AAIPHARMA INC - Annual Report (10-K) PART I

The terms “we”, “us” or “our” in this Form 10-K include aaiPharma Inc., its corporate predecessors and its subsidiaries, except where the context may indicate otherwise. Our corporation was incorporated in 1986, although its corporate predecessor was founded in 1979. In 1999, we merged with Medical & Technical Research Associates, Inc.

Our principal executive offices are located at 2320 Scientific Park Drive, Wilmington, North Carolina (telephone: 910-254-7000).

Our Internet address is www.aaipharma.com. We make available through our internet website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

We own the following registered and unregistered trademarks: Darvon®, Darvon-N®, Darvocet-N®, M.V.I.®, M.V.I.-12®, M.V.I. Pediatric™, M.V.I. Adult™, Aquasol®, Aquasol A®, Aquasol E®, Brethine®, ProSorb®, ProSorb-D™, ProSLO™, ProSLO II™, ProCore®, ProSpher®, ProLonic™, ProMelt®, NeoSan™, AzaSan™, aaiPharma™, and AAI®. References in this document to Darvon are to Darvon® and Darvon-N® collectively and references to Darvocet are to Darvocet-N®. We also reference trademarks owned by other companies. Cataflam® is a registered trademark of Novartis Corporation, Infuvite® is a registered trademark of Sabex Inc., Oxycontin® is a registered trademark of Purdue Pharma L.P., Prilosec® is a registered trademark of AstraZeneca AB, Proventil® is a registered trademark of Schering Corporation, Prozac® is a registered trademark of Eli Lilly and Company, Volmax® is a registered trademark of GlaxoSmithKline, Imuran® is a registered trademark of Prometheus Laboratories, Inc. and Ultram® is a registered trademark of Johnson & Johnson. All references in this document to any of these terms lacking the “®” or “™” symbols are defined terms that reference the products, technologies or businesses bearing the trademarks with these symbols.

We are a science-based specialty pharmaceutical company focused on the commercialization of branded pharmaceutical products that we develop or acquire. We have over 23 years of pharmaceutical research and development experience, with operations primarily in the United States and Europe. We have acquired three branded product lines since August 2001 — the M.V.I. and Aquasol family of products, Brethine and the Darvon and Darvocet family of products. In addition, we are developing our own proprietary products, as well as developing improvements and line extensions to our acquired products, by applying our scientific expertise and portfolio of proprietary and in-licensed drug-delivery technologies. Historically, we have generated our revenues by providing a comprehensive spectrum of pharmaceutical research and development services on a fee-for-service basis to a broad base of customers, including large pharmaceutical companies such as AstraZeneca PLC, Bayer AG, Eli Lilly and Company, Novartis Corporation, Medicis Pharmaceuticals Corp., and Roche Pharmaceuticals.

In 2001, we began acquiring established, branded pharmaceutical products within our targeted therapeutic classes —critical care, pain management, and gastrointestinal diseases. We seek to acquire products whose sales we believe can be increased through enhanced marketing and promotion and that we can improve by applying our significant research and development capabilities.

The Pharmaceuticals Division commercializes branded pharmaceutical products that we develop and acquire in our targeted therapeutic classes — critical care, pain management, and gastrointestinal diseases. We market and promote our branded products directly through our sales force to high-prescribing physicians. We directly hire and manage our own internal sales force and, as of February 28, 2003, we had a sales force of approximately 80 representatives, which we plan to significantly expand during the remainder of 2003 to 150 sales representatives. We use data generated by third-parties to identify physicians who prescribe our products and other products in our targeted therapeutic classes. When we acquire products, we seek products that we believe will benefit from our sales promotion and to which we can apply the scientific expertise of our other divisions to develop product line extensions and improvements.

In August 2001, we acquired from AstraZeneca the U.S. rights to the M.V.I. and Aquasol branded product lines of critical care injectable and oral nutritional products, which provide nutrients to cancer, AIDS, post-operative and nutritionally compromised patients. In December 2001, we acquired from Novartis the U.S. rights to the Brethine branded product line, which treats asthma. In February 2002, we acquired from Aesgen Inc. the U.S. rights to calcitriol, an injectable vitamin D nutritional product, as a line extension opportunity for the Aquasol product line. In March 2002, we acquired from Eli Lilly the U.S. rights to the Darvon and Darvocet branded product lines, which treat mild-to-moderate pain.

Through the Pharmaceuticals Division, we seek commercially stable products within our targeted therapeutic classes with strong brand recognition and high gross margins. We also seek to acquire and commercialize established pharmaceutical products that we believe have not been actively marketed and promoted for at least several years prior to our acquiring them. Our goal is to increase the value of the brands that we acquire by promoting them to high-prescribing physicians, using one-on-one meetings, product sampling, educational programs, advertising, direct mail, and website promotion. In the future, we intend to acquire products that we can promote to our existing customer base, thereby leveraging our sales force.

We also plan to apply the scientific expertise of AAI International and the Research and Development Division’s portfolio of patents and proprietary and in-licensed drug-delivery technologies and other intellectual property to develop new formulations, delivery systems, indications, dosage forms and line extensions for our branded products that will improve their safety, efficacy, convenience or cost effectiveness

or reduce their side effects. Once approved by the FDA, we intend to market these products under the acquired brand names, thereby leveraging the value of the existing brands for our product improvements and line extensions. Additionally, we will seek renewed regulatory or patent exclusivity for these improved products. A new indication for an existing product or changes in product composition, method of use, formulation and process may, in appropriate cases with the addition of Phase III studies showing efficacy and safety, provide three-year non-patent regulatory exclusivity or longer-term patent protection.

Additionally, through the development expertise of the Research and Development Division, our Pharmaceuticals Division is continuing internal development efforts on our own branded pharmaceutical products. Product candidates in the later stages of development include an imidapril tablet, which is an angiotensin converting enzyme (ACE) inhibitor, for treatment of cardiovascular disease. Earlier stage products include a quick-dissolving omeprazole tablet for treatment of stomach and ulcer ailments and a controlled release mesalamine tablet for treatment of ulcerative colitis, or Crohn’s disease, a particular type of gastrointestinal disease. The details of our pipeline of product candidates from the development work of our Research and Development Division is discussed in “Research and Development Division — Our Product Development Business.” However, because of the inherent uncertainties of pharmaceutical development, we do not know whether we will ever be able to successfully commercialize any of these product candidates.

On March 28, 2002, we acquired from Eli Lilly the U.S. rights to the Darvon and Darvocet branded product lines in the U.S. (and the existing inventory of these products) for $211.4 million in cash, subject to adjustments described below. The Darvon and Darvocet products are prescribed for the treatment of mild-to-moderate pain. The acquired products include Darvon (propoxyphene hydrochloride), Darvocet-N (propoxyphene napsylate and acetaminophen) and Darvon-N (propoxyphene napsylate).

These product lines have been sold in the U.S. for over 25 years, with the initial marketing of Darvon beginning in 1957. Darvon lost its patent exclusivity in 1973 and Darvon-N and Darvocet-N in 1985. The first generic version of Darvon was introduced in 1973, and by 1985, numerous generic products were being marketed for substitution for Darvon and Darvocet. We believe that Eli Lilly ceased actively promoting these brands in approximately 1993.

Acquisition Terms. We paid $211.4 million in cash for the rights in the U.S. to these products and Eli Lilly’s existing inventory of these products. In addition, we have agreed to pay Eli Lilly royalties upon sales of our future developed improvements to the Darvon and Darvocet products or other products containing the active ingredient propoxyphene and any other pharmaceutical products sold under the name Darvon, Darvocet or certain other trademarks. We will pay a royalty on sales of each of these future products during each calendar quarter for a ten-year period beginning upon the product’s commercial introduction, provided that the total net sales of all of these future products, combined with the total net sales of the current Darvon and Darvocet products, exceed $15.8 million in the applicable calendar quarter. We will not owe any royalties on the sales of the Darvon and Darvocet products themselves that we acquired from Eli Lilly.

Supply of Product. Under a manufacturing agreement that we have entered into with Eli Lilly, Eli Lilly agreed to supply a specified percentage of our requirements from and after closing for the existing twelve Darvon and Darvocet product presentations (form and dosage). The supply agreement will extend through December 31, 2004. Upon the satisfaction of certain conditions, including payment by us of a $4.0 million extension fee, we may extend the agreement for an additional six months, during which Eli Lilly will use commercially reasonable efforts to supply the Pharmaceuticals Division with a full calendar year’s supply of products during the extension period, subject to certain maximum and minimum quantities. Under this agreement, we have agreed to order the manufacture of certain minimum amounts of Darvon and Darvocet products and certain minimum percentages of our requirements: 60% of our requirements in the first year, 50% in the second year, and 40% in the third year. Also under this agreement, the supply obligation of Eli Lilly is subject to a maximum amount of the Darvon and Darvocet products over the life of the contract. We anticipate that this maximum supply obligation of Eli Lilly is sufficient to cover all of our supply needs through the end of 2005. We will purchase these products manufactured by Eli Lilly for a fixed unit cost,

subject to a percentage increase on each January 1 plus any increase in Eli Lilly’s cost of raw materials during that year. However, the purchase price for these products will be no less than Eli Lilly’s standard cost of manufacturing, which includes raw materials, direct labor, and plant overhead attributable to the Darvon and Darvocet products. Prior to expiration of this agreement, we intend to have FDA approval permitting the transfer of the manufacturing of these products to our manufacturing facilities, one or more third-party manufacturing facilities, or a combination of these facilities. This approval, however, could require significant expense and time, and it is possible that we never receive it.

On December 13, 2001, we acquired the U.S. rights to the Brethine branded product line from Novartis Pharmaceuticals Corporation and Novartis Corporation for $26.6 million in cash. Brethine is administered in oral and injectable forms for the prevention and reversal of bronchospasm in patients age 12 and older with asthma and reversible bronchospasm associated with bronchitis and emphysema. Although physicians also prescribe Brethine to stop premature labor, this drug has not been approved by the FDA for this indication and thus it cannot be marketed or promoted for this use. Brethine was initially marketed beginning in 1975. We believe that Novartis ceased actively promoting Brethine in the early 1990s, although Novartis selectively marketed and promoted Brethine since then and a third party provided marketing support for Brethine during 1999 and 2000.

Brethine, or terbutaline sulfate, is a beta-adrenergic agonist bronchodilator, meaning that it aids in the flow of air through the bronchial tubes for people suffering from asthma, emphysema, chronic bronchitis, and other lung diseases. IMPAX Laboratories has been marketing a generic form of the oral form of Brethine since July 2001. There are no approved generic forms of the injectable form of this drug. Major branded products competing against Brethine to treat these ailments include Volmax, Proventil, and branded and generic forms of albuterol.

Supply of Product. We entered into an interim supply agreement with Novartis providing for its manufacture and packaging of the oral and injectable form of Brethine for sale by us in the U.S. through December 13, 2004. We may terminate the manufacturing component of the supply agreement on twelve months’ notice and the packaging component on six months’ notice. Under the supply agreement, we may purchase the products for a fixed unit cost during the term of the agreement, subject to an annual price adjustment on January 1, 2003 and January 1, 2004 tied to the Consumer Price Index and to a downward adjustment in the event product packaging is moved to a third party. We intend to transfer the Brethine manufacturing processes to our own facilities prior to expiration of the supply agreement. This move, however, is subject to FDA approval, and it is possible that this approval will involve significant expense and will not be obtained on a timely basis, if at all.

On August 17, 2001, we acquired the U.S. rights to a line of critical care injectable and oral nutritional products from AstraZeneca. These products are M.V.I.-12, M.V.I. Pediatric, Aquasol A and Aquasol E. The M.V.I.-12, M.V.I. Pediatric and Aquasol A products are administered by intravenous or injected solution to provide nutrients to severely ill patients for whom oral nutrition is not feasible. Aquasol E is administered by oral solution. We acquired these products for up to $100 million in cash, of which we paid $52.5 million at closing of the acquisition. A post-acquisition guaranteed payment of $1.0 million was paid in August 2002. A second guaranteed payment of $1.0 million is due in August 2003. The acquisition agreement provided for future contingent payments. A contingent payment of $2.0 million would have been due in August 2003 if the FDA had approved by December 31, 2002 the reformulated M.V.I.-12 product with a minimum shelf life of 12 months. In addition, a contingent payment of up to $43.5 million is due in August 2004 if FDA approval of the reformulated M.V.I.-12 product is received on or before December 31, 2003, with the $43.5 million payment being reduced by $1.0 million for each month after December 31, 2002 during which FDA approval has not been obtained. The $43.5 million payment will become zero in the event FDA approval is not obtained on or before December 31, 2003. An application for approval of this reformulated product was submitted to the FDA in February 2003.

The initial M.V.I. product and Aquasol A were approved for marketing over 45 years ago, and M.V.I. Pediatric was approved in 1983. No FDA approval is necessary to market Aquasol E.

The M.V.I. products and Aquasol A are approved by the FDA for the following uses:

The FDA has examined the product formulation and the current state of medical thought on the vitamin and nutrient levels needed in M.V.I.-12. After examining data from a public workshop between the FDA and the American Medical Association as to the appropriate dosage level of vitamins in parenteral multivitamin preparations, the FDA increased the targeted dosage levels of vitamins B1, B6, C and folic acid to be included in multivitamin injectable products to a level greater than that included in any existing product and required the inclusion of Vitamin K. Prior to our acquisition of the M.V.I. product line from AstraZeneca, we had been working with AstraZeneca on a fee-for-service basis to reformulate M.V.I.-12 to meet these guidelines.

Supply of Product. In connection with the M.V.I. and Aquasol acquisition, we entered into an interim supply arrangement with AstraZeneca to supply us with M.V.I.-12 in single-dose vials, multi-dose vials and bulk, Aquasol A and Aquasol E. The initial term of this interim supply agreement was for two years through August 17, 2003, and we have exercised the option to extend the term for an additional year, through August 17, 2004. Under the interim supply agreement, we may purchase the products for a fixed unit cost for the first two years equal to AstraZeneca’s variable cost of goods sold during 2000 for the relevant product, adjusted in August 2002 for changes in the cost of raw materials and adjusted (limited to changes in the Consumer Price Index) for changes in other manufacturing costs. During the third year of supply, the price will increase to AstraZeneca’s full variable and fixed costs plus 20%. If we obtain FDA approval for the reformulated M.V.I.-12 product, AstraZeneca will supply the reformulated product to us at a price equal to AstraZeneca’s costs, including materials, labor and variable overhead. In addition, AstraZeneca assigned to us its manufacturing agreement with a third-party supplier for the production of M.V.I. Pediatric for an indefinite period of time, provided that either party can terminate this agreement upon at least four years’ prior notice.

M.V.I. product line shortages existed in the mid-1990s due to third-party manufacturing problems, which were resolved in 2000 when AstraZeneca brought manufacturing of M.V.I.-12 in-house. Similarly, M.V.I. Pediatric product line shortages existed after a September 2001 inspection by the FDA of the facilities of our third party supplier in which this product is manufactured, which led to a cessation of production until the manufacturer resumed production in February 2002. Shipments of new M.V.I. Pediatric products recommenced to our customers in April 2002. This product is currently being manufactured at full production levels.

We expect to transfer the manufacture of the Aquasol products to our Charleston and Wilmington manufacturing facilities, and to either bring the manufacture of the M.V.I. product lines in-house or contract with third-party manufacturers to ensure a continued, long-term supply on market terms.

On February 13, 2002, we acquired from Aesgen, Inc. the rights to its calcitriol product, a generic injectable vitamin D nutritional product that we intend to market as a line extension to our Aquasol product line. This product is used primarily to treat chronic kidney dialysis patients with abnormally low levels of calcium in their circulating blood. We paid $1.0 million for this product at the time of acquisition and agreed to make additional contingent milestone payments of up to $1.5 million and certain royalty payments for the eight-year period following the first commercial sale of this product. To date, we have paid an additional $500,000 to Aesgen with respect to this product.

On February 20, 2003, we were notified by the FDA of marketing approval for our calcitriol product, with shared 180-day marketing exclusivity for this drug product with a second company. No other companies will be approved for the sale of calcitriol until the expiration of this market exclusivity period. In March 2003, we commenced commercial sales of our calcitriol product and also entered into a long-term manufacturing and co-promotion agreement with another company with respect to such other company’s calcitriol product under their regulatory approval. We also sell product manufactured by another source pursuant to purchase orders issued by us.

We have developed, and recently received FDA approval to market, three line extensions to our current 50 milligram azathioprine tablet product: 25 milligram, 75 milligram and 100 milligram tablets. Azathioprine is an immunosuppression agent used in the prevention of organ rejection in kidney transplants and for the management of severe, active rheumatoid arthritis unresponsive to rest, aspirin or other nonsteroidal anti-inflammatory drugs, or NSAIDs. These azathioprine products are generic forms of Imuran, a branded product sold by Prometheus Laboratories, Inc., and will be sold by us as branded products under our Azasan trademark. Our 50 milligram azathioprine tablet product was previously developed by us and launched in 1999 by Geneva Pharmaceuticals, Inc.

These three new line extension products are intended to provide better patient compliance and convenience to the patients, as patients typically begin treatment with 25 milligram dosages of azathioprine and move up over time in dosages to 150 to 200 milligrams per day, and greater flexibility to the prescribing physician to tailor the dose for the patient. Our Azasan products are manufactured in our own facilities.

We have our own sales force to sell our pharmaceutical product lines. As of February 28, 2003, we had a sales force of approximately 80 sales representatives, with plans to increase the size of our sales force to 150 during 2003.

We have contracted with a subsidiary of Cardinal Health, Inc. to provide warehousing, distribution, inventory tracking, customer service and financial administrative assistance related to the distribution program (including management of applicable rebates, chargebacks and accounts receivable collection).

We currently manufacture certain high-potency and high-toxicity drug products, along with controlled substance products, for clients in our manufacturing facility in Wilmington, North Carolina. Our manufacturing generally covers small volume products, and our manufacturing capability has been upgraded to allow manufacture of a portion of the Darvon and Darvocet family of products in our own facility. We also manufacture certain drugs developed on behalf of clients for commercial sale. We also operate a 48,000 square foot sterile facility in Charleston, South Carolina where we manufacture sterile, injectable products. We also provide manufacturing, packaging and labeling of clinical trial materials.

The Research and Development Division provides research and development expertise and a portfolio of proprietary and in-licensed drug-delivery technologies and intellectual property rights, which we use to enhance and develop products that are innovative, safer, or more effective, convenient or cost-efficient. This can result in renewed regulatory or patent exclusivity, adding to the commercially valuable life of the product. We offer these product improvement, or life cycle management, activities to our customers for royalties, milestone payments and fees. In addition, we apply this expertise to improve our acquired products and internally develop our own new products. Net revenues for the Research and Development Division in 2002 were $19.6 million.

In addition to product development, the Research and Development Division seeks to develop proprietary drug-delivery technologies for licensing to our clients. We also dedicate a portion of our technical resources and operating capacity to internal drug and technology development with the objective of licensing marketing rights to third parties.

Our internal product and technology development program has resulted in multiple product applications filed with the FDA and European regulatory agencies. Many of these products have been licensed or sold. Others are still in development. The internal development program has also resulted in patents covering drugs and drug technology and numerous pending patent applications.

We have significant experience in providing product life cycle management services to our clients, which we leverage to develop our own proprietary products. Product life cycle management offers product improvement and line extension opportunities to clients, generally for marketed products facing patent expiration and that could commercially benefit from improvements or line extensions. Product improvements and line extensions offer clients an opportunity to improve product or product delivery characteristics, thus enhancing and extending the commercial value of a branded product line. Improved product characteristics may include enhancement of product stability, creation of additional absorption profiles (e.g., quick or sustained release), higher drug absorption or bioavailability (permitting reduced drug loads per dose with the potential for lower costs and side effects), improved taste, more attractive appearance, or better dosage regimes (e.g., once a day versus multiple doses per day). Product line extensions may include new dosage forms, such as solids, liquids and chewables, to increase patient populations who can benefit from such drugs (e.g., pediatric or geriatric patient populations), as well as new dosage strengths that may be more convenient for doctors and patients under current treatment regimens. Product modifications and line extensions offer clients the opportunity to target new patient populations and improve patient compliance and convenience. Product life cycle management activities also can lead to new inventions and discoveries in the course of the research and development work, providing new opportunities for long-term patent protection for the modified products and potential long-term value for licensees of our technologies.

Our portfolio of internally developed and in-licensed drug-delivery technologies provide us with some opportunities for the expansion of a drug product’s effective market life. Our currently available technologies include:

The ProCore and ProSorb technologies are proprietary to us. The ProSLO and ProSLO II technologies are available for use by us and our clients in the U.S. through a recently amended agreement with Osmotica Corporation. During January 2003, we agreed to amend the original agreement from an exclusive arrangement to a non-exclusive arrangement. As such, Osmotica is permitted to develop its own products for use in the U.S. without our involvement, but we may also jointly develop products using Osmotica’s technology upon mutual agreement.

Additionally, the ProLonic, ProMelt and ProSpher technologies are available to us pursuant to a joint development agreement with Tanabe Seiyaku Co. Ltd. This agreement with Tanabe provides for the joint development by us and Tanabe of certain mutually agreeable drug technologies developed by Tanabe. Under this agreement, we have an exclusive worldwide license, other than in certain Asian countries, to the developed technologies and we are required to pay Tanabe a portion of all down payments, milestone payments and royalties, received by us in connection with the commercialization of products using these jointly developed technologies.

The Research and Development Division has continued our internal development of products to be licensed to third parties that have additional marketing and distribution capabilities or a therapeutic focus different than ours. We have entered into multiple licensing agreements for products that are currently in development. The terms of the agreements vary as to amounts of milestone payments and fees, as well as methods and extent of revenue participation such as royalties. While we anticipate that most of our product licensing agreements will provide that prospective clients will ultimately sponsor the approved product, in certain instances we have made submissions for internally developed products in our own name.

In 2002, aaiPharma and Tanabe Holding America, the U.S. subsidiary of Tanabe Seiyaku of Japan, formed a joint venture whose objectives are to develop, manufacture, sell and potentially license pharmaceutical products. Tanabe’s contribution consists of candidate compounds from its drug discovery pipeline, while aaiPharma’s contribution is its extensive expertise in research, development and clinical trials management with respect to new drug development. The joint venture’s revenue opportunities include: potential direct marketing of drugs developed by the joint venture; potential licensing opportunities for our

Pharmaceuticals Division; potential third-party licensing opportunities; and potential third-party co-promotion. The initial therapeutic focus areas of the joint venture are cardiovascular diseases and gastrointestinal diseases.

We have a number of proprietary pharmaceutical products under development, which include the products in the chart below. We are pursuing internal product development candidates in three primary categories:

Our product development strategy focuses on products that we expect will have some period of market exclusivity, such as through patent or regulatory exclusivity, without competition from generic substitutes or other third-party products that infringe the patents covering our line extensions or other developed products.

In addition to the line extensions to our acquired products discussed above in “Pharmaceuticals Division — Our Product Sales Business,” we are developing the following products:

Darvon/Darvocet Line Extensions. We plan to develop improved products and line extensions with improved product delivery and therapeutic characteristics and potential regulatory and patent exclusivity. For example, we are considering the development of a liquid form of Darvocet, formulations which can be taken less frequently than every four hours and some products that would combine propoxyphene, the active ingredient in Darvon and Darvocet, with a non-steroidal, anti-inflammatory drug.

M.V.I. Line Extensions. Our product line strategy for M.V.I. and Aquasol will also focus on developing and marketing new products, product improvements and product line extensions. The reformulation of M.V.I.-12 to add vitamin K will create additional product line opportunities within and outside the U.S. We also plan to formulate M.V.I. products to be used for patients in specialized markets.

Brethine Line Extensions. Our strategy for Brethine also involves product line extensions and improvements. We are developing a glass vial form of the injectable Brethine product, rather than the current glass ampoule presentation, to improve the safety and convenience of administering this drug. We are also taking steps to reduce aluminum in the product to address potential aluminum issues, and we are exploring new indications for the Brethine product as well as development of the single chiral isomer product.

Imidapril. We are developing an imidapril tablet for sale in the United States. Imidapril is an angiotensin converting enzyme (ACE) inhibitor for the treatment of cardiovascular disease. It has been sold in Japan since 1993 by Tanabe Seiyaku Co., Ltd. under the name Tanatril for the treatment of hypertension, or high blood pressure. In addition, Tanabe has recently obtained approval in Japan to market Tanatril for the treatment of kidney disease associated with Type I insulin dependent diabetes mellitus. We licensed the U.S. rights to this product from Tanabe in January 2002.

Imidapril is also approved for sale in Europe for hypertension. We are presently obtaining the clinical data from the European dossier used by Tanabe to obtain approval for sale of imidapril in Europe as a basis for our regulatory filings with the FDA for approval to sell imidapril in the United States.

ProSorb-D. ProSorb-D is a softgel capsule that combines diclofenac, a proven pain medication, with our ProSorb rapid-absorption technology. We are developing this product for the management of pain and have recently completed Phase III clinical trials and plan to file a New Drug Application, or NDA, following further discussions with the FDA.

6-Omeprazole. We acquired the exclusive U.S. rights to the ProMelt technology in 2001 from Tanabe Seiyaku Co. Ltd. We are using this technology with an isomer of omeprazole patented by us to develop a convenient quick-dissolving tablet for the treatment of ulcers, heartburn and symptoms associated with gastroesophageal reflux disease. The ProMelt technology allows specially coated fine particles of omeprazole in a tablet dosage form to rapidly disintegrate in the mouth. Our patented isomer of omeprazole is potentially more stable than existing omeprazole products.

Fexofenadine/pseudoephedrine. Using our ProSLO II technology licensed from Osmotica Corporation, we are developing a product that combines an immediate release of fexofenadine with a controlled release of pseudoephedrine. This new product will only require one dose per day as opposed to the currently approved product, which requires two doses per day. The currently approved product is indicated for the relief of symptoms associated with seasonal allergic rhinitis in adults and children age 12 and older.

We have completed the scale-up of the manufacturing process at our client’s manufacturing facilities. Pivotal batches of this product were placed on stability studies in the fourth quarter of 2002 and a pivotal bioequivalence study was begun. The pivotal batches will also be used for a clinical study comparing the pharmacokinetic effect of this product with fed and fasted persons. We do not believe that the FDA will require any additional clinical trials.

We have licensed the rights to this fexofenadine/pseudoephedrine product to a client for milestones and royalty payments. The latest milestone payment was received in the fourth quarter of 2002.

Other Product Candidates. In addition to the specifically identified products named above, we have targeted and will target additional products to develop. As we continue our product development activities and evaluate our interim results and other information, we may decide to change the scope and direction of any of our development programs and projects and we may change how we allocate our research and development spending to pursue more promising product candidates. Moreover, we may not be able to successfully develop, commercialize or license any of the products discussed in this Form 10-K.

AAI International offers a comprehensive range of pharmaceutical product development services to our customers on a worldwide basis. These services include formulation development, analytical, microbiological, bioanalytical and stability testing services, production scale-up, biotechnology analysis and synthesis, human clinical trials, regulatory consulting, and manufacturing. These services generally are provided on a fee-for-service basis. Net revenues for AAI International were $82.4 million in 2002.

Prior to our transition to a specialty pharmaceutical company, this development services business was the core of our operations. AAI International provides its services, both individually and in an integrated fashion, to:

Since our founding in 1979, we have contributed to the submission, approval or continued marketing of many client products, encompassing a wide range of therapeutic categories and technologies. We believe that

our ability to offer an extensive portfolio of high quality drug development and support services enables us to effectively compete as pharmaceutical and biotechnology companies look for a mixture of standalone and integrated drug development solutions that offer cost-effective results on an accelerated basis.

We have a strong base of resources, expertise and ideas that allows us to develop and improve drug products and carry out product life cycle management activities both for our customers and ourselves. Our expertise covers many therapeutic categories and types of pharmaceutical products. We are enhancing our expertise in the key therapeutic areas of pain management, critical care, and gastrointestinal products.

We focus on our customers’ individual needs when marketing our services, often placing our technical personnel with our clients’ development teams to participate in planning meetings for the development or improvement of a product. We assign our sales and technical personnel as contacts for our larger clients, understanding that technical personnel may be better able to identify the full scope of our client’s needs and suggest innovative approaches. Additionally, we host several technical seminars each year to help our customers stay abreast of the latest developments in their industries.

Our organization has a long history of focus on the needs of our clients. In order to further enhance our ability to meet the needs of our clients, fulfill our mandate to provide the highest level of quality, and improve our operating efficiency, we have dedicated resources to “Operation Excellence,” our internal continuous process improvement effort. This commitment has already paid benefits to us by providing a focal point for improvement initiatives throughout our AAI International operations.

Our third-party product development contracts typically provide for upfront fees and milestone payments. The commercialization of the products on which AAI International works is the responsibility of our client. We typically provide signed service estimates estimating fees for specified services. During our performance of a project, clients often adjust the scope of services to be provided by us, at which time the amount of fees is adjusted accordingly. Generally, AAI International’s fee-for-service contracts are terminable by the client upon notice of 30 days or less. Although the contracts typically permit payment of certain fees for winding down a project, the loss of a large contract or the loss of multiple contracts could adversely affect our future revenue and profitability in our development services business. Contracts may be terminated for a variety of reasons, including the client’s decision to stop a particular study, the failure of product prototypes to satisfy safety requirements, and unexpected or undesired results of product testing.

AAI International’s core services are organized internally along pharmaceutical, analytical, biopharmaceutical, clinical and regulatory affairs lines to mirror the movement of pharmaceutical products through the drug development pipeline.

AAI International provides a variety of pharmaceutical services to its customers, including drug formulation development, niche manufacturing, and storage and distribution of clinical trial supplies. The services are organized to help clients from the pre-clinical to post-marketing stages.

Formulation Development Services. AAI International provides integrated formulation development services for its customers’ pharmaceutical products, by which it takes a compound and works to develop a safe and stable product with desired characteristics. AAI International provides formulation development services during each phase of the drug development process, from new compounds to modifications of existing products. AAI International’s formulation development projects may support a small segment of critical development activities for a short duration or may last for several years, ranging from early formulation development to a validated, production-scale, commercial product.

In addition to new drug development, AAI International’s formulations team provides product modification and line extension services to clients through product life cycle management contracts we enter into, generally for marketed products facing patent expiration or that can benefit from formulation improvements. Modifications of existing products offer clients an opportunity to improve product characteristics, increasing product market viability. Improved product characteristics include enhancement of stability, absorption profiles (e.g., quick, controlled or sustained release), taste, and appearance. Product line

extensions may include new dosage forms, such as solids, liquids and chewables, as well as new dosage strengths. Product modifications and line extensions offer clients the opportunity to target new patient populations and improve patient acceptance of the product. AAI International’s product optimization services also cover investigation of impurities, contaminants and degradation, the updating of mature products to meet current regulatory standards and laboratory validation services.

Manufacture of Clinical Trial Supplies. AAI International manufactures clinical trials materials for Phase I through IV drug-product clinical trials. It has expertise in manufacturing tablets, capsules, sachets, liquids and suspensions, creams, gels, lotions and ointments. Outsourcing of clinical supply manufacturing is particularly attractive to pharmaceutical companies that maintain large, commercial-quantity, batch facilities, where clinical supply manufacturing would divert resources from revenue-producing manufacturing. AAI International has a dedicated 25,000 square foot facility in Wilmington, North Carolina and another facility in Neu-Ulm, Germany to distribute and track clinical trial materials used in clinical studies, with the capacity for controlled substance storage and handling. In addition, AAI International provides its clients with assistance in scaling up production of clinical supply quantities to commercial quantity manufacturing.

AAI International provides a wide variety of analytical services, as well as services pertaining to method development and validation, drug product and active pharmaceutical ingredient characterization and control, microbiological support, stability storage and studies, and technical support and problem solving with respect to pharmaceuticals. In support of the drug development and compliance programs of its customers, AAI International offers laboratory services to characterize and measure drug components and impurities. We have more than two decades of experience in providing analytical testing services dedicated exclusively to the drug industry and have developed the scientific expertise, technologically advanced equipment, and broad range of scientific methods to accurately and quickly analyze almost any compound or product. Our analytical services include:

AAI International integrates a Phase I clinical study capability with strong bioanalytical and biotechnology expertise to provide biopharmaceutical services to its customers. The analysis of drugs, metabolites and endogenous compounds in biological samples is a core service of AAI International. Our biopharmaceutical services include:

AAI International provides a broad range of Phase I through IV clinical services to customers in the pharmaceutical, biotechnology and medical device industries for assistance in the drug development and regulatory approval process in North America. The clinical services include clinical trial management and monitoring, site selection, medical affairs (including safety surveillance and serious adverse event management), data management and statistics.

AAI International provides consulting services with respect to regulatory affairs, quality compliance, and process validations. It assists in the preparation of regulatory submissions for drugs, devices and biologics, audits a client’s vendors and client operations, conducts seminars, provides training courses, and advises clients on applicable regulatory requirements. AAI International also assists clients in designing development programs for new or existing drugs intended to be marketed in the United States and Europe.

We believe that our ability to apply our scientific expertise to develop new and improved products and product line extensions, to leverage our marketing and promotion organization and our strong relationships with many large pharmaceutical companies and to identify and acquire branded pharmaceutical products, positions our company for continued growth. Specifically, we intend to pursue the following growth strategies:

We have made significant investments in information technology. Our customized data management system connects analytical instruments with multiple software architectures permitting automated data capture. We believe that information technology will enable us to expedite the development process by designing innovative services for individual client needs, providing project execution, monitoring and control capabilities that exceed a client’s internal capabilities, streamlining and enhancing data presentation to the FDA and enhancing our own internal operational productivity while maintaining quality.

We continue to upgrade and expand our enterprise wide financial and operational integrated management information system, which includes significant systems licensed from SAP. Initial financial components became operational at year-end 1998, other operational management systems followed in 1999 and 2000, and we continue the implementation of these systems company-wide.

Historically, our primary customers have been large and small pharmaceutical and biotechnology companies serviced by the Research and Development Division and AAI International. Recently, our largest customers have been large medical wholesalers and distributors of our pharmaceutical products sold into the marketplace.

Significant research and development projects have a defined cycle, and accordingly, the composition of our customer group in the AAI International and Research and Development Division areas of our business changes from year to year. In addition, because of the project nature of engagements in these segments of our business, we may have a concentration of business among some large customers in one period that we would not expect to continue into subsequent periods. We have experienced concentration in these areas of our business in the past, and we do not believe that this is unusual for companies in the same markets as the Research and Development Division and AAI International.

The Pharmaceuticals Division’s customers are primarily large well-established medical wholesalers and distributors. Cardinal Health, Inc., AmerisourceBergen Corporation and McKesson Corporation accounted for approximately 19%, 18% and 12% of our consolidated net revenues, respectively. We do not believe that revenues from any large pharmaceutical company or other customer of the Research and Development Division or AAI International is likely to exceed 10% of our consolidated net revenues in future years.

Backlog consists of anticipated net revenues from signed fee-for-service contracts for which services have not been completed. Once contracted work begins, net revenues are recognized as the service is performed. Backlog does not include anticipated net revenues for work performed for internal clients or for any variable-priced contracts. In addition, during the course of a project, the client may substantially adjust the requested scope of services and corresponding adjustments are made to the price of services under the contract.

We believe that our backlog as of any date is not a meaningful predictor of future results for much of our business due to rapid signing and completion of many of our contracts. Additionally, the backlog can be affected by a number of factors, including variable size and duration of contracts and adjustments in the scope of a contracted project as interim results become available. At December 31, 2002 and 2001, backlog was approximately $57 million and $66 million, respectively. Of the 2002 amount, we do not expect to fill approximately $12 million by December 31, 2003.

We compete with companies and organizations in multiple segments of the pharmaceutical industry. The branded drug products of our Pharmaceuticals Division are subject to competition from the branded and generic products of other pharmaceutical companies, ranging from other small specialty pharmaceutical companies to the large pharmaceutical companies who are among the customers of the development services business of AAI International.

The main competition for M.V.I.-12 is Infuvite Adult, which is marketed by Baxter Healthcare Corporation. The main competition of M.V.I. Pediatric is Infuvite Pediatric, which also is marketed by Baxter Healthcare Corporation. Aquasol A is the only injectable Vitamin A product on the market. Aquasol E competes with various other vitamin E products.

The main competition of calcitriol is Calcijex and Zemplar, marketed by Abbott Laboratories. Other competitors include Hectorol, marketed by Bone Care International, Inc.; a generic calcitriol product in ampoule form, approved but not yet marketed by American Pharmaceutical Partners, Inc.; and, following the 180-day regulatory exclusivity period that is triggered by the commercial sales of calcitriol by us, certain additional generic suppliers of calcitriol products. Calcitriol has been approved by the FDA as a generic substitute for Calcijex, although our calcitriol product will be packaged in a vial, rather than an ampoule, form. We believe the vial format will be more attractive to medical professionals than competing products in ampoule form, due to safety and convenience reasons.

Brethine competes in the market for the treatment of asthma and related bronchial ailments, which is a market led by Volmax, Proventil, and branded and generic forms of albuterol sulfate.

Darvon and Darvocet compete primarily in the broad pain management market, especially with products indicated for the management of mild-to-moderate pain. Competitive products indicated for the management of mild-to-moderate pain include Ultram and other non-steroidal anti-inflammatory drugs such as ibuprofen. Additionally, major promotional efforts in the U.S. pain management market today involve a relatively new class of drugs, the cyclo-oxygenase 2, or the COX-2, enzyme inhibitors. They are designed to work as effectively as Darvon and Darvocet and NSAIDs, but without side effects such as ulcers and gastrointestinal bleeding. These new COX-2 inhibitors are more selective than traditional NSAIDS. The non-selective inhibition of both COX-1 and COX-2 enzymes in other NSAIDs is responsible for the toxicities and side effects. However, the existence of actual improvement in gastrointestinal side effects of COX-2 inhibitors over diclofenac-based products is presently unclear, with the FDA noting in June 2002, after review of a large clinical study of a major COX-2 inhibitor product, that the COX-2 inhibitor product did not show a safety advantage in upper gastrointestinal events in comparison to either ibuprofen or diclofenac.

The Darvon and Darvocet product lines no longer have patent exclusivity. While precise data on generic substitution for these products is not available, we believe a vast majority of the prescriptions written for Darvon and Darvocet are filled with generic products. These generic substitutes are sold at significantly lower

prices, without the research, development and approval costs associated with the branded Darvon and Darvocet products. Two of the world’s largest manufacturers of generic products, Teva Pharmaceutical Industries Ltd. and Mylan Laboratories Inc., sell propoxyphene generic substitutes to Darvon and Darvocet.

Sellers of generic products typically do not bear the related research and development costs associated with branded products and, thus, are able to offer their products at considerably lower prices. There are, however, a number of factors that enable branded products to remain profitable once patent protection has ceased. These include the establishment of a strong brand image with the prescriber or the consumer, supported by the development of improved products and line extensions to differentiate the branded products from the generic competition.

Our AAI International and Research and Development Divisions compete primarily with in-house research, development, quality control, and other support service departments of pharmaceutical and biotechnology companies, as well as university research laboratories and other contract research organizations. In addition, we believe that although there are numerous fee-for-service competitors in our industry, there are few competitors that offer the depth or breadth of scientific capabilities that we provide. Some of our competitors, however, may have significantly greater resources than we do. Competitive factors generally include reliability, turn-around time, reputation for innovative and quality science, capacity to perform numerous required services, financial viability, and price. We believe that we compete favorably in each of these areas.

The services that we perform and the pharmaceutical products that we develop and manufacture are subject to various rigorous regulatory requirements designed to ensure the safety, effectiveness, quality and integrity of pharmaceutical products, primarily under the Federal Food, Drug, and Cosmetic Act, including current Good Manufacturing Practice regulations. These regulations are commonly referred to as the cGMP regulations and are administered by the FDA in accordance with current industry standards. Our services and development efforts performed outside the U.S. and products intended to be sold outside the U.S. are also subject to additional foreign regulatory requirements and government agencies.

U.S. laws and federal regulations apply to all phases of investigational and commercial development (i.e. manufacturing, testing, promotion and distribution of drugs, including with respect to our personnel, record keeping, facilities, equipment, control of materials, processes, laboratories, packaging, labeling, storage and advertising.) If we fail to comply with these laws and regulations, our drugs, drug improvements, and product line extensions will not be approved by the FDA or will be withdrawn from the market and the data we collect may be out of specification and not acceptable to the FDA requirements, which may result in not being permitted to market our products. Additionally, we could be subject to significant monetary fines, recalls and seizures of products, closing of our facilities, revocation of drug approvals previously granted to us, and criminal prosecution. Any of these regulatory actions could materially and adversely affect our business, financial condition and results of operations.

To help assure our compliance with applicable laws and regulations, we have quality assurance controls in place at our facilities and we use FDA regulations and guidelines, as well as applicable international standards, as a basis for our quality policies and standard operating procedures. We regularly audit test data, inspect our facilities and revise our standard operating procedures to meet current cGMPs in preparation for routine and periodic FDA inspections. A system for monitoring product-related complaints for all of our commercial products has been established.

The balance of adhering to FDA compliance while bringing products to market requires us to continuously improve our operating standards in order to reduce the possible risk of additional FDA actions. In the event of any such action of a material nature, the resulting restrictions on our business could materially and adversely affect our business, financial condition and operating results.

All of our drugs, investigational and commercial, must be manufactured in conformity with International Conference on Harmonization, or ICH, guidances, cGMP regulations and FDA guidances and guidelines.

Drug products subject to an approved FDA-application must be manufactured, processed, packaged, held and labeled in accordance with information contained in the application. Modifications, enhancements or changes in manufacturing sites of approved products are in many cases subject to additional FDA inspections and supplemental approvals to the existing application. The circumstances requiring inspections and supplemental filings may require a lengthy application process. Our facilities, including the facilities used in our development services business, and those of our third-party manufacturers are periodically subject to inspection by the FDA and other governmental agencies. If such inspections prove unsatisfactory, the operations at these facilities could be interrupted or halted for lengthy periods of time.

Failure to comply with FDA or other governmental regulations can result at first in warning letters. If those warning letters are not adequately addressed, further actions may lead to fines, unanticipated compliance expenditures, recall or seizure of products or total or partial suspension of production or distribution. For drugs under FDA review, failure to be compliant at manufacturing facilities could stop the FDA’s review of our drug approval application that could, in certain circumstances, extend to the termination of ongoing research, disqualification of data for submission to regulatory authorities, enforcement actions, injunctions and criminal prosecution. Under certain circumstances, the FDA also has the authority to revoke previously granted drug approvals. Although we have instituted internal compliance programs that consistently comply with cGMPs through strong training and corporate quality oversight, we are cognizant that if these programs do not meet regulatory agency standards or if compliance is deemed deficient in any significant way, it could have a material adverse effect on us, our third party manufacturers and our vendors. Most of our vendors are subject to similar regulations and periodic inspections.

Some of our development and testing activities, including the manufacture, development and testing of the Darvon and Darvocet products, are subject to the Controlled Substances Act, administered by the Drug Enforcement Administration, or the DEA, which strictly regulates all narcotic and habit-forming substances. We maintain separate, restricted-access facilities and heightened control procedures for projects involving such substances due to the level of security and other controls required by the DEA.

Our business also involves the controlled storage, use and disposal of hazardous materials and biological hazardous materials. We are subject to numerous federal, state, local and foreign environmental regulations governing the use, storage, handling and disposal of these materials. Although we believe that our safety procedures for handling and disposing of these hazardous materials comply in all material respects with the standards prescribed by law and regulation in each of our locations, the risk of accidental contamination or injury from hazardous materials cannot be completely eliminated. We maintain liability insurance for some environmental risks that our management believes to be appropriate and in accordance with industry practice. However, we may not be able to maintain this insurance in the future on acceptable terms. In the event of an accident, we could be held liable for damages that are in excess or outside of the scope of our insurance coverage or that deplete all or a significant portion of our resources.

We are also governed by federal, state and local laws of general applicability, such as laws regulating intellectual property, including patents and trademarks, working conditions, equal employment opportunity, and environmental protection.

In connection with our activities outside the U.S., we also are subject to foreign regulatory requirements governing the testing, approval, manufacture, labeling, marketing and sale of pharmaceutical products, which requirements vary from country to country. Whether or not FDA approval has been obtained for a product, approval by comparable regulatory authorities of foreign countries must be obtained prior to marketing the product in those countries. For example, some of our foreign operations are subject to regulations by the European Medicines Evaluations Agency and the U.K. Medicines Control Agency. The approval process may be more or less rigorous from country to country, and the time required for approval may be longer or shorter than that required in the U.S., therefore pharmaceutical product approval and policies for pricing required for marketing will vary from country to country due to different regulations and policies required by each.

New Drug Approval Process. FDA approval is required before any new drug can be marketed and sold in the U.S. This approval is obtained through the new drug application, or NDA, process, which involves the submission to the FDA of complete pre-clinical data about new compounds and their characteristics and then clinical data obtained from studies in humans showing the safety and effectiveness of the drug for the proposed therapeutic use.

Before introducing a new drug into humans, stringent government requirements for pre-clinical data must be satisfied. The pre-clinical data is obtained from laboratory studies, and tests performed on animals, which are submitted to the FDA in an investigational new drug application, or an IND. The pre-clinical data must provide an adequate basis for evaluating both the safety and the scientific rationale for the initiation of clinical trials of the new drug in humans. Pursuant to the IND, the new drug is tested in humans for safety, adverse effects, dosage, tolerance absorption, metabolism, excretion and other elements of clinical pharmacology, and for effectiveness for the proposed therapeutic use.

Clinical trials are conducted in three sequential phases (i.e., Phase I, Phase II, and Phase III). The clinical development plan, or the process of completing clinical trials during the investigational period, for a new drug may take several years and require the expenditure of substantial operational and financial resources. Phase I clinical trials frequently begin with the initial introduction of the investigational drug product into healthy humans and test primarily for safety. Phase II clinical trials typically involve a small sample of the intended patient population to assess the efficacy of the investigational drug product for a specific indication, to determine dose tolerance and the optimal dose range and to gather additional information relating to safety and potential adverse effects. Phase III clinical trials are studies with a statistically qualified larger study population that compares the active drug product against a placebo. These studies, conducted in a randomized group where the drug and placebo are blinded from the patient, further evaluate clinical safety and efficacy at different study sites to determine the overall risk-benefit ratio of the drug and provide an adequate basis for product labeling

Each clinical trial is conducted in accordance with rules, or protocols, that are developed to detail the objectives of the study, including methods to monitor safety and efficacy and the precise criteria to be evaluated. These protocols must be submitted to the FDA as part of the IND. In some cases, the FDA allows a company to rely on data developed in foreign countries, or previously published data, which eliminates the need to independently repeat some or all of the studies.

Once sufficient data have been developed pursuant to the IND, the NDA is submitted to the FDA to request approval to market the new drug. Preparing an NDA involves substantial data collection, verification and analysis, and expense, and there is no assurance that FDA approval of an NDA can be obtained on a timely basis, if at all. The approval process is affected by a number of factors, primarily the risks and benefits demonstrated in clinical trials as well as the severity of the disease and the availability of alternative treatments. The FDA might not approve an NDA if the regulatory criteria are not satisfied or, alternatively, may require additional studies to enhance the overall risk-benefit ratio prior to an approval action.

Referencing and Relying on New Drug Applications. With respect to the branded pharmaceutical products (i.e., Darvon and Darvocet) that we acquire, we are often able to reference the original NDA that we acquired along with the marketing rights to the products. As a result, when improving these products or developing product line extensions, we are permitted to file a supplemental NDA, or a new drug application known as a 505(b)(2) NDA, that directly cross references all of the data in the original application. This provision in the Food, Drug and Cosmetic Act allows us to shorten our development process for improvements and line extensions. For example, we may be able to reduce the number of clinical trials in a clinical development plan with less extensive, less time-consuming, and less costly Phase II and Phase III testing, with respect to any new products that we may select to develop.

Similarly, a 505(b)(2) application allows us to cross reference NDAs, or information therein, that we do not own and are not authorized to reference directly. The 505(b)(2) NDA may, in certain cases, permit us to meet NDA approval requirements with less original scientific data than would normally be required, and may

allow us to begin drug development in a later phase, so as to reduce the time and expense involved in any particular phase, for any new products we select to develop. Applications under 505(b)(2) are subject to certain patent and non-patent exclusivity rights applicable to the NDAs on which they rely, if such rights remain in effect when such applications are submitted. If we are unable to proceed with anticipated 505(b)(2) applications for several of the products that we are developing, our FDA approval costs will increase.

Abbreviated New Drug Application Process for Generic Products. A generic drug contains the same active ingredient as a specified brand name drug and usually can be substituted for the brand name drug by the pharmacist. FDA approval is required before a generic drug can be marketed. Approval of a generic drug is obtained through the filing of an abbreviated new drug application, or an ANDA, under section 505(j) of the Food, Drug and Cosmetic Act. Submission and approval of an ANDA is subject to certain patent and non-patent exclusivity rights applicable to the brand name drug, if such rights remain in effect when the ANDA is submitted. When processing an ANDA, the FDA waives the requirement of conducting full clinical studies provided that the drug is proven bioequivalent to the innovator’s drug (i.e., the applicant of the NDA) in a Phase I study conducted in a small number of healthy volunteers. Bioavailability relates to the rate and extent of absorption and levels of concentration of a drug active ingredient in the blood stream needed to produce a therapeutic effect. Bioequivalence compares the bioavailability of one drug with another that contains the same active ingredient, and when established, indicates that the rate and extent of absorption and levels of concentration of a generic drug in the body are the same as the previously approved brand name drug. An ANDA may be submitted for a drug on the basis that it is the equivalent to a previously approved drug or, in the case of a new dosage form or other close variant, is suitable for use under the conditions specified.

The timing of final FDA approval of ANDAs depends on a variety of factors, including whether the applicant challenges any listed patents for the brand name drug and whether the brand-name manufacturer is entitled to one or more non-patent statutory exclusivity periods, during which the FDA is prohibited from accepting or approving applications for generic drugs.

Under section 505(j), the FDA may impose debarment and other penalties on individuals and companies that commit certain illegal acts relating to the generic drug approval process. In some situations, the FDA is required not to accept or review ANDAs for a period of up to three years from a company or an individual that has committed certain violations. The FDA may temporarily deny approval of ANDAs during the investigation of certain violations that could lead to debarment and also, in more limited circumstances, suspend the marketing of approved generic drugs by the affected company. The FDA also may impose civil penalties and withdraw previously approved ANDAs. Neither we nor any of our employees have ever been the subject of debarment procedures.

Manufacturing Requirements. Before approving a drug, the FDA also requires that our procedures and operations conform to cGMP regulations, ICH guidances and manufacturing guidelines and guidances published by FDA. We must closely be in compliance with all of the regulatory and quality regulations at all times during the manufacture of our products. To help insure compliance with the regulatory and quality regulations, we must continue to spend time, money and effort in the areas of production and quality control to ensure full technical compliance. If the FDA believes a company is not in compliance with its regulations, it may withhold new drug approvals, as well as approvals for supplemental changes to existing approvals, preventing the company from exporting its products. It may also classify the company as an unacceptable supplier, thereby disqualifying the company from selling products to federal agencies. We believe we are currently in compliance with the cGMP regulations.

Post-approval Requirements. After initial FDA approval for the marketing of a drug has been obtained, further studies, including Phase IV studies, typically regarded as post-marketing studies, may be required to provide additional data on safety or effectiveness. Also, the FDA may require post-marketing reporting to monitor the adverse effects of the drug. Results of post-marketing programs may limit or expand the further marketing of the drug. Further, if there are any modifications to the drug, including changes in indication, manufacturing process, or manufacturing facility, a supplemental application seeking approval of the modifications must be submitted to the FDA or other regulatory authority. Prospectively, the FDA

regulates our post-approval promotional labeling and advertising activities to assure that such activities are being conducted in conformity with statutory and regulatory requirements.

Federal and state health care fraud and abuse laws have been applied to restrict certain marketing practices in the pharmaceutical industry in recent years. These laws include antikickback statutes and false claims statutes. The federal health care program antikickback statute makes it illegal for anyone to knowingly and willfully make or receive “kickbacks” in return for any health care item or service reimbursed under any federally financed healthcare program. This statute applies to arrangements between pharmaceutical companies and the persons to whom they market, promote, sell and distribute their products. In August 1994, the Office of the Inspector General of the Department of Health and Human Services issued a “Special Fraud Alert” describing pharmaceutical companies’ activities that may violate the statute. There are a number of exemptions and safe harbors protecting certain common marketing activities from prosecution. These include exemptions or safe harbors for product discounts, payments to employees, personal services contracts, warranties, and administrative fees paid to group purchasing organizations. These exemptions and safe harbors, however, are drawn narrowly.

Federal false claims laws prohibit any person from knowingly making a false claim to the federal government for payment. Recently, several pharmaceutical companies have been investigated or prosecuted under these laws, even though they did not submit claims to government healthcare programs. The prosecutors alleged that they were inflating drug prices they report to pricing services, which are in turn used by the government to set Medicare and Medicaid reimbursement rates. Pharmaceutical companies also have been prosecuted under these laws for allegedly providing free products to customers with the expectation that the customers would seek reimbursement under federal programs for the products.

Additionally, the majority of states have laws similar to the federal antikickback law and false claims laws. Sanctions under these federal and state laws include monetary penalties, exclusion from reimbursement for products under government programs, criminal fines and imprisonment.

We have internal policies and practices requiring and detailing compliance with the health care fraud and abuse laws and false claims laws. Because of the breadth of these laws and the narrowness of the safe harbors, however, it is possible that some of our business practices could be subject to challenge under one or more of these laws, which could have a material adverse effect on our business, financial condition and results of operations.

At December 31, 2002, we had approximately 1,160 full-time equivalent employees, of which 82 hold Ph.D. or M.D. degrees, or the foreign equivalent. We believe that our relations with our employees are good. None of our employees in the U.S. are represented by a union. German and French laws provide certain representative rights to our employees in those jurisdictions.

Our continued performance depends on our ability to attract and retain qualified professional, scientific and technical staff. The level of competition among employers for these skilled personnel is high. We believe that our employee benefit plans enhance employee morale, professional commitment and work productivity and provide an incentive for employees to remain with aaiPharma. We have experienced difficulty in attracting and retaining qualified staff for certain positions in our Phase II and III operations, where high turnover is an industry-wide problem. It is possible that as competition for these skilled employees increases at our other locations, we could experience similar problems there as well.

Our ability to successfully commercialize new branded products or technologies is significantly enhanced by our ability to secure strong intellectual property rights — generally patents — covering these products and technologies and to avoid infringement of valid third-party patents. We intend to seek patent protection in the

United States and selected foreign countries and to vigorously prosecute patent infringements, as we deem appropriate. We currently own 29 patents issued by the U.S. Patent and Trademark Office, and we currently have 17 patent applications filed and pending with the Patent and Trademark Office. Additionally, we have assigned or transferred an additional six of our patents to third parties for value.

Our patents cover proprietary processes and techniques, or formulation technologies, that may be applied to both new and existing products and chemical compounds. Our patents also cover new chemical entities or compounds, pharmaceutical formulations, and methods of using certain compounds. We also seek to patent discoveries of new structures of known compounds, new physical and chemical characteristics of known compounds, and previously unknown compounds.

We have two exclusive licenses in the U.S. and some other countries to use the patents, patent applications, and know-how associated with four pharmaceutical formulation technologies for mutually acceptable drug candidates. The ProSLO and ProSLO II technologies are licensed from Osmotica Corporation. The other three technologies, ProLonic, ProMelt and ProSpher are licensed from Tanabe Seiyaku. Like our own formulation technologies mentioned above, these technologies may be used to develop mutually acceptable new drug products or improve the physical characteristics of mutually acceptable existing products and compounds.

In addition to our patents, we rely upon trade secrets and unpatented proprietary know-how where we believe the public disclosures and limited patent life associated with obtaining patent protection would not be in our best strategic interest. We seek to protect these assets as permitted under state or federal law and by requiring our employees, consultants, licensees, and other companies to enter into confidentiality and nondisclosure agreements and, when appropriate, assignment of invention agreements.

In the case of strategic partnerships or collaborative arrangements requiring the sharing of data, our policy is to disclose to our partner only such data as relevant to the partnership or arrangement during its term and so long as our partner agrees to keep that data confidential.