UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

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

For the fiscal year ended December 31, 2004

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

For the transition period from ________to _________

Commission File Number 0-21185

aaiPharma Inc.

2320 Scientific Park Drive, Wilmington, NC 28405
(Address of principal executive offices) (Zip code)

(910) 254 7000
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

COMMON STOCK, $0.001 PAR VALUE PER SHARE
(Title of class)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)

The aggregate market value of the registrant’s common stock held by non-affiliates of the registrant as of June 30, 2004, computed by reference to the closing price of the common stock on that date was $ 59,666,943.

The number of shares outstanding of registrant’s common stock as of April 1, 2005 was 28,585,582 shares.

TABLE OF CONTENTS

PART I

Item 1. Business

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

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

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

Trademarks and Trade Names

We own the following registered and unregistered trademarks: Darvocet®, Darvon®, Darvon-N®, Darvocet-N®, Darvocet A500™, Brethine®, ProSorb®, ProSorb-D™, Lynxorb™, ProSLO®, ProSLO II™, ProCore®, Oramorph® SR, ProLonic AQ™, Roxanol™, Roxicodone®, AzaSan®, aaiPharma®, AAI®, AAI Development Services™ and Applied Analytical Industries®. AzaSan® is a registered trademark owned by us and licensed to Salix Pharmaceuticals. Unless the context otherwise requires, references in this document to Darvon are to Darvon® and Darvon-N® collectively and references to Darvocet are to Darvocet-N® and Darvocet A500™. We also reference trademarks owned by other companies. Prilosec® is a registered trademark of AstraZeneca AB, Dolophine® is a registered trademark of Eli Lilly and Company, Allegra-D® is a registered trademark of Aventis Pharmaceuticals Inc., Proventil® is a registered trademark of Schering Corporation, Volmax® is a registered trademark of GlaxoSmithKline, Imuran® is a registered trademark of Prometheus Laboratories Inc., M.V.I.® and Aquasol® are registered trademarks owned by Mayne Pharma (USA) Inc., Duraclon® is a registered trademark owned by Fujisawa Healthcare, Inc. and licensed to us, Avinza® is a registered trademark owned by Ligand Pharmaceuticals, Inc., MS Contin® is a registered trademark owned by Purdue Pharma, L.P., and Kadian® is a registered trademark owned by Alpharma Inc. All references in this document to any of these terms lacking the “®” or “TM” symbols are defined terms that reference the products, technologies or businesses bearing the trademarks with these symbols.

Overview

Our company was founded in 1979 to provide laboratory services, such as analytical testing on pharmaceutical compounds, to pharmaceutical companies. In the 1980s, we increased our service offerings to include clinical trials material manufacturing, microbiological testing and regulatory and quality consulting. We continued expanding our scientific base in the 1990s by adding bioanalytical, biotechnical, commercial manufacturing and human clinical trials management capabilities. We offer our clients scientific solutions to their pharmaceutical

development needs. In our history, we have worked with large and small companies offering a wide range of services across the drug development continuum.

We also use our drug development capacity to work on our own internal product pipeline. In the 1990s, we helped establish two companies which received approvals for products we developed. We also entered into various shared-risk arrangements with companies to bring pharmaceutical products to the market based on development work we conducted.

In 2001, we began pursuing a product acquisition strategy to expand our operations as a specialty pharmaceutical company. Between August 2001 and April 2002, we acquired three lines of pharmaceutical products. In late 2003, we completed the acquisition of a line of pain products from Elan Corporation, plc (“Elan”). In April 2004, we sold the multivitamin infusion product line that we had acquired in 2001.

In 2004, we operated through the following businesses:

	•	Product Sales (the Pharmaceuticals Division);
	•	Development Services (the AAI Development Services Division); and
	•	Product Development (Research and Development).

For information about the net revenues, income (loss) from operations and total assets of each segment of our business for each of the last three years, see Note 14 of Notes to Consolidated Financial Statements included in Part II, Item 8 “Financial Statements and Supplementary Data.”

In March 2005, we reorganized our operating structure to reflect our decision to curtail our research and development activities in light of our financial condition. As a result of this reorganization of our operating structure, we currently operate in only two business segments – proprietary pharmaceutical product development and sales through our Pharmaceuticals Division and development services offered to third parties through our AAI Development Services Division.

Overview of Financial Condition

We incurred a substantial net loss and loss from operations for 2004 and the quarter ended December 31, 2004. (See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Overview of Results of Operations.”) In 2005, our results of operations have continued to deteriorate as customer concerns regarding our financial condition have affected sales of our pharmaceutical products and our ability to obtain and maintain development services engagements. As a result of our substantial and recurring operating losses, we believe that we do not have adequate sources of liquidity to fund our operations in the near term unless we obtain additional sources of liquidity. We did not make the $10.5 million scheduled interest payment due on our senior subordinated notes on April 1, 2005 and have discontinued payments under leases for assets not used in operations.

In light of our current financial condition, we believe that our operations can no longer support our existing debt and that we must restructure our debt to levels that are more in line with our operations. Thus, it is highly likely that we will seek relief under chapter 11 of Title 11 of the U.S. Code

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(the “Bankruptcy Code”) which would substantially dilute and may eliminate the interests of the holders of our common stock. For additional discussion of our financial condition and liquidity, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources.”

Pharmaceuticals Division – Our Product Sales Business

The Pharmaceuticals Division markets and commercializes the pharmaceutical products that we have acquired or developed. In addition, the Pharmaceuticals Division manages the development of our pipeline products, see “Research and Development – Our Internal Product Development Pipeline.” We commercialize products in the pain and critical care therapeutic areas. Our pain products include Duraclon, Drug Enforcement Administration (DEA) Schedule IV products (Darvon/Darvocet) and DEA Schedule II products (Methadone injectable, Roxicodone, Roxanol, and Oramorph SR). Our critical care products are used to treat organ rejection in kidney transplants (azathioprine) and severe asthma (Brethine).

Potential Divestiture of Assets

We have been exploring a potential sale of some or all of the assets of our Pharmaceuticals Division, including the Darvon/Darvocet products, as well as other operating assets. On March 31, 2005, we entered into an exclusivity agreement with a potential purchaser of the assets of our Pharmaceuticals Division to facilitate continued due diligence and negotiation over a potential sale. This written agreement expired on April 22, 2005, though we are continuing to negotiate with this potential purchaser on an exclusive basis. We have not yet reached a definitive agreement with this potential purchaser for the sale of any assets. In addition, we have not determined to sell any material assets, and we plan to continue to operate our Pharmaceuticals Division if we do not complete a sale of its assets. Any sale of some or all of the assets of our Pharmaceuticals Division would likely occur as part of a bankruptcy proceeding, and thus would be subject to the approval of the bankruptcy court and may be subject to the approval of the lenders under our senior credit facilities, the holders of our notes and our stockholders.

Distribution of Pharmaceutical Products

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

On December 26, 2003, we entered into an agreement with a second subsidiary of Cardinal Health, Inc., effective as of October 1, 2003, to act as our exclusive distributor for our Brethine injectable product for a three-year period.

Manufacturing Capability

We currently manufacture a highly toxic drug product, along with DEA controlled substance products, for ourselves in our manufacturing facility in Wilmington, North Carolina. Although our manufacturing generally covers small volume products, our manufacturing capability has been upgraded to allow commercial volume manufacture of a portion of the Darvon and Darvocet family of products in our own facility. In addition, we operate a 48,000-square-foot

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sterile manufacturing facility in Charleston, South Carolina where we manufacture sterile, injectable products, including our Methadone injectable product and the vial presentation of our Brethine injectable product.

Marketing and Sales

We initially marketed our pharmaceutical product lines through a contract sales force. In late 2002, we created an internal sales and marketing capability to augment this contract sales force. In connection with our launch of Darvocet A500, we entered into a Service Agreement with Athlon Pharmaceuticals, Inc. pursuant to which representatives of Athlon would promote the sale of our Darvocet A500 product to physicians. We terminated this agreement in June 2004, but it remains the subject of litigation between the parties. (See Part I, Item 3, “Legal Proceedings – Athlon Litigation” below). In the second quarter of 2004, we made a strategic decision to refocus our sales force to the hospital and pain clinic markets following our acquisition of Duraclon, Oramorph SR and a Methadone injectable product. Our sales force was redesigned to provide experienced and knowledgeable professionals to sell our complex, highly technical specialty pharmaceutical products to a sophisticated target market. We believed that this new, narrower focus would create greater efficiencies for our sales team and allow us a forum to discuss the clinical benefits of our products. In the fourth quarter of 2004, we made the decision to eliminate our sales force due to our liquidity issues. We reached the conclusion that we could not afford to build our sales force to a sufficient scale that would be effective in increasing product revenues sufficient to justify the cost of our sales force. As of December 31, 2004, we no longer employed a pharmaceutical products sales force. Instead, we rely on a small commercial group that works at maintaining logistical supply, works with large wholesalers and hospital buying groups, and performs other activities needed to maintain an ongoing pharmaceutical products commercial business.

Our Pharmaceutical Products

We commercialize products in two therapeutic areas: pain management and critical care.

Pain Management Products

Roxicodone, Oramorph SR, Roxanol and Duraclon Product Lines. On December 2, 2003, we acquired a line of pain management products, which treat moderate-to-severe pain, and existing inventory from subsidiaries of Elan. We acquired these product lines, inventory and related intangible assets for $102.5 million, exclusive of transactional costs. These products consist of three brands of DEA Schedule II (CII) pain products — Roxicodone (oxycodone hydrochloride) tablets and immediate release oral solutions, Oramorph SR (morphine sulfate) sustained-release tablets, and Roxanol (morphine sulfate) immediate release oral solutions. We also acquired a non-scheduled pain management product, Duraclon (clonidine hydrochloride) injection, as part of the same transaction. DEA Schedule II pain products are regulated as controlled substances by the U.S. Drug Enforcement Administration. Each of these DEA Schedule II pain products, other than Oramorph SR, is subject to generic competition. Oramorph SR is subject to therapeutic substitution by pharmacists in certain states.

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Supply of Product. Roxicodone, Oramorph SR, Roxanol and Duraclon are manufactured and supplied by third parties. Duraclon is currently purchased on a purchase order basis from American Pharmaceutical Partners, Inc. Roxicodone, Oramorph SR, and Roxanol are purchased pursuant to a manufacturing agreement between Roxane Laboratories, Inc. (“Roxane”) and Elan Pharma International Limited dated September 28, 2001 (the “Roxane Supply Agreement”). We assumed Elan Pharma International Limited’s rights and obligations under the Roxane Supply Agreement. The term of the Roxane Supply Agreement expires on September 27, 2006. Roxane manufactures the applicable products in its Columbus, Ohio facility.

Darvon and Darvocet. On March 28, 2002, we acquired from Eli Lilly the U.S. rights to the Darvon and Darvocet branded product lines in the U.S. (and the existing inventory of these products). The Darvon and Darvocet products are prescribed for the treatment of mild-to-moderate pain. The acquired products include Darvon (propoxyphene hydrochloride), Darvocet-N (propoxyphene napsylate and acetaminophen), Darvon-N (propoxyphene napsylate) and Darvon Compound-65 (propoxyphene hydrochloride, aspirin, and caffeine).

These product lines have been sold in the U.S. for over 25 years, with the initial marketing of Darvon beginning in 1957. Darvon’s patent exclusivity expired in 1973 and Darvon-N and Darvocet-N’s patent exclusivity expired in 1985. The first generic version of Darvon was introduced in 1973, and by 1985, numerous generic products were being marketed for substitution for Darvon and Darvocet.

We paid $211.4 million in cash, exclusive of transactional costs, for the rights in the U.S. to these products and Eli Lilly’s existing inventory of these products. In addition, we have agreed to pay Eli Lilly royalties upon sales of our future developed improvements to the Darvon and Darvocet products or other products containing the active ingredient propoxyphene and any other pharmaceutical products sold under the name Darvon, Darvocet or certain other trademarks. We agreed to pay royalties for future products during each calendar quarter for a ten-year period beginning upon the product’s commercial introduction, provided that the total net sales of all of these future products, combined with the total net sales of the current Darvon and Darvocet products, exceed $15.0 million in the applicable calendar quarter. Darvocet A500 is the only product we currently sell that could subject us to a royalty payment; however, no royalties were payable for sales made in 2004. Under our agreement with Eli Lilly, we are not required to pay any royalties on the sales of the Darvon and Darvocet products themselves that we acquired from Eli Lilly.

Supply of Product. Until the agreement expired on December 31, 2004, we were party to a manufacturing agreement, as amended, that we entered into with Eli Lilly under which Eli Lilly agreed to supply specified quantities of the acquired products and the bulk active ingredient from and after closing for the then-existing twelve Darvon and Darvocet product presentations (form, dosage and packaging). We purchased these products manufactured by Eli Lilly for a fixed unit cost, subject to a percentage increase on each January 1 plus any increase in Eli Lilly’s cost of raw materials during that year. However, the purchase price for these products was no less than Eli Lilly’s standard cost of manufacturing, which included raw materials, direct labor, and plant overhead attributable to the Darvon and Darvocet products. We are currently manufacturing in our Wilmington, North Carolina facility all of the products previously manufactured by Eli Lilly,

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except for our Darvocet N 100 product. This product is manufactured by DSM Pharmaceuticals Inc. pursuant to a supply agreement that expires in January 2009.

Darvocet A500. We acquired a product which we subsequently branded as Darvocet A500 from Athlon Pharmaceuticals in July 2003. Darvocet A500 contains 500 mg of acetaminophen, compared to 650 mg in Darvocet-N 100. We received FDA approval of Darvocet A500 on September 10, 2003, launched the product in September 2003 and initiated a national campaign in October 2003. Under the acquisition agreement for this product, we owe Athlon royalties on a quarterly basis until 2023 in an amount equal to 10% of net sales of our Darvocet A500 product and any other combination propoxyphene napsylate and acetaminophen products we may sell in the future.

In connection with the acquisition, we entered a three-year services agreement with Athlon Pharmaceuticals to provide sales support in designated territories throughout the United States for the Darvocet A500 product. After providing notice to Athlon of its material breach under this agreement, we terminated this agreement on June 4, 2004 and initiated litigation. Athlon has brought counterclaims seeking payment of unpaid monthly payments under the terminated contract and additional litigation, now consolidated, with respect to the royalty provisions of the asset purchase agreement pertaining to Darvocet A500. The litigation is continuing. See Part I, Item 3, “Legal Proceedings – Athlon Litigation” below.

Supply of Product. Darvocet A500 is manufactured and supplied by Mikart, Inc. (“Mikart”). Mikart manufactures Darvocet A500 in its Atlanta, Georgia facility. We have entered into an agreement with Mikart to supply us with our requirements for Darvocet A500 for an initial term ending 2013. Thereafter, the agreement with Mikart will continue for successive one-year renewal terms unless terminated by either party as set forth in the agreement. The agreement requires us to make a payment to Mikart if we have not purchased a set amount of Darvocet A500 by September 2006. In the fourth quarter of 2004, we incurred a purchase commitment charge of $11.7 million in connection with the establishment of a reserve related to this minimum purchase requirement. We are currently negotiating with Mikart to extend the term of the agreement by an additional multi-year period, and to amend our obligation to purchase the minimum level of Darvocet A500 products to include additional products to be manufactured by Mikart for us under this agreement and applied against our minimum purchase requirement. If we are successful in amending the agreement on this basis, the reserve and corresponding charge may be reversed in a subsequent period. We cannot provide any assurance, however, that we will be successful in amending the agreement on any terms.

Methadone Hydrochloride Injection. In April 2003, we acquired exclusive rights to a parenterally administered methadone injectable product, formerly branded as Dolophine Hydrochloride Injection, from Roxane. This product is indicated for the treatment of moderate-to-severe pain not responsive to non-narcotic analgesics, and for use in temporary treatment of opioid dependence in patients unable to take oral medication.

We manufacture this product at our facility in Charleston, South Carolina.

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Critical Care Products

Brethine. On December 13, 2001, we acquired the U.S. rights to the Brethine branded product line from Novartis Pharmaceuticals Corporation and Novartis Corporation for $26.6 million in cash, exclusive of transactional costs. On April 19, 2004, the FDA approved our Supplemental New Drug Application for a vial presentation of the injectable form of this product, which replaced our former ampul presentation. On November 1, 2004, we launched our Brethine vial presentation into the U.S. market.

IMPAX Laboratories has been marketing a generic version of the oral form of Brethine since July 2001. Multiple generic versions of the injectable form of this drug, including a vial presentation, were approved starting in May 2004.

Supply of Product. Until the agreement expired on December 13, 2004, we were party to an interim supply agreement with Novartis providing for manufacture and packaging of the oral and injectable form of Brethine for sale by us in the U.S. Under this supply agreement, we purchased the products for a fixed unit cost that was subject to an annual price adjustment on January 1, 2003 and January 1, 2004 tied to the Consumer Price Index. We have transferred the Brethine vial manufacturing processes to our Charleston, South Carolina facility.

Azathioprine. In 2003, we received FDA approval to market three internally developed line extensions of additional strengths to our current 50 mg generic azathioprine tablet product: 25 mg, 75 mg and 100 mg tablets. We began selling the 75 mg and 100 mg products in the first quarter of 2003. In November 2003, we granted Salix Pharmaceuticals an exclusive license to market the 25 mg, 75 mg, and 100 mg strengths of Azasan (azathioprine) and we licensed our Azasan trademark to Salix. Under the agreement with Salix, we receive royalties on net sales. Salix has the right to terminate this agreement at any time with six months’ written notice after October 31, 2006. We entered into a three-year supply agreement with Salix to continue to manufacture these products and supply all of Salix’s needs. We continue to manufacture and sell our 50 mg azathioprine tablet product as a generic product.

Product Disposition and Discontinuance During 2004

M.V.I. and Aquasol. On August 17, 2001, we acquired the M.V.I. and Aquasol branded lines of critical care injectable and oral nutritional products from AstraZeneca for $52.5 million, exclusive of transactional costs, paid at closing, plus additional consideration described below. Our M.V.I. and Aquasol product line acquisition agreement was amended on July 22, 2003. As amended, it provided for two $1.0 million guaranteed payments, which were made in August 2002 and 2003, eliminated a contingent payment of $2.0 million that was potentially due in August 2003 under the original agreement, and provided for a future contingent payment of $43.5 million potentially due in August 2004, depending on the status of certain reformulation activities being carried out by the seller and regulatory approval of the reformulation by the FDA. The amount of the $43.5 million contingent payment was to be reduced by $1 million per month if the conditions for the contingent payment had not occurred by December 31, 2002. The conditions for the contingent payment were not met by the required date, so the amount of the contingent payment had decreased by $12.0 million by the end of December 2003. Such conditions were satisfied in January and February 2004, fixing the liability at $31.5 million,

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which was charged to operations and recorded as a liability on our consolidated financial statements in the first quarter of 2004. Also on July 22, 2003, the M.V.I. supply agreement with the seller was extended through 2008, subject to early termination rights by us on six months’ notice given at any time, and by the supplier on twenty-four months’ notice given at any time on or after August 17, 2004. The M.V.I. and Aquasol product lines did not have separable assets and liabilities associated with them other than inventory; therefore, we allocated the remaining purchase price to acquired identifiable intangible assets.

On April 26, 2004, we sold our M.V.I. and Aquasol product lines to Mayne Pharma (USA) Inc. for $105 million, subject to adjustments based on inventory levels at closing and other post-closing obligations. Of that amount, $10 million was held in escrow to satisfy our post-closing obligations under the agreement. In September 2004, approximately $1.6 million of this escrowed amount was paid to us. We do not anticipate receiving any additional payments out of this escrow. At the closing of the transaction, we paid to AstraZeneca AB the $31.5 million payment due in August 2004, which was discounted to approximately $31.0 million. This payment represented a payment upon FDA approval of the reformulated product under the terms of the amended purchase agreement with AstraZeneca.

Calcitriol. In February 2002, we purchased a calcitriol product from Aesgen, Inc. for payments of $1.0 million in cash and additional contingent milestone payments of up to $1.5 million. Calcitriol is a drug used primarily to treat chronic kidney dialysis patients with abnormally low levels of calcium in their blood. In 2003, the prerequisite for payment of $500,000 of such contingent milestones occurred and such payment was made to Aesgen. The prerequisites for payment of the remaining $1.0 million of such contingent milestones were not met.

We also sold calcitriol under an exclusive manufacturing and co-promotion agreement with Sicor Pharmaceuticals, Inc. pursuant to which we acquired U.S. marketing rights to, and sold, Sicor Pharmaceuticals’ calcitriol product under their regulatory approval. We amended the 2002 calcitriol injection acquisition agreement with Aesgen in 2003 to provide for royalty payments to Aesgen on the gross margin we realized from our sales of the calcitriol product marketed under Sicor’s regulatory approval and to provide for potential payments to Aesgen in connection with a reacquisition by Sicor or an assignment to a third party of the U.S. marketing rights to calcitriol injection. On December 23, 2004, Sicor Pharmaceuticals reacquired its U.S. marketing rights to calcitriol injection, pursuant to the termination of the manufacturing and co-promotion agreement discussed above. In connection with such termination, Sicor paid us $3.5 million. We no longer commercialize calcitriol.

AAI Development Services — Our Development Services Business

AAI Development Services offers a comprehensive range of pharmaceutical product development services to our customers, who are located worldwide. These services include formulation development, analytical, microbiological, bioanalytical and stability testing services, production scale-up, biotechnology analysis, human clinical trials, regulatory and quality consulting, and manufacturing. These services generally are provided on a fee-for-service basis.

AAI Development Services provides its services, both individually and in an integrated fashion, to:

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	•	our customers, to help them develop, optimize, control, and supply their drug products;
	•	our Pharmaceuticals Division, to support product life cycle management and commercial manufacture of the acquired drug products; and
	•	our research and development activities, by executing on defined project plans and managing our portfolio of patents and drug-delivery technologies.

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

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

	•	Method development and validation;
	•	Product characterization;
	•	Raw materials and product release testing; and
	•	Stability studies.

Biopharmaceutical Services

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

	•	Phase I clinical services from our 88-bed Phase I clinical trial facility located in Research Triangle Park, North Carolina, and a 72-bed facility in Neu-Ulm, Germany;
	•	Microbiological testing;
	•	Bioanalytical testing; and

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•

Biotechnology analysis.

Phase I to IV Clinical Services

AAI Development Services provides a broad range of Phase I through IV clinical services to customers in the pharmaceutical, biotechnology, and medical device industries for assistance in the drug development and regulatory approval process in North America and Europe. The clinical services include clinical protocol and program development, global clinical strategy consulting, investigator/site management, clinical trial management and monitoring, Project Management, site selection, medical affairs (including safety surveillance, pharmacovigilance and serious adverse event management), data management, and biostatistics.

Regulatory and Other Consulting Services

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

Research and Development

Our research and development expenditures for 2005 will be significantly below historical trends due to our financial condition. In March 2005, we reorganized our research and development group to maximize efficiency, given the limited resources available to us. Our research and development efforts are currently focused on three products in development. The oversight of the development efforts on our pipeline products is conducted by a group within our Pharmaceuticals Division to ensure the proper alignment of development efforts and commercial opportunities. The management of our intellectual property assets, including our drug delivery technologies and patents, is conducted by the Formulations Development Services group in our AAI Development Services Division.

Our Drug-Delivery Technologies

Our portfolio of internally developed and in-licensed drug-delivery technologies includes:

	•	ProCore — a patented technology for controlled release of a drug incorporated into a two-layer coated pellet. The first layer allows for control of the lag time before an active agent begins its release while the second layer controls the rate of release, and thus the duration of the sustained release effect for the product.
	•	ProSorb — a technology designed to accelerate absorption rates and potentially minimize inter- or intra-patient variability. It generally permits weakly acidic compounds to exhibit a shorter onset of action relative to conventional dosage forms. The concept is that acidic drugs with the benefit of the technology form a dispersion pattern upon release in the stomach that allows for faster stomach clearance and more rapid absorption in the intestinal tract. ProSorb is a broad-based technology primarily used with liquid or

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encapsulated drug products. The application of this technology to diclofenac, a non-steroidal anti-inflammatory drug, has resulted in our proprietary Lynxorb product candidate, which is discussed below.

	•	ProLonic AQ — a drug-delivery technology specifically designed to release an active agent in the colon. This technology can be incorporated into a tablet, a pellet, or a capsule dosage form and uses conventional manufacturing equipment and aqueous coating processes. The advantage represented by this technology is the ability to control the location and timing of release and eliminate the need for solvent-based safety concerns.
	•	ProSLO and ProSLO II — an osmotic technology designed to produce controlled release product therapy with either a single drug or a combination of drugs. Osmotic action is the natural movement of an aqueous solution through a membrane and is used to make oral drug administration more accurate, precise, and convenient. This technology allows for an immediate release component in the outside layer of a laser drilled tablet. This facilitates two release patterns for a single drug (i.e., bi-phasic) or a combination of multiple active ingredients with different release requirements. The advantages over existing technologies are its easy scalability, the ability to use it with numerous active ingredients, the ability to create both a long- and short-acting drug combination, and its ability to handle what normally are reasonably insoluble active ingredients.

We own the ProCore, ProSorb, and Prolonic AQ technologies. The ProSLO and ProSLO II technologies are available for use by us and our clients throughout the world, except Latin America, through an agreement with Osmotica Corporation. We have entered into a Cooperative Venture Agreement with Osmotica Corporation to develop, manufacture, and license various new drug products with third party organizations. This agreement enables us to develop mutually acceptable new drug products or improve the characteristics of mutually acceptable products and compounds utilizing patents, patent applications, and know-how associated with pharmaceutical formulation technologies for such products.

On January 15, 2004, we announced that Aventis submitted an NDA to the FDA for Allegra-D 24-hour tablets. This is a fexofenadine/pseudoephedrine formulation developed under our agreement with Osmotica with a patented extended release drug-delivery technology, ProSLO II. This product was approved by the FDA on October 19, 2004. We received a milestone payment from Aventis for that approval and expect to receive royalties on sales of the product in 2005.

Our Internal Product Development Pipeline

In 2004, we worked on three development projects:

	•	A modified release Darvocet product. We have discussed our development plan with the FDA and, based on FDA input, we are implementing a development plan which we believe will be appropriate for filing our regulatory submission. We hope to complete pivotal trials for this product in early 2006.
	•	Lynxorb - a formulation of diclofenac that utilizes our proprietary ProSorb technology to enhance the amount and speed of absorption of this potent inhibitor of COX1 and COX2

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		enzymes. We have submitted our pivotal trial protocol to the FDA for comment. Pivotal trials for this product may be delayed due to budget constraints and liquidity concerns.
	•	An aaiPharma formulation of a generic proton pump inhibitor has made significant progress in achieving the desired pharmacokinetic profile. We believe further development of this product will be delayed due to budget constraints and liquidity concerns.

For fiscal years 2004, 2003 and 2002, our expenditures on research and development were $16.3 million, $21.8 million and $20.9 million, respectively. Due to liquidity constraints, we anticipate that 2005 expenditures on research and development will significantly decline. We can provide no assurances that we will be able to fund further research and development activities on these or any other projects in 2005, or at all. The only product under active development is the Darvocet line extension.

Information Technology

Significant upgrades to our core information systems were completed during 2004. These upgrades will help improve on-going compliance with legal requirements and expand our capabilities to automate data capture. New systems were placed into operational use in 2004 to handle increased data volume and to ensure compliance with FDA regulations for the clinical trials work provided by AAI Development Services. The end of 2004 marked the completion of a three-year information technology cycle where all personal computers and core infrastructure were replaced. Our customized data management system connects analytical instruments with multiple software architectures permitting automated data capture. We believe that information technology enables us to expedite the development process by designing innovative services for individual client needs, providing project execution, monitoring and control capabilities that exceed a client’s internal capabilities, streamlining and enhancing data presentation to the FDA and improving our own internal operational productivity, while helping to maintain quality.

Customers

The Pharmaceuticals Division’s customers are primarily large well-established pharmaceutical wholesalers. Cardinal Health, Inc., AmerisourceBergen Corporation and McKesson Corporation accounted for approximately 7.3%, 9.4% and 13.1% of our 2004 consolidated net revenues, respectively, and 20.2%, 26.0% and 36.3%, respectively, of our Pharmaceuticals Division net revenues. As is customary in the pharmaceutical industry, we accept returns of products we have sold as the products near their expiration date.

Significant research and development projects have a defined cycle, and accordingly, the customers of our AAI Development Services Division and customers for our research and development activities change from year to year. Because of the project nature of engagements in these business segments, large customers may represent a significant portion of the business in one period but not subsequent periods. We have experienced concentration in these areas of our business in the past, and do not believe that this is unusual for companies which operate in this market.

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Backlog

Our order backlog consists of anticipated net revenues from signed fee-for-service contracts for which services have not been completed. Once contracted work begins, net revenues are recognized as the service is performed. The order backlog does not include anticipated net revenues for work performed for internal clients or for any variable-priced contracts. During the course of a project, a client may substantially adjust the requested scope of services and corresponding adjustments are made. Our order backlog also includes orders for pharmaceutical products that have been ordered by our customers, but have not yet been shipped.

We believe that our order backlog as of any date is not a complete predictor of future results due to the variability and short duration of many of our development services contracts. The backlog can also be affected by adjustments in the scope of contracted projects. At December 31, 2004 and 2003, our order backlog was approximately $47.8 million and $52.0 million, respectively. We do not expect to fill approximately $11.2 million of the 2004 amount by December 31, 2005, which is related to longer term clinical trials and stability projects. Included in the backlog total at December 31, 2004 is $3.1 million for pharmaceutical products ordered but not yet shipped.

Competition

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

The following tables illustrate the products that compete with the products we sell:

Our Branded Products

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Our Generic Product

We do not believe that there are any products that are competitive with our Duraclon product. In addition to the competitive products listed above, additional competitive products may be introduced in the future.

Our AAI Development Services Division and research and development activities compete primarily with in-house research, development, quality control, and other support service departments of pharmaceutical and biotechnology companies, as well as university research laboratories and other contract research organizations. Some of our competitors, however, may have significantly greater resources than we do. Competitive factors generally include reliability, turn-around time, reputation for innovative and quality science, capacity to perform numerous required services, financial viability, and price.

Government Regulation

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

U.S. laws and federal regulations apply to all phases of investigational and commercial development (i.e. manufacturing, testing, promotion and distribution of drugs, including with respect to our personnel, record keeping, facilities, equipment, control of materials, processes, laboratories, packaging, labeling, storage, and advertising). If we fail to comply with these laws and regulations, our drugs, drug improvements, and product line extensions will not be approved by the FDA or will be withdrawn from the market and the data we collect may be out of specification and not acceptable to the FDA requirements, which may result in us not being

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permitted to market our products. Additionally, we could be subject to significant monetary fines, recalls and seizures of products, closing of our facilities, revocation of drug approvals previously granted to us, and criminal prosecution. Any of these regulatory actions could materially and adversely affect our business, financial condition, and results of operations.

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

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

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

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

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Some of our development and testing activities for our customers, and the manufacture, development, and testing of the line of pain management products (the “New Pain Products”) that we acquired from subsidiaries of Elan, our Darvon and Darvocet products, and our methadone hydrochloride product, are subject to the Controlled Substances Act, administered by the Drug Enforcement Administration, which strictly regulates all narcotic and habit-forming substances. We maintain separate, restricted-access facilities and heightened control procedures for projects involving such substances due to the level of security and other controls required by the DEA.

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

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

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

The Drug Development Regulatory Process

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

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

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

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

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

Referencing and Relying on New Drug Applications. With respect to the branded pharmaceutical products (e.g., Darvon and Darvocet) that we have acquired, we are often able to reference the original NDA along with the marketing rights to the products. As a result, when improving these products or developing product line extensions, we are permitted to file a supplemental NDA, or a new drug application known as a 505(b)(2) NDA, that directly cross references all of the data in the original application. This provision in the federal Food, Drug, and Cosmetic Act allows us to shorten our development process for improvements and line extensions. For example, we may

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be able to reduce the number of clinical trials in a clinical development plan with less extensive, less time-consuming, and less costly Phase II and Phase III testing, with respect to any new products that we may select to develop.

Similarly, a 505(b)(2) application allows us to cross reference NDAs, or information therein, that we do not own and are not authorized to reference directly. The 505(b)(2) NDA may, in certain cases, permit us to meet NDA approval requirements with less original scientific data than would normally be required, and may allow us to begin drug development in a later phase, so as to reduce the time and expense involved in any particular phase, for any new products we select to develop. Applications under 505(b)(2) are subject to certain patent and non-patent exclusivity rights applicable to the NDAs on which they rely, if such rights remain in effect when such applications are submitted. If we are unable to proceed with anticipated 505(b)(2) applications for any of the products that we are developing, our FDA approval costs will increase.

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

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

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

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

Post-approval Requirements. After initial FDA approval for the marketing of a drug has been obtained, further studies, including Phase IV studies, typically regarded as post-marketing studies, may be required to provide additional data on safety or effectiveness. Also, the FDA requires post-marketing reporting to monitor the adverse effects of the drug. Results of post-marketing programs may limit or expand the further marketing of the drug. Further, if there are any modifications to the drug, including changes in indication, manufacturing process, or manufacturing facility, a supplemental application seeking approval of the modifications must be submitted to the FDA or other regulatory authority. Prospectively, the FDA regulates our post-approval promotional labeling and advertising activities to assure that such activities are being conducted in conformity with statutory and regulatory requirements.

Health Care Fraud and Abuse Laws

Federal and state health care fraud and abuse laws have been applied to restrict certain marketing practices in the pharmaceutical industry in recent years. These laws include antikickback statutes and false claims statutes. The federal health care program antikickback statute makes it illegal for anyone to knowingly and willfully make or receive “kickbacks” in return for any health care item or service reimbursed under any federally financed healthcare program. This statute applies to arrangements between pharmaceutical companies and the persons to whom they market, promote, sell, and distribute their products. In 2003, the Office of the Inspector General of the Department of Health and Human Services issued a “Compliance Program Guidance for Pharmaceutical Manufacturers” describing pharmaceutical companies’ activities that may violate the statute. There are a number of exemptions and safe harbors protecting certain common marketing activities from prosecution. These include exemptions or safe harbors for product discounts, payments to employees, personal services contracts, warranties, and administrative fees paid to group purchasing organizations. These exemptions and safe harbors, however, are drawn narrowly.

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

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providing free products to customers with the expectation that the customers would seek reimbursement under federal programs for the products.

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

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

Employees

At December 31, 2004, we had 924 full-time equivalent employees, a material reduction from the approximate 1,300 employees at December 31, 2003. At March 31, 2005, we had 855 full time equivalent employees. The decline in the number of employees resulted both from reductions in force and voluntary attrition of employees who were not replaced. While we believe that our relations with our employees are good, our uncertain financial condition has resulted in the loss of a significant number of employees at all levels, including management. None of our employees in the U.S. are represented by a union. European laws provide certain representative rights to our employees in those jurisdictions.

Our continued performance depends on our ability to attract and retain qualified professional, scientific, and technical staff. The level of competition among employers for these skilled personnel is high. We have experienced difficulty in attracting and retaining qualified staff for certain positions in our Phase II and III U.S. operations, where high turnover is an industry-wide problem, and in other skilled positions. It is possible that as competition for skilled employees increases at our other operations or locations, we could experience similar problems there as well. Our liquidity issues and uncertain financial condition, our potential bankruptcy filing, our potential sale of material assets, declines in our stock price, and reductions in force have also decreased, and may continue to decrease, our ability to attract and retain employees.

Intellectual Property

Our ability to successfully commercialize new branded products or technologies is significantly enhanced by our ability to secure and enforce strong intellectual property rights — generally patents — covering these products and technologies, and to avoid infringement of valid third-party patents. We intend to seek patent protection in the United States and selected foreign countries and to vigorously prosecute patent infringements, as we deem appropriate. We currently own patents issued by the U.S. Patent and Trademark Office, and have additional patent applications filed and pending with the U.S. Patent and Trademark Office. Additionally, we have assigned or transferred six of our U.S. patents, one Canadian patent and three of our invention disclosure memoranda to third parties for value.

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Our patents cover proprietary processes and techniques, or formulation technologies, that may be applied to both new and existing products and chemical compounds. Our patents also cover new chemical entities or compounds, pharmaceutical formulations, and methods of using certain compounds.

We are actively pursuing patent infringement against Kremers Urban Development Co., Schwarz Pharma Inc. and their related companies to protect our rights under two of our patents with respect to omeprazole. During the first twenty-two months of sales, the defendants in this action have publicly confirmed approximately $1.3 billion in sales from the product that we believe is infringing our patents. Litigation involves a high degree of uncertainty as to outcomes, and we cannot predict the outcome of our infringement claims. The defendants have also asserted various counter claims against us, including violations of antitrust laws. See “Item 3. Legal Proceedings – Patent Litigation” for more information on this proceeding.

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

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

In the case of strategic partnerships or collaborative arrangements requiring the sharing of data, our policy is to disclose to our partner only such data as is relevant to the partnership or as required under the arrangement during its term.

Item 2. Properties

Our principal executive offices are located in Wilmington, North Carolina, in a 73,000 square foot owned facility. Our primary U.S. facilities are located in Wilmington, North Carolina; Research Triangle Park, North Carolina; Natick, Massachusetts; Charleston, South Carolina; and Shawnee, Kansas. These facilities provide approximately 358,000 square feet of total operational and administrative space. Our primary European facility is located in Neu-Ulm, Germany and includes approximately 112,400 square feet of operational and administrative space. We also have U.S. sales representatives for our Development Services business based throughout the United States and foreign sales representatives for such business based in Japan, Sweden, Germany, and the U.K. We believe that our facilities are adequate for our current operations and that suitable additional space will be available when needed.

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Primary Operating Facilities

We have been notified by the landlords of our leased facilities in New Jersey and California, as well as one leased facility in North Carolina, that we are in default for failure to make the April 2005 lease payments for these facilities. We are not using any of these leased facilities.

Item 3. Legal Proceedings

We are party to lawsuits and administrative proceedings incidental to the normal course of our business. Our material legal proceedings are described below. We cannot predict the outcomes of these matters. As noted below, we believe that any liabilities related to such lawsuits or proceedings, if adversely determined, could have a material adverse effect on our consolidated financial condition, results of operations and cash flows. Prosecuting and defending these material legal proceedings, including responding to governmental inquiries, has resulted, and is

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expected to continue to result, in a significant diversion of management’s attention and resources and an increase in professional fees.

Government Investigations

In April 2004, in connection with an investigation conducted by the United States Attorney’s Office for the Western District of North Carolina (the “U.S. Attorney’s Office”), we received five federal grand jury subpoenas for document production and potential testimony related to, among other things, certain transactions regarding our 2002 and 2003 financial information, the terms, conditions of employment, and compensation arrangements of certain of our senior management personnel, compensation and incentive arrangements for employees responsible for the sale of our Brethine, Darvocet, calcitriol, azathioprine and Darvon Compound products, qu