CURON MEDICAL INC - 10-K Annual Report

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and, (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

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 the 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. ¨

This Report on Form 10-K contains certain forward-looking statements regarding future events. Actual events or results may differ materially as a result of the factors described herein and in the documents incorporated herein by reference, including, in particular, those factors described under “Additional Risk Factors”.

Curon was incorporated in Delaware in May 1997. We develop, manufacture and market innovative proprietary products for the treatment of gastrointestinal disorders. Our products consist of radiofrequency generators and single-use disposable devices. Our first product, the Stretta System^®, received United States Food and Drug Administration clearance in April 2000 for the treatment of gastroesophageal reflux disease, commonly referred to as GERD, which affects approximately 14 million U.S. adults on a daily basis. Unlike medication, which temporarily suppresses GERD symptoms, our Stretta System is designed to apply radiofrequency energy to treat the causes of GERD. Our Stretta System consists of a disposable flexible catheter with needle electrodes and a control module, which is a radiofrequency energy generator. Using the control module, the physician delivers a precise amount of radiofrequency energy to the lower esophageal sphincter. The delivery of this thermal energy creates lesions in the muscle of the lower esophageal sphincter that reabsorb over time causing tissue contraction. This results in a tightening of the sphincter which reduces reflux into the esophagus.

We commercially launched the Stretta System in May 2000 at a major gastroenterology conference and have only limited revenues to date. As of December 31, 2001, approximately 2,300 patients have been treated with the Stretta procedure. Our second product, the Secca System^™, is a radiofrequency treatment for fecal incontinence. In April 2001, we completed the U.S. clinical trial of the Secca System, the results of which were submitted to the FDA in December 2001. In March 2002, we received 510(k) clearance from the FDA to market the Secca System for the treatment of fecal incontinence in patients who have failed more conservative therapies like diet modification and biofeedback. We will commercialize the Secca System in the second quarter of 2002.

We have a direct sales force to market and sell our products in the United States. We target the Stretta System at high volume gastroenterologists and gastroenterology practice groups and general surgeons. In addition, we market to endoscopy suite facilities. In the U.S., there are approximately 9,000 gastroenterologists, 3,000 surgeons, 4,000 hospital endoscopy suites and approximately 4,000 ambulatory treatment centers that perform procedures similar to the Stretta procedure. As of December 31, 2001, we have delivered 146 control modules in the U.S. We intend to continue to focus expansion of our marketing program to the medical community, and develop brand awareness of our products.

The Secca System is targeted primarily at colon and rectal surgeons, the physicians that most commonly treat fecal incontinence. There are approximately 1,000 colon and rectal surgeons in the U.S. Secondarily, the Secca System will be marketed to general surgeons and gastroenterologists. The Secca System additionally carries the CE Mark and will be sold through distributors in the European Union. The first European Secca procedures were performed in Germany, Denmark and Italy in March 2002.

Our Stretta System has also received European, Australian and Canadian clearance, and our Secca System has received clearance in Europe. We opened an office in Belgium in March 2001 and signed distribution agreements for the sale of our products in Europe. We have a total of seven distribution agreements: one each in Germany, Italy, Greece, Portugal and South Africa one covering sales in the region of Belgium, the Netherlands, and Luxembourg (Benelux) and one covering sales in the region of Denmark, Sweden, Norway and Finland (Scandinavia). We do not expect to significantly expand our sales coverage beyond the United States and Europe before 2003.

Our strategy is to establish the Stretta System, which delivers radiofrequency energy in a temperature controlled, minimally-invasive manner, precisely to the lower esophageal sphincter, as the standard of care for GERD. We believe that the benefits patients enjoy from the use of the Stretta System are:

We believe the Stretta System also benefits the payor through improved outcomes and lower costs. In addition, the Stretta System provides gastroenterologists with the flexibility to perform the procedure in endoscopy suites rather than requiring them to refer patients to general surgeons.

We have evaluated our Secca System through clinical trials and received clearance from the FDA in March 2002 to market it in the United States for the treatment of fecal incontinence in patients who have failed more conservative therapies like diet modification and biofeedback. The system is CE marked and can be sold in the European Union countries. We intend to make the Secca System the standard of care for fecal incontinence. We will commercialize the Secca System in the United States by geographical area commencing in June 2002. In Europe we will concentrate first on the German and Italian markets.

For the Stretta System, we have established a direct sales and distribution network in the United States to target the approximately 4,000 hospital endoscopy suites and approximately 4,000 ambulatory treatment centers. We are also developing a network of distributors in selected European countries. In the United States, we have 16 salespeople and 6 clinical applications specialists. In Europe, we have seven distributors covering 12 countries. We may hire additional salespeople or enter new distributorships to further market our products and penetrate other areas of the world.

We have acquired and may continue to acquire complementary technologies. We have a license agreement with Gyrus Group PLC (formerly Somnus Medical Technologies, Inc) for the use of technology related to Gyrus’ radiofrequency generator. We also have entered into license agreements with the University of Kansas Medical Institute and with Messrs. Shadduck and Baker relating to applying radiofrequency energy to tissue. We intend to enter into license agreements with other persons or companies covering technology relating to treating diseases of the gastrointestinal tract.

GERD is the frequent backward flow, or reflux, of stomach contents into the esophagus, the muscular tube that connects the mouth to the stomach. In the lower part of the esophagus, there is an area of thickened muscle known as the lower esophageal sphincter which, when functioning properly, acts as a one-way valve, allowing food to pass down from the esophagus into the stomach, but preventing reflux. In GERD patients, the lower

esophageal sphincter does not function properly and allows chronic reflux to occur. Stomach acid, enzymes and bile irritate the esophagus and cause a wide range of symptoms and complications, most commonly persistent severe heartburn and chest pain. In some GERD sufferers, the pain is acute enough to require an emergency room visit. People with GERD often have difficulty sleeping due to increased reflux and heartburn when they lie down. Also, damage to the esophagus caused by reflux may result in more serious complications, such as erosion or ulceration of the esophagus, build-up of scar tissue that can narrow and obstruct the esophagus, and Barrett’s epithelium, a condition that increases the risk of esophageal cancer.

Prescription medication is the primary treatment option used by people with GERD. There are many widely prescribed medications, including Prilosec, with worldwide sales of approximately $7 billion in 2001, Prevacid, Tagamet, Pepcid and Zantac. Although these medications temporarily ease heartburn symptoms by reducing stomach acid, they do not prevent reflux or treat the underlying causes of GERD. Side effects may include diarrhea, headaches, dizziness and nausea. Taken regularly, these medications are expensive, costing an estimated average of $2,300 per year based solely on retail prices for medication requirements of the patients in our clinical trial. Many GERD patients do not want to be dependent on medications and have difficulty complying with prescribed lifestyle modifications that require ongoing fundamental changes in eating, drinking and sleeping behavior.

The most common corrective treatment for GERD is fundoplication surgery. This inpatient surgical procedure costs approximately $11,700, involves a prolonged recovery period, and exposes the patient to a significant risk of serious side effects. Consequently, physicians are reluctant to refer otherwise healthy patients for the surgery. An estimated 70,000 patients underwent fundoplication surgery in the United States in 2001.

Our proprietary Stretta System provides physicians with the tools to perform a minimally invasive, outpatient and cost-effective procedure for the treatment of GERD. Unlike medication, the Stretta procedure is designed to treat GERD, rather than simply manage symptoms. Unlike fundoplication surgery, the Stretta procedure is an outpatient procedure with minimal side effects. The Stretta procedure, which we believe costs about $2,000, is designed to take less than an hour utilizing techniques commonly used by gastroenterologists. Most treated patients have been able to return to normal activities within one day of treatment and reduce or eliminate medication use shortly thereafter. We believe that the Stretta procedure’s effectiveness and relatively low cost, combined with the absence of significant discomfort and side effects, makes it a clinically and economically attractive GERD treatment compared to either medication or fundoplication surgery.

The Stretta System consists of the Stretta Catheter, which is a disposable flexible catheter with needle electrodes, and the Curon Control Module, which is a radiofrequency energy generator. Using these devices, the physician delivers precisely controlled radiofrequency energy to create thermal lesions in the muscle of the lower esophageal sphincter. These lesions reabsorb over several weeks and cause tissue contraction, which increases the ability of the lower esophageal sphincter to act as a barrier to reflux.

We have applied our experience with the Stretta System to the development of the Secca System, which is designed to treat fecal incontinence, a condition that affects up to 16 million U.S. adults. Fecal incontinence is caused by damage to the anal sphincter from childbirth or surgery, neurologic disease, injury or age. It is a life-altering condition that, like GERD, lacks minimally invasive corrective treatment alternatives. The most common treatment options control, but do not correct, the condition, and include the use of protective undergarments, diet modification and over-the-counter dietary supplements. Current corrective treatment options include highly invasive surgery and are rarely utilized.

the Stretta System. Using our Curon Control Module and our handheld disposable device called the Secca Handpiece, physicians deliver radiofrequency energy into the muscle of the anal sphincter to improve its barrier function. We completed a U.S. clinical trial of the Secca System in April 2001, and submitted the results to the FDA in the December 2001. In March 2002, we received 510(k) clearance from the FDA to market the Secca System for the treatment of fecal incontinence in patients who have failed more conservative therapies like diet modification and biofeedback.

We have developed a suite of products incorporating proprietary design features for use in the Stretta and Secca procedures. These products consist of a disposable catheter and a disposable handpiece for delivery of controlled radiofrequency energy to tissue and a radiofrequency generator, known as the Curon Control Module. Both our current products and products under development utilize proprietary software to interface with our Curon Control Module.

The Stretta System and the Secca System both incorporate our radiofrequency energy generator, the Curon Control Module. The Curon Control Module has four channels, which allow for independent control of each of the four needle electrodes on the Stretta Catheter and Secca Handpiece. The generator uses continuous data feedback to achieve precise tissue temperatures at the treatment site. The generator tracks surface tissue temperatures from each electrode, and if temperatures at either the treatment site or surface tissue exceed pre-set safe levels, the generator automatically stops delivering energy to that electrode. An integrated pump delivers water to surface tissue during the procedure. The Stretta System and the Secca System each utilize proprietary software installed onto the Curon Control Module. The software provides a distinct graphical user interface and the functions and parameters that are required for the particular procedure.

In April 2000, we received 510(k) clearance from the FDA to market the Stretta System for the treatment of GERD. To evaluate the Stretta System, we conducted an open label multi-center U.S. clinical trial with leading investigators at 14 institutions, in which 131 patients were treated. We measured how well the procedure eliminated the need for heartburn medication, improved symptoms, improved quality of life, and reduced the amount of acid detected in the esophagus. Results from the initial 47 patients treated were submitted to the FDA. Six-month data was available for 44 of the 47 treated patients because three patients did not participate in the voluntary follow-up testing. The follow-up data indicated that the Stretta procedure led to significant improvement in both objective and subjective measurements. A subset of this data was presented at the Digestive Disease Week 2000 and published in abstract form in GI Endoscopy. Twelve-month data for 118 of the 131 patients was presented at the Digestive Disease Week 2001 and published in GI Endoscopy Volume 55, No. 2, 2002.

Patients in our trials experienced no persistent side effects or other significant complications during the treatment and follow-up period. Most patients resumed normal levels of activity on the day after treatment. A few patients reported difficulty swallowing, increased flatulence or mild abdominal discomfort for a period of days. These symptoms were significantly milder and shorter in duration than those typically experienced after surgical fundoplication.

We believe that the lower esophageal sphincter is more resistant to reflux after radiofrequency treatment. We believe that this increased resistance is due to the collagen contraction that occurs after the creation of the lesions, as well as interruption of nerve pathways that are responsible for inappropriate relaxations of the lower esophageal sphincter. These neural pathways are similar to those in the heart muscle, which may cause irregular heartbeats shown in electrophysiology procedures to respond favorably to radiofrequency energy treatment. Two scientific papers were presented at the annual major meeting of the American Gastroenterological Association in May 2000 reporting on the ability of the Stretta procedure to disrupt nerve pathways in animals and humans.

Stretta procedure or a placebo procedure, and the results were compared. Patients who had received the placebo procedure are now eligible to receive the Stretta procedure and we compiled complete results during the first quarter of 2002. We are using the data generated for future peer-reviewed publications and for presentations at national scientific meetings and expect that this data will influence physician adoption rates, facilitate reimbursement approvals and enhance marketing activity.

In November 1999, we conducted a pilot study at a leading medical institution in Mexico City. Ten patients with fecal incontinence were treated with the Secca System. One year following the procedure, most patients showed significant improvements in fecal incontinence symptoms, incontinence-related quality of life and general quality of life, each as measured by validated questionnaires. We have received no reports of persistent complications or persistent side effects. Based on these encouraging preliminary results, we have further evaluated the Secca System in a multi-center U.S. clinical study involving six sites and 50 patients, which began in July 2000. This study was completed in April 2001, and the data was compiled and submitted to the FDA in December 2001. We received 510(k) clearance from the FDA in March 2002 to market the Secca System for the treatment of fecal incontinence in patients who have failed more conservative therapies like diet modification and biofeedback. We intend to target the Secca System primarily to colorectal surgeons, approximately 1,000 of whom practice in the United States. Secondarily, we intend to target gastroenterologists, particularly those who are familiar with the Stretta System.

Our research and development activities are conducted internally by a research and development staff and, as of December 31, 2001, we had 10 employees. Our research and development efforts are focused on development of additional products for new gastrointestinal indications, design changes intended to reduce manufacturing cost as well as evaluation of existing product alternatives. We intend to develop products that leverage our existing radiofrequency energy platform, and we also plan to explore options utilizing technology not associated with this platform. We have a number of new projects and products under development, including several projects related to development of a new generator as well as development of additional products for treatment of gastrointestinal disorders.

In addition to working on new products, our research and development organization is developing products and fixtures that are designed to reduce the time to manufacture, improve quality or reduce cost of products. Our research and development expenditures were $2.8 million in 2001, $4.2 million in 2000 and $9.0 million in 1999. Amortization of stock-based compensation included in these numbers was $205,000 in 2001, $629,000 in 2000 and $4.1 million in 1999. Pilot manufacturing costs included in the research and development expenditures were $1.0 million in 1999 and $1.1 million in the first two quarters of 2000.

Our manufacturing strategy is to conduct a significant portion of the manufacturing process in-house to control quality and manufacturing efficiency. Over time, we intend to move some manufacturing operations to less costly manufacturing locations both within and outside the United States, to manufacturers meeting our quality standards, in order to reduce costs and to add additional capacity. As of December 31, 2001, we did not subcontract the manufacture of sub-assemblies to outside manufacturers.

We manufacture, assemble and test each Stretta Catheter in-house. The manufacturing process consists primarily of assembling internally manufactured and externally purchased components and sub-assemblies in an environmentally controlled area. After assembly, each Stretta Catheter is internally inspected and then sent out for sterilization by a sub-contractor. We manufacture the Curon Control Module primarily by in-house assembly and testing of components ordered from outside manufacturers.

We have no experience manufacturing our products in the volumes that will be necessary for us to achieve significant commercial sales, and we cannot assure you that we can establish high volume manufacturing or, if established, that we will be able to manufacture our products in high volumes with commercially acceptable yields. To achieve our business plan, we expect to hire additional personnel to assemble our catheters. There is a shortage of such personnel in our area and we cannot be sure that we will be able to recruit and retain them. We will also need to achieve some enhancements to our manufacturing operations to increase our capacity. We cannot guarantee we will achieve this objective.

We purchase various materials and components from qualified suppliers that are subject to stringent quality specifications and inspections. We conduct quality audits of our key suppliers, several of which are experienced in the supply of components to manufacturers of medical devices. Most purchased components and services are available from more than one supplier. For the few components for which relatively few alternate supply sources exist, we have identified back-up suppliers. The qualification of these back-up suppliers may require regulatory approval, which may or may not be available on a timely basis or at all.

Currently, only one supply source exists for the peristaltic pump and the computer chip used in our Curon Control Module. For these two components, we believe we have accumulated enough product to allow time to research alternatives without harming our business. The peristaltic pump integrated into the Control Module is manufactured by our supplier in accordance with our specifications. We have contracted with the supplier for ongoing supply, and we have secured inventory that we believe is sufficient to allow us time to locate and qualify a new pump supplier should our current supplier fail to fulfill our needs. If a new pump is incorporated into the Control Module, then the Control Module may require regulatory clearance under the FDA’s 510(k) process, which could take several months or more. Also, a computer chip in the Control Module is no longer manufactured. This chip is currently available from multiple suppliers, but we cannot assure you that it will be available in the future. We have purchased an inventory of these chips sufficient to meet our projected manufacturing needs for at least the next 18 months and we are currently working on developing a new generator that will use newer chip technology. As with the pump, we cannot incorporate a new chip into the generator without regulatory clearance under the FDA’s 510(k) process, which could take several months or more.

Our manufacturing facility is subject to periodic inspection by regulatory authorities. Our quality assurance systems are subject to FDA regulations. These regulations require that we conduct our product design, testing, manufacturing, and control activities in conformance with these regulations and that we maintain our documentation of these activities in a prescribed manner. Our manufacturing facility is licensed by the California Department of Health Services, Food and Drug Branch. In addition, our facility has received ISO 9001/EN46001 certification and the European Union Certificate pursuant to the European Union Medical Device Directive 93/42/EEC, allowing us to CE mark our products after assembling appropriate documentation. ISO 9001/EN46001 certification standards for quality operations have been developed to ensure that companies know the standards of quality on a worldwide basis. Failure to maintain the CE mark will preclude us from selling our products in Europe. We cannot assure you that we will be successful in maintaining certification requirements in Europe or elsewhere.

As of December 31, 2001, we had 18 issued or allowed U.S. patents and 21 pending U.S. patent applications. We intend to continue to file for patents for our technologies to strengthen our position. We require our employees, consultants and advisors to execute confidentiality agreements in connection with their employment, consulting or advisory relationships with us. We also require employees, consultants and advisors who are expected to work on our products to agree to disclose and assign to us all inventions conceived during

Certain aspects of our products incorporate technology subject to patents that we have licensed from others. As of December 31, 2001, we had licensed in 16 issued and allowed U.S. patents and 17 pending U.S. patent applications. We have a license with Gyrus Group PLC for their generator technology. The non-exclusive license gives us the right to manufacture, have manufactured, use, offer to sell, sell and import Gyrus’ radiofrequency generator technology for use in the treatment of GERD and other medical disorders of the digestive tract. The license expires on October 6, 2017. During the term of the license, we are obligated to pay a royalty to Gyrus for our sale of generators that incorporate the licensed technology. We have also licensed patented technology from the University of Kansas Medical Research Institute relating to applying radiofrequency energy to tissue. This is an exclusive, worldwide and royalty-bearing license allowing us to incorporate the patented technology in our products to treat medical disorders throughout the gastrointestinal tract. The license expires on September 17, 2013 and may be terminated earlier for breach. We have also licensed other patents that we believe may apply to our current business or that we may incorporate into future products. We intend to continue to license technologies to strengthen our competitive position.

The medical device industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. As the number of entrants into our market increases, the possibility of an infringement claim against us grows. While we attempt to ensure that our products do not infringe other parties’ patents and proprietary rights, our competitors may assert that our products and the methods they employ may be covered by U.S. patents held by them. In addition, our competitors may assert that future products we may market infringe their patents.

Our primary competitors in the GERD market are manufacturers and marketers of existing pharmaceutical and surgical treatments for GERD, and manufacturers focused on innovative outpatient treatments. We compete with manufacturers of medications, such as Zantac, Pepcid, Aciphex, Prontonex, Prilosec and Nexium. These manufacturers and manufacturers of generic medication equivalents have significantly greater resources than we do. These companies may market products more aggressively, gain influence among opinion leaders, or lower their prices, all of which may affect the adoption of and the market for our products. We also compete with manufacturers of devices and equipment used in laparoscopic fundoplication. Increased publicity regarding these procedures or advantageous pricing may adversely affect the market for our products. Both medication treatment and fundoplication are established GERD therapies with well-defined reimbursement profiles.

We also compete with a number of companies that are working on GERD treatments that eliminate or reduce the need for medication but are less invasive than surgery. For example, C.R. Bard has developed an endoscopic suturing system that enables patients to undergo a fundoplication-like surgery in the endoscopy suite as an outpatient procedure. The device used in this procedure received FDA marketing clearance in March 2000. We compete with several companies that are developing bulking agents to be injected into the muscle of the lower esophageal sphincter. Enteric Medical has developed a liquid polymer for injection into the lower esophageal sphincter. Endonetics, which was recently acquired by Medtronic, is also developing an injectable system. There may also be other companies developing innovative therapies of which we are not aware.

treatment of severe fecal incontinence, and Medtronic, who is developing an implantable device for treatment of severe incontinence. Both of these competitors have significantly greater resources than we do, and we cannot assure you that we will be able to compete effectively with these companies.

Each medical device that we wish to commercially distribute in the United States will likely require either prior 510(k) clearance or prior PMA approval from the U.S. Food and Drug Administration under the Federal Food, Drug, and Cosmetic Act. Devices deemed to pose relatively minimal risk are placed in either class I or II, which requires the manufacturer to submit a premarket notification requesting permission for commercial distribution; this is known as 510(k) clearance. Some low risk devices are exempted from this requirement. Devices deemed by the FDA to pose the greatest risk, such as life-sustaining, life-supporting or implantable devices, or devices deemed not substantially equivalent to a previously 510(k) cleared device or a preamendment class III device for which PMA applications have not been called, are placed in class III, requiring PMA approval.

510(k) Clearance Pathway: To obtain 510(k) clearance for one of our products, we must submit a premarket notification demonstrating that the proposed device is substantially equivalent in intended use and in safety and effectiveness to a previously 510(k) cleared device or a device that was in commercial distribution before May 28, 1976, for which the FDA has not yet called for submission of PMA applications. The FDA’s 510(k) clearance pathway usually takes from four to 12 months, but it can last longer.

After a device receives 510(k) clearance, any modification that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, requires a new 510(k) clearance or could require a PMA approval. The FDA requires each manufacturer to make this determination in the first instance, but the FDA can review any such decision. If the FDA disagrees with a manufacturer’s decision not to seek a new 510(k) clearance, the agency may retroactively require the manufacturer to seek 510(k) clearance or PMA approval. The FDA also can require the manufacturer to cease marketing and/or recall the modified device until 510(k) clearance or PMA approval is obtained.

PMA Approval Pathway: If the FDA denies 510(k) clearance for one of our products, the product must follow the PMA approval pathway, which requires proof of the safety and effectiveness of the device to the FDA’s satisfaction. A PMA application must provide extensive preclinical and clinical trial data and also information about the device and its components regarding, among other things, device design, manufacturing and labeling. After approval of a PMA, a new PMA or PMA supplement is required in the event of a modification to the device, its labeling or its manufacturing process. The PMA approval pathway is much more costly, lengthy and uncertain than 510(k) clearance. It generally takes from one to three years or even longer.

Clinical Trials: A clinical trial is almost always required to support a PMA application and is sometimes required for a 510(k) premarket notification. Such trials generally require submission of an application for an Investigational Device Exemption, or IDE. The IDE application must be supported by appropriate data, such as animal and laboratory testing results, showing that it is safe to test the device in humans and that the testing protocol is scientifically sound. The IDE must be approved in advance by the FDA for a specified number of patients unless the product is deemed a nonsignificant risk device eligible for more abbreviated IDE requirements. Clinical trials may begin once the IDE application is approved by the FDA and the appropriate institutional review boards at the clinical trial sites. In June 2000, we received IDE approval allowing us to commence a multicenter clinical trial of the Secca System. We began the trial in July 2000. In April 2001, we completed this trial and the results were submitted to the FDA in December 2001.

In April 2000, we received 510(k) premarket clearance from the FDA for the Stretta System for the treatment of GERD, and in March 2002 we received 510(k) premarket clearance from the FDA for the Secca System for the treatment of fecal incontinence in patients who have failed more conservative therapies like diet modification and biofeedback. We cannot assure you that the FDA will not deem one or more of our future products to be a class III device subject to the more burdensome PMA approval process.

After a device is placed on the market, numerous regulatory requirements apply. These include: the quality system regulation, or QSR, which requires manufacturers to follow elaborate design, testing, control, documentation and other quality assurance procedures during the manufacturing process; labeling regulations; the FDA’s general prohibition against promoting products for unapproved or off-label uses; and the Medical Device Reporting regulation, which requires that manufacturers report to the FDA if their device may have caused or contributed to a death or serious injury or malfunctioned in a way that would likely cause or contribute to a death or serious injury if it were to recur. Class II devices also can have special controls such as performance standards, postmarket surveillance, patient registries, and FDA guidelines that do not apply to class I devices. Unanticipated changes in existing regulatory requirements or adoption of new requirements could hurt our business, financial condition and results of operations.

We are subject to inspection and marketing surveillance by the FDA to determine our compliance with regulatory requirements. If the FDA finds that we have failed to comply, the Agency can institute a wide variety of enforcement actions against us, ranging from a public Warning Letter to more severe sanctions such as:

The FDA also has the authority to require repair, replacement or refund of the cost of any medical device manufactured or distributed by us. Our failure to comply with applicable requirements could lead to an enforcement action that may have an adverse effect on our financial condition and results of operations.

We have been an FDA registered medical device facility since January 1999 and we obtained our manufacturing license from the California Department of Health Services, or CDHS, in September 1999. We are subject to inspection by both the FDA and CDHS for compliance with the quality systems regulations and other applicable regulations.

We also must comply with numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control and hazardous substance disposal. We may be required to incur significant costs to comply with such laws and regulations in the future and such laws and regulations may hurt our business, financial condition and results of operations.

Our products are also regulated as medical devices outside the United States by government agencies and are subject to registration requirements in many of the foreign countries in which we plan to sell our products. Our Stretta and Secca Systems carry a CE Mark, which is required for European product sales. The Stretta System carries a Therapeutic Goods Administration license, which is required for product sales in Australia. Our facility has been audited and certified to be ISO9001/EN46001 compliant, which allows us to sell our products in Europe. Our facility is subject to inspection by TUV/Essen. We plan to seek approval to sell the Stretta and Secca Systems in additional foreign countries. The time and cost required to obtain clearance required by foreign countries may be longer or shorter than that required for FDA clearance, and requirements for licensing a product in a foreign country may differ significantly from FDA requirements.

In the United States, health care providers generally rely on third-party payors, principally private health insurance plans, Medicare and Medicaid, to reimburse all or part of the cost of procedures in which medical devices are used. Medicare reimburses hospital outpatient clinics on a prospectively determined fixed amount for the costs associated with an outpatient procedure. Individual outpatient procedures are assigned Ambulatory Payment Classification (APC) codes. Effective October 1, 2001, the Center for Medicare and Medicaid Services, CMS (formerly HCFA), revised its outpatient coding and payment for the Stretta procedure. Further, CMS has provided guidance on the use of existing physician CPT codes for Stretta as well. However, as this coding direction does not constitute a coverage decision, we cannot assure you that the Stretta procedure will be reimbursed or that the amounts reimbursed under this code will be adequate.

The current cost reduction orientation of the third-party payor community makes it exceedingly difficult for new medical devices and surgical procedures to obtain reimbursement. Often, it is necessary to convince these payors that the new devices or procedures will establish an overall cost savings compared to currently reimbursed devices and procedures. We believe that the Stretta System may offer an opportunity for payors to reduce the cost of treating GERD patients by possibly eliminating or reducing the costs of medication or fundoplication surgery. While we believe that the Stretta System possesses economic advantages that will be attractive to payors, we cannot assure you that they will make reimbursement decisions based upon these advantages.

Reimbursement by third-party payors is often positively influenced by the existence of peer-reviewed publications of long-term safety and efficacy data. We have collected and published data on six-month results after treatment with the Stretta System which was published in a peer-reviewed journal in 2001. We have collected and published data on twelve-month results which has been published in early 2002. While we cannot assure you that our products will be reimbursed without publications of longer-term data, we are actively encouraging ongoing research studies to evaluate and publish the long-term safety and efficacy of the Stretta System. In addition, many third-party payors require that randomized studies be conducted to determine the effect of the procedure versus placebo or another standard of care. As of December 31, 2001, we have completed a randomized, controlled, multi-center study to generate this data, and plan to publish the results in the first quarter of 2002. We cannot assure you that the Stretta System will have compelling results in this study, or that the results will be published in a timely manner or at all, or that such publication will benefit our reimbursement efforts.

procedure. Among other things, this group works directly with third-party payors to ensure their understanding of the therapeutic and economic benefits of the Stretta Procedure, and seeks to influence them to develop coverage decisions which incorporate the Stretta System into their standards of care for GERD.

Reimbursement systems in international markets vary significantly by country and, within some countries, by region. Reimbursement approvals must be obtained on a country-by-country basis or a region-by-region basis. In addition, reimbursement systems in international markets may include both private and government sponsored insurance. We have not obtained any international reimbursement approvals. We cannot assure you that we will obtain any such approvals in a timely manner, if at all. If we fail to receive international reimbursement approvals at all or in acceptable amounts, market acceptance of our products would be adversely affected.

As of December 31, 2001, we had 91 employees, with 29 employees in operations, 10 employees in research and development, 35 employees in sales and marketing, 11 employees in general and administrative, and 6 employees in clinical and regulatory affairs. We believe that our future success will depend in part on our continued ability to attract, hire and retain qualified personnel. None of our employees is represented by a labor union, and we believe our employee relations are good.

We have only a limited operating history upon which you can evaluate our business. We have incurred losses every year since we began operations. In particular, we incurred net losses of $15.4 million in 2001, $15.8 million in 2000 and $14.1 million in 1999. We have generated limited revenues from the sale of our products, and it is possible that we will never generate significant revenues from product sales in the future. Even if we do achieve significant revenues from our product sales, we expect to incur significant net losses over the next several years and these losses may increase. It is possible that we will never achieve profitable operations.

In 2001, we became aware of some issues that negatively impacted our earnings. For example, we learned that it is time consuming to obtain purchase commitments for our products because of the number of individuals at hospitals who need to approve the purchase. As a result, we changed our sales and marketing models to more effectively address this issue. We also became aware of misinformation in the marketplace regarding past adverse events associated with our procedure. In response, we dedicated resources to educating physicians regarding the use of our products to combat this misinformation. Our efforts to rectify these situations may not be sufficient. In addition, the cost of our efforts in addressing these matters diverts resources that could be allocated to increasing revenues. In the future, we may experience similar problems and if we are unable to take appropriate action and take it quickly our results of operations and our financial performance will be harmed.

We commercially introduced our Stretta System, which consists of a radiofrequency generator and a disposable handheld device, in May 2000. We are highly dependent on Stretta System sales because we anticipate that the Stretta System will account for substantially all our revenue through at least 2002. To achieve increasing sales, our product must gain recognition and adoption by physicians who treat gastrointestinal disorders. The Stretta System represents a significant departure from conventional GERD treatment methods. We believe that physicians will not use our Stretta System unless they determine, based on published peer-reviewed journal articles, long-term clinical data and their professional experience, that the Stretta System provides an

effective and attractive alternative to conventional means of treatment for GERD. Currently, there is one peer-reviewed journal article, limited peer-reviewed clinical reports and 12-month clinical follow-up data on our Stretta System. Physicians are traditionally slow to adopt new products and treatment practices, partly because of perceived liability risks and uncertainty of third-party reimbursement. For example, we believe that physician adoption rates were negatively impacted by adverse events and a voluntary recall, which occurred early in the launch of the Stretta System. Future adverse events or recall would also impact future acceptance rates. If physicians do not adopt our Stretta System, we may never achieve significant revenues or profitability.

If we do not produce clinical data supported by the independent efforts of clinicians, our products may never be accepted. We received clearance from the FDA for the use of the Stretta System to treat GERD based upon the study of 47 patients. Safety and efficacy data presented to the FDA for the Stretta System was based on six month follow-up studies on 44 of these patients. Although the twelve-month follow-up data supports the six-month data, we may find that data from longer-term patient follow-up studies is inconsistent with those indicated by our relatively short-term data. However, if longer-term patient studies or clinical experience indicate that treatment with the Stretta System does not provide patients with sustained benefits or that treatment with our product is less effective or less safe than our current data suggests, our sales could decline and we could be subject to significant liability. Further, we may find that our data is not substantiated in studies involving more patients, in which case we may never achieve significant revenues or profitability.

Our clinical studies of the Secca System are in the early stages. The Secca System has undergone a 10-patient pilot study and the FDA approved our application to conduct a U.S. multi-center clinical study, which we began in July 2000. In April 2001, we completed the U.S. clinical trial of the Secca System, the results of which were submitted to the FDA in December of 2001. In 2002, we intend to commence a randomized, double-blinded, sham controlled trial in the U.S. If patient studies or clinical experience do not meet our expectations regarding the benefits of the Secca System, our expected revenues from this product may never materialize.

It is important to the success of our sales efforts to educate physicians in the techniques of using the Stretta System. We rely on physicians to spend their time and money to attend our pre-sale educational sessions. Positive results using the Stretta and Secca Systems are highly dependent upon proper physician technique. If physicians use either system improperly, they may have unsatisfactory patient outcomes or cause patient injury, which may give rise to negative publicity or lawsuits against us, any of which could have a material adverse effect on our sales and profitability.

Although the Center for Medicare and Medicaid Services, or CMS, granted a new specific APC code providing higher reimbursement levels for the Stretta Procedure for Medicare purposes on October 1, 2001, there is no assurance that private, third-party payors will conform to this. Physicians, hospitals and other health care providers are unlikely to purchase our products if they are not adequately reimbursed for the Stretta procedure or the products. To date, only a limited number of private third-party payors have agreed to reimburse for the cost of the Stretta procedure or products. Until a sufficient amount of positive peer-reviewed clinical data has been published, insurance companies and other payors may refuse to provide reimbursement for the cost of the Stretta procedure or may reimburse at levels that are not acceptable to providers. Some payors may refuse adequate reimbursement even upon publication of peer-reviewed data. If users of our products cannot obtain sufficient reimbursement from health care payors for the Stretta procedure or the Stretta System disposables, then it is unlikely that our product will ever achieve significant market acceptance. The Secca procedure has not yet

received any coding decision and no tests have yet been made of the willingness of third party health care payors to reimburse the costs of the procedure. We cannot assure you that the procedure will ever by reimbursed. Failure to achieve reimbursement will have a serious negative effect on our revenues.

Even if third-party payors provide adequate reimbursement for the Stretta procedure, adverse changes in third-party payors’ policies toward reimbursement could preclude market acceptance for our products and have a material adverse effect on our sales and revenue growth. We are unable to predict what changes will be made in the reimbursement methods used by third-party health care payors.

For example, some health care payors are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person. We cannot assure you that in a prospective payment system, which is used in many managed care systems, the cost of our products will be incorporated into the overall payment for the procedure or that there will be adequate reimbursement for our products separate from reimbursement for the procedure.

Internationally, market acceptance of our products will be dependent upon the availability of adequate reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary significantly by country and include both government-sponsored health care and private insurance. Although we intend to seek international reimbursement approvals, we cannot assure you that any such approvals will be obtained in a timely manner or at all. If foreign third-party payors do not adequately reimburse providers for the Stretta procedure and the products used with it, then our sales and revenue growth may be limited.

The market for the treatment of GERD is dominated by companies that have well-established products, reputations and resources. We primarily compete with large pharmaceutical companies such as AstraZeneca, Takeda Abbott Pharmaceuticals and Merck, which collectively generate over $6 billion in annual U.S. revenues from sales of medication for the treatment of GERD symptoms. We also compete with large medical device companies such as Johnson & Johnson/Ethicon, which makes instrumentation for fundoplication surgery, and C.R. Bard, which received FDA clearance for an endoscopic suturing device for the treatment of GERD in April 2000. C.R. Bard announced on May 30, 2001, that it had received an offer to be acquired by Tyco International, Inc., one of whose divisions is U.S. Surgical. Boston Scientific has recently signed an agreement with Enteric to market a liquid polymer that is injected into the lower esophageal sphincter for the treatment of GERD. In December 2001, Medtronic announced that it had purchased Endonetics, Inc., a developer of biomaterial that can be endoscopically place in the wall of the lower esophagus, improving performance of the esophageal sphincter for treatment of GERD.

At any time, these competitors or other companies may develop new competitive products that are more effective or less expensive than ours. For example, AstraZeneca has developed a new product, Nexium, for the treatment of GERD, which doctors may prescribe in lieu of recommending our Stretta Procedure. Less expensive, generic drugs will be introduced to treat GERD as AstraZeneca’s patent for Prilosec, the leading prescription medication for the treatment of GERD, expired in 2001, although pending lawsuits may delay the appearance of competition until at least the second quarter of 2002. If we cannot compete effectively in this highly competitive market, we may not be able to achieve our expected revenue growth.

We have limited sales and marketing experience. As of December 31, 2001, we relied on 16 direct sales employees to sell our Stretta System in the United States. We must manage this sales team over the next 24 months to achieve our market share and revenue growth goals. Since we have only recently launched the Stretta System, our sales force has little experience marketing the product, and we cannot predict how successful they will be in selling the product. Since we have not yet commercially launched our Secca System, our sales force has no experience marketing that product. There are significant risks involved in building and managing our sales force and marketing our products, including our:

Internationally, we are training third-party distributors who will begin selling our products, and we cannot assure you that these distributors will commit the necessary resources to effectively market and sell our products or that they will be successful in selling our products.

We currently have a total of seven distribution agreements: one each in Germany, Italy, Greece, Portugal, and South Africa, one covering sales in the region of Belgium, the Netherlands, and Luxembourg (Benelux) and one covering sales in the region of Denmark, Sweden, Norway and Finland (Scandinavia). If we fail to adequately build and manage our domestic and foreign sales force, or to effectively market and distribute our products internationally, then our revenues and our profitability will be materially and negatively impacted.

Because we have only limited experience in manufacturing our products in commercial quantities, we may encounter unforeseen situations that would result in delays or shortfalls. For example, in December 2000, we voluntarily recalled certain of our catheters because of manufacturing issues. We may encounter difficulties and delays in manufacturing our products for the following additional reasons:

Although we believe that our current manufacturing facility will be adequate to support our commercial manufacturing activities for the foreseeable future, we may be required to expand our manufacturing facilities to begin large-scale manufacturing. If we are unable to provide customers with high-quality products in a timely manner, we may not be able to achieve market acceptance for our Stretta or Secca Systems. Our inability to successfully manufacture or commercialize our devices could have a material adverse effect on our product sales.

Third-party suppliers provide materials and components used in our products. If these suppliers become unwilling or unable to supply us with our requirements, replacement or alternative sources might not be readily obtainable due to regulatory requirements applicable to our manufacturing operations. Obtaining components from a new supplier may require a new or supplemental filing with applicable regulatory authorities and clearance or approval of the filing before we could resume product sales. This process may take a substantial period of time, and we cannot assure you that we would be able to obtain the necessary regulatory clearance or approval. This could create supply disruptions that would reduce our product sales and revenue.

Our manufacturing processes are required to comply with the quality system regulation, or QSR, which covers the methods and documentation of the design, testing, production, control, quality assurance, labeling, packaging and shipping of our products. The FDA enforces the QSR through inspections. In May 2001, we received the report on our first QSR inspection, which was completed in March 2001. There were no significant findings. If we fail any future QSR inspections, our operations could be disrupted and our manufacturing delayed. Failure to take corrective action in response to a QSR inspection could force a shut-down of our manufacturing operations and a recall of our products, which would have a material adverse effect on our product sales, revenues, and expected revenues and profitability. Furthermore, we cannot assure you that our key component suppliers are, or will continue to be, in compliance with applicable regulatory requirements, will not encounter any manufacturing difficulties, or will be able to maintain compliance with regulatory requirements. Any such event could have a material adverse effect on our available inventory and product sales.

Our products are considered medical devices and are subject to extensive regulation in the United States and in foreign countries where we intend to do business. Unless an exemption applies, each medical device that we wish to market in the United States must first receive either 510(k) clearance or premarket approval from the FDA. Either process can be lengthy and expensive. The FDA’s 510(k) clearance process usually takes from four to twelve months, but may take longer. The premarket application (“PMA”) approval process is much more costly, lengthy and uncertain. It generally takes from one to three years or even longer. Delays in obtaining regulatory clearance or approval will adversely affect our revenues and profitability.

Although we have obtained 510(k) clearance for both the Stretta System, for use in treating GERD, and the Secca System, for treatment of fecal incontinence in patients who have failed more conservative therapies like diet modification and biofeedback, our clearance can be revoked if postmarketing data demonstrates safety issues or lack of effectiveness. Moreover, we will need to obtain 510(k) clearance or PMA approval to market any other new products. We cannot assure you that the FDA will not impose the more burdensome PMA approval process upon this technology in the future. More generally, we cannot assure you that the FDA will ever grant 510(k) clearance or premarket approval for any product we propose to market. If the FDA withdraws or refuses to grant approvals, we will be unable to market such products in the United States.

Our Stretta and Secca Systems are cleared by the FDA; the Stretta System for the treatment of GERD and the Secca System for the treatment of fecal incontinence in patients who have failed more conservative therapies like diet modification and biofeedback. FDA regulations prohibit us from promoting or advertising either system, or any future cleared or approved devices, for uses not within the scope of our clearances or approvals, and prohibit us from making unsupported safety and effectiveness claims. These determinations can be subjective, and the FDA may disagree with our promotional claims. If the FDA requires us to revise our promotional claims or takes enforcement action against us based upon our labeling and promotional materials, our sales could be delayed, our profitability could be harmed and we could be required to pay significant fines or penalties.

Delaware		77-0470324
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

Title of each class:		Name of each exchange on which registered:
None		N/A

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PART I

Item 1.	Business	1

Item 2.	Properties	21

Item 3.	Legal Proceedings	21

Item 4.	Submission of Matters to a Vote of Security Holders	21

PART II

Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters	22

Item 6.	Selected Financial Data	23

Item 7.	Management’s Discussion and Analysis of Results of Operations and Financial Condition	24

Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	29

Item 8.	Financial Statements and Supplementary Data	30

	Report of Independent Accountants	31

	Consolidated Balance Sheets at December 31, 2001 and December 31, 2000	32

	Consolidated Statements of Operations for each of the Three Years in the Period Ended December 31, 2001	33

	Consolidated Statements of Stockholders’ Equity (Deficit) for each of the Three Years in the Period Ended December 31, 2001	34

	Consolidated Statements of Cash Flows for each of the Three Years in the Period Ended December 31, 2001	35

	Notes to Consolidated Financial Statements	36

	Quarterly Results of Operations (Unaudited)	50

Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	51

PART III

Item 10.	Directors and Executive officers of the Registrant	51

Item 11.	Executive Compensation	51

Item 12.	Security Ownership of Certain Beneficial Owners and Management	51

Item 13.	Certain Relationships and Related Transactions	51

PART IV

Item 14.	Exhibits, Financial Statements Schedules, and Reports on Form 8-K	52