ITEM 1. BUSINESS
The Company
Overview
Cheung Laboratories, Inc. ("CLI" or the "Company") was incorporated in the State of Maryland in 1982 under the name A.Y. Cheung Associates, Inc. The Company changed its name to Cheung Laboratories, Inc. on June 31, 1984. CLI is engaged in developing and marketing minimally invasive medical devices and systems utilized in the treatment of cancer and in the treatment of genitourinary diseases associated with benign growth of the prostate in older males, the most common being benign prostatic hyperplasia ("BPH"). The Company has recently acquired the right to use technologies which the Company believes have the potential to significantly enhance the capabilities of both its cancer and BPH treatment systems.
The Company's current cancer treatment system is the Microfocus 1000, which is designed to increase the efficacy of existing cancer treatment modalities, including external beam radiation, interstitial radiation, brachytherapy and chemotherapy. The Microfocus 1000 utilizes proprietary microwave technology to preferentially heat the cancerous area to a temperature sufficient to cause cell death in the cancerous cells. Because healthy cells are not as susceptible to heat as cancerous cells, they can survive the thermotherapy. The treatment is currently utilized primarily on surface cancers. The Microfocus 1000 also utilizes licensed patented technology which the Company calls Direct Coupling Technology ("DCT"). The DCT allows the Microfocus 1000 to air cool the body surface while applying the heat. The Microfocus 1000 has Food and Drug Administration ("FDA") premarket approval ("PMA") and has been marketed by the Company since 1989.
The Company recently acquired an exclusive license to use three patents involving a technology known as Adaptive Phased Array ("APA") from the Massachusetts Institute of Technology ("MIT"). APA technology was originally developed for use in microwave radar systems for the U.S. Department of Defense to track targets and to nullify the energy beam from enemy jamming equipment. The Company is incorporating the APA technology into a device based on the current Microfocus 1000 which is currently designated as the Microfocus APA (the "Microfocus APA"). Based upon information currently available, the Company believes the Microfocus APA will allow focusing microwave heat on target tumors inside the body and will nullify undesired heat induced in healthy tissue. The current thermotherapy systems, including the Microfocus 1000, are useful only on superficial cancers. The Microfocus APA will allow thermotherapy treatment to be administered to malignant tumors deep within the body such as lung, pancreatic, breast and prostate cancer. It will be minimally invasive in that one or more thin catheters will be inserted into the tumor and surrounding area to facilitate the placement of sensors and a temperature probe. The sensor acts as a guidance center which generates feedback signals to the system to make adjustment in order to maintain the focus of heat within the tumor even if a patient moves his or her position. The temperature probe maintains proper temperature within the tumor and surrounding areas. The Company is in the engineering stage to develop the commercial applications of the APA technology. The Company is required to seek an investigational device exemption ("IDE") from the FDA to begin patient studies in the United States. Data from such studies will used to seek PMA which must be received prior to commercial distribution of the Microfocus APA in the United States.
The Company's BPH systems currently include the Microfocus 800, 500C, 100C and 100 (collectively "Microfocus System") which are all designed to treat BPH. The Microfocus 800 is the most current design and is targeted for use by private
urologists in their offices. The procedure utilizes a non-surgical catheter-based therapy that incorporates proprietary microwave technology and is designed to preferentially heat diseased areas of the prostate to a temperature sufficient to cause cell death in those areas. The Company does not have an IDE or PMA on the Microfocus System and it is therefore not currently available for commercial distribution in the United States. The Microfocus System is manufactured in Canada and is approved for export from Canada.
The Microfocus System is a thermotherapy system which utilizes transurethral and transrectal applicators to deliver heat directly to diseased portions of the prostate. CLI has conducted preclinical evaluations on its Microfocus System and is now waiting for protocol from its principal investigator to obtain data for the filing of an IDE with the FDA to allow restricted sales of systems to hospitals in the United States. This procedure is required to place the Microfocus System in hospitals within the United States and gather clinical data for safety and efficacy demonstrations. Such demonstrations are necessary to obtain a PMA from the FDA for commercialization in the United States. The Microfocus System is currently sold outside of the United States.
The Company has recently acquired by license patented compression technology from MMTC, Inc. ("MMTC") which is being incorporated into a device to be utilized with the catheter used in the Microfocus System. The device consists of a microwave antenna combined with a balloon mechanism which expands to compress the walls of the urethra as the prostate is heated. The Company is in the engineering stage to develop a commercial application of the technology. The device will require the Company to seek an IDE and PMA from the FDA prior to any commercial sales of the device in the United States.
The Company's objective is to establish itself as a leader in the design, development, and marketing of clinically effective minimally-invasive thermotherapy solutions for the treatment of cancer and for urological disorders. To date, the Company has focused on marketing current products and, other than for the Microfocus 1000, has not had the capital to seek governmental approvals and complete commercialization of its technology. The focus will now be expanded to integrate new technology recently acquired by the Company to significantly expand the capabilities and market for its products and increase efforts for FDA approval of all products. Key elements to achieve the broadened strategy are to (i) develop products for the oncology market, (ii) focus on the large and growing urology market, (iii) develop new marketing strategies and relationships based upon selling services and sharing treatment revenue, (iv) establish strategic partnerships, (v) maintain technological leadership and protect technology advantages through patents and (vi) seek early regulatory approvals in target markets.
Targeted Illnesses
The Company's products and potential products seek to treat cancer and BPH.
a. Cancer. Historically, cancer has been treated by surgical intervention, chemotherapy or radiation therapy. The Company's equipment for the treatment of cancer is based upon a microwave thermotherapy system. Thermotherapy (also known as hyperthermia), or heat therapy, has been used in medicine since antiquity. In modern thermotherapy, a controlled heat dose is targeted to treatment sites using microwave and/or other energy for therapeutic benefits. Thermotherapy is effective in treating malignant tumors because these tumors cannot effectively withstand the increased temperatures brought about by the thermotherapy treatment, while normal tissue can withstand the higher temperatures. Because cancerous tissue has poor blood circulation, its capacity to dissipate heat is
less than that of normal tissue. As an adjuvant to surgery, thermotherapy is used to decrease tumor mass and thereby facilitate its removal surgically. As an adjuvant to radiation therapy, thermotherapy has been shown to be particularly effective in killing cells which are resistant to radiation therapy. Thermotherapy has also been shown to enhance the effectiveness of certain forms of chemotherapy by killing cells in areas poorly served by the tumor's circulatory system. In the case of both radiation therapy and chemotherapy, thermotherapy may, in time, permit lower dosages and, therefore, reduced side effects.
Thermotherapy can be administered to various anatomical sites through local, regional or whole body administration. Local thermotherapy treatment may be invasive (internal) or non-invasive (external). Invasive heating techniques, in turn, may be interstitial (via implants into body tissue) or intracavitary (via natural bodily orifice). Regional thermotherapy treatment is primarily non-invasive, via external beam radiation. Whole body thermotherapy has been effectively employed as an adjuvant to chemotherapy, but only by practitioners skilled in the complex techniques which minimize the side affects of the procedure.
Thermotherapy has been the subject of medical investigation and commercial interest in the United States, Canada, Europe, and Asia for almost 25 years. Because of a well-documented biological rationale for the use of thermotherapy as a tumor-shrinking agent, it was originally greeted with great optimism by oncologists. This optimism was founded on many published reports that thermotherapy enhanced the effectiveness of radiation by killing cells exponentially as a function of temperature at temperatures greater than 42 degrees celsius maintained for certain minimal time periods, and selectively killing S-phase and other radiation-resistant cells. Thermotherapy was also found to enhance the effectiveness of chemotherapeutic agents through a variety of mechanisms including increase in drug uptake, inhibition of repair mechanisms, and temperature-dependent increases in drug activity.
The results of early clinical trials in the United States, however, have been disappointing due to the lack of effective equipment. Most of the equipment used in the past to heat the tumors was crudely designed. In many instances, the equipment was thought to be able to heat large deep-seated tumors when only small superficial tumors could in fact be heated.
Due to the initial hope associated with the use of thermotherapy to treat cancer, many companies attempted to develop thermotherapy systems. Early developers of thermotherapy equipment conducted phase III randomized studies in the United States. These trials became known as the Radiation Therapy Oncology Group 81-04 study (the "RTOG Study"). The results of the RTOG Study published in 1989 showed no clear treatment benefits when combining thermotherapy and radiation therapy as compared to the radiation therapy alone. These study results had a negative effect on thermotherapy use and research. Until the recent publication of numerous European clinical trials reporting the effectiveness of the thermotherapy as an adjuvant therapy to radiation, the RTOG Study proved to be a difficult barrier to companies attempting to win market acceptance for their FDA- approved thermotherapy devices. Despite the negative RTOG Study, thermotherapy is currently used on a limited basis at oncology centers in the United States, primarily for the treatment of superficial cancer.
In contrast to the use of thermotherapy in the United States, the use of thermotherapy in Europe and Asia is more widespread both commercially and clinically. Since 1993, numerous randomized clinical trials have reported that:
o thermotherapy combined with radiation therapy doubles the tumor complete response compared to radiation therapy alone; and
o thermotherapy combined with chemotherapy doubles the tumor complete response compared with chemotherapy alone.
Unlike radiation therapy or chemotherapy, which are highly toxic treatment modalities, thermotherapy is relatively innocuous. For this reason, thermoenhanced combination therapies are associated with little or no additional patient morbidity or side effects. Nevertheless, the fundamental shortcoming of existing thermotherapy equipment is the same everywhere: the inability to achieve focused heating of deep tumors while sparing adjacent and intervening normal tissue and skin. Despite 25 years of effort by engineers and clinicians, the problem of targeting the cancerous tumor with the therapeutic agent (heat) has not advanced far beyond what was possible at the beginning of the thermotherapy "era." For this reason, the Company believes that the combination of the thermotherapy treatment and the APA focusing technology for heating of deep tumors constitutes a significant advance in the use of thermotherapy as a cancer treatment.
b. Benign Prostatic Hyperplasia. BPH is a non-cancerous urological disease in which the prostate enlarges and constricts the urethra. Symptoms associated with BPH affect the quality of life of millions of sufferers worldwide and BPH can lead to irreversible bladder or kidney damage. The prostate is a walnut-size gland surrounding the male urethra that produces seminal fluid and plays a key role in sperm preservation and transportation. As the prostate expands, it compresses or constricts the urethra, thereby restricting the normal passage of urine. This restriction of the urethra may require a patient to exert excessive bladder pressure to urinate. Since the urination process is one of the body's primary means of cleansing impurities, the inability to urinate adequately increases the possibility of infection and bladder and kidney damage.
Because BPH is an age-related disorder, its incidence increases as the population ages. As many as 27 million men between the age of 50 and 80 in the United States alone suffer from BPH. As the population continues to age, the number will continue to increase dramatically. Current estimates are that by the age of 55, fifty percent of all men, and by 80, eighty percent of all men will have BPH.
Like cancer, BPH historically has been treated by surgical intervention or by drug therapy. As BPH progresses, the urethra passing through the prostate constricts making urination difficult. The primary surgical treatment for BPH is transurethral resection of the prostate ("TURP"), a procedure in which the prostatic urethra and surrounding diseased tissue in the prostate are trimmed, thereby widening the urethral channel for urine flow. While the TURP procedure typically has been considered the most effective treatment available, the procedure has many shortcomings which undermine its value. A significant number of patients who undergo TURP encounter significant complications. These complications can include painful urination, infection, impotence, incontinence and excessive bleeding. Furthermore, the cost of the TURP procedure is also very high, ranging from $8,000 to $12,000. Medicare alone spent $1 billion to cover TURP procedures last year. This high cost also fails to reflect the cost of lost work time and reduction in quality of life. Finally, the TURP procedure is time consuming, requiring hospitalization for up to three days.
Other less radical surgical procedures are available in addition to the TURP procedure. Interstitial RF Therapy and Laser Therapies employ concentrated radiofrequency waves or laser radiation instead of a surgical knife. There is minimal bleeding and damage to the urethra associated with these procedures. However, the side effects and costs associated with surgery still remain.
Drug therapy has emerged as an alternative to surgery in the last several years. There are several drugs available for BPH treatment, the two most widely prescribed drugs being Hytrin and Proscar. Hytrin works by relaxing certain involuntary muscles surrounding the urethra, thereby easing urinary flow and Proscar is intended to actually shrink the enlarged gland. Drugs, however, offer only modest relief and cost hundreds of dollars per year. In short, neither the surgical nor the medicinal treatments available for BPH provide satisfactory, cost-effective solutions to BPH.
With the limited effectiveness of BPH drugs and the cost and potential side effects associated with surgery, the Company believes thermotherapy provides a better alternative for the treatment of BPH. The Company further believes the percentage of men with moderate to severe symptoms of the disease who seek treatment will increase in the future as a result of increased consumer knowledge of the disease and the development of treatments with less severe complications and side effects than traditional treatments.
Cheung Laboratories Approach.
Cancer Treatment. The Company has received PMA from FDA for the use of the Microfocus 1000 as an adjuvant to radiation therapy for surface and subsurface cancer. The Company's clinical studies submitted to the FDA indicate a better than 86% positive response rate which is the best among all competing systems. However, the Microfocus 1000 still suffers from the limitations of inability to focus deep and surface hot spots at undesirable locations. The Company intends to utilize the licensed APA technology to improve the performance of the Microfocus 1000. With added hardware and software, the Company is in the development stage of a thermotherapy system capable of focusing accurately and delivering repeatable microwave energy to induce hyperthermia without undesirable hot spots within surface and subsurface tumors such as breast tumors. With additional antenna and geometric configuration design, and frequency modification, the Company hopes to develop thermotherapy systems for deep seated tumors such as those located in the lung, prostate, rectum, liver and pancreas. The Company now possesses the technology which it believes will lead to the capability to develop and commercialize the next generation of thermotherapy equipment which is capable of overcoming the previous limitations of current thermotherapy systems, thus allowing the realization of minimally invasive, non-toxic and side effect free treatment to cancer.
BPH Treatment. The Microfocus patented technology further enhances the therapeutic capabilities of the treatment by providing combined therapy of compression and heat. Preclinical studies in phantoms and animal tissues indicate the technology will not only provide long term clinical benefits as in the case of other BPH systems but also immediate symptomatic relief which is also necessary for most BPH patients.
Business Strategy
The Company's mission is to develop effective and clinically-practical means of applying heat for therapeutic purposes. The Company's initial objective will be the design, development and marketing of microwave-based treatments for urological disorders, cancer and other diseases. The Company believes its depth of experience and its relationship with third parties in technological, manufacturing and marketing matters position the Company to exploit this market. To meet this objective, the Company has identified the following actions upon which the Company will focus its efforts:
Enhancement of Benign Prostatic Treatments.
The technology licensed from MMTC allows the design of a catheter which combines tissue compression with thermotherapy for BPH treatment. Such a combination therapy is believed to be synergistically beneficial clinically since compression may provide immediate urine obstruction relief and thermotherapy produces long term symptom relief control resulting from shrinkage of the benign growth. With this new technology, the Company believes that it will be able to offer a new BPH treatment system superior to other commercially available BPH thermotherapy devices.
Development of Specific Cancer Treatments.
The Microfocus APA is in the design stage and will be a patented breast cancer thermotherapy system for the purpose of heating both primary ductal tumors in compressed breast tissue as well as recurrent breast cancer (chest wall) tumors. The compressed breast tissue geometry is desirable in a thermotherapy treatment for four primary reasons:
o compressing the breast tissue to the range of 6 to 8 centimeters requires less penetration for microwaves;
o breast compression to a flat geometry allows a single applicator design to treat a wide range of breast sizes;
o standard x-ray imaging techniques can be used with the breast compression to accurately locate the tumor; and
o patient motion effects which could degrade the thermotherapy treatment are minimized.
The amount of breast compression can be varied to accommodate patient tolerance. When completed, the Company anticipates that the standard breast-compression thermotherapy system will feature a phased array system using dual-opposed applicators. If marketing studies determine that compression is undesirable, the Company can design a somewhat more costly four-channel phased array system that will deliver deep thermotherapy using an adaptive breast cradle to immobilize but not compress the breast.
The Microfocus APA will later be modified to incorporate additional patented technology licensed from MIT. This additional technology allows deep-heating thermotherapy. A prototype of this system involving a monopole annular phased array which would surround the patient is presently planned. The adaptive phased array will be used to treat deep-seated tumors in organs like prostate, liver, pancreas, rectum, and cervix. Rings of different sizes will permit thermotherapy for other cancer sites such as the head, neck and limbs.
In addition, the APA technology will also allow the development of an externally focused minimally invasive treatment system for prostate cancer.
Develop Technological Partnerships.
In addition to collaboration with MIT and MMTC, the Company is working with, or anticipates working with various international and domestic institutions to assist in the development and testing of new Microfocus products. There is no assurance that such partnerships will develop.
Marketing.
The Company intends to create a marketing and sales strategy to allow it to become the market leader in the business of microwave thermotherapy systems for treatment of cancer, BPH and other diseases. The Company will seek to establish itself as the technology leader in the thermotherapy business and form strategic marketing alliances with other partners to implement its marketing and sales plan worldwide.
The Company believes its licensed proprietary technology will allow the instrumentation of a new line of thermotherapy systems which will provide significant benefits over existing products. The Company has retained a product design firm in Chicago to coordinate the engineering of initial prototypes and manufacturing of the final products. Working closely with clinicians, scientists and the Company, the product designers will construct working prototypes for clinical trials. The Company anticipates that such prototypes will result in enhanced thermotherapy systems for manufacturing and marketing.
The Company further believes that with its licensed technologies, the Company can develop clinical thermotherapy treatment systems capable of offering minimally-invasive, effective non-toxic and side effect free treatment which targets only the tumors in patients suffering from cancer, BPH and other diseases. The Company is formulating a sale and distribution strategy based on placements of systems in hospitals and clinics in order to derive profit from sharing of patient treatment revenue.
In the cancer treatment market, the Company is developing the concept of thermoenhanced combination treatment procedures which combine thermotherapy with radiation therapy and/or chemotherapy. Thermotherapy treatment is used to improve the efficacy of these existing treatments while decreasing system toxicity. The Company plans to place Microfocus 1000 systems, and when available Microfocus APA systems, in treatment centers at nominal costs to the centers themselves and to share in treatment revenue.
The Company intends to re-engineer its Microfocus System to include the MMTC technology, to create a second generation, versatile and low cost BPH treatment system with the added capability of balloon compression and minimally-invasive temperature sensing. With these new technologies, the Company believes it can obtain governmental approval which will allow it to compete in the new BPH treatment market recently created as a result of the FDA's approval of the first microwave BPH treatment device, as well as the growing market of prostate cancer treatment. The Company plans to market its lines of prostate treatment systems by forming individual joint ventures with private entrepreneurs and urologists to operate prostate treatment clinics. The Company intends to derive most of its revenue from sharing treatment revenue rather than from the initial sale of the systems.
Cheung Laboratories Product Description and Technology.
Cancer Treatment.
Microfocus 1000
The Company's Microfocus 1000 is manufactured at the Company's headquarters from various components provided by suppliers. Some of the components are modified by the Company or by the manufacturer at the Company's direction. The Company considers there to be proprietary trade secret knowledge involved in the manufacture of some of the components of the Microfocus 1000 and
in the assembly of the components to form the Microfocus 1000. The Company has taken what it considers appropriate steps to safeguard this proprietary information. Other than its rights to use patents under license, the Company does not have patents on any of the components of the Microfocus 1000 or on the complete Microfocus 1000.
Competitors of the Company, particularly BSD Medical Corporation and Labthermics Technologies, Inc., have obtained a number of patents on thermotherapy products. The Company does not believe that the Microfocus 1000 infringes on any valid patents granted to others.
The Company expects to rely upon trade secrets, unpatented proprietary know-how and technological innovation in maintaining the competitive position of its Microfocus 1000. The Company intends to apply for patent protection for any patentable product it may develop. The Company believes it possesses significant proprietary knowledge relating to its hardware and software that are utilized in connection with the Microfocus 1000. However, there can be no assurance that competitors may not independently develop similar technology or that the Company will be able to maintain the secrecy of its proprietary information. There can also be no assurance that competitors will not claim that the Microfocus 1000 or another Company product infringes on a patent held by such competitor. If an owner of a patent were to assert an infringement of its patent(s) against the Company, and the Company were ultimately determined to be infringing a valid and enforceable patent, and if a license could not be obtained on a reasonable basis from such patent owner or such products could not be re-designed so that they no longer infringed the other patent(s), there could be a material adverse effect on the Company's business.
The Microfocus 1000 has FDA premarket approval and has been marketed since 1989. For the year ended September 30, 1996, the Company sold 0 Microfocus 1000 systems. Since obtaining the PMA, the Company has sold over 35 Microfocus 1000 systems worldwide.
Prostatic Treatment.
BPH Systems
CLI designed the Microfocus System for the treatment of BPH ("Microfocus Systems"). The four versions of the Microfocus System are the Microfocus Models 800, 500C, 100C and 100. The Microfocus System is presently being manufactured via a joint venture in Canada and sold in Europe and the Far East. For the year ended September 30, 1996 the Company sold four (4) Microfocus Systems, with sales from inception of the Company to date totalling over 75 Microfocus Systems.
CLI is conducting preclinical evaluations on its BPH systems to obtain data for the filing of an IDE (Investigational Device Exemption) with the FDA to allow restricted sales of systems to hospitals in the USA. The Company is recently received the protocol from its principal investigator which will allow the Company to proceed with its FDA approval efforts. This procedure is required to place the BPH system in United States hospitals and gather clinical data for safety and efficacy demonstrations. Such demonstrations are necessary to obtain a PMA from the FDA for commercialization in the United States.
Patents and Proprietary Rights
The Company owns no patents. The Company has under license one U.S. patent on the Microfocus 1000, three U.S. patents on the technology underlying the Microfocus APA and one U.S. patent on the technology underlying the improved BPH
treatment system. The United States patents licensed to the Company claim methods and devices which the Company believes are critical to providing safe and efficacious treatment for cancer and BPH. One of the MIT patents as well as the BPH patent also have or will have patent protection in a number of foreign jurisdictions, including Canada and selected European nations.
The patents and the rights under which they are asserted are as follows:
1. DCT Technology. The Company received an exclusive license to the use of the DCT technology from Haim Bither Cancer Institute ("H.B.C.I."). The DCT technology allows the Company to air cool the area being treated with microwaves. The Company has no further obligations to maintain or preserve its rights to use this patent. The Patent expires on May 31, 1999.
2. APA Technology. On June 12, 1996, the Company entered into a Patent License Agreement with the Massachusetts Institute of Technology ("MIT"). The terms of the license agreement have since been modified. Pursuant to the license, the Company has the exclusive right to use the technology in breast, head and neck and deep seated thermotherapy of other organs. Assuming certain milestone criteria are met, the license will not expire until 10 years after the first annual sale or use of the licensed technology or June 1, 2008, unless further extended. The Company is obligated to pay a royalty to MIT based principally upon treatment revenue.
3. BPH Balloon Therapy. On August 23, 1996 the Company entered into a License Agreement with MMTC, Inc. ("MMTC"). Pursuant to the license, the Company has the exclusive worldwide license to use microwave balloon catheters. The license is perpetual unless certain events of default occur. The Company has paid and is obligated to pay royalties and licensing fees. Failure to comply with the payment obligations will allow MMTC to cancel the license.
There can be no assurance, however, that the patents being licensed will offer any degree of protection from competitors. There can be no assurance that any of the licensed patents or applications will not be challenged, invalidated or circumvented in the future. In addition, there can be no assurance that competitors, many of which have substantial resources and have made substantial investments in competing technologies, will not seek to apply for and obtain patents that will prevent, limit or interfere with the Company's ability to make, use or sell products utilizing the patented technologies in the United States or in international markets.
Other companies have developed or are in the process of developing medical methods and devices to treat BPH and cancer with microwave energy. Several companies have applied for, and in some cases received, patents related to such medical methods and devices. The Company has not received any notices of infringement from any other company.
The Company also relies on trade secrets and proprietary know-how, which it seeks to protect, in part, through proprietary information agreements with employees, consultants and other parties. The Company's proprietary information agreements with its employees and most of its consultants contain industry standard provisions requiring such individuals to assign to the Company, without additional consideration, any inventions conceived or reduced to practice while retained by the Company, subject to customary exceptions. The Company's officers and other key employees also agree not to compete with the Company for a period following termination. There can be no assurance that proprietary information or non-compete agreements with employees, consultants
and others will not be breached, that the Company would have adequate remedies for any breach, or that third parties will not nonetheless gain access to the Company's technology.
Third Party Reimbursement
The Company believes that third party reimbursement will be essential to commercial acceptance of the Microfocus 1000, the Microfocus APA and Microfocus System procedures, and that overall cost effectiveness and physician advocacy will be keys to obtaining such reimbursement. The Company believes that the procedure can be performed for substantially lower total cost than surgical treatments for BPH or cancer or continuous drug therapy. Consequently, the Company believes that third party payers seeking procedures that provide quality clinical outcomes at lower cost will help drive acceptance of the Company's products.
The Company's strategy for obtaining reimbursement in the United States is to obtain appropriate reimbursement codes and perform studies in conjunction with clinical studies to establish the efficacy and cost effectiveness of the its procedures as compared to surgical and drug treatments for BPH and cancer. The Company plans to use this information when approaching health care payers to obtain reimbursement authorizations. The Company also plans to work closely with the medical community to establish an attractive relative value and reimbursement level for the Microfocus procedure.
With the increasing use of managed care and capitation as a means to control health care costs in the United States, the Company believes that physicians may view the Company's products as a tool to efficaciously treat BPH and cancer patients at a lower total cost, thus providing them with a competitive advantage when negotiating managed care contracts. This is especially important in the United States, where a significant portion of the aging Medicare population is moving into a managed care system.
Following regulatory approval, physicians using the Company's Microfocus 1000 or, when completed, the Microfocus APA to treat cancer and the Microfocus System to treat BPH will submit insurance claims for reimbursement for the procedure to third party payers, such as Medicare carriers, Medicaid carriers, Health Maintenance Organizations ("HMOs") and private insurers. In the United States and in international markets, third party reimbursement is generally available for existing therapies used to treat cancer and BPH. The availability and level of reimbursement from such payors for the use of the Company's Microfocus 1000 and the Microfocus System will be a significant factor in the Company's ability to commercialize its cancer and BPH systems. The Company believes that new regulations regarding third party reimbursement for certain investigational devices in the United States will allow it to pursue early reimbursement from Medicare with individual clinical sites prior to receiving FDA approval. However, the Company believes that FDA approval will be necessary to obtain a national coverage determination from Medicare. The national coverage determination for third party reimbursement will depend on the determination of the United States Health Care Financing Administration ("HCFA"), which establishes national coverage policies for Medicare carriers, including the amount to be reimbursed, for coverage of claims submitted for reimbursement related to specific procedures. Private insurance companies and HMOs make their own determinations regarding coverage and reimbursement based upon "usual and customary" fees. Reimbursement experience with a particular third party payor does not reflect a formal reimbursement determination by the third party payor. There can be no assurance that the Company will receive favorable coding,
coverage and reimbursement determinations for its Microfocus System, Microfocus 1000, and when available, Microfocus APA from Medicare and other payers or that amounts reimbursed to physicians for performing its procedure will be sufficient to encourage physicians to use the Company's products.
Internationally, reimbursement approvals for the Microfocus procedure will be sought on an individual country basis. Some international countries currently have established reimbursement authorizations for transurethral microwave therapy. Clinical studies and physician advocacy will be used to support reimbursement requests in countries where there is currently no reimbursement for such procedures.
Manufacturing
The Microfocus 1000 and the Microfocus System were designed to be manufactured under FDA approved Good Manufacturing Procedures ("GMP"). Historically, the Company has manufactured and assembled the Microfocus 1000 in its Columbia, Maryland facility and its Microfocus System at the site of its joint venture in Canada. While the Microfocus System will continue to be manufactured at the current location in Canada, the Microfocus 1000 (and successor products) will be manufactured by third party contractors. The Company intends to manufacture the Microfocus APA in the same manner as the Microfocus 1000.
The Company's products are designed and manufactured with proprietary know how the Company has developed over its history. Proprietary know how is required to manufacture the subassemblies including, but not limited to, the solid-state microwave generators, cooling units, microwave applicators and control algorithms that run the systems. All third party contractors will be required to sign agreements to protect any disclosed proprietary know how.
Research and Development
The Company continues to refine and upgrade the components of its Microfocus 1000 and Microfocus System and to pursue the use of thermotherapy in the treatment of various diseases. The Company also has been successful in developing relationships with outside parties for research and development.
The APA technology recently licensed by the Company was originally developed for phased array radar applications. MIT and the Company have worked together over the past two years in the development of a comprehensive phased array thermotherapy system using prototypes of various array applicators developed for various tumor sites. Preclinical evaluations in test phantoms have demonstrated that one configuration of this system is suitable for the heating of tumors in breast tissue. Further developments will lead to other configurations most suitable for treatment of prostate, brain, liver, lung and other deep seated tumors.
The Company intends to initiate clinical evaluations of the APA technology in the United Kingdom at a cancer research center. The Company is presently negotiating a clinical study research agreement with the institution. Clinical trials in the United States will begin after the receipt of an IDE from the FDA.
The MMTC technology recently licensed by the Company is a bimodal treatment which the Company believes will yield a better and faster response rate while using lower and safer amounts of power. Based upon initial review of the technology, the Company believes the technology can easily be incorporated into the current Microfocus 800 system. Clinical trials are planned for early 1997.
In September 1996, the Company retained the engineering firm of Herbst LaZar Bell Inc. ("HLB") to assist in the adaptation of the APA technology into the Microfocus APA. Under the agreement with HLB, the APA technology will be used to develop a prototype Microfocus APA which will be utilized in treating breast cancer. The engineering will focus on integrating the Microfocus 1000 with the Microfocus APA and updating software. The Company will pay HLB 55% of its standard fee rate and the balance of any fees will be paid in shares of Common Stock at a value of $1.25 per share.
Competition
Thermotherapy For Cancer
The Company believes that there are at least six other domestic firms, as well as a number of foreign firms, producing, or designing and intending to produce, thermotherapy systems to treat cancer. Of those firms, at least four have obtained PMA for their machines and several have obtained IDE for their machines. Some, and possibly all, of those firms have greater resources than those which the Company now has or may reasonably be expected to have in the near future. Other firms not presently in competition with the Company may decide to produce thermotherapy systems which compete with those of the Company. At least some of those firms may reasonably be expected to have resources greater than those of the Company. As acceptance of thermotherapy as a cancer treatment increases, the Company expects that the competition will also increase. There can be no assurance that the Company will be able to successfully meet such competition. In addition, the thermotherapy industry is one of rapid technological change. There can be no assurance that systems or technologies superior to that of the Company will not be produced.
The two major competitors of the Company for the Microfocus 1000 are BSD Medical Corporation in Salt Lake City, Utah ("BSD") and Labthermics Technology, Inc. in Champaign, Illinois ("Labthermics"), each of which manufactures thermotherapy machines competitive with the Company's Microfocus 1000. The major factors in competition for sales of thermotherapy equipment are product performance, product service and product cost. The product performance of the Company's Microfocus 1000 in PMA clinical trials has been superior to the performance of competing machines. The system manufactured by BSD uses microwave technology. Labthermics uses ultrasound technology to heat the cancer site. As previously mentioned, the Company received PMA approval of its Microfocus 1000 on November 17, 1989.
BSD received its FDA approval in 1983 and was allowed to begin marketing its system at that time. To date, BSD has sold approximately 200 thermotherapy systems worldwide. As of September 30, 1996 with the Company's limited marketing efforts, 35 of the Microfocus 1000 have been sold worldwide. Therefore, BSD has a much larger presence in the thermotherapy market than has the Company.
As thermotherapy manufacturers penetrate the market, there will be an increase in price competition. There are signs that price competition is actively taking place in the current market. The Company feels that its business strategy and low production costs for its Microfocus 1000 will enable it to be very price competitive.
Service in the thermotherapy business includes maintenance of the thermotherapy machines to minimize downtime as well as training for personnel who will utilize the machines to render treatment to patients. The Company has warranty and service policies which are competitive within the industry.
The Company's warranty for the Microfocus 1000 is for a period of 12 months and the Company offers a service policy following expiration of the warranty. These terms are substantially similar to the warranties and service policies offered by competitors. The Company provides three to four days of training for the personnel who will be operating each machine that the Company sells. The Company also provides training programs at its facility in Maryland for doctors who desire to receive training on the Company's Microfocus 1000. Both training courses are helpful in marketing the Company's Microfocus 1000, because users who become familiar with one machine have a reluctance to switch to another machine which would require additional training. For this reason, the Company will seek to increase the frequency of its training sessions given at its facility in Maryland. BSD provides a similar training course on a quarterly basis at its facility in Salt Lake City.
Thermotherapy For Prostatic Diseases
The thermotherapy industry is highly competitive. Along with technological developments affecting the equipment, increasing usage of thermotherapy for other medical purposes is also developing. The latest and potentially largest market is the use of thermotherapy for the treatment of prostatic diseases, namely the urethral obstruction caused by Benign Prostatic Hyperplasia (BPH). Due to the increased potential of this marketplace, there will be a greater number of domestic and international companies entering this field. The Company believes there are as many as 10 companies in the USA and as many as 15 companies worldwide which are planning or already active in this marketplace.
On May 7, 1996, the FDA for the first time approved a microwave based BPH treatment device manufactured by EDAP Technomed, Inc. ("Technomed"). This approval should enhance market acceptance of microwave BPH treatment systems both in the United States and abroad but gives Technomed a competitive advantage of being first to the market in the United States. Currently, the Company manufactures and sells its BPH treatment systems outside of the United States through its Canadian facility. The Company's BPH systems are not approved by the FDA for sale in the United States. However, the Company intends to apply for FDA approval in the near future.
With the increased number of companies in the BPH thermotherapy treatment market, many of those companies have greater resources than the companies already in the field of thermotherapy treatment for cancer. Large global companies such as Dornier, Olympus and EDAP Technomed International ("Technomed") will spend large amounts of resources to market and develop the BPH industry. In addition to the above companies, the following are companies offering BPH thermotherapy systems in the worldwide marketplace: BSD, Direx Medical, Technomatix (Primus), Lund Science, Quantum, GENEMED, Bruker, Urologix, and Meditherm. There are several other companies which have not yet brought their products to the international marketplace. Presently, Technomed is considered the market leader with its system called the Prostatron. The Prostatron unit is a high cost system which sells for approximately U.S. $500,000. Other companies are marketing their systems in the range of US $100,000 to $300,000. The Company is manufacturing its line of Microfocus BPH Systems at its facility in Canada and is presently offering the systems in the range of U.S. $50,000 to $150,000. To date, it is believed there are over 600 installed BPH Systems worldwide of which Technomed and Direx have the largest share of approximately 30% combined. There are approximately 75 Microfocus BPH Systems installed worldwide.
Government Regulation
United States Regulation. In the United States, the FDA regulates the sale and use of medical devices, which include the Company's thermotherapy systems for both cancer and BPH. A company introducing a medical device in the United States must go through a two step process. The company must first obtain an Investigational Device Exemption ("IDE") permit from the FDA. In IDE is granted upon the manufacturer adequately demonstrating the safety of the device for patient use. Receipt of the IDE allows the use of the device on patients for the purpose of obtaining efficacy confirmation. A PMA is granted upon compilation of sufficient clinical data to establish efficacy for the indicated use of the device. This process is not only time consuming but is also expensive. Obtaining PMA is a significant barrier to entry into the thermotherapy market. Firms which lack PMA face significant impediments to the successful marketing of their thermotherapy equipment, because under applicable regulations customers can obtain reimbursement from Medicare, Medicaid and health insurers only for treatment with products that have PMA.
CLI has an IDE and PMA for the Microfocus 1000. The Company does not have an IDE on the Microfocus System.
The Federal Communications Commission (the "FCC") regulates the frequencies of microwave and radio-frequency emissions from medical and other types of equipment to prevent interference with commercial and governmental communications networks. The frequency of 915 MHZ has been approved by the FCC for medical applications and machines utilizing that frequency do not require shielding to prevent interference with communications. The Microfocus 1000 and the Microfocus System utilize the 915 MHZ frequency.
In December 1984, the Health Care Financing Administration ("HCFA") approved reimbursement under Medicare and Medicaid for thermotherapy treatment when used in conjunction with radiation therapy for the treatment of surface and subsurface tumors. At this time, most of the large medical insurance carriers in the United States have approved reimbursement for such thermotherapy treatment under their health policies. Thermotherapy treatment administered using equipment which has received PMA is eligible for such reimbursement.
The Company and its facilities are subject to inspection by the FDA at any time to insure compliance with FDA regulations in the production and sale of medical products. Failure to comply or maintain compliance with those regulations could have a material adverse effect upon the Company's operations. The Company believes that it is substantially in compliance with FDA regulations governing the manufacturing and marketing of medical devices.
Foreign Regulation. Sales of medical devices outside of the United States are subject to United States export requirements and foreign regulatory requirements. Export sales of investigational devices that are subject to PMA requirements and have not received FDA marketing approval generally may be subject to FDA export permit requirements under the Federal Food, Drug and Cosmetic Act ("FDC Act") depending upon, among other things, the purpose of the export (investigational or commercial) and on whether the device has valid marketing authorization in a country listed in the FDA Export Reform and Enhancement Act of 1996. In order to obtain such a permit, when required, the Company must provide the FDA with documentation from the medical device regulatory authority of the country in which the purchaser is located, stating that the device has the approval of the country. In addition, the FDA must find that exportation of the device is not contrary to the public health and safety of the country in order for the Company to obtain the permit.
The Company currently sells products in selected countries in Asia and Europe. The registration requirements within these countries is the sole responsibility of the distributors in each of these countries. Legal restrictions on the sale of imported medical devices vary from country to country. The time required to obtain approval by a foreign country may be longer or shorter than that required for FDA approval, and the requirements may differ. The Company expects to receive approvals for marketing in a number of countries outside the United States prior to the time that it will be able to market its products in the United States. The timing for such approvals is not known.
Product Liability and Insurance
The business of the Company entails the risk of product liability claims. Although the Company has not experienced any product liability claims to date, any such claims could have an adverse impact on the Company. In the past and currently, the Company has not maintained product liability insurance. The Company is currently in the process of securing product liability insurance in the amount of $5,000,000. The Company evaluates its insurance requirements on an ongoing basis. There can be no assurance that product liability claims will be covered by such insurance, will not exceed such insurance coverage limits or that such insurance will be available on commercially reasonable terms or at all.
Terminated Business Opportunities
Due to the slow development of the market for thermotherapy products, the Company sought to develop other business opportunities to provide a quicker and greater return to the Company's shareholders. With the recent acquisition of new technology, the Company believes that its best opportunity for long-term growth is to focus its activities on its core business--thermotherapy products. Accordingly, the Company has terminated, or is terminating, the joint ventures and/or business opportunities which do not focus on or enhance the core business. The following are assets and projects which have been terminated during 1996:
Aestar Fine Chemical Company. The Company has previously disclosed the investment in the Company by Mr. Gao Yu Wen of assets valued at approximately $10,000,000 in exchange for 20,000,000 shares of Common Stock of the Company. As part of the investment of Mr. Gao in the Company, Mr. Gao transferred to the Company a 9.5% interest in the Aestar Fine Chemical Incorporation Limited Company ("Aestar"). Aestar is a corporation organized under the laws of the People's Republic of China. The Company originally looked to this interest in Aestar as a significant source of dividend income and as a vehicle to facilitate joint ventures for the manufacturing and sale of cosmetics in China.
On June 8, 1996, the parties entered into a Redemption Agreement by which the Company agreed to repurchase from Mr. Gao 16,000,000 shares of the Company's Common Stock in consideration for the Company's 9.5% interest in Aestar and to repurchase an additional 4,000,000 shares of Common Stock at a price of $.55 per shares for a total of $2.2 million. Under the terms of the Redemption Agreement, the entire 20,000,000 shares were retained by Mr. Gao to secure the payment of the $2.2 million. On October 23, 1996, the Company and Mr. Gao, through his representatives, executed an Amendment by which Mr. Gao agreed (i) to immediately deliver to the Company the 16,000,000 shares of Common Stock; (ii) to give the Company an additional one month to purchase the remaining 4,000,000 shares; and (iii) to reduce the purchase price to $2,160,000. Pursuant to the terms of the Amendment, on October 23, 1996, Mr. Gao's representatives delivered duly executed stock certificates and stock powers for the 16,000,000
shares of Common Stock which stock has been cancelled on the records of the Company. This represents a repurchase by the Company of nearly forty percent (40%) of its issued and outstanding stock.
Eastwell Management Services Limited. The Company entered into negotiations to acquire 100% of the outstanding stock of Asia-Pacific Communication Corporation Limited, formerly known as Novatel, Asia ("APC"), from Eastwell Management Services Limited ("Eastwell") in exchange for 24 million shares of the Company's Common Stock and warrants to acquire another five percent (5%) interest in the Company. The proposed terms of the agreement were set forth in an Acquisition Agreement, dated March, 1994 (the "Acquisition Agreement"). APC (which was formerly known as Novatel, Asia) is in the business of manufacturing telecommunications equipment and providing telecommunications services. The consummation of the agreement with Eastwell was contingent upon satisfaction of certain conditions precedent. Because those conditions were not satisfied, the Company elected not to proceed with the agreement with Eastwell. There is no written agreement terminating the contemplated transaction with Eastwell.
Rainbow Ball Development Limited. On October 11, 1993, the Company entered into an agreement with Mr. Carlton Poon ("Poon") whereby Poon agreed to provide approximately $125,000 U.S. to fund a joint venture between the Company and Poon named Rainbow Ball Development Limited ("Rainbow Ball"). Rainbow Ball was formed to develop, manufacture and market certain medical imaging technology and a portable x-ray device. After Mr. Poon funded the $125,000 the parties decided not to proceed with the joint venture. By means of a Termination Agreement, dated August 28, 1996, the parties terminated the joint venture. Under the terms of the Termination Agreement, the Company is to deliver to Mr. Poon 355,757 fully paid and non-assessable shares of Company Common Stock in full satisfaction of all obligations of the Company and Rainbow Ball to Mr. Poon.
Unisol. By Purchase Agreement, dated April 26, 1995, the Company entered into an agreement to purchase a 50% interest in the United Aerosol and Home Products Company, Ltd. ("Unisol"), located in Zhongshan, China, from Cosmos Peace Development Corporation, a Hong Kong corporation ("Cosmos"). The Company was introduced to Unisol through Mr. Gao as part of the joint ventures to be implemented in China. Unisol is a specialty chemical and fine chemical aerosol packaging and bottle/can filling business. The purchase price was to be 20% of the appraised value of Unisol equipment, payable in the Company's Common Stock based upon the value of the Common Stock at the close of business on April 26, 1996. The Unisol acquisition was executed as part of the Gao transaction. The intent of the Unisol acquisition was to manufacture and package personal care and cosmetic products. The agreement was verbally terminated on October 23, 1996, at the same time that the Company executed the Amendment by which the Company redeemed its stock from Mr. Gao. There is no written agreement terminating the relationship between the Company and Unisol.
Ardex Equipment, LLC. The Company invested $450,000 (of which $50,000 has been repaid to the Company) to acquire a 17.1111% interest in Ardex Equipment, LLC ("Ardex"). The Company originally contracted to acquire a controlling interest in Ardex. Ardex manufactures industrial plumbing equipment. With the redemption of the Common Stock from Mr. Gao, the Company is also terminating its relationship with Ardex. Under the terms of a Binding Letter of Intent, dated August 2, 1996, agreed to convert the Company's equity interest into a 5 year negotiable promissory note, to bear interest at the rate of eight percent (8%). The note is payable on an interest-only basis until the principal becomes due. Principal becomes due upon the first to happen of the following: (i) a public or private offering successfully completed by Ardex of $1.5 million in the aggregate or more; (ii) ninety (90) days following a year end of Ardex in which
sales for the year have been $3,000,000 or more; (iii) Ardex having a cash balance of $800,000 or more from operations; or (iv) five years from the date of the promissory note.
Employees
As of September 30, 1996, the Company had seven (7) full-time employees, of whom three (3) are managerial, one (1) is engineering, one (1) administrative, one (1) is in production in the main office in Maryland and one (1) employee is in the Hong Kong office.
None of the Company's employees is represented by a collective bargaining organization. The Company considers its relations with its employees to be good.
ITEM 2.
ITEM 2. PROPERTIES
The Company's corporate headquarters consist of approximately 5,918 square feet of office, laboratory and production space at 10220-I Old Columbia Road, Columbia, Maryland 21046-1705. The Company leases the premises from an unaffiliated party on an oral month-to-month basis. Monthly rent is $4,172.00.
The Company also leases office space consisting of approximately 500 square feet located at 11/F Flat B, Hanley House 68 Canton Road, T.S.T. Kowloon, Hong Kong. The property is leased on an oral month-to-month basis from an unaffiliated party at a monthly lease rate of $1,200 (U.S.).
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company presently is not a party to any litigation, and the Company is not aware of any threat of litigation.
In the normal course of business, the Company may be subject to warranty and product liability claims on its thermotherapy equipment. The Company does not have a product liability insurance policy in effect. The assertion of any product liability claim against the Company, therefore, may have an adverse affect on its financial condition. As of September 30, 1996, no liability claims against the Company have been asserted.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the security holders during the calendar year ending 1996.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded on the NASD OTC Bulletin Board. The quotations set forth below reflect inter-dealer prices, do not include retail markups, markdowns or commissions, and may not necessarily represent actual transactions. There were approximately 2,600 holders of record of the Common Stock as of September 30, 1996. The Company has never paid cash dividends on its stock and does not expect to pay any cash dividends in the foreseeable future.
Year ended September 30 Period 1995 1996 - ------ ---- ---- High Low High Low ---- --- ---- --- 1st Quarter (Oct. 1 to Dec. 31) 19/32 1/4 17/32 1/2 2nd Quarter (Jan. 1 to March 31) 35/64 1/4 5/8 25/64 3rd Quarter (April 1 to June 30) 1 5/8 1-1/16 17/64 4th Quarter (July 1 to Sept. 30) 1-23/32 31/32 1-9/32 21/32
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table summarizes certain financial data for the Company for the years ended September 30, 1996, 1995, 1994, 1993, and 1992 and is qualified in its entirety by, and should be read in conjunction with the Financial Statements, the related Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this report.
(1) Includes $17,009 gain on disposition of investment in Ardex Equipment, L.L.C.
(2) On October 23, 1996, the Company, based on the provisions of an agreement reached on June 6, 1996, as amended, redeemed 16,000,000 shares of its Common Stock. The redemption provided for the Company to return its investment in Aestar Fine Chemical Company (valued at $8,000,000 on the Company's September 30, 1996 balance sheet) and to relinquish its rights to the funds held under an investment contract ($40,000 at September 30, 1996) in order to affect the transaction. This transaction has a significant impact on the financial position, current ratios and stockholder's equity of the Company. If the foregoing transaction had occurred on or before September 30, 1996, total assets would have been reduced by $8,040,000 and stockholder's equity would have reduced by $8,040,000, resulting in a negative stockholder's equity of ($1,284,126).
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-Looking Statements
Statements regarding the Company's expectations as to demand for its products and certain other information presented in this Form 10-K constitute forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Although the Company believes that its expectations are based on reasonable assumptions within the bounds of its knowledge of its business and operations, there can be no assurance that actual results will not differ materially from its expectations. Factors which could cause actual results to differ from expectations include, but are not limited to the following:
1. Decreasing Sales, Increasing Losses and Undercapitalization. The Company's product sales have been substantially decreasing over the past three years. There is no assurance sales will increase with the application of new technologies being developed by the Company. The Company has had increasing losses for the last three years which have resulted in an accumulated deficit of $12,211,633 for the period ending September 30, 1996. Losses will continue until current and future sales increase substantially. The Company lacks adequate capital to finance its research and development and marketing. Lack of adequate capital and governmental regulatory approvals will effect future sales. Furthermore, hyperthermia has not been widely accepted by the medical community as an effective cancer treatment.
2. Limited Products. The Company currently has a limited number of products. Failure to develop new products utilizing current products and newly acquired technology will effect the profitability of the Company.
3. Lack of a Current Marketing Plan. The Company does not have an active current marketing plan. It is developing a plan to share revenue from treatment which is dependant on market acceptance and adequate capitalization.
General
Since inception, the Company has incurred substantial operating losses, principally from expenses associated with the Company's research and development programs, the clinical trials conducted in connection with the Company's thermotherapy systems and the preparation of the related IDE and PMA application for submission to the FDA. The Company has experienced significant operating losses and as of September 30, 1996 had an accumulated deficit of $12,211,633. The Company expects such operating losses to continue and possibly increase in the near term and for the foreseeable future as it continues its product development efforts, expands its marketing and sales activities and scales up its manufacturing operations. The Company's ability to achieve profitability is dependent upon its ability to successfully obtain governmental approvals, manufacture, market and sell its new technology and integrate such technology
into its thermotherapy systems. The Company has not been able to successfully market its current thermotherapy system. There can be no assurance that the Company will be able to successfully commercialize its newly acquired technology and apply it to its current thermotherapy systems or that profitability will ever be achieved. The operating results of the Company have fluctuated significantly in the past on an annual and a quarterly basis. The Company expects that its operating results will fluctuate significantly from quarter to quarter in the future and will depend on a number of factors, many of which are outside the Company's control.
The major obstacles facing the Company over the last several years have been inadequate funding, a negative net worth, and the slow development of the thermotherapy market as a sizeable market due to technical shortcomings of the thermotherapy equipment available commercially. To overcome these problems, during the past two years the Company embarked upon a diversification program whereby the Company sought a strategic partner that could provide both capital and new opportunities for the Company. The result of this effort was the agreement with Mr. Gao Yu Wen which infused capital and gave the Company the opportunity to develop through a strategic alliance was to be a cosmetic and fine chemical business for the sale of these products in China. As set forth above in "Terminated Business Opportunities," the relationship with Mr. Gao has been terminated and the Company has redeemed 16 million of the 20 million shares purchased by Mr. Gao.
The Company has refocused the Company's efforts on the enhancement of current products through the development of new technology and sale of the thermotherapy products as the Company's core business. The Company is currently focused on the enhancement of its thermotherapy equipment and obtaining governmental approvals. Towards this end the Company has licensed the APA technology and the MMTC technology.
The Company anticipates that its results of operations will be affected for the foreseeable future by a number of factors, including its ability to develop the new technology to enhance its current systems, regulatory matters, health care cost reimbursements, clinical studies and market acceptance.
Results of Operations
Comparison of Fiscal Year Ended September 30, 1996 to Fiscal Year Ended September 30, 1995
Product sales decreased to $74,006 in fiscal 1996 from $157,618 in fiscal 1995. The decrease was due, primarily, to decreased emphasis on sales of Microfocus products as the Company sought other business opportunities. With the renewed focus on the development and sale of the Microfocus products, the Company anticipates that sales of its thermotherapy systems will account for all sales in the foreseeable future. The Company will focus on developing its new products. Increased sales of products are not expected until the new technologies are developed and approved for sale by governmental regulatory agencies.
Cost of product sales decreased to $64,406 in fiscal 1996 from $67,350 in fiscal 1995 due to decreased sales volume. The Company expects gross margins to increase in the future due to improved overhead absorption and manufacturing efficiencies.
Research and development expense increased to $94,012 in fiscal 1996 from $18,546 in fiscal 1995 due to increased emphasis on technology enhancements. The Company expects to significantly increase its expenditures for research and
development to fund the development or enhancement of products by incorporating the APA technology and the MMTC technology.
Selling, general and administrative expenses decreased in amount to $1,338,370 in fiscal 1996 from $1,369,845 in fiscal 1995. The Company expects selling and marketing expense to increase substantially as it expands its advertising and promotional activities and increases its marketing and sales force, principally for the commercialization of its thermotherapy systems.
Interest expense decreased to $85,506 in fiscal 1996 from $90,805 in fiscal 1995.
Comparison of Fiscal Year Ended September 30, 1995 to Fiscal Year Ended September 30, 1994
Product sales decreased to $157,618 in fiscal 1995 from $1,086,393 in fiscal 1994. The decrease was due, primarily, to continued slowing sales in the thermotherapy market.
Cost of product sales decreased to $67,350 in fiscal 1995 from $494,946 in fiscal 1994 due to decreased sales volume.
Research and development expense decreased to $18,546 in fiscal 1995 from $202,569 in fiscal 1994. Most of the decrease was due a softening of the marketplace for thermotherapy products and a shift in focus from development efforts relating to the Company's core technologies to seeking new business opportunities and partners.
Selling, general and administrative expenses increased to $1,369,845 in fiscal 1995 from $704,295 in fiscal 1994.
Interest expense decreased to $90,808 in fiscal 1995 from $184,700 in fiscal 1994 due to conversion of debt to equity.
Liquidity and Capital Resources
Since inception, the Company's expenses have significantly exceeded its revenues, resulting in an accumulated deficit of $12,211,633 at September 30, 1996. The Company has funded its operations primarily through the sale of equity securities. At September 30, 1996, the Company had cash, cash equivalents and short-term investments aggregating approximately $246,931. Net cash used in the Company's operating activities was $1,462,588 for the fiscal year ended September 30, 1996.
The Company does not have any bank financing arrangements. The Company's indebtedness consists of two notes payable to Dr. Augustine Cheung with a total face amount of $121,419; a note payable to Yu Shai Lai in the amount of $36,041; a note payable to Ada Lam in the amount of $28,502; a note payable to Ruth Kurz in the amount of $93,750; a note payable to Lake Shu Loon in the amount of $10,000; an oral agreement to pay Charles Shelton an amount currently estimated between $35,000 and $50,000; and trade debt totaling $197,190. In addition, commencing on July 10, 1996, the Company sold $1,205,000 in senior secured convertible notes accruing interest at 8 percent per annum (the "Senior Notes"). The Senior Notes have priority over payment of any other indebtedness of the Company. The holders of the Senior Notes can elect to either convert the notes into Common Stock at an option price of $0.41 per share or be paid principal and interest upon the earlier to occur of (i) the next private offering; or (ii) December 31, 1997.
The Company has incurred negative cash flows from operations since its inception, and has expended, and expects to continue to expend in the future, substantial funds to complete its planned product development efforts, including seeking FDA approval for the domestic sale of the Company's products, expand its sales and marketing activities and scale up its manufacturing. The Company expects that its existing capital resources will not be adequate to fund the Company's operations through the next twelve months. The Company is dependent on raising additional capital to fund its development of technology and to implement a marketing plan. Such dependence will continue at least until the Company begins marketing its new technologies. The Company's future capital requirements and the adequacy of available funds will depend on numerous factors, including the successful commercialization of the thermotherapy systems progress in its product development efforts, the magnitude and scope of such efforts, progress with preclinical studies and clinical trials, the cost and timing of manufacturing scale-up, the development of effective sales and marketing activities, the cost of filing, prosecuting, defending and enforcing patent claims and other intellectual property rights, competing technological and market developments, and the development of strategic alliances for the marketing of its products. To the extent that funds generated from the Company's operations are insufficient to meet current or planned operating requirements, the Company will be required to obtain additional funds through equity or debt financing, strategic alliances with corporate partners and others, or through other sources. The Company does not have any committed sources of additional financing, and there can be no assurance that additional funding, if necessary, will be available on acceptable terms, if at all. If adequate funds are not available, the Company may be required to delay, scale-back or eliminate certain aspects of its operations or attempt to obtain funds through arrangements with collaborative partners or others that may require the Company to relinquish rights to certain of its technologies, product candidates, products or potential markets. If adequate funds are not available, the Company's business, financial condition and results of operations will be materially and adversely effected.
The Company has agreed to pay Gao Yu Wen $2,160,000 on or before March 31, 1997 to redeem 4,000,000 shares of the Company's Common Stock. The Company has agreed to pay MIT $10,000 in 1997 and also must develop time table which requires the expenditure of research and development funds. The Company has also entered into a Settlement Agreement, dated October 28, 1996, whereby the Company undertook to use its best efforts to pay to William O. Cave, a former director, the sum of $194,825 on or before February 28, 1997. The Company has a contingent liability to MMTC in the amount of $50,000 in 1997 if the Company fails to meet the milestones identified under "Patents and Proprietary Rights," above; and must develop criteria which require the expenditure of research and development funds. The Company is also required to pay HLB certain engineering fees, the amount of which are presently unknown. The Company is also required to do clinical trials to prepare for submission of products to the FDA. The amount required to perform such trials and to prosecute the applications in not currently known. The Company does not currently have funds available to do such trials and clinical work. The Company has committed to pay advisors and officers pursuant to contractual arrangements set forth in "Directors and Executive Officers of the Registrant" and "Certain Relationships and Related Transactions." The Company will be dependent on additional capital to be raised to fulfill all of the above agreements and obligations.
During fiscal year 1996, the Company issued a large number of options and warrants in connection with its funding activities. Options or warrants to officers, directors, related parties and five percent (5%) shareholders are addressed in Part III of this Form 10-K. In addition to those options and warrants, the Company has issued options and warrants in connection with funding activities to purchase a total of 4,670,715 shares of Common Stock, with
exercise prices ranging from $.25 per share to $.41 per share. Some of the warrants issued have anti-dilution provisions which may affect the total number of shares available for purchase under the warrants.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements, supplementary data and report of independent public accountants are filed as part of this report on pages through.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
No change of accountants and/or disagreements on any matter of accounting principles or financial statement disclosures have occurred within the last two years.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The directors and executive officers of the Company are as follows:
Name Age Positions with the Company - -------------------- ----- -----------------------------------
Augustine Y. Cheung 49 Chairman of the Board Verle D. Blaha 66 Chief Executive Officer, President and Director Charles C. Shelton 51 Executive Vice President and Director Robert F. Schiffmann 61 Director Joseph M. Colino 57 Director John Mon 44 Treasurer/General Manager
Dr. Cheung was the founder of the Company, was President from 1982 to 1986, was Chief Executive Officer from 1982 to 1996 and has been Chairman since 1982. From 1982 to 1985, Dr. Cheung was a Research Associate Professor of the Department of Electrical Engineering and Computer Science at George Washington University and from 1975 to 1981 was a Research Associate Professor and Assistant Professor at the Institute for Physical Science and Technology and the Department of Radiation Therapy at the University of Maryland. Dr. Cheung holds a Ph.D. and Masters degree from University of Maryland.
Mr. Blaha has been a director, President and Chief Executive Officer of the Company since September 6, 1996. Prior to joining the Company, Mr. Blaha provided consulting services to the microwave industry. From 1986 to 1991, Mr. Blaha was a director, and the President and Chief Operations Officer for the Company. From 1982 to 1986, Mr. Blaha was Vice President and General Manager of Holaday Industries, Inc. From 1957 to 1982, Mr. Blaha held a succession of senior management positions at Litton Industries, Inc. Mr. Blaha was Senior Vice President of Technology and Development of Litton's Microwave Cooking Products Division. Mr. Blaha holds a B.S.B and an MBA degree from University of Minnesota.
Mr. Shelton has served as the Company's in-house counsel from 1993 to 1996, and as Executive Vice President and a director from 1993. Mr. Shelton has practiced in the areas of corporate and tax law with Charles C. Shelton, PA, from 1993 to the present. From 1973 to 1993, he practiced law with Semmes, Bowen & Semmes. Mr. Shelton is a Vice President and director with HRP Technologies, Inc. (previously known as Ardex Equipment, LLC), a public company traded on the Bulletin Board.
Mr. Colino has been a director since 1995. From 1991 to the present, Mr. Colino has served as the President of HRP Technologies, Inc. (previously known as Ardex Equipment, LLC) and Parec Enterprises, Inc..
Mr. Schiffmann has served as a director of the Company since September 1986. Since 1991, Mr. Schiffmann has served as President of R. F. Schiffmann Associates, Inc., a microwave consulting laboratory. He is also Chairman of Quicklave L.L.C., and Microwave Concepts, Inc., which are independent research companies specializing in microwave technology. Mr. Schiffmann holds a Bachelor of Science Degree in Pharmaceutical Science from Columbia University and a Master of Science degree from Purdue University.
Mr. Mon has served as Treasurer/General Manager of the Company since 1989. From 1984 to 1988, Mr. Mon was an economist with the U.S. Department of Commerce in charge of forecasting business sales, inventory and prices for all business sectors in the estimation of Gross National Product. Mr. Mon holds a B.S. degree from the University of Maryland.
Mr. Shelton and Mr. Colino have notified the Company that they will not serve on the Board of Directors after the expiration of their current terms and, accordingly, they are not seeking re- election to the Board of Directors.
Nominee to the Board of Directors
The following individual has been nominated to serve on the Board of Directors:
Warren C. Stearns. Mr. Stearns was nominated to serve to on the Board of Directors on August 14, 1996. Mr. Stearns has been and currently is President of Stearns Management Company, a capital advisory firm, since 1989. Prior to 1989, Mr. Stearns acted as vice president of Stearns Management Company. Mr. Stearns holds an M.B.A. degree from Harvard University and a B.A. degree from Amherst College.
Advisory Board
The Company is presently organizing an Advisory Board to be comprised of business and industry professionals and experts. The Company presently anticipates have as many as six members on the Advisory Board. The purpose of the Advisory Board will be to assist the management of the Company in identifying technology trends and new business opportunities within the industry. The Advisory Board will operate in a consulting fashion and will not act as managers or directors of the Company. The following persons have been nominated to serve on the Company's Advisory Board:
Stuart Fuchs. Mr. Fuchs has been nominated to serve as Chairman of the Advisory Board. He is President of Nace Resources, Inc., a firm providing consulting and marketing services to companies in the biotechnology and medical device fields.
Prior to founding Nace in 1995, Mr. Fuchs was an investment banker in the Fixed Income Division of Goldman Sachs & Co. in New York and Chicago. Until joining Goldman Sachs in 1976, he was an attorney practicing securities and tax law with Barrett Smith Shapiro & Simon in New York, New York. Mr. Fuchs is a graduate of Harvard College and Harvard Law School.
Michael Davidson, M.D. Dr. Davidson has been nominated to serve as a member of the Advisory Board. Dr. Davidson is a physician specializing in design of clinical trials. Dr. Davidson currently practices and is President of the Chicago Center for Clinical Research. Dr. Davidson holds a B.A., M.S. from Northwestern University and a M.D. from Ohio State University.
The Company may designate additional individuals to serve on the Advisory Board as the Company identifies individuals with appropriate qualifications.
Compliance with Section 16(a) of the Exchange Act
Section 16(a) of the Securities Exchange Act of 1934 requires the Company's officers and directors, and persons who own more than ten percent of a registered class of the Company's equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission and the National Association of Securities Dealers. Officers, directors and greater than ten-percent shareholders are required by Securities and Exchange Commission regulations to furnish the Company with copies of all Section 16(a) forms they file. Based solely on a review of the copies of such forms furnished to the Company between October 1, 1995 and September 30, 1996, on year-end reports furnished to the Company after September 30, 1996 and on representations that no other reports were required, the Company has determined that during the last fiscal year all applicable 16(a) filing requirements were met except as follows:
Dr. Augustine Y. Cheung, Chairman of the Board of Directors, acquired 2,000 shares of Common Stock on January 17, 1994; acquired 1,2000,000 shares of Common Stock on June 30, 1994; acquired 2000 shares of Common Stock on December 31, 1994; acquired 249,058 shares of Common Stock on June 30, 1995; acquired 52,000 shares of Common Stock on September 30, 1996; and disposed of 195,000 shares of Common Stock on March 7, 1995. Dr. Cheung also received an option to acquire 50,000 shares of Common Stock on December 31, 1996 and an option to acquire 400,000 shares of Common Stock on May 16, 1996. Each of these transactions should have been reported on Form 3 and Forms 4. The transactions were instead disclosed on a Form 5 filed on or about November 10, 1996.
John Mon, Treasurer/General Manager, and a former director of the Company, acquired 2,000 shares of Common Stock on January 17, 1994; acquired 49,800 shares of Common Stock on January 17, 1994; acquired 2,000 shares of Common Stock on December 31, 1994; and acquired 58,505 shares of Common Stock on June 30, 1995. Mr. Mon also received an option to acquire 400,000 shares of Common Stock on May 16, 1996. These transactions should have been reported on Form 3 and Form 4. The transactions were instead disclosed on a Form 5 filed on or about November 10, 1996.
Robert F. Schiffman, a director, acquired 62,000 shares of Common Stock on September 30, 1996 and received an option to purchase 100,000 shares of Common Stock on May 16, 1996. These transactions should have been disclosed on Forms 4. The transactions were instead disclosed on a Form 5 filed on or about November 13, 1996.
Charles C. Shelton, a director and Executive Vice President, acquired 103,000 shares of Common Stock on December 20, 1993; acquired 2,000 shares of Common Stock on January 17, 1994; acquired 150,000 shares of Common Stock on September 9, 1994; acquired 2,000 shares of Common Stock on January 17, 1996; and received an option to acquire 400,000 shares of Common Stock on May 16, 1996. These transactions should have been reported on Form 3 and Form 4. The transactions were instead disclosed on a Form 5 filed on or about November 16, 1996.
Joseph M. Colino, a director, acquired 2800 shares of Common Stock on June 30, 1995. This transaction should have been reported on Form 3. The transaction was instead disclosed on a Form 5 filed on or about November 15, 1996.
ITEM 11.
ITEM 11. Executive Compensation
The following table sets forth the aggregate cash compensation paid for services rendered to the Company in all capacities during the last three fiscal years to the Company's Chief Executive Officer and to each of the Company's other executive officers where annual salary and bonus for the most recent fiscal year exceeded $100,000.
(1) In each of 1994, 1995 and 1996, Dr. Cheung received 2,000 shares of Common Stock for his services as a director.
(2) In 1996, Dr. Cheung received an option to purchase 400,000 shares at $0.35 per share, exercisable on or before May 16, 2001
(3) In 1994, Dr. Cheung received and option to purchase 50,000 shares at $0.125 per share, which he exercised on September 30, 1996.
There are no option, retirement, pension, or profit sharing plans for the benefit of the Company's officers, directors and employees. The Company does provide health insurance coverage for its employees. The Board of Directors may recommend and adopt additional programs in the future for the benefit of officers, directors and employees.
Option Grants in 1996
Information concerning 1996 grants to named executive officers is reflected in the table below. The amounts shown for each of the named executive officers as potential realizable values are based on arbitrarily assumed annualized rates of stock price appreciation of five percent and ten percent over the full five (and in one case eight) year term of the options. These potential realizable values are based solely on arbitrarily assumed rates of price appreciation required by applicable SEC regulations. Actual gains, if any, on option exercises and Common Stockholdings are dependent on the future performance of
the Company and overall stock market conditions. There can be no assurance that the potential realizable values shown in this table will be achieved.
Option Grants in 1996
Aggregated Option Exercises and Year-End Option Values in 1996
The following table summarizes for each of the named executive officers of the Company the number of stock options, if any, exercised during 1996, the aggregate dollar value realized upon exercise, the total number of unexercised options held at September 30, 1996 and the aggregate dollar value of the in-the-money unexercised options, if any, held at September 30, 1996. Value realized upon exercise is the difference between the fair market value of the underlying stock on the exercise date and the exercise price of the option. The value of unexercised, in-the-money options at September 30, 1996 is the difference between its exercise price and the fair market value of the underlying stock on September 30, 1996, which was $1.03 per share based on the closing bid price of the Common Stock on September 30, 1996. The underlying options have not been and may never be exercised; and actual gains, if any, on exercise will depend on the value of the Common Stock on the actual date of exercise. There can be no assurance that these values will be realized.
Aggregated Option Exercises in 1996 and Year-End Option Values
Long-Term Incentive Plan Awards in 1996
The registrant has no "long-term incentive plan".
Future Benefits or Pension Plan Disclosure in 1996
The Company has no such benefit plans.
Director Compensation
During 1996, the Company paid to each outside board member $500 per year. Each director receives an automatic grant of 2,000 shares of Common Stock for each year served.
Employment Contracts and Termination of Employment and Change-In-Control Arrangements
Verle D. Blaha. On August 15, 1996, the Company entered into a letter agreement with New Opportunities, Ltd. ("NOL") a company controlled by Mr. Blaha. Pursuant to the Agreement, Mr. Blaha agreed to become a director, President and Chief Executive Officer of the Company in exchange for the Company paying NOL the following:
1. Payment of $25,000.
2. Payment of $175.00 per hour, to a maximum of 8 hours per day, 40 hours per week regardless of actual time spent.
3. Reimbursement of business expenses and providing residential accommodations in Maryland and all utilities.
4. Options to acquire 400,000 shares of the Company's Common Stock for a term ending August 13, 2004 at a price of $.41.
5. Full indemnity by the Company.
6. The Agreement terminates January 27, 1997, but the Company and Mr. Blaha anticipate that the employment relationship will continue on similar terms.
Other
Stock Option Plans
The Company does not currently have any Stock Option Plans. The Company anticipates adopting such a plan during fiscal year 1997.
Report of the Compensation Committee on Executive Compensation
The Company does not presently have a Compensation Committee, but the Company contemplates formation of a Compensation Committee during the fiscal year 1997.
The Compensation Committee of the Board of Directors will be composed of two non-employee directors. The Committee will be responsible for establishing and administering the compensation policies applicable to the Company's officers and key personnel.
Stockholder Return Performance Graph
Federal regulation requires that inclusion of a line graph comparing cumulative total shareholder return on Common Stock with the cumulative total return of (1) NASDAQ Combined Index and (2) a published industry or line-of-business index. The performance comparison appears below. The Board of Directors and its Compensation Committee recognize that the market price of stock is influenced by many factors, only one of which is Company performance. The stock price performance shown on the graph is not necessarily indicative of future price performance.
[GRAPHIC OMITTED]
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management
The following table sets forth information regarding shares of voting securities of the Company beneficially owned as of September 30, 1996 by: (i) each person known by the Company to beneficially own 5% or more of the outstanding voting securities, (ii) by each director or nominee for director, (iii) by each person named in the summary compensation table and (iv) by all officers and directors as a group.
Name and Addresses Percentage of Officers, Directors and Amount of of Voting Principal Shareholders Common Stock* Securities*(1) - ----------------------------- --------------- ---------------
Augustine Y. Cheung(2)(3) 10220-I Old Columbia Road Columbia, MD 21046-1705 6,669,408 26.46
Verle D. Blaha(2)(5)(6) 14 Sunset Lane North Oaks, MN 55127 1,053,186 4.18
John Mon(2)(7) 10220-I Old Columbia Road Columbia, MD 21046-1705 566,418 2.25
Robert F. Schiffmann(2)(8) 149 West 88th Street New York, NY 10024 310,684 1.23
Joseph M. Colino(2) 1952 Cardinal Lake Drive Cherry Hill, NJ 08003 5,500 **
Charles C. Shelton(2)(3) 9160 Rumsey Road, Suite B-1 Columbia, Maryland 21045-1928 665,250 2.64
Revlon Group, Incorporated and its wholly-owned subsidiary PPI Four Corp. 767 Fifth Avenue New York, New York 10153 1,500,000 5.95
Yue Soon Limited 287-291 Des Vouex Rd. Central, 21st Floor Hong Kong 1,600,000 6.34
Gao Yu Wen Zhongshan Economic Committee Sun Wen Road E. Shigizhongshan Guangdong, China 4,030,000(3) 15.99
Executive Officers and Directors as a group (6 individuals) 9,270,446 36.78 ===================================== ================= ================
* Assumes exercise of all exercisable options held by listed security holders which can be exercised within 60 days from September 30, 1996.
** Less than 1%.
(1) Except as noted, the above table does not give effect to an aggregate of approximately 4,670,715 shares of Common Stock underlying outstanding stock options and warrants held by persons not reflected in this table. Outstanding options and warrants entitle the holders thereof to no voting rights.
(2) Director or Executive Officer.
(3) Includes 400,000 shares underlying an option exercisable commencing May 16, 1995 through May 16, 2001 at $.35 per share.
(4) Since the end of the Fiscal Year, the Company has repurchased from Mr. Gao 16,000,000 shares in exchange for the Company's 9.5% interest in Aestar. Accordingly, Mr. Gao presently owns only 4,030,000 shares.
(5) Does not include 42,000 Common Shares owned by Luveral Blaha, Mr. Blaha's wife. Mr. Blaha disclaims any beneficial ownership with respect to said Common Shares. The Company believes Luveral Blaha owns 42,000 Common Shares.
(6) Includes 400,000 shares underlying an option to New Opportunities, Ltd, an affiliate of Mr. Blaha's. The option exercisable commencing August 15, 1996 through August 14, 2004 at $.41 per share.
(7) Includes 400,000 shares underlying an option to Mr. Mon exercisable commencing May 16, 1996 through May 16, 2001 at $.35 per share.
(8) Includes 100,000 shares underlying an option to Mr. Schiffmann exercisable commencing May 16, 1996 through May 16, 2001 at $.35 per share. Also includes 1,500 shares held by Marilyn T. Schiffmann, his wife; 725 shares held as custodian for Erica M. Payne, UGMA NY; and 725 shares held as custodian for Robert F. Schiffmann Jr. UGMA NY.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
SMC Contract. On May 28, 1996, the Company entered into a consulting agreement with Stearns Management Company ("SMC"). Warren C. Stearns, a nominee to the Board of Directors, is President of SMC. Pursuant to the Agreement, SMC has an exclusive arrangement to render services involving solicitation of outside capital, restructuring the Company, business plans, marketing, election of advisory personnel, adding additional directors and sale of stock by insiders. The agreement is terminable upon 10 days written notice or otherwise stays in effect for one year or until a registration statement covering a public offering of the Company's securities is declared effective by the SEC.
In exchange for such services, SMC was paid $57,000 and the Company (i) granted to SMC a transferable warrant to purchase 168,292 shares of Common Stock (which have been assigned to Amalgam and (ii) agreed to grant to assignees of SMC a warrant to purchase, in the aggregate, a five percent (5%) interest in the equity of the Company as of the next registered public offering of Common Stock of the Company. The warrants, all of which are exercisable at $0.41 per share, contain anti-dilution provisions and are exercisable for five years and renewable for an additional five years. Mr. Stearns is paid a per diem expense of $1,500 per day or $190 per hour and reimbursement for expenses at cost plus 20%.
Nace Resources Contract. On August 1, 1996, the Company entered into a Consulting Agreement with Nace Resources, Inc. ("NRI"), an affiliate of Mr. Fuchs, chairman of the Advisory Board. The agreement requires Mr. Fuchs, as designated consultant, to consult and advise the Company with respect to the development and application of the Company's products and proprietary
technology. The term of the agreement is for a one year period with an additional renewal period. The Company paid $75,000 to NRI and commencing August 1, 1996, shall pay $20,000 per month. NRI has agreed to defer $5,000 per month until the Company receives $5,000,000 of gross proceeds from an offering of the Company's stock. In addition, the Company will reimburse NRI for expenses.
In addition to the compensation due under the terms of the consulting agreement, the Company has agreed to grant to NRI warrants to purchase 397,619 shares of Common Stock, subject to adjustment, at an exercise price of $0.41 per share for consulting services. In addition, the Company has granted to NRI warrants to purchase approximately 195,122 shares of Common Stock at an exercise price of $0.41 per share in exchange for providing certain financial advisory services to the Company in 1996. Finally, Mr. Fuchs will be entitled to additional warrants to purchase shares of Common Stock after completion of the next offering. The number of shares granted will depend on the offering price of the Common Stock.
Promissory Notes. From 1987 through 1995, the Company borrowed money from related parties. In 1996, the Company formalized such borrowings by executing promissory notes to the following related parties:
An unsecured term note, dated June 30, 1994, payable to Dr. Augustine Cheung, accruing interest at the rate of ten percent (10%) per annum, in the amount of $42,669. The principal and accrued interest shall be due and payable on its maturity date on June 30, 1998.
An unsecured term note, dated January 26, 1987, payable to Dr. Augustine Cheung, accruing interest at the rate of twelve percent (12%) per annum, in the amount of $78,750. The principal and accrued interest shall be due and payable on its maturity date on January 26, 1998.
A demand note, dated May 16, 1988, payable to Yu Shai Lai, a relative of Dr. Cheung, accruing interest at the rate of twelve percent (12%) per annum, in the amount of $36,041.
A demand note, dated October 2, 1990, payable to Ada Lam, a former employee, accruing interest at the rate of twelve percent (12%) per annum, in the amount of $28,502.
The Company also may have the obligation to execute a promissory note payable to Charles C. Shelton in the face amount of $50,000. The Company has certain offsets available against Mr. Shelton so the final amount to be due under this promissory note is still under negotiation.
Settlement Agreement. On October 28, 1996, the Company entered into a Settlement Agreement with William O. Cave, a former director of the Company. Under the terms of the Settlement Agreement, the Company paid $30,000 to Mr. Cave and agrees to pay an additional $194,825. The Company is to use its best efforts to pay this sum on or before February 28, 1997. If the balance owing is not paid on or before February 28, 1997, then the outstanding balance shall accrue interest at the rate of 15% per annum. In addition, the Company agreed to grant to Mr. Cave warrants to purchase 56,340 shares of Common Stock at an exercise price of $.50 per share.
Rescission Agreement. On February 16, 1995, Gao Yu Wen executed a subscription agreement with the Company to purchase 20,000,000 shares of Common Stock at $.50 per share or $10,000,000. The price was paid by paying $2,000,000 cash and property transferring to the Company 9.5% of the outstanding equity of Aestar Fine Chemical Company ("Aestar"). On June 6, 1996 the Company and Gao entered a Redemption Agreement wherein the Company renounced any interest in Aestar and Gao agreed that upon the Company delivery $2,200,000 to Gao he would return
return the 20,000,000 shares of the Company. The promise to pay $2,200,000 by November 30, 1996 was secured by all 20,000,000 shares. On October 23, 1996, the Company and Mr. Gao executed a Amendment by which the terms of the Redemption Agreement were modified. Under the terms of the First Amendment, Mr. Gao agreed to immediately convey to the Company certificates representing 16 million shares of Common Stock. The $2,200,000 payment was reduced to $2,160,000 and the timing was extended until December 31, 1996, with an additional three months period at a penalty of 3/4% per month. On October 23, 1996, Mr. Gao conveyed the 16 million shares to the Company.
On April 26, 1995, the Company entered into an Investment Agreement with Gao whereby the Company transferred $700,000 to Gao to invest as agent of the Company at the rate of no less than 17% per annum. Gao repaid $190,000 by September 30, 1996. The remaining amount has been forgiven as part of the Redemption Agreement.
Rescission of Ardex Acquisition. On or about March 31, 1995, the Company invested $400,000 in Ardex Equipment, LLC ("Ardex") and paid $50,000 to Charles C. Shelton and Joseph Colino, who were then directors of the Company, in exchange for a 17.1111% interest in Ardex. In 1996, the Company received $50,000 distribution from Ardex. On August 2, 1996, the Company and Ardex entered into a binding Letter of Intent rescinding the Company's investment in Ardex (the "Rescission"). Pursuant to the Rescission, the Company was to receive a 5-year negotiable promissory note for $350,000 bearing interest at 8% per annum. Interest only is paid until the principal becomes due. Principal is due upon the first of the following events to occur: (i) completion of a public or private offering by Ardex of $1,500,000 or more; (ii) 90 days following the year end in sales have been or exceed $3,000,000; (iii) Ardex having a cash balance of $800,000 or more from operations; or (iv) five years from the date of the note. The note is to be secured by a limited guarantee of Charles C. Shelton, Joseph Colino and John Kohlman only to the extent of their interest in Ardex and their options in the Company. In addition, Mr. Shelton is to execute a promissory note for $15,000; Mr. Colino is to execute a note for $22,500; and Mr. Kohlman is to execute a note for $12,000. These notes will be secured by the same security as the Ardex note. Under the terms of the Rescission, all of the previously mentioned notes and ancillary documents were to have been executed on or before August 31, 1996, but none have been delivered to the Company as of the date hereof. The Company is continuing with its efforts to obtain the documents contemplated by the Rescission.
Legal Fees. Charles C. Shelton, Esq. rendered legal services to the Company throughout the year ended September 30, 1996. Mr. Shelton billed the Company fees totalling $118,204, $92,052 of which was billed by Charles C. Shelton, $10,000 of which was for services as an employee of Company, and $16,152 for expenses.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) Index to Financial Statements and Supplemental Schedules
Title of Documents Page No.
Independent Auditors' Report
Balance Sheet
Statements of Operations
Statements of Changes in Stockholders' Equity
Statements of Cash Flows
Notes to Financial Statements
(a)(2) No schedules are provided because of the absence of conditions under which they are required.
(b) Reports on Form 8-K.
The following reports on Form 8-K were filed by the Company during the last quarter of the period covered by this report.
On August 28, 1996, the Company filed a report on Form 8-K announcing the execution of the an exclusive license agreement with MMTC.
On September 6, 1996, the Company filed a report on Form 8-K announcing the appointment of Verle D. Blaha as acting President and Chief Executive Officer of the Company.
On October 23, 1996, the Company filed a report on Form 8-K announcing the redemption of 16,000,000 shares of the Company's Common Stock from Mr. Gao Yu Wen.
The Company filed no other reports on Form 8-K during the fourth quarter of its fiscal year ended December 31, 1996.
(c) Exhibits.
The following documents are included as exhibits to this report:
Exhibit Description Number 3.1 Articles of Incorporation of the Company as filed May 19, 1982 with the State of Maryland Department of Assignments and Taxation.(1) 3.1.1 Articles of Amendment and Restatement to the Articles of Incorporation of the Company as filed June 21, 1984 with the State of Maryland Department of Assignments and Taxation.* 3.1.2 Articles of Amendment to the Aritcles of Incorporation of the Company as filed December 14, 1994 with the State of Maryland Department of Assignments and Taxation* 3.2.1 Amendment to the By-laws of the Company adopted December 9, 1994*
Exhibit Description Number 9.1 Irrevocable Proxy between Augustine Y. Cheung, as representative of the Company and Gao Yu Wen regarding 20,000,000 shares of Common Stock dated June 6, 1996 (pursuant to the Redemption Agreement, the number of shares governed by the proxy has been reduced to 4,000,000)* 10.1 Patent License Agreement between the Company and Massachusetts Institute of Technology dated June 1, 1996 (Confidential Treatment Requested)* 10.2 License Agreement between the Company and MMTC, Inc. dated August 23, 1996 (Confidential Treatment Requested)* 10.3 Letter Agreement between the Company and H.B.C.I., Inc. dated September 17, 1996* 10.4 Letter Agreement between the Company and Herbst, Lazar, Bell, Inc. dated october 4, 1996* 10.5 Agreement between the Company and Stearns Management Company dated May 28, 1996* 10.6 Consulting Agreement between the Company and NACE Resources, Inc. dated August 1, 1996* 10.7 Settlement Agreement between the Company and William O. Cave, dated October 28, 1996* 10.8 Redemption Agreement between the Company and Mr. Sun Shou Y. representative of Mr. Gao Yu Wen, dated June 6, 1996 and Letter of Intent between the parties dated May 27, 1996* 10.9 Amendment among the Company, Sun Shau Yi, Ou Yang An, Gao Yu Wen, dated October 23, 1996* 10.10 Binding Letter of Intent Concerning Rescission of Cheung Laboratories, Inc. Investment in Ardex Equipment, LLC between the Company and Ardex dated August 2, 1996* 10.11 Letter Agreement between the Company and New Opportunities, Ltd., an affiliate of Verle D. Blaha, dated August 15, 1996* 10.12 Unsecured Promissory Note, dated June 30, 1994, in the amount of $42,669 and bearing interest at ten percent per annum, payable to Augustine Cheung* 10.13 Unsecured Promissory Note, dated January 26, 1987, in the amount of $78,750 and bearing interest at the rate of twelve percent, payable to Augustine Cheung* 10.14 Demand Promissory Note, dated October 2, 1990, in the amount of $28,502 and bearing interest at the rate of twelve percent, payable to Ada Lam* 10.15 8% Senior Secured Convertible Note* 10.16 Registration Rights Agreement* 10.17 Warrant to Purchase Shares of Common Stock of Cheung Laboratories, Inc.* 10.18 Certificate of Warrant to Purchase Common Stock of Cheung Laboratories, Inc. dated June 1, 1996* 10.19 Certificate of Warrant to Purchase Common Stock of Cheung Laboratories, Inc. dated May 28, 1996* 21.1 Subsidiaries of the Registrant 23.1 Consent of Stegman & Company, independent public accountants of the Company* 27.1 Financial Data Schedule
- ------------------ * Filed herewith
(1) Pursuant to Rule 12b-32, this exhibit is incorporated herein by reference to the exhibits filed with respect to the Company's Registration Statement on Form S-1, as amended, originally filed on October 17, 1984, Registration No. 2-93826-W.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CHEUNG LABORATORIES, INC.
December __, 1996 By /s/ Verle D. Blaha --------------------- Verle D. Blaha Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated:
Signature Title Date
/s/ Verle D. Blaha Chief Executive Officer, December __, 1996 - -------------------- President and Director Verle D. Blaha
/s/ John Mon General Manager, Treasurer December __, 1996 - --------------------- John Mon
/s/ Dr. Augustine Y. Cheung Chairman December __, 1996 - ---------------------------- Dr. Augustine Y. Cheung
/s/ Robert F. Schiffmann Director December __, 1996 - ------------------------- Robert F. Schiffmann
/s/ Charles C. Shelton Director December __, 1996 - ------------------------- Charles C. Shelton
/s/ Joseph M. Colino Director December _, 1996 - ------------------------- Joseph M. Colino
CHEUNG LABORATORIES, INC.
REPORT ON AUDITS OF FINANCIAL STATEMENTS
FOR THE YEARS ENDED SEPTEMBER 30, 1996, 1995 AND 1994
No extracts from this report may be published without our written consent
Stegman & Company
INDEPENDENT AUDITORS' REPORT
FINANCIAL STATEMENTS Page
Balance Sheets 1 - 2
Statements of Operations 3
Statements of Changes in Stockholders' Equity 4
Statements of Cash Flows 5 - 6
NOTES TO FINANCIAL STATEMENTS 7 - 15
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders Cheung Laboratories, Inc. Columbia, Maryland
We have audited the accompanying balance sheets of Cheung Laboratories, Inc., as of September 30, 1996 and 1995, and the related statements of operations, changes in stockholders' equity, and cash flows for each of the three years in the period ended September 30, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Cheung Laboratories, Inc., as of September 30, 1996 and 1995, and the results of its operations and its cash flows for each of the three years in the period ended September 30, 1996 in conformity with generally accepted accounting principles.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 of the financial statements, the Company has suffered recurring losses from operations, which raise substantial doubt about its ability to continue as a going concern. Management's plans regarding those matters are also described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Towson, Maryland November 1, 1996
CHEUNG LABORATORIES, INC. BALANCE SHEETS SEPTEMBER 30, 1996 AND 1995
ASSETS
See accompanying notes.
LIABILITIES AND STOCKHOLDERS' EQUITY
CHEUNG LABORATORIES, INC.
STATEMENTS OF OPERATIONS FOR THE YEARS ENDED SEPTEMBER 30, 1996, 1995 AND 1994
See accompanying notes.
CHEUNG LABORATORIES, INC.
STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY FOR THE YEARS ENDED SEPTEMBER 30, 1996, 1995 AND 1994
See accompanying notes.
CHEUNG LABORATORIES, INC.
STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED SEPTEMBER 30, 1996, 1995 AND 1994
See accompanying notes
Cheung Laboratories, Inc.
Statements of Cash Flows (Continued) For the Years Ended September 30, 1996, 1995 and 1994
See accompanying notes.
CHEUNG LABORATORIES, INC.
NOTES TO FINANCIAL STATEMENTS FOR THE YEARS ENDED SEPTEMBER 30, 1996, 1995 AND 1994
1. DESCRIPTION OF BUSINESS
Cheung Laboratories, Inc. (the "Company") is in the business of providing hyperthermia products for medical applications. The Company markets its products internationally and was classified as a development stage company until October 1, 1989.
In an effort to diversify the Company's operations and investments, the Company acquired an interest in the Aestar Fine Chemical Company ("Aestar") in 1995. Aestar is located in the City of Zhongshan, China, and operates in the cosmetic and fine chemicals business. The Company's previous business plan relating to this investment was to use the dividend income it anticipated to receive from Aestar for development of cosmetics and fine chemical joint ventures. Subsequently, in 1996 the Company has reached an agreement with Aestar to rescind this agreement.
Additionally, the Company has rescinded its interest in Ardex Equipment, L.L.C., (Ardex) which operates in the industrial plumbing equipment business.
2. GOING CONCERN UNCERTAINTY
The accompanying financial statements have been prepared in conformity with generally accepted accounting principles, which contemplates continuation of the Company as a going concern. However, the Company has sustained substantial operating losses in recent years. In addition, the Company has used substantial amounts of working capital in its operations.
Further, at September 30, 1996, current liabilities exceed current assets by $646,754. The Company has defaulted on a substantial majority of its loan agreements because cash flow is insufficient to make principal and interest payments on a timely basis. In view of these matters, realization of a major portion of the assets in the accompanying balance sheet is dependent upon continued operations of the Company, which in turn is dependent upon the Company's ability to meet its financing requirements and the success of its future operations.
During 1996, in an attempt to focus its resources on its core business, the Company rescinded its investment in Ardex and entered into an agreement to rescind its investment in Aestar. The rescission of Aestar has been disclosed in the notes to the financial statements as a subsequent event and it had a significant impact on the Company's financial condition and stockholder's equity. See note 14 for a further impact of the rescission.
Despite these efforts, working capital deficits continue as the majority of cash funds raised during 1996 was in the form of the issuance of capital stock and deft financing through private placement.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Accounts Receivable
Accounts receivable consist of the following:
1996 1995 --------------------------
Trade receivables $138,465 $192,444 Related party receivables: Microfocus 1,910 1,316 Ardex Equipment, L.L.C. 34,730 - Allowance for doubtful accounts (20,770) (56,659) --------- --------- $154,335 $137,101 ======== ========
Inventories
Inventories are stated at the lower of cost or market. Cost is determined using the average cost matters. Inventories are comprised of the following at September 30:
1996 1995 -----------------------------
Materials $169,752 $220,553 Work-in-process 46,062 52,449 Finished products 55,138 28,277 --------- ---------
$270,952 $301,279 ======== ========
Property and Equipment
Depreciation is computed using the straight-line method for financial reporting and accelerated methods for tax reporting purposes. Depreciation is computed over the estimated useful lives of the assets as follows:
Furniture and office equipment 5 years Laboratory and shop equipment 5 years
Depreciation expense for the years ended September 30, 1996, 1995 and 1994 was $7,868, $7,259 and $6,380 respectively. Major renewals and betterments are capitalized at cost, and ordinary repairs and maintenance are charged against operations as incurred. Related costs and accumulated depreciation are eliminated from the accounts upon disposition of an asset and the resulting gain or loss is reflected in the statement of operations and accumulated deficit.
Investments - at Equity
Investments in which the Company has a 20% to 50% interest or otherwise exercises significant influence are carried at cost, adjusted for the Company's proportionate share of their undistributed earnings or losses. Otherwise, investments are carried at cost and dividend income is recognized as earned in other income.
Patent Licenses
The Company has purchased several licenses to use the rights to patented technologies. Patent licenses are amortized straight-line over the remaining patent life. Amortization expense for the years ended September 30, 1996, 1995 and 1994 was $10,678, $6,663 and $6,663, respectively.
Revenue Recognition
Revenue is recognized when systems, products or components are shipped and when consulting services are rendered. Deferred revenue includes customer deposits received on contingent sale agreements.
Research and Development
Research and development costs are expensed as incurred. Equipment and facilities acquired for research and development activities which have alternative future uses are capitalized and charged to expense over their estimated useful lives.
Net Income (Loss) Per Share
Net income (loss) per share is computed based upon common shares outstanding during the periods after giving retroactive effect to all stock splits and conversions. Net income (loss) is based on the actual weighted average number of common shares outstanding during the period of 39,499,650 for 1996, 23,466,070 for 1995, and 16,912,978 for 1994.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
4. PROSPECTIVE ACCOUNTING PRONOUNCEMENTS
Accounting for the Impairment of Long-Lived Assets
In March 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, (SFAS No. 121). SFAS No. 121 requires that assets to be held and used be evaluated for impairment whenever events or circumstances indicate that the carrying value may not be recoverable. SFAS No. 121 also requires that assets to be disposed of be reported at the lower of cost or fair value less selling costs. Implementation of SFAS No. 121 is not expected to have a material impact on the results of operations or financial position. SFAS No. 121 is effective for the Company as of October 1, 1996.
Accounting for Stock Based Compensation
In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation (SFAS No. 123), which is effective for the Company's year ending September 30, 1997. SFAS No. 123 allows companies either to continue to account for stock-based employee compensation plans under existing accounting standards or to adopt a fair-value-based method of accounting as defined in the new standard. The Company will follow the existing accounting standards for these plans, but will provide pro forma disclosure of net income and earnings per share as if the expense provisions of SFAS No. 123 had been adopted. Implementation of SFAS No. 123 is not expected to have a material impact on results of operations or financial condition.
5. RELATED PARTY TRANSACTIONS
Notes Receivable - Related Parties
Notes receivable due from related parties consist of the following:
1996 1995 ------------------------
Term note due August 31, 2001 from Ardex Equipment, L.L.C., accruing interest at 8% per annum. $350,000 $ -
Term note due August 31, 2001 from the principals of Ardex Equipment, L.L.C., accruing interest at 8% per annum. 50,000 - --------- ------
$400,000 $ - ======== =====
Notes Payable - Related Parties
Notes payable to related parties as of September 30 are comprised of the following:
Interest accrued on these notes amounted to $339,660 and $343,265 at September 30, 1996 and 1995, respectively.
Notes Payable - Private Placement
During the year ended September 30, 1996, the Company issued $1,205,000 in senior secured convertible notes accruing interest at 8% per annum. The notes and accrued interest have priority over payment of any other indebtedness of the Company. On or after the next private offering, or upon maturity, whichever shall first occur, the holder may elect to convert the principal amount and any accrued interest into common stock at an option price of $.41 per share or can elect to be repaid from the proceeds of the private offering. The notes mature and become due the earlier of the next private offering or December 31, 1997. Interest accrued on these notes amounted to $1,262 at September 30, 1996.
6. INVESTMENT IN AESTAR FINE CHEMICAL COMPANY - AT COST
During 1995, the Company acquired a 9.5% equity interest in Aestar Fine Chemical Company (Aestar) in exchange for 16,000,000 shares of its common stock. The investment is carried at cost, as measured by the $.50 per share fair market value of the 16,000,000 shares of the Company's common stock. There were no dividends received during the years ended September 30, 1996 and 1995. The common stock of Aestar is not actively traded, therefore the market value of this investment is not readily determinable. The Company has subsequently entered into an agreement to rescind this investment. See note 14 to the financial statements.
7. INVESTMENT IN ARDEX EQUIPMENT, L.L.C. - AT EQUITY
The Company purchased a 19.25% equity interest in Ardex Equipment, L.L.C. (Ardex) in 1995. The investment is carried at cost, adjusted for the Company's proportionate share of Ardex's loss from the purchase date through September 30, 1995. Ardex is not actively traded, therefore the market value of this investment is not readily determinable. During 1996, the Company entered into an agreement to rescind its investment in Ardex, the effects of which are reflected in these financial statements.
8. FUNDS HELD UNDER INVESTMENT CONTRACT
During 1995, the issuance of 20,000,000 shares of common stock to Mr. Gao Yu Wen enabled Mr. Gao to obtain a majority interest in the Company. Mr. Gao has essentially recapitalized the Company through this investment of $2,000,000 in cash and an $8,000,000 interest in Aestar. Pursuant to the terms of an investment agreement between the Company and Mr. Gao, the Company has invested surplus working capital funds in Hong Kong and China. At September 30, 1995, the Company had drawn $50,000 from the account, reducing the balance to $650,000. The balance as of September 30, 1996 has been further reduced to $40,000 to reflect $471,000 in costs incurred by Mr. Gao while developing a cosmetic division in Hong Kong on behalf of the Company, per an agreement, subsequently entered into to rescind the investment in Aestar Fine Chemical Company.
9. INCOME TAXES
Income tax expense on (loss) income before extraordinary item differs from that computed at the federal income tax rate as follows:
1996 1995 1994 ------------------------------------
Income tax (benefit) at statutory rate (34%) $(657,380) $(475,088) $(128,272) Tax benefits not recognized 657,380 475,088 - --------- --------- --------
Income tax (benefit) expense $ - $ - $(128,272) =========== ========= =========
The tax benefit of net operating losses has been completely offset by a valuation allowance until the Company demonstrates earnings that would utilize the net operating loss carryforwards. The 1994 tax benefit resulted from utilizing net operating loss carryforwards as a result of a gain from the forgiveness of debt. At September 30, 1996, the Company has net operating loss carryforwards exceeding $10,000,000. These carryovers expire in various amounts through the period 1997 to 2011. Due to the sale of stock to the majority stockholder, the use of the net operating losses will be subject to an annual limitation.
10. COMMON STOCK
During the year ended September 30, 1996, the Company issued 1,299,711 shares of common stock for $419,510, 689,985 shares were issued to extinguish debt, and 9,000 shares were issued as payments for various operating expenses.
During the year ended September 30, 1995, the Company issued 20,000,000 shares of common stock in exchange for $2,000,000 in cash and $8,000,000 as a 9.5% interest in the Aestar from an investor. This transaction enabled the investor to obtain a majority interest in the Company's common stock. Additionally, the Company issued 3,000 shares of common stock for $1,500, 360,000 shares were issued to extinguish debt, and 221,000 shares were issued as payments for various operating expenses.
During the year ended September 30, 1994, the Board of Directors and stockholders authorized the issuance of 35,100,000 additional shares of common stock. In addition 219,251 of retired shares were reissued, 2,174,800 shares were issued to extinguish debt and 329,600 shares were issued as employee wages.
11. STOCK OPTIONS AND WARRANTS
The Company has granted stock options to certain employees on a periodic basis at the discretion of the Board of Directors. Options are granted at market value at the date of the grant and are immediately exercisable. Following is a summary of stock options as of and for the year ended September 30, 1996:
For the year ended September 30, 1996:
Share options granted 2,420,000 Price range of share options granted $.35 to $.41 Options exercised 100,000 Price range of shares exercised $.35 to $.41
As of September 30, 1996:
Unexercised options outstanding 2,850,000 Weighted average exercise price $.34 Price range of outstanding options $.25 to $.41
As of September 30, 1996 there were warrants outstanding to purchase 3,320,715 shares of the Company's stock at a price of $.41 per share. The Company is also obligated to sell additional shares to certain individuals at a price based on future stock sales by the Company.
12. COMMITMENTS AND CONTINGENCIES
Potential Liability and Insurance
In the normal course of business, the Company may be subject to warranty and product liability claims on its hyperthermia equipment. Currently, the Company does not have a product liability insurance policy in effect although management does anticipate obtaining such coverage when adequate financial resources are available. The assertion of any product liability claim against the Company, therefore, may have an adverse effect on its financial condition. As of September 30, 1996, no product, warranty claims or other liabilities against the Company have been asserted.
Warranty Reserve
The Company warrants its hyperthermia units to be free from defects in material and workmanship under normal use and service for the period of one year from the date of shipment. Claims have been confined to basic repairs. Given the one year limitation of the warranty, management has elected to not set up a warranty reserve but, instead, to expense repairs as costs are incurred.
13. GAIN ON EXTINGUISHMENT OF DEBT
The 1994 extraordinary gain of $591,728 (net of income taxes) results from the forgiveness of notes payable and accrued interest.
14. SUBSEQUENT EVENT - STOCK REDEMPTION
On October 23, 1996, the Company, based on the provisions of an agreement reached on June 6, 1996, redeemed 16,000,000 shares of its common stock.
The redemption provided for the Company to return its investment in Aestar Fine Chemical Company (valued at $8,000,000 on the Company's September 30, 1996 balance sheet) and to relinquish its rights to the funds held under investment contract ($40,000 at September 30, 1996) in order to affect the transaction. This transaction has a significant impact on the financial position, current ratios and stockholders' equity of the Company. If the foregoing transaction had occurred on or before September 30, 1996, total assets would have been reduced by $8,040,000, and stockholders' equity would have decreased by $8,040,000, resulting in a total negative stockholders' equity of $(1,284,126).
As part of this agreement, the Company has the option to redeem an additional 4,000,000 shares owned by the Gao Group if a payment of $2,160,000 is made on or before December 31, 1996. This deadline may be extended until March 31, 1997 with the payment of an .75% monthly interest factor.
15. SUBSEQUENT EVENT - PURCHASE OF PORTABLE X-RAY TECHNOLOGY
On August 28, 1996, the Company entered into a termination agreement with Carlton Poor, a representative of Rainbow Ball Development Limited ("Rainbow Ball"). This agreement terminated a previous agreement with Rainbow Ball under which the Company was to share its portable x-ray business line. The termination agreement returns all rights to the portable x-ray business line to the Company in exchange for 355,757 shares of the Company's common stock to be issued in October 1996.
16. SUBSEQUENT EVENT - TERMINATION OF PURCHASE OPTION
On April 26, 1995, the Company entered into an agreement to purchase a 50% interest in the United Aerosol and Home Products Company, LTD ("Unisol"), located in Zhongshan, China. Unisol is a specialty chemical and fine chemical aerosol packaging and bottle/can filling business. The purchase price was to be 20% of the appraised value of Unisol equipment, payable in the Company's common stock at the close of business on April 26, 1996. The Unisol acquisition was executed as part of the Gao transaction. This agreement was verbally terminated on October 23, 1996, at the same time that the Company executed the agreement by which the Company redeemed its stock from Mr. Gao.