ITEM 1.
BUSINESS
Overview
In recent years, we have engaged primarily in the sale of nutraceutical dietary supplements and cosmetic products, and pursuing ongoing research and development by our subsidiary, Rock Creek Pharmaceuticals, of related dietary supplements and pharmaceutical products. As previously disclosed and as discussed below, in December 2013 we underwent a fundamental corporate transition that significantly changed our operational direction to focus on drug development. We expect that, by leveraging the underlying science and clinical data accumulated by us in relation to our existing products, we will be able to focus our operations on the research and development of drug candidates. It is anticipated that much of these research and development efforts will initially focus on developing our anatabine compound as a potential drug candidate. We also continue to operate our nutraceutical supplement and cosmetic lines of business and have been evaluating the prospects for this part of our business in light of our corporate transition and the matters raised in a warning letter we recently received from the Food and Drug Administration, or FDA, regarding our CigRx® and Anatabloc® dietary supplements (discussed below).
Our History and the Corporate Transition
Prior to the corporate transition in December 2013, our business strategy focused on selling nutraceutical dietary supplements that provide anti-inflammatory support and decrease the urge to smoke. We also have been involved in selling an associated line of cosmetic products, pursuing ongoing research and development by Rock Creek of related dietary supplements and pharmaceutical products, and to a much lesser degree seeking to license our low-TSNA curing technology and related products. In late 2013, our senior management and Board of Directors determined to undertake certain significant corporate changes in order to better take advantage of the potential opportunities in the area of pharmaceutical products, including the development of products approved by the FDA. In December 2013, our stockholders approved various matters necessary to effect the corporate transition. As part of the corporate transition, Michael J. Mullan, MBBS (MD), PhD was appointed our Chief Executive Officer and Chairman of our Board of Directors, and Christopher C. Chapman, MD was appointed our President. In addition to these significant management changes, our shareholders elected a new Board of Directors consisting of five new directors (including Dr. Mullan) and one existing director (Dr. Chapman).
The corporate transition was driven, in large part, by our belief that our company has evolved such that, from an operational standpoint, it was in our best interest to focus more on pharmaceutical products because there is potential for greater revenue growth through pharmaceutical product sales (for various reasons, including market acceptance of FDA-approved pharmaceutical products, the ability to market such products on a broader scale and recent Anatabloc® research in support of the feasibility of pursuing FDA applications. In this regard, Drs. Mullan and Chapman have extensive experience in the commercial aspects of the development, approval process and marketing of pharmaceutical products. Additionally, we will be required to generate the appropriate preclinical and clinical data needed for Investigational New Drug, or IND, applications related to pharmaceutical products. Drs. Mullan and Chapman are highly experienced in this area. Dr. Chapman has extensive experience with the IND process that will be invaluable as part of the Company’s strategy going forward. Further, Dr. Mullan has strong scientific credentials that will be necessary to generate the information for the IND process as well as interacting with applicable scientific consultants and others with respect to the IND process.
Recent Financing Transaction
On March 12, 2014, we entered into a series of equity and financing transactions that resulted in gross cash proceeds to our Company of approximately $9.3 million and cash availability under a credit facility of approximately $5.8 million, for total available funds of $15.1 million. Under one transaction, holders of previously held warrants with strike prices ranging from $1.50 to $2.00 agreed to immediately exercise on an aggregate of 4.2 million warrants at a reduced strike price of $1.00 per share. The investors also were issued new warrants for an equal number of shares that have a term of seven years and a strike price of $1.00 per share. This transaction resulted in proceeds of $4.2 million. Under another transaction we sold 5.1 million shares with a matching warrant for 5.1 million shares to investors at $1.00 for the shares and warrant shares. This transaction resulted in proceeds to us of $5.1 million. Finally, we entered into a credit facility with another investor under which that investor agreed to loan us up to $5.8 million (subject to specified limitations and exceptions). The credit facility provides for an annual interest rate of 3% on any funds drawn by us. It also provides the lender with the option to convert any loan amount to a unit of our common stock and a matching seven-year warrant at a conversion price of $1.00 per unit. For more information related to this financing, See Item 9B, “Other Information” in this Report.
Our Strategy
As discussed below, we expect to primarily focus on leveraging the underlying science and clinical data accumulated by our Company in relation to our existing nutraceutical products in order to develop drug candidates. Secondarily, we will continue to seek profitability from the existing dietary supplement part of the business and our low-tobacco specific nitrosamine, or low-TSNA, curing technology.
Existing Products; FDA Warning Letter
We historically have focused on utilizing certain alkaloids found in the Solanacea family of plants, which includes potatoes, tomatoes, and eggplants, initially to address issues related to the desire to smoke or use of other traditional tobacco products. More recently, we have concentrated on the anti-inflammatory aspects of one of those alkaloids, anatabine. Currently, Rock Creek manufactures and sells two nutraceutical dietary supplements: Anatabloc®, for anti-inflammatory support, and CigRx ®, for assistance in fighting the urge to smoke cigarettes. Rock Creek also has been involved in the development of a cosmetic line of products that utilizes our anatabine compound to improve the appearance of the skin. We introduced Anatabloc ® Facial Crème in September 2012 and related line extensions in 2013. Since the introduction of Anatabloc ®, our revenues have been derived almost exclusively from the sale of our anatabine based nutraceutical products and, more particularly, Anatabloc ®. We do not expect to recognize any revenues related to our drug development initiatives for the foreseeable future. See “Our Dietary Supplements and Related Products” below for more information related to our existing product portfolio.
We had been developing a “time-release” version of our Anatabloc® dietary supplement. However, for the reasons discussed below related to the FDA, we are not proceeding with the development of the “time-release” version of Anatabloc® at this time.
On December 24, 2013, we received a warning letter from the FDA regarding our CigRx® and Anatabloc® dietary supplements. In the letter, the FDA asserted that CigRx® and Anatabloc® were not properly marketed as dietary supplements, since our company had not filed a New Dietary Ingredient Notification for anatabine as a dietary ingredient prior to the introduction of our dietary supplements. The FDA also claimed that certain materials on our websites, including published research articles, contained drug claims for Anatabloc®. We responded to the FDA’s letter on January 31, 2014 contesting the FDA’s position with respect to the status of our dietary supplements and noting that we had voluntarily removed website and other materials objected to by the FDA. We are currently communicating with the FDA in an effort to reach an amicable resolution of the issues asserted in the warning letter. In light of our receipt of the FDA letter, we have currently limited the advertising and marketing of our dietary supplements and information available on our website regarding our dietary supplement products.
Drug Development
Anatabine. We intend to leverage the underlying science and clinical data accumulated by us in relation to our existing products to advance our drug development program. Our desire to more aggressively pursue a drug development program was the driving force behind the corporate transition in December 2013. Using our existing technology and intellectual property, we intend to seek to identify human diseases most responsive to the pharmacologic and biologic properties of our compounds. Specifically, we intend to develop anatabine and related compounds as drug candidates because we believe that anatabine exhibits drug-like properties including, for instance, binding to known pharmacologically relevant receptors and exhibiting biological effects relevant to disease states in preclinical models. Further, there are existing anecdotal reports and clinical studies that suggest that anatabine and related compounds have the potential to be drug candidates. We believe that a critical aspect of this strategy is that the preclinical animal and anecdotal human data suggest anatabine has the potential to impact a number of inflammatory disorders in addition to being able to modulate certain brain receptors. This is potentially important, for instance, in mitigating nicotine addiction.
Part of our drug development strategy is to leverage the previous and ongoing research and development efforts of Rock Creek, much of which had been undertaken in conjunction with the Roskamp Institute. In particular, in his position as Chief Executive Officer of the Roskamp Institute, Dr. Mullan has been intimately involved with the research being conducted with respect to anatabine over the last four years. This research shows that in a number of preclinical cell based and animal models anatabine inhibits the activation of Nuclear Factor Kappa B (NFK-B), a critical regulatory protein complex responsible for the generation of inflammatory molecules in a wide range of inflammatory conditions. As a result, in these preclinical models of inflammatory conditions, in the presence of anatabine, there is reduced activation of inflammatory cells, reduced release of inflammatory molecules and reduced tissue damage. Research conducted by the Roskamp Institute also demonstrates that anatabine is well tolerated in anti-inflammatory doses in animal models.
Drug Development Process; IND/NDA. The results of the quality and pre-clinical tests/studies, in addition to any non-clinical pharmacology, are submitted to the FDA along with the initial clinical study protocol as part of the initial IND and are reviewed by the FDA before the commencement of human clinical trials. Unless the FDA objects to it, an IND becomes effective 30 days following its receipt by the FDA. The FDA reviews all protocols, protocol amendments, adverse event reports, study reports, and annual reports in connection with a new pharmacological product.
We intend to submit an IND with the FDA related to our drug development of anatabine and related compounds. While we cannot predict the precise timing of our submission, we currently expect to file our IND during the second quarter of 2014.
Clinical trials involve the administration of a new drug to humans under the supervision of qualified investigators. The protocols for the trials must be submitted to the FDA as part of the IND. Also, each clinical trial must be approved and conducted under the auspices of an Institutional Review Board, or IRB, which considers, among other things, ethical factors, the safety of human subjects, and the possible liability of the institution conducting the clinical trials.
Clinical trials are typically conducted in three sequential phases (Phase I, Phase II, and Phase III), but the phases may overlap. Phase I clinical trials test the drug on healthy human subjects for safety and other aspects, but usually not effectiveness. Phase II clinical trials are conducted in a limited patient population to gather evidence about the efficacy of the drug for specific purposes, to determine dosage tolerance and optimal dosages, and to identify possible adverse effects and safety risks. When a compound has shown evidence of efficacy and acceptable safety in Phase II evaluations, Phase III clinical trials are undertaken to evaluate and confirm clinical efficacy and to test for safety in an expanded patient population at clinical trial sites in different geographical locations. The FDA and other regulatory authorities require that the safety and efficacy of therapeutic product candidates be supported through at least two adequate and well-controlled Phase III clinical trials (known as Pivotal Trials). The successful completion of Phase III clinical trials is a mandatory step in the approval process for the manufacturing, marketing, and sale of drug products.
In the United States, the results of quality, pre-clinical studies and clinical trials, if successful, are submitted to the FDA in a New Drug Application, or NDA, to seek approval to market and commercialize a drug product for a specified use. The NDA is far more specific than the IND and must also include proposed labeling and detailed technical sections based on the data collected. The FDA is governed by the Prescription Drug User Fee Act (or PDUFA) regarding response time to the application, which is generally 12 months (and shorter for a priority application). It may deny an NDA if it believes that applicable regulatory criteria are not satisfied. The FDA also may require additional clarifications on the existing application or even additional testing for safety and efficacy of a drug.
We cannot be sure that any of our proposed products (including anatabine-based drugs) will receive FDA approval. The multi-tiered approval process means that our products could fail to advance to subsequent steps without the requisite data, studies, and FDA approval along the way. Even if approved by the FDA, our products and the facilities used to manufacture our products will remain subject to review and periodic inspection by the FDA.
Our Dietary Supplements and Related Products
Dietary Supplements
We currently manufacture and market two nutraceutical, dietary supplements through Rock Creek. Our Anatabloc® product, which provides anti-inflammatory support, was introduced into the market in August 2011 and we introduced an unflavored version of Anatabloc ® in mid-2012. Our CigRx ® product, that is designed to curb the urge to smoke, was introduced in the market in August 2010. Both of these products utilize as the primary dietary ingredient anatabine citrate, a compound that is based on the anatabine alkaloid found in the Solanacea family of plants. The development of both Anatabloc ® and CigRx ® grew out of our prior research and development efforts relating to tobacco alkaloids that were known to have certain MAO inhibiting properties.
Our Anatabloc® product is being sold through our interactive website, a customer service center and on a consignment basis through General Nutrition Corporation, or GNC, a retailer of dietary supplements. GNC began selling Anatabloc® through its online store in early 2012 and Anatabloc® is now available at GNC’s more than 4,000 retail locations throughout the country. Initially, marketing of Anatabloc® was directed toward physicians and other healthcare professionals. More recently we have been focusing our marketing efforts on athletes and other groups of individuals who are frequently seeking to maintain healthy levels of inflammation. CigRx ® is being marketed through our interactive website and customer service centers and, to a lesser extent, at retail locations in the Richmond, Virginia metropolitan area. See “-Our Sales and Marketing Efforts- Dietary Supplement” for a discussion of our manufacturing, storage, order processing and delivery arrangements with third parties related to Anatabloc ® and CigRx ®.
Since the introduction of Anatabloc ® in August 2011, almost all of our revenues have been generated by the sales of Anatabloc® and, to a much lesser degree, CigRx®, each of which are manufactured and sold by Rock Creek.
Facial Creme and Related Cosmetics
Rock Creek also manufactures Anatabloc® Facial Crème, an anatabine citrate based face cream designed to improve the appearance of the skin. This product is being sold on our interactive website and promoted through select dermatology practices. In February 2013 GNC also began carrying the face cream on its website. In 2013 Rock Creek also introduced Anatabloc® Revitalizing Facial Serum and Anatabloc® Clarifying Facial Cleanser. These products are available on our website and our Anatabloc® Facial Crème and Revitalizing Facial Serum are also available on GNC’s online store and at select GNC franchise stores.
Other Nutraceutical Products and Related Research Initiatives
Through Rock Creek, we have explored the development of: (a) other related nutraceutical products that may assist in stabilizing metabolism; and (b) pharmaceuticals for a range of conditions, including arthritic conditions, inflammatory bowel disorders, Alzheimer’s disease, and multiple sclerosis. We are working with the Roskamp Institute and other research institutions to further our research on our anatabine and related compounds. See below “Our Current Product Development Initiatives.” This research included:
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a multi-site clinical trial of Rock Creek’s anatabine compound to examine its effect on chronic inflammation in individuals who have elevated blood levels of C-reactive protein, or CRP;
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an in-house clinical trial of approximately 100 smokers to determine the potential for Anatabloc® to lower CRP levels and curb the urge to smoke;
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a clinical study to determine the effect of Rock Creek’s anatabine compound on Hashimoto’s autoimmune thyroiditis;
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a clinical study of the safety and tolerability of anatabine citrate on individuals with mild to moderate Alzheimer’s diseases; and
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a dermatological study related to the use of our Anatabloc® Facial Créme.
We expect that, as a result of the corporate transition, our research and development efforts in 2014 will shift to focus on the development of anatabine and related compounds as drug candidates. In particular, our efforts will focus on conducting the research and development efforts required not only to submit an IND with the FDA related to our drug development of anatabine and related compounds, but also with respect to clinical trials related to the various phases (Phase I, Phase II, and Phase III) of the drug development process should we be permitted to initiate studies under our IND. Thus, we expect our research and development efforts with respect to our dietary supplement and cosmetic products will be minimized from levels in prior years given the attention we anticipate giving to our drug development program.
In 2014 we anticipate filing an IND to cover one or more disease indications. Assuming that we are permitted to initiate clinical trials under the IND, we anticipate beginning Phase I clinical trials in 2014 and completing those trials in later this year. Thereafter, we expect to enter Phase II trials in early 2015. For information related to the costs and expenses related to research and development for drug products, see “Item 7. Management’s Discussion and Analysis of Results of Operations.”
Our Technology
Our Intellectual Property Initiatives Relating to Anatabine and Related Compounds and Anatabine Citrate Based Products
Since 2010 we have filed United States patent applications relating to the active ingredient of our dietary supplement products, uses of the products and product formulations. These included:
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two applications for therapeutic methods involving the administrations of anatabine or an isomer or salts thereof, for treating chronic inflammation that may be associated with disorders such as thyroiditis, cancer, arthritis, Alzheimer’s disease and multiple sclerosis;
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an application for our CigRx® and our Anatabloc® formulations;
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an application for the synthesis of anatabine and an application for a relapse prevention product;
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an application for an inhaler that would use anatabine for smoking cessation;
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an application for a beverage product containing anatabine or a derivative or salt thereof; and
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an application for a skin care product containing anatabine or a derivative thereof.
We also filed an application for a design patent relating to the 20-piece container used for our CigRx® and Anatabloc® products and a divisional application for food grade salts of anatabine.
In 2013 the United States Patent and Trademark Office, or PTO, issued a patent to Rock Creek covering anatabine citrate under our divisional application for food grade salts of anatabine. In June 2012 the PTO issued a patent to Rock Creek for an improved method of synthesizing anatabine that facilitates large scale commercial production of high purity anatabine and in August 2012, issued a patent to Rock Creek for an anatabine and yerba mate composition and uses thereof in assisting weight loss and curbing the urge for tobacco. In 2011 the PTO issued a design patent to Rock Creek for the 20-piece dispenser used for our CigRx ® and Anatabloc ® products. We also have several foreign and international applications pending that relate to our Anatabloc ® product, a relapse prevention product and the administration of anatabine, its isomers and any derivatives thereof for treating inflammatory mediated disorders generally, and also for autism and seizure indications. In 2014 Rock Creek filed a divisional application with method claims in connection with its prior application for the Anatabloc® formulation and in lieu of the previously filed application.
Our Current Product Development Initiatives
Dietary Supplements and Pharmaceutical Products
Since 2011, Rock Creek, the Roskamp Institute and researchers at Johns Hopkins University, have completed and reported on a number of studies designed to assess the safety and tolerability of anatabine and its ability to lower chronic inflammation in a variety of pre-clinical (non-human) and clinical (human) settings. One study conducted by the Roskamp Institute and reported in the European Journal of Pharmacology showed that anatabine lowered levels of amyloid production both in the test tube and when administered to mice vulnerable to accumulation of amyloid which, at excessive levels, damages brain tissue. A second manuscript written by the same researchers and published online in The European Journal of Pharmacology in 2012 and in manuscript form in January 2013, further characterized the anti-inflammatory effects of anatabine in several types of animal tissues, in human cells, and in human whole blood. The Roskamp Institute also presented results of pre-clinical studies of anatabine in mouse models of multiple sclerosis, traumatic brain injury, and Alzheimer’s disease at the Neuroscience 2012 conference held in New Orleans in October 2012. In January 2013, the results of the animal multiple sclerosis study were published in PLoS One under the title “Amelioration of Experimental Autoimmune Encephalomyelitis by Anatabine.” Further, a pre-clinical investigator-initiated and independently funded study from Johns Hopkins that examined the effect of anatabine supplementation in a mouse model of autoimmune thyroiditis was published in September 2012 in an article entitled, “Anatabine Ameliorates Experimental Autoimmune Thyroiditis” in the Endocrine Society’s journal, Endocrinology (Endocrinology. 2012 Sep; 153(9):4580-7).
In 2013, Rock Creek received positive results from a study conducted by researchers at the University of Virginia Medical School investigating the effects of anatabine in an animal model of ulcerative colitis. Rock Creek also received functional binding data from a study it sponsored that offers an explanation and a possible mechanism of action for some of the observed effects of anatabine.
Rock Creek also has been involved in human (clinical) trials evaluating the impact of supplementation with anatabine citrate on an inflammatory marker, (C-reactive protein, which is also believed to be an indicator of coronary heart disease), on Hashimoto’s autoimmune thyroiditis, the safety and tolerability of anatabine supplementation in individuals with mild to moderate Alzheimer’s disease and in a multi-site study of Anatabloc ® Facial Crème. In February 2012, Rock Creek reported research on the first clinical trial demonstrating that Anatabloc ® lowers chronic inflammation measured by CRP levels in the blood. The reported results were obtained in connection with an in-house study undertaken by Rock Creek that involved a group of smokers who had been using Anatabloc ® on an extended basis. In October 2012 Rock Creek reported further results, based on an interim look at the results of a second CRP study that was conducted by the Roskamp Institute as the study sponsor. That interim look showed that 61% of diabetic subjects (11 of 18) taking metformin (the most common drug prescribed to diabetics) had a CRP reduction, as did 38% of the general trial population not taking metformin (31 of 81). Overall, 42 of 99 subjects (42%) had a decrease in CRP after one month of anatabine supplementation. After further, extensive review of the interim data from this CRP study, Rock Creek and the Roskamp Institute completed the study report, which confirmed the interim findings reported in October 2012. The report further confirmed that the supplement was safe and well tolerated, but that given the cyclical nature of CRP levels further enrollment in the study would not be productive.
On January 7, 2013 Rock Creek reported initial results for its Thyroid health study. Those results suggest that dietary supplementation with anatabine ameliorates the immune system’s targeting of the thyroid gland in cases of autoimmune thyroiditis. On October 31, 2013 the results of the Thyroid Health Study were published on-line in The Journal of Clinical Endocrinology & Metabolism in a peer-reviewed brief report entitled “Anatabine supplementation decreases thyroglobulin antibodies in patients with chronic lymphocytic autoimmune (Hashimoto’s) thyroiditis”. Also in October 2013 a peer-reviewed article titled, “Effects of Dietary Supplementation with the Solanaceae Plant Alkaloid Anatabine on Joint Pain and Stiffness: Results from an Internet-Based Survey Study", was published in Clinical Medicine Insights: Arthritis and Musculoskeletal Disorders.
The Alzheimer’s study that is being sponsored by Rock Creek and conducted at and paid for by the Roskamp Institute began enrolling subjects at the end of August 2012. As of March 1, 2014, 83 subjects had been screened, 62 subjects had been enrolled in the study and 53 subjects had completed the study. This study has now been suspended pending filing of an IND but an interim analysis is anticipated, the results of which may influence the decision to proceed with the study under an IND. Both the double-blind and open-label portion of the Anatabloc ® Facial Crème study were completed at the end of August 2013. A total of 109 of the 117 subjects enrolled in the study completed the double-blind portion of the study and 85 of 88 subjects completed the open-label extension. The study report is in preparation, but a first look at the data shows that both the active and placebo treatments produced marked improvement in both investigator and subject-rated measures of appearance and severity of conditions.
In 2012, the Roskamp Institute completed human pharmacokinetics and dose response studies relating to anatabine citrate. Further, in 2012 and 2013 Harvard University’s McLean Hospital continued follow-up research relating to its initial assessment of the abuse potential for anatabine as an alkaloid of tobacco and those results were published in two peer-reviewed articles in 2014: Caine SB et al., Nicotine-like behavioral effects of the minor tobacco alkaloids nornicotine, anabasine, and anatabine in male rodents. Exp Clin Psychopharmacol, 2014 Feb;22(1):9-22.; and Mello NK et al., Anatabine significantly decreases nicotine self-administration. Exp Clin Psychopharmacol, 2014 Feb;22(1):1-8.
In 2009 and 2010 our company completed initial research relating to anatabine citrate in connection with the development of our CigRx ® dietary supplement.
Our ability to continue our research efforts, including advancement of the research and development activities of Rock Creek, will depend in large part on our working capital constraints and our ability to procure funding for these initiatives. See “Item 7. Management’s Discussion and Analysis of Results of Operations-Liquidity and Capital Resources” and our consolidated financial statements included in “Item 15. Exhibits, Financial Statement Schedules” of this Report for further information on our working capital constraints and results of operations.
Our Relationship with the Roskamp Institute
The Roskamp Institute is a private medical research organization in Sarasota, Florida whose stated purpose is understanding causes of and finding cures for neuropsychiatric and neurodegenerative disorders and addictions. In 2010 and 2011, respectively, Robert G. Roskamp, the founder of the Roskamp Institute, purchased from us for cash, (i) 769,230 shares of our common stock and warrants to purchase an additional 769,230 shares at an exercise price of $1.50 per share, and (ii) 254,452 shares and warrants to purchase an additional 254,452 shares at an exercise price of $4.00 per share. We have entered into a Research and Royalty Agreement with an affiliate of the Roskamp Institute pursuant to which we pay royalties of 5% of Anatabloc ® sales to this affiliate (such royalties being equal to $50, $301 and $431 thousand for the years 2011, 2012 and 2013, respectively). During the same three year period the Company has paid research related fees of $1.1, $1.1 and $0.7 million to the Roskamp Institute.
In addition, Dr. Mullan, our Chief Executive Officer, is also the Chief Executive Officer of the Roskamp Institute.
Our Sales and Marketing Efforts; Current Limitations on Marketing
Our Rock Creek subsidiary currently manufactures and sells a nutraceutical, dietary supplement Anatabloc® as well as an unflavored version of Anatabloc ®. Our Anatabloc ® product is being sold through our interactive website, a customer service center and on a consignment basis through GNC, a retailer of dietary supplements. GNC began selling Anatabloc® through its online store in early 2012. In March 2012, GNC began carrying Anatabloc® at its company-owned stores and franchised retail locations. Anatabloc ® is now available at GNCs more than 4,000 retail locations throughout the country and in February 2013 our Company received GNC’s 2012 top vendor award for product innovation in the “wellness” product category. Initially, marketing of Anatabloc® was directed toward physicians and other healthcare professionals. More recently we have been focusing our marketing efforts on athletes and other groups of individuals who regularly are seeking to maintain healthy levels of inflammation.
In February 2012, we entered into an endorsement agreement with Fred Couples, a member of the PGA golf tour, under which Mr. Couples has acted as our initial brand ambassador for Anatabloc ® and has been active in promoting Anatabloc ® at various PGA golf events and other settings. On January 7, 2013 we announced that tennis pro John Isner, who has been a member of the ATP tour since 2007, had become our second brand ambassador for Anatabloc ®. The selection of John Isner as our company’s second brand ambassador is consistent with our focus on the use of Anatabloc ® in dealing with the type of muscle soreness that typically is experienced by professional athletes and others who regularly are engaged in vigorous physical activity. In September 2013, we entered into an agreement with Hall of Fame golfer Nancy Lopez, under which she became the first female brand ambassador for Anatabloc®. Mr. Couples, who was inducted into the World Golf Hall of Fame in 2013, continues to be the principal brand ambassador for Anatabloc ®.
CigRx®, our non-nicotine, non-tobacco dietary supplement, which is designed to temporarily reduce the desire to smoke, was introduced into the market in August 2010. CigRx® is being sold through our interactive website and through retail outlets in the Richmond, Virginia metropolitan area. Since the introduction of Anatabloc ® sales of CigRx ® have been de minimis.
Anatabloc® Facial Crème was introduced on September 10, 2012 as a cosmetic to improve the appearance of the skin and in 2013 we introduced line extensions consisting of Anatabloc® Revitalizing Facial Serum and Anatabloc® Clarifying Facial Cleanser. We currently sell our cosmetic products through our interactive website and a customer service center. GNC also carries our Anatabloc ® Facial Crème and Revitalizing Facial Serum on its website and these products are available at select GNC franchise stores.
In light of the FDA warning letter we received in December 2013, as discussed above, we have currently limited the marketing of our dietary supplements, though we continue to sell those supplements through our existing channels. Depending on the outcome of our discussions with the FDA regarding its letter, and our strategy to place a greater focus on drug development, we may reevaluate our marketing strategy with respect to our dietary supplements and related products.
Our Availability of Raw Materials, Manufacturing and Distribution Capabilities
Dietary Supplements and Cosmetic Products
We obtain all of the raw materials and packaging supplies for the manufacture of our Anatabloc®, Anatabloc® cosmetics and CigRx ® products from various vendors and we maintain an inventory of critical raw materials and packaging at the manufacturing location where these products are produced. We believe that the vendors from whom we obtain raw materials and packaging have sufficient capacity to meet our supply needs on a timely basis and to allow us to maintain inventory levels adequate to meet expected sales volume for the foreseeable future.
We have outsourced the product manufacturing for Anatabloc®, our Anatabloc® cosmetics and CigRx® to companies who we believe comply with FDA requirements of current Good Manufacturing Practices, or cGMP, that have sufficient capacity to provide us finished product on a timely basis and at quantities necessary to fulfill expected product sales volume for the foreseeable future. To facilitate this contract manufacturing arrangement, we purchased and installed, at the manufacturing location for our Anatabloc ® and CigRx ® products, certain dedicated packaging equipment that is used in conjunction with the production of Anatabloc ® and CigRx ® in our patented 20-piece dispensing packs. All other packaging configurations are packed on standard machinery owned by the contract manufacturers. The special packing machinery used to pack our 20-piece dispensing packs, while located at the contract manufacturer’s facility, remains titled in our company’s name.
We have outsourced the storage, order processing and delivery of Anatabloc®, Anatabloc® cosmetics and CigRx ® through contracts and arrangements with a number of third party suppliers. We anticipate that the arrangements which have been put in place with these various entities should be sufficient to meet our storage and distribution needs for our products for the foreseeable future.
Our Competition
Drug Development
The pharmaceutical and biotechnology industries are intensely competitive and subject to rapid and significant technological change. With respect to our drug development program, we are an early stage company with no history of operations in that area. Many of our competitors have substantially more resources than we do, particularly financial resources to conduct product development efforts. In addition, many of our competitors have more experience than us in pre-clinical and clinical development, manufacturing, regulatory and global commercialization. We are also competing against academic institutions, governmental agencies and private organizations that are conducting research in the field of drug development.
Our competition will be determined in part by the potential indications for which drugs are developed and ultimately approved by regulatory authorities. Additionally, the timing of market introduction of some of our potential products or our competitors’ products may be an important competitive factor. Accordingly, the speed with which we can develop products, complete pre-clinical testing, clinical trials, approval processes, and supply commercial quantities to market are expected to be important competitive factors. We expect that competition among products approved for sale will be based on various factors, including product efficacy, safety, reliability, availability, price, reimbursement, and patent position. Because anatabine is the principal compound for our dietary supplement products, there is risk that any pharmaceutical product that we develop with respect to anatabine may experience competition with other dietary supplements that have anatabine as their active dietary ingredient.
Dietary Supplements and Other Products and Services
Anatabloc® competes with other dietary supplements that are marketed for anti-inflammatory support and for use in maintaining a healthy metabolism. Also, while Anatabloc ® is intended to support the body’s natural anti-inflammatory properties, there are a number of dietary supplements and prescription and non-prescription products that are marketed for pain relief that, in many cases, may be due in part to excessive inflammation. While Anatabloc ® is not a pain relief medication; it is possible that by providing anti-inflammatory support, Anatabloc ® may be viewed as competing with these products to the extent that the use of Anatabloc ® supports the body’s maintenance of healthy levels of inflammation.
CigRx® is a dietary supplement product that allows individuals to use a non-tobacco, non-nicotine product in situations where they are not in a position to use tobacco or wish to have an alternative to a tobacco product. Smoking cessation products that are approved by the FDA for sale in the United States are designed to wean the smoker from nicotine addiction over a period of time ranging from 30 days to six weeks. These products are referred to as “nicotine replacement therapies.” Some of these products are sold over the counter and others are available by prescription. Although such pharmaceutical products are not intended to be substitutes for tobacco products, we believe that many smokers use such products for nicotine maintenance and that CigRx ® may compete with such products.
Our Anatabloc® cosmetic products are intended to improve the appearance of the skin. This line of products competes with other cosmetic products that are marketed as providing an improvement in the appearance of the skin and an improvement to the look and feel of the skin.
There can be no assurance that in the future our competitors will not succeed in developing technologies and products that are more effective than the products we develop, or that would render our products obsolete or non-competitive. In addition, our competitors may have far greater resources and access to capital to fund their businesses, which may put us at a competitive disadvantage.
Our Patents, Trademarks and Licenses
Our Portfolio of Patents and Pending Patent Applications
We believe that our patent portfolio through Rock Creek and under the License Agreement with Regent Court discussed below, along with our pending patent applications relating to uses of anatabine and products derived therefrom, establishes us as a world leader in the anti-inflammatory property of anatabine and for curing technology that consistently produces very low-TSNA tobacco. We currently have four (4) United States patents that have issued in the name of Rock Creek and we have exclusive rights to thirteen (13) United States patents issued to Regent Court and/or Jonnie R. Williams, Sr. under our license arrangement with Regent Court. There can be no assurances that the claims that have been or may be granted to us under these patents will be sufficient to protect our intellectual property or the intellectual property licensed to us, or that we or Regent Court will develop or obtain the rights to any additional products or processes that are patentable. Further, no assurances can be given that any patents licensed to us will not be challenged, invalidated, infringed or circumvented, or that the rights granted thereunder will provide competitive advantages to us. The patents that Rock Creek has been issued or which our company has rights to under the exclusive license arrangement with Regent Court are set forth below.
Our License Agreement with Regent Court
We are the exclusive licensee under a License Agreement with Regent Court that provides, among other things, for the grant of an exclusive, worldwide, irrevocable license to us, with the right to grant sublicenses, to make, use and sell tobacco and tobacco containing products using Regent Court’s patent rights and know-how relating to the processes for curing tobacco so as to substantially prevent the formation of TSNAs, whether such patent rights and know-how are now in existence or hereafter developed. The License Agreement provides us exclusive rights to any inventions of Regent Court and its affiliates during the term of the License Agreement relating to the production, treatment or curing of tobacco, or a method of manufacturing a product containing tobacco, and to any method of extracting one or more substances from tobacco for the purpose of incorporating such substance or substances in a product or products. Absent a material breach, the License Agreement will continue until the expiration of the last of the applicable patents, which includes 13 U.S. patents and corresponding foreign patents, as well as any additional patents issued to Regent Court during the term of the License Agreement. Generally, patents have a term of 20 years from the initial date of filing of a patent application. The U.S. patents subject to the License Agreement expire at various dates between June 28, 2016 and March 9, 2030.
We are obligated to pay to Regent Court a royalty of 2% on the net sales of our products and the products of any affiliated sub-licensees, and 6% on all fees and royalties received by us from unaffiliated sub-licensees, less any related research and development costs incurred by us as well as costs incurred in enforcing the patent rights. The License Agreement may be terminated by us upon 30 days written notice. Regent Court may terminate the License Agreement upon a default in the payment of royalties or a failure to submit a correct accounting continuing for at least 30 days after written notice from Regent Court, a material breach of any other of our obligations under the License Agreement continuing for at least 60 days after written notice from Regent Court, or in the event of a change of control resulting from the purchase of our stock or all or substantially all of our assets. The License Agreement obligates us to enforce and pay for United States and foreign patent rights and contains other provisions typically found in patent license agreements, such as provisions governing patent enforcement and the defense of any infringement claims asserted against us or our sub-licensees. The License Agreement further provides that any and all costs, obligations or liabilities related to patent infringement matters brought against us will be borne by us. We have agreed to indemnify and defend Regent Court and its affiliates against losses incurred in connection with our use, sale or other disposition of any licensed product or the exercise of any rights under the License Agreement. Regent Court has made no representations to us in any document regarding the efficacy of the licensed technology.
In December 2008, we filed a new United States patent application for a variant of our patented curing technology that results in the production of cured tobacco that contains virtually undetectable levels of carcinogenic TSNAs as measured by prevailing standards and in April 2012 the PTO issued a patent for this curing method. Also, in 2012 we filed utility applications for an enriched form of tobacco, an alkaloid composition for e-cigarettes and for a new tobacco product that are currently pending before the PTO. We believe that through the StarCured ® process and our related technology we have the ability to reduce exposure to carcinogenic TSNAs, particularly the subgroups of nitrosamines commonly referred to as NNNs and NNKs, to very low levels (with carcinogenic NNNs and NNKs that measure 200 parts per billion and below) and that we have demonstrated that our process for curing tobacco using these processes can be scaled up to meet broad commercial needs in the United States and abroad. While we have discontinued the sale of tobacco products as of December 31, 2012, we continue to pursue means of collecting royalties for our curing technology through licensing arrangements and through monitoring of the curing practices of industry participants as applicable and in 2013 we licensed certain patents for use in the manufacture and sale of low-TSNA dissolvable smokeless tobacco products to a Virginia tobacco manufacturer.
Patent Number
Date of
Issue
Description
Expiration Date
U.S. Patent No. 5,803,081
09/08/1998
Method of Treating Tobacco with Microwave Radiation to Prevent Formation of Nitrosamines
06/28/2016
U.S. Patent No. 5,845,647
12/08/1998
Tobacco Products Improved by the Use of Propolis
06/28/2016
U.S. Patent No. 6,135,121
(Reissued as RE 38,123 E)
10/24/2000
Tobacco Products Having Reduced Nitrosamine Content
06/28/2016
U.S. Patent No. 6,202,649
03/20/2001
Method of Preventing Nitrosamine Formation by Treating Tobacco in Controlled Environment
12/02/2016
U.S. Patent No. 6,311,695 B1
11/06/2001
Method of Treating Tobacco With High Frequency Energy to Prevent Nitrosamine Formation
06/28/2016
U.S. Patent No. 6,338,348 B1
01/15/2002
Method of Treating Tobacco With Microwave Energy to Prevent Nitrosamine Formation
06/28/2016
U.S. Patent No. 6,350,479 B1
02/26/2002
Method of Administering Alcohol Extracts of Tobacco
06/04/2019
U.S. Patent No. 6,425,401
07/30/2002
Method of Preventing Nitrosamine Formation By Treating Tobacco in Controlled Environment
12/02/2016
U.S. Patent No. 6,569,470 B2
05/27/2003
Method of Administering Alcohol Extracts of Tobacco
06/04/2019
U.S. Patent No. 6,668,839 B2
12/30/2003
Smokeless Tobacco Products Made from Powdered Tobacco
05/06/2021
U.S. Patent No. 6,834,654
12/28/2004
Smokeless Tobacco Product Made from Compressed Powdered Tobacco
05/01/2021
U.S. Patent No. 6,929,811 B2
8/16/2005
Method of Modulating Monoamine Oxidase (MAO) Activity Using Tobacco Alkaloids
06/04/2019
U.S. Design Patent No. D639,178
6/07/2011
Dispenser
08/03/2024
U.S. Patent No. 8,151,804
4/10/2012
Tobacco Curing Method
03/09/2030
U.S. Patent No. 8,207,346
6/26/2012
Method of Synthesizing Anatabine
10/16/2030
U.S. Patent No. 8,241,680
8/14/2012
Nutraceutical Product Containing Anatabine and Yerba Mate
7/30/2030
U.S. Patent No. 8,557,999
10/15/13
Anatabine citrate compositions and formulation
05/20/2030
Our Trademarks
We have obtained trademark protection for the brand names of the current products manufactured and sold by Rock Creek and other trade names associated with those products. Currently, we have a total of 18 registered trademarks and 4 marks that have been issued on “an intent to use” basis. In the case of our prior products, we have licensed three of our trademarks in connection with a license agreement entered into in 2007 and other trademarks relating to our low-TSNA smokeless tobacco products under a license agreement entered into in 2013.
Government Regulation
FDA Regulation
The Food and Drug Administration, regulates the safety, manufacturing, labeling, packaging, storage and distribution of dietary supplements, drugs, and cosmetic products, among others, in the United States under the Federal Food, Drug, and Cosmetic Act, or FDCA, as amended, and the Dietary Supplement Health and Education Act, or DSHEA, which amended the FDCA in 1994.
Federal Food, Drug, and Cosmetic Act. Under the FDCA and its implementing regulations, the FDA has authority for reviewing and approving any new drug product prior to its introduction into commerce in the United States. The process of seeking regulatory approval to market a pharmaceutical product is expensive and time consuming. The FDA approval process involves, among other things, successfully completing clinical trials under an Investigational New Drug Application and obtaining premarket approval after filing a New Drug Application. The NDA process requires a company to establish the safety and efficacy of a new drug product to the FDA’s satisfaction. Also, any FDA approved new drug will be subject to ongoing review and oversight by the FDA which include, among others, the submissions of safety and other post marketing information and reports including adverse events, registration requirements, compliance with current Good Manufacturing Practice (cGMP) requirements relating to quality control, quality assurance, and corresponding maintenance of records and documents, requirements regarding the distribution of samples to physicians and recordkeeping, and review and approval of labeling changes and advertising and promotional materials. Since drugs are approved for certain indications, we could not market or promote any drug products approved through the NDA process for indications that exceed FDA approval and FDA could challenge our compliance with any restrictions that may have been placed on the approval or applicable regulatory requirements. Violations of the FDCA can result in warning letters from the FDA, injunctions, product seizure, and civil and criminal penalties.
The FDA has jurisdiction over cosmetic products, including the safety, quality and labeling claims made for such products, under the FDCA, the Fair Packaging and Labeling Act, and its implementing regulations. Premarket approval is not required prior to the marketing of cosmetic products, however, the ingredients in such products must be recognized as being safe and appropriate for use in cosmetics and the FDA has authority with respect to the labeling, packaging and promotion of such products. If a product is manufactured and sold as a cosmetic, the FDA may challenge the status of that product classification or the claims being made for the product.
Dietary Supplement Health and Education Act. DSHEA amended the FDCA by defining the dietary supplement regulatory category and providing the FDA with authority over the manufacture, distribution, packaging, labeling, marketing, and quality of dietary supplements. DSHEA also requires notification to the FDA before a company begins to market a dietary supplement with a “new dietary ingredient” and, if structure or function claims are made for a product in the product labeling, notification of such claims within 30 days of the introduction of the product into commerce. DSHEA and its implementing regulations require that dietary supplements be manufactured under “good manufacturing practices” and that the label and labeling for such products meet specific requirements. DSHEA does not require prior approval by the FDA for the introduction of dietary supplements into the market, other than for “new dietary ingredients,” but does require that dietary supplement products comply with the requirements of DSHEA prior to and after their introduction into commerce. If products are manufactured and sold as dietary supplements, it is possible that the FDA may challenge the product classification, the product claims, or the indications for use.
Currently, we are marketing our Anatabloc ® and CigRx ® products as dietary supplements. We believe that we have appropriately marketed Anatabloc ® and CigRx ® as dietary supplements and only have made claims for those products that are consistent with those for dietary supplements. If Anatabloc ® or CigRx ® were determined to be a pharmaceutical product, as opposed to a dietary supplement, sale of the affected product would be considered to be in violation of the FDCA and the product would require the submission and approval of a NDA to be sold in the United States. Also, in 2009 the FDA obtained jurisdiction over the manufacturing and sale of tobacco products under the FDA Tobacco Act. We had registered as a manufacturer of low-TSNA smokeless tobacco products under the FDA Tobacco Act and the smokeless tobacco products we manufactured and sold through December 31, 2012 were required to comply with the requirements of the FDA Tobacco Act. Also, as a tobacco manufacturer, we were taxed on the sale of our smokeless tobacco products pursuant to regulations promulgated by the Tax and Trade Bureau, under authority of the Internal Revenue Code of 1986, as amended. While we ceased manufacturing and selling any tobacco products as of December 31, 2102, we were obligated for Federal Excise taxes on all products sold prior to that date.
Product Liability
Prior to the introduction of Anatabloc®, Anatabloc® Facial Crème and CigRx®, we obtained product liability insurance for each of those products. This insurance covers claims arising from product defects or claims arising out of the sale, distribution and marketing of Anatabloc ®, Anatabloc ® cosmetics and CigRx ®. There have been no claims asserted with respect to any injury arising from the use of our products to date. If any such claims are asserted in the future and ultimately result in liability that exceeds the limits of our insurance coverage, this could have a materially adverse effect on our financial condition. In 2014 a purported class action was filed with respect to the purchase of our Anatabloc® product. In that case, plaintiff seeks a refund on all persons purchasing Anatabloc® on the basis that the products were not effective for claims asserted. We have been advised by our insurance carrier that the claims asserted in this case are not covered by our product liability insurance.
In the past, we maintained product liability insurance only with respect to claims that tobacco products manufactured by or for us contained any foreign object (i.e., any object that was not intended to be included in the manufactured product). The product liability insurance previously maintained did not cover health-related claims such as those that have been made against the major manufacturers of tobacco products. We do not believe that insurance for health-related claims can currently be obtained. Although we ceased selling cigarettes in 2007 and exited from the tobacco business as of December 31, 2012, we may be named as a defendant in such cases in the future. However, we believe that we have conducted our business in a manner that decreases the risk of liability in a lawsuit of the type described above, because we have attempted to consistently present to the public the most current information regarding the health risks of long-term smoking and tobacco use generally, have always acknowledged the addictive nature of nicotine and have never targeted adolescent or young persons as customers.
Our Employees and Consultants
As of December 31, 2013, we employed 25 full-time employees, as compared to 23 employees as of December 31, 2012.
From time to time, we engage temporary personnel to augment our regular employee staff. Further, we utilize the services of consultants, scientific and technical experts and, from time-to-time, independent contractors to provide key functions in the scientific, medical, public healthcare, compliance, technology, legal, communications, financial and related fields. The use of such third-party providers enables us to secure unique expertise on both a formal and informal basis in a wide variety of areas that we might otherwise not be in a position to obtain or which we would otherwise be required to obtain through the hiring of additional employees at a potentially greater cost to us. Substantially all of our research and development efforts have been, and are expected to continue to be, conducted pursuant to contractual arrangements with universities, scientific, medical and public health consultants, independent investigators and research organizations.
Discontinued Operations
We exited the cigarette business in June 2007 and discontinued the sale of our low-TSNA smokeless tobacco products as of December 31, 2012. Although we no longer manufacture or sell any tobacco products, we continue to look for licensing opportunities related to our low-TSNA curing technology and our related products. See Note 3 to our consolidated financial statements included in “Item 15, Exhibits, Financial Statement Schedules.”
Internet Address and Internet Access to Periodic and Current Reports
Our Internet address is www.starscientific.com. You may obtain through our Internet website, free of charge, copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and Proxy Statements on Schedule 14A, including any amendments to those reports or other information filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act. These reports will be available as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission, or SEC. You can also obtain these reports directly from the SEC at its website, www.sec.gov, or you may visit the SEC in person at the SEC’s Public Reference Room at Station Place, 100 F. Street, N.E., Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. We will also provide a copy of our annual report on Form 10-K free of charge upon any written request by a shareholder.
Financial information about our business segments, product sales and research and development expenses are included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Notes to our Consolidated Financial Statements.
ITEM 1A.
ITEM 1A. RISK FACTORS
This section highlights specific risks that could affect our company and its businesses. Readers should carefully consider each of the following risks and all of the other information set forth in this Annual Report on Form 10-K. Based on the information currently known to us, we believe the following information identifies the most significant risk factors affecting our company. However, the risks and uncertainties our company faces are not limited to those described below. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business. If any of the following risks and uncertainties develops into actual events or if the circumstances described in the risks and uncertainties occur or continue to occur, these events or circumstances could have a material adverse effect on our business, financial condition, results of operations, cash flows or liquidity. These events could also have a negative effect on the trading price of our common stock.
Risks Related to our Financial Condition
We expect to have limited product revenue in the foreseeable future.
In 2013, almost all of our revenue was derived from sales of our Anatabloc ® dietary supplement. In late 2013, we announced that, while we expect to continue our nutraceutical supplement and cosmetic lines of business, we intend to shift to a greater focus on pharmaceutical products. The revenue generated from our nutraceutical supplement and cosmetic products has not historically exceeded our operating expenses, and given our shift in focus away from these lines of business, we do not expect such revenues to exceed operating expenses in the foreseeable future, particularly given the fact that the status of these products as dietary supplements is the subject of a warning letter that we received from the FDA in December 2013. We anticipate that our future revenue will be highly dependent on the successful development and commercialization of one or more new pharmaceutical products. We currently do not have any pharmaceutical product candidates in advance development stage, and there can be no assurance that we will ever develop a product candidate that will generate revenue. Even if we successfully develop one or more product candidates, until, and unless, we receive approval from the FDA, we will not be permitted to sell, and will not generate any revenue from, such drugs.
We are not currently profitable and might never become profitable.
We have a history of losses and expect to incur substantial losses for the foreseeable future, and we might never achieve or maintain profitability. Our future prospects will be dependent on the successful development and commercialization of one or more new pharmaceutical products. We do not currently have any pharmaceutical products in advance development stage or on the market, and because it takes years to develop, test and obtain regulatory approval for pharmaceutical products before they can be sold, we likely will continue to incur substantial losses for the foreseeable future. Our net losses were approximately $(38.0) million for the year ended December 31, 2011, $(22.9) million for the year ended December 31, 2012 and $(32.8) million for the year ended December 31, 2013. Our accumulated deficit as of December 31, 2013 was approximately $(264.4) million. Actual losses will depend on a number of considerations, including:
·
the pace and success of drug development activities;
·
possible out-licensing of any product candidates we develop;
·
obtaining regulatory approvals for any product candidates we develop;
·
the pace of development of new intellectual property for any product candidates we develop;
·
implementing additional internal systems and infrastructure;
·
our ability to continue to market and sell our existing products; and
·
changes in existing staffing levels.
To become and remain profitable, we must succeed in developing and commercializing drugs with significant market potential. This will require us to be successful in a range of challenging activities, including the development of product candidates, successful completion of preclinical testing and clinical trials of our product candidates, obtaining regulatory approval for these product candidates and manufacturing, marketing and selling those products for which we may obtain regulatory approval. We are only in the preliminary stages of these activities. We may never succeed in these activities and may never generate revenues that are large enough to achieve profitability. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. Our failure to become or remain profitable could depress the market price of our common stock and could impair our ability to raise capital, expand our business, diversify our product offerings or continue our operations.
We may not be able to secure financing necessary to operate and grow our business.
The recurring losses generated by our operations continue to impose significant demands on our liquidity. Over the last several years our liquidity demands have been met principally by private placements of our common stock and from the exercise of related warrants and stock options. In 2013 our company received proceeds of approximately $7.7 million from warrant exercises. See Note 8 to our consolidated financial statements included in “Item 15. Exhibits, Financial Statement Schedules” for further details of these transactions. On March 12, 2014, we entered into a series of equity and financing transactions that resulted in gross cash proceeds to our Company of approximately $9.3 million and cash availability under a credit facility of $5.8 million, for total funds available of $15.1 million. Under one transaction, holders of previously held warrants with strike prices ranging from $1.50 to $2.00 agreed to immediately exercise on an aggregate of 4.2 million warrants at a reduced strike price of $1.00 per share. The investors also were issued new warrants for an equal number of shares that have a term of seven years and a strike price of $1.00 per share. This transaction resulted in proceeds of approximately $4.2 million. Under another transaction we sold 5.1 million shares with matching warrants for 5.1 million shares to other investors at $1.00 for the shares and warrant shares. This transaction resulted in proceeds to us of $5.1 million. Finally, we entered into a credit facility with another investor under which that investor agreed to loan us up to $5.8 million (subject to certain limitations). The credit facility provides for an annual interest rate of 3% on any funds drawn by us. It also provides the lender with the option to convert any loan amount to a unit of our common stock and a matching seven-year warrant at a conversion price of $1.00 per unit. We believe that with this recent transaction we have sufficient funds to support our operations through the first quarter 2015. However, our business and operations may consume resources faster than we anticipate, and depending upon market conditions and the price of our common stock, we may decide to seek additional funds before that time. Additional financing may not be available on favorable terms, if at all. If adequate funds are not available on acceptable terms, we may be unable to fund our operations or the expansion of our research and development efforts, which could materially harm our business. Further, if we issue additional equity securities, existing stockholders will experience dilution.
Risks Related to our Pharmaceutical Business
Even if we file an IND, there can be no assurance that an IND will result in the actual initiation of clinical trials or that our products will ultimately be approved or achieve or maintain expected levels of market acceptance.
In late 2013, we announced our intention to shift our focus to pharmaceutical products, given our belief in the potential for greater revenue growth through pharmaceutical product sales. However, we do not currently have any pharmaceutical products in the advance development stage, and we will be required to file an IND application related to any new pharmaceutical products we intend to introduce. While we intend to file IND applications during the second quarter 2014, the filing of an IND could be delayed if there is difficulty in assembling scientific data necessary to support the IND application. In addition, once an IND application is filed, the FDA could impose a regulatory hold on the initiation of clinical trials, if the FDA believes that the data supporting the IND are insufficient and marketing cannot begin until we obtain necessary data to submit an NDA and receive FDA approval.
Even if we are able to obtain and maintain regulatory approvals for our new pharmaceutical products, generic or branded, the success of these products is dependent upon achieving and maintaining market acceptance. Commercializing products is time consuming, expensive and unpredictable. There can be no assurance that we will be able to, either by ourselves or in collaboration with partners or through licensees, successfully commercialize new products or gain market acceptance for such products. New product candidates that appear promising in development may fail to be approved or to reach the market or may have only limited or no commercial success.
Further, the discovery of significant problems with a product similar to one of our products that implicate (or are perceived to implicate) an entire class of products could have an adverse effect on the regulatory status of the products or sales of the affected products. Accordingly, new data about our products (particularly as related to the anatabine compound), or products similar to our products, could negatively impact FDA approval or demand for our products due to real or perceived side effects or uncertainty regarding efficacy and, in some cases, could result in product withdrawal.
Any drug products that we bring to the market may not gain market acceptance by physicians, patients, third party payors, and others in the medical community. If these products do not achieve an adequate level of acceptance, we may not generate significant product revenue and we may not become profitable. The degree of market acceptance of our product candidates, if approved for commercial sale, will depend on a number of factors, including:
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the prevalence and severity of any side effects, including any limitations or warnings contained in a product’s approved labeling;
·
the efficacy and potential advantages over alternative treatments;
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the pricing of our product candidates;
·
relative convenience and ease of administration;
·
the willingness of the target patient population to try new therapies and of physicians to prescribe these therapies;
·
the strength of marketing and distribution support and timing of market introduction of competitive products;
·
publicity concerning our products or competing products and treatments; and
·
sufficient third party insurance coverage or reimbursement.
Even if a potential product displays a favorable efficacy and safety profile in preclinical and clinical trials, market acceptance of the product will not be known until after it is launched. Our efforts to educate patients, the medical community, and third party payors on the benefits of our product candidates may require significant resources and may never be successful. Such efforts to educate the marketplace may require more resources than are required by the conventional technologies marketed by our competitors.
The drug development business is very capital intensive, and our research and development efforts may be curtailed by our lack of available research funds.
The drug development business is very capital intensive, particularly for early stage companies that do not have significant off-setting revenues. Even if we are successful in filing an IND, our product development initiatives will be substantially dependent on our ability to continue our research initiatives and to obtain the funding necessary to support these initiatives. Our inability to continue these initiatives and initiate new research and development efforts could result in a failure to develop new products or to improve upon existing products, which could have a material and adverse impact on our sales, operating income and cash flows.
If we are not successful in managing the preclinical development activities and clinical trials we might not be able to commercialize our products.
We have not obtained regulatory approval nor commercialized any drug product candidates. Our limited experience might prevent us from successfully designing or implementing any clinical trials. If we are not successful in conducting and managing our pre-clinical development activities or clinical trials or obtaining regulatory approvals, we might not be able to commercialize our developmental product candidates, or might be significantly delayed in doing so, which may materially harm our business.
Our drug development program may depend upon third-party researchers who are outside our control.
We may depend upon independent clinical research organizations, investigators and other collaborators, such as universities and medical institutions, to conduct our preclinical and clinical trials under agreements with us. These collaborators may not be our employees and, if so, we will not be able to control the amount or timing of resources that they devote to our programs. They might not assign as great a priority to our programs or pursue them as diligently as we would if we were undertaking such programs ourselves. If outside collaborators fail to devote sufficient time and resources to our drug development programs, if their performance is substandard or the FDA determines there are issues upon review of the study data, the approval of our FDA applications, if any, and our introduction of new drugs, if any, will be delayed. If we cannot successfully enter into new agreements with outside collaborators on acceptable terms, or if we encounter disputes over or cannot renew or, if necessary, amend existing agreements, the development of our drug candidates could be delayed. These collaborators might also have relationships with other commercial entities, some of which might compete with us. If our collaborators assist our competitors at our expense, our competitive position may be harmed.
We may be subject to competition from other dietary supplements that have anatabine as their active dietary ingredient.
We expect much of our research and development efforts will focus on developing our anatabine compound as a potential drug candidate. Because anatabine is the principal compound for our dietary supplement products, there is risk that any pharmaceutical product that we develop with respect to anatabine may experience competition with other dietary supplements.
See also “Regulatory Risks” below for additional risks related to our pharmaceutical business.
Risks Related to our Nutraceutical Supplement and Cosmetic Lines of Business
In response to our receipt of an FDA warning letter in December 2013, we have substantially limited the marketing and advertising of our dietary supplements.
On December 24, 2013, we received a warning letter from the FDA regarding our CigRx® and Anatabloc® dietary supplements. In the letter, the FDA asserted that CigRx® and Anatabloc® were not properly marketed as dietary supplements, since we had not filed a New Dietary Ingredient Notification for anatabine as a dietary ingredient prior to the introduction of our dietary supplements. The FDA also claimed that certain materials on our websites, including published research articles, contained drug claims for Anatabloc®. We responded to the letter on January 31, 2014. We are currently communicating with the FDA in an effort to reach an amicable resolution of the issues asserted in the warning letter. In light of our receipt of the FDA letter, we have substantially limited the marketing and advertising of our dietary supplements. Moreover, if we are not able to resolve the issues raised by the FDA we may not be in a position to continue to market Anatabloc® and CigRx® as dietary supplements. Our inability to market our dietary supplements could materially adversely impact our business, particularly since the sale of supplements is our only source of substantive revenue.
There can be no assurance that we will be successful in developing a “time-release” version of our Anatabloc® dietary supplement, or that such version will gain market acceptance.
We had been developing a “time-release” version of our Anatabloc® dietary supplement. We are not proceeding with the development of a time-release version of Anatabloc® at this time. However, if we decide to move forward on a time-recourse product, there can be no assurance that we will be successful in ultimately bringing a time-release version of Anatabloc® to market and it is possible that we will not be able to introduce this product as a dietary supplement given the position taken by the FDA with respect to our current dietary supplements. If we were to introduce a time-release product, there can be no assurance that the supplement will gain market acceptance.
We have limited retail or independent distributors selling our Anatabloc® dietary supplement and our cosmetic products and a loss or material reduction in our existing distribution channels could result in reduced sales of our products.
Anatabloc®, which is intended to provide anti-inflammatory support, is currently being sold through our interactive website, a customer service center and on a consignment basis through GNC, a retailer of dietary supplements. GNC initially sold Anatabloc ® through its online store and, beginning in late March 2012, GNC began carrying Anatabloc ® at its company-owned stores and franchised retail locations. Initially, marketing of Anatabloc ® was directed toward physicians and other healthcare professionals. More recently we have been focusing our marketing efforts on athletes and other groups of individuals who are frequently seeking to maintain healthy levels of inflammation. Through Rock Creek we have also been developing extensions of our Anatabloc ® product line. We introduced an unflavored version of Anatabloc ® in the second quarter 2012 and introduced into the market Anatabloc ® Facial Crème in September, 2012 as a cosmetic to improve the appearance of the skin and Anatabloc® Revitalizing Facial Serum and Anatabloc® Clarifying Facial Cleanser in 2013. Our Anatabloc® Facial Crème and Revitalizing Facial Serum are available at GNC’s online store and at select GNC franchise locations. Our success in marketing our dietary supplements and our cosmetic products will be dependent upon the willingness and ability of retail distributors to market and sell our products to consumers, as well as our success in developing new distribution channels for our dietary supplements and cosmetic products. If our distribution arrangement with GNC terminated or if GNC reduced the quantity of our products it carries or promotes, or if we are unable to open new distribution channels for our products, our financial condition and results of operations could be adversely affected.
Independent retailers and distributors generally purchase products from us on a purchase-order basis and do not have long-term contracts with us. Consequently, with little or no notice and without penalty, our independent retail and independent distributors may terminate their relationships with us or materially reduce the level of their purchases of our products. If this were to occur with one or more retail or independent distributors, who purchase significant quantities of our products, it may be difficult for us to establish substitute relationships in a timely manner, which could have a material adverse effect on our financial condition and results of operations.
We are dependent on domestic sales of our Anatabloc® and CigRx® dietary supplements and for sales of our Anatabloc ® cosmetic products.
Virtually all of our revenues beginning January 1, 2013 are derived from sales of our dietary supplements, Anatabloc® and CigRx® and our cosmetic products. While Anatabloc ® is available for shipment to numerous foreign countries outside the United States, sales outside the United States have been limited and we do not have any direct distribution arrangements for Anatabloc ® or our cosmetic products outside of the U.S.
Our products are subject to ongoing FDA oversight. If we experience product recalls or regulatory action, we may incur significant and unexpected costs and our business reputation could be materially adversely affected.
Dietary supplements are subject to a wide array of regulatory requirements which include, among others, compliance with current Good Manufacturing Practice regulations, labeling and marketing requirements, new dietary ingredient notifications, structure/function claims notification, adverse event reporting, and record keeping, Cosmetic products are subject to fewer regulatory requirements, but they must comply with the quality and labeling requirements prescribed by the FDA. Failure to comply with applicable FDA requirements could result in sanctions being imposed on us, including warning letters, product recalls, seizures, injunctions, or criminal prosecution. We may be exposed to product recalls and adverse public relations if our dietary supplement products or our cosmetic products are alleged to cause illness or injury, or if we are alleged to have violated governmental regulations. A product recall and/or responding to a regulatory action could result in substantial and unexpected expenditures, which could reduce operating profits and cash flow. In addition, a product recall may require significant management time and attention and may adversely impact the value of our brands. Product recalls may lead to greater scrutiny by federal or state regulatory agencies and increased litigation, which could have a material adverse effect on our financial condition and results of operations.
We may face disruptions relating to the manufacture and sale of Anatabloc®, CigRx ® and our Anatabloc® cosmetics based on the fact that we have arranged for third parties to manufacture and distribute these products.
In order to facilitate the launch of Anatabloc®, CigRx® and our Anatabloc® cosmetics, and to limit capital expenditures, we have outsourced the manufacturing, storage, order processing and delivery of these products through contracts and arrangements with a number of third-party contractors. In a number of cases our arrangement with our contractors are on a sole source basis. If our contractors experience delays or disruptions that could adversely impact their ability to meet our manufacturing and distribution needs. In the event that our third-party contractors are unable to meet our needs, we would need to find alternative sources for the manufacturing and/or distribution of Anatabloc ®, CigRx ®, and our Anatabloc® cosmetics which may be difficult to obtain in a timely and cost effective manner, or at all. Also, if sales volumes for Anatabloc ® , CigRx ® and our Anatabloc® cosmetics increase substantially over a short period of time, our current contractors may have difficulty meeting our manufacturing and supply demands. In the event we are not able to obtain adequate amounts of Anatabloc ® , CigRx ® and our Anatabloc® cosmetics or if we are not able to supply product to consumers on a timely basis, our customers may seek to fulfill their supply needs by purchasing competing products, which, in turn, would reduce our market share and ability to successfully commercialize Anatabloc ® , CigRx ®, and our Anatabloc® cosmetics which could have a material adverse effect on our results of operations, financial position and cash flows.
Regulatory Risks
If we are not able to obtain and maintain required regulatory approvals for any new pharmaceutical candidates we develop, we will not be able to commercialize such product candidates, and our ability to generate revenue will be materially impaired.
Any pharmaceutical business and any pharmaceutical product candidates we develop are subject to extensive regulation by the FDA and other regulatory agencies in the United States and by comparable authorities in other countries. Failure to adhere to regulations set out by these bodies for one or more of our commercial products could prevent us from commercializing the product candidate in the jurisdiction of the regulatory authority. We have only limited experience in meeting the regulatory requirements incumbent on the sale of drugs in the United States and elsewhere. If we fail to adequately adhere to the regulation on drug sales we may be unable to sell our products, which could have a material effect on our ability to generate revenue.
Any product candidates and the activities associated with their development and commercialization, including testing, manufacture, safety, efficacy, recordkeeping, labeling, storage, approval, advertising, promotion, sale and distribution, are subject to comprehensive regulation by the FDA and other regulatory agencies in the United States and by comparable authorities in other countries. Failure to obtain regulatory approval for a product candidate will prevent us from commercializing the product candidate in the jurisdiction of the regulatory authority. We have not obtained regulatory approval to market any product candidate in any jurisdiction.
Securing FDA approval requires the submission of extensive preclinical and clinical data and supporting information to the FDA for each therapeutic indication to establish the product candidate’s safety and efficacy. Securing FDA approval also requires the submission of information about the product manufacturing process to, and inspection of manufacturing facilities by, the FDA. Our future products may not be effective, may be only moderately effective or may prove to have undesirable or unintended side effects, toxicities or other characteristics that may preclude our obtaining regulatory approval or prevent or limit commercial use.
Our product candidates may fail to obtain regulatory approval for many reasons, including:
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our failure to demonstrate to the satisfaction of the FDA or comparable regulatory authorities that a product candidate is safe and effective for a particular indication;
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the results of clinical trials may not meet the level of statistical significance required by the FDA or comparable regulatory authorities for approval;
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our inability to demonstrate that a product candidate’s benefits outweigh its risks;
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our inability to demonstrate that the product candidate presents an advantage over existing therapies;
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the FDA’s or comparable regulatory authorities’ disagreement with the manner in which we interpret the data from preclinical studies or clinical trials;
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the FDA’s or comparable regulatory authorities’ failure to approve the manufacturing processes, quality procedures or manufacturing facilities of third party manufacturers with which we contract for clinical or commercial supplies; and
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a change in the approval policies or regulations of the FDA or comparable regulatory authorities or a change in the laws governing the approval process.
The process of obtaining regulatory approvals is expensive, often takes many years, if approval is obtained at all, and can vary substantially based upon a variety of factors, including the type, complexity and novelty of the product candidates involved. Changes in regulatory approval policies during the development period, changes in or the enactment of additional statutes or regulations, or changes in regulatory review for each submitted product application may cause delays in the approval or rejection of an application. The FDA and non-United States regulatory authorities have substantial discretion in the approval process and may refuse to accept any application or may decide that our data is insufficient for approval and require additional preclinical, clinical or other studies. In addition, varying interpretations of the data obtained from preclinical and clinical testing could delay, limit or prevent regulatory approval of a product candidate. Any regulatory approval we ultimately obtain may be limited or subject to restrictions or post approval commitments that render the approved product not commercially viable. Any FDA or other regulatory approval of our product candidates, once obtained, may be withdrawn, including for failure to comply with regulatory requirements or if clinical or manufacturing problems follow initial marketing.
We will need to obtain FDA approval of any proposed product brand names, and any failure or delay associated with such approval may adversely impact our business.
A pharmaceutical product cannot be marketed in the U.S. or other countries until we have completed rigorous and extensive regulatory review processes, including approval of a brand name. Any brand names we intend to use for our product candidates will require approval from the FDA regardless of whether we have secured a formal trademark registration from the U.S. Patent and Trademark Office. The FDA typically conducts a review of proposed product brand names, including an evaluation of potential for confusion with other product names. The FDA may also object to a product brand name if it believes the name inappropriately implies medical claims. If the FDA objects to any of our proposed product brand names, we may be required to adopt an alternative brand name for our product candidates. If we adopt an alternative brand name, we would lose the benefit of our existing trademark applications for such product candidate and may be required to expend significant additional resources in an effort to identify a suitable product brand name that would qualify under applicable trademark laws, not infringe the existing rights of third parties and be acceptable to the FDA. We may be unable to build a successful brand identity for a new trademark in a timely manner or at all, which would limit our ability to commercialize our product candidates.
If we are successful in obtaining approval for any drug candidates, we will be subject to various laws and regulations, including "fraud and abuse" laws and anti-bribery laws, and a failure to comply with such laws and regulations or prevail in any litigation related to noncompliance could have a material adverse impact on our business, financial condition and results of operations and could cause the market value of our common stock to decline.
Pharmaceutical companies have faced lawsuits and investigations pertaining to violations of health care “fraud and abuse” laws, such as the federal False Claims Act, the federal Anti-Kickback Statute, the U.S. Foreign Corrupt Practices Act or FCPA, and other state and federal laws and regulations. We also face increasingly strict data privacy and security laws in the U.S. and in other countries, the violation of which could result in fines and other sanctions. The United States Department of Health and Human Services Office of Inspector General recommends and, increasingly states, requires pharmaceutical companies to have comprehensive compliance programs and to disclose certain payments made to healthcare providers or funds spent on marketing and promotion of drug products. If we are in violation of any of these requirements or any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant impact on our business, including the imposition of significant fines, exclusion from federal healthcare programs or other sanctions.
The FCPA and similar worldwide anti-bribery laws generally prohibit companies and their intermediaries from making improper payments to officials for the purpose of obtaining or retaining business. Our policies mandate compliance with these anti-bribery laws. We cannot assure you that our internal control policies and procedures will protect us from reckless or criminal acts committed by our employees or agents. Violations of these laws, or allegations of such violations, could disrupt our business and result in criminal or civil penalties or remedial measures, any of which could have a material adverse effect on our business, financial condition and results of operations and could cause the market value of our common stock to decline.
Our product candidates may cause undesirable side effects or have other properties that could delay or prevent their regulatory approval or commercialization.
Undesirable side effects caused by any future pharmaceutical product candidates could interrupt, delay or halt clinical trials and could result in the denial of regulatory approval by the FDA or other regulatory authorities for any or all targeted indications, and in turn prevent us from commercializing such product candidates and generating revenues from their sale.
In addition, if any product candidates receive marketing approval and we or others later identify undesirable side effects caused by the product:
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regulatory authorities may require the addition of restrictive labeling statements;
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regulatory authorities may withdraw their approval of the product; and
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we may be required to change the way the product is administered or conduct additional clinical trials.
Any of these events could prevent us from achieving or maintaining market acceptance of the affected product or could substantially increase the costs and expenses of commercializing the product candidate, which in turn could delay or prevent us from generating significant revenues from its sale or adversely affect our reputation.
Any product for which we obtain marketing approval could be subject to restrictions or withdrawal from the market and we may be subject to penalties if we fail to comply with regulatory requirements or if we experience unanticipated problems with our products, when and if any of them are approved.
Any product for which we obtain marketing approval, along with the manufacturing processes, post approval clinical data, labeling, advertising and promotional activities for such product, will be subject to continual requirements of and review by the FDA and comparable regulatory authorities. These requirements include submissions of safety and other post marketing information and reports, registration requirements, cGMP requirements relating to quality control, quality assurance and corresponding maintenance of records and documents, requirements regarding the distribution of samples to physicians and recordkeeping. Even if we obtain regulatory approval of a product, the approval may be subject to limitations on the indicated uses for which the product may be marketed or to the conditions of approval, or contain requirements for costly post marketing testing and surveillance to monitor the safety or efficacy of the product. We also may be subject to state laws and registration requirements covering the distribution of our products. Later discovery of previously unknown problems with our products, manufacturers or manufacturing processes, or failure to comply with regulatory requirements, may result in actions such as:
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restrictions on such products, manufacturers or manufacturing processes;
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warning letters;
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withdrawal of the products from the market;
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refusal to approve pending applications or supplements to approved applications that we submit;
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voluntary or mandatory recall;
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fines;
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suspension or withdrawal of regulatory approvals or refusal to approve pending applications or supplements to approved applications that we submit;
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refusal to permit the import or export of our products;
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product seizure or detentions;
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injunctions or the imposition of civil or criminal penalties; and
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adverse publicity.
If we, or our suppliers, third party contractors, clinical investigators or collaborators are slow to adapt, or are unable to adapt, to changes in existing regulatory requirements or adoption of new regulatory requirements or policies, we or our collaborators may lose marketing approval for our products when and if any of them are approved, resulting in decreased revenue from milestones, product sales or royalties.
Other Business Risks
We have responded to subpoenas in a government investigation and are subject to several pending class actions and derivative action cases, and our expenses and cash demands related to these matters have been and could continue to be material.
In late January and February 2013 our company, directors and others received subpoenas from the United States Attorney’s Office, or USAO, for the Eastern District of Virginia seeking documents. We believe we have responded to substantially all of the issues being reviewed by the USAO. In addition, the international law firm of Chadbourne & Parke LLP conducted an internal investigation of these matters and that investigation was substantially completed in late June 2013.
We incurred substantial legal expenses in connection with the government and internal investigations discussed above in 2013. We expect to continue to incur additional legal expenses in 2014 in connection with the USAO investigation which has resulted in an indictment against former Governor Robert McDonnell and his wife, Maureen McDonnell. We also expect to continue to incur legal expenses (and related cash demands) in connection with the civil actions and other matters discussed under “Part II-Item 1 - Legal Proceedings” and such expenses and cash demands relating to those matters may be material. While we expect that much of the cost related to the ongoing securities class action and derivative actions discussed in Part II-Item I will be covered by insurance, we cannot provide any assurances with respect to the outcome of the pending actions, or action yet to arise, including that such claims will not exceed the limits of our insurance policies.
We may lose our key personnel or fail to attract and retain additional personnel.
Effective December 27, 2013, our former Chief Executive Officer, Jonnie R. Williams and our former President and Chief Operating Officer, Paul L. Perito, resigned from their positions with the Company as part of our corporate transition. Our future operations will depend in large part on the efforts of our new Chairman and Chief Executive Officer, Michael J. Mullan, MBBS (MD), PhD and our new President, Christopher C. Chapman, MD In addition, we are highly dependent upon the continued services of our incumbent senior management team for our continued success. The loss of any of the officers could have a serious negative impact on our business and operating results.
Our future success also depends in large part on our ability to attract and retain, on a continuing basis, consulting services from highly qualified scientific, technical, management, financial and marketing personnel. Competition for such personnel is intense and there can be no assurance that we will be able to attract and retain the personnel necessary for the development and operation of our business or that given the operating losses we have suffered over the past eleven years we will have the financial ability to do so. The loss of the services of key personnel or the termination of relationships with independent scientific and medical investigators could have a material and adverse effect on our business.
We have experienced a significant change in the composition of our Board of Directors and senior management.
On December 27, 2013, Dr. Mullan became our new Chief Executive Officer and Dr. Chapman became our new President. In addition, our shareholders recently elected five new directors to our Board of Directors and one of our directors left office in February 2014 due to other business commitments. The failure of our directors or any new members of management to perform effectively could have a significant negative impact on our business, financial condition and results of operations. In addition, our Board of Directors and management have begun to institute strategies focusing more effort on drug development that differ from those we had been applying previously. These new strategies may take management a significant amount of time to fully implement. If these new strategies are unsuccessful or if we are unable to execute them successfully, there could be a significant negative impact on our business, financial condition, and results of operations.
If we are unable to protect our intellectual property rights, our competitive position could be harmed and we could be required to incur significant expenses to enforce our rights.
Our future success will depend in part on obtaining patent and other intellectual property protection for the technology related to our products, and on successfully defending our patents and other intellectual property against third-party challenges. In particular, this will include obtaining patent protection for the technology relating to the manufacture and uses of anatabine in our pharmaceutical product candidates, dietary supplements and cosmetic products based on the patents issued to date for the improved synthesis of anatabine, the composition used in our CigRx® product, and utility applications filed to date and our success in commercially marketing the curing technology for which we have exclusive patent rights under our license arrangement with Regent Court. This will depend in large part on our ability to continue to protect the patents related to the synthesis of anatabine and our anatabine yerba mate composition as well as our low-TSNA tobacco curing technology and related products, to obtain further patent protection for our technology in the United States and other jurisdictions and to operate without infringing upon the patents and proprietary rights of others.
We do not know whether we will obtain the patent protection we seek through our existing patents, patent applications that are pending or patent applications that we file in the future, or that the protection we do obtain will be found valid and enforceable, if challenged. If we fail to obtain adequate protection of our intellectual property, or if any protection we obtain is reduced or eliminated, others could use our intellectual property without compensating us, resulting in harm to our business. We may also determine that it is in our best interests to voluntarily challenge a third party’s products or patents in litigation or administrative proceedings, including patent interferences or reexaminations. In the event that we seek to enforce any of our owned or exclusively licensed patents against an infringing party, it is likely that the party defending the claim will seek to invalidate the patents we assert. If successful this could result in the loss of the entire patent or the relevant portion of our patent, which would not be limited to any particular party. Any litigation to enforce or defend our patent rights, even if we were to prevail, could be costly and time-consuming and could divert the attention of our management and key personnel from our business operations. Our competitors may independently develop similar or alternative technologies or products without infringing any of our patents or other intellectual property rights, or may design around our proprietary technologies.
United States patents and patent applications may also be subject to interference proceedings and United States patents may be subject to reexamination proceedings and other post-grant challenges in the PTO. Foreign patents may be subject to opposition or comparable proceedings in the corresponding foreign patent offices’, and those proceedings could result in either loss of the patent or denial of the patent application, or loss or reduction in the scope of one or more of the claims of the patent or patent application. In addition, such interference, reexamination and opposition proceedings may be costly. Thus, any patents that we own or license from others may provide limited or no protection against competitors. Our pending patent applications, those we may file in the future, or those we may license from third parties, may not result in patents being issued. If issued, they may not provide us with proprietary protection or competitive advantages against competitors with similar technology.
We may also rely on unpatented trade secrets and know-how to maintain our competitive position, that we seek to protect, in part, by confidentiality agreements with employees, consultants, suppliers and others. There can be no assurance that these agreements will not be breached or terminated, that we will have adequate remedies for any breach, or that our trade secrets will not otherwise become known or be independently discovered by competitors.
Product liability lawsuits against us could cause us to incur substantial liabilities and to limit commercialization of any products that we may develop.
We face an inherent business risk of exposure to significant product liability and other claims in the event that the use of our products cause, or is alleged to have caused, adverse effects. Furthermore, our products may cause, or may appear to have caused, adverse side effects (including death) or potentially dangerous drug interactions that we may not learn about or understand fully until the drug has been administered to patients for some time. The withdrawal of a product following complaints and/or incurring significant costs, including the requirement to pay substantial damages in personal injury cases or product liability cases, could have a material adverse effect on our business, financial condition and results of operations and could cause the market value of our common stock to decline.
Prior to the introduction of Anatabloc®, our Anatabloc® cosmetics and CigRx® we obtained product liability insurance for these products as dietary supplements and as cosmetics. This insurance covers claims arising from product defects or claims arising out of the sale, distribution and marketing of our Anatabloc ®, Anatabloc ® cosmetics and CigRx ® products. In 2014 a purported class action was filed with respect to the purchase of our Anatabloc® product. In that case, plaintiff seeks a refund on behalf of all persons purchasing our dietary supplement on the basis that the product was not effective for claims allegedly asserted by our company. We have been advised by our insurance carrier that our product liability insurance does not cover the claims asserted in this action.
We are not, nor have we ever been, named as a defendant in any legal proceedings involving claims arising out of the sale, distribution, manufacture, development, advertising, marketing and claimed health effects relating to the use of our tobacco products. While we exited the tobacco business as of December 31, 2012, we could have claims asserted against us in connection with our prior manufacture and sale of such products. While we believe the risk of being named a defendant in such a lawsuit is relatively low, we could be named as a defendant in such litigation, as there has been a noteworthy increase in the number of these cases pending. Punitive damages, often in amounts ranging into the hundreds of millions, or even billions of dollars, are asserted in a number of these cases in addition to compensatory and other damages. We currently do not have and do not believe that insurance coverage for health-related claims arising from the use of tobacco products can be obtained. If, in the future, we are named as a defendant in any actions related to our smoked or smokeless tobacco products, we will not have insurance coverage for damages relating to any such claims, which could have a material adverse effect on our financial condition.
We have had substantial obligations under state laws adopted under the Master Settlement Agreement.
In November 1998, 46 states and the District of Columbia, or the Settling States, entered into the Master Settlement Agreement, or MSA, to resolve litigation that had been instituted against the major tobacco manufacturers. We did not join the MSA and while we manufactured and sold cigarette products we were required to satisfy certain escrow obligations pursuant to statutes that the MSA required the Settling States to adopt in order for such states to receive the full benefits of the settlement. We discontinued the sale of any cigarette products in June 2007 and we sold the rights, title and interest in and to all income from and reversionary interest in our MSA escrow accounts in May 2007. Although we sold the rights in and to all income from and reversionary interest in the funds deposited into the MSA escrow accounts for sales through 2006, these MSA escrow funds remain in our name and the principal amount of these accounts will be available to satisfy portions of any state judgments or settlements for the type of claims asserted against the major tobacco manufacturers in the suits that resulted in the negotiation of the MSA, notwithstanding that we stopped selling cigarettes in 2007 and exited from the tobacco industry completely as of December 31, 2012. Moreover, if such claims are successfully asserted in litigation against us in the future, the claims could exceed the amounts that have been deposited into escrow under the MSA which could adversely affect our operating income and cash flows.
If we do not effectively manage our growth, we may be unable to successfully develop, market and sell our products.
Our future revenue and operating results will depend on our ability to manage the anticipated growth of our business. If we are successful in increasing market acceptance for our products, we will be required to manage substantial volume from our customers. To accommodate any such growth and compete effectively, we will be required to attract, integrate, motivate and retain additional highly skilled sales, technical and other employees. We face competition for these people. Also, we will have to maintain sufficient capacity for the contract manufacturing of our pharmaceutical, dietary supplement and cosmetic products. There can be no assurance that we can overcome the challenge of scaling up our processing and production operations, that our personnel, systems, procedures and controls will be adequate to support our future operations or that we will be able to increase or secure additional capacity through third-party contractors for the manufacturing, sale and distribution of our products. Any failure to implement and improve our operational, financial and management systems, to attract, integrate, motivate and retain additional employees required by future growth, if any, or to secure any needed capacity through third party contractors, if required, could have a material adverse effect on our business and prospects, financial condition and results of operations.
Risks Related to our Common Stock
We have many potentially dilutive derivative securities outstanding and the issuance of these securities as well as the future sales of our common stock could have a dilutive effect on current stockholders.
At March 10, 2014, we had outstanding options granted to directors, employees and consultants to purchase approximately 22,395,000 shares of our common stock, with a weighted-average exercise price of $2.27 per share, of which options for 17,435,000 shares were exercisable at March 10, 2014. We also had outstanding warrants, exercisable into 10,649,832 shares of our common stock, with a weighted-average exercise price of $1.87 per share. Exercise of outstanding stock options or warrants would cause dilution, which could adversely affect the market price of our common stock. If we issue additional shares of our common stock for sale (which has historically been our principal means of financing our operations) in connection with future financings, our stockholders could experience further dilution. See Note 8, “Stockholders’ Equity”, to our Notes to Consolidated Financial Statements for information related to our outstanding securities that may become exercisable for future shares of our common stock. Also see Note 16, “Subsequent Events” of our Consolidated Financial Statements for information on our most recent financing.
Our stock price has been and may continue to be volatile and an investment in our common stock could suffer a decline in value.
The trading price of the shares of our common stock has been, and may continue to be, highly volatile. Our stock has traded at prices ranging from $0.57 to $2.96 for the period January 1, 2013 to March 10, 2014. We receive only limited attention from securities analysts and may experience an imbalance between supply and demand for our common stock resulting from our trading volumes. The market price of our common stock may fluctuate significantly in response to a variety of factors, some of which are beyond our control, including the following:
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announcements of new products, technological innovations, contracts, acquisitions, financings, corporate partnerships or joint ventures by us or our competitors;
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the approval by the FDA and/or other regulatory agencies of any new pharmaceutical products we develop;
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developments related to our patents or other proprietary rights;
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negative regulatory action or regulatory approval with respect to our products or our competitors’ products; and
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market conditions in the dietary supplement and pharmaceutical industries in general.
The stock market from time to time, and in particular over the last several years, has experienced extreme price and volume fluctuations that have particularly affected the market prices for small companies, and which have often been unrelated to their operating performance or prospects for future operations. These broad fluctuations may adversely impact the market price of our common stock. In addition, sales of substantial amounts of our common stock in the public market could lower the market price of our common stock.
We do not anticipate paying cash dividends in the foreseeable future and, as a result, our investors’ sole source of gain, if any, will depend on capital appreciation, if any.
We have never paid cash dividends on our capital stock and we do not anticipate paying any cash dividends in the foreseeable future. You should not invest in us if you require dividend income. Any income from an investment in us would only come from a rise in the market price of our common stock, which is uncertain and unpredictable. We currently intend to retain our future earnings, if any, to fund the development and growth of our business and do not foresee payment of a dividend in any upcoming fiscal period. In addition, the terms of existing or any future debt agreements may preclude us from paying dividends. As a result, capital appreciation, if any, of our common stock will be your sole source of gain for the foreseeable future.
Provisions in our bylaws could discourage, delay or prevent a change of control of our company and may result in an entrenchment of management and diminish the value of our common stock.
Our bylaws provide that special meetings of the stockholders may be called at any time by our Chairman of the Board, our President, a majority of our Board of Directors or by the holders of at least a majority of the issued and outstanding shares of our stock issued and outstanding and entitled to vote. These provisions may discourage, delay or prevent a merger, acquisition or other change of control that our stockholders may consider favorable. Such provisions could impede the ability of our common stockholders to benefit from a change of control and, as a result, could materially adversely affect the market price of our common stock and your ability to realize any potential change-in-control premium.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
We received one comment from the SEC staff regarding our company’s Annual Report filed on form 10-K for the year ended December 31, 2012. We responded to the comment and the matter was resolved without changes to our financial statements and related footnotes. We have not received any comments on our Quarterly reports on Form 10-Q or Current Reports on Form 8-K in the 180 days preceding December 31, 2013.
ITEM 2.
ITEM 2.
PROPERTIES
As part of our company’s transition, we are in the process of consolidating our offices to Sarasota, FL. The relocation will centralize most of our executive, scientific, marketing and administrative functions. We currently lease approximately 2,500 square feet of space in Glen Allen, Virginia and have 1.5 years remaining on a five year lease for that location. We also lease space in Washington, DC to support our executive, administrative and scientific activities and Rock Creek has scientific and research offices in Gloucester, MA. The lease on our Washington, DC office will end July 31, 2014 and our office lease in Gloucester, MA. will end June 30, 2014. We do not expect to renew the current lease for space in Gloucester, Glen Allen and Washington, DC.
We lease from the Mecklenburg County Industrial Development Authority approximately nine acres of land in Chase City, Virginia. This lease also includes a building containing approximately 91,000 square feet of space that accommodated our dissolvable tobacco manufacturing operations, an expanded testing facility and office space. We have approximately nine years remaining on a twenty-year lease for this facility. In 2013 we entered into a sublease for approximately 36,000 square feet of the facility which has an initial term of one year with automatic renewal for eight consecutive one year periods unless after the second anniversary the sub-tenant provides 120 days written notice of termination. The sublease rental rate is $2,000 per month. This facility was previously used for the manufacturing of our low-TSNA smokeless tobacco products. We are actively pursuing additional sublease opportunities for the remainder of the space in order to minimize our lease expense with respect to this property.
We own specialized packaging equipment that has been installed at our dietary supplement contract manufacturing vendor to package CigRx ® and Anatabloc ® in their 20-piece container format. We have invested in equipment to process anatabine, the primary ingredient in our Anatabloc ®, Anatabloc ® cosmetics and CigRx ® products at a separate contract manufacturing facility.
We believe our manufacturing arrangements will be sufficient to allow us to respond to the demand for our dietary supplements and cosmetic products for the foreseeable future.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
Virginia Sales and Use Tax Assessment
In 2002, the Virginia Department of Taxation asserted a Virginia Sales and Use Tax assessment for the period January 1, 1999, through March 31, 2002, against us in the amount of $860,115. We applied for a correction of the assessment and an abatement of the tax on the grounds that our tobacco curing barns are exempt from sales and use taxes under the industrial use and processing exemption and/or the agricultural exemption. In a letter dated October 7, 2004, our company received notification from the Commonwealth of Virginia that an adverse decision had been made by the Commissioner of Taxation with respect to the sales and use tax assessment previously issued to our company. On August 10, 2010 the Commonwealth of Virginia responded to our request for reconsideration of the state’s sales and use tax assessment with respect to our tobacco curing barns. The Commonwealth disagreed with our position that the barns are part of the manufacturing process and, therefore, exempt from sales and use taxes under the industrial use and processing exemption and/or the agricultural exemption, concluding that the barns are taxable under the Commonwealth’s sales tax laws and regulation. On July 14, 2011 we filed a lawsuit in the Circuit Court for Mecklenburg County, Virginia seeking a determination that the purchase of our company’s curing barns was exempt from Virginia sales and use tax and an abatement of all taxes and interest assessed against our company by Virginia’s Commissioner of Revenue, which as of November 2013 we estimated were approximately $1.9 million. The Commonwealth of Virginia filed an answer to our complaint on July 29, 2011 asserting that the assessment amount was properly determined and the case was set for trial on December 13 and 14, 2013. On November 18, 2013, a mandatory mediation was held in this case before a retired Circuit Court Judge in Henrico County, Virginia. As a result of that mediation, the parties reached a settlement under which the claims asserted by the Commonwealth were dismissed with prejudice in return for the payment by our company of $975,000 in full settlement of the outstanding tax assessment, interest and penalties.
Securities Class Action Lawsuits
Three individuals, Francis J. Reuter, Charles Boravian and Marty Cole, filed separate similar purported class actions on behalf of putative classes of persons or entities collectively encompassing those who purchased or otherwise acquired shares of our common stock between October 31, 2011 and March 18, 2013. The first action was filed on or about March 25, 2013 in the United States District Court for the Eastern District of Virginia, Francis J. Reuter v. Star Scientific, Inc. et al., E.D. Va. Richmond Division, 13-00183-JAG (the “Reuter Action”). The Reuter Action named as defendants us, our subsidiary, Rock Creek Pharmaceuticals, Inc., and certain of our officers and/or employees. The second action was filed on or about March 26, 2013 in the United States District Court for the District of Massachusetts, Boravian v. Star Scientific, Inc. et al. D. Mass. 13-1-695-DJC (the “Boravian Action”). The Boravian Action named as defendants our company and Jonnie R. Williams Sr. and was voluntarily dismissed by the plaintiff. The Third action was filed on or about May 7, 2013 in the United States District Court for the Eastern District of Virginia, Cole v. Star Scientific, Inc. et al., E.D. Va. Richmond Division, 13-00287-JAG (the “Cole Action”). The Cole Action names as defendants, us, our subsidiary, Rock Creek Pharmaceuticals, Inc., and certain of our officers and employees. In general, the complaints collectively allege that our company and the individual defendants violated Section 10(b) under the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder as related to statements made by us regarding our past and future prospects and certain scientific data relating to our products, as well as related to unspecified private placements and related party transactions we have engaged in since 2006. The Reuter Action and the Cole Action have been consolidated and a lead plaintiff was appointed by the Court in the consolidated cases on June 21, 2013. Pursuant to a joint scheduling order in place in these cases, plaintiff filed a consolidated operative complaint on September 5, 2013 and defendants filed a motion to dismiss the consolidated operative complaint on October 25, 2013. Following full briefing and argument on January 7, 2014, the Court indicated that it would not grant the motion to dismiss at that time, and would allow the case to proceed to discovery, but ordered additional briefing on one aspect of the motion. Also, the Court entered a scheduling order for discovery and an order directing the parties to participate in mediation before a Magistrate Judge. Defendants thereafter filed answers. Subsequently, the United States on January 28, 2014, moved to stay discovery in the case pending the completion or other disposition of the criminal trial of former Governor McDonnell and his wife. That motion was granted on January 28, 2014. On February 12, 2014, the Court granted a joint motion by the parties to stay all deadlines other than a Court sponsored mediation session and the issuance of the Court's opinion on the motion to dismiss. We intend to continue to defend vigorously these claims. However, at this time, we cannot predict the probable outcome of these claims. Accordingly, no amounts have been accrued in our consolidated financial statements.
Derivative Action Lawsuits
Four individuals, David C. Inloes, William Skillman, Harold Z. Levine and Louis Lim, filed separate, but similar derivative actions naming all or most of our company’s then current Directors, several Officers of our company and, in one case, one former Director as defendants. Two of the actions were filed in the United States District Court for the Eastern District of Virginia, Alexandria Division (the “Alexandria Actions”). The first Alexandria Action, William Skillman v. Jonnie R. Williams et al., was filed on May 2, 2013. The second Alexandria Action, David C. Inloes v. Jonnie R. Williams et. al. was filed on May 3, 2013. The Alexandria Actions have been consolidated and co-lead counsel appointed by the Court. Pursuant to a court order plaintiffs filed a consolidated amended complaint on January 13, 2014 and a motion to dismiss was filed on February 3, 2014 on behalf of all of the defendants. Also, on February 3, 2014 our company, as nominal defendant, moved to stay or dismiss this action pending a resolution of the securities class action litigation pending in Federal Court in Richmond, Virginia. Separately, on January 29 , 2014, the United States moved to stay discovery in the case pending the completion or other disposition of the criminal trial of former Governor McDonnell and his wife. That motion was granted by the Court on January 30, 2014. On February 28, 2014, the Court granted our motion to stay the case, ruling that the case would be stayed for all purposes pending further order of the Court and ordering our company, within ten days of the dismissal or resolution of the Richmond securities class action or the trial court's verdict in the McDonnell case, whichever occurs first, to file a report indicating what action, if any, we intend to take with regard to this case, including specifically, without limitation, whether we intend to pursue or seek dismissal of the claims asserted against each of the named individual defendants.
The third derivative action, Harold Z. Levine v. Jonnie R. Williams, et. al. was filed on July 8, 2013, in the Circuit Court for the City of Richmond and the fourth case, Louis Lim v. Christopher C. Chapman, et. al. was filed in the Circuit Court for Henrico County on July 11, 2013. In general, the complaints collectively allege that the our company’s Directors and Officers breached their fiduciary duties by causing our company to issue false and misleading statements regarding our past and future prospects and certain scientific data relating to our products, as well as engaging in certain unspecified private placements and related party transactions since 2006. On July 1, 2013 and August 1, 2013 stipulations were filed in each of the state court actions which would stay the period for defendants to respond to the complaints until a date established in an agreed upon schedule is in place or until forty days after the parties advise the court that they are unable to reach an agreement on such a schedule. Our company intends to defend vigorously these claims. However, at this time, we cannot predict the probable outcome of these claims. Accordingly, no amounts have been accrued in our consolidated financial statements.
Demands for Inspection of Books and Records and for Investigation
Two individuals, Bruce A. Welker and Michael Weber, have written to our company requesting that we produce various books and records pursuant to Delaware Code Section 220. Mr. Welker’s letter was dated May 31, 2013 and the letter sent on behalf of Mr. Weber was dated June 5, 2013. We have responded by letter to these demands and have been in subsequent communications with counsel regarding the demands. One individual, Steven Segall, has written to our company’s Board of Directors and demanded that the Board investigate certain claims and take appropriate remedial action in response to alleged wrongdoing that took place between 2010 and 2013. Our company advised Mr. Segall that our Board of Directors would review the issues raised in his demand letter and further respond once that review was complete. Following a full review by a Committee of Independent Directors, assisted by separate outside counsel, the Board upon recommendation of the Committee determined that Mr. Segall’s demand should be refused pending the outcome of related securities litigation and directed that this decision be communicated to counsel for Mr. Segall.
FDA Warning Letter
On December 24, 2013, our company received a warning letter, from the FDA regarding our CigRx® and Anatabloc® dietary supplements. In the Letter the FDA asserted that CigRx® and Anatabloc® were not properly marketed as dietary supplements, since our company had not filed a New Dietary Ingredient Notification for anatabine as a dietary ingredient prior to the introduction of our dietary supplements. The FDA also claimed that certain materials on our websites, including published research articles, contained drug claims for Anatabloc®. We responded to the letter on January 31, 2014 contesting the FDA’s position with respect to status of our dietary supplements and noting that we had voluntarily removed website and other materials objected to by the FDA. We are currently communicating with the FDA in an effort to reach an amicable resolution of the issues asserted in the warning letter.
Consumer Class Action
On January 27, 2014, Howard T. Baldwin filed a purported class action naming our company, Rock Creek and GNC Holding, Inc., as defendants. The case was filed in the United States District Court of the Northern District of Illinois. Generally, the complaint alleges that claims made for our company’s Anatabloc® product have not been proven and that individuals purchased the product based on alleged misstatements regarding the characteristics, uses, benefits, quality and intended purposes of the product. The complaint purports to allege claims for violations of state consumer protection laws, breach of express and implied warranties and unjust enrichment. We have agreed to indemnify and defend GNC pursuant to the terms of the purchasing agreement between Rock Creek and GNC. Consistent with that commitment, we have agreed to assume the defense of this matter on behalf of our company as well as GNC. The defendants have received an extension of time to respond to the complaint in this case until March 24, 2014. We intend to vigorously defend against these claims. However, at the present time, we cannot predict the possible outcome of these claims. Accordingly, no amount has been accrued in our consolidated financial statements.
ITEM 4.
ITEM 4.
MINE SAFETY DISCLOSURES
Not Applicable
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our company’s common stock, par value $0.0001 per share, is traded on the Nasdaq Global Market under the symbol “STSI”. On March 7, 2014, the closing price of our common stock as reported on the Nasdaq Global Market was $0.93. Set forth below are the high and low sales prices for each full quarterly period during 2013 and 2012, as reported by Nasdaq. From time to time, during the periods indicated, trading activity in our common stock was infrequent. As of March 7, 2014, there were approximately 600 registered holders of our common stock.
We have never paid dividends on our common stock, and our Board of Directors currently intends to retain any earnings for use in our business for the foreseeable future. Any future determination as to the payment of such cash dividends would depend on a number of factors including future earnings, results of operations, capital requirements, our financial condition and any restrictions under credit agreements outstanding at the time, as well as such other factors as the Board of Directors might deem relevant. No assurance can be given that we will pay any dividends in the future.
Securities Authorized for Issuance Under Equity Compensation Plan
The following table provides certain information as of December 31, 2013, with respect to our equity compensation plans under which our common stock is authorized for issuance:
Subsequent to December 31, 2013 we issued a combination of 3,523,052 in stock and stock option grants. As a result, the number of securities remaining available under the plans at March 14, 2014 is 8,239,404. This amounts reflects an adjustment for the number of shares that would be issued to our company’s CEO and President under performance based grants totaling an aggregate value of $3,750,000 at the time of award, calculated using our company’s Nasdaq market closing price of $1.00 at March 13, 2014.
Option Grants and Stock Awards
In 2013, we granted our directors, or the Purchaser Class, options to purchase our common stock as described in our Quarterly Reports on Form 10-Q filed during 2013 or during the fourth quarter of 2013 from our company’s 2008 Incentive Plan. On December 16, 2011, our shareholders approved the grant of stock options previously issued to Jonnie R. Williams, our former CEO, and Paul L. Perito, our former President and COO, for 4.9 million and 4.0 million option shares, respectively. Those stock options have a strike price of $2.95. Sixty-five percent of the stock options, constituting 5,785,000 option shares, vested in December 2011 and had an aggregate stock compensation value of $14.5 million that was recognized in the fourth quarter 2011. On December 24, 2013, Mr. Williams forfeited his unvested stock options in the amount of 1,715,000 option shares. On the same date, 1,400,000 option shares, the remaining shares granted to Mr. Perito, vested upon the determination by our company’s Compensation Committee that a performance criteria covering eighty percent of the stock options had been satisfied. Based on that determination, we recognized an aggregate stock compensation value for the options issued to Mr. Perito in the amount of $3.5 million in the fourth quarter 2013. Given the fact that Mr. Williams forfeited his stock options before vesting, we did not calculate any stock compensation value for those stock options. On October 22, 2013, 50,000 options for shares of our common stock with an exercise price of $1.90 were granted to one member of the Purchaser Class, on December 14, 2013, 50,000 options for shares of our common stock with an exercise price of $1.25 were granted to another member of the Purchaser Class and on December 27, 2013, a total of 6,200,000 options for shares of our common stock were issued to members of the Purchaser Class as part of the compensation packages for our CEO and President and as initial option grants to new Directors elected by our stockholders at our Annual Meeting held that date.
Five-year financial performance graph: 2009-2013
Comparison of five-year cumulative return among Star Scientific, the S&P Composite and the peer group
The Peer Group consists of:
NU SKIN ENTERPRISES, INC
HERBALIFE, LTD
USANA HEALTH SCIENCES
NATURE SUNSHINE PRODUCTS, INC.
RELIVE INTERNATIONAL, INC.
NATURAL ALTERNATIVES INTERNATIONAL, INC.
The Stock Performance Graph shall not be deemed to be “soliciting materials” or to be “filed” with the SEC or subject to the liabilities of Section 18 under the Securities Exchange Act of 1934, as amended, or Exchange Act. In addition, it shall not be deemed incorporated by reference by any statement that incorporates this Annual Report on Form 10-K by reference into any filing under the Securities Act of 1933, as amended, or Securities Act, or the Exchange Act, except to the extent that we specifically incorporate this information by reference.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The selected consolidated financial data of our company, for and as of the end of each of the periods indicated in the five-year period ended December 31, 2013, have been derived from our company’s audited consolidated financial statements. The selected consolidated financial data should be read in conjunction with “Item 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion provides an assessment of our consolidated results of operations, capital resources, and liquidity and should be read together with our consolidated financial statements and related notes in “Item 15. Exhibits, Financial Statement Schedules” of this Report. This discussion includes forward-looking statements based on current expectations that involve risks and uncertainties and should be read together with “Item 1A. Risk Factors” and “Special Note on Forward-Looking Statements” elsewhere in this Report.
Overview
Corporate Transition, Leadership and Operational Changes
Prior to the corporate transition in December 2013, our business strategy focused on selling nutraceutical dietary supplements that provide anti-inflammatory support and decrease the urge to smoke. We also have been involved in selling an associated line of cosmetic products, pursuing ongoing research and development by Rock Creek of related dietary supplements and pharmaceutical products, and to a much lesser degree seeking to license our low-TSNA curing technology and related products. In late 2013, our senior management and Board of Directors determined to undertake certain significant corporate changes in order to better take advantage of the potential opportunities in the area of pharmaceutical products, including the development of products approved by the FDA. In December 2013, our stockholders approved various matters necessary to effect the corporate transition. As part of the corporate transition, Michael J. Mullan, MBBS (MD), PhD was appointed our Chief Executive Officer and Chairman of our Board of Directors, and Christopher C. Chapman, MD was appointed our President. In addition to these significant management changes, our stockholders elected a new Board of Directors consisting of five new directors (including Dr. Mullan) and one existing director (Dr. Chapman).
The corporate transition was driven, in large part, by our belief that our company has evolved such that, from an operational standpoint, it was in our best interest to focus more on pharmaceutical products because there is potential for greater revenue growth through pharmaceutical product sales (for various reasons, including market acceptance of FDA-approved pharmaceutical products, the ability to market such products on a broader scale and recent Anatabloc® research in support of the feasibility of pursuing FDA applications). In this regard, Drs. Mullan and Chapman have extensive experience in the commercial aspects of the development, approval process and marketing of pharmaceutical products. Additionally, we will be required to generate the appropriate preclinical and clinical data needed for Investigational New Drug applications related to pharmaceutical products. Drs. Mullan and Chapman are highly experienced in this area. Dr. Chapman has extensive experience with the IND process that will be invaluable as part of the Company’s strategy going forward. Further, Dr. Mullan has strong scientific credentials that will be necessary to generate the information for the IND process as well as interacting with applicable scientific consultants and others with respect to the IND process.
As part of our corporate transition we are consolidating offices and moving functions to a new corporate headquarters in Sarasota, FL. Our company’s Compensation Committee has approved a severance plan for employees whose positions will not be continued as a result of this transition. Also as part of our transition, our former Chief Executive Officer, Jonnie R. Williams, Sr. and our former President and Chief Operating Officer, Paul L. Perito, resigned from their prior positions with the Company and assumed the role of a non-executive employee, in the case of Mr. Williams, and the role of Vice President and Senior Counsel, Legal and Regulatory affairs, in the case of Mr. Perito. We anticipate that as part of our transition that our company will enter into separate severance arrangements with Messrs. Perito and Williams.
This “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations”, particularly our Results of Operations reported below, discloses information principally related to our company from a historical perspective and our operations prior to the corporate transition. We expect that in the future, as we seek to implement our strategy to better take advantage of the potential opportunities in the area of pharmaceutical products, our results of operations and financial condition may vary significantly from what we have reported in the past.
Our Company and Products
In recent years, we have engaged primarily in the sale of nutraceutical dietary supplements and related cosmetic products, and pursuing ongoing research and development by our subsidiary, Rock Creek, of related dietary supplements and pharmaceutical products. We continue to operate our nutraceutical supplement and cosmetic lines of business and have been evaluating this aspect of our business in light of our corporate transition and the matters raised in a warning letter we recently received from the FDA regarding our CigRx® and Anatabloc® dietary supplements (discussed above in “Item 1. Business”). However, we also expect that, by leveraging the underlying science and clinical data accumulated by us in relation to our existing products, we will focus our operations on the research and development of drug candidates. We expect much of these research and development efforts will initially focus on developing our anatabine compound as a potential drug candidate, as discussed above in “Item 1. Business.”
We historically have focused on utilizing certain alkaloids found in the Solanacea family of plants, which includes potatoes, tomatoes, and eggplants, initially to address issues related to the desire to smoke or use other traditional tobacco products. More recently, we have concentrated on the anti-inflammatory aspects of one of those alkaloids, anatabine. Currently, Rock Creek manufactures and sells two nutraceutical dietary supplements: Anatabloc®, for anti-inflammatory support, and CigRx ®, for assistance in fighting the urge to smoke cigarettes. Rock Creek also has been involved in the development of a cosmetic line of products that utilizes our anatabine compound to improve the appearance of the skin. We introduced Anatabloc ® Facial Crème in September 2012 and related line extensions in 2013. Since the introduction of Anatabloc ®, our revenues have been derived almost exclusively from the sale of our anatabine based nutraceutical products and, more particularly, Anatabloc ®. We do not expect to recognize any revenues related to our drug development initiatives for the foreseeable future. See “Our Dietary Supplements and Related Products” above in “Item 1. Business” for more information related to our existing product portfolio.
Prospects for Our Operations
The following discussion is designed to summarize and highlight what we believe to be significant factors that could have an important impact on our business and future operations. You should read this summary in conjunction with the additional disclosure provided in this Report, including in particular the balance of this “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Item 1. Business” and “Item 1A. Risk Factors”.
General Overview of Operations and Current Financial Condition
The recurring losses generated by our business continue to impose significant demands on our liquidity. Our future prospects will be highly dependent on our ability to successfully implement our current strategy to better take advantage of the potential opportunities in the area of pharmaceutical products, including the development of products approved by the FDA. Our ability to appropriately scale our sales and marketing expenses for these products, manage overall operating expenses, as well as raise additional capital necessary to support our operations, will be key to future operations and financial condition (particularly given the capital intensive nature of drug development). Sales of Anatabloc ® were responsible for virtually all of our dietary supplement revenue during 2013 and we do not expect to generate revenue from the sale of pharmaceutical products in the near term, given the long timeframe for approval of these products. We have and will continue to seek to generate revenues through royalties from the patented tobacco curing process to which we are the exclusive licensee and for our related products, but royalty revenues have been insignificant to date.
We recognized net revenue of approximately $9.1 million for 2013 and a loss from continuing operations of approximately $(33.2) million. The recurring losses generated by our operations continue to impose significant demands on our company’s liquidity. As of December 31, 2013, we had approximately $5.2 million of working capital, of which approximately $3.9 million was cash and cash equivalents. On March 12, 2014, we entered into a series of equity and financing transactions that resulted in gross cash proceeds to us of approximately $9.3 million and a credit facility of $5.8 million, for total funds available of $15.1 million. Under one transaction, holders of previously held warrants with strike prices ranging from $1.50 to $2.00 agreed to immediately exercise on an aggregate of 4.2 million warrants at a reduced strike price of $1.00 per share. The investors also were issued new warrants for an equal number of shares that have a term of seven years and a strike price of $1.00 per share. This transaction resulted in proceeds of approximately $4.2 million. Under another transaction we sold 5.1 million shares and matching warrants for 5.1 million shares to other investors at $1.00 for the shares and warrant shares. This transaction resulted in proceeds to us of $5.1 million. Finally, we entered into a credit facility with another investor under which that investor agreed to loan us up to $5.8 million (subject to certain limitations). The credit facility provides for an annual interest rate of 3% on any funds drawn by us. It also provides the lender with the option to convert any loan amount to a unit of our common stock and a matching seven-year warrant at a conversion price of $1.00.per unit. For a discussion of this financing transaction, see Item 9B, “Other Information” and Note 16 “Subsequent Events” of the consolidated financial statements in “Part IV-Item 15” of this Report. We currently believe that, after giving effect to this transaction, we have sufficient funding to support our operations through the first quarter of 2015. However, there are factors that could make it necessary for us to seek to raise additional capital before that time, and there is no assurance that we will be successful in obtaining funding at commercially favorable terms, if at all. For a discussion of these factors, see “Liquidity and Capital Resources,” below.
Regulatory Hurdles; IND Process
The drug development business is highly regulated, and will require us to file an IND application related to any new pharmaceutical products we intend to introduce. While we intend to file an IND application during the second quarter 2014, the filing of the IND could be delayed if there is difficulty in assembling scientific data necessary to support the IND application. In addition, there can be no assurance that, once we file, an IND application the FDA will not impose a regulatory hold on the initiation of clinical trials, if it believes that the data supporting the IND is insufficient. See “Item 1A. Risk Factors - Risks Related to our Pharmaceutical Business” and “ - Regulatory Risks” for more information on the regulatory challenges presented by our business.
Capital Intensive Nature of Drug Development
The drug development business is very capital intensive, particularly for early stage companies that do not have significant off-setting revenues. Even if we are successful in filing an IND, our product development initiatives will be substantially dependent on our ability to continue our research initiatives and to obtain the funding necessary to support these initiatives. Our inability to continue these initiatives and initiate new research and development efforts could result in a failure to develop new products or to improve upon existing products.
FDA Warning Letter
On December 24, 2013, we received a warning letter from the FDA regarding our CigRx® and Anatabloc® dietary supplements. In the letter, the FDA asserted that CigRx® and Anatabloc® were not properly marketed as dietary supplements, since our company had not filed a New Dietary Ingredient Notification for anatabine as a dietary ingredient prior to the introduction of our dietary supplements. The FDA also claimed that certain materials on our websites, including published research articles, contained drug claims for Anatabloc®. We responded to the FDA’s letter on January 31, 2014 contesting the FDA’s position with respect to the status of our dietary supplements and noting that we had voluntarily removed website and other materials objected to by the FDA. We are currently communicating with the FDA in an effort to reach an amicable resolution of the issues asserted in the warning letter.
Investigations and Other Litigation
In late January and February 2013 our company, directors and others received subpoenas from the United States Attorney’s Office, or USAO, for the Eastern District of Virginia seeking documents. We believe we have responded to substantially all of the issues being reviewed by the USAO. In addition, the international law firm of Chadbourne & Parke LLP conducted an internal investigation of these matters and that investigation was substantially completed in late June 2013. As previously reported, based on the results of the internal investigation, the cooperation with the USAO, and discussions and communications between our outside counsel and the USAO, we do not believe our company will be prosecuted for any of the matters that the USAO has been investigating.
We incurred substantial legal expenses in connection with the government and internal investigations discussed above in 2013, although those expenses declined significantly later in 2013 as the USAO investigation with respect to our company neared completion. However, we expect to continue to incur additional legal expenses in 2014 in connection with the USAO investigation which has resulted in the indictment against former Governor Robert McDonnell and his wife, Maureen McDonell. We also expect to continue to incur legal expenses (and related cash demands) in connection with the civil actions and other matters discussed under “Part I-Item 3 - Legal Proceedings” and such expenses and cash demands relating to those matters may be material. We expect that much of the cost related to the ongoing securities class action and derivative actions discussed in Part II-Item I will be covered by insurance, but cannot provide any assurances with respect to the outcome of the pending actions, or action yet to arise, including that such claims will not exceed the limits of our insurance policies.
Our Product and Product Development Initiatives
Dietary Supplements and Development of Pharmaceutical Products. Anatabloc®, which is intended to provide anti-inflammatory support, is currently being sold through our interactive website and our customer service center. Also, Anatabloc® is available on a pay-on-scan basis through GNC, a retailer of dietary supplements, through its online store as well as through its more than 4,000 company-owned stores and franchised retail locations. The Company’s initial marketing of Anatabloc ® had been primarily directed toward physicians and other healthcare professionals. More recently we have been focusing our marketing efforts on athletes and other groups of individuals who are frequently seeking to maintain healthy levels of inflammation. In 2013, our company sought to further align our marketing and distribution efforts with GNC as our primary strategic partner for growth. Following this realignment we experienced a decline in sales volumes in our company’s internet sales and although sales volumes at GNC increased, our overall sales volume and revenue declined given the lower wholesale pricing to GNC as compared to our retail pricing for product sold through the Company’s website. We have been evaluating our dietary supplement business in light of our corporate transition and in light of the FDA warning letter that we received in December 2013.
In 2009, Rock Creek developed a non-nicotine, non-tobacco nutraceutical, CigRx® that is intended to temporarily reduce the desire to smoke. We continue to market this product on our interactive website and through limited retail distribution. Consistent with the transition of our company’s focus we anticipate concentrating more of our effort in the future on the development of pharmaceutical products with clinical claims, as well as pharmaceutical products for the treatment of a range of conditions, including Alzheimer’s disease, Parkinson’s disease, multiple sclerosis, schizophrenia, depression and Hashimoto's autoimmune thyroiditis.
Cosmetics. We introduced our anatabine-based cosmetic products, Anatabloc® Facial Crème in September 2012 and Anatabloc ® Revitalizing Facial Serum in March 2013. Our Anatabloc ® Clarifying Facial Cleanser, which does not contain anatabine, was introduced in August 2013. These products, which are intended to improve the appearance of the skin, are currently sold on our interactive website and customer service center. Also, GNC began carrying our Anatabloc ® Facial Crème on its website in February 2013 and in April 2013 began carrying our Anatabloc ® Revitalizing Facial Serum. Our Anatabloc ® Facial Crème and Anatabloc ® Revitalizing Facial Serum also are available at select GNC franchise locations.
Research Related to Our Dietary Supplements and Cosmetic Products. Since 2011, Rock Creek, the Roskamp Institute and researchers at Johns Hopkins University, have completed and reported on a number of studies designed to assess the ability of our anatabine compound to lower chronic inflammation in a variety of pre-clinical (non-human) and clinical (human) settings. For a description of our relationship with the Roskamp Institute, see “Item 1. Business - our relationship with the Roskamp Institute.” One study conducted by the Roskamp Institute and reported in the European Journal of Pharmacology showed that anatabine lowered levels of amyloid production both in the test tube and when administered to mice vulnerable to accumulation of amyloid which, at excessive levels, damages brain tissue. A second manuscript written by the same researchers and published online in The European Journal of Pharmacology in 2012 and in manuscript form in January 2013, further characterized the anti-inflammatory effects of anatabine in several types of animal tissues, in human cells, and in human whole blood. The Roskamp Institute also presented results of pre-clinical studies of anatabine in mouse models of multiple sclerosis, traumatic brain injury, and Alzheimer’s disease at the Neuroscience 2012 conference held in New Orleans in October 2012. In January 2013, the results of the animal multiple sclerosis study were published in PLoS One under the title “Amelioration of Experimental Autoimmune Encephalomyelitis by Anatabine.” Further, a pre-clinical investigator-initiated and independently funded study from Johns Hopkins that examined the effect of anatabine supplementation in a mouse model of autoimmune thyroiditis was published in September 2012 in an article entitled, “Anatabine Ameliorates Experimental Autoimmune Thyroiditis” in the Endocrine Society’s journal, Endocrinology (Endocrinology. 2012 Sep; 153(9):4580-7).
In 2013, Rock Creek received positive results from a study conducted by researchers at the University of Virginia Medical School investigating the effects of anatabine in an animal model of ulcerative colitis. Rock Creek also received functional binding data from a study it sponsored that offers an explanation and a possible mechanism of action for some of the observed effects of anatabine.
Rock Creek also has been involved in human (clinical) trials evaluating the impact of supplementation with anatabine citrate on an inflammatory marker, C-reactive protein, or CRP, (which is believed to be an indicator of coronary heart disease), on Hashimoto’s autoimmune thyroiditis, in individuals with mild to moderate Alzheimer’s disease and in a multi-site study of Anatabloc ® Facial Crème. In February 2012, Rock Creek reported research on the first clinical trial demonstrating that Anatabloc ® lowers chronic inflammation measured by CRP levels in the blood. The reported results were obtained in connection with an in-house study undertaken by Rock Creek that involved a group of smokers who had been using Anatabloc ® on an extended basis. In October 2012 Rock Creek reported further results, based on an interim look at the results of a second CRP study that was conducted by the Roskamp Institute as the study sponsor. That interim look showed that 61% of diabetic subjects (11 of 18) taking metformin (the most common drug prescribed to diabetics) had a CRP reduction, as did 38% of the general trial population not taking metformin (31 of 81). Overall, 42 of 99 subjects (42%) had a decrease in CRP after one month of anatabine supplementation. After further, extensive review of the interim data from this CRP study, Rock Creek and the Roskamp Institute completed the study report, which confirmed the interim findings reported in October 2012. The report further confirmed that the supplement was safe and well tolerated, but that given the cyclical nature of CRP levels further enrollment in the study would not be productive.
On January 7, 2013 Rock Creek reported initial results for its Thyroid health study. Those results suggest that dietary supplementation with anatabine ameliorates the immune system’s targeting of the thyroid gland in cases of autoimmune thyroiditis. On October 31, 2013 the results of the Thyroid Health Study were published on-line in The Journal of Clinical Endocrinology & Metabolism in a peer-reviewed brief report entitled “Anatabine supplementation decreases thyroglobulin antibodies in patients with chronic lymphocytic autoimmune (Hashimoto’s) thyroiditis”. Also in October 2013 a peer-reviewed article titled, “Effects of Dietary Supplementation with the Solanacea Plant Alkaloid Anatabine on Joint Pain and Stiffness: Results from an Internet-Based Survey Study", was published in Clinical Medicine Insights: Arthritis and Musculoskeletal Disorders.
The Alzheimer’s study that is being sponsored by Rock Creek and conducted and paid for by the Roskamp Institute began enrolling subjects at the end of August 2012. As of March 1, 2014, 83 subjects had been screened, 62 subjects had been enrolled in the study and 53 subjects had completed the study. This study has now been suspended pending filing of an IND, but an interim analysis is anticipated which may influence the decision to proceed with this study. Both the double-blind and open-label portion of the Anatabloc ® Facial Crème study were completed at the end of August 2013. A total of 109 of the 117 subjects enrolled in the study completed the double-blind portion of the study and 85 of 88 subjects completed the open-label extension. The study report is in preparation, but a first look at the data shows that both the active and placebo treatments produced marked improvements in both investigator and subject-related measures of appearance and severity of conditions.
Federal Regulations of Dietary Supplements, Drug Products and Cosmetics
Under the Food, Drug and Cosmetic Act, the Food and Drug Administration, has authority for reviewing and approving any new drug product prior to its introduction into commerce. The FDA approval process involves, among other things, successfully completing clinical trials under an Investigational New Drug Application and obtaining a premarket approval after filing a New Drug Application. The NDA process requires a company to prove the safety and efficacy of a new drug product to the FDA’s satisfaction. The Dietary Supplement Health and Education Act, provides the FDA with authority over the production and marketing of dietary supplements. In certain cases DSHEA also requires notification to the FDA before a company begins to market a dietary supplement. DSHEA does not require prior approval by the FDA for the introduction of dietary supplements into the market, but does require that such products comply with the requirements of DSHEA prior to and after their introduction into commerce. The FDA also has jurisdiction over cosmetic products and claims made for such products. While premarket approval is not required prior to the marketing of cosmetic products, the ingredients in such products must be recognized as being safe and appropriate for use in cosmetics and the FDA has authority with respect to the labeling, packaging and promotion of such products. See “Item 1. Business-Government Regulation” for more information relating to governmental regulation of products by the FDA.
Licensing and Intellectual Property.
Since 2010 we have filed United States patent applications relating to the active ingredient of our dietary supplement products, uses of the products and product formulations. These included two applications for therapeutic methods involving the administrations of anatabine, its isomers and derivatives thereof for treating chronic inflammation that may be associated with disorders such as thyroiditis, cancer, arthritis, Alzheimer’s disease, and multiple sclerosis, an application for a beverage product containing anatabine or a derivative or salt thereof, an application for our CigRx ® formulation and our Anatabloc ® formulation as well as an application for the synthesis of anatabine and an application for a relapse prevention product. It also includes two applications that we filed in 2013 for our Anatabloc ® Facial Crème formulation and for an anatabine based inhaler for smoking cessation. We also filed an application for a design patent relating to the 20-piece container used for our CigRx ® and Anatabloc ® products and a divisional application for food grade salts of anatabine. On October 15, 2013, the United States Patent and Trademark Office, issued a patent (Patent No. 8,557,999) to Rock Creek covering anatabine citrate, the active component in our company’s Anatabloc® and CigRx ® products. In June 2012, the PTO issued a patent to Rock Creek for an improved method of synthesizing anatabine that facilitates large scale commercial production of high purity anatabine. Also, in August 2012, the PTO issued a patent to Rock Creek for an anatabine and yerba mate composition and uses thereof in assisting weight loss and curbing the urge for tobacco. In 2011, the PTO issued a design patent to Rock Creek for the 20-piece dispenser used for our CigRx ® and Anatabloc ® products. In 2014 Rock Creek filed a divisional application with method claims in connection with its prior application for the Anatabloc® formulation and in lieu of the previously filed application. We also have several international applications pending that relate to inflammation-mediated disorders, our anatabine and yerba mate composition, our Anatabloc ® formulation, a relapse prevention product and the administration of anatabine, its isomers and derivatives thereof generally, and also for autism and seizure indications.
We are the exclusive licensee under a License Agreement with Regent Court Technologies, LLC which grants us exclusive worldwide rights to and a right of sublicense for the StarCured ® process, related patents covering the production of low-TSNA dissolvable smokeless tobacco products and the use of certain MAO inhibitors in treating neurological conditions. This technology essentially arrests or eliminates microbial activity that normally occurs during curing, thereby preventing the formation of TSNAs. See “Item 1. Business - Our Patents, Trademarks and Licenses for more information relating to our patents.
Critical Accounting Policies and Estimates
Accounting principles generally accepted in the United States of America, or GAAP, require estimates and assumptions to be made that affect the reported amounts in our company’s consolidated financial statements and accompanying notes. Some of these estimates require difficult, subjective and/or complex judgments about matters that are inherently uncertain and, as a result, actual results could differ from those estimates. Due to the estimation processes involved, the following summarized accounting policies and their application are considered to be critical to understanding our business operations, financial condition and results of operations.
Inventories
Inventories are valued at the lower of cost or market. Cost is determined on the first-in, first-out (FIFO) method.
Revenue Recognition
Revenue is recognized when products are received by consumers or independent wholesalers from our third party fulfillment vendor based on orders entered by the customers or independent wholesalers on our interactive website and we have received confirmation of a valid credit card charge, which is the only payment option offered for sales on the interactive website. We also record appropriate provisions for rebates, discounts and credits for returns. These amounts are estimated due to the variability in credits as a result of temporary promotional programs, and allowances for product which may be returned by consumers after a sale is completed. In order to quantify these amounts, we make quarterly estimates in these areas based on the available quarterly information and historical experience.
Under certain retail agreements we have agreed to “pay on scan” terms of sale for our dietary supplement products. The “pay on scan” terms do not constitute a sale of the product until the product is sold to a consumer. Under these agreements revenue is recognized by us at the time the customer purchases the product from the consignee. The sales of products through these outlets are also subject to the same promotional and return credits discussed above. Our products that are sold on a “pay-on-scan” basis, whether in a warehouse or retail location, are considered consignment inventory and accordingly we retain all risk of loss until sale.
Sales Incentives Estimates
We record consumer incentives and trade promotion activities as a reduction of revenues based on amounts estimated as being due to customers and consumers at the end of a period. The estimates are based principally on historical utilization and redemption rates of our products. Such programs include discounts, coupons, rebates, slotting fees, in-store display incentives and volume-based incentives. To the extent that redemption rates exceed our estimates, this would increase our liability related to outstanding coupons in the period the estimate is revised.
Impairment of Long-Lived Assets
We review the carrying value of our amortizing long-lived assets whenever events or changes in circumstances indicate that the historical cost-carrying value of an asset may no longer be appropriate. We also assess recoverability of the asset by estimating the future undiscounted net cash flows expected to result from the asset, including eventual disposition. If the estimated future undiscounted net cash flows are less than the carrying value of the asset, an impairment loss is recorded equal to the difference between the asset’s carrying value and its fair value. Non-amortizing intangibles (trademarks) are reviewed annually for impairment.
Commitment and Contingency Accounting
We evaluate each commitment and/or contingency in accordance with the accounting standards which state that if the item is probable then our company will record the liability in the financial statements. If not, we will disclose any material commitments or contingencies that may arise.
Year Ended December 31, 2013 Compared to Year Ended December 31, 2012
Net Sales. For the year ended December 31, 2013, net sales (gross sales less cash discounts, product discounts and product return allowance) were approximately $ 9.1 million compared to approximately $6.2 million during the same period in 2012, an increase of approximately $2.9 million. The improved net sales are attributable to increased sales volume of our Anatabloc ® dietary supplement for anti-inflammatory support.
Gross Profit. We had a gross profit of $4.0 million during the year ended December 31, 2013 compared to a gross profit of $2.6 million for the same period in 2012, an improvement of $1.4 million. The increase in gross profit is attributable to increased Anatabloc ® sales.
Total Operating Expenses. Total operating expenses (comprised of Sales and Marketing, General and Administrative and Research and Development expenses) were approximately $36.9 million for the year ended December 31, 2013, an increase of approximately $9.7 million, or 35.5%, from approximately $27.2 million for the same period in 2012. General and administrative expenses increased by approximately $7.2 million, and sales and marketing expenses increased by approximately $4.0 million. Research and development costs decreased $1.6 million.
Sales and Marketing Expenses. Sales and marketing expenses were approximately $10.2 million for the year ended December 31, 2013, an increase of approximately $4.0 million, or 64.9%, from approximately $6.2 million for the same period in 2012. The increase in sales and marketing expense was attributable to the expanded promotion of our Anatabloc ® dietary supplement. We expect our sales and marketing expenses to trend lower in 2014 as we have significantly curtailed the marketing of our Anatabloc® product as we begin to concentrate more of our resources on the drug development aspects of our business and as we have undertaken to review and revise marketing materials in response to the FDA warning letter we received in December 2013.
General and Administrative Expenses. General and administrative expenses were approximately $23.7 million for the year ended December 31, 2013, an increase of approximately $7.2 million, or 43.7%, from approximately $16.5 million for the same period in 2012. For the year ended December 31, 2013, we had increased legal expenses of $6.6 million primarily related to our efforts in responding to subpoenas in the government investigation and in connection with our related internal investigation, related civil actions and management transition. Net non-cash charges increased $3.2 million related to stock options, stock grants and the modification of the time to exercise previously issued stock options. These expense increases were partially offset by reduced executive salaries of $1.4 million, and by reductions in executive travel payments of $1.0 million. The aggregate of all other expenses were lower by $0.5 million. We expect our investigation-related expenses will be lower in 2014 as we believe the investigation by the USAO as to our company is nearing completion. However, we expect to continue to incur in 2014 increased legal expenses (and related cash demands) in connection with the related civil actions, other matters discussed under “Part II-Item 1 - Legal Proceedings,” and management transition, and such expenses and cash demands may be material.
Research and Development Expenses. We expended approximately $3.0 million on research and development during 2013, a decrease of $1.6 million or 34.2% from approximately $4.6 million for the comparable period in 2012. The research and development cost in 2013 were directed principally toward the ongoing clinical trial for Anatabloc ® Facial Crème and the analysis of results of the CRP and Hashimoto’s autoimmune thyroiditis clinical trials. In 2013 we incurred $436 thousand of expense based on the Research and Royalty Agreement with an affiliate of the Roskamp Institute under which we are obligated to pay a royalty of 5% on all Anatabloc ® sales. See “Item 1. Business-Our Relationship with the Roskamp Institute” in this Report for more information relating to our relationship with the Roskamp Institute. We expect our research and development expenses to trend higher in 2014 as we seek to expand the scope of our drug development effort, including initiating Phase I clinical trials following the filing of an IND with the FDA.
Interest Income and Expense. We had interest income of $14 thousand and no interest expense for the year ended December 31, 2013. For the same period in 2012, we had interest income of $17 thousand and interest expense of $104 thousand, for a net interest expense of $87 thousand. The lower interest expense for the year ended December 31, 2013 reflected principally the extinguishment of our long term debt obligations to R J Reynolds, or RJR, pursuant to the terms of our 2012 settlement agreement as well as the extinguishment of other minor long-term debt in 2013. The lower interest income during the year ended December 31, 2013 was primarily due to lower cash balances in the period.
Other Income and Expense. Other income and expense was a net expense of $0.3 million for the year ended December 31, 2013 compared to $6.6 million in net income for the comparable period in 2012, a decrease of $6.9 million. The net expense for 2013 was primarily due to the reversal of an accrual of $1.3 million as a result of a resolution of a contingent fee arrangement with the law firm representing the Company in the RJR patent lawsuit offset by the State of Virginia sales and use tax case settlement expense of $1.0 million and the write off of unusable equipment of $0.7 million. The $6.6 million in net income for the year ended December 31 2012 was primarily due to the settlement of the RJR patent lawsuit which consisted of debt forgiveness and a cash payment to our company in September 2012.
Income Tax Expense. During the years ended December 31, 2013 and 2012, we had no income tax obligation due to our net operating losses.
Discontinued Operations. During the year ended December 31, 2013 we recognized a gain from the sale of equipment and inventory specific to the dissolvable tobacco business of $0.4 million. During the year ended December 31, 2012 we elected to close our dissolvable tobacco business and exited the tobacco business as of December 31, 2012. We incurred a charge of $(3.1) million in connection with the discontinuation of those operations and losses from operations of $(1.7) million for a total discontinued operations charge of $(4.8) million.
Net Loss. We had a net loss from continuing operations of approximately $(33.2) million for the year ended December 31, 2013 compared to a net loss from continuing operations of approximately $(18.1) million in 2012, an increased loss of $15.1 million. The net loss after discontinued operations for the year ended December 31, 2013 was $(32.8) million compared to the net loss after discontinued operations of $(22.9) million for the same period in 2012 an increased loss of $9.9 million. The results for the year ended December 31, 2012 included miscellaneous one-time income of $6.6 million primarily as a result of the resolution of the RJR litigation matters. While we had an increase in gross profit of $1.4 million for the year ended December 31, 2013, that increase was offset by increased marketing costs of $4.0 million for Anatabloc ® , increased legal expenses of approximately $6.6 million and increased non-cash stock compensation of $3.2 million. These increases were offset by decreased executive salaries of $1.4 million, executive travel of $1.0 million and research and development expenses of $1.6 million.
For the year ended December 31, 2013, our basic and diluted loss per share from continuing operations was $(0.20) compared to a basic and diluted loss per share from continuing operations of $(0.12) for the year ended December 31, 2012. For the year ended December 31, 2012, our basic and diluted loss per share, including $(0.03) from discontinued operations, was $(0.15). This compared to a basic and diluted loss per share of $(0.20) for the year ended December 31, 2013. However, on a pro-forma basis, excluding the net gain from the resolution of the RJR litigation matters and the discontinued operations, our net loss per share, both basic and diluted, would have been $(0.17) for the year ended December 31, 2012. We believe that this non-GAAP measure is important to an investor’s understanding of our net losses from core business operating results, and that the net gain from the resolution of the RJR litigation reflects a one-time event that will not recur in future periods.
Year Ended December 31, 2012 Compared to Year Ended December 31, 2011
Please refer to “Item 6. Selected Financial Data” elsewhere in this Report to view the five-year comparison of our results of operations and selected financial data. The amounts in this analysis have been restated for discontinued operations resulting from the closing of our dissolvable tobacco business.
Net Sales. For the year ended December 31, 2012, net sales (gross sales less cash discounts, product discounts and product return allowance) were approximately $6.2 million compared to approximately $1.2 million during the same period in 2011, an increase of approximately $5.0 million. The improved net sales were attributable to increased sales volume of our Anatabloc ® dietary supplement for anti-inflammatory support.
Gross Profit (Loss). We had a gross profit of $2.6 million during the year ended December 31, 2012 compared to a gross loss of $(0.6) million for the same period in 2011, an improvement of $3.2 million. The increase in gross profit was attributable to increased Anatabloc ® sales.
Total Operating Expenses. Total operating expenses were approximately $27.2 million for the year ended December 31, 2012, a decrease of approximately $7.9 million, or 22.3%, from approximately $35.1 million for the same period in 2011. This change was attributable to decreases in general and administrative expenses of approximately $12.8 million offset by increases in marketing and distribution costs of approximately $3.6 million and increased research and development costs of approximately $1.3 million. The increased research and development costs principally related to clinical (human) trials and pre-clinical (non-human) studies of our Anatabloc ® product or the principal dietary ingredient in Anatabloc ®.
Marketing Expenses. Marketing and distribution expenses were approximately $6.2 million for the year ended December 31, 2012, an increase of approximately $3.6 million, or 140.8%, from approximately $2.6 million for the same period in 2011. The increase in marketing costs during the year ended December 31, 2012 was attributable solely to the promotion of Anatabloc ® as we decreased our spending on marketing for CigRx ® during this period. Our Anatabloc ® marketing consisted of a mix of advertising on radio and television and in print media and through online channels as we attempted to reach a wider audience of potential consumers for Anatabloc ®. We varied the frequency of ads and changed content as we sought to better communicate the benefits of Anatabloc ® to a wider audience.
General and Administrative Expenses. General and administrative expenses were approximately $16.5 million for the year ended December 31, 2012, a decrease of approximately $12.8 million, or 43.7%, from approximately $29.3 million for the same period in 2011. During the year ended December 31, 2012, we had a non-cash charge of $3.2 million for stock based compensation compared to a charge of $17.3 million during the same period in 2011 for a net decrease of $14.1 million during 2012. Also, we had an expense of $0.3 million in connection with bonuses paid to certain employees who contributed to the successful launch of Anatabloc ® , while no bonuses were paid in the comparable period in 2011. We recorded severance expense of approximately $0.2 million in 2012 and had no comparable expense in the same period in 2011. During the year ended December 31, 2012, legal expenses increased approximately $0.4 million compared to the prior period in 2011 in connection with our ongoing efforts to protect and expand the patented technology relating to our dietary supplements and the RJR litigation settlement. Various other expenses increased by a total of $0.5 million.
Research and Development Expenses. During the year ended December 31, 2012, we expended approximately $4.6 million primarily in connection with clinical (human) trials and pre-clinical (non-human) studies of our Anatabloc ® product or the principal dietary ingredient in Anatabloc ® . This included costs related to the development and testing of our Anatabloc ® Facial Crème prior to its introduction into the market on September 10, 2012, as well as payment of royalties of 5% of Anatabloc ® sales to an affiliate of the Roskamp Institute under the Research and Royalty Agreement entered into with that entity in 2010. For a description of our relationship with the Roskamp Institute, see “Part I - Item 1. Business - Our Current Product Development Initiatives - Our Relationship with the Roskamp Institute.” During the year ended December 31, 2011, Rock Creek expended approximately $3.2 million primarily in connection with the product development of Anatabloc ®.
Interest Income and Expense. We had interest income of $17 thousand and interest expense of $104 thousand for the year ended December 31, 2012, for a net interest expense of $87 thousand during the period. For the same period in 2011, we had interest income of $46 thousand and interest expense of $263 thousand, for a net interest expense of $217 thousand. The lower interest expense for the year ended December 31, 2012 reflected lower outstanding principal of our long-term debt and the extinguishment of our RJR long-term debt obligation pursuant to the terms of the September 21, 2012 settlement agreement with RJR. The lower interest income during the year ended December 31, 2012 was primarily due to lower cash balances in the period.
Other Income and Expense. We had other income for the year ended December 31, 2012 in the net amount of $6.6 million, primarily in connection with the resolution of the RJR litigation matters. This consisted of the satisfaction and forgiveness of unsecured promissory notes in the amount of $3.4 million as of August 1, 2012 that has been payable to RJR following its combination with Brown & Williamson Tobacco Company, or B&W, in 2004 and a separate cash payment of $5.0 million for a total amount of $8.4 million. This amount was partially offset by $1.3 million in connection with a contingent fee arrangement with counsel relating to this litigation. We had $0.5 million in other expenses during 2011.
Income Tax Expense. During the years ended December 31, 2012 and 2011, we had no income tax obligation due to our net operating losses.
Discontinued Operations. During the year ended December 31, 2012 we elected to close our dissolvable tobacco business and exited the tobacco business as of December 31, 2012. We incurred a charge of $(3.1) million in connection with the discontinuation of those operations and losses from operations of $(1.7) million for a total discontinued operations charge of $(4.8) million. During the comparable period in 2011 discontinued operations related to the tobacco business was $(2.2) million.
Net Loss. We had a net loss from continuing operations of approximately $(18.1) million for the year ended December 31, 2012 compared to a net loss from continuing operations of approximately $(35.9) million in 2011. The net loss after discontinued operations for the year ended December 31, 2012 was $(22.9) million compared to the net loss after discontinued operations of $(38.0) million for the same period in 2011. The results for the year ended December 31, 2012 included miscellaneous one-time income of $6.6 million primarily as a result of the resolution of the RJR litigation matters. While we had an increase in gross profit of $3.2 million for the year ended December 31, 2012, that increase was offset by increased marketing costs of $3.6 million for Anatabloc ® , severance expense of $0.2 million, bonuses paid to certain employees in connection with the successful launch of Anatabloc ® amounting to $0.3 million, increased legal expenses of approximately $0.4 million and increased research and development expenses of $1.3 million. These increases were offset by decreased charges for stock based compensation awards of $14.1 million.
For the year ended December 31, 2012, our basic and diluted loss per share from continuing operations was $(0.12) compared to a basic and diluted loss per share from continuing operations of $(0.27) for the year ended December 31, 2011. For the year ended December 31, 2012, our basic and diluted loss per share, including $(0.03) from discontinued operations, was $(0.15). This compared to a basic and diluted loss per share, including $(0.01) from discontinued operations, of $(0.28) for the year ended December 31, 2012. However, on a pro-forma basis, excluding the net gain from the resolution of the RJR litigation matters and the discontinued operations, our net loss per share, both basic and diluted, would have been $(0.17) for the year ended December 31, 2012. We believe that this non-GAAP measure is important to an investor’s understanding of our net losses from core business operating results, and that the net gain from the resolution of the RJR litigation reflects a one-time event that will not recur in future periods.
Liquidity and Capital Resources
We have been operating at a loss for the past eleven years, which imposes significant cash demands on our business. These conditions were exacerbated by the expenses we incurred in 2013 in connection with the USAO investigation, which we believe has now been substantially completed as to our Company, as well as costs associated with the corporate transition. Our future prospects will be dependent on our ability to transition into the area of drug development, the distribution and consumer acceptance of our products and related line extensions of those products, our ability to appropriately scale our sales and marketing expenses for these products and manage our overall operating expenses, and our ability to obtain additional capital necessary to support our operations (particularly research and development and related expenses in connection with our drug development operations). In the long-term, we expect that our revenues will shift to be more dependent on our ability to successfully implement our drug development program.
Since the introduction of Anatabloc®, our revenues have been derived almost entirely from the sales of our anatabine based nutraceutical products and, more particularly, Anatabloc ®. Future sales of our dietary supplements will be dependent on our resolving issues with the FDA relating to status of our Anatabloc® and CigRx ® products and any other developments with respect to the status of these products, given the fact that we have limited the marketing and advertising of our dietary supplements following our receipt of the FDA warning letter in December 2013. Our future prospects also will be dependent on our ability to develop pharmaceuticals, particularly given our intent to concentrate more effort and focus on this area as part of our ongoing corporate transition, and on our ability to begin generating income through royalties from the patented tobacco curing process to which we are the exclusive licensee. We continue to market our CigRx ® non-tobacco nutraceutical dietary supplement to reduce the desire to smoke, but sales of CigRx ® have been and continue to be insignificant.
On March 12, 2014, we entered into a series of equity and financing transactions that resulted in gross proceeds to our company of approximately $9.3 million and cash availability under a credit facility of $5.8 million, for total funds available of $15.1 million. Under one transaction, holders of previously held warrants with strike prices ranging from $1.50 to $2.00 agreed to immediately exercise on an aggregate of 4.2 million warrants at a reduced strike price of $1.00 per share. The investors also were issued new warrants for an equal number of shares that have a term of seven years and a strike price of $1.00 per share. This transaction resulted in proceeds of approximately $4.2 million. Under another transaction we sold 5.1 million shares with matching warrants for 5.1 million shares to other investors at $1.00 for the shares and warrant shares. This transaction resulted in proceeds to us of $5.1 million. Finally, we entered into a credit facility with other investors under which that investor agreed to loan us up to $5.8 million. The credit facility provides for an annual interest rate of 3% on any funds drawn by us. It also provides the lender with the option to convert any loan amount to a unit of our common stock and a matching seven-year warrant at a conversion price of $1.00 per unit. For a discussion of this financing transaction, see Item 9B “Other Information” and Note 16 “Subsequent Events” of the condensed consolidated financial statements in this Report. We currently believe that, after giving effect to this transaction, we have sufficient funding to support our operations through the first quarter of 2015. However, depending upon, among other factors, product sales levels, the results of ongoing product development initiatives and trials, market conditions, increased expenses beyond what we currently budgeted for 2014 (in particular, our operating expenses or increased expenses related to the corporate transition matters), increased costs beyond our forecast, and cost associated with the ongoing investigation and civil litigation matters to the extent not covered by insurance, and the price of our common stock, it may be necessary for us to seek additional capital before that time, including debt financing and additional equity offerings. There can be no assurance that we will be successful in obtaining such funding at commercially favorable terms, if at all. If we are unable to raise additional capital (including through the exercise of outstanding warrants and stock options and through private placements of our securities, each of which has been a primary source of our financing in the past) our liquidity may be materially adversely affected. Any equity financing will be dilutive to our existing shareholders.
Corporate Transition Matters
As discussed above, as part of our ongoing corporate transition, we are shifting focus of our operations to concentrate more on the development of pharmaceutical products, in addition to the maintenance of our nutraceutical and cosmetic lines of business. The costs and expenses related to the drug development industry may vary significantly from those associated with our nutraceutical supplement and cosmetic lines of business, including costs and expenses related to clinical trials, regulatory compliance and generally bringing to market drug candidates. These factors, among others, may require us to seek additional capital resources as we move forward with our drug development program on a more expedited basis.
Summary of Balances and Recent Sources and Uses
As of December 31, 2013, we had approximately $5.2 million of working capital, which included cash of approximately $3.9 million.
Net Cash From Operating Activities. For the year ended December 31, 2013, approximately $26.0 million of cash was used in operating activities compared to approximately $17.7 million of cash used in operating activities during the same period in 2012. Cash used in operations was approximately $8.3 million higher during the year ended December 31, 2013 as compared to the same period in 2012, due primarily to increased payments for legal fees related to our response to subpoenas in the government investigation and our related internal investigation, increased Anatabine® marketing, and the settlement of the State of Virginia sales and use tax case, partially offset by reductions in inventory to support our product sales of Anatabloc ®.
Net Cash From Investing Activities. For the year ended December 31, 2013, we generated $39 thousand from investing activities, primarily due to royalty payments from the licensing of trademarks related to the sale of our cigarette business in 2007. During the period ending December 31, 2012, we had cash net usage of $(21) thousand with cash used for property and equipment acquisition and intangible assets offset, in part, with cash received from licensing of cigarette trademarks of $30 thousand.
Net Cash From Financing Activities. For the year ended December 31, 2013, we generated net cash from financing activities of $7.8 million through the exercise of warrants. During the period ending December 31, 2012, we generated net cash from financing activities of approximately $32.2 million, primarily through the exercise of warrants and stock options for $32.2 million and the sale of common stock for gross proceeds of approximately $1.7 million, offset, in part, by debt payments of $1.7 million.
Net Cash Used in MSA Escrow Payments. Given the fact that we discontinued the sale of cigarettes in June 2007, we do not have any ongoing obligation to make any deposits into escrow for the year ended December 31, 2013. During the year ended December 31, 2012, we deposited $113 thousand into escrow for sales from 2006 in one MSA state, based on an audit of cigarette sales for that year.
Cash Demands on Operations
During the year ended December 31, 2013, we had losses from continuing operations that totaled $(33.2) million and a net loss of $(32.8). See “Overview” and “Results of Operations” above for a discussion of our increased operating expenses that resulted in increased use of cash during 2013.
Contingent Liabilities and Cash Demands
Litigation Costs. We have paid or accrued all existing obligations. Also, as part of our fee arrangements in certain litigation matters, we had agreed to pay counsel a percentage of any damage awards, a percentage of the resulting payments we actually received in the event that the litigation was resolved in our favor or a result fee in return for a cap on fee payments during the litigation. In connection with the settlement of the RJR litigation, we accrued $1.2 million with respect to a contingent fee arrangement with counsel relating to that litigation. Based on an agreement reached with counsel in the RJR matter in July 2013, we accounted for this item as a contingent liability beginning in the third quarter of 2013.
Product Liability. Prior to the introduction of our dietary supplements and cosmetics, we obtained product liability insurance for each of our products. This insurance covers claims arising from product defects or claims arising out of the sale, distribution and marketing of these products. There have been no claims asserted with respect to any injury arising from the manufacture, sale or use of our dietary supplements or cosmetics to date. If any such claims are asserted in the future and ultimately result in liability that exceeds the limits of our insurance coverage, we would be liable for any such excess amount.
In 2014 a purported class action was filed with respect to the purchase of our Anatabloc® product. In that case, plaintiff seeks a refund on behalf of all persons purchasing our dietary supplement on the basis that the product was not effective for claims allegedly asserted by our company. We have been advised by our insurance carrier that there is no coverage for the claims asserted in this case.
In the past, we maintained product liability insurance only with respect to claims that tobacco products manufactured by or for us contained any foreign object (i.e., any object that was not intended to be included in the manufactured product). The product liability insurance previously maintained did not cover health-related claims such as those that have been made against the major manufacturers of tobacco products. We do not believe that insurance for health-related claims can currently be obtained. Although we ceased selling cigarettes in 2007 and exited from the tobacco business as of December 31, 2012, we may be named as a defendant in such cases in the future. However, we believe that we have conducted our business in a manner that decreases the risk of liability in a lawsuit of the type described above, because we have attempted to consistently present to the public the most current information regarding the health risks of long-term smoking and tobacco use generally, have always acknowledged the addictive nature of nicotine and have never targeted adolescent or young persons as customers.
Government Investigation. In late January and February of 2013, our company, directors and others received subpoenas from the United States Attorney’s Office for the Eastern District of Virginia seeking documents. In connection with this matter on January 21, 2014, a Grand Jury in the Eastern District of Virginia returned an indictment as a result of this investigation against former Governor McDonnell and his wife. No charges have been filed against our company or any of our employees or directors. Our present understanding is that the investigation as to our company is nearing completion and based on discussions and communications between our outside counsel and the USAO, we do not believe our company will be prosecuted for any of the matters that the USAO has been investigating.
FDA Warning Letter. On December 24, 2013, our company received a warning letter from the FDA regarding our CigRx® and Anatabloc® dietary supplements. In the letter the FDA asserted that CigRx® and Anatabloc® were not properly marketed as dietary supplements, since our company had not filed a New Dietary Ingredient Notification for anatabine as a dietary ingredient prior to the introduction of our dietary supplements. FDA also claimed that certain materials on our websites, including published research articles, constitute drug claims for Anatabloc®. We responded to the FDA Letter on January 31, 2014 contesting the FDA’s position with respect to the status of our dietary supplements and noting that we had voluntarily removed from our website materials objected to by the FDA. We are currently communicating with the FDA in an effort to reach an amicable resolution of the issues asserted by FDA in its letter. While we believe our dietary supplements are legally on the market and we continue to sell these products, if we are unable to resolve our issues with the FDA, the agency could seek to prohibit us from continuing to sell these products as dietary supplements. While we seek to resolve these issues with the FDA, we are continuing to focus on our core business activities, including the sale of our dietary supplements and the development of pharmaceutical products, consistent with our stated intent to focus more of our company’s effort on drug development efforts on a going forward basis.
Recent Transactions and Potential for Additional Financing
See Note 16 to our consolidated financial statements included in “Item 15. Exhibits, Financial Statement Schedules” of this Report.
Off-Balance Sheet Arrangements
Our company does not have any off-balance sheet arrangements as defined by Item 303(a)(4) of Regulation S-K.
Contractual Obligations
At December 31, 2013, our company’s contractual cash obligations, with initial or remaining terms in excess of one year, were as follows (in thousands):
Our company had purchase commitments as of December 31, 2013 totaling $1.3 million.
Employment contracts are not included in the above table.
Accounting and Reporting Developments
See Note 1 to our consolidated financial statements included in “Item, 15 Exhibits, Financial Statement Schedules” of this Report.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our company has not entered into any transactions using derivative financial instruments or derivative commodity instruments and believes that our exposure to market risk associated with other financial instruments (such as investments and borrowings) and interest rate risk is not material.
ITEM 8.
ITEM 8.
CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements and notes thereto and the Report of Cherry Bekaert LLP are included in “Item 15. Exhibits, Financial Statement Schedules” and are incorporated herein by reference.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
(a) Disclosure Controls and Procedures.
As required by Rule 13a-15 under the Exchange Act management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Report. Disclosure controls and procedures refer to controls and other procedures designed to provide reasonable assurance that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding our required disclosure. In designing and evaluating our 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 was required to apply its judgment in evaluating and implementing possible controls and procedures.
Our Chief Executive Officer and Chief Financial Officer have concluded, based on this evaluation, that as of December 31, 2013, the end of the period covered by this Report, our disclosure controls and procedures were effective at a reasonable assurance level.
(b) Management’s Annual Report on Internal Control Over Financial Reporting.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting, as defined in rules promulgated under the Exchange Act, is a process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer and effected by our Board of Directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America, or GAAP. Internal control over financial reporting includes those policies and procedures that:
·
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
·
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that our receipts and expenditures are being made only in accordance with authorizations of our management and our Board of Directors; and
·
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.
Our internal control over financial reporting is evaluated on a regular basis by personnel in our organization. The overall goals of these various evaluation activities are to monitor our internal control over financial reporting and to make modifications as necessary, as disclosure and internal controls are intended to be dynamic systems that change (including improvements and corrections) as conditions warrant. Part of this evaluation is to determine whether there were any significant deficiencies or material weaknesses in our internal control over financial reporting, or whether we had identified any acts of fraud involving personnel who have a significant role in our internal control over financial reporting. Significant deficiencies are control issues that could have a significant adverse effect on the ability to record, process, summarize and report financial data in the financial statements. Material weaknesses are particularly serious conditions where the internal control over financial reporting does not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur in amounts that would be material in relation to the financial statements and not be detected within a timely period by employees in the normal course of performing their assigned functions.
Management conducted an assessment of the effectiveness of our company’s internal control over financial reporting as of December 31, 2013, utilizing the framework established in “INTERNAL CONTROL-INTEGRATED FRAMEWORK” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management has determined that our internal controls over financial reporting as of December 31, 2013 were effective.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Cherry Bekaert LLP, an independent registered public accounting firm, has audited the effectiveness of our internal control over financial reporting as of December 31, 2013, as stated in their report, which appears on page of “Item 15, Exhibits, Financial Statement Schedules” of this Report.
(c) Changes in Internal Control Over Financial Reporting.
During the fourth quarter of 2013, in connection with the evaluation of internal controls described above in paragraph (b) of this Item 9A, there were no changes in our internal control over financial reporting for the year ended December 31, 2013 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
On March 12, 2014, we entered into a series of financing transactions that resulted in gross cash proceeds to our company of approximately $9.3 million and a credit facility of approximately $5.8 million, for total available funds of $15.1 million.
Equity Transactions
On March 12, 2014, we entered into separate Securities Purchase and Registration Rights Agreements (the “March 12th Warrant Agreements”) with two accredited investors who held previously issued warrants for 4,167,940 shares of our common stock, at exercise prices ranging from $1.50 per share to $2.00 per share. Pursuant to the March 12th Warrant Agreements, in order to induce each warrant holder to immediately exercise the prior warrants, we agreed to (i) reduce the exercise price of the prior warrants to $1.00 per share, and (ii) grant each warrant holder a new warrant with an exercise price of $1.00 per share for the same amount of shares of common stock as the prior warrants (an aggregate of 4,167,940 shares of common stock). In exchange, each warrant holder agreed to immediately exercise its prior warrants, whereby the warrant holder purchased an aggregate of 4,167,940 shares of common stock resulting in gross proceeds to our company of $4.2 million. The new warrants are exercisable beginning six months following the date of the March 12th Warrant Agreement into an aggregate of 4,167,940 shares of common stock, and expire on September 12, 2021. Additionally, the March 12th Warrant Agreements grant the warrant holders certain customary resale registration rights with respect to the shares common stock underlying the new warrants. In addition, we granted these investors certain rights to participate in our future equity financings for a period of two years.
On March 12, 2014, we also entered into separate Securities Purchase and Registration Rights Agreements (the “March 12th Direct Investment Agreements”) with four different accredited investors (each, a “Direct Investor”) to sell an aggregate of 5,100,000 shares of common stock, at $1.00 per share and warrants to purchase an aggregate of 5,100,000 shares of common stock at an exercise price of $1.00 per share. This transaction resulted in gross proceeds to us of $5.1 million. The warrants are exercisable beginning six months following the date of the March 12th Direct Investment Agreement into an aggregate of 5,100,000 shares of common stock, and expire on March 12, 2021. Additionally, the March 12th Direct Investment Agreements grant the Direct Investors certain customary resale registration rights with respect to the shares of common stock underlying the warrants. In addition, we granted these investors certain rights to participate in our future equity financings for a period of two years.
Each of offerings referred to above was made only to accredited investors as such term is defined in Rule 501 of Regulation D promulgated under the Securities Act of 1933, as amended. We relied on the exemption from the registration requirements of the Securities Act set forth in Section 4(2) thereof and the rules and regulations promulgated thereunder. Each of the investors are third parties not affiliated with our company (except for such investor’s previous investments in our company), except that one investor is a non-employee consultant to our company (and this individual paid an additional $0.125 per warrant issued to him, as required by the rules of the Nasdaq Stock Market). Our common stock is traded on the Nasdaq Global Market under the symbol “STSI”. On March 12, 2014, the last reported sale price of the common stock was $1.00 per share.
Loan Agreement
On March 12, 2014, we also entered into a loan agreement with another existing investor pursuant to which that investor agreed to loan us up to $5.8 million (the “Loan Agreement”). The term of the Loan Agreement is through April 15, 2015 (and each note representing an advance under the Loan Agreement will have a two year term before maturity). Interest for outstanding advances under the Loan Agreement will bear interest at three percent. In consideration for lender’s entry into the Loan Agreement, we issued to the investor 500,000 warrants that have the same terms and conditions (and strike price) of the warrants described above related to the March 12th offerings.
Each advance made by the lender to us must be in increments of $1.250 million, and the aggregate amount of advances to us during any 30 day period cannot exceed $1.250 million. We are not permitted to request any advances under the Loan Agreement until a majority of the proceeds from the March 12th offerings discussed above have been used by us. Unless consented to by the lender, we are not permitted to re-borrow advances once they have been repaid by us. Further, the maximum amount under the Loan Agreement of $5.8 million will be reduced over the term to the extent that we raise third party equity financing. We are permitted to terminate the Loan Agreement if we raise equity financing greater than $5.8 million during the term, subject to lender’s conversion rights discussed below.
Pursuant to the Loan Agreement, the lender has certain conversion rights whereby the lender would be permitted to convert outstanding advances into shares of our common stock and a matching warrant to purchase an equal number of additional shares of common stock. The conversion price would be $1.00, and any warrant issued upon conversion would have the same terms and conditions (and strike price) of the warrants described above related to the March 12th offerings. Lender would not be permitted to convert outstanding advances if, upon conversion, lender would beneficially own more than 9.9% of our then outstanding common stock.
Other terms and conditions of the Loan Agreement include the following:
·
We will provide lender with a statement of how we use proceeds of any advances.
·
We are permitted to draw down the entire amount available for advance at the end of the term, and are permitted to force lender to convert such draw (subject to the 9.9% ownership cap discussed above, with any amounts not converted either paid by us in cash or left outstanding for the term of the underlying note).
·
We granted the lender certain rights to participate in our future equity financings for a period of two years (but only to the extent there are then outstanding advances under the Loan Agreement).
·
We granted the lender certain customary resale registration rights with respect to the shares of common stock and warrants that may be issued in connection with the conversion rights discussed above.
·
Lender is permitted to accelerate the payment of any note if we fail to deliver common stock or warrants upon conversion, we fail to repay a note on its maturity date or actions generally being taken with respect to bankruptcy and similar proceedings.
PART III
ITEM 10.
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
This information is incorporated by reference from our company's Proxy Statement with respect to the 2014 Annual Meeting of Stockholders to be filed with the SEC no later than April 30, 2014.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
This information is incorporated by reference from our company's Proxy Statement with respect to the 2014 Annual Meeting of Stockholders.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
This information is incorporated by reference from our company's Proxy Statement with respect to the 2014 Annual Meeting of Stockholders.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
This information is incorporated by reference from our company's Proxy Statement with respect to the 2014 Annual Meeting of Stockholders.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
This information is incorporated by reference from our company's Proxy Statement with respect to the 2014 Annual Meeting of Stockholders.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) Documents filed as part of this Report.
1. Consolidated Financial Statements
2. Financial Statements Schedules
None.
(b) Exhibits.
An index to exhibits has been filed as part of this Report beginning on page E-1 and is incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: March 17, 2014
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX TO EXHIBITS
Item
Description
2.1
Asset Purchase Agreement between Star Scientific, Inc., a Delaware corporation and Eyetech, LLC, a Minnesota limited liability company, by Robert J. Fitzsimmons, an individual residing in St. Paul, Minnesota, dated December 30, 1998(1)
3.1
Ninth Amended and Restated Certificate of Incorporation of Star Scientific, Inc.(2)
3.2
Amended and Restated Bylaws of Star Scientific, Inc.(3)
10.1
License Agreement between Star Tobacco and Pharmaceuticals, Inc., as Licensee and Regent Court Technologies, Jonnie R. Williams, and Francis E. O’Donnell, Jr., M.D., as Licensor, dated January 5, 1998(4)
10.2
Amendment No. 1 to License Agreement between Regent Court Technologies, Jonnie R. Williams, Francis E. O’Donnell, Jr., M.D. and Star Tobacco and Pharmaceuticals, Inc., dated August 3, 1998(5)
10.3
1998 Stock Option Plan, as amended(6)
10.4
2000 Equity Incentive Plan, as amended(7)
10.5
Third Amended and Restated 2008 Incentive Award Plan
10.6
Qualified Stock Option Agreement dated as of April 27, 1999 between Star Scientific, Inc. and Paul L. Perito(8)
10.7
Lease and Purchase Option Contract between Star Scientific, Inc. and the Industrial Development Authority of the Town of Chase City, Virginia, dated March 10, 2000(6)
10.8
Form of Director Indemnification Agreement(6)
10.9
Form of Officer Indemnification Agreement(6)
10.10
Executive Employment Agreement between Star Scientific, Inc. and David M. Dean, dated October 6, 2000(7)
10.11
Restated Loan Agreement between Star Scientific, Inc., Star Tobacco and Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation, dated August 21, 2000(9)
10.12
Restated Security Agreement between Star Scientific, Inc. and Brown & Williamson Tobacco Corporation, dated August 21, 2000(9)
10.13
Security Agreement between Star Tobacco and Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation, dated August 21, 2000(9)
10.14
Guaranty Agreement between Star Scientific, Inc. and Brown & Williamson Tobacco Corporation, dated August 21, 2000(9)
10.15
Guarantee Agreement between Star Tobacco and Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation, dated August 21, 2000(9)
10.16
Amended and Restated Executive Employment Agreement dated as of March 15, 2001 between Star Scientific, Inc. and Christopher G. Miller(7)
10.17
Executive Employment Agreement dated as of March 30, 2001 between Star Scientific, Inc. and Robert E. Pokusa(7)
10.18
Restated Master Agreement, dated April 25, 2001, by and between Star Scientific, Inc. and Brown & Williamson Tobacco Corporation(10)
10.19
First Amendment to Restated Loan Agreement dated April 25, 2001, among Star Scientific, Inc., Star Tobacco & Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation(10)
10.20
Trademark License and Royalty Agreement, dated April 25, 2001, between Star Scientific, Inc. and Brown & Williamson Tobacco Corporation(10)
10.21
Other Low TSNA Tobacco Royalty Agreement, dated April 25, 2001 by and between Star Scientific, Inc. and Brown & Williamson Tobacco Corporation(10)
10.22
First Amendment to Regent/B&W License Agreement, dated April 25, 2001, by and among Regent Court Technologies, Jonnie R. Williams, Francis O’Donnell, Jr., Star Scientific, Inc. and Brown & Williamson Tobacco Corporation(10)
Item
Description
10.23
Exclusive License Agreement dated as of March 16, 2001 by and among Regent Court Technologies and Star Scientific, Inc.(11)
10.24
Consent to Assignment dated March 16, 2001 by and among Regent Court Technologies, Jonnie R. Williams, Francis O’Donnell, Jr., M.D., Star Tobacco & Pharmaceuticals, Inc., Star Scientific, Inc. and Brown & Williamson Tobacco Corporation(11)
10.25
Amendment No. 1 dated April 5, 2001 to Exclusive License Agreement by and among Regent Court Technologies and Star Scientific, Inc.(11)
10.26
Contract with Lease and Option to Purchase by and among The Industrial Development Authority of Mecklenburg County, Virginia, The Industrial Development Authority of the Town of Chase City, Virginia, and Star Scientific, Inc., dated April 10, 2002(12)
10.27
Convertible Debenture, dated March 25, 2004, issued by Star Scientific, Inc. to Manchester Securities Corp. Debenture was amended and then converted(13)
10.28
Warrant, dated March 25, 2004, issued by Star Scientific, Inc. to Manchester Securities Corp.(13)
10.29
Securities Purchase Agreement, dated March 25, 2004, between Star Scientific, Inc. and Manchester Securities Corp.(13)
10.30
Registration Rights Agreement, dated March 25, 2004, between Star Scientific, Inc. and Manchester Securities Corp.(13)
10.31
Common Stock Purchase Warrant, dated as of March 25, 2004, issued by Star Scientific, Inc. to Reedland Capital Partners, an Institutional Division of Financial West Group(13)
10.32
Executive Employment Agreement, dated December 30, 2005 between Star Scientific, Inc. and Jonnie R. Williams(14)
10.33
Second Amended and Restated Employment Agreement, dated December 30, 2005 between Star Scientific, Inc. and Paul L. Perito(14)
10.34
Securities Purchase and Registration Rights Agreement, dated as of March 3, 2006, between Star Scientific, Inc. and Joseph L. Schwarz(15)
10.35
Common Stock Purchase Warrant, dated as of March 3, 2006, issued by Star Scientific, Inc. to Joseph L. Schwarz(15)
10.36
Securities Purchase and Registration Rights Agreement, dated July 14, 2006, by and between Star Scientific, Inc. and Iroquois Capital(16)
10.37
Common Stock Purchase Warrant, dated July 14, 2006, issued by Star Scientific, Inc. to Iroquois Capital(16)
10.38
Securities Purchase and Registration Rights Agreement, dated July 14, 2006, by and between Star Scientific, Inc. and Delaware Charter Guarantee and Trust Company, FBO Joseph L. Schwarz, IRA(16)
10.39
Common Stock Purchase Warrant, dated July 14, 2006, issued by Star Scientific, Inc. to Delaware Charter Guarantee and Trust Company, FBO Joseph L. Schwarz IRA(16)
10.40
First Amendment to Executive Employment Agreement, dated December 15, 2006 between Star Scientific, Inc. and Jonnie R. Williams(3)
10.41
First Amendment to Second Amended Executive Employment Agreement, dated December 15, 2006 between Star Scientific, Inc. and Paul L. Perito(3)
10.42
Escrow Releases Purchase Agreement dated March 14, 2007 by and among QVT Associates LP, Whitebox Hedged High Yield Partners, LP, Star Scientific, Inc. and Star Tobacco, Inc.(17)
10.43
Second Amendment to Second Amended Executive Employment Agreement, dated March 23, 2007 between Star Scientific, Inc. and Paul L. Perito(18)
10.44
License Agreement, dated May 10, 2007 between Star Tobacco, Inc., Star Scientific, Inc. and Tantus Tobacco, LLC(19)
10.45
Securities Purchase and Registration Rights Agreement, dated June 29, 2007, by and between Star Scientific, Inc. and Joseph L. Schwarz(20)
10.46
Common Stock Purchase Warrant dated June 29, 2007, issued by Star Scientific, Inc. to Pershing LLC, FBO Joseph L. Schwarz Roth IRA(20)
Item
Description
10.47
Common Stock Purchase Warrant dated June 29, 2007 issued by Star Scientific, Inc. to Joseph L. Schwarz(20)
10.48
Securities Purchase and Registration Rights Agreement, dated June 29, 2007 by and between Star Scientific, Inc. and Joseph Rice(20)
10.49
Common Stock Purchase Warrant dated June 29, 2007 issued by Star Scientific, Inc. to Joseph Rice(20)
10.50
Agreement dated October 10, 2007 by and between Christopher G. Miller and Star Scientific, Inc.(21)
10.51
Agreement dated October 10, 2007 by and between Park A. Dodd, III and Star Scientific, Inc.(21)
10.52
Securities Purchase and Registration Rights Agreement, dated March 13, 2008 by and between Star Scientific, Inc. and the several Investors party thereto, including the form of Warrant thereunder(22)
10.53
Securities Purchase and Registration Rights Agreement, dated March 14, 2008 by and between Star Scientific, Inc. and the several Investors party thereto, including the form of Warrant thereunder(22)
10.54
Securities Purchase and Registration Rights Agreement, dated May 12, 2008 by and between Star Scientific, Inc. and the several Investors party thereto, including the form of Warrant thereunder(23)
10.55
Letter Agreement with Jonnie R. Williams, dated March 14, 2008(23)
10.56
Executive Employment Agreement dated February 26, 2008 between Star Scientific, Inc. and Curtis Wright, M.D. MPH(22)
10.57
Amendment to Executive Employment Agreement dated as of December 19, 2008 between Star Scientific, Inc. and Robert E. Pokusa(24)
10.58
Securities Purchase and Registration Rights Agreement, dated March 2, 2009 by and between Star Scientific, Inc. and the several Investors party thereto, including the form of Warrant thereunder(25)
10.59
Securities Purchase and Registration Rights Agreement, dated September 22, 2009 by and between Star Scientific, Inc. and the Investor party thereto, including the form of Warrant thereunder(26)
10.60
Executive Employment Agreement dated January 1, 2010 between Star Scientific, Inc. and Park A. Dodd, III(27)
10.61
Securities Purchase and Registration Rights Agreement, dated March 5, 2010, by and between Star Scientific, Inc. and the several Investors party thereto.(28)
10.62
Amended Warrant, dated March 5, 2010, by and between Star Scientific, Inc. and Iroquois Master Fund Ltd.(28)
10.63
Amended Warrant, dated March 5, 2010, by and between Star Scientific, Inc. and Iroquois Capital, LP.(28)
10.64
Securities Purchase and Registration Rights Agreement, dated March 9, 2010, by and between Star Scientific, Inc. and the several Investors party thereto.(29)
10.65
Amended Warrant No. 1, dated March 9, 2010, by and between Star Scientific, Inc. and Tradewinds Master Fund (BVI), Ltd.(29)
10.66
Amended Warrant No. 2, dated March 9, 2010, by and between Star Scientific, Inc. and Tradewinds Master Fund (BVI), Ltd.(29)
10.67
Amended Warrant No. 1, dated March 9, 2010, by and between Star Scientific, Inc. and Feehan Partners, L.P.(29)
10.68
Amended Warrant No. 2, dated March 9, 2010, by and between Star Scientific, Inc. and Feehan Partners, L.P.(29)
10.69
Amended Warrant No. 1, dated March 9, 2010, by and between Star Scientific, Inc. and PV Partners, L.P.(29)
10.70
Amended Warrant No. 2, dated March 9, 2010, by and between Star Scientific, Inc. and PV Partners, L.P.(29)
10.71
Securities Purchase and Registration Rights Agreement, dated March 9, 2010, by and between Star Scientific, Inc. and the several Investors party thereto, including the form of Warrant attached as Exhibit A thereon.(29)
10.72
Securities Purchase and Registration Rights Agreement, dated March 10, 2010, by and between Star Scientific, Inc. and the Investor party thereto, including the form of Warrant attached as Exhibit A thereon.(29)
10.73
Amended Securities Purchase and Registration Rights Agreement, dated March 12, 2010, by and between Star Scientific, Inc. and the Investor party thereto.(29)
Item
Description
10.74
Securities Purchase and Registration Rights Agreement, dated March 12, 2010, by and between Star Scientific, Inc. and the several Investor party thereto, including the form of Warrant attached as Exhibit A thereon.(29)
10.75
Securities Purchase and Registration Rights Agreement, dated November 5, 2010, by and between Star Scientific, Inc. and the several Investors party thereto, including the form of Warrant attached as Exhibit A thereon.(30)
10.76
Securities Purchase and Registration Rights Agreement, dated February 28, 2011, by and between Star Scientific, Inc. and the Investor party thereto, including the form of Warrant attached as Exhibit A thereon.(31)
10.77
Securities Purchase and Registration Rights Agreement, dated March 4, 2011, by and between Star Scientific, Inc. and the several Investors party thereto, including the form of Warrant attached as Exhibit A thereon.(31)
10.78
Executive Employment Agreement, dated March 14, 2011, between Star Scientific, Inc. and Jonnie R. Williams.(32)
10.79
Third Amended and Restated Executive Employment Agreement, dated March 14, 2011, between Star Scientific, Inc. and Paul L. Perito.(32)
10.80
Amended and Restated Executive Employment Agreement, dated March 14, 2011, between Star Scientific, Inc. and Curtis Wright, IV, MD, MPH.(32)
10.81
Securities Purchase and Registration Rights Agreement, dated December 22, 2011, by and between Star Scientific, Inc. and the Investor party thereto, including the form of Warrant attached as Exhibit A thereon.(33)
10.82
Securities Purchase and Registration Rights Agreement, dated February 28, 2012, by and between Star Scientific, Inc. and the Investor party thereto, including the form of Warrant attached as Exhibit A thereon. (34)
10.83
Amendment to Third Amended and Restated Executive Employment Agreement, dated December 28, 2012 between Star Scientific, Inc. and Paul L. Perito(35)
10.84
Amendment to Executive Employment Agreement, dated December 28, 2012 between Star Scientific, Inc. and Jonnie R. Williams(35)
10.85
Executive Employment Agreement, dated December 27, 2013, between Star Scientific, Inc. and Michael J. Mullan
10.86
Executive Employment Agreement, dated December 27, 2013, between Star Scientific, Inc. and Christopher C. Chapman
10.87
Second Amendment to Executive Employment Agreement, dated December 26, 2013 between Star Scientific, Inc. and Jonnie R. Williams
10.88
Second Amendment to Third Amended and Restated Executive Employment Agreement, dated December 26, 2013 between Star Scientific, Inc. and Paul L. Perito
10.89
Form of Agreement for Extension of Stock Options for Directors on Board as of December 26, 2013
21.1
Subsidiaries of the Company
23.1
Consent of Cherry Bekaert LLP
31.1
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Certification of the Chief Executive Officer pursuant to 18 U.S.C. § 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002
32.2
Certification of the Chief Financial Officer pursuant to 18 U.S.C. § 1350, as created by Section 906 of the Sarbanes-Oxley Act of 2002
EX-101
INSTANCE DOCUMENT
EX-101
SCHEMA DOCUMENT
EX-101
CALCULATION LINKBASE DOCUMENT
EX-101
LABELS LINKBASE DOCUMENT
EX-101
PRESENTATION LINKBASE DOCUMENT
EX-101
DEFINITION LINKBASE DOCUMENT
(1)
Incorporated by reference to Current Report on Form 8-K filed on March 3, 1999
(2)
Incorporated by reference to Current Report on Form 8-K filed on December 30, 2013
(3)
Incorporated by reference to Current Report on Form 8-K filed on December 21, 2006
(4)
Incorporated by reference to Quarterly Report on Form 10-QSB for the quarter ended March 31, 1998
(5)
Incorporated by reference to Current Report on Form 8-K filed on September 14, 1998
(6)
Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1999
(7)
Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 2000
(8)
Incorporated by reference to Quarterly Report on Form 10-QSB for the quarter ended June 30, 1999
(9)
Incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended September 30, 2000
(10)
Incorporated by reference to Current Report on Form 8-K filed on May 17, 2001
(11)
Incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended September 30, 2001
(12)
Incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended June 30, 2002
(13)
Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 2003
(14)
Incorporated by reference to Current Report on Form 8-K filed on December 30, 2005
(15)
Incorporated by reference to Current Report on Form 8-K filed on March 7, 2006
(16)
Incorporated by reference to Current Report on Form 8-K filed on July 18, 2006
(17)
Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 2006
(18)
Incorporated by reference to Current Report on Form 8-K filed on March 28, 2007
(19)
Incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended June 30, 2007
(20)
Incorporated by reference to Current Report on Form 8-K filed on July 6, 2007
(21)
Incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended September 30, 2007
(22)
Incorporated by reference to Annual Report on Form 10-K filed for the year ended December 31, 2007
(23)
Incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended March 31, 2008
(24)
Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 2008
(25)
Incorporated by reference to Current Report on Form 8-K filed on March 3, 2009
(26)
Incorporated by reference to Current Report on Form 8-K filed on September 25, 2009
(27)
Incorporated by reference to Current Report on Form 8-K filed on January 28, 2010
(28)
Incorporated by reference to Current Report on Form 8-K filed on March 5, 2010
(29)
Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 2009
(30)
Incorporated by reference to Registration Statement on Form S-3 filed on December 10, 2010
(31)
Incorporated by reference to Current Report on Form 8-K filed on March 4, 2011
(32)
Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 2010
(33)
Incorporated by reference to Current Report on Form 8-K filed on December 28, 2011
(34)
Incorporated by reference to Current Report on Form 10-Q for the quarter ending March 31, 2012
(35)
Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 2012
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Star Scientific, Inc. and Subsidiaries
We have audited the accompanying consolidated balance sheets of Star Scientific, Inc. and Subsidiaries (the “Company”) as of December 31, 2013 and 2012, and the related statements of operations, stockholders’ equity (deficit) and cash flows for each of the years in the three-year period ended December 31, 2013. We also have audited the Company’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Annual Report on Internal Control over Financial Reporting included in Item 9A - Controls and Procedures in the Company’s 2013 Annual Report on Form 10-K. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Star Scientific, Inc. and Subsidiaries as of December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2013 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion the Company maintained, in all material respects, effective control over financial reporting as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
/s/ Cherry Bekaert LLP
Richmond, Virginia
March 17, 2014
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2013 AND 2012
($ in thousands except per share data)
(A)
$.0001 par value, 274,800,000 shares authorized; and 172,384,178 and 166,349,158 shares issued and outstanding as of December 31, 2013 and 2012, respectively.
(B)
Class A, convertible, $.01 par value, 4,000 shares authorized, no shares issued or outstanding; Series B, convertible; $.01 par value 15,000 shares authorized, no shares issued or outstanding.
See notes to consolidated financial statements.
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2013, 2012 AND 2011
($ and share in thousands except per share data)
See notes to consolidated financial statements.
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
YEARS ENDED DECEMBER 31, 2013, 2012 AND 2011
($ and shares in thousands except per share data)
See notes to consolidated financial statements.
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2013, 2012 AND 2011
($ in thousands except per share data)
See notes to consolidated financial statements.
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Nature of business and summary of significant accounting policies:
Nature of business:
Star Scientific is a technology-oriented company with a mission to promote the maintenance of a healthy metabolism and lifestyle. Since the incorporation of its Rock Creek Pharmaceuticals, or Rock Creek, subsidiary in 2007, it has focused on utilizing certain alkaloids found in the Solanacea family of plants, which includes potatoes, tomatoes, and eggplants, initially to address issues related to the desire to smoke or use other traditional tobacco products. More recently, Rock Creek has been concentrating on the anti-inflammatory aspects of one of those alkaloids, anatabine. The Company believes its research and development efforts relating to the anatabine alkaloid has positioned it to utilize its technology to develop a range of non-nicotine dietary supplements and potentially related pharmaceutical products that could be beneficial in maintaining a healthy metabolism and in supporting good nutrition. In December 2013, the Company underwent a fundamental corporate transition that significantly changed the operation direction and focus of the Company. The Company’s future prospects will be dependent on its ability to transition into the area of drug development, the distribution and consumer acceptance of its products and related line extensions of those products, its ability to appropriately scale its sales and marketing expenses for these products and manage its overall operating expenses, and its ability to obtain additional capital necessary to support its operations (particularly research and development and related expenses in connection with its drug development operations).
Since the introduction of the Company’s Anatabloc® dietary supplement in 2011, its revenues have been derived almost entirely from sales of its anatabine based nutraceutical products. Future sales of the Company’s dietary supplements will be dependent on the Company resolving issues with the FDA regarding a warning letter it received in December 2013, relating to the status of its Anatabloc ® and CigRx ® products and any other developments with respect to the status of those products, given the fact that the Company has limited the marketing and advertising of its dietary supplements following receipt of the FDA warning letter.
Due to continuing operating losses, the Company ceased selling any tobacco products as of December 31, 2012, although it continues to look for licensing opportunities related to its low-TSNA curing technology and related products. The Company’s technological development of reducing TSNA levels led to the focus on the development of non-nicotine tobacco-based pharmaceutical products and the non-nicotine dietary supplements.
Principles of consolidation:
The accompanying consolidated financial statements include the accounts of Star Scientific and its wholly owned subsidiaries, Rock Creek and Star Tobacco. All intercompany accounts and transactions have been eliminated.
Cash and cash equivalents:
For purposes of the statements of cash flows, the Company classifies all highly liquid investments with an original maturity of three months or less as cash equivalents.
Inventories:
Inventories are valued at the lower of cost or market. Cost is determined on the first-in, first-out (FIFO) method.
The Company accounts for freight, handling and wasted materials costs as current period charges. The Company outsources the production and storage of all of its dietary supplement and cosmetic products. The cost charged by the outsourced vendors is included in inventory costs.
Property and equipment:
Property and equipment are recorded at cost. Depreciation is determined using the straight-line method over the estimated useful lives of three to seven years for office equipment and machinery and equipment and improvements. Assets held for sale are the equipment that was idled as a result of exiting the dissolvable smokeless tobacco business. The ultimate disposition of the equipment has not been determined.
Intangible assets:
Intangible assets consist primarily of licensing costs, patents and trademarks and packaging design costs. Intangibles are amortized using the straight-line method over a period of seventeen years for patents and licensing costs and five years for packaging design costs (the assets’ estimated lives). Substantially all trademarks owned by the Company have indefinite lives and, as such, the cost of trademarks are not amortized, but are evaluated annually for impairment.
The Master Settlement Agreement (“MSA” or Master Settlement Agreement”) escrow fund:
Cash deposits to which the Company has not transferred its ownership rights and which are restricted pursuant to the MSA have been reflected as a non-current asset in the Company’s consolidated financial statements. Amounts deposited into MSA escrow accounts are required to be held in escrow for 25 years. (See note 14 for contingency discussion.)
Income taxes:
Deferred income tax assets and liabilities are computed annually for differences between the financial statement and federal income tax bases of assets and liabilities that will result in taxable or deductible amounts in the future, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. As of the date of this Report, the Company’s income tax returns for the years 2012, 2011, and 2010 are open to examination by the relevant taxing authority. Management has evaluated all other tax positions that could have a significant affect on the financial statements and determined the Company had no uncertain tax positions at December 31, 2013 and 2012.
Employee stock-based compensation:
The Company uses a fair-value based method to determine compensation for all arrangements under which employees and others receive shares of stock.
Impairment of long-lived assets:
The Company reviews the carrying value of its amortizing long-lived assets whenever events or changes in circumstances indicate that the historical cost-carrying value of an asset may no longer be appropriate.
The Company assesses recoverability of the asset by estimating the future undiscounted net cash flows expected to result from the asset, including eventual disposition. If the estimated future undiscounted net cash flows are less than the carrying value of the asset, an impairment loss is recorded equal to the difference between the asset’s carrying value and its fair value. Non-amortizing intangibles (trademarks) are reviewed annually for impairment.
Loss per common share:
Basic loss per common share is computed using the weighted-average number of common shares outstanding.
Diluted loss per share is computed assuming conversion of all potentially dilutive stock options and warrants. Potential common shares outstanding are excluded from the computation if their effect is anti-dilutive (See note 8).
Revenue Recognition:
Revenue for the Company’s dietary supplements and cosmetic products that are shipped to its direct buying consumers is recognized upon delivery of the product to the consumer. The dietary supplement products are shipped once the Company has received confirmation of a valid credit card charge, which is the only payment option offered to consumers of the dietary supplements and cosmetic products purchasing through the Company’s webstore.
Under certain retail agreements we have agreed to “pay on scan” terms of sale for its dietary supplement products. The “pay on scan” terms do not constitute a sale of the product until the product is sold to a consumer. Under these agreements, revenue is recognized by us at the time the consumer purchases the product from the consignee. The Company uses weekly reports from the consignee to derive the revenue recorded. The sales of products through these outlets are also subject to the same promotional and return credits discussed in the next paragraph. All of the Company’s products sold on a “pay-on-scan” basis, whether in a warehouse or retail location, is considered consignment inventory and accordingly we retain all risk of loss until sale.
The Company records consumer incentives and trade promotion activities as a reduction of revenues based on amounts estimated as being due to customers and consumers at the end of a period. The estimates are based principally on historical utilization and redemption rates of the Company’s products. Such programs include discounts, coupons, rebates, slotting fees, in-store display incentives and volume-based incentives.
Cost of Goods Sold
Cost of Goods Sold consists of the direct and indirect costs to produce and distribute the Company’s products. Inventory related costs include materials, inbound freight, production costs, inventory obsolescence and shrinkage. In addition to the aforementioned, the costs for the Company’s dietary supplement products (Anatabloc ® and CigRx ®) and cosmetic products (Anatabloc ® Facial Crème, Anatabloc Serum and Anatabloc Cleanser) include fulfillment partner fees, credit card processing fees, and costs of consumer support.
Shipping costs:
The Company’s dietary supplement products and cosmetic products are currently offered to direct buying consumers and are sold on consignment at certain retail locations. All shipping costs are paid for by the Company; however, the Company offers some premium shipping in the United States and charges its customers additional fees. International customers are charged a shipping fee, which is included in the sales price. All shipping costs are included in the cost of goods sold.
Advertising Costs:
Advertising costs are expensed as incurred and are included in marketing and sales expenses. Advertising costs for the years 2013, 2012 and 2011, were $3.8 million, $2.9 million, and $0.9 million, respectively.
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 income and expenses during the reporting period. Actual results could differ from those estimates.
Research and Development:
Research and development costs are expensed as incurred.
Research and Development royalty contracts:
The Company entered into a contract under which royalty payments are due based on Anatabloc® product sales. The contract requires the other party to the contract to perform research and development services at a minimum investment level before royalties are payable. The royalty is a percentage of gross sales and recorded at the contracted rate, however the royalty is subject to adjustment annually based on the other party performing research and development services at a required minimum level. Changes in the estimated royalty to be paid are treated as changes in estimates and are recognized in the period of change.
Commitment and contingency accounting:
The Company evaluates each commitment and/or contingency in accordance with the accounting standards which state that if the item is probable to become a direct liability then the Company will record the liability in the financial statements. If not, it will disclose any material commitments or contingencies that may arise.
Recent Accounting and Reporting Pronouncements:
From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board, or FASB, or other standard setting bodies that may have an impact on the Company’s accounting and reporting.
In July 2013, the FASB issued ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carry forward, a Similar Tax Loss, or a Tax Credit Carry forward Exists ("ASU 2013-11"). ASU 2013-11 is effective for the first interim or annual period beginning on or after December 15, 2013 with early adoption permitted. ASU 2013-11 amends ASC Topic 740, Income Taxes, to provide guidance and reduce diversity in practice on the financial statement presentation of an unrecognized tax benefit when a net operating loss carry forward, a similar tax loss, or a tax credit carry forward exists. The initial application of the standard is not expected to significantly impact the Company.
The Company believes that all recently issued accounting pronouncements and other authoritative guidance for which the effective date is in the future either will not have an impact on its accounting or reporting or that such impact will not be material to its financial position, results of operations, and cash flows when implemented.
2.
Liquidity and managements’ plans:
The Company has been operating at a loss for the past eleven years. Star Scientific’s future prospects will depend on its ability to transition into the area of drug development, the distribution and consumer acceptance of its products and line extensions of those products. In the long term, the Company expects that its revenues will shift to be more dependent on the ability to successfully implement its drug development program, but it has no drug products in advance development as of this date. The Company has considerable intellectual property related to the low-TSNA curing methodology and dissolvable tobacco products, which it intends to pursue through licensing agreements.
Star Scientific introduced Anatabloc®, its dietary supplement for anti-inflammatory support, in August 2011 through an interactive website and a customer service center. Since the introduction of Anatabloc ®, the Company’s revenues have been derived almost exclusively from the sale of this product. Future sales of the Company’s dietary supplements will be dependent on it resolving issues with the FDA relating to the status of its Anatabloc ® and CigRx ® products and any other developments with respect to the status of those products, given the fact that the Company has limited the marketing and advertising of its dietary supplements following receipt of the FDA warning letter in December 2013.
On March 12, 2014, the Company entered into a series of equity and financing transactions that resulted in gross cash proceeds to it of approximately $9.3 million and cash availability under a credit facility of approximately $5.8 million, for total available funds of $15.1 million. Under one transaction, holders of previously held warrants with strike prices ranging from $1.50 to $2.00 agreed to immediately exercise on an aggregate of 4.2 million warrants at a reduced strike price of $1.00 per share. The investors also were issued new warrants for an equal number of shares that have a term of seven years and a strike price of $1.00 per share. This transaction resulted in proceeds of approximately $4.2 million. Under another transaction the Company sold 5.1 million shares with matching warrants for 5.1 million shares to other investors at $1.00 for the shares and warrant shares. This transaction resulted in proceeds to us of $5.1 million. Finally, the Company entered into a credit facility with another investor under which that investor agreed to loan it up to $5.8 million. The credit facility provides for an interest rate of 3% on any funds drawn by the Company. It also provides the lender with the option to convert any loan amount to a unit of the Company’s common stock and a matching seven-year warrant at a conversion price of $1.00 per unit.
While the Company may seek to obtain funds in the future through other financing arrangements, there is no guarantee that these efforts would be successful or commercially feasible given its continued operating losses. Moreover, the Company’s ability to raise future financings on terms acceptable to it (including through the exercise of outstanding warrants) will depend on a number of factors, including the performance of the Company’s stock price and its operational performance. Any equity financing will be dilutive to the Company’s existing shareholders.
The Company believes it has sufficient funds to operate through the first quarter of 2015. Depending upon market conditions and the price of its common stock, the Company may decide to seek additional funds before that time. There can be no assurance that the Company will be successful in obtaining such funding at commercially reasonable terms.
3.
Discontinued Operations:
Since the 1990s, the Company has sought to develop processes that significantly prevent the formation of one of the most abundant and significant groups of carcinogens, tobacco specific nitrosamines, or TSNAs, found in tobacco and tobacco smoke. The Company utilized this technology in producing low-TSNA tobacco and related low-TSNA dissolvable smokeless tobacco products as less harmful alternatives to cigarettes and traditional smokeless tobacco products and as a platform to provide a base of financial support for its intellectual property, licensing and development initiatives.
On December 14, 2012, the Company’s Board of Directors voted unanimously to discontinue the manufacturing, distribution and sale of the Company’s dissolvable smokeless tobacco products, Ariva ® and Stonewall Hard Snuff® as of December 31, 2012. The Board was motivated to take this action in light of the continued losses and low sales for its dissolvable tobacco products over the last several years. It was also motivated by the fact that restrictions under the Family Smoking Prevention and Tobacco Control Act which prohibit a company from making any statements about the comparative safety of various types of tobacco products made it extremely difficult to effectively market its dissolvable tobacco products, notwithstanding that they represented a meaningful alternative to cigarettes and traditional smokeless tobacco products. The Board’s action was further influenced by the fact that continuing to manufacture dissolvable tobacco products had a negative impact on its ability to interest leading research centers in undertaking clinical research related to its anatabine compound and its potential for providing support in managing excessive inflammation.
At the time it discontinued its smokeless tobacco operations, the Company noted that it would continue to look for licensing opportunities for its patented tobacco curing technology and related low-TSNA smokeless tobacco products. On October 2, 2013, the Company entered into a series of transactions with Starion LLC, or Starion, a tobacco manufacturer, under which, among other things, it sold equipment and inventory previously utilized in its discontinued smokeless tobacco business and licensed certain trademarks and patents to Starion for use in the manufacture and sale of low-TSNA dissolvable smokeless tobacco products. The Company continues to look for licensing opportunities related to its dissolvable tobacco products and related technology.
The Company incurred severance costs in the form of salary continuation payments and continued health benefit costs under COBRA of approximately $829,000, for employees transitioning from Star Tobacco. In addition, the Company issued stock awards under the Company’s 2008 Incentive Award Plan in the aggregate amount of 330,000 shares to those employees transitioning from Star Tobacco, in recognition of their long-time service to the Company. The stock awards had a total fair value of approximately $1.1 million as well as a gross up charge for taxes of approximately $0.8 million. The total cost in connection with the discontinuance of the Company’s dissolvable tobacco business was approximately $3.1 million consisting of cash and non-cash items and were recorded in the fourth quarter of 2012.
The following represents a summary of the Company’s operating results and the loss on the disposition of the smokeless tobacco operations.
Assets and liabilities of the discontinued operations consist of the following:
4.
Inventories:
Inventories consist of the following:
5.
Property and equipment:
Property and equipment consists of the following:
The Company owns specialized packaging equipment that has been installed at its dietary supplement contract manufacturing vendor to package CigRx® and Anatabloc ® in its 20 piece container format. The Company also has invested in equipment to process anatabine, the primary ingredient in Anatabloc ®, CigRx ® and its Anatabloc® cosmetic products, at a separate contract manufacturer facility. The Company has assessed impairment values at each reporting periods. As of December 31, 2013 the equipment to process anatabine was deemed impaired due in larger part to the Company’s recent focus on drug development. Therefore the Company wrote down the value of the anatabine process equipment to zero thus incurring a $690 thousand charge.
Depreciation expense is included in the consolidated statement of operations for the years ended December 31, 2013, 2012 and 2011, as follows:
6.
Intangible assets:
Intangible assets consist of the following:
Amortization expense associated with the intangibles was $69, $68 and $67 thousand in 2013, 2012 and 2011, respectively. An aggregate of $83 thousand in trademarks have indefinite lives and are therefore not amortized. Expected future amortization of intangibles with finite lives is as follows:
7.
Long-term debt:
As of December 31, 2013 the Company had no outstanding long-term debt.
In 2012, the Company’s principal long-term debt consisted of unsecured promissory notes arising from its prior business relationship with Brown and Williamson Tobacco Company, or B&W. Following the combination of the operations of R.J. Reynolds, or RJR, and B&W in 2004, those notes were being paid to RJR and had a principal balance of $3.4 million as of August 1, 2012. As part of the resolution of the RJR litigation, the outstanding principal balance of the debt ($3.4 million), plus any accrued interest was satisfied and forgiven and the notes were returned to the Company as satisfied.
The Company’s long-term debt, as of December 31, 2012, was $7 thousand and was reflected as the current portion of long-term debt. The long-term debt consisted of an installment note secured by a vehicle purchased in 2010. The note was fully paid in April 2013.
8.
Stockholders’ equity:
Warrants:
The Company grants common stock warrants in connection with direct equity shares purchased by investors as an additional incentive for providing long-term equity capital to the Company and as additional compensation to consultants and advisors. The warrants are granted at negotiated prices in connection with the equity share purchases and at the market price of the common stock in other instances. The warrants have been issued for various terms ranging from several months to ten years.
Common stock warrants issued, redeemed and outstanding during the years ended December 31, 2013, 2012 and 2011 are as follows:
Sale of equity securities and exercise of warrants 2011:
On February 28, 2011, the Company entered into a Securities Purchase and Registration Rights Agreement (the “February 28 Agreement”) with an accredited investor who held previously issued warrants (the “Warrant Holder”) for 2,000,000 shares of the Company’s common stock, par value $0.0001 per share, at an exercise price of $1.00 per share (the “Prior Warrants”). Pursuant to the February 28 Agreement, the Warrant Holder exercised on the Prior Warrants and the Company granted the Warrant Holder new warrants with an exercise price of $2.00 per share for the same amount of shares of common stock as the Prior Warrants (the “New Warrants”). The February 28 Agreement resulted in gross proceeds to the Company of $2.0 million. The New Warrants were exercisable immediately into an aggregate of 2,000,000 shares of common stock and expire on February 28, 2016.
On March 4, 2011, the Company entered into a Securities Purchase and Registration Rights Agreement (the “March 4 Agreement”) with certain accredited investors (the “March 4 Investors”), to sell 4,856,730 shares of common stock (the “March 4 Shares”) and warrants to purchase an aggregate of 4,856,730 shares of common stock at an exercise price of $2.00 per share (the “Warrants”) (collectively, the “March 4 Offering”). The March 4 Offering resulted in gross proceeds to the Company of $9.0 million. The Warrants were first exercisable on September 4, 2011 and expire on September 4, 2016.
On March 30, 2011, the Company entered into a Securities Purchase and Registration Rights Agreement (the “March 30 Agreement”) with an accredited investor (the “March 30 Investor”), to sell 254,452 shares of common stock (the “March 30 Shares”), and warrants to purchase an aggregate of 254,452 shares of common stock at an exercise price of $4.00 per share (the “Warrants”) (collectively, the “March 30 Offering”). The March 30 Offering resulted in gross proceeds to the Company of $1.0 million. The Warrants were first exercisable on September 30, 2011 and expire on September 30, 2016.
On June 4, 2011, 200,000 warrants were exercised resulting in proceeds to the Company of $0.2 million.
On December 22, 2011, the Company entered into a Securities Purchase and Registration Rights Agreement (the “December 22 Agreement”) with an accredited investor who held previously issued warrants (the “Warrant Holder”) for 5,000,000 shares of the Company’s common stock, par value $0.0001 per share, at an exercise price of $1.50 per share (the “Prior Warrants”). Pursuant to the December 22 Agreement, the Warrant Holder exercised on 4,200,000 of the Prior Warrant shares and the Company granted the Warrant Holder new warrants with an exercise price of $2.32 per share for the same amount of shares of common stock as the exercised portion of the Prior Warrants (the “New Warrants”). The December 22 Agreement resulted in gross proceeds to the Company of $6.3 million. The New Warrants were exercisable immediately into an aggregate of 4,200,000 shares of common stock and were to expire on December 22, 2016.
Sale of equity securities and exercise of warrants 2012:
On February 28, 2012, the Company entered into a Securities Purchase and Registration Rights Agreement ("Agreement No. 1") with an accredited investor (the "Investor") who held previously issued warrants for: (i) 3,260,869 shares of the Company's common stock, par value $0.0001 per share ("Common Stock"), at an exercise price of $2.00 per share and (ii) 2,554,385 shares of the Company's Common Stock at an exercise price of $1.50 per share (collectively, the "Prior Warrants").
Pursuant to Agreement No. 1, in order to induce the Investor to immediately exercise the Prior Warrants, the Company agreed to grant the Investor new warrants with an exercise price of $4.05 per share for the same amount of shares of Common Stock as the Prior Warrants (the "New Warrants") in exchange for the exercise of the Investor's Prior Warrants for cash whereby the Investor purchased 5,815,254 shares of Common Stock for gross proceeds to the Company of $10.4 million (collectively, the "First February 28 Transaction"). The New Warrants were exercisable immediately into an aggregate of 5,815,254 shares of Common Stock and expire on February 28, 2017.
Additionally, on February 28, 2012, the Company entered into a Securities Purchase and Registration Rights Agreement ("Agreement No. 2") with the Investor to sell 410,000 shares (the "Shares") of the Company's Common Stock at $4.05 per share and warrants to purchase an aggregate of 410,000 shares of Common Stock at an exercise price of $4.05 per share (the "Warrants") (collectively, the "Second February 28 Transaction"). The Second February 28 Transaction resulted in gross proceeds to the Company of $1.7 million. The Warrants were first exercisable on August 28, 2012 and expire on August 28, 2017.
Pursuant to a warrant reset agreement, between November 13 and 15, 2012, holders of previously issued warrants exercisable for 18,500,000 shares of the Company’s common stock, par value $0.0001 per share (“Common Stock”), with a weighted average exercise price of $2.71 per share (the “Prior Warrants”), agreed with the Company to immediately exercise the Prior Warrants for cash in exchange for a reduction of exercise price of the Prior Warrants to $1.00 per share. Mr. Williams also exercised 1,000,000 warrants issued to him in a prior transaction at the full warrant exercise price of $1.50 per share. The gross proceeds from the exercise of the Prior Warrants and Mr. Williams’ exercise of his warrants resulted in gross proceeds to the Company of $20 million. The exercise resulted in the issuance of 19,500,000 shares of Common Stock and the cancellation of warrants exercisable for 19,500,000 shares of Common Stock.
In addition to the warrant exercises noted above, 352,540 warrants were exercised during the year ended December 31, 2012 resulting in gross proceeds to the Company of $0.5 million.
Exercise of warrants 2013:
During the year ended December 31, 2013, there were no warrants granted; however, 5,859,335 warrants were exercised. The details of the warrant exercises during 2013 follows:
During the first quarter 16,666 warrants were exercised resulting in gross proceeds to the Company of $30 thousand.
On August 1, 2013, two of the Company’s long-term shareholders who held previously issued warrants exercisable for 2,580,646 shares of the Company’s common stock, par value $0.0001 per share (“Common Stock”), with a weighted average exercise price of $1.85 per share (the “Prior Warrants”) agreed with the Company to immediately exercise the Prior Warrants for cash in exchange for a reduction of the exercise price of 1,830,646 warrants from $2.00 per share to $1.66 per share and the reduction of the exercise price for 750,000 warrants from $1.50 per share to $1.34 per share. The transaction resulted in gross proceeds to the Company of approximately $4.0 million.
On November 7, 2013, two of the Company’s long-term shareholders who held previously issued warrants exercisable for 3,262,023 shares of the Company’s common stock, par value $0.0001 per share (“Common Stock”), with a weighted average exercise price of $1.50 per share (the “Prior Warrants”), agreed with the Company to immediately exercise the Prior Warrants for cash in exchange for a reduction of the exercise price of the 3,262,023 warrants from $1.50 to $1.15. The transaction resulted in gross proceeds to the Company of $3.7 million.
Stock option plans:
Prior to 2008 the Company adopted a 1998 Stock Option Plan, a 2000 Equity Incentive Plan, and in September 2008 it adopted a 2008 Incentive Award Plan (the “Plans”). The Plans provide for grants of options to those officers, key employees, directors and consultants whose substantial contributions are essential to the continued growth and success of the Company. In the aggregate the Plans provide for grants of both qualified and non-qualified stock options to purchase up to 43,200,000 shares at a purchase price equal to the fair market value on the date of grant in the case of qualified options granted to employees.
Common stock options issued, redeemed and outstanding during the years ended December 31, 2013, 2012 and 2011 are as follows:
The following table summarizes information for options outstanding and exercisable at December 31, 2013.
A summary of the status of the Company’s non-vested stock options as of December 31, 2013, and changes during the year then ended, is presented below.
As of December 31, 2013, there was approximately $7.1 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Plans. Of the $7.1 million of unrecognized compensation costs $6.9 million relates to performance based stock options granted to Drs. Mullan and Chapman in 2013, which will be recognized over the expected period the performance goals will be achieved. The remaining $0.2 million cost will be recognized over the next two years. There were no options exercised in the year ended December 31, 2013. In December 2011 the shareholders approved performance stock options granted to Mr. Williams and Mr. Perito, the Company’s former CEO and Chairman of the Board, respectively. In 2011 sixty-five percent of the options granted vested upon shareholder approval and satisfaction of two of the performance criteria. In 2013 Mr. Williams forfeited his unvested shares from the grant in the amount of 1,715,000 options. Mr. Perito’s remaining unvested performance stock options (1,400,000 options) vested upon satisfaction of one of the other performance criteria and the Company recorded a stock compensation expense of $3.5 million for those options in the fourth quarter 2013.
The fair value of options was estimated on the date of grant issuance using the Black-Scholes option pricing model with the following weighted average assumptions:
Total stock-based compensation (stock and stock option) cost recognized is as follows:
In 2013 the Company issued a total of 175,685 shares of common stock and 100,000 stock options to consultants in connection with services provided to the Company. These grants had a fair value of $0.6 million.
In 2012 the Company issued a total of 330,000 shares of common stock to employees as part of a severance plan granted to long term employees who transitioned from the Company as a result of the discontinuation of its dissolvable tobacco business and 50,000 shares of common stock to a marketing consultant. The total of 380,000 shares of common stock had a fair value of $1.2 million. These shares were issued from the Company’s 2008 Incentive Award Plan.
Additional stock options and common stock grants were awarded subsequent to December 31, 2013. See Note 16 “Subsequent Events” for details of these transactions.
9. Earnings per share:
The following table sets forth the computation of basic and diluted earnings per share for the years ended December 31:
(a)
Securities outstanding that were excluded from the computation because they would have been anti-dilutive are as follows:
10. Income taxes:
Net deferred tax assets and liabilities consist of the following:
* Based on the information available, management believes the allowance is appropriate.
Income tax benefit consists of the following:
The provision for income tax expense varies from that which would be expected based on applying the statutory federal rate to pre-tax accounting loss as follows:
At December 31, 2013, the Company had net operating loss carry-forwards of approximately $219 million, which expire from 2022 through 2033. As a result of previous ownership changes, an aggregate of $532 thousand in Federal loss carry-forwards are limited to $116 thousand annually.
11. Related party transactions:
Related party activity:
The Company has entered into certain transactions with companies in which members of management, stockholders and one Director have an ownership interest. The following is a summary of the significant related party transactions for the year ended December 31:
Effective September 1, 2008, the Company entered into an agreement for the use of the aircraft owned by Starwood Aviation, Inc., a company wholly owned by Mr. Williams, the Company’s former CEO. The 2008 agreement with Starwood Aviation was amended in May 2010 to clarify the types of items that would be included as “out of pocket” expenses and to recognize that certain costs, such as for fuel, would be variable depending on the actual cost of the item at the time of use. In 2013 Starwood Aviation purchased a new aircraft and arranged for the Company’s use of the aircraft that it previously owned. The Company reimbursed Starwood Aviation for actual cost associated with the use of these aircrafts in 2013.
Related party license agreement:
Effective January 1, 1998, the Company entered into an exclusive license agreement with Regent Court Technology, LLC, of which the Company’s founder and former CEO, Jonnie R. Williams, and the beneficiary of the O’Donnell Trust, are the owners. Pursuant to this license agreement, the Company has the exclusive world-wide rights to produce and sell tobacco products with low-TSNA tobacco and to sublicense that technology to third parties. In connection with this agreement, the Company is obligated to pay royalties equal to 2% of all product sales (less certain costs incurred by the Company) and 6% of any royalty income earned from sublicensing (less certain costs incurred by the Company). Since the costs incurred by the Company were in excess of the royalty obligations there were no royalties due under this agreement for 2013, 2012 or 2011.
Due (to) from stockholders:
Due (to) from Stockholders consists of unsecured non-interest bearing advances of $(50) thousand as of December 31, 2013 and December 31, 2012.
Share purchase and warrant exercise:
On March 4, 2011 Jonnie R. Williams purchased 508,905 shares of our common stock at a price of $1.84 per share and, for a price of $0.125 per share, purchased a warrant for an equal number of warrant shares at an exercise price of $2.00 per share. In accordance with the Company’s related party transaction policy, Mr. Williams’ intention to purchase shares and warrant shares of the Company’s stock was considered and approved by the Audit Committee of the Board of Directors on March 4, 2011. See Note 7, “Stockholders’ Equity” for details of the transaction.
On November 15, 2012, Jonnie R. Williams exercised 1,000,000 warrants previously issued to him in a prior transaction at the full warrant exercise price of $1.50 per share for a personal investment of $1,500,000.
Roskamp Institute and related entities
The Roskamp Institute is a private medical research organization in Sarasota, Florida whose stated purpose is understanding causes of and finding cures for neuropsychiatric and neurodegenerative disorders and addictions. In 2010 and 2011, respectively, Robert G. Roskamp, the founder of the Roskamp Institute, purchased from us for cash, (i) 769,230 shares of our common stock and warrants to purchase an additional 769,230 shares at an exercise price of $1.50 per share, and (ii) 254,452 shares and warrants to purchase an additional 254,452 shares at an exercise price of $4.00 per share. We have entered into a Research and Royalty Agreement with an affiliate of the Roskamp Institute pursuant to which we pay royalties of 5% of Anatabloc ® sales to this affiliate (such royalties being equal to $431, $301 and $50 thousand for the years 2013, 2012 and 2011, respectively). During the same three year period the Company has paid research related fees of $0.9, $1.2 and $1.1 million to the Roskamp Institute.
In addition, Dr. Mullan, our Chief Executive Officer, is also the Chief Executive Officer of the Roskamp Institute.
12. Employee benefit plan:
The Company is the sponsor of a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code. The plan covers all employees who meet certain eligibility and participation requirements. Participants may contribute up to 15% of their annual compensation. The Company matches these contributions at a rate of 75% of the first 6% of pay that an employee contributes to the plan. The Company made contributions of approximately $84, $108, and $98 thousand to the 401-K Plan in 2013, 2012 and 2011, respectively.
13. Fair value of financial instruments, concentrations and credit risk and major customer information:
Fair value of financial instruments:
The estimated fair value of cash and cash equivalents, trade receivables, licensing rights receivable, MSA escrow funds, due from and to stockholders and trade payables approximate the carrying value due to their short-term nature, variable interest rates or interest rates charged at rates at which the Company can currently borrow. On September 21, 2012, the Company and RJR reached a settlement of pending litigation matters and, as part of the settlement, the Company’s long-term debt with RJR was forgiven.
Differences between fair value and carrying amount of long-term debt are primarily due to instruments that provide fixed interest or zero interest rates or contain fixed interest rate elements. Inherently, such instruments are subject to fluctuations in fair value due to subsequent movements in interest rates.
Credit risk and major customer information:
Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, accounts receivable and licensing rights receivable.
The Federal Deposit Insurance Corporation insures up to $250,000 for substantially all interest bearing depository accounts. During 2013 the Company had amounts on deposit which exceed these insured limits and as of December 31, 2013, had $3.4 million which exceeded these insured limits.
The receivable from the sale of licensing rights is collectible in monthly installments. Only $18 thousand of the original $3.2 million due under the licensing rights agreement had not been collected by December 31, 2013. All required payments to date have been timely received. As such, management believes this receivable is fully collectible.
The Company’s dietary supplement products, Anatabloc® and CigRx®, and its cosmetic products are sold directly to consumers through credit card transactions that are approved prior to shipment. Anatabloc ® is also sold through retailers who maintain a stock of the product on a consignment basis. The Company is paid weekly for cash sales at these retail locations.
In 2013 the Company sold approximately 68 % of its Anatabloc® product through its consignment arrangement with GNC. Pursuant to this arrangement, the Company is paid weekly for sales from the previous week. The accounts receivable for consignment sales therefore is not outstanding for a period longer than seven days.
14. Commitments, contingencies, and other matters:
Operating leases:
The Company leases a warehouse and manufacturing facility that was used for manufacturing of its dissolvable tobacco products through December 31, 2012. The cost for this lease, which expires in 2022, is approximately $7 thousand per month. Because the lease is non-cancellable, the Company is obligated to continue the lease payments through the lease term. The Company in 2013 entered into a one year sublease renewable annually for eight years for a portion of this property for $2,000 per month and will look for opportunities to further sublease this facility. The Company also leases office space for its Rock Creek subsidiary in Gloucester, Massachusetts for approximately $5 thousand per month, maintains space for Star Scientific and Rock Creek in the Washington, DC area at a cost of approximately $12 thousand per month and began leasing office space in February 2010 in Glen Allen, Virginia for its corporate marketing and administrative activities for approximately $3 thousand per month.
The following represents the future minimum rental payments required under operating leases that have initial or remaining non-cancelable terms in excess of one year as of December 31, 2013.
Rent expense for all operating leases was approximately $345, $343 and $296 thousand for the years ended December 31, 2013, 2012 and 2011, respectively.
Obligations under Master Settlement Agreement:
In November 1998, 46 states and the District of Columbia, the Settling States, entered into the Master Settlement Agreement, or MSA, to resolve litigation that had been instituted against the major cigarette manufacturers. The Company was not named as a defendant in any of the litigation matters and chose not to become a participating manufacturer under the terms of the MSA. As a non-participating manufacturer, the Company was required to satisfy certain escrow obligations for cigarette sales pursuant to statutes that the MSA required the Settling States to adopt in order for such states to receive the full benefits of the settlement. On March 14, 2007, the Company sold the rights, title and interest in and to all income from and reversionary interest in its MSA escrow accounts, including its 2006 MSA escrow deposits made in April 2007. Although the Company sold the rights in and to all income from and reversionary interest in the funds deposited into the MSA escrow accounts for the years up to and including 2006, these MSA escrow funds remain in the Company’s name and the principal amount of these accounts will be available to satisfy portions of any state judgments or settlements for the type of claims asserted against the major tobacco manufacturers in the suits that resulted in the negotiation of the MSA, if such claims are successfully asserted in litigation against the Company.
As of December 31, 2013, the Company had deposited into escrow a net amount of approximately $472 thousand for sales of cigarettes in Settling States, in addition to deposits for which the Company previously sold its rights, title and interest as part of the March 2007 transaction noted above. The Company’s total escrow obligation for 2007 sales (paid in April of 2008) was $365 thousand. In May 2007, the Company entered into a license agreement for the exclusive licensing of its trademarks Sport®, MainStreet ® and GSmoke ® and ceased manufacturing cigarettes in June 2007. In 2010 the Company deposited $3 thousand into escrow for sales in 2006 and 2007 in the State of Tennessee, based on an audit of cigarette sales for those years. The Company made no deposits into escrow in 2011. In 2012 the Company deposited $113 thousand as a result of an audit by the State of Tennessee. Given the discontinuation of the Company’s cigarette operations in June 2007, the Company does not anticipate having any material MSA escrow obligations in the future.
Virginia Sales and Use Tax Assessment
In 2002, the Virginia Department of Taxation asserted a Virginia Sales and Use Tax assessment for the period January 1, 1999, through March 31, 2002, against the Company in the amount of $860,115. The Company applied for a correction of the assessment and an abatement of the tax on the grounds that its tobacco curing barns are exempt from sales and use taxes under the industrial use and processing exemption and/or the agricultural exemption. In a letter dated October 7, 2004, the Company received notification from the Commonwealth of Virginia that an adverse decision had been made by the Commissioner of Taxation with respect to the sales and use tax assessment previously issued to it. On August 10, 2010 the Commonwealth of Virginia responded to the Company’s request for reconsideration of the state’s sales and use tax assessment with respect to the tobacco curing barns. The Commonwealth disagreed with the position that the barns are part of the manufacturing process and, therefore, exempt from sales and use taxes under the industrial use and processing exemption and/or the agricultural exemption, concluding that the barns are taxable under the Commonwealth’s sales tax laws and regulation. On July 14, 2011 the Company filed a lawsuit in the Circuit Court for Mecklenburg County, Virginia seeking a determination that the purchase of the Company’s curing barns was exempt from Virginia sales and use tax and an abatement of all taxes and interest assessed against the Company by Virginia’s Commissioner of Revenue, which as of November 2013 the Company estimated were approximately $1.9 million. The Commonwealth of Virginia filed an answer to the complaint on July 29, 2011 asserting that the assessment amount was properly determined and the case was set for trial on December 13 and 14, 2013. On November 18, 2013, a mandatory mediation was held in this case before a retired Circuit Court Judge in Henrico County, Virginia. As a result of that mediation, the parties reached a settlement under which the claims asserted by the Commonwealth were dismissed with prejudice in return for the payment by the Company of $975,000 in full settlement of the outstanding tax assessment, interest and penalties.
Securities Class Action Lawsuits
Three individuals, Francis J. Reuter, Charles Boravian and Marty Cole, filed separate similar purported class actions on behalf of putative classes of persons or entities collectively encompassing those who purchased or otherwise acquired shares of the Company’s common stock between October 31, 2011 and March 18, 2013. The first action was filed on or about March 25, 2013 in the United States District Court for the Eastern District of Virginia, Francis J. Reuter v. Star Scientific, Inc. et al., E.D. Va. Richmond Division, 13-00183-JAG (the “Reuter Action”). The Reuter Action named as defendants the Company, its subsidiary, Rock Creek Pharmaceuticals, Inc., and certain of the Company’s officers and/or employees. The second action was filed on or about March 26, 2013 in the United States District Court for the District of Massachusetts, Boravian v. Star Scientific, Inc. et al. D. Mass. 13-1-695-DJC (the “Boravian Action”). The Boravian Action named as defendants the Company and Jonnie R. Williams, Sr. and was voluntarily dismissed by the plaintiff. The Third action was filed on or about May 7, 2013 in the United States District Court for the Eastern District of Virginia, Cole v. Star Scientific, Inc. et al., E.D. Va. Richmond Division, 13-00287-JAG (the “Cole Action”). The Cole Action named as defendants, the Company, its subsidiary, Rock Creek Pharmaceuticals, Inc., and certain of its officers and employees. In general, the complaints collectively allege that the Company and the individual defendants violated Section 10(b) under the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder as related to statements made regarding its past and future prospects and certain scientific data relating to its products, as well as related to unspecified private placements and related party transactions engaged in since 2006. The Reuter Action and the Cole Action have been consolidated and a lead plaintiff was appointed by the Court in the consolidated cases on June 21, 2013. Pursuant to a joint scheduling order in place in these cases, plaintiff filed a consolidated operative complaint on September 5, 2013 and defendants filed a motion to dismiss the consolidated operative complaint on October 25, 2013. Following full briefing and argument on January 7, 2014, the Court indicated that it would not grant the motion at that time and would allow the case to proceed to discovery, but ordered additional briefing on one aspect of the motion. Also the Court entered a scheduling order for discovery and an order directing the parties to participate in mediation before a Magistrate Judge. Defendants thereafter filed answers. Subsequently, the United States on January 28, 2014 moved to stay discovery in the case pending the completion or other disposition of the criminal trial of former Governor McDonnell and his wife. That motion was granted by the Court on January 28, 2014. On February 12, 2014, the Court granted a joint motion by the parties to stay all deadlines other than a court sponsored mediation session and the issuance of the Court's opinion on the motion to dismiss. The Company intends to continue to defend vigorously these claims. However, at this time, it cannot predict the probable outcome of these claims. Accordingly, no amounts have been accrued in the consolidated financial statements.
Derivative Action Lawsuits
Four individuals, David C. Inloes, William Skillman, Harold Z. Levine and Louis Lim, filed separate, but similar derivative actions naming all or most of the Company’s then current Directors, several Officers of the Company and, in one case, one former Director as defendants. Two of the actions were filed in the United States District Court for the Eastern District of Virginia, Alexandria Division (the “Alexandria Actions”). The first Alexandria Action, William Skillman v. Jonnie R. Williams et al., was filed on May 2, 2013. The second Alexandria Action, David C. Inloes v. Jonnie R. Williams et. al. was filed on May 3, 2013. The Alexandria Actions have been consolidated and co-lead counsel appointed by the Court. Pursuant to a court order plaintiffs filed a consolidated amended complaint on January 13, 2014 and a motion to dismiss was filed on February 3, 2014 on behalf of all of the defendants. Also, On February 3, 2014 the Company, as nominal defendant, moved to stay or dismiss this action pending a resolution of the securities class action litigation pending in Federal Court in Richmond, Virginia. Separately, on January 29, 2014, the United States moved to stay discovery in the case pending the completion or other disposition of the criminal trial of former Governor McDonnell and his wife. That motion was granted by the Court on January 30, 2014. On February, 28, 2014, the Court granted the Company’s motion to stay the case, ruling that the case would be stayed for all purposes pending further order of the Court and ordering the Company, within ten days of the dismissal or resolution of the Richmond securities class action or the trial court's verdict in the McDonnell case, whichever occurs first, to file a report indicating what action, if any, it intends to take with regard to this case, including specifically, without limitation, whether it intends to pursue or seek dismissal of the claims asserted against each of the named individual defendants.
The third derivative action, Harold Z. Levine v. Jonnie R. Williams, et. al. was filed on July 8, 2013, in the Circuit Court for the City of Richmond and the fourth case, Louis Lim v. Christopher C. Chapman, et. al. was filed in the Circuit Court for Henrico County on July 11, 2013. In general, the complaints collectively allege that the Company’s Directors and Officers breached their fiduciary duties by causing the Company to issue false and misleading statements regarding its past and future prospects and certain scientific data relating to its products, as well as engaging in certain unspecified private placements and related party transactions since 2006. On July 1, 2013 and August 1, 2013 stipulations were filed in each of the state court actions which would stay the period for defendants to respond to the complaints until a date established in an agreed upon schedule is in place or until forty days after the parties advise the court that they are unable to reach an agreement on such a schedule. The company intends to defend vigorously these claims. However, at this time, it cannot predict the probable outcome of these claims. Accordingly, no amounts have been accrued in the consolidated financial statements.
Demands for Inspection of Books and Records and for Investigation
Two individuals, Bruce A. Welker and Michael Weber, have written to the Company requesting that it produce various books and records pursuant to Delaware Code Section 220. Mr. Welker’s letter was dated May 31, 2013 and the letter sent on behalf of Mr. Weber was dated June 5, 2013. The Company has responded by letter to these demands and has been in subsequent communication with counsel regarding the demands. One individual, Steven Segall, has written to the Company’s Board of Directors and demanded that the Board investigate certain claims and take appropriate remedial action in response to alleged wrongdoing that took place between 2010 and 2013. The Company advised Mr. Segall that the Board of Directors would review the issues raised in his demand letter and further respond once that review was complete. Following a full review by a Committee of Independent Directors, assisted by separate outside counsel, the Board upon recommendation of the Committee determined that Mr. Segall’s demand should be refused pending the outcome of related securities litigation and directed that this decision be communicated to counsel for Mr. Segall.
FDA Warning Letter
On December 24, 2013, the Company received a Warning Letter, from the FDA regarding its CigRx® and Anatabloc® dietary supplements. In the letter the FDA asserted that CigRx® and Anatabloc® were not properly marketed as dietary supplements, since the Company had not filed a New Dietary Ingredient Notification for anatabine as a dietary ingredient prior to the introduction of its dietary supplements. The FDA also claimed that certain materials on the Company’s websites, including published research articles, contained drug claims for Anatabloc®. The Company responded to the Letter on January 31, 2014, contesting the FDA’s position with respect to the status of the Company’s dietary supplements and noting that it had voluntarily removed materials objected to by the FDA. The Company is currently communicating with the FDA in an effort to reach an amicable resolution of the issues asserted in the Warning Letter.
Consumer Class Action
On January 27, 2014, Howard T. Baldwin filed a purported class action naming the Company, Rock Creek and GNC Holding, Inc., or GNC, as defendants. The case was filed in the United States District Court of the Northern District of Illinois. Generally, the complaint alleges that claims made for the Company’s Anatabloc® product has not been proven and that individuals purchased the product based on alleged misstatements regarding characteristics, uses, benefits, quality and intended purposes of the product. The complaint purports to allege claims for violation of state consumer protection laws, breach of express and implied warranties and unjust enrichment. The Company has agreed to indemnify and defend GNC pursuant to the terms of the purchasing agreement between Rock Creek and GNC. Consistent with that commitment, the Company has agreed to assume the defense of this matter on its own behalf as well as on behalf of GNC. The defendants have received an extension of time to respond to the complaint in this case until March 24, 2014. The Company intends to vigorously defend against these claims. However, at the present time, it cannot predict the possible outcome of these claims. Accordingly, no amount has been accrued in the consolidated financial statements.
15. Restructure Charge
In 2012, in conjunction with the discontinuation of the manufacture and sale of its low-TSNA dissolvable tobacco product, the Company incurred severance costs in the form of salary continuation payments and continued health benefit costs under COBRA of approximately $829,000, for employees transitioning from Star Tobacco, Inc. as of December 31, 2012. In addition, the Company issued stock awards under the Company’s 2008 Incentive Award Plan in the aggregate amount of 330,000 shares to those employees transitioning from Star Tobacco, in recognition of their long-time service to the Company. The stock awards had a total value of approximately $1.1 million as well as a gross up charge for taxes of approximately $0.8 million. The total cost in connection with the discontinuance of the Company’s dissolvable tobacco business was approximately $3.1 million consisting of cash and non-cash items all of which were recorded in the fourth quarter 2012.
16. Subsequent Events:
Stock options and share grants issued
On January 2, 2014 the Company issued 3,000,000 stock options with an exercise price of $1.16 to Michael J. Mullan, the Company’s Chairman and CEO pursuant to his employment contract. On January 3, 2014 the Company issued 223,052 share grants that vested immediately with a share price of $1.02 per share to two of its brand ambassadors pursuant to their agreements with the Company to promote its dietary supplement and cosmetic products. On February 2, 2014 the Company issued 100,000 and 150,000 stock options with an exercise price of $1.30 and $2.00, respectively and issued 50,000 shares of stock to the Company’s Vice President of Corporate Development and Strategy at the time he joined the Company.
Financing
On March 12, 2014, the Company entered into a series of equity and financing transactions that resulted in gross cash proceeds to the Company of approximately $9.3 million and cash availability under a credit facility of approximately $5.8 million, for total available funds of $15.1 million. Under one transaction, holders of previously held warrants with strike prices ranging from $1.50 to $2.00 agreed to immediately exercise on an aggregate of 4.2 million warrants at a reduced strike price of $1.00 per share. The investors also were issued new warrants for an equal number of shares that have a term of seven years and a strike price of $1.00 per share. This transaction resulted in proceeds of approximately $4.2 million. Under another transaction the Company sold 5.1 million shares with matching warrants for 5.1 million shares to other investors at $1.00 for the shares and warrant shares. This transaction resulted in proceeds to us of $5.1 million. Finally, the Company entered into a credit facility with another investor under which that investor agreed to loan the Company up to $5.8 million. The credit facility provides for an annual interest rate of 3% on any funds drawn by the Company. It also provides the lender with the option to convert any loan amount to a unit of the Company common stock and a matching seven-year warrant at a conversion price of $1.00 per unit.
Office consolidation and severance plan
In January 2014 the Company announced plans to consolidate its offices and headquarters in Sarasota, FL. The Company’s Compensation Committee approved a severance plan for employees who will separate from the Company as a result of this transition. The severance program consist of salary and benefit continuation based on employee length of service with the Company and extension of any stock option grant exercise period for three additional years after separation from the Company. The stock option plan provides for a 90 day period after separation upon which the employee is able to exercise their options. An exact number of employees separating from the Company is not known at this time. In addition, as part of the Company’s transition its former Chief Executive Officer, Jonnie R. Williams, Sr. and its former President and Chief Operating Officer, Paul L. Perito, resigned from their prior positions with the Company as of December 27, 2013 and assumed the role of a non-executive employee, in the case of Mr. Williams, and the role of Vice President and Senior Counsel, Legal and Regulatory affairs, in the case of Mr. Perito. The Company anticipates that as part of its transition it will enter into separate severance arrangements with Messrs. Perito and Williams. Two of our three office leases expire by July 31, 2014, and will not be renewed, while the third office lease expires June 30, 2015. As a result, the Company does not expect significant rent-related expenses in connection with the relocation of the Company’s offices.
17. Quarterly results (unaudited):
The following is a summary of quarterly unaudited results of operations for the years ended December 31, 2013, 2012 and 2011.
Per share amounts for each quarter are required to be computed independently and, therefore, may not equal amounts computed on an annual basis.
18. Segment Information
The Company operated in two segments during 2012 and 2011 dietary supplements and dissolvable tobacco. However, in December 2012 the Company discontinued its operations in the dissolvable tobacco business and accordingly, has restated prior years information related to that business as discontinued operations on the face of the respective years financial statements. As of December 31, 2012 the Company operates in one business segment only, the results of which are presented in the financial statements. Accordingly, the Company has no segment information to present in footnote form in this Report.