entity that manufactures or imports certain branded prescription drugs, beginning in 2011;

 

   

increased minimum Medicaid rebates owed by manufacturers under the Medicaid Drug Rebate Program, retroactive to January 1, 2010;

 

   

redefined a number of terms used to determine Medicaid drug rebate liability, including average manufacturer price and retail community pharmacy, effective October 2010;

 

   

extended manufacturers’ Medicaid rebate liability to covered drugs dispensed to individuals who are enrolled in Medicaid managed care organizations, effective March 2010;

 

   

expanded eligibility criteria for Medicaid programs by, among other things, allowing states to offer Medicaid coverage to additional individuals beginning April 2010 and by adding new mandatory eligibility categories for certain individuals with income at or below 133 percent of the Federal Poverty Level beginning 2014, thereby potentially increasing manufacturers’ Medicaid rebate liability;

 

   

established a new Patient-Centered Outcomes Research Institute to oversee, identify priorities in and conduct comparative clinical effectiveness research;

 

   

required manufacturers to participate in a coverage gap discount program, under which they must agree to offer 50 percent point-of-sale discounts off negotiated prices of applicable brand drugs to eligible beneficiaries during their coverage gap period, as a condition for the manufacturer’s outpatient drugs to be covered under Medicare Part D, beginning 2011; and

 

   

increased the number of entities eligible for discounts under the Public Health Service pharmaceutical pricing program, effective January 2010.

 

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While this legislation will, over time, increase the number of patients who have insurance coverage for our products, it also is likely to adversely affect our results of operations. Although this legislation was recently upheld by the U.S. Supreme Court, it is possible that it may be modified or repealed in the future. Some states are also considering legislation that would control the prices of drugs, and state Medicaid programs are increasingly requesting manufacturers to pay supplemental rebates and/or requiring prior authorization by the state program. It is likely that federal and state legislatures and health agencies will continue to focus on additional healthcare reform in the future.

As a result of these or other reform measures, we may determine to change our current manner of operation or change our contract arrangements, any of which could harm our ability to operate our business efficiently or on the scale we would like and our ability to raise capital. In addition, in certain foreign markets, the pricing of prescription drugs is subject to government control and reimbursement may in some cases be unavailable or insufficient.

Current healthcare reform measures and any future legislative proposals to reform healthcare or reduce government insurance programs may result in lower prices for Silenor and any other product that we commercialize or exclusion of Silenor or any such other product from coverage and reimbursement programs. Either of those could harm our ability to market our products and significantly reduce our revenues from the sale of our products.

Managed care organizations are increasingly challenging the prices charged for medical products and services and, in some cases, imposing restrictions on the coverage of particular drugs. Many managed care organizations negotiate the price of medical services and products and develop formularies which establish pricing and reimbursement levels. Exclusion of a product from a formulary can lead to its sharply reduced usage in the managed care organization’s patient population. The process for obtaining coverage can be lengthy and costly, and it can take several months before a particular payor initially reviews our product and makes a decision with respect to coverage. For example, third-party payors may require cost-benefit analysis data from us in order to demonstrate the cost-effectiveness of any product we might market and sell. For any individual third-party payor, we may not be able to provide data sufficient to gain reimbursement on a similar or preferred basis to competitive products, or at all.

In addition, many insurers and other healthcare payment organizations encourage the use of less expensive alternative generic brands and over the counter, or OTC, products through their prescription benefits coverage and reimbursement policies. The availability of generic prescription and OTC products for the treatment of insomnia has created, and will continue to create, a competitive reimbursement environment. Insurers and other healthcare payment organizations frequently make the generic or OTC alternatives more attractive to the patient by providing different amounts of reimbursement so that the net cost of the generic or OTC product to the patient is less than the net cost of a prescription branded product to the patient. Aggressive pricing policies by our generic or OTC product competitors and the prescription benefit policies of insurers could have a negative effect on our product revenues and profitability.

The competition among pharmaceutical companies to have their products approved for reimbursement also results in downward pricing pressure in the industry and in the markets where our products compete. In some cases, we may discount our products in order to obtain reimbursement coverage, and we may not be successful in any efforts we take to mitigate the effect of a decline in average selling prices for our products. Declines in our average selling prices would also reduce our gross margins.

In addition, once reimbursement at an agreed level is approved by a third-party payor, we may lose that reimbursement entirely. As reimbursement is often approved for a period of time, this risk is greater at the end of the time period, if any, for which the reimbursement was approved.

We may face additional challenges with regard to reimbursement which could affect our ability to successfully commercialize Silenor or any other product candidate that we commercialize, including:

 

   

the variability of reimbursement rates likely to be caused by the use of miscellaneous drug codes and procedure codes may discourage physicians from providing Silenor or any other product candidate that we commercialize to certain or all patients depending on their insurance coverage;

 

   

the initial use of “miscellaneous drug codes” for billing Silenor or any other product candidate that we commercialize until such time as specific drug codes are approved could result in slow and/or inaccurate reimbursement and thereby discourage product use;

 

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an increase in insurance plans that place more cost liability onto patients may limit patients’ willingness to pay for Silenor or any other product candidate that we commercialize and thereby discourage uptake; and

 

   

unforeseen changes in federal health care policy guidelines may negatively impact a physician practice’s willingness to provide novel treatments.

If our products are not included within an adequate number of formularies or adequate reimbursement levels are not provided, or if those policies increasingly favor generic or OTC products, our overall business and financial condition would be adversely affected.

Further, there have been a number of legislative and regulatory proposals concerning reimportation of pharmaceutical products and safety matters. For example, in an attempt to protect against counterfeit drugs, the federal government and numerous states have enacted pedigree legislation. In particular, California has enacted legislation that requires development of an electronic pedigree to track and trace each prescription drug at the saleable unit level through the distribution system. California’s electronic pedigree requirement is scheduled to take effect beginning in January 2015. Compliance with California and future federal or state electronic pedigree requirements will likely require an increase in our operational expenses and will likely be administratively burdensome.

We expect intense competition in the marketplace for Silenor and any other product to which we acquire rights, and new products may emerge that provide different and/or better therapeutic alternatives for the disorders that our products are intended to treat.

Silenor competes with well-established drugs approved for the treatment of insomnia, including Lunesta, marketed by Sunovion Pharmaceuticals Inc., a wholly-owned subsidiary of Dainippon Sumitomo Pharma Co., Ltd., and the branded and generic versions of Sanofi-Synthélabo, Inc.’s Ambien and Ambien CR and Pfizer Inc.’s Sonata, all of which are GABA-receptor agonists, and Takeda Pharmaceuticals North America, Inc.’s Rozerem, a melatonin receptor antagonist.

A number of companies are marketing reformulated versions of previously approved GABA-receptor agonists. For example, in November 2011, Transcept Pharmaceuticals, Inc. received approval from the FDA for Intermezzo, a low-dose sublingual tablet formulation of zolpidem. Transcept and Purdue Pharmaceutical Products L.P. have entered into an exclusive U.S. license and collaboration agreement to commercialize Intermezzo, which was launched by Purdue in April 2012. Meda AB and Orexo AB launched Edluar, formerly known as Sublinox, a sublingual tablet formulation of zolpidem, in the third quarter of 2009. ECR Pharmaceuticals Company, Inc., a wholly owned subsidiary of Hi-Tech Pharmacal Co., Inc., launched NovaDel Pharma, Inc.’s ZolpiMist, an oral mist formulation of zolpidem, in the United States in February 2011.

In addition to the currently approved products for the treatment of insomnia, a number of new products may enter the insomnia market over the next several years. It has been reported that Neurim Pharmaceuticals Ltd. is seeking FDA approval of Circadin, a prescription form of melatonin that is already approved in the European Union and several other countries. Neurim also announced positive results from Phase 1 and 1b clinical trials for Neu-P11, a melatonin and serotonin agonist for the treatment of insomnia associated with pain.

Alexza Pharmaceuticals, Inc. has announced positive results from a Phase 1 clinical trial of an inhaled formulation of zaleplon, the API in Sonata. In July 2010, Alexza announced that it was advancing this product candidate into Phase 2 clinical trials during the first half of 2011 for the treatment of insomnia in patients who have difficulty falling asleep, including those patients who awake in the middle of the night and have difficulty falling back asleep, but has not yet done so. Somnus Therapeutics, Inc. has announced positive results from two Phase 1 clinical trials and one Phase 2 clinical trial of a delayed-release formulation of zaleplon.

Vanda Pharmaceuticals Inc. has completed two Phase 3 clinical trials of tasimelteon, a melatonin receptor agonist. Tasimelteon received orphan drug designation status for non-24 hour sleep/wake disorder in blind individuals with no light perception. Vanda has initiated Phase 3 clinical trials for tasimelteon to treat this disorder and plans to file an NDA with the FDA in the first half of 2013.

 

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Merck & Co., Inc. has completed Phase 3 clinical trials for suvorexant, an orexin antagonist, for the treatment of insomnia and has MK-6096 and MK-3697 in Phase 2 clinical trials for the treatment of insomnia. Merck has announced that it plans to file regulatory applications for suvorexant in 2012.

Several other companies, including Sunovion Pharmaceuticals, are evaluating 5HT2 antagonists as potential hypnotics, and Eli Lilly and Company is evaluating a potential hypnotic that is a dual histamine/5HT2 antagonist. Additionally, several other companies are evaluating new formulations of existing compounds and other compounds for the treatment of insomnia.

Furthermore, generic versions of Ambien, Ambien CR and Sonata have been launched and are priced significantly lower than approved, branded insomnia products. Some managed health care plans require that patients try generic versions of these branded insomnia products before the patient can be reimbursed for Silenor. Sales of all of these drugs may reduce the available market for, and could put downward pressure on, the price we are able to charge for Silenor, which could ultimately limit our ability to generate significant revenues.

The active ingredient of Silenor is doxepin, which has been used at higher doses for over 40 years for the treatment of depression and anxiety. Doxepin is available generically in strengths as low as 10 mg in capsule form, as well as in a concentrated liquid form dispensed by a marked dropper and calibrated for 5 mg. Some physicians are prescribing generic 10 mg doxepin capsules and generic oral solution doxepin for insomnia off-label for insomnia. In addition, some managed health care plans are requiring the substitution of these generic doxepin products for Silenor, and some pharmacies are suggesting such substitution. Such off label uses of generic doxepin may reduce the sales of Silenor and may put a downward pressure on the price we are able to charge for Silenor, which could ultimately limit our ability to generate significant revenues.

Upon the expiration of, or successful challenge to, our patents or licenses covering Silenor, generic competitors may introduce a generic version of Silenor at a lower price. Some generic manufacturers have also demonstrated a willingness to launch generic versions of branded products before the final resolution of related patent litigation, known as an “at-risk launch”. A launch of a generic version of Silenor could have a material adverse effect on our business and we could suffer a significant loss of sales and market share in a short period of time.

We received notices from Actavis, Mylan, Par, and Zydus that each has filed with the FDA an ANDA for a generic version of Silenor 3 mg and 6 mg tablets. The notices included paragraph IV certifications with respect to eight of the nine patents listed in the Orange Book for Silenor.

We, together with ProCom, filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that each of Actavis, Mylan, Par and Zydus infringed the ’229 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In addition, we filed suit in the United States District Court for the District of Delaware against each of Actavis, Mylan, Par and Zydus alleging that such parties infringed the ’307 patent by seeking approval from the FDA to market generic versions of Silenor 3 mg and 6 mg tablets prior to the expiration of this patent.

In July 2012 we and ProCom One entered into separate settlement agreements with each of Mylan, Par and Zydus to resolve the pending patent litigation between the parties. Mylan has the exclusive right under the ‘229 patent and the ‘307 patent to sell an authorized generic version of Silenor under our NDA in the United States for a limited period beginning January 1, 2020, or earlier under certain circumstances. After Mylan’s license to sell such authorized generic product expires, Mylan will have a non-exclusive license to sell a generic version of Silenor under Mylan’s ANDA in the United States. Par and Zydus each have a non-exclusive license under the ‘229 patent and the ‘307 patent to sell a generic version of Silenor in the United States 180 days after the earlier of the date that a third party’s generic version of Silenor is first sold in the United States under a license from us or a final court decision that the ’229 patent and the ’307 patent are not infringed, invalid or unenforceable, or earlier under certain circumstances. In July 2012, the U.S. District Court for the District of Delaware entered an order dismissing the litigation with respect to each of Mylan, Par and Zydus.

Pursuant to the provisions of the Hatch-Waxman Act, FDA final approval of the Actavis and Mylan ANDAs can occur no earlier than May 3, 2013, FDA final approval of the Par ANDA can occur no earlier than June 23, 2013 and FDA final approval of the Zydus ANDA can occur no earlier than November 13, 2013, unless in each case there is an earlier court decision that the ’229 patent and the ’307 patent are not infringed and/or invalid or unless any party to the action is found to have failed to cooperate reasonably to expedite the infringement action.

 

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We intend to vigorously enforce our intellectual property rights relating to Silenor, but we cannot predict the outcome of ongoing or any future actions. Any adverse outcome in ongoing or any future actions could result in one or more generic versions of Silenor being launched before the expiration of the listed patents, which could adversely affect our ability to successfully generate sales of Silenor and would negatively impact our financial condition and results of operations, including causing a significant decrease in our revenues and cash flows, such events could also significantly impact our ability to continue as a going concern.

The biotechnology and pharmaceutical industries are subject to rapid and intense technological change. We face, and will continue to face, competition in the development and marketing of Silenor or any other product candidate to which we acquire rights from academic institutions, government agencies, research institutions and biotechnology and pharmaceutical companies. There can be no assurance that developments by others, including the development of other drug technologies and methods of preventing the incidence of disease, will not render Silenor or any other product candidate that we develop obsolete or noncompetitive.

Compared to us, many of our potential competitors have substantially greater:

 

   

capital resources;

 

   

manufacturing, distribution and sales and marketing resources and experience;

 

   

research and development resources, including personnel and technology;

 

   

regulatory experience;

 

   

experience conducting non-clinical studies and clinical trials, and related resources; and

 

   

expertise in prosecution and enforcement of intellectual property rights.

As a result of these factors, our competitors may develop drugs that are more effective and less costly than ours and may be more successful than we are in manufacturing, marketing and selling their products. Our competitors may also obtain patent protection or other intellectual property rights or seek to invalidate or otherwise challenge our intellectual property rights, limiting our ability to successfully market and sell products.

In addition, manufacturing efficiency and selling and marketing capabilities are likely to be significant competitive factors. We currently have no commercial manufacturing capability and more limited sales and marketing infrastructure than many of our competitors and potential competitors.

If the manufacturers upon whom we rely fail to produce our products in the volumes that we require on a timely basis, or to comply with stringent regulations applicable to pharmaceutical drug manufacturers, we may face delays in the development and commercialization of, or be unable to meet demand for, our products and may lose potential revenues.

We do not manufacture Silenor, and we do not plan to develop any capacity to do so. We have a contract with Patheon Pharmaceuticals Inc. to manufacture our future required clinical supplies, if any, of Silenor, and we have a contract with Patheon to manufacture our commercial supplies of Silenor. In addition, in connection with our settlement agreement with Mylan, in July 2012 we entered into an agreement with Mylan to manufacture our commercial supplies of Silenor for the United States. We have also entered into agreements with Plantex USA, Inc. to manufacture our supply of doxepin API and with Anderson Packaging, Inc. to package Silenor finished products.

In addition, in October 2006, we entered into a supply agreement with JRS Pharma L.P., or JRS, under which we purchase from JRS all of our requirements for ProSolv®HD90, an ingredient used in our formulation for Silenor. In August 2008, we amended our supply agreement to provide us with the exclusive right to use this ingredient and any successor product to ProSolv®HD90 in combination with doxepin, as well as the right to list the U.S. patents owned by JRS and covering ProSolv®HD90 in the Orange Book relating to Silenor. JRS also agreed to enforce any such patents listed in the Orange Book on our behalf. The term of the agreement runs through January 1, 2013, but it will be automatically extended for additional one year periods unless we terminate the license upon written notice at least 90 days prior to the end of the term. Either party may terminate the agreement upon written notice to the other party if the other

 

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party commits a material breach of its obligations and fails to remedy the breach within 30 days, or upon the filing of bankruptcy, reorganization, liquidation, or receivership proceedings relating to the other party. We also have the right to terminate the agreement if JRS no longer has any valid patent claim in the U.S. covering ProSolv®HD90 or any successor product to ProSolv®HD90 used by us in combination with doxepin. Each of the current patents listed in the Orange Book by us relating to Silenor expires in 2015.

As part of the amendment, we made an upfront license payment of $0.2 million and are obligated to pay a royalty of less than 1% on net sales of Silenor beginning as of the expiration of the statutory exclusivity period for Silenor in each country in which a Silenor formulation containing ProSolv®HD90 or any successor product to ProSolv®HD90 is marketed, which with respect to U.S. sales of Silenor we expect to occur in March 2013. This royalty is only payable if one or more patents under the license agreement continues to be valid in each such country and a patent relating to our formulation for Silenor has not issued in such country.

The manufacture of pharmaceutical products requires significant expertise and capital investment, including the development of advanced manufacturing techniques and process controls. Manufacturers of pharmaceutical products often encounter difficulties in production, particularly in scaling up and validating initial production. These problems include difficulties with production costs and yields, quality control, including stability of the product and quality assurance testing, shortages of qualified personnel, as well as compliance with strictly enforced federal, state and foreign regulations. In connection with our supply agreement with Mylan, the FDA must approve Mylan’s facilities and processes prior to our use of commercial products supplied by Mylan, which could require new testing and compliance inspections. In addition, Mylan will have to be educated in or independently develop the processes necessary for production.

Our manufacturers may not perform as agreed or may terminate their agreements with us. Additionally, our manufacturers may experience manufacturing difficulties due to resource constraints or as a result of labor disputes or unstable political environments. If our manufacturers were to encounter any of these difficulties, or otherwise fail to comply with their contractual obligations, our ability to sell Silenor or any other product candidate that we commercialize or provide any product candidates to patients in our clinical trials would be jeopardized. Any delay or interruption in the supply of clinical trial supplies could delay the completion of our clinical trials, increase the costs associated with maintaining our clinical trial program and, depending upon the period of delay, require us to commence new clinical trials at significant additional expense or terminate the clinical trials completely. In addition, any delay or interruption in our ability to meet commercial demand for Silenor will result in the loss of potential revenues.

In addition, all manufacturers of pharmaceutical products must comply with current good manufacturing practice, or cGMP, requirements enforced by the FDA through its facilities inspection program. The FDA is also likely to conduct inspections of our manufacturers’ facilities as part of their review of any marketing applications we submit. These cGMP requirements include quality control, quality assurance and the maintenance of records and documentation. Manufacturers of our products may be unable to comply with these cGMP requirements and with other FDA, state and foreign regulatory requirements. A failure to comply with these requirements may result in fines and civil penalties, suspension of production, suspension or delay in product approval, product seizure or recall, or withdrawal of product approval. If the safety of any quantities supplied is compromised due to our manufacturers’ failure to adhere to applicable laws or for other reasons, we may not be able to obtain regulatory approval for or successfully commercialize our products.

Moreover, our manufacturers and suppliers may experience difficulties related to their overall businesses and financial stability, which could result in delays or interruptions of our supply of Silenor. In addition, once Mylan’s supply of commercial quantities of Silenor is approved by the FDA, we will be required to procure minimum percentages of our U.S. commercial requirements of Silenor from Mylan, which could limit our flexibility with respect to supply and inventory management. Except for the dual supply of Silenor commercial requirements from Mylan and Patheon, we do not have alternate manufacturing plans in place at this time. If we need to change to other manufacturers, the FDA and comparable foreign regulators must approve these manufacturers’ facilities and processes prior to our use, which would require new testing and compliance inspections, and the new manufacturers would have to be educated in or independently develop the processes necessary for production.

Any of these factors could adversely affect the commercial activities for Silenor or suspend clinical trials, regulatory submissions, and required approvals for any other product candidate that we develop, or entail higher costs or result in our being unable to effectively commercialize our products. Furthermore, if our manufacturers failed to deliver the required commercial quantities of raw materials, including bulk drug substance, or finished product on a timely basis and at commercially reasonable prices, we would likely be unable to meet demand for our products and we would lose potential revenues.

 

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We, Paladin, CJ or any other future licensee may never receive approval or commercialize Silenor outside of the United States, or our or their activities may not be effective or in compliance with applicable laws.

We have licensed to Paladin the rights to commercialize Silenor in Canada, South America, the Caribbean and Africa, and we have licensed to CJ the rights to commercialize Silenor in South Korea. Silenor has not been approved for marketing in any jurisdiction outside of the United States. Paladin and CJ will be responsible for regulatory submissions for Silenor in their respective licensed territories and will have the exclusive right to commercialize Silenor in such licensed territories. Paladin’s New Drug Submission filing in Canada was accepted for review by Health Canada in February 2012, but there is no assurance regulatory approval will be obtained in Canada or any of the other licensed territories. We may license rights to Silenor or other future products to others for territories outside the United States in the future.

Compared to a development and commercialization strategy for an ex-U.S. product that involves a third-party collaborator, the development and commercialization of such a product by us without a collaborator is likely to require substantially greater resources on our part and potentially adversely impact the timing and results of the development or commercialization of the product.

In order to market any products outside of the United States, we or our licensees must establish and comply with numerous and varying regulatory requirements regarding safety and efficacy. Approval procedures vary among countries and can involve additional product testing and additional administrative review periods. Any additional clinical studies that may be required to be conducted as part of the regulatory approval process may not corroborate the results of the clinical studies we have previously conducted or may have adverse results or effects on our ability to maintain regulatory approvals in the United States or obtain them in other countries. The time required to obtain approval might differ from that required to obtain FDA approval for Silenor.

The regulatory approval process in other countries may include all of the risks regarding FDA approval in the U.S. as well as other risks. Regulatory approval in one country does not ensure regulatory approval in another, but a failure or delay in obtaining regulatory approval in one country may have a negative effect on the regulatory process in others. Failure to obtain regulatory approval in other countries or any delay or setback in obtaining such approval could limit the uses of the product candidate and have an adverse effect on potential royalties and product sales. Such approval may be subject to limitations on the indicated uses for which the product may be marketed or require costly, post-marketing follow-up studies.

In addition, any revenues we receive from sales of Silenor outside the United States will likely depend upon the efforts of Paladin, CJ or any other future licensees, as applicable, which will not be within our control. If we are unable to maintain our license agreements or to effectively establish alternative arrangements to market such products, or if Paladin, CJ or any future licensees do not perform adequately under such agreements or arrangements or comply with applicable laws, our business could be adversely affected and we could be subject to regulatory sanctions.

We or any collaborator may not be successful in developing, receiving approval for or commercializing an OTC product for Silenor.

In March 2012, P&G notified us that P&G elected not to exercise its right to negotiate with us for rights to develop and commercialize an OTC pharmaceutical product containing doxepin as the sole API. As a result, P&G no longer has any rights relating to an OTC product and we are seeking potential collaborations with other third parties interested in rights to develop and commercialize an OTC product. We cannot assure you that we will find another suitable third party interested in such rights, or that any negotiations with such a third party will result in a completed transaction or that such a transaction will be successful or on attractive terms. If we are unable to establish an OTC collaboration, we will require substantial additional funds, which may not be available, if we should decide to develop and commercialize the product on our own.

 

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Even if we are successful in establishing a collaboration with a third party for an OTC product, we or such third party must establish and comply with numerous and varying regulatory requirements regarding safety and efficacy of OTC products prior to selling the product, and we cannot give any assurance that any such OTC product will receive applicable regulatory approval or be successfully commercialized.

Risks Related to Our Finances and Capital Requirements

If we are unable to comply with the minimum requirements for listing on the Nasdaq Capital Market, we may be delisted from the Nasdaq Capital Market, which would likely cause the liquidity and market price of our common stock to decline.

Our stock is listed on the Nasdaq Capital Market. In order to continue to be listed on the Nasdaq Capital Market, we must meet specific quantitative standards, including maintaining a minimum bid price of $1.00 for our common stock, a public float of $1.0 million, and either $2.5 million in stockholders equity or a market capitalization of $35 million. On December 13, 2011, we received a letter from the Listing Qualifications Department of Nasdaq informing us that because the closing bid price for our common stock had been below $1.00 for 30 consecutive trading days, we did not comply with the minimum closing bid price requirement for continued listing on the Nasdaq Capital Market.

In June 2012, we received a second letter from the Listing Qualifications Department of the Nasdaq Stock Market notifying us that we had been granted an additional 180-day compliance period, or until December 10, 2012, to regain compliance with the $1.00 per share minimum closing bid price requirement under Nasdaq Marketplace Rule 5550(a)(2). Nasdaq’s determination was based on us meeting the continued listing requirement for market value of publicly held shares and all other applicable requirements for initial listing on the Nasdaq Capital Market, with the exception of the bid price requirement, and our written notice of our intention to cure the deficiency during the second compliance period by effecting a reverse stock split, if necessary.

We may regain listing compliance by maintaining a closing bid price of our common stock of at least $1.00 per share for a minimum of 10 consecutive business days at any time before December 10, 2012. If, pursuant to Nasdaq Marketplace Rule 5810(c)(3)(A), we meet the outlined requirements, Nasdaq will provide written confirmation to us that we comply with Nasdaq Marketplace Rule 5550(a)(2), unless Nasdaq exercises its discretion to extend this 10-day period pursuant to its Listing Rule 5810(c)(3)(F).

If compliance is not demonstrated within the applicable compliance period, Nasdaq will notify us that our securities will be delisted from the Nasdaq Capital Market. However, we may appeal Nasdaq’s determination to delist our securities to a Nasdaq Hearings Panel. During any appeal process, shares of our common stock would continue to trade on the Nasdaq Capital Market.

If we were to be delisted from the Nasdaq Capital Market, trading, if any, in our shares may continue to be conducted on the Over-the-Counter Bulletin Board or in a non-Nasdaq over-the-counter market, such as the “pink sheets.” Delisting of our shares would result in limited release of the market price of those shares and limited analyst coverage and could restrict investors’ interest in our securities. Also, a delisting could have a material adverse effect on the trading market and prices for our shares and our ability to issue additional securities or to secure additional financing. In addition, if our shares were not listed and the trading price of our shares was less than $5.00 per share, our shares could be subject to Rule 15g-9 under the Exchange Act which, among other things, requires that broker/dealers satisfy special sales practice requirements, including making individualized written suitability determinations and receiving a purchaser’s written consent prior to any transaction. In such case, our securities could also be deemed to be a “penny stock” under the Securities Enforcement and Penny Stock Reform Act of 1990, which would require additional disclosure in connection with trades in those shares, including the delivery of a disclosure schedule explaining the nature and risks of the penny stock market. Such requirements could severely limit the liquidity of our securities and our ability to raise additional capital in an already challenging capital market.

Capital raising activities, such as issuing securities, incurring debt, assigning receivables or royalty rights or entering into collaborations or other strategic transactions, may cause dilution to existing stockholders or a reduction in our stock price, restrict our operations or require us to relinquish proprietary rights and may be limited by applicable laws and regulations.

 

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Based on our recurring losses, negative cash flows from operations and working capital levels, we will need to raise substantial additional funds. If we are unable to maintain sufficient financial resources, including by raising additional funds when needed, our business, financial condition and results of operations will be materially and adversely affected. The report of our independent registered public accounting firm on our financial statements for the year ended December 31, 2011 contains an explanatory paragraph stating that our recurring losses raise substantial doubt about our ability to continue as a going concern.

Because we will need to raise additional capital to fund our business, among other things, we may conduct substantial equity offerings. For example, on July 24, 2012, we sold to institutional investors an aggregate of 9,422,496 shares of our common stock and warrants to purchase up to an additional 4,711,248 shares of our common stock at a combined purchase price of $0.32 per share and per warrant. The warrants have an exercise price of $0.46 per share, will be exercisable beginning six months and one day from the date of issuance and will expire on the fifth anniversary of the date they first become exercisable. The total gross proceeds from the offering were approximately $3.0 million, before deducting anticipated selling commissions and expenses of approximately $300,000. In addition, in August 2011 we entered into the sales agreement with Citadel pursuant to which we agreed to sell, at our option, up to an aggregate of $30.0 million in shares of our common stock through Citadel, as sales agent, of which we have sold $0.8 million to date. Sales of the common stock made pursuant to the sales agreement, if any, will be made on the Nasdaq Stock Market, or Nasdaq, under our currently-effective Registration Statements on Form S-3 by means of ordinary brokers’ transactions at then-prevailing market prices. Additionally, under the terms of the sales agreement, we may also sell shares of our common stock through Citadel, on Nasdaq or otherwise, at negotiated prices or at prices related to the prevailing market price. However, there can be no assurance that we can or will consummate such sales based on prevailing market conditions or in the quantities or at the prices that we deem appropriate.

We will not be able to make sales of our common stock pursuant to the sales agreement unless certain conditions are met, which include the accuracy of representations and warranties made to Citadel under the sales agreement; compliance with laws; and the continued listing of our stock on the Nasdaq Capital Market.

In December 2011, we received a letter from the Listing Qualifications Department of the Nasdaq Stock Market, or Nasdaq, informing us that because the closing bid price of our common stock listed on Nasdaq was below $1.00 for 30 consecutive trading days, we did not comply with the minimum closing bid price requirement for continued listing on the Nasdaq Capital Market under Nasdaq Marketplace Rule 5550(a)(2). In June 2012, we received a second letter from the Listing Qualifications Department of the Nasdaq Stock Market notifying us that we had been granted an additional 180-day compliance period, or until December 10, 2012, to regain compliance with the $1.00 per share minimum closing bid price requirement under Nasdaq Marketplace Rule 5550(a)(2). Nasdaq’s determination was based on us meeting the continued listing requirement for market value of publicly held shares and all other applicable requirements for initial listing on the Nasdaq Capital Market, with the exception of the bid price requirement, and our written notice of our intention to cure the deficiency during the second compliance period by effecting a reverse stock split, if necessary.

We may regain listing compliance by maintaining a closing bid price of our common stock of at least $1.00 per share for a minimum of 10 consecutive business days at any time before December 10, 2012. If, pursuant to Nasdaq Marketplace Rule 5810(c)(3)(A), we meet the outlined requirements, Nasdaq will provide written confirmation to us that we comply with Nasdaq Marketplace Rule 5550(a)(2), unless Nasdaq exercises its discretion to extend this 10-day period pursuant to its Listing Rule 5810(c)(3)(F). If compliance is not demonstrated within the applicable compliance period, Nasdaq will notify us that our securities will be delisted from the Nasdaq Capital Market. However, we may appeal Nasdaq’s determination to delist our securities to a Hearings Panel.

In addition, the rules and regulations of the SEC or other regulatory agencies may restrict our ability to undertake certain types of financing activities, including sales under the sales agreement, or may affect the timing of and the amounts we can raise by undertaking such activities. For example, under current SEC regulations, because the aggregate market value of our public float, is less than $75 million, the amount that we can raise through primary public offerings of securities in any twelve-month period using one or more registration statements on Form S-3 is limited to an aggregate of one-third of our public float. Our July 2012 offering of stock and warrants was a primary offering using one of our effective shelf registration statements on Form S-3 and was subject to this limitation.

Citadel or we are permitted to terminate the sales agreement at any time. Sales of shares pursuant to the sales agreement will have a dilutive effective on the holdings of our existing stockholders, and may result in downward pressure on the price of our common stock.

 

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To the extent that we raise any required additional capital by issuing equity securities, our existing stockholders’ ownership will be diluted. Any such dilution of the holdings of our current stockholders may result in downward pressure on the price of our common stock.

Any debt, receivables or royalty financing we enter into may involve covenants that restrict our operations or conditions that require repayment.

Equity financing, debt financing, receivables assignments, royalty interest assignments and other types of financing are often coupled with an additional equity component, such as warrants to purchase stock. To the extent that any of our outstanding warrants or additional warrants that we may issue in the future, are exercised by their holders, dilution of our existing stockholders’ ownership interests will result.

In December 2011 we hired Stifel Nicolaus Weisel as a strategic advisor to assist us in identifying and evaluating strategies to maximize stockholder value by leveraging our rights in Silenor. The exploration of strategic alternatives may not result in any agreement or transaction and, if completed, any agreement or transaction may not be successful or on attractive terms. The inability to enter into a strategic transaction, or a strategic transaction that is not successful or on attractive terms, could accelerate our needs for cash and make securing funding on reasonable terms more difficult. In addition, if we raise additional funds through collaborations or other strategic transactions, it may be necessary to relinquish potentially valuable rights to our products, potential products or proprietary technologies, or grant licenses on terms that are not favorable to us.

We may not be able to sell shares of our common stock under our equity sales agreement with Citadel at times, prices or quantities that we desire and if such sales do occur, they may result in dilution to our existing stockholders.

In August 2011, we entered into the sales agreement with Citadel. Under the terms of the sales agreement, Citadel will use its commercially reasonable efforts to sell shares of our common stock designated by us. However, there can be no assurance that we can or will consummate such sales based on prevailing market conditions or in the quantities or at the prices that we deem appropriate. Citadel or we are permitted to terminate the sales agreement at any time.

We will not be able to make sales of our common stock pursuant to the sales agreement unless certain conditions are met, which include the accuracy of representations and warranties made to Citadel under the sales agreement; compliance with laws; and the continued listing of our stock on the Nasdaq Capital Market.

In December 2011, we received a letter from the Listing Qualifications Department of Nasdaq informing us that because the closing bid price of our common stock listed on Nasdaq was below $1.00 for 30 consecutive trading days, we did not comply with the minimum closing bid price requirement for continued listing on the Nasdaq Capital Market under Nasdaq Marketplace Rule 5550(a)(2). In June 2012, we received a second letter from the Listing Qualifications Department of Nasdaq notifying us that we had been granted an additional 180-day compliance period, or until December 10, 2012, to regain compliance with the $1.00 per share minimum closing bid price requirement under Nasdaq Marketplace Rule 5550(a)(2). Nasdaq’s determination was based on us meeting the continued listing requirement for market value of publicly held shares and all other applicable requirements for initial listing on the Nasdaq Capital Market, with the exception of the bid price requirement, and our written notice of our intention to cure the deficiency during the second compliance period by effecting a reverse stock split, if necessary.

We may regain listing compliance by maintaining a closing bid price of our common stock of at least $1.00 per share for a minimum of 10 consecutive business days at any time before December 10, 2012. If, pursuant to Nasdaq Marketplace Rule 5810(c)(3)(A), we meet the outlined requirements, Nasdaq will provide written confirmation to us that we comply with Nasdaq Marketplace Rule 5550(a)(2), unless Nasdaq exercises its discretion to extend this 10-day period pursuant to its Listing Rule 5810(c)(3)(F). If compliance is not demonstrated within the applicable compliance period, Nasdaq will notify us that our securities will be delisted from the Nasdaq Capital Market. However, we may appeal Nasdaq’s determination to delist our securities to a Hearings Panel. During any appeal process, shares of our common stock would continue to trade on the Nasdaq Capital Market.

 

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In addition, the rules and regulations of the SEC or other regulatory agencies may restrict our ability to make sales under the sales agreement, or may affect the timing of and the amounts we can raise by making such sales. For example, under current SEC regulations, because the aggregate market value of our common stock held by non-affiliates (our “public float”), is less than $75 million, the amount that we can raise through primary public offerings of securities in any twelve-month period using one or more registration statements on Form S-3 is limited to an aggregate of one-third of our public float.

Should we sell shares pursuant to the sales agreement, it will have a dilutive effective on the holdings of our existing stockholders, and may result in downward pressure on the price of our common stock. If we sell shares under the sales agreement at a time when our share price is decreasing, we will need to issue more shares to raise the same amount than if our stock price was higher. Issuances in the face of a declining share price will have an even greater dilutive effect than if our share price were stable or increasing, and may further decrease our share price. During 2011, we sold an aggregate of 786,825 shares of our common stock and received gross proceeds of $0.8 million, and paid $0.3 million of legal and accounting fees associated with the execution of the sales agreement and commissions.

We have never been profitable and we may not be able to generate revenues sufficient to achieve profitability.

We only began generating revenues from the commercialization of Silenor late in the third quarter of 2010, we have not been profitable since inception, and it is possible that we will not achieve profitability. We incurred net losses of $2.2 million for the three months ended June 30, 2012, and have accumulated losses totaling $280.4 million since inception. We expect to continue to incur significant operating losses and capital expenditures. As a result, we will need to generate sufficient revenues relative to our operating expenses to achieve and maintain profitability. We cannot assure you that we will achieve significant revenues, or that we will ever achieve profitability. Even if we do achieve profitability, we cannot assure you that we will be able to sustain or increase profitability on a quarterly or annual basis in the future. If revenues are not sufficient or if operating expenses exceed our expectations or cannot be adjusted accordingly, our business, results of operations and financial condition will be materially and adversely affected. If we are unable to maintain sufficient financial resources, including by raising additional funds when needed, our business, financial condition and results of operations will be materially and adversely affected and we may be unable to continue as a going concern. If we are unable to continue as a going concern, it is likely that investors will lose all or a part of their investment.

Our quarterly operating results may fluctuate significantly.

We expect our operating results to be subject to quarterly fluctuations. The revenues we generate, if any, and our operating results will be affected by numerous factors, including:

 

   

the scope and effectiveness of commercial activities relating to Silenor or any other product that we may commercialize, alone or with a collaborator;

 

   

commercial activities of our competitors;

 

   

our entering into collaborations;

 

   

developments in our current intellectual property lawsuit with Actavis;

 

   

any other intellectual property infringement lawsuit in which we may become involved;

 

   

our addition or termination of development programs or funding support;

 

   

variations in the level of expenses related to development of any product candidate that we develop;

 

   

non-cash charges which we incur, including relating to share-based compensation; and

 

   

regulatory developments.

If our quarterly operating results fall below the expectations of investors or securities analysts, the price of our common stock could decline substantially. Furthermore, any quarterly fluctuations in our operating results may, in turn, cause the price of our stock to fluctuate substantially. We believe that quarterly comparisons of our financial results are not necessarily meaningful and should not be relied upon as an indication of our future performance.

Risks Relating to Securities Markets and Investment in Our Stock

There may not be a viable public market for our common stock, and market volatility may affect our stock price and the value of your investment.

 

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Our common stock had not been publicly traded prior to our initial public offering, which was completed in December 2005, and an active trading market may not develop or be sustained. We have never declared or paid any cash dividends on our capital stock. We currently intend to retain all available funds and any future earnings to support operations and finance the growth and development of our business. We do not intend to pay cash dividends on our common stock for the foreseeable future. Therefore, investors will have to rely on appreciation in our stock price and a liquid trading market in order to achieve a gain on their investment. The market prices for securities of biotechnology and pharmaceutical companies have historically been highly volatile, and the market has from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. Since our initial public offering on December 15, 2005 through June 30, 2012, the trading prices for our common stock have ranged from a high of $21.24 to a low of $0.18.

The market price of our common stock may fluctuate significantly in response to a number of factors, most of which we cannot control, including:

 

   

variations in our quarterly operating results;

 

   

events affecting our existing license agreements, and any future collaborations or other strategic transactions, commercial agreements and grants;

 

   

announcements of new products or technologies, commercial relationships or other events by us or our competitors;

 

   

developments in our current intellectual property lawsuit with Actavis;

 

   

any other intellectual property infringement lawsuit in which we may become involved;

 

   

regulatory approval or other changes in the regulatory status of our products or product candidates;

 

   

decreased coverage and changes in securities analysts’ estimates of our financial performance;

 

   

our ability to maintain our listing on the Nasdaq Capital Market;

 

   

regulatory developments in the United States and foreign countries;

 

   

fluctuations in stock market prices and trading volumes of similar companies;

 

   

sales of large blocks of our common stock, including sales by our executive officers, directors and significant stockholders;

 

   

announcements concerning financing activities;

 

   

additions or departures of key personnel; and

 

   

discussion of us or our stock price by the financial and scientific press and in online investor communities.

The realization of any of the risks described in these “Risk Factors” could have a dramatic and material adverse impact on the market price of our common stock. In addition, class action litigation has often been instituted against companies whose securities have experienced periods of volatility or declines in market price. Any such litigation brought against us could result in substantial costs and a diversion of management’s attention and resources, which could hurt our business, operating results and financial condition.

 

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable.

 

Item 3. Defaults Upon Senior Securities

Not applicable.

 

Item 4. Mine Safety Disclosures

Not applicable.

 

Item 5. Other Information

Not applicable.

 

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Item 6. Exhibits

EXHIBIT INDEX

 

Exhibit

Number

 

Description

3.1(1)   Amended and Restated Certificate of Incorporation of the Registrant
3.2(2)   Amended and Restated Bylaws of the Registrant
4.1(3)   Form of the Registrant’s Common Stock Certificate
4.2(4)   Amended and Restated Investor Rights Agreement dated June 2, 2005
4.3(5)   Warrant issued to Silicon Valley Bank dated May 21, 2008
4.4(5)   Warrant issued to Oxford Finance Corporation dated May 21, 2008
4.5(5)   Warrant issued to Kingsbridge Capital Limited dated May 21, 2008
4.6(6)   Form of Warrant issued to certain Purchasers under the Securities Purchase Agreement dated July 2, 2009
4.7(8)   Warrant issued to Silicon Valley Bank dated December 19, 2012
4.8(8)   Warrant issued to Oxford Finance LLC dated December 19, 2012
4.9(7)   Warrant issued to Silicon Valley Bank dated August 2, 2011
4.10(7)   Warrant issued to Oxford Finance LLC dated August 2, 2011
4.11(7)   Warrant issued to Oxford Finance LLC dated August 2, 2011
10.1(9)   License Agreement between the Registrant and CJ CheilJedang Corporation dated April 26, 2012
10.2(10)   Supply Agreement between the Registrant and CJ CheilJedang Corporation dated April 26, 2012
10.3(11)   Letter agreement dated May 11, 2012, between the Registrant and The Procter & Gamble Distributing Company LLC
31.1   Certification of chief executive officer pursuant to Rule 13a-14 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended
31.2   Certification of chief financial officer pursuant to Rule 13a-14 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended
32.1*   Certification of chief executive officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2*   Certification of chief financial officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101**   XBRL Instance Document
101**   XBRLTaxonomy Extension Schema Document
101**   XBRL Taxonomy Calculation Linkbase Document
101**   XBRL Taxonomy Label Linkbase Document
101**   XBRL Taxonomy Presentation Linkbase Document
101**   XBRL Taxonomy Definition Linkbase Document

 

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*   These certifications are being furnished solely to accompany this quarterly report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934 and are not subject to the liability of that section. These certifications are not to be incorporated by reference into any filing of Somaxon Pharmaceuticals, Inc., whether made before or after the date hereof, regardless of any general incorporation language in such filing.
**   Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, are deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, and otherwise are not subject to liability under these sections.
(1)   Filed with Amendment No. 3 to the Registrant’s Registration Statement on Form S-1 on November 30, 2005.
(2)   Filed with Registrant’s Current Report on Form 8-K on December 6, 2007.
(3)   Filed with Amendment No. 4 to the Registrant’s Registration Statement on Form S-1 on December 13, 2005.
(4)   Filed with the Registrant’s Registration Statement on Form S-1 on October 7, 2005.
(5)   Filed with Registrant’s Current Report on Form 8-K on May 22, 2008.
(6)   Filed with Registrant’s Current Report on Form 8-K on July 8, 2009.
(7)   Filed with Registrant’s Current Report on Form 8-K on August 2, 2011.
(8)   Filed with Registrant’s Annual Report on Form 10-K on March 9, 2012.
(9) †   Filed with Registrant’s Current Report on Form 8-K/A on May 17, 2012
(10) †   Filed with Registrant’s Current Report on Form 8-K on May 2, 2012
(11)   Filed with Registrant’s Current Report on Form 8-K on May 15, 2012

 

Confidential treatment has been requested as to certain portions, which portions have been omitted and filed separately with the Securities and Exchange Commission.

 

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SIGNATURES

Pursuant to the requirements 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.

 

    SOMAXON PHARMACEUTICALS, INC.
Dated: August 8, 2012     /s/ Richard W. Pascoe
   

Richard W. Pascoe

President and Chief Executive Officer

(Principal Executive Officer)

Dated: August 8, 2012    
    /s/ Tran B. Nguyen
   

Tran B. Nguyen

Senior Vice President and Chief Financial Officer

(Principal Financial Officer & Principal Accounting Officer)

 

34

XFRA:S6UN Quarterly Report 10-Q Filling

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XFRA:S6UN Quarterly Report 10-Q Filing - 6/30/2012
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