View:
10/18/07
Securities
and Exchange Commission
100
F
Street, NE
Washington,
D.C. 20549
Attn:
Brian R. Cascio, Accounting Branch Chief, Division of Corporation
Finance
RE: Response
to SEC Comment Letter dated 09/27/07
Dear
Mr.
Cascio,
We
received a letter from you dated September 27, 2007 with review comments
on our
Form 10-K for the fiscal year ended December 31, 2006 and Form 10-Q for the
quarter ended June 30, 2007 (File No. 0-32501).
We
are
pleased to provide the following response to your comments.
SEC
Comment #1:
Form
10-K for the fiscal year ended 12/31/2006 – Variable Interest Entity, page
46
We
note
your disclosure that Olympus is protected from absorbing all expected losses
in
the Joint Venture and may not be an “at risk” holder. Please tell us
how you concluded that Olympus and not Cytori is the primary
beneficiary.
Company
response to SEC comment #1:
As
noted
in our disclosure, significant judgment was involved in determining the primary
beneficiary of the Joint Venture (or “JV”). We determined Olympus to
be the primary beneficiary based on analysis performed in accordance with
FIN
46R. Paragraph 17 of FIN 46R states if two or more related parties
together hold an aggregate variable interest in a Variable Interest Entity
(“VIE”) that would, if held by a single party, identify that party as the
primary beneficiary, then the primary beneficiary is the party most closely
associated with the VIE. Paragraph 17 requires an analysis of all
relevant facts and circumstances in determining who is most closely associated
with the VIE, including the following considerations:
A)
The
existence of a principal-agency relationship between parties within the related
party group.
Although
Olympus and Cytori (as 50/50 owners) are both exposed to the economic
variability of the Joint Venture, a de facto agency relationship exists between
Olympus and the JV due to provisions contained within the Shareholders’
Agreement that provide that Olympus controls the JV Board, with three out
of
five Board members including Chairman. All significant decisions are
made by the Board, and although certain specified activities of the JV require
the consent of both shareholders, under the current ownership structure Cytori
does not have any participatory rights that would overcome the presumption
of
control by Olympus.
1
B)
The
relationship and significance of the activities of the VIE to the various
parties within the related party group.
The
Joint
Venture was formed to develop and manufacture future generation medical devices
based on our Celution™ System. Cytori contributed intellectual
property (“IP”) to the JV that will be used to develop the
device. While the primary development activities are currently the
responsibility of Olympus, Cytori will contribute ongoing research efforts
and
assistance in the coordination of the quality systems in conjunction with
Cytori’s regulatory efforts. Since Olympus is currently the primary
developer and effectively controls the JV (which includes the intellectual
property contributed by Cytori), we have concluded that the principal activities
of the JV are more closely associated with Olympus than Cytori.
C)
A
party’s exposure to the expected losses of the VIE.
Although
both Olympus and Cytori are exposed to the economic variability of the Joint
Venture (as noted in “A.” above), Olympus also holds a put option that could
require Cytori to repurchase its interests in the Joint Venture. This
possibility is contingent upon certain specific insolvency or change of control
events at Cytori. The put option does create a possibility that
Olympus could be protected from absorbing expected losses in the Joint
Venture. However, it was our judgment that this somewhat remote
possibility did not outweigh the additional factors under consideration,
namely
the activities of the JV and Olympus’ majority control of the Board of
Directors.
D)
The
design of the VIE.
The
Joint
Venture is set up with each shareholder owning a 50% interest. Cytori
contributed IP to the JV in exchange for its 50% ownership, while Olympus
contributed $30,000,000. The Common Stock Purchase Agreement entered
into in mid-2005 granted Olympus a 7% (as of 9/30/05) equity stake in Cytori,
but the proceeds received by Cytori of $11,000,000 exceeded the fair value
of
the equity received by Olympus. This premium was paid (at least in
part) as a direct incentive by Olympus for Cytori to grant Olympus an interest
in the JV. Also, as noted above, in paragraph A, Olympus controls the
JV Board, with three out of five Board members including the
Chairman.
Based
on
the above analysis, we believe that Olympus is the party which has activities
most closely associated with those of the JV and should therefore be considered
the primary beneficiary and consolidate the entity.
2
SEC
Comment #2:
Financial
Statements – Note 2. Revenue Recognition, page 61
Please
tell us and disclose in future filings your basis for recognizing revenues
under
research and development arrangements and why these would not be recorded
as a
reduction to research and development expenses. We note the
disclosure on page 61 that you are reimbursed for “qualifying expenditures”
under some of these arrangements.
Company
response to SEC comment #2:
Reimbursement
for “qualifying expenditures” relates to grant funding from our arrangement with
the National Institute of Health (“NIH”). Revenues derived from
reimbursement of direct out-of-pocket expenses for research costs associated
with grants are recorded in compliance with EITF Issue 99-19, Reporting
Revenue Gross as a Principal Versus Net as an Agent, and EITF
Issue 01-14, Income Statement Characterization of Reimbursements
Received for “Out-of-Pocket” Expenses Incurred. According to the
criteria established by these EITF Issues, in transactions where we have
the
discretion to choose suppliers, bear credit risk and perform part of the
services required in the transaction, we record revenue for the gross amount
of
the reimbursement. The costs associated with these reimbursements are
reflected as a component of research and development expense in the consolidated
statements of operations. We also note that the government obtains
substantial rights under the arrangement, in the same manner (but perhaps
not to
the same extent) as a commercial customer that similarly contracts with Cytori
to perform research activities. Accordingly, the NIH grant
arrangement should be treated like other customer contracts and recognized
inflows should be classified as revenues in the income
statement. Additionally, similar research and development efforts
would have taken place with or without NIH funding as they are key component
of
the entity’s ongoing or central operations. Thus inflows generated by
such activities are recognized as revenue in accordance with SFAS No. 6 as
discussed below.
Statement
of Financial Accounting Concepts No. 6 defines revenues as “inflows or other
enhancements of assets of an entity or settlements of its liabilities (or
a
combination of both) from delivering or producing goods, rendering services,
or
other activities that constitute the entity's ongoing major or central
operations”. Research arrangements we have with commercial
enterprises such as Olympus and Senko are considered a key component of our
central and ongoing operations. Accordingly, the inflows from such
arrangements are presented as revenues in our income statement.
Revised
Future Disclosure:
Revenues
derived from reimbursement of direct out-of-pocket expenses for research
costs
associated with grants are recorded in compliance with EITF Issue No.
99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent,
and EITF Issue No. 01-14, Income Statement Characterization of
Reimbursements Received for “Out-of-Pocket” Expenses Incurred. In
accordance with the criteria established by these EITF Issues, the Company
records grant revenue for the gross amount of the reimbursement. The costs
associated with these reimbursements are reflected as a component of research
and development expense in the consolidated statements of
operations.
Additionally,
research arrangements we have with commercial enterprises such as Olympus
and
Senko are considered a key component of our central and ongoing
operations. Accordingly, the inflows from such arrangements are
presented as revenues in the consolidated statements of operations.
3
SEC
Comment #3:
Note
4. Transaction with Olympus Corporation, page 67
Please
tell us and disclose in future filings the basis for your accounting treatment
of the proceeds received from the common stock purchase agreement with
Olympus. Clarify why you recorded the difference between the proceeds
received and the fair values of your common stock and option liability as
deferred revenue. Clarify the specific revenue arrangement or
activity that this relates to, how the amount of deferred revenue related
to
this activity was determined and how it will be recognized. Clarify
why the difference should not have been recorded to additional paid-in
capital.
Company
response to SEC comment #3:
The
difference between the proceeds received and the fair values of the common
stock
and option liability was recorded as deferred revenue, since conceptually,
at
least some of the excess proceeds represent a prepayment for future
contributions and obligations of Cytori for the benefit of the Joint Venture,
rather than solely as an equity investment in Cytori. These
contributions include 1) the granting of an exclusive, perpetual license
to
Cytori’s device related Adipose Stem Cell intellectual property to the JV, and
2) Cytori’s performance of research and development activities related to
Adipose Stem Cell device technology that will benefit the JV. Cytori
will also perform work relative to the development and commercialization
of the
specific Devices that the JV is developing, in addition to certain regulatory
efforts under the development agreement.
According
to EITF 00-21 and SFAS 133, separate contracts should be combined and evaluated
as a single arrangement when they are negotiated in tandem. The
Common Stock Purchase Agreement specifically contemplated and identified
the
Joint Venture arrangement, subsequently entered into by Olympus and Cytori,
as
its “Purpose”. Accordingly, we believe that it is most accurate that these
be linked for accounting purposes. Therefore, in light of the direct
linkage between the Common Stock Purchase Agreement and the JV arrangement,
and
the premium paid above the market price of the shares, we have concluded
that it
is reasonable to presume that the $11,000,000 proceeds paid by Olympus
contemplate more than a simple equity investment in Cytori.
As
a
result, the common stock and additional paid-in capital balances resulting
from
the Olympus transactions have been valued based on Cytori’s closing market price
for its listed shares on the last trading day prior to the time that the
Common
Stock Purchase Agreement was signed. Also note that the fact that
Cytori’s common stock was relatively thinly traded has no bearing on the
accounting described above. Management believes that SFAS 123R (the
closest analogous accounting guidance) suggests that the best measure of
fair
value is quoted market prices, even if a company’s stock is thinly
traded.
4
As
noted
above and in our footnote disclosure, the deferred revenue component of the
$11,000,000 was calculated as the remaining proceeds after deducting the
fair
value of the option liability and the market value of the common
stock. The recognition of this deferred amount is based on a
proportional performance methodology. Cytori will recognize revenues
from the license/development accounting unit using a proportional performance
methodology, resulting in the de-recognition of amounts recorded as deferred
revenues as Cytori completes various milestones underlying the development
services.
The
relative values assigned to each milestone involved substantial judgment.
The
assignment process was based on discussions with persons responsible for
the
various aspects of the development process as well as the relative cost of
completing each milestone. Cytori acknowledges that the SEC believes
that recognizing revenues based on costs incurred is not appropriate for
most
contractual arrangements (i.e., other than for long-term construction
contracts). However, we are not, in fact, recognizing revenues as
costs are incurred, but instead recognizing revenues once substantive milestones
(i.e., output measures) are achieved.
Revised
Future Disclosure:
The
difference between the proceeds received and the fair values of the common
stock
and option liability was recorded as deferred revenue, since conceptually,
the
excess proceeds represent a prepayment for future contributions and obligations
of Cytori for the benefit of the Joint Venture (or “JV”), rather than additional
equity investment in Cytori.
The
recognition of this deferred amount will require the achievement of service
related milestones, under a proportional performance methodology. If
and as such revenues are recognized, deferred revenue will be
decreased.
SEC
Comment #4:
Note
4. Transaction with Olympus Corporation, page 67
We
note
the disclosure on pages 36, 45 and 68 of the use of an independent valuation
firm. While management may elect to take full responsibility for
these valuations, if you choose to continue to refer to the expert in any
capacity, please revise future filings, beginning with your next 10-Q, to
name
the independent valuation firm. In addition, please note that if you
intend to incorporate your Form 10-K by reference into any registration
statement, you will be required to include the consent of the independent
valuation firm as an exhibit to the registration statement.
Company
response to SEC comment #4:
Management
has elected to take full responsibility for the valuations of the
Put. In the future filings (beginning with our 3rd quarter
10-Q), we
will discontinue referencing the independent valuation firm.
5
SEC
Comment #5:
Note
5. Gain on Sale of Assets, Related Party, page 70
Note
6. Gain on Sale of Assets, Thin Film Product Line, page
70
We
note
the gain on sale of assets included in other income each year and through
the
second quarter 2007, including the sale of your Thin Film and other product
lines. Please tell us why these gains were not included in income
from operations and why the assets sold do not relate to your operating
activities. See paragraph 46 SFAS 144 and Question 2 of SAB Topic
5.P.
Company
response to SEC comment #5:
We
believed presentation of these gains as other income combined with related
disclosures in the notes to our financial statements was the most conservative
and transparent presentation from the perspective of an outside reader of
our
financial statements based upon the fact these gains were infrequent and
unrelated to our ongoing operations and essentially represented miscellaneous
income.
We
considered Rule 5-03(7) of Regulation S-X which states that material amounts
included miscellaneous other income shall be separately stated in the income
statement or in a note thereto, indicating clearly the nature of the
transactions out of which the items arose. Of the captions specified
by Rule 5-03, we believe this one best captures the essence of the transactions,
which were infrequent dispositions of non-core activities.
We
considered paragraph 26 of APB Opinion 30, which states that an item that
does
not meet the criteria for classification as an extraordinary item should
be
reported as a component of income from continuing operations, but it does
not
specify that the activity must be included within operating income.
We
had
considered Question 2 of SAB Topic 5.P. but concluded that the staff’s guidance
regarding restructuring charges was not analogous to gains from our product
line
sales.
We
acknowledge the applicability of paragraph 45 of SFAS 144, but felt that
the
clearest presentation of the gains for an outside reader was to present them
separately from our on-going operations. As we disclosed in Form 10-K, we
anticipated expanding our research and development expenses to fund clinical
trials costs, pre-clinical research, and general and administrative activities
and expect to continue incurring losses for the foreseeable future and did
not
want to in any way understate the significance of our operating
losses.
Additionally,
as requested by your letter, we are providing the following written statement
in
connection with our response to your comments, acknowledging that:
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The
Company is responsible for the adequacy and accuracy of the disclosure
in
the filing;
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Staff
comments or changes to disclosure in response to staff comments
do not
foreclose the Commission from taking any action with respect to
the
filing; and
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The
Company may not assert staff comments as a defense in any proceeding
initiated by the Commission or any person under the federal securities
laws of the United States.
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You
may
contact us at (858) 458-0900 if you have any questions regarding our
responses.
Sincerely,
/s/
Christopher J. Calhoun
Christopher
J. Calhoun, Chief Executive Officer
/s/
Mark E. Saad
Mark
E.
Saad, Chief Financial Officer
cc:
Jeanne Bennett