UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF … · landscape and processes applicable to payer third-party reimbursement issues in its SEC Form 10-K filed on July 18, 2003,

UNITED STATES DISTRICT COURT

SOUTHERN DISTRICT OF TEXAS

In re CYBERONICS, INC. SECURITIES LITIGATION

This Document Relates To:

ALL ACTIONS.

) ) ) ) ) ) ) ) )

Master File No. H-05-2121

FIRST AMENDED COMPLAINT FOR VIOLATIONS OF THE SECURITIES LAWS

CLASS ACTION DEMAND FOR JURY TRIAL

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INTRODUCTION

1. This is a securities class action for violations of the Securities Exchange Act of

1934 (the “Exchange Act”) brought on behalf of plaintiffs and all other persons, other than

defendants and their affiliates, who purchased the securities of defendant Cyberonics, Inc.

(“Cyberonics” or the “Company”) during the period from February 5, 2004, through August 1,

2006, inclusive (the “Class Period”), and were damaged thereby.

2. Cyberonics is a medical device company focused on the development and

marketing of a programmable electrical pulse generator for cranial nerve stimulation known as

the Cyberonics Implanted Vagus Nerve Stimulation System (“VNS System” or the “VNS

Device”).1 The VNS Device was originally approved for sale by the U.S. Food and Drug

Administration (FDA) in July 1997 as an adjunctive therapy for a very specific use – reducing

the frequency of seizures in a defined group of certain epilepsy patients. Thereafter, based on

scientific data and testing conducted by Cyberonics as to the VNS System’s effectiveness for this

specific epilepsy-related use, Payers (defined herein and by the Company as governmental and

private entities providing insurance payment or coverage for medical treatment) also approved

the VNS Device as “medically necessary” – the established Payer approval standard – for the

device’s intended epilepsy-related purpose. Subsequent to this, the Company undertook to

expand the use of the VNS Device as a therapy for treatment-resistant depression (“TRD”).2

3. The fundamental importance of Payer acceptance and approval of medical devices

such as the VNS System as “medically necessary” for a given usage – i.e., the willingness of

insurers to pay for the product – cannot be understated. Indeed, nothing is more central or

1 The VNS Device is an electric pulse generator, similar to a pacemaker, which is surgically implanted under the skin of the left chest with an electric wire connected from the generator to the patient’s left vagus nerve. Operating on battery power, the VNS Device’s generator sends electric impulses to stimulate the vagus nerve via the electric wire.

2 TRD is form of major depression that is resistant to drug therapy and is often characterized as a poor or unsatisfactory response to several (two to four) courses of therapy with different types of antidepressant medications.

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significant to the actual financial success of a medical device than Payer approval. Put simply,

from a Cyberonics investor’s perspective, while FDA approval opens the door to the potential

for the Company to increase revenue derived from TRD-related VNS Device sales, absent

Cyberonics’ ability to scientifically demonstrate to established Payer standards that the device is

“medically necessary,” the VNS Device for defendants’ represented TRD-related use will be a

market failure.

4. Thus, plaintiffs allege, attendant to defendants’ efforts to expand the acceptable

use of the VNS System to include TRD treatment, defendants simultaneously throughout the

Class Period misled the investing public as to not only the existence of an enormous potential

market for the VNS Device as a TRD treatment but that scientific evidence demonstrated the

“medical necessity” of the device for TRD treatment and that Payers agreed. Defendants’

representations had the desired effect. Cyberonics’ stock price during the Class Period reflected

defendants’ representations, soaring to a Class Period high of $46 on June 24, 2005.

5. Throughout the Class Period, however, defendants knew but concealed from the

investing public that scientific research and evidence fell far short of Payer “medical necessity”

standards for reimbursement, regardless of any FDA approval of the device for sale, and that the

Company had no reasonable basis to represent that Payers agreed otherwise or even supported

the VNS Device for TRD treatment. Throughout the Class Period, defendants concealed that

which their own research specifically indicated – that the VNS Device for TRD treatment not

only fell far short of known science-based Payer standards but remained, at best during the

Class Period, investigational in nature. Indeed, presently pending is a U.S. Senate investigation

into, inter alia, whether “accurate, science-based information on the safety and effectiveness of

the VNS for treatment-resistant depression” had been withheld by defendants from the public

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and Payers, including Medicare and Medicaid (which collectively cover roughly 40% of the U.S.

population).

6. As more fully set forth herein, on the last day of the Class Period the stock price

of Cyberonics’ stock plummeted over 25% to close at $15.89 per share on tremendous single-day

volume, exceeding $5.4million shares, as defendants could no longer continue to pretend that

Payers broadly supported the VNS Device for TRD treatment. Indeed, the Company was forced

to disclose on August 1, 2006, that, rather than determining that there was adequate scientific

evidence to support a finding of “medical necessity” as to the VNS Device for TRD treatment in

the broad population previously defined by defendants, Payers broadly were not providing

favorable coverage and that those Payers willing to consider the device on a case-by-case basis

had denied to approve the device in over 4,000 TRD cases with only approximately 1,600 TRD

patients having actually received the device. The Company further disclosed, inter alia, that

until such time – if ever – as Cyberonics obtained “favorable coverage policies for VNS Therapy

in TRD” – i.e., until such time that scientific evidence supported a finding by Payers of “medical

necessity” – “Cyberonics is not likely to return to corporate profitability ….”

7. Responding to this devastating news, market commentators in an August 1, 2006

Reuters article recognized the truth that Payers “cited a need for more clinical evidence that the

device is effective” and that “Cyberonics has not delivered the sales it projected, hurting its

credibility in the eyes of investors.” Further demonstrating the falsity of defendants’ misleading

Class Period representations as to supposed Payer support for the device, the publisher of the

monthly journal NeuroInvestment stated, “Cyberonics has neither the clinical data nor the

reputation that would be necessary to change the minds of insurers about covering VNS in

depression.” Indeed, not only was the U.S. Senate investigating whether accurate science had

been withheld by defendants from Medicare and Medicaid, but the Blue Cross Blue Shield

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Association (which association represents no less than one of every three members of the U.S.

population) explained that “Blue Cross, like many other health insurance plans, [has] balked at

paying for the stop-watch-like Vagus Nerve Stimulator” in short because, according to Naomi

Aronson, executive director of the technology evaluation center at Blue Cross, “‘[t]here are

many ways you can slice [Cyberonics’ research data] but the bottom line is that it is weak.’”3

8. But defendants’ fraudulent scheme and course of conduct goes beyond their

active concealment of the Company’s issues with the VNS Device. During the Class Period,

defendants actively concealed the existence of improprieties related to the award of stock option

grants, including fraudulent backdating of options, flawed and defective internal controls over

accounting bearing on the accuracy of financial reporting and forward guidance, and violations

of generally accepted accounting practices (“GAAP”), resulting from the improper recording of

executive compensation and expenses. The value of the Company’s stock was also artificially

inflated during the Class Period due to defendants’ concealment of these significant problems.

Indeed, at least one member of the Company’s board of directors has already resigned as a result

of his concerns regarding executive compensation practices at the Company, suggesting that

serious corporate governance issues currently exist at the Company. And Cyberonics is being

investigated by the Securities and Exchange Commission (“SEC”) and the U.S. Attorney’s

Office for the Southern District of New York, is facing potential delisting by NASDAQ, and has

received a letter of default from the trustee of its $125 million worth of convertible notes.

3 Blue Cross’s Aronson further expressed that there was credible evidence available but that it did not support Payer approval of the device. Remarking on an initial trial of the VNS Device as a treatment for TRD in which half of the depressed patients had the device turned on and half did not but which showed no statistically significant benefit for those whose devices had been turned on, Ms. Aronson stated, “This was a well-designed trial that deserves credit. The result showed there was no difference between the two groups.”

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OVERVIEW OF THE FRAUD

9. Once approved by FDA, the most important step in achieving the full marketing

potential of a new drug or medical device is the determination by payers that a new treatment or

therapy is “medically necessary.” Cyberonics demonstrated its expert knowledge regarding the

landscape and processes applicable to payer third-party reimbursement issues in its SEC Form

10-K filed on July 18, 2003, as it impacted commercialization of the VNS Device generally,

which stated in part:4

THIRD-PARTY REIMBURSEMENT

Our ability to expand the commercialization of the Vagus Nerve Stimulation successfully depends on favorable coverage, coding and reimbursement for VNS Therapy. Currently, VNS Therapy has been recommended and/or adopted by most payers across the U.S., including Aetna, Blue Cross/Blue Shield Technology Evaluation Center, CHAMPUS, Kaiser Permanente, Centers for Medicare & Medicaid Services (CMS) and most state Medicaid programs.

In deciding to cover a new therapy, payers base their initial coverage decisions on several factors including, but not limited to, the status of FDA's review of the product, CMS coverage decision, Blue Cross/ Blue Shield Technology Evaluation Center, the product's safety and efficacy, the number of studies performed and peer-reviewed articles published with respect to the product and how the product and therapy compares to alternative therapies. The Cyberonics Reimbursement Department is available to assist hospitals and physicians with any reimbursement questions. The department's Regional Alliance Managers and Reimbursement Case Managers are available through our Reimbursement Hotline, to help with coverage, coding and reimbursement issues.

10. The Medicare Program Integrity Manual of the Centers for Medicare to Medicaid

Services (“CMS”) defines “medically necessary” in terms of criteria for determining whether or

not a service is “reasonable and necessary,” as follows:

Reasonable and Necessary

4 Except where otherwise indicated in this Complaint, all bold emphasis is added.

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In order to be covered under Medicare, a service shall be reasonable and necessary. When appropriate, contractors shall describe the circumstances under which the proposed LCD for the service is considered reasonable and necessary under 1862(a)(1)(A). Contractors shall consider a service to be reasonable and necessary if the contractor determines that the service is:

Safe and effective;

Not experimental or investigational (exception: routine costs of qualifying clinical trial services with dates of service on or after September 19, 2000 which meet the requirements of the Clinical Trials NCD are considered reasonable and necessary); and

Appropriate, including the duration and frequency that is considered appropriate for the service, in terms of whether it is:

Furnished in accordance with accepted standards of medical practice for the diagnosis or treatment of the patient's condition or to improve the function of a malformed body member;

Furnished in a setting appropriate to the patient's medical needs and condition;

Ordered and furnished by qualified personnel;

One that meets, but does not exceed, the patient's medical need; and

At least as beneficial as an existing and available medically appropriate alternative.

11. The Technology Evaluation Center (“TEC”) of the Blue Cross and Blue Shield

Association has, since 1985, developed and applied scientific criteria for assessing medical

technologies through comprehensive reviews of clinical evidence for its 38 independently owned

and operated Blue Cross and Blue Shield Plan affiliates and their subsidiaries. The TEC has

undertaken to make science-based evaluations of new medical therapies for its member

companies since 1985.5 Together, Blue Cross and Blue Shield Plan affiliates and their

subsidiaries insure one of every three Americans, making them the single largest group of

medical coverage providers in the United States.6 The TEC also defines “medically necessary,” 5 See http://www.bcbs.com/tec/evidence.html , last accessed on August 8, 2006.

6 See http://www.bcbs.com/whoweare/index.html and http://www.bcbs.com/tec/whatistec.html, last accessed on August 9, 2006.

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in terms of five evidence-based criteria to “assess whether a technology improves health

outcomes such as length of life, quality of life and functional ability,” described in part:

1. The technology must have final approval from the appropriate governmental regulatory bodies.

This criterion applies to drugs, biological products, devices and any other product or procedure that must have final approval to market from the U.S. Food and Drug Administration or any other federal governmental body with authority to regulate the technology.

Any approval that is granted as an interim step in the U.S. Food and Drug Administration's or any other federal governmental body's regulatory process is not sufficient.

The indications for which the technology is approved need not be the same as those which Blue Cross and Blue Shield Association's Technology Evaluation Center is evaluating.

2. The scientific evidence must permit conclusions concerning the effect of the technology on health outcomes.

The evidence should consist of well-designed and well-conducted investigations published in peer-reviewed journals. The quality of the body of studies and the consistency of the results are considered in evaluating the evidence.

The evidence should demonstrate that the technology can measure or alter the physiological changes related to a disease, injury, illness, or condition. In addition, there should be evidence or a convincing argument based on established medical facts that such measurement or alteration affects health outcomes.

Opinions and evaluations by national medical associations, consensus panels, or other technology evaluation bodies are evaluated according to the scientific quality of the supporting evidence and rationale.

3. The technology must improve the net health outcome.

The technology's beneficial effects on health outcomes should outweigh any harmful effects on health outcomes.

4. The technology must be as beneficial as any established alternatives.

The technology should improve the net health outcome as much as, or more than, established alternatives.

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5. The improvement must be attainable outside the investigational settings.

When used under the usual conditions of medical practice, the technology should be reasonably expected to satisfy TEC criteria #3 and #4.

12. Medical science begins with the hope that proven treatments and therapies can be

found for unmet medical needs to bring hope to the afflicted. As Cyberonics explains, Payers

base their coverage decisions in part on the evidence-based coverage decisions of CMS and

TEC. These decisions in turn rely on a finding that the treatment is “medically necessary.”

According to CMS and TEC, that standard cannot be met unless the treatment is both safe and

effective and not experimental or investigational. Finally, these coverage decisions require not

merely FDA approval, but clinical studies, data and other necessary information demonstrating

the “medical necessity” of the device for any intended purpose.

13. Cyberonics was well aware that the existence of an unmet medical need or the

speculative hopes of patients cannot be relied upon to support positive Payer claims, even if there

was an objective basis to believe that the Company would meet Payer requirements for a positive

determination of a “medically necessary” treatment or therapy. In spite of this, the Company

heralded an immense “unmet need” for use of the VNA System in TRD treatment which

translated into a $66 billion “marketing opportunity,” several times larger than its epilepsy

marketing opportunity.7 The Company also warned of “horrific” implications of non-availability

of its TRD treatment option and that suicide would continue to be the way that “too many

Americans, 2,500 every month, to be precise, chose to relieve their pain….”

14. While unfortunate, it is irrelevant whether or not defendants’ claims of “immense

unmet need” or “horrific consequences” are true. What is relevant is whether or not during the

Class Period the Company and the defendants misleadingly bragged of the size of the market,

warned of claimed dire consequences of the unavailability of its TRD treatment option, and

actively concealed that, on the basis of the deficient quality and type of the scientific evidence

7 See defendant Cummins’ remarks to a Barron’s analyst during the Company’s conference call of June 16, 2004 and http://www.forbes.com/markets/newswire/2004/01/16/rtr1214747.html, last accessed on November 17, 2005.

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supplied, the likelihood of profitable positive Payer coverage following FDA approval was

undermined. Indeed, throughout the Class Period, Cyberonics knowingly and fraudulently

converted the deficient and controversial nature of its FDA application (Premarket Approval

Application or “PMA-S”) clinical studies and data into a false “expectation” of positive

coverage determinations from the Payers.

15. During the Class Period, defendants made material misrepresentations to and

concealed material information from the investing public regarding: (i) the PMA-S for its VNS

System, (ii) about the safety, effectiveness and marketability of the device as a therapy for TRD;

and (iii) GAAP violations and other adverse consequences that would result from ethical lapses

at the Company. Defendants’ false and misleading statements included, inter alia, the following:

(a) Although defendants characterized their relationship with FDA as a

“partnership,” they concealed serious disagreements with FDA reviewers regarding the

Company’s clinical studies data comparison and plan for its PMA-S submission, specifically that

the data comparison and plan was sufficient to demonstrate safety and effectiveness. So serious

were these concerns that FDA reviewers informed the Company that just prior to the PMA-S

100-day meeting the reviewers had asked FDA upper management to entertain the possibility

of an issuance of a “Not-Approvable” Letter;

(b) Defendants knowingly and fraudulently converted the deficient and

controversial nature of its PMA-S, clinical studies and data into an illusory expectation of

positive coverage determinations from the Payers. Well-aware of FDA reviewer concerns and

the negative implications of those concerns for positive Payer determinations, defendants

knowingly and recklessly provided investors with claimed “data points that may make you

comfortable with regard to the likely coverage and access to VNS therapy;”

(c) Defendants publicly dismissed and concealed data and expert, including

FDA reviewers, observations challenging the efficacy of the VNS Device for TRD treatment and

directly undermining the likelihood of Payer approval of the device;

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(d) While undertaking the duty to inform investors of important “positive”

regulatory steps it would take in the submission review and approval process, defendants

concealed important “negative” regulatory steps in that same process;

(e) Executive compensation issues, violations of GAAP and corporate

governance issues at the Company existed and were concealed during the Class Period, as

evidenced by improprieties in the award of executive stock options following the highly positive

outcome of its June 15, 2004 FDA advisory committee meeting, which were pegged to the

previous day’s trading price. As a result, the Company subjected itself to the possibility of

criminal and civil litigation resulting from its GAAP violations, while impressive gains were

locked-in for the Company’s June 15th optionees, including a gain of $2.8 million for the

Company’s Chairman and CEO, within two days after the advisory panel meeting;

(f) Executive compensation issues, violations of GAAP and corporate

governance issues at the Company existed during the Class Period, as evidenced by the “noisy

resignation” on July 24, 2005, of Ronald A. Matricaria, Cyberonics Board Director and

Chairman of the Board’s Compensation Committee, who stated that he could no longer “support

the direction of the governance practices of the Cyberonics board, in particular its practices

regarding CEO compensation and succession;”

(g) Despite the controversial nature of the February 2, 2005 FDA

“Approvable Letter,” defendants sold more than $17.4 million dollars of their Cyberonics shares

within 2 weeks of its receipt well before the truth as to actual Payer coverage – or the lack

thereof – could come to light. Defendants knew and concealed that, in spite of a fortuitous

administrative override to approve the PMA-S, the undisclosed, objective and nearly unanimous

science-based dissent at FDA in support of a “Not Approvable Letter” demonstrated that broad

positive Payer determinations following the approval was not likely. As a result, Company

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executives knew that they continued to face potentially ruinous consequences in the marketplace,

once Payers conducted their own evaluation and discovered the science-based deficiencies;

(h) Defendants summarily dismissed an August 2005 negative Blue Cross

Blue Shield (“BC/BS”) TEC evaluation, falsely stating in November 2005 that the Company had

the requisite information to reverse the TEC negative evaluation. In truth, while the Company’s

submission to TEC contained what the Company called “new publications” and “new analysis,”

it was devoid of any new substantive data or other evidence necessary to reverse the TEC’s

negative evaluation;

(i) Defendants summarily dismissed the efforts of a Senate Finance

Committee (“SFC”) in May of 2005 to investigate the VNS for TRD approval and then later the

conclusions of the Senate Report that followed in February 2006, first falsely stating that “[t]he

TRD status quo that a few FDA personnel involved in the original not-approvable decision are

apparently attempting to preserve has miserably failed millions of Americans with TRD…” and

then falsely portraying the report as “politically motivated.”8 However, in light of the role of the

SFC with respect to Medicare and the Company’s active concealment of the meaningful and

nearly unanimous scientific dissent at FDA that occurred during the prosecution of the

Company’s PMA-S application, defendants lacked an objective or reasonable basis to contend

that the issuance of the Senate Report was politically motivated and knew that broad Payer

coverage was not likely;

(j) Defendants misleadingly stated during the Class Period that the Company

was making “good progress towards favorable TRD coverage policy and, while defendants

falsely stated that any Payer negative coverage determinations were “ill-informed”, in truth, the

8 The February 2006 Senate Report is incorporated by reference in this complaint. The Report was previously lodged with the Court on March 31, 2006, as Exhibit A to the Declaration of John G. Emerson, Esq., in Support of Plaintiffs’ Motion to Take Judicial Notice of Certain Facts.

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Company knew that it lacked substantive data or other evidence to implement positive coverage

determinations with the Payers or to later reverse the vast majority of negative coverage

determinations;

(k) In May of 2006, defendants purported the existence of “momentum” and

“traction” in its “TRD franchise,” heralding the fact that the Company had managed to implant

more than 1,100 TRD patients with the VNS device. And the Company falsely stated that it was

capable of providing “adequate evidence” to insurance Payers to implement positive coverage

determinations. In truth, the Company already knew that it lacked any new data or studies to

provide Payers; and

(l) When faced with a June 8, 2006 accusation of improprieties related to the

Company’s grant of 170,000 stock options by SunTrust Robinson Humphrey (“STRH”) analyst

Amit Hazan, the Company falsely stated that “[t]he assertions and claims made in the STRH

report are inaccurate and without merit.”

16. Despite defendants’ positive claims during the class Period, however, on August

1, 2006 the Company issued a shocking press release entitled, “Cyberonics Revises Guidance

For FY07 And Confirms Receipt Of Nasdaq Staff Determination Letter.” While defendants had

tried to “guide down” their previous marketability claims for the Company’s TRD treatment

option, investors finally learned the true dimensions of the hollow, false and misleading nature of

these claims. Finally, the Company admitted that it could not demonstrate in the vast majority of

cases that its TRD treatment option was “medically necessary” for its broadly defined treatment-

resistant depression population.

17. As if these admissions were not enough, the Company also reported that it had

received a Nasdaq Staff Determination Letter on July 31, 2006 in connection with its stock

option award improprieties, GAAP violations and inability to timely file its financial reports. The

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Company put investors on notice “…that its securities are, therefore, subject to delisting from

The Nasdaq Global Market.”

JURISDICTION AND VENUE

18. Plaintiffs, on behalf of themselves and all others similarly situated, allege that

defendants violated §§10(b) and 20(a) of the Exchange Act and SEC Rule 10b-5, 17 C.F.R.

§240.10b-5. Jurisdiction is conferred pursuant to §27 of the Exchange Act. Venue is proper in

this District pursuant to §27 of the Exchange Act. The corporate headquarters of Cyberonics is

located in this District. In connection with the acts and conduct alleged herein, defendants

directly and indirectly used the means and instrumentalities of interstate commerce, including the

United States mails and the facilities of the national securities exchanges.

THE PARTIES

19. Lead Plaintiffs EFCAT, Inc., John E. and Cecilia Catogas, Blanca Rodriguez and

Mohamed Bakry purchased Cyberonics securities during the Class Period and were damaged

thereby as set forth in their respective Plaintiff Certifications attached hereto.

20. Defendant Cyberonics designs, develops, manufactures and markets medical

devices, including the VNS System, submitted under a premarket approval application

supplement (“Implanted Vagus Nerve Stimulation System, PMA P970003/S50,” or “PMA-S”) to

FDA as a therapy for treatment-resistant depression. Cyberonics maintains its corporate and

administrative offices where the Company’s day-to-day business activities are conducted at 100

Cyberonics Blvd., Houston, Texas 77058.

21. Defendant Robert P. Cummins (“Cummins”) was Chairman and CEO of

Cyberonics. In those positions, defendant Cummins was the primary “speaker” of the Company,

responsible for communications to the investment community and knew the material, adverse

non-public information about the VNS System, the PMA-S for the TRD indication and the

clinical studies alleged herein from: (i) corporate documents, including the Company’s

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regulatory submissions to the FDA prior to and during the Class Period; (ii) internal FDA

documents of a confidential nature, that were subsequently made public as a result of the Senate

Report; (iii) confidential documents provided to the SEC and in response to a subpoena from the

US District Attorney for the Southern District of NY; and (iv) oral and written communications

with other corporate officers and employees. During 53 weeks ending April 30, 2004, defendant

Cummins was granted 250,000 stock options or 16% of the total options granted to all employees

during that period.9 On June 15, 2004, following the outcome of an FDA advisory committee

meeting regarding the approvability of Cyberonics’ TRD treatment option, defendant Cummins

was awarded 150,000 stock options which were unfairly pegged to the price achieved at the end

of the previous trading day. As of June 21, 2004, defendant Cummins beneficially owned

1,087,928 or 4.4% of all outstanding Cyberonics stock. During the Class Period, defendant

Cummins sold 350,000 shares of his Cyberonics stock for proceeds of approximately $14.7

million.

22. Defendant Richard L. Rudolph (“Rudolph”) was Vice President of Clinical and

Medical Affairs and Chief Medical Officer (“CMO”) of Cyberonics. Along with defendant

Totah, defendant Rudolph conducted the Company’s extensive communications with the FDA

concerning the VNS System clinical studies, the PMA-S submission for the TRD indication and

subsequent amendments and as a result, was fully informed about the safety, efficacy and

marketability issues for the TRD indication, including issues in the design and results of the

clinical studies. As a result, defendant Rudolph knew of the material, adverse non-public

information about the VNS System, the PMA-S for the TRD indication and the clinical studies

alleged herein from: (i) corporate documents, including the Company’s regulatory submissions

to the FDA prior to and during the Class Period; (ii) internal FDA documents of a confidential 9 For this and other details governing the holdings, employment and severance agreements between Cyberonics and all of the individual defendants, see the Company’s SEC Form DEF 14A, filed on August 27, 2004.

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nature, that were subsequently made public as a result of the Senate Report; and (iii) oral and

written communications with other corporate officers and employees. On June 15, 2004,

following the outcome of the FDA advisory committee meeting regarding the approvability of its

TRD treatment option, defendant Rudolph was awarded 10,000 stock options which were

unfairly pegged to the price achieved at the end of the previous trading day. During the Class

Period, defendant Rudolph sold 17,338 shares of his Cyberonics stock for proceeds of

approximately $400,000.

23. Defendant Alan Totah (“Totah”) was Vice President of Regulatory Affairs of

Cyberonics. Along with defendant Rudolph, defendant Totah conducted the Company’s

extensive communications with the FDA concerning the VNS System clinical studies, the PMA-

S submission for the TRD indication and subsequent amendments and as a result, was fully

informed about the safety, efficacy and marketability issues for the TRD indication, including

issues in the design and results of the clinical studies. As a result, defendant Totah knew of the

material, adverse non-public information about the VNS System, the PMA-S for the TRD

indication and the clinical studies alleged herein from: (i) corporate documents, including the

Company’s regulatory submissions to the FDA prior to and during the Class Period; (ii) internal

FDA documents of a confidential nature, that were subsequently made public as a result of the

Senate Report; and (iii) oral and written communications with other corporate officers and

employees. On June 15, 2004, following the outcome of the FDA advisory committee meeting

regarding the approvability of its TRD treatment option, defendant Totah was awarded 10,000

stock options which were unfairly pegged to the price achieved at the end of the previous

trading day. During the Class Period, defendant Totah sold 2,410 shares of his Cyberonics stock

for proceeds of approximately $73,626. On or before July 14, 2006, defendant Totah left

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Cyberonics, to join medical device maker MicroMed Cardiovascular, Inc., as that Company’s

head of regulatory affairs and quality systems.10

24. Defendant Michael A. Cheney (“Cheney”) was Vice President of Marketing of

Cyberonics. Along with defendant Jennings, defendant Cheney developed, communicated and

executed the Company’s sales and marketing strategies, including the marketability argument for

the VNS System as a therapy for TRD. As a member of the Cyberonics executive management

team, Cheney was fully informed about the safety, efficacy and marketability issues for the TRD

indication, including issues in the design and results of the clinical studies. As a result, defendant

Cheney knew of the material, adverse non-public information about the VNS System, the PMA-

S for the TRD indication and the clinical studies alleged herein from: (i) corporate documents,

including the Company’s regulatory submissions to the FDA prior to and during the Class

Period; (ii) internal FDA documents of a confidential nature, that were subsequently made public

as a result of the Senate Report; and (iii) oral and written communications with other corporate

officers and employees. During the Class Period, defendant Cheney sold 28,408 shares of his

Cyberonics stock for proceeds of approximately $1.1 million.

25. Defendant W. Steven Jennings (“Jennings”) was Vice President of Sales of

Cyberonics. Along with defendant Cheney, defendant Jennings developed, communicated and

executed the Company’s sales and marketing strategies, including the marketability argument for

the VNS System as a therapy for TRD. As a member of the Cyberonics executive management

team, Jennings was fully informed about the safety, efficacy and marketability issues for the

TRD indication, including issues in the design and results of the clinical studies. As a result,

defendant Jennings knew of the material, adverse non-public information about the VNS System,

the PMA-S for the TRD indication and the clinical studies alleged herein from: (i) corporate

10 See http://biz.yahoo.com/bizj/060714/1316140.html?.v=2, last accessed on August 12, 2006.

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documents, including the Company’s regulatory submissions to the FDA prior to and during the

Class Period; (ii) internal FDA documents of a confidential nature, that were subsequently made

public as a result of the Senate Report; and (iii) oral and written communications with other

corporate officers and employees. During the Class Period, defendant Jennings sold 26,000

shares of his Cyberonics stock for proceeds of approximately $600,000.

26. Defendant Pamela B. Westbrook (“Westbrook”) was Vice President of Finance

and Administration and CFO of Cyberonics. In this position, defendant Westbrook conducted the

Company’s communications to the investment community along with defendants Cummins,

Rudolph and Totah. Defendant Westbrook knew the material, adverse non-public information

about the VNS System, the PMA-S for the TRD indication and the clinical studies alleged herein

from: (i) corporate documents, including the Company’s regulatory submissions to the FDA

prior to and during the Class Period; (ii) internal FDA documents of a confidential nature, that

were subsequently made public as a result of the Senate Report; (iii) confidential documents

provided to the SEC and in response to a subpoena from the US District Attorney for the

Southern District of NY; and (iv) oral and written communications with other corporate officers

and employees.

27. Defendants Cummins, Rudolph, Totah, Cheney, Jennings and Westbrook are

collectively referred to herein as the “Individual Defendants.” Individual Defendants, by reason

of their executive and Board positions, were controlling persons of Cyberonics during the Class

Period and had the power and influence and exercised the same to cause Cyberonics to engage in

the conduct complained of herein.

28. During the Class Period, each Individual Defendant occupied a position that made

him or her privy to non-public information concerning Cyberonics. Because of this access, each

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of these defendants knew the adverse material facts specified herein and that they were being

concealed.

29. Each of the defendants is liable for making false and misleading statements,

and/or for willfully participating in a scheme and course of business that operated as a fraud on

purchasers of Cyberonics securities and damaged Class members in violation of the federal

securities laws. All of the defendants pursued a common goal, i.e., inflating the price of

Cyberonics stock by making false and misleading statements and concealing material adverse

information. The scheme and course of business was designed to and did: (i) deceive the

investing public, including plaintiffs and other Class members; (ii) artificially inflate the price of

Cyberonics securities during the Class Period; (iii) allow defendants to sell over 424,156 shares

of Cyberonics at inflated prices, for proceeds of $17.0 million; and (iv) cause plaintiffs and the

other members of the Class to purchase Cyberonics securities at inflated prices and to sustain

damages.

30. Each defendant had the opportunity to commit and participate in the violations of

law described herein. The Individual Defendants were top officers and Directors of Cyberonics

and they controlled its press releases, corporate reports, SEC filings and its communications with

analysts, including the documents that are alleged herein to have been materially false and

misleading. Thus, the defendants controlled the public dissemination of, and did misrepresent,

information about Cyberonics business, products and finances that reached the public and caused

the inflation in the price of Cyberonics securities.

31. The Individual Defendants had actual knowledge that each of the representations

alleged herein were materially false and misleading when made and/or omitted material

information based on the Company’s own submissions to and communications with the FDA, as

well as correspondence from and responses to the SFC, the BC/BS TEC, Payers, stock analysts,

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and in its correspondence and communications in response to a subpoena issued by the U.S.

Attorney’s Office for the Southern District of New York in cooperation with an ongoing SEC

investigation, and to the NASDAQ National Market, including: (a) FDA confidential

correspondence with the Company, whether or not they are described or contained within the

Senate Report, including those that pointed to serious FDA concerns regarding the Company’s

regulatory strategy for the pursuit of its TRD indication; (b) all Company protocols, protocol

amendments, data and reports submitted to FDA comprising the clinical studies and programs

supporting the PMA-S; (c) communications related to the PMA-S 100-day meeting, the March 1,

2004 “Major Deficiency Letter, the September 23, 2004 PMA-S Amendment, as well as other

communications and correspondence to or from FDA for the reconsideration of the “Not-

Approvable” Letter; (e) communications from Payers, including correspondence to CMS and

BC/BS TEC, including those communications related to the TEC evaluation of the Company’s

TRD treatment option in August 2005 and June 2006, as well as the Company’s November 2005

appeal of the TEC’s August 2005 evaluation; and (f) communications to analysts, shareholders

and trustees involved in the administration of the Company’s $125 million convertible notes,11

relating to corporate governance issues at the company, executive compensation issues,

executive succession, improprieties in the award of stock option grants, false financial statements

and other GAAP violations.

11 On September 27, 2005, Cyberonics sold $125 million aggregate principal amount of 3.0% Convertible Senior Subordinated Notes due 2012 to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended. On August 4, 2006, the Company filed SEC Form 8-K, stating that, on July 31, 2006, Wells Fargo Bank, National Association (the "Trustee") delivered a notice of default and demand letter dated July 28, 2006, asserting that the Company is in default under the Indenture as a result of its failure (a) to timely file with the SEC its Annual Report on Form 10-K for the fiscal year ended April 28, 2006 ("2006 Form 10-K") by July 12, 2006 and (b) to deliver a copy of the 2006 Form 10-K to the Trustee by July 27, 2006. The trustee has required the Company to deliver all information, documents and other reports that the Company is required to file with the SEC deliver "within 15 days after it files them.”

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BACKGROUND TO THE CLASS PERIOD

The Senate Report

32. In February 2006 the U.S. Senate issued a report entitled, “Review of the FDA’s

Approval Process For the Vagus Nerve Stimulation Therapy System for Treatment-Resistant

Depression.” The content of the report amply demonstrates that a climate of concealment

regarding the safety, effectiveness and approvability of the VNS Device for TRD existed

during the Class Period. This is also the observation of the Hon. U.S. Senators Charles Grassley

and Max Baucus, in their roles as Chairman and ranking Democratic Member of the bipartisan

SFC. In their statements before the Senate, as published in the February 16, 2006 issue of the

Congressional Record, Senators Grassley and Baucus took stock of the FDA review process of

the PMA-S for TRD and noted in relevant part:

Senator Grassley:

Third, the Food and Drug Administration has not ensured that the public has all the accurate, science-based information on the safety and effectiveness of the VNS for treatment-resistant depression. So health care providers, relying on the FDA’s information about this device, may not be able to convey complete risk information to each patient.

In the end, this senior Food and Drug Administration official not only overruled more than 20 Food and Drug Administration employees, but he stated to our committee staff that the public would not be made aware of the scientific dissent over whether the device is reasonably safe and effective. Until today, this official’s detailed conclusions remain confidential and unavailable to the public. We are releasing these confidential conclusions in the appendix to the report. Some of his own conclusions raise serious questions in our minds. For example, I quote from his override memorandum:

I think it needs to be stated clearly and unambiguously that [certain VNS data] failed to reach, or even come close to reaching, statistical significance with respect to its primary endpoint. I think that one has to conclude that, based on [that] data, either the device has no effect, or, if it does have an effect, that in order to measure that effect a longer period of follow-up is required.

***

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Senator Baucus:

In the case of the VNS Therapy system, the FDA review team was comprised of more than a dozen FDA staff, including doctors, scientists, safety officers, and statisticians. This review team unanimously recommended against FDA approval. The team argued that the data were insufficient to justify approval and that additional premarket testing was in order. Three levels of management concurred with the team’s recommendation. The uppermost manager—the Director of the Center for Devices—disagreed. With the stroke of a pen, he overruled the analysis and conclusions of his staff, and he approved the device. Now the FDA seal of approval has been attached to that VNS Therapy system by one person, over the objections of several technical experts who studied the device.

Without this report from the Finance Committee, the public would not know that the team of scientists and doctors who reviewed this device did not believe it should be approved. Without this report, there would be no way for providers and patients to make fully informed health care decisions because they would not be aware of all of the risks.

In short, we present this report out of a concern for public safety. We believe that doctors and patients considering this device should know that it was approved over the objection of a team of seasoned scientists. It is important for the public to know what the FDA scientists and doctors thought about the risk to which patients would be exposed.

The FDA has not made public any information regarding the level of scientific dissent. So I am glad we have this report. I am greatly concerned about this unusual turn of events at the FDA. I hope this is not a sign of things to come. I hope that FDA approval can remain the gold standard, and I hope Medicare and Medicaid can continue to pay for FDA-approved products knowing they are safe.

33. As this Report identified, the scientific data known to defendants which

defendants reported as supporting even the less than Payer-required standards of the FDA for

TRD sale approval was substantially lacking, rendering Payer approval from any meaningful

business perspective unlikely at best. An internal memo issued by the FDA PMA-S review

Team Leader in January 2005 (“January 2005 Memo”) concluded:

From a scientific standpoint, there are several serious limitations to the clinical data set submitted that the Sponsor cannot address, other than by providing data from a new, scientifically sound, randomized, controlled study, which addresses concomitant treatment use and includes adequate safety assessments in both the treatment and the control group (new clinical trial designs have been suggested earlier in the review memo). Any proposed mood disorder therapy would need to have evidence to establish effectiveness and safety for

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FDA approval. I recommend the VNS Therapy System not be approved for the proposed indications for treatment-resistant depression, based on the belief that the Sponsor has not scientifically demonstrated a reasonable assurance of safety or effectiveness, nor adequate indications or instructions for use.

34. Not only had the PMA-S Team Leader reiterated FDA’s not-approvable decision

of August 11, 2004, but, this time, as many as five FDA managers had concurred, including the

Director of the Office of Device Evaluation, who noted in a hand-written inscription of

January 10, 2005, that, “I concur with the not-approvable recommendation.”

35. The FDA approval of the VNS System for sale in conjunction with TRD

treatment was solely the result of an “override decision” at an unusually high level of

accountability by the Director of the Center For Devices and Radiologic Health (CDRH). For

reasons that defy explanation, in his “override memo” of June 12, 2005, the CDRH Director

noted:

With regard to effectiveness, I think it needs to be stated clearly and unambiguously that the short-term randomized comparison of VNS active to VNS sham at 12 weeks failed to reach, or even come close to reaching, statistical significance with respect to its primary endpoint. I think that one has to conclude that, based on that data; either the device has no effect, or, if it does have an effect that in order to measure that effect a longer period of followup is required.

36. The findings of an FDA advisory committee and the decision to issue an FDA

marketing approval usually are the result of strong scientific evidence of safety and

effectiveness. As a result, these findings and decisions are normally entitled to strong

presumptive weight. However, the documentary evidence provided by the Senate Report

demonstrates that the presumptive weight afforded defendants’ FDA panel review to recommend

approval in June 2004 and the February 2005 FDA approvable letter cannot be afforded any

presumption – particularly as related to whether the scientific data evidenced or supported

defendants’ false positive statements as to the likelihood that the VNS Device could satisfy the

higher Payer “medical necessity” standards. As Senator Grassley stated to the Senate, in part:

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I am greatly concerned that the Food and Drug Administration standard for approval may not have been met here. If that is the case, it raises further difficult questions, including whether Medicare and Medicaid dollars should be used to pay for this device now. Accordingly, we are forwarding the report to Secretary Leavitt, Administrator McClellan, and Acting Commissioner von Eschenbach for their consideration and comment. These are difficult matters that deserve their full attention.

Before I close, I commend the commitment and dedication of the more than 20 FDA scientists who tried to do the right thing in this case, as they probably do in every case, and not stray from evidence-based science. I applaud their effort on behalf of the American people.

Revising the Studies/Statistical Plan

37. The evidence now known that defendants knew all along and which demonstrates

the unlikelihood that the VNS Device would contribute meaningfully to Cyberonics’ profitability

once FDA-approved for sale is set forth in large part in the Senate Report. According to the

Senate Report, on March 1, 2002, defendants Cummins, Rudolph and Totah met with senior

FDA officials to discuss the possibility of a way to move forward despite the failure of the

Company’s D-02 protocol,12 the minutes of which are contained in an FDA Contact Report

dated March 21, 2002.13 According to the contact report, the Director of Division of General,

Restorative and Neurological Devices (“DGRND”) expressed serious concerns regarding the

Company’s attempts to “fix” its failed D-02 protocol and steered the Company towards the

performance of another long term comparative study, stating in part:

DGRND Director – As you know, the issue here for you and us is the validity of the control group. I am not convinced that you won’t need to do another study such as the long-term comparative study (D-08) which you presented in December. What is the status of the D-08 study.

Sr. Dir. Reg. Affairs [Totah] stated that the study has not yet started and that Cyberonics is currently preparing responses to FDA’s questions included in FDA’s conditional approval of the D-08 study.

12 “D-02,” “D-04,” and “D-08,” refer herein to safety and efficacy studies performed by Cyberonics concerning the VNS Device for TRD treatment.

13 Senate Report, at pp294-296.

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VP Clin/Med Affairs [Rudolph] mentioned that if it takes VNS Therapy 6 months or longer to show response then a randomized, placebo control study would be problematic considering the severity of this populations’ treatment resistant depression.

DGRND Director – this is something you are going to have to wrestle with. We recognize the importance of it and when we found out about the press release [D-02 study failure] we were disappointed as well. A suggestion based on the presentation is if you find specific factors that point out a certain subgroup of the patients that this may work for, then you might be able to use a Bayesian analysis on a subset and design a smaller pivotal study. I am not sure how the data from the initial subgroup would be weighted in the final analysis. In any case, we will review anything you submit.

38. While defendant Totah stated that a “D-08” study was “in the works,” defendant

Rudolph “pushed back,” stating the Company’s argument for the “imprudence” of doing any

further randomized, placebo controlled studies. In response, the DGRND Director told the

Company make a choice, either to “wrestle” with what it must do, which meant risking yet

another failed trial or to alternatively consider identifying a subgroup and perform a smaller

pivotal study, which would limit the marketability of the VNS Device to but a small subgroup

of the broad TRD patient population previously represented by defendants.

39. Following this, on October 4, 2002, the Company again presented to FDA its

preferred regulatory strategy and new analysis plan to again “push back” on doing another

randomized, placebo-controlled study without losing an indication for the broad TRD patient

population.14 According to an October 11, 2002 Company memo prepared by defendant Totah,15

while FDA again stated that it would look at any data that the Company was willing to submit,

the agency had become far more critical of the Company’s “avoidance” strategy.

40. In the October 11, 2002 confidential Company memo, defendant Totah again

confirmed that FDA was still not on board, that the agency continued to express serious

14 The October 4, 2002 IDE-S meeting is specifically referred to and described in the Cyberonics confidential memo of October 11, 2002 and the “Major Deficiency” Letter of March 1, 2004. Senate Report at pp297ff.

15 Senate Report, at p297.

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concerns about the Company’s new analysis plan, while acknowledging defendants’ Rudolph’s

lead to “push back” on any new studies. Totah stated in part:

The FDA was very disappointed in our acute D-02 results as the need for alternative depression treatments is great. The Expedited Review status granted by FDA acknowledged this need.

The FDA did not need to “approve” or “disapprove” this particular IDE-S that changed the proposed Stat Plan for the ongoing Depression Study.

After reviewing the IDE-S supplement, FDA does not believe that the new analysis plan will provide convincing evidence of effectiveness. However, FDA will, of course, review the data because, “the clinical data could be overwhelming and be accepted by many people.” FDA agrees that, “the clinical data is key.”

41. Incredibly, the Company had also decided it would not give FDA any choice

regarding the level of scientific evidence necessary to prove the effectiveness of its TRD

treatment option, as Totah pointed out in his October 11, 2002 Company memo, stating in part

that “[t]he FDA did not need to approve or disapprove this particular IDE-S that changed the

proposed Stat Plan for the ongoing Depression Study.”

42. In November of 2002, defendant Cummins falsely stated to analysts a

dramatically different version of FDA’s position, in that FDA found it “imprudent” to move

forward with another randomized, placebo-controlled study when, in fact, this is what the

Company had told FDA in order to avoid doing good science.16 This wasn’t FDA’s argument at

all – Cummins was, rather, stating the Company’s argument as defendant Rudolph presented it

to FDA for “pushing back” on the agency.17

16 During the Company’s November 11, 2002 conference call, Cummins explained that FDA was “…also telling you [Cyberonics] that embarking on any other study, until you have the data would not be in the patient's best interests. Because until you have the data, you don't know if another study is required or another study is even prudent.”

17 FDA later reiterated its position in the “Major Deficiency” Letter of March 1, 2004, stating that, “[a]s we informed you during the February 4, 2004 100 Day Meeting, and previously in our October 4, 2002 IDE correspondence letter, we have serious concerns regarding your revised statistical plan for the D-02 Study and whether the comparison of D-02 and D-04 that your provided would be appropriate to support your new indication….”

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43. On July 23, 2003, the Company held a conference call in which it rolled out its

“Depression Causality Results” and revised statistical analysis plan to the investment

community. The Company used this opportunity to state that “FDA respects our commitment to

good clinical practices and science” while it rolled out a regulatory submissions strategy that

FDA had already challenged on the merits.

44. Nevertheless, defendants represented that FDA had blessed its new regulatory

submissions strategy, since the Company had, after all, submitted the revised statistical plan to

FDA for review in September of 2002 and, presumably as a result, the VNS Device was “the

only anti-depressant treatment to be granted expedited review status by the FDA. Conveniently,

defendant Totah reminded investors that the “expedited review status” was granted at a far

earlier stage of clinical investigation -- “during the IDE process”-- while continuing to conceal

the fact that FDA maintained its serious concerns about the new plan, as he himself admitted in

his October 11, 2002 confidential Company memo.

Making The Payers Pay

45. Defendant Cummins boasted about the strength and “world-class” skills of the

Company’s medical insurance Payer reimbursement team as an industry leader in its “battles”

with Medicare and Medicaid to gain Payer approval of the VNS Device for epilepsy-related

treatment. Cummins stated in part during the Company’s November 11, 2002 conference call,

as answers to questions regarding epilepsy reimbursement issues:

Kurt Kruger - Banc of America Securities

Thanks. You know, going to the reimbursement, help us if you would sort out some of the numbers that we have received here. You know, with the APCs, the new final determination that they came out with earlier this week. Or was it last week? I guess last week. I'm looking at implantation of neurological device, $11,876 payment rate and you have electrodes at $7,266. Are those the right categories for you? What does that mean in terms of the hospital's ability to get any additional reimbursement or are they behind, if they only get that kind of money back from CMS?

Robert Skip Cummins - Cyberonics - Chairman and President and CEO

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Correct. Basically the story of what happened with CMS is as you know, they came out with initial guidelines that they were looking for comments on to reduce reimbursement for VNS therapy and other neurostimulators and pumps by some 30 to 40 percent in 2003 over 2002.Well, our reimbursement team in our humble opinion is world class then put together, recruited consultants and put together strategies and tactics to present our case effective to CMS. We had, we were successful in doing that. Medtronic and ANSI asked if they could join us in the meeting since we were leading the charge. We of course said," Great, there's strength in numbers.” We presented our compelling case to CMS which was the basis not only for their decision to provide reasonable reimbursement which you can see is a total of $19,500 if you add the generator, the electrode and the in hospital programming that goes along with the implant, but what wasn't said in our press release is that also, which was a pleasant surprise, CMS removed the second and third code discount from those codes. So hospitals will get the full $19,500 as opposed to in many cases where the second and third code gets discounted.

Kurt Kruger - Banc of America Securities

Uh-huh. In other words, there was a victory and that doesn't serve to be any kind of impediment to reimbursement?

Robert Skip Cummins - Cyberonics - Chairman and President and CEO

No. It was absolute victory. We had exposure, our estimate was we had about18 percent of our sales to CMS. But obviously we regard any reductions in access to patients who are covered by any insurance companies or public entities as inconsistent with our mission. So our reimbursement team went to work, led the charge, and made sure that all patients continue to have access not only to VNS therapy but also to other neurostimulation products.

46. In a subsequent February 6, 2003 Company conference call, defendant Cummins

capitalized on the claimed success of its reimbursement team and the Company’s deep

knowledge and expertise in the area of third-party Payer reimbursements for medical devices, as

he responded to key questions on reimbursement for TRD-related treatment:

Bill Plovanic - First Albany - Analyst

Great. Thanks. My question is in regards to reimbursement should the best case scenario happen. If depression is approved, is it reimbursement for the implantation of a neuro stimulator? Is it indication specific or is it just product specific? In other words, do you have to go get a separate reimbursement code for it?

Skip Cummins - Cyberonics - Chairman and CEO

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Well, we learned a number of things from epilepsy that we are applying to the opportunity in depression. One of the things that we learned, Bill, is that you cannot have too much health economics and cost effectiveness data. And you can’t be too prepared from a reimbursement perspective for your launch. We learned that because in epilepsy, we weren’t prepared and we had no health economics and cost effectiveness data. Although, we have ended up with very favorable coverage in reimbursement.

But in depression, so what we did is prior to getting the disappointing results, we had actually formed a depression reimbursement advisory board, and actually funded several health economic and health care utilization studies. And the findings of that board and of those studies to date would suggest that VNS, if anything, will be much more cost effective and offer a much shorter pay back in depression than in epilepsy when you’re considering that the average annual out-of-pocket payment by payers for patients in a five-year period subsequent to when they had been hospitalized once or attempted suicide for depression, was $41,000 a year. So in epilepsy, what we’ve seen documented by studies, is a pay back of approximately two years from ER and hospitalization savings. We would anticipate that the pay back in depression could be as short as one year just based on the health, economic and cost studies we’ve done so far.

Now, the feedback from this board of advisers on depression reimbursement which includes the who’s who of medical directors, some of the largest mental health benefit payers in the country, is that we may not even need a new indication code. But, we may just be able to use the existing codes and just transfer them to depression. Because I can tell you categorically, just as is the case with psychiatrists’ awareness and acceptance of the need and the potential of VNS Therapy will be greater if we ever get the launch than it was in epilepsy, but that the awareness and acceptance of the need and the potential pay back on VNS Therapy amongst payers in depression is already equivalent to -- if not greater -- than the awareness and the acceptance of the need from the pay back in epilepsy.

And as a matter of fact, as we have looked forward to the potential of some day being in front of the advisory panel, most likely one of the presenters at the advisory panel will be one of the senior medical directors from the major health -- mental health payer in the country, which again, is very unusual for the panel to hear from a medical director from a payer who would be enthusiastic about a $20,000 implant.

47. Although analysts on the call had no reason to disagree with the representation of

any viable TRD treatment option, the horrific nature of suicides, hospitalizations and Payer

costs, they remained in the dark – as investors would throughout the Class Period -- regarding

FDA’s serious concerns with the Company’s preferred regulatory strategy and statistical plan for

the VNS Device as a therapy for TRD.

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48. Moreover, as was the case during the Class Period, unbeknownst to the

investment community or to Payers, the Company had gone against the advice of FDA to

embark on what can fairly be described as a “lowball” regulatory strategy to submit a lower

level of scientific evidence than FDA had advised, in the good judgment of the agency’s

scientists, to demonstrate safety and effectiveness for the proposed TRD indication – a decision

knowingly made and one that necessarily placed that scientific evidence far below the known

Payer “medical necessity” standard.

The Need Justifies The Plan

49. During the July 23, 2003 conference call, defendant Cheney finally connected the

Company’s purportedly “compelling depression data” that it would submit in its PMA-S to FDA

to a “huge patent protected U.S. market opportunity and need,” based on a potential of over 4.4

million patients in need per Datamonitor. Assuming that the device might cost as much as

$15,000 per patient,18 this represented a claimed marketing opportunity of as much as $66 billion

per patient. Defendant Cheney stated in part:

Michael A. Cheney - Cyberonics - SVP Marketing and Sales

Thanks, Alan. The market opportunity for VNS in depression is tremendous. What I'd like to do over the next few minutes is to help you understand why Cyberonics is positioned to be successful in this therapeutic arena.

Now, the first key point to understand is that the need for more effective non-drug options, like VNS Therapy, has become more apparent to psychiatrists in recent years as their recognition of pharmacoresistant depression has increased. A data monitor estimates the size of the U.S. pharmacoresistant depression market at about 4.4 million patients, or about 20% of the combined population of uni-polar and bi-polar depressed patients. That market potential is greater than 10 times the size of the refractory epilepsy market that VNS currently serves.

18 Defendant Cummins has stated that there are 4.4 million Americans in the pharmacoresistant depression market and that this translates into a $66 billion market for Cyberonics .See http://www.forbes.com/markets/newswire/2004/01/16/rtr1214747.html, last accessed on November 17, 2005.

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The data monitor also estimates that another 30% to 40% of depressed patients, or somewhere between 5.8 million and 7.8 million are partial responders, or patients with incomplete recovery between depressive episodes. And because these partial responders have much higher risk of recurrence or relapse, data monitor believes that many of these patients may also migrate to the VNS Treatment pool, due to their need for a more effective maintenance therapy to help them achieve and sustain remission.

Now, a comparison of the market dynamics, the relative value proposition of VNS and Cyberonics' capabilities at launch would suggest that our penetration of the depression market should exceed our historical performance in epilepsy.

***

Second, VNS may be a more robust therapy in depression than in epilepsy. Just looking at the remission rates or the percentage of patients who became symptom free or well, after years of pharmacoresistant illness, about one in six experienced remission from depression with VNS, vs. fewer than one in 20 with epilepsy.

***

The important thing to understand here is that these practice guidelines create a standard of care opportunity that points favorably toward the VNS value proposition. Remission, tolerability, the efficacy sustained over years and restored function of quality of life are attributes of VNS that have been demonstrated in the clinical data.

50. Defendant Cheney’s statements and representations during the Company’s

conference call of July 23, 2003, set a false and misleading stage for defendants’ Class Period

misrepresentations. Had it been known during the class Period that FDA had serious concerns

regarding the Company’s regulatory submissions strategy, in that the Company had strayed

from the performance of good science, Cheney’s statements would not have connected with a

claimed viable product in the eyes of investors or the approximately 2,500 psychiatrists from the

Company’s target audience.

DEFENDANTS’ FALSE AND MISLEADING STATEMENTS DURING THE CLASS PERIOD

51. On February 5, 2004, the Company issued a press release and conducted a

conference call to discuss its substantive discussions with FDA regarding the agency’s February

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4, 2004 review of the PMA-S. The most critical component of these substantive discussions was

captured by FDA in its confidential minutes of the February 4th meeting, which stated in part:

Meeting Minutes of 100-Day Meeting:

After the introductions, and prior to the formal presentation from Cyberonics, FDA provided a summary of the PMA-S submission substantive review status:

This complex PMA-S is currently under substantive review and is a work in progress. The list of items provided to Cyberonics on January 28, 2004 is a preliminary list of items associated with the substantive review.

The intent of this meeting is not to provide executive answers to questions and make final decisions. The 100 day meeting is an open forum to discuss where we believe you are at in the review process and discuss the next steps that will be involved with in this process;

FDA noted Cyberonics did a good job of interpreting and responding to the preliminary list of items as was voluntarily provided in the meeting materials in advance of the 101-day meeting. Not all FDA team members had the opportunity to review this package in full prior to the meeting. The meeting materials included a proposed agenda and preliminary responses to the 51 issues. FDA stated options for FDA action on this submission included either a not approvable letter or major deficiency letter, and after discussions with upper management, a major deficiency letter was determined. .

Based on the substantive review to date, the impression of the PMA-S is the following:

FDA has serious concerns whether this data set could support safety and effectiveness, because of the concerns with the study previously discussed.

***

FDA stated these reservations regarding with the data would be part of the FDA review provided to panel members. FDA commented it would be beneficial to have a harmonious approach in moving to the Panel Meeting in which unresolved issues can be brought. FDA also stated that the Major Deficiency Letter would be sent soon and that the Panel Meeting date would be scheduled.

***

FDA stated that the letter would most probably be a Major Deficiency letter. FDA explained that the previously sent list of issues may not be a complete list since the review of the PMA-S is on-going and she also cautioned against making the assumption that the Major Deficiency letter questions are a subset of the previously provided 51-items. It was further stated that the Major Deficiency letter questions could not be provided interactively.

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52. These minutes simply do not square with the prospect that the Payers would make

a finding of “medical necessity” as a result of their own science-based review in that the

Company’s TRD data did not represent adequate evidence of safety and effectiveness in the

eyes of the FDA scientists involved in the review. Defendants knew that, on the basis of these

comments alone, even if they somehow managed to get their VNS treatment approved by FDA

for sale, the scientific evidence was extraordinarily weak, so weak that the Company faced the

very likely prospect of ruinous consequences in the marketplace once Payers completed their

own science-based evaluations.

53. In light of these highly discouraging and alarming developments, defendants

issued a press release entitled, “CYBERONICS ANNOUNCES Q3 FINANCIAL RESULTS,

REVISED FY04 GUIDANCE AND FDA FEEDBACK FROM 100 DAY MEETING.” The

press release stated in part:

HOUSTON, Texas, February 5, 2004 -- Cyberonics, Inc. (NASDAQ:CYBX) today announced financial results for the third quarter ended January 23, 2004 of its fiscal year ending April 30, 2004.

***

“The improvements in FY04 post-reorganization sales force productivity and the reductions in our epilepsy investments have favorable implications for profitability going forward, with or without depression,” concluded Mr. Cummins. “In FY04, epilepsy contribution as measured by net income excluding direct new indications development expenses will total approximately $15.8 million or 14% of sales. In FY05, assuming no growth in new patient units, we expect epilepsy contribution to increase to approximately $20 million or 18% of sales. Regarding depression, our top down launch strategy will likely target 120 centers of excellence and 6,125 psychiatrists who treat an estimated 1 million to 1.6 million Americans with treatment resistant depression. If we receive a favorable approvability decision from FDA, the sales organization required to address the served epilepsy market and the at-launch target depression market will likely be less than 175 total personnel or 35% below the previous sales headcount estimate of 292.”

“Our 100-Day Meeting with FDA occurred on February 4, 2004,” commented Alan D. Totah, Vice President Regulatory Affairs and Quality. “Based on FDA feedback at that 100-Day meeting we now believe that the climb to a U.S. regulatory approvability decision will be completed on the original

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schedule which was Advisory Panel Meeting in July and an approvability decision on our depression PMA-Supplement (PMA-S) in October 2004. The 100-Day meeting feedback from FDA supercedes prior FDA communications. According to FDA at the 100-Day Meeting, (1) the PMA-S is a very large and complicated application; (2) the substantive, Expedited Review of the PMA-S is a “work in progress;” (3) Cyberonics will receive a list of questions/issues covering safety, effectiveness and clinical significance and trial design in the form of a “Deficiency Letter” once FDA’s substantive review is completed; (4) Cyberonics should respond to those issues/questions in a PMA-S Amendment; and (5) an Advisory Panel Meeting will most likely occur approximately 12 weeks after FDA receives that PMA-S Amendment. Obviously, Cyberonics believes that all issues and questions are answered by our original application and we are prepared to respond immediately to FDA’s needs to facilitate a timely Panel Meeting and approvability decision.”

54. Defendants’ comments in the press release of February 5, 2004, were false and

misleading. Defendants Cummins and Totah knew that, on the basis of the feedback received

from FDA the previous day, it was objectively unreasonable that the Company’s efforts to

“target 120 centers of excellence and 6,125 psychiatrists who treat an estimated 1 million to 1.6

million Americans with treatment resistant depression” would be a profitable endeavor.

Defendant Totah also knew that the outcome of the meeting could hardly be referred to as a

“successful ascent” in the Company’s climb towards approval. The “feedback” Totah and the

Company received, including that “FDA has serious concerns whether this data set could support

safety and effectiveness, because of the concerns with the study previously discussed” was

wholly consistent with FDA’s prior communications, including the feedback delivered to the

Company on October 4, 2002.

55. As admitted both prior to and during the Class Period, defendants knew that the

decision of the Payers to issue positive coverage determinations would be made on the basis of

the scientific evidence, including that which FDA scientists had reviewed. However, they

concealed the fact that FDA scientists engaged in the review were so concerned that the

Company’s TRD data did not represent adequate evidence of safety and effectiveness that they

- 34 -

went to their management with a “Not Approvable Letter” as one of the “official response”

options.

56. During the Company’s February 5, 2004 conference call, defendants stated in

part:

Alan Totah - Cyberonics - VP Regulatory and Quality

***

Finally, what is our level of confidence in the approval? We remain confident in our data and believe we have a compelling case to make to the neurological devices panel, which the FDA told us yesterday, will meet approximately 12 weeks after they receive our response to their 100-day meeting issues and questions which we expect to receive sometime toward the end of this month. That concludes my comments and I would now like to turn the meeting over to Pam Westbrook.

***

Mark Landy - Leerink Swann - Analyst

Hi, guys. Okay let's delve into the 100-day meeting if we can. The biggest issue that we all have going forward now is the validity of the D 04. Could you share with us the commentary made at that meeting by the FDA on the D 04 (ph) study?

Robert Cummins - Cyberonics - Chairman, President, CEO

As Alan mentioned, FDA has indicated that they will group their issues/questions into three separate buckets, as it were. One is safety. And obviously, their concern there would be safety specifically among patients with treatment-resistant depression. The second is effectiveness in clinical significance, and the last one would be trial design, which of course, the validity of a D 04 control would be a big part of it.


Okay, so what discussions were heard over D 04?


At the 100-day meeting?


Yes.

- 35 -


The issue was just brought up as one of the issues that they would have -- that they would expect to continue to review as part of our PMA supplement, and that it may be part of the questions and issues that they would want us to respond to in the PMA supplement amendment, which would precede the panel meeting.

57. Defendant Cummins’ response above was false and misleading. As the

confidential meeting minutes indicated, FDA stated its most important impression upon PMA-S

review, that, “FDA has serious concerns whether this data set could support safety and

effectiveness, because of the concerns with the study previously discussed.” As determined

from prior and subsequent confidential FDA documents, “this data set” meant the combining of

the data from the Company’s D-04 study with its D-02 study, a decision the Company had

unilaterally made to salvage the results of that failed D-02 study. For these same reasons

defendant Totah’s expression of confidence in the data was false and misleading as well.

58. In fact, defendant Cummins knew that the Company’s use of the D-04 study

wasn’t simply “one of the issues” – it was the key issue defendants faced in its efforts to gain

approval of the PMA-S. It was also wrong to state that “it may be part” of the subsequent

questions the Company would have to deal with – it was the most important question facing

approval of the PMA-S. Defendants continued, in part:


Okay, so the previous communications from the FDA that you have released to us, such as you (indiscernible) the panel and they agree with you that you don't need randomization, all of that stuff, should we just as you disregard all of that or are some of the comments still consistent with what we had seen?


Well, the previous -- the filing letter that we received from them where they quoted the regulation with regard to valid scientific evidence from all controlled investigations is indeed the regulation. So that is the regulation and

- 36 -

that was addressed also in our filing letter. And the point here is that -- that's a very valid question for the panel -- is whether or not D04 represent a valid control such that we have scientific evidence from well controlled investigations. Obviously, our position on that for all the reasons that we have provided to all of you with regard to baseline elements and with regard to no difference and treatments as usual during the long-term follow-up phase is that, yes, it is a valid, active control as defined by the regulation. And the regulation does not require that that control be a randomized placebo or otherwise control. Active controls are deemed to be appropriate.

***


Great thanks. Two questions, if I may. First, Skip, if it came down to it, would you do another full depression study if you had to?


As we have repeatedly stated, Bill, we find no basis in the results of our study, the safety and effectiveness that has been demonstrated, the design of that study and whether or not it needs the active controlled regulation defined requirements or in drug or neuro device approval precedents that would suggest that another study would be required to demonstrate safety and effectiveness. So the answer to that question is we want FDA's decision on the approvability of the existing depression PMAS.

59. Defendant Cummins’ further response to Mr. Landy was false and misleading. As

the confidential meeting minutes indicated, FDA did not agree to bind itself in the way Cummins

described. If anything, the language contained in the filing letter was a warning to the Company,

in light of its fundamental and unresolved disagreement with the Company, to assure that it did

good science, to submit “valid scientific evidence.” Cummins twisted the meaning of this to

construe FDA’s ministerial act of accepting the application as evidence that FDA had blessed its

data and statistical plan in accordance with regulations and then to make it appear as if

something “new” and “unexpected” had come out of the 100-day meeting. In fact, nothing new

had come out at all. Rather, the nature and quality of the scientific evidence defendants

unilaterally defined and then submitted was so weak that FDA was forced to once again repeat

its message of “serious concerns.”

- 37 -

60. Defendant Cummins’ response to Mr. Landy’s question regarding his

unwillingness to do another study was also false and misleading. Cummins told Landy that he

wouldn’t be willing to do another study because the data was sufficient to establish safety and

effectiveness. However, these stated reasons are contradicted by the offer defendants made to

FDA to do another study during the February 4, 2004 meeting, as evidenced by the following

confidential FDA e-mail:

From: Psychopharmacology Team Leader

Sent: Wednesday, February 04, 2004 1:56 PM

To: Review Team Leader; Branch Chief

Cc: Pyschopharmacology Team Leader, CDER Medical Reviewer

Subject: Post approval study

I would like to point out that Cyberonics spent an hour telling why it was completely impossible for them to do a placebo controlled long-term (or short-term) study (even though other sponsors are doing this with TRD with drugs that we review in our Division without any reported trouble from IRBs or recruiting patients) but then, completely out of the blue; promised that if we approved the device that they would do such a study post approval.

I find this offer extremely puzzling since their argument centered around troubles with ethics, IRB cooperation, and patient recruitment. These are definitely not problems that would go away post approval.

I suggest that we note this lapse In logic In the minutes.

Psychopharmacology Team Leader USPBS

61. If anything, the FDA e-mail of February 4, 2004, demonstrates just how far apart

FDA and the Company were on the substantive issues impacting approval, as well as the ethical

lapses and “special treatment” the Company sought, to “lower the bar” for the nature and quality

of the scientific evidence the Company could provide. In the company’s February 4, 2004

conference call, defendants further stated, in part:


- 38 -

Have you ever had one that went out significantly longer than that?


In the approval cycle?


No, just getting the deficiency letter back and having it kick back for more questions after that?


Back to the question you had a little while ago, that definitely can happen. It's a possibility that that could happen. But based on the 100-day meeting and who we had there again and who was representing FDA, which was their top man -- by the way, let me clarify that right now. We're not talking about comments coming from the leader reviewer. I'm talking about comments coming from management at FDA. That's who's at this meeting. And basically, when you do the substantive review, what happens is the lead reviewer's comments and everybody else they have looking at the submission, eventually those comments go in for a management review at FDA and that is where eventually a letter can be issued to the company, that is exactly where we are. And I think we should get those questions very soon. I do think -- maybe I can answer it this way. In my view, I would have found it highly unlikely for FDA to go ahead and state that they have a target of going to panel in twelve weeks post our response if they felt that our response was not going to be adequate already based on probably what is already in the application and that would allow us to go forward.

62. Defendant Totah’s statements were false and misleading. Again, based on the

confidential meeting minutes, defendant Totah lacked an objectively reasonable basis for

asserting that FDA believed that the issues facing the PMA-S were minor enough that the

Company’s response a “deficiency letter” was going to be adequate to respond to FDA’s

legitimate concerns.

63. Defendants were then asked on the February 5 conference call what was meant,

in the Company’s case, by the term “deficiency letter.” Defendants stated in part:

Alex Arrow - Lazard - Analyst

Okay. Finally, you said the deficiency letter is one of three ways that they can handle it. Can you say what the other two ways are?


- 39 -

Another thing that can happen to you is it can be approvable or it can also be not approved.

Alex Arrow - Lazard - Analyst

So the middle ground most common.


Actually, the path we're on is the routine path, which is they have some questions. Even though there is an interactive review, they still had some questions that we're not given to us specifically as part of the interactive review and we picked up here at the end.


Alex, the reason for that is the approvable just means okay, we don't have any questions or issues that you need to address in your pre-panel PMA amendment supplement or PMA supplement amendment, which as Alan was saying, was now extraordinarily rare. And the unapprovable or nonapprovable means no way in America are you going to panel. So the vast majority end up exactly where we are and the designation deficiency letter is the way they formally communicate to you what they would like to see in your PMA supplement amendment which needs to be filed well in advance of the panel to be considered by the panel and to be included in your ultimate labeling if you are approved.

64. What defendant Cummins omitted from the discussion, as previously explained,

was just how far apart FDA and the Company were on the substantive review issues, including

underlying science, for the PMA-S, so far apart that FDA reviewers had already asked their

upper management to entertain the possibility of the issuance of a “Not Approvable Letter.” In

fact, Cummins’ statement that the vast majority of applicants wind up where the Company

found itself was false and misleading on the basis of the meeting minutes, which placed the

Company quite close to a “Not Approvable” decision.

65. The Company continued in its false and misleading statements during the period

leading up to the June 15, 2004 advisory panel meeting. On April 1, 2004, the Company issued a

press release entitled, “CYBERONICS’ DEPRESSION PMA-S ON THE AGENDA FOR FDA

- 40 -

NEUROLOGICAL DEVICES ADVISORY PANEL MEETING SCHEDULED FOR JUNE 15,

2004,” which stated in part:

HOUSTON, Texas, April 1, 2004 -- Cyberonics, Inc. (NASDAQ:CYBX) today announced that it has been formally notified by FDA that a meeting of FDA’s Neurological Devices Advisory Panel has been scheduled for June 15, 2004 to review Cyberonics’ PMA-Supplement (PMA-S) seeking approval to market the VNS TherapyTM System “as an adjunctive long-term treatment of chronic or recurrent depression for patients over the age of 18 who are experiencing a major depressive episode that has not had an adequate response to two or more adequate antidepressant treatments.” The meeting date is tentative until such time as it is officially confirmed by FDA by announcement in the Federal Register or on FDA’s CDRH website.

“We are very pleased with FDA’s timely decision to set a Panel date within two weeks of our response to FDA’s Deficiency Letter and to hold an Advisory Panel Meeting within eight months of accepting our depression PMA-S for filing,” commented Robert P. (“Skip”) Cummins, Cyberonics’ Chairman and Chief Executive Officer. “Up to 4.4 million Americans and their families living with treatment-resistant depression need an FDA-approved, effective, safe and tolerable long-term treatment, and we are looking forward to presenting the compelling long-term safety and effectiveness data from the VNS Therapy studies to the Advisory Panel.”

HISTORY OF VNS THERAPY DEPRESSION STUDIES

Cyberonics’ comprehensive VNS Therapy depression study program began with the first pilot study implant in July 1998. The depression study program includes the following studies: a 60-patient acute and long-term pilot study (D-01); a 235-patient double blind, randomized, placebo controlled 8-week fixed dose acute pivotal study with a long-term extension (D-02); a 127-patient long-term observational study of patients with chronic or recurrent treatment resistant depression treated only with treatment as usual (D-04); neuroimaging, neurochemical and sleep mechanism of action studies; and several healthcare utilization and cost effectiveness studies. The patients in these studies were suffering from chronic or recurrent treatment resistant depression. In the D-02 and D-04 studies, the average lifetime illness exceeded 25 years and the average duration of the current depressive episode exceeded 48 months.

Highly statistically and clinically significant acute and long-term response and remission rates were observed in the D-01 pilot study. The first implant in the D-02 pivotal study occurred in August 2000. In January 2002, Cyberonics announced that although clinically meaningful, the difference in the D-02 treatment and placebo group HRSD-24 response rates at the end of the eight-week fixed dose acute study was not statistically significant. In September 2002, after determining the likely contributors to the lack of statistical significance, Cyberonics submitted a revised, prospective long-term pivotal study analysis plan to FDA. That plan was designed to determine the statistical and clinical

- 41 -

significance of the long-term improvements from baseline in all D-02 study patients treated over a one-year period with VNS Therapy and treatment as usual and to determine the causal relationship between those outcomes and VNS Therapy by comparing those D-02 outcomes with the outcomes of the D-04 patients treated only with treatment as usual.

In January 2003, Cyberonics announced that the one-year data from its D-02 depression pivotal study, analyzed pursuant to the D-02 analysis plan submitted to the FDA in September 2002, showed statistically and clinically significant improvements compared to baseline. Statistical significance was determined using a repeated measures linear regression technique to analyze improvements from pre-treatment baseline in the 24-item Hamilton Rating Scale (HRSD-24) during one year of VNS Therapy. The HRSD-24 improvements observed over the first year were highly significant with a p-value < 0.001. The secondary measures of statistical significance showed similarly positive results. Clinical significance was determined by analyzing the percent of patients who showed a sustained HRSD-24 response between nine and 12 months of treatment with VNS Therapy. In the absence of published literature that defines a long-term success criterion, Cyberonics’ psychiatric clinical advisors suggested that a sustained response rate of approximately 30% would be significant. Approximately 30% of the patients from the original acute treatment group and 27% of all patients in the analysis showed a sustained response between months nine and 12.

In July 2003, Cyberonics announced that the preliminary one-year results from its D-02 VNS Therapy depression pivotal study and D-04 companion study of chronic and recurrent treatment resistant depression, analyzed pursuant to the D-02 analysis plan submitted to the U.S. Food and Drug Administration (FDA) in September 2002, showed a highly statistically significant causal relationship (p-value < 0.001) between VNS Therapy and the depression improvements from baseline observed in the D-02 VNS Therapy study. The causal relationship between VNS Therapy and the D-02 patients’ one-year outcomes was determined using a repeated measures linear regression analysis to compare depression improvements as measured by the Inventory of Depressive Symptomatology-Self Report (IDS-SR) over one year in 205 D-02 patients receiving VNS Therapy and treatment as usual with the IDS-SR outcomes of 124 patients in a companion study, D-04, receiving only treatment as usual. In D-04, patients with chronic or recurrent treatment resistant depression who met the critical D-02 inclusion criteria were treated with standard medical management at 13 total study sites including 12 of the 21 D-02 study sites. Statistically and clinically significant differences in the physician and patient reported D-02 and D-04 patients’ one-year response and remission rates were also observed. One-year response rates, defined as at least a 50% improvement in depression symptoms as measured by the IDS-SR and HRSD-24 (24 item clinician rated Hamilton Rating Scale for Depression) were 22% and 30%, respectively in D-02 and 12% and 13%, respectively in D-04. One-year remission rates, defined as the percentage of patients free of depressive symptoms after one year of treatment, were 15% and 17%, respectively in D-02 and 4% and 7%, respectively in D-04.

- 42 -

In October 2003, Cyberonics submitted an 87-volume PMA-Supplement (PMA-S) to the U.S. Food and Drug Administration (FDA) seeking approval to market the VNS Therapy System in the United States as an adjunctive long-term treatment of chronic or recurrent treatment-resistant depression. That PMA-S included acute and one-year data and analyses on approximately 335 patients treated with VNS plus treatment as usual and approximately 125 patients treated only with treatment as usual. FDA accepted the depression PMA-S for filing on December 15, 2003. The official filing date for regulatory timeline purposes is October 27, 2003. A Neurological Devices Advisory Panel Meeting has been tentatively scheduled by FDA for June 15, 2004 to review the depression PMA-S.

66. Defendants’ press release of April 1, 2004, was false and misleading. The press

release recounted the “History Of VNS Depression Studies,” in which defendants made three

separate references to its September 2002 submission of “ a revised, prospective long-term

pivotal study analysis plan to FDA,” as indicative of the prior approval of the statistical plan by

FDA. Unbeknownst to investors, Cyberonics already knew that FDA had disapproved of that

plan, having been told this on three separate occasions: in FDA’s October 4, 2002 IDE

correspondence letter; during the PMA-S 100-day meeting; and in the “Major Deficiency Letter”

of March 1, 2004. Finally, as if the false and misleading answers given during the February 4,

2004 conference call weren’t sufficiently egregious, the April 1, 2004 press release certainly

was, as the Company was already in receipt of that Major Deficiency Letter, which again

addressed the statistical comparison as it involved the D-04 study as its number one concern.

67. While the Company continued to mislead investors regarding a claimed

“partnership” with FDA as well as the status and true issues defining FDA regulatory review of

the PMA-S, the Company relied on its reimbursement team “health economics” and “cost-

effectiveness” data to intentionally misrepresent the true marketing opportunity for the TRD

indication. For example, the Company showcased its reimbursement team data in the April 1,

2004 press release, stating that “[u]p to 4.4 million Americans and their families living with

treatment-resistant depression…” to intentionally mislead investors in two distinctly different

ways. First, the company justified to investors the “marketing opportunity” for the TRD

- 43 -

indication on the basis of its calculation of 4.4 million Americans with unmet needs for TRD

therapies, as opposed to its purported “marketability,” which was illusory as a result inadequate

scientific evidence for Payer approval purposes.

68. Second, the marketability of the VNS Device to 4.4 million Americans stood

solely for the proposition that the Company was poised for explosive growth. This

“marketability” claim was outrageous, false and misleading, simply because the Company knew

and concealed the fact that the claim failed to meet good science, which risked inadequacy of the

scientific evidence the Company could provide for Payer evaluation purposes. Nevertheless, this

wildly inflated marketing claim would potentially serve to propel rapid inflation in the

Company’s stock price, upon any positive news – including defendants’ misleading

representations -- on the status of the PMA-S review.

69. On June 15, 2004, the Company proceeded to the FDA advisory panel review of

its PMA-S. Unbeknownst to investors, FDA scientists present at the panel meeting saw the

Company’s use of panel meeting for what it was -- an emotional play, devoid of any new data,

substance or persuasiveness for approval purposes. According to confidential notes of meeting

proceedings by the FDA Medical Officer, whose opinion represented a key input, the Company

resorted to emotionally charged tactics to win a positive panel review, despite the serious

science-based nature of FDA’s true concerns.

70. These notes show that the Company finally admitted to the panel that a

randomized long-term trial was feasible but also claimed that 36,000 patients would die as a

result in the three years that it would take to complete a trial. In his June 22, 2004 opinion

memo, the FDA Medical Officer assigned to the PMA-S review, recounted his observations and

views, in part.19

19 According to one confidential witness with knowledge (“CW1”), the Company also violated protocols for its VNS clinical studies. CW1 is a former employee of Cyberonics who held various positions with the Company at times relevant to this

- 44 -

Outstanding efficacy issues: During panel deliberations (this section to be edited when transcript is available) several panel members indicated that they felt efficacy was not adequately demonstrated by the non-randomized study design. They felt, however, that the device could be labeled for use in patients only after all other therapies that have been proven based on rigorous study designs were exhausted. The C[FR] 860.7(e)(1) states that for a device to be approved there must be reasonable assurance of efficacy. In the panel vote, the panel chose to vote for conditional approval based on an unmet need despite a lack of efficacy. The burden for proof of efficacy is not variable based on the need of a patient population in which it is too be applied. The sponsor admitted that a prospective, randomized, long-term trial was now feasible. They however attempted to persuade the panel by claiming that 36000 patients would die during the three years that it would take to complete such a trial. The data provided in the PMA do not support a decreased rate of suicide in the treated patients compared to the control population (D04). Therefore it is not unethical to conduct an appropriate trial, but is unethical to approve the implantation of a device who’s efficacy is unproven.

***

Recommendation: I recommend this application is not approvable. The sponsor has failed to show a reasonable assurance of efficacy. While the panel was swayed by emotional pleas and was made to feel responsible for future suicides of patients with TRD should this device not be approved, the sponsor failed to provide adequate data to support the efficacy of this device in the treatment of chronic, resistant depression. Despite the sponsor’s attempts, the issue of placebo effect, concomitant antidepressant treatment changes, and the difference between the treatment and observational control groups remain potential factors in the observed benefit of the device.

This device represents a treatment for depression that should be viewed as no different tha[n] any drug labeled for depression, thus the requirement of a prospective, randomized, placebo controlled, double blinded trial should be equally applied to this device as it is to drug therapies.

71. On June 15, 2004, following the panel review, Cyberonics issued a press release

entitled, “FDA ADVISORY PANEL RECOMMENDS APPROVAL OF CYBERONICS’

DEPRESSION DEVICE - Conference Call Scheduled for June 16, 2004 at 4:00 PM EDT.” On

this day, the Neurological Devices Panel of the Medical Devices Advisory Committee met to

make recommendations and vote on the approvability of the Company’s PMA-S No.

action and defendants’ knowledge, including VNS Specialist, Territory Manager and Team Leader. CW1 specifically referred to the VNS clinical studies as “awful science” based on an “extremely flawed” study design.

- 45 -

P970003/S50. The panel reviewed the Company’s application and indicated use of the device,

the adjunctive long term treatment of chronic or recurrent depression for patients who are

experiencing a major depressive episode that has not had an adequate response to two or more

antidepressant treatments.20 The press release stated in part:

HOUSTON, Texas, June 15, 2004 -- Cyberonics, Inc. (NASDAQ:CYBX) announced that the Neurological Devices Panel of FDA’s Medical Devices Advisory Committee today voted 5 to 2 to recommend approval with conditions of Cyberonics’ VNS Therapy™ System “as an adjunctive long-term treatment of chronic or recurrent depression for patients over the age of 18 who are experiencing a major depressive episode that has not had an adequate response to four or more adequate antidepressant treatments.” Regarding conditions, the Panel recommended several labeling changes, that the VNS depression prescribers and implanting surgeons have appropriate experience and adequate training in the implantation and programming of the VNS Therapy System, that patients receive adequate education and that Cyberonics implement a long-term depression patient registry following approval. FDA’s Division of General and Restorative Neurological Devices will consider the deliberations, vote and recommendation of the Advisory Panel and make the final decision on approval of the VNS Therapy System for the proposed indication for use.

“The Panel’s recommendation represents a major step forward toward U.S. availability of the first FDA-approved, safe, tolerable and effective long-term treatment for patients with treatment-resistant depression,” commented Robert P. (“Skip”) Cummins, Cyberonics’ Chairman of the Board and Chief Executive Officer. “Millions of Americans today suffer from treatment-resistant depression (TRD), a devastating, lifelong and life-threatening illness. According to published studies, 15% of previously hospitalized patients commit suicide and annual depression treatment costs in the United States exceed $30 billion including $13.7 billion for drugs alone. Today’s Panel vote suggests that not only was there agreement on the significant unmet need, but also that the comprehensive one-year data and analyses on 460 patients included in Cyberonics’ PMA-Supplement demonstrated the safety and effectiveness of VNS Therapy as an adjunctive long-term treatment for chronic or recurrent treatment-resistant depression.

“Cyberonics is looking forward to working with FDA to finalize labeling that will ensure informed use of VNS Therapy, implement the Panel’s recommendations and obtain a timely approvability decision,” continued Mr. Cummins. “The Panel’s recommended conditions are consistent with Cyberonics’ depression plans and epilepsy history, including the proposed depression patient

20 The lengthy and highly technical transcript of FDA advisory panel review of June 15, 2004 can be found on the FDA website, at http://www.fda.gov/ohrms/dockets/ac/04/transcripts/2004-4047t1.htm. A summary of that transcript can be accessed at http://www.fda.gov/ohrms/dockets/ac/04/minutes /4047m1.pdf (both documents last accessed on November 3, 2005).

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registry, which will be similar to our existing epilepsy registry. The Panel’s vote is a tribute to the patients, families, psychiatrists and other clinicians whose courage, determination and pioneering spirit made the last six years of depression clinical studies possible. Special thanks go to (1) the six VNS patients, Drs. John Rush and Harold Sackeim, the American Psychiatric Association and the Depression and Bipolar Society of America for speaking at today’s meeting, (2) the Advisory Panel and FDA for their timely reviews of our PMA-Supplement and all supporting information and (3) last but not least to the dedicated men and women on Cyberonics’ depression team led by Dr. Richard Rudolph, Vice President of Clinical and Medical Affairs and Chief Medical Officer and Alan Totah, Vice President of Regulatory Affairs and Quality for their unwavering commitment to the 4 million Americans and their families suffering with TRD.

“Cyberonics’ mission is to improve the lives of people touched by epilepsy, depression and other chronic illnesses that prove to be treatable with our patented therapy, VNS,” concluded Mr. Cummins. “The plan to accomplish our mission in epilepsy in fiscal 2005 has been implemented and the plan to properly scale our organization to accomplish our mission in depression will be implemented as soon as we are confident of depression approval.”

72. Defendant’s press release of June 15, 2004, was false and misleading. According

to confidential notes of meeting proceedings by the FDA Medical Officer, the Company resorted

to emotionally charged tactics to win a positive panel review as opposed to objective science-

based discussions on the merits, in light of the serious science-based nature of FDA’s true

concerns. In fact, according to the FDA Chief Medical Officer, the “effectiveness” argument had

been ignored. While the Company finally admitted to the panel that a randomized long-term trial

was feasible, it emphasized that 36,000 patients would die in the three years that it would take

to complete a trial. The Medical Officer also noted the Company’s peculiar lapse of ethical

judgment in making this emotional play in that, while the panel was swayed by it, the PMA-S

data was so deficient that did not support the proposition that a decreased rate of suicide

would result from the use of the device.

73. On June 16, 2004, defendants conducted a post-panel review conference call.

Defendants stated in part:

Bill Alpert - Barrons - Analyst

Greetings. How do you get to the $60 billion market?

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Skip Cummins - Cyberonics - Chairman, Pres, CEO

4 million patients times $15,000 average system selling price.

***

Alex Arrow - Lazard Freres & Co. LLC - Analyst

Okay. Thanks. And then the last question, can you give us any guidance or have you said anything about potential timing for a CMS decision or other reimbursement type time lines that we can look forward to?


When we launched in epilepsy, we have neither coverage coding or reimbursement. In this case, we have coding and we have reimbursement. The issue will be coverage. We have already met with CMS. Obviously given that the same device and same therapy is already approved in epilepsy, the momentum is already on our side towards an early CMS coverage decision. We already have three major payers on the East Coast that have issued contingent coverage policy and a number of payers that we're aware of have actually paid for the device for depression off label that we've discovered after the fact, after it has been done, and after it has been paid for.

Alex Arrow - Lazard Freres & Co. LLC - Analyst

Can you be any more specific than early for your early CMS coverage?


Well, as you can imagine, we would love to have it on the same day we get FDA approval, but I don't think that is very likely. So I would say that our goal would be certainly within six months.

74. Defendant Cummins knew that this statement was false and misleading, in that it

reinforced the prospects of a positive outcome with FDA and the “marketability” outcome he had

instilled in the minds of the analysts. In truth, while the Company’s “emotional play” with the

panel had succeeded, defendants were well-aware that FDA was locked on the serious science-

based issues it had with the data going into the meeting. Defendants continued at the June 16

conference call in part:

James Gallgher - Waddell and Reed - Analyst

- 48 -

Good afternoon, gentlemen and again I add my congratulations to your successes. The question that I have relates to the perception of insurance companies for devices such as the one you anticipate. I'm not too familiar with the industry. Do insurance companies reimburse their covered patients, let's call them, for any similar devices or do you anticipate this happening? Is there any out there now that that do cover their patients? What's the status on that?


Let me give you a couple of data points that may make you comfortable with regard to the likely coverage and access to VNS therapy. The first is, is that ECT is widely reimbursed. Which is electroconvulsive therapy. That is widely reimbursed. We have all the data on what levels it is being reimbursed at. And interestingly enough, ECT is associated with extended hospital admissions. On average of about 16 days.

The total cost of each ECT series is about $11,000. So yes, there is a precedent, even under mental health benefits in this case, for a device-like procedure to be reimbursed. The other -- the other issue is, is that payers know very well that TRD is one of the biggest consumers of their dollars. In studies that we conducted, we showed that patients hospitalized once for depression or who had attempted suicide at least on one occasion, cost payers over $42,000 per patient per year.

Now, the payers are very sensitive to that, as are the employers, and et cetera, so there is a significant sense of urgency among payers to find a solution, a cost-effective solution to this gigantic problem of theirs.

75. Defendant Cummins’ statement that analysts should be “comfortable with regard

to the likely coverage and access to VNS therapy” was false and misleading, in that he knew

and concealed the serious nature of the science-based disagreements the Company had with FDA

going into the panel review, as well as the general deficiencies of the scientific and research data

to support a Payer finding of “medical necessity.” He also knew and concealed the fact that the

“panel win” was based on an emotional play, as opposed to data-driven arguments necessary to

determine “good science” grounds that merited approval. Knowing this, Cummins justified the

merits and promise of the Company’s TRD treatment option on “unmet need” and cost

comparisons, when he knew that the Payers would have to make science-based evaluations of the

available data, with key elements of the required science-based evidence becoming available as

of June 15, 2004, as a result of the panel review.

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76. There were also questions at this time regarding the performance of the studies

themselves. According to one confidential witness with knowledge (“CW1”), the Company

violated protocols for its TRD clinical studies. CW1 is a former employee of Cyberonics who

held various positions with the Company at times relevant to this action and defendants’

knowledge, including VNS Specialist, Territory Manager and Team Leader. CW1 specifically

referred to the VNS clinical studies as “awful science” based on “extremely flawed” study

design. A most noteworthy problem with the VNS clinical studies indicated by CW1 was that

Cyberonics employed inadequate study site coordinators. CW1 further explained that companies

normally hire several study site coordinators when conducting clinical trials to ensure that the

study protocols are being followed. According to CW1, study site coordinator’s responsibilities

include traveling to each clinical trial site (hospital), approximately 26 sites nationwide in

Cyberonics case, to ensure that physicians are following the study protocol. According to CW1,

only 3 of the approximately 26 sites actually followed the protocols. CW1’s statements further

demonstrate that defendants had no basis to represent during the Class Period that general and

profitable Payer approval was likely.

77. The findings of the FDA Chief Medical Officer are validated by another

confidential witness with knowledge who was present at the June 2004 panel meeting (“CW2” –

CW2 is a former employee of Cyberonics who held various positions with the Company at times

relevant to this action and defendants’ knowledge, including Assistant Program Coordinator,

Program Coordinator and Senior Program Coordinator), CW2 perceived as a Company insider

that there were too many questions left unanswered for the FDA advisory committee.

78. In an egregious insider-privileged act, on the evening of June 15, 2004, the

Company rewarded its executive staff with stock options pegged to the previous day’s trading

price. The Company did so knowing that it had already primed the Company’s stock for

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explosive gains as a result of their previously blatantly false and misleading “marketability”

claims in addition to the June 15, 2004 press release and the media accounts that followed.

79. As a result, following the news of June 15-16, 2004, including the Company’s

glowing claims of success and expectations to “finalize labeling” for the device with FDA, the

price of Cyberonics stock rocketed upward, achieving a two-day gain of $18.82 or ninety-six

percent, on record volume21 totaling over 72 million shares, closing on June 17, 2004 at $38.40

per share. The unprecedented volume and price gains also resulted in impressive gains for the

Company’s June 15th optionees, including a gain of $2.8 million for the Company’s Chairman

and CEO, within two days after the advisory panel meeting.

80. On August 11, 2004, the Company issued a press release entitled,

“CYBERONICS REPORTS Q1 RESULTS - Conference call scheduled for 4:30 PM EDT.” The

press release stated in part:

HOUSTON, Texas, August 11, 2004 -- Cyberonics, Inc. (NASDAQ:CYBX) today announced financial results for the first quarter ended July 30, 2004 of its fiscal year ending April 29, 2005. Net sales were $25.1 million, compared to net sales of $26.7 million for the quarter ended July 25, 2003. U.S. net sales for the first quarter were $22.5 million compared to U.S. net sales of $25.0 million for the first quarter last year. International sales for the first quarter were $2.6 million, compared to $1.7 million for the first quarter last year.

***

Robert P. (“Skip”) Cummins, Cyberonics’ Chairman of the Board and Chief Executive Officer commented, “Cyberonics’ goals for fiscal 2005 are to maintain our epilepsy business while at the same time obtaining regulatory approval and successfully launching VNS TherapyTM as a treatment for chronic or recurrent treatment-resistant depression. We made good progress towards those objectives in the first quarter. In Q1, Cyberonics not only obtained a favorable FDA Advisory Panel depression recommendation, but we also prudently managed our depression investments to report a better than planned net loss and positive cash flow.”

21 Trading in the Company’s shares achieved record volume of 44 million shares on June 16, 2004, followed by heavy volume of 28 million shares on June 17, 2004.

- 51 -

“Depression investments are both direct and indirect,” continued Mr. Cummins. “In Q1, direct new indications expenses were essentially on plan at $3.4 million. Indirect depression investments increased in Q1 and were made primarily by Cyberonics’ U.S. sales and operations departments. A successful depression launch will require approximately six months to adequately scale Cyberonics’ sales and operations organizations and processes to accomplish our mission both in epilepsy and depression. A delicate balance between the regulatory approval process and a successful launch must be maintained with investments triggered by regulatory milestones. One such milestone was the favorable Advisory Panel recommendation that triggered (1) an investment of U.S. epilepsy sales resources in depression pre-launch activities and (2) the commencement of the recruiting process to identify and qualify the additional sales personnel necessary to support depression. Those two investments are reflected in a sequential increase in administration expenses and a sequential decrease in U.S. sales. The other Q1 indirect depression investment was made in operations. In Q1 a planned one-time doubling of production to evaluate the scalability of Cyberonics’ manufacturing personnel, equipment and processes highlighted several opportunities for improvements that were made in Q1 with a one-quarter impact on gross margin.”

“We continue to work with FDA to obtain a favorable depression decision,” concluded Mr. Cummins. “Regulations and precedents would suggest that FDA should make its decision by October. We are optimistic that FDA’s decision will be favorable considering that (1) all PMA-Supplements with Expedited Review status and a favorable Panel recommendation in the last seven years have been approved by FDA, (2) 4.4 million Americans suffering with treatment-resistant depression today have no FDA-approved, safe and effective long-term treatment, (3) VNS Therapy is the only anti-depressant to have Expedited Review status, (4) FDA’s Advisory Panel including four deputized psychiatrists voted in favor of approval with straightforward conditions, (5) the one-year data from the VNS studies shows remarkable safety and efficacy in a group of patients with extreme, previously unstudied levels of treatment-resistant depression, and (6) widespread support for approval has been expressed by psychiatric thought leaders, patients and payers.”

“Our guidance for the second quarter reflects planned progress in depression and an increase in depression spending,” commented Pamela B. Westbrook, Vice President, Finance and Administration and Chief Financial Officer. “We expect that direct new indications expenses will increase to at least $6 million and that indirect investments to properly scale and train our U.S. sales organization will also increase. As a result, we expect sales for the second quarter to be essentially flat versus Q1 at $25 million and that gross margin will be 84%. Although we are not planning to hire the majority of the sales personnel to support a depression launch until we receive a formal communication from FDA, we expect that the net loss for the quarter will be approximately $9 million or $0.38 per fully diluted share reflecting an increase in direct and indirect depression spending. With our strong balance sheet, including $62 million in cash, Cyberonics has more than adequate capital to internally fund its growth and development going forward.”

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81. Defendants’ press release of August 11, 2004, was false and misleading.

Defendants again stated that approvability hinged on a successful panel review that, once

achieved, would progress the application to the end of the process, product labeling and the

approvability decision. This was false and misleading in that defendants knew and concealed the

serious nature of the science-based disagreements the Company had with FDA going into the

panel review. Defendants knew and concealed the fact that the “panel win” was based on an

emotional play, as opposed to data-driven arguments necessary to determine “good science”

grounds that merited approval. Moreover, defendants knew that their claims of “widespread

support” for approval by Payers was objectively baseless in that significant science-based

evidence the Payers needed to make their evaluations was lacking. Finally, defendants knew and

concealed that on July 12, 2004, FDA inspectors had descended on Cyberonics to begin an

inspection of the Company’s facilities, systems and records in connection with its PMA-S.

Moreover, unlike the extremely short FDA inspection that occurred on January 22 to 25, 30 and

February 1, 2001, triggering the FDA Warning Letter of March 23, 2001,22 the current

inspection, initiated a month prior to the August 11, 2004 press release, was ongoing and

unlikely to end soon.

82. On August 12, 2004, the Company issued a press release entitled “FDA

IGNORES PANEL RECOMMENDATION AND DETERMINES CYBERONICS’

EXPEDITED REVIEW DEPRESSION PMA-SUPPLEMENT NOT-APPROVABLE - 4.4

Million Americans with treatment-resistant depression left with no long-term treatment option.”

The press release stated in part:

HOUSTON, Texas, August 12, 2004 -- Cyberonics, Inc. (NASDAQ:CYBX) today announced that late yesterday it was notified by FDA in writing that “notwithstanding their (the Neurological Devices Panel’s)

22 The FDA “Warning Letter” of March 31, 2001 can be accessed at http://www.fda.gov/foi/warning_letters/g1054d.pdf.

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recommendation, we regret to inform you that (your) PMA-Supplement, absent additional information, must be considered not-approvable.” FDA’s stated reasons included worsening depression, potential biases stemming from a non-randomized control and an inability to distinguish one-year VNS effects from placebo and concomitant treatment effects.

“We are shocked and bewildered by FDA’s decision to ignore its expert Advisory Panel’s recommendation,” commented Robert P. (“Skip”) Cummins, Cyberonics’ Chairman of the Board and Chief Executive Officer. “FDA’s Center for Neurological and Restorative Devices had no prior depression experience before the VNS submission and as a result, FDA deputized four of the seven voting members of its expert Advisory Panel. All four of these deputized members were psychiatrists, including three who also serve on the antidepressant drug Advisory Panel. All of the reasons cited in yesterday’s not-approvable letter were addressed at the Panel meeting on June 15 prior to the Panel’s vote recommending approval. FDA has now chosen inexplicably to ignore not only the recommendation of its panel of experts, but also the strong recommendations of numerous psychiatric thought leaders and the compelling testimony and needs of people with treatment-resistant depression who today have no long-term treatment for their lifelong and life-threatening illness.”

***

“This is the first Expedited Review PMA-Supplement in history with a favorable Panel recommendation that has been determined by FDA to be not-approvable,” concluded Mr. Cummins. “In its letter, FDA seems to be rationalizing its unprecedented decision based on FDA’s seemingly arbitrary preference for a randomized controlled study that is neither required by the regulations nor the norm in the majority of device approval precedents reported by FDA in a recent CDRH Staff College Report. Apparently, FDA believes that the absence of a randomized control is adequate justification to leave 4.4 million Americans at significant suicide risk without a treatment option. FDA’s expert Advisory Panel, people living with treatment-resistant depression, psychiatric thought leaders, payers and all of us at Cyberonics strongly disagree.”

“We are in the process of arranging a meeting with senior FDA management to discuss their letter,” commented David S. Wise, Cyberonics’ Vice President and General Counsel. “We are actively considering all regulatory and legal options, including those successfully employed by other device companies to reverse inexplicable decisions and obtain PMA approvals.”

83. On August 12, 2004, following the press release, defendants made the following

statements and remarks:

Robert Cummins - Cyberonics, Inc. - Chairman, President, CEO

Hello seems more appropriate than good morning for the subject of our call today, and we'll dispense with any forward-looking statements disclaimer

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because I don't think they are appropriate. Needless to say, last night when we finished our call I didn't anticipate that we would be talking to you again this morning with the news that we are about to present, but, indeed here we are, and with me, as usual, is Pam Westbrook, our Chief Financial Officer. I will apologize in advance for being not as well organized as we've been on past conference calls, but as you might guess this was rather shocking, and I haven't had time to adequately prepare our normal well messaged script, so, it will be a little helter-skelter, and I apologize for that.

But, anyway, late last evening we received, from FDA, out of the blue an inexplicable, not-approvable, letter. Needless to say, we are shocked and continue to be shocked, and bewildered by FDAs decision to ignore its expert advisory panels recommendation. FDAs Center for Neurological and Restorative Devices had no prior depression experience, or knowledge, for that matter, before the D. N. S. submission, and as a result, FDA deputized 4 of the 7 voting members of its expert advisory panel. Now that's fairly unusual, and as you know from yesterday's call, we were not inform or we didn't learn of these deputized members and the make up of the panel until the afternoon of the day before. But, nonetheless, all 4 of these deputized members were psychiatrists, including 3 who also serve on the antidepressant drug advisory panel.

***

Apparently, FDA believes that the absence of a randomized control is adequate justification to leave 4.4 million Americans at significant suicide risk without a treatment option. FDAs expert advisory panel including 3 of the 4 deputized members of that panel, people living with treatment resistant depression, psychiatric thought leaders, payers and all of us at Cyberonics, obviously, strongly, disagree.

***

Yet, many of you will know doubt recall the interesting three-week period in January of this year where we first accelerated then pushed back our depression spending plans. A lot of people wondered about our motivations and why we did that. Well, within one week after our September, 2003, pre PMA meeting with FDA, a tentative February 22nd panel date was confirmed with us. With that, we accelerated our plans and properly disclosed that revised guidance to you. Three weeks, after then receiving our 87 volume PMAs, we were told, would, whoa, that's a lot of information, and there's no way for FDA to finish their review in time for a February 22 panel. So, the panel would have to be in April. We then, once again, properly disclosed re-revised guidance to you. Not because we were crazy. Not because we were trying to read a crystal ball. But because of tentative confirmations of panel base and promises made to us by FDA. Promises that were, obviously, broken.

I'll give you one last example. Immediately after the panel, senior FDA management complimented us on the thoroughness of our panel presentation, and

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said that if all presentations were as good as ours had been FDA's job would be much easier.

In the ten weeks since the panel, when over 5,000 Americans have committed suicide, our regulatory team has been working with FDAs reviewer, following up on information presented at the panel. We had no discussions with the division director or other members of FDAs senior management because the final review seems to be proceeding. Until yesterday evening. When, out of the blue, Alan Totah received a call from the division director, asking for our fax number so she can fax a not-approvable letter. For the first expedited review, PMA supplement, in history, with a favorable panel vote from FDAs especially chosen, deputized panel of experts, to receive such a letter.

***

So, where does FDAs inexplicable, unprecedented decision leave those 4.4 million Americans with TRD? With exactly what they had before Cyberonics had the courage, with the help of psychiatric thought leaders, to embark on a six-year development program to develop a treatment for them. And that is nothing. No hope, and nothing but a bunch of expensive, ineffective drugs, who's safety and efficacy in patients with TRD has never been, and never will be, studied. A bunch of drugs with as many failed acute studies as there are successful studies. A bunch of drugs who's efficacy is rarely, if ever, tested beyond eight to ten weeks. And, of course, with ECT. And more ECT. And more ECT. And more ECT and more ECT.

And, last but not least, as one of the patients testimony verified at the panel meeting with a final option that way too many Americans, 2500 every month, to be specific, choose to relief their pain, and that's suicide. And all because FDA wants a randomized control that is inconsistent with device regulations and device approval precedence.

***

And, last but not least, in the words of the thought leader that is I have shared this inexplicable decision with, it leaves us outraged. And with renewed determination and support to reverse this inexplicable decision and bring hope back to 4.4 million Americans who today really only have one way out. And we know what that one way out is.

***

Mark Landy - Susquehanna Financial Group - Analyst

And lastly, previously, you hade been pretty [inaudible] that, if the FDA turned you down in depression that was it. Was that just pandering, and can we assume that you remain very commit to depression? And then lastly, why wouldn't a three-month study work for the FDA if that seems what they are harping on.

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Well, you know, again you go back all the way to 1999 and every approval, every protocol approval that we've gotten from FDA, Mark, and we were pushing our acute study design at that point because that's all we really new from epilepsy and all we had from the depression pilot studies. Every protocol approval letter that we got from FDA they said, okay, we will give you approval for your acute randomized placebo controlled study, but don't forget that you better have at least 100 patients with one year longitudinal patients that have their owned controlled data, analyzing using repeated measures regression analysis, or otherwise you would not have adequately demonstrated the effectiveness of the long-term implant. They reiterated that, and reiterated that, and reiterated that, and then when we gave them that, and then we augmented that with an unprecedented comparison to a group of patients treated with all currently available treatment, again, it wasn't good enough. So, again, what is good enough appears to once again, disappointingly, to be consistent with our epilepsy experience, which is an ever changing and moving target, based on more personal preferences than regulations and precedence.

Mark Landy - Susquehanna Financial Group - Analyst

Thank you for your candid insight, Skip.

***

84. Defendants’ August 12, 2004 press release and remarks during the conference call

were false and misleading. First, defendant Cummins stated that the Company enjoyed FDA’s

approval for its clinical studies going back “all the way to 1999,” that FDA reiterated again and

again what it wanted and that the Company gave FDA what it wanted and then some. However,

he knew that his comments were false and misleading in that FDA had, in fact, reiterated again

and again its serious concerns and advice on the type and quality of the scientific evidence it

sought for TRD safety and efficacy. Defendant Cummins knew that the failure was his, not

FDA’s, as the Company was steadfast in its refusal to provide what FDA had advised and, as

documented in the FDA minutes of March 1, 2002, the FDA letter of October 4, 2002, the

minutes of the PMA-S meeting of February 4, 2004, the “Major Deficiency Letter” of March 1,

2004 and finally in the “Not Approvable Letter” of August 11, 2004. In other words, it is

absolutely clear from FDA internal documents that the communication of strong concerns

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regarding the adequacy of the Company’s scientific evidence was consistently communicated

and consistently ignored.

85. Defendants’ August 12, 2004 remarks continued, in part:

Bill Slattery - Unidentified - Analyst

Skip, I see this is putting you in a very awkward position, in one sense you are litigating with the agency or approaching litigation. In the other sense you're negotiating. I wouldn't want to be in your shoes, especially after this call. The question I have, specifically, if I think about negotiations to get to an agreeable trial design, 6 to 12 months, and 12 months to control the study, and 12 months to complete the study, we are talking three to four years before you have data in front of the agency again. Would you take that route.


Yeah, basically, what you are talking is best case, if we were to start the process today, best case is we probably would have a submission into FDA for their review, expedited review, in about three years. So, three years give or take six months, we would be kind of right back to where we are today, which is starting a process that seems to be ever changing with goal posts that seem to be moving from right to left and north and south.

K. McKay - Unidentified - Analyst

When would you expect that you would have your strategy in place, and then go back to the FDA as far as negotiation or discussion on this?


Well, we already have approaches being made to the highest levels of FDA management to contact them, and we've also, just so you know, following the panel meeting, there have been significant expressions of support from all walks of life, political, professional, patient advocacy, medical, et cetera, expressed to FDA. So, and what I can tell you is, many, many people approached us who wanted to go to FDA, and we said, no, look, they are doing their work, they seem to be cross proceeding, let them do their work. But now unfortunately, I don't control that because patient and clinician outrage will take its course. It's beyond my control now. So, we are going to meet with FDA, as soon as we possibly can, and try to get somebody at a high level there to understand that this unprecedented decision was a mistake.


So, within the next few weeks, or is that your objective?


- 58 -

Well I would be in Washington, D.C. right now if they would have agreed to meet today, but the person who is working on the meeting, a very senior regulatory attorney that we've worked with in DC, hasn't called me and told me when I need to be there. But, I believe when I will go there I will be meeting with more than just FDA. Because there are a lot of other interested parties in Washington, D.C. that will be very disappointed in this decision.


Okay. Thank you.

86. For the reasons already stated, defendant Cummins’ claim that FDA had shifted

the goalposts from “right to left and north to south” was blatantly false and misleading. As

evidence by the chain of communications and correspondence received by the Company,

including the FDA minutes of March 1, 2002, the FDA letter of October 4, 2002, the minutes of

the PMA-S meeting of February 4, 2004, the “Major Deficiency Letter of March 1, 2004, and

finally in the “Not Approvable Letter” of August 11, 2004, it is absolutely clear that FDA’s

communication of strong concerns regarding the adequacy of the Company’s scientific evidence

was consistently communicated and consistently ignored. The August 12 conference call

continued with defendants stating in part:

Stephen Sabba - Sturza's Medical Research - Analyst

Hi, thanks for taking my question. I actually have a question about, two questions, really. One, it seems to me that if there's a problem with IRBs signing on to long-term studies, I'm wondering why you can't do VNS versus ECT. Because, it seems that part of the issue with the sham procedure is that the person feels that something is being done, something, and even though ECT isn't an implant it is something quite similar, I think, in people's minds and that's part of, really, the placebo effect. And, secondly, I'm wondering if you don't feel that your language is somewhat inflammatory, and that's not helping you in the future with the FDA using inflammatory language using vis-a-vis the FDA.


On the inflammatory language side, we have always dealt with FDA very fairly and in good faith. And, all I can tell you is, a letter out of the blue, yesterday, with no heads up from FDA senior management, given the process that

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we've been through in depression, in itself is our opinion more inflammatory than any language that I would use.


You keep saying arbitrary, inexplicable, it's obviously one of the randomized control trial, and you could have done one and that would have solved the problem.


That's inconsistent with regulation and device approval precedence and a vote of their panel.


Most devices though, the primary implants are objective, and the problem with depression is there's a high degree of subjectivity, and that's, you know, so it's an unprecedented indication. You have to realize that, right? Is that not the case?


Of course, that's why we rely on psychiatric thought leader who use end points that are standardized and well accepted in the industry and with FDA.


But you didn't provide a randomized control trial. That seems to be the issue.


No, but there is no randomized control trial precedent with a one-year study.

87. Defendant Cummins’ remarks were false and misleading. Based on the

confidential record of communications between FDA and the Company, it appears that the

Company sought, on the basis of the regulations, the ability to “lower the bar” for the type and

quality of scientific evidence FDA required to make a threshold determination of safety and

efficacy. Instead, Cummins purported that this was a “broken deal” between FDA in that the

agency had previously agreed to what constituted “good science” for the purposes of approval,

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that the Company provided it, but FDA had now “inexplicably” reneged and that FDA’s

decision to do so was unprecedented.

88. The August 12 conference call continued:

Your next question comes from Frank Habella

Frank Unidentifiable - Investors Market Asset Management - Analyst

Skip, good morning, this is Frank [inaudible] at [Investors Market Asset Management]. Of course, we are disappointing as everyone about the decision. But, do you have any reason to believe today that there was any undue influence brought on by FDA or the directors or by anyone before or after the advisory panel meeting?


Until yesterday when I was asked that question and, for instance, on [inaudible] and [Kraemer], I always get that question about the undue influence of the drug companies, I always discounted it, believing that that wouldn't be the case. However, at this point, I have to say I don't know. But, the manner in which this decision was made, raises all sorts of questions in our minds that will never be answered, and I don't know if it's productive to even speculate. But, what I can tell you, as you know from reading the Wall Street Journal, et cetera, that there's a fire storm going on right now among Congress, FDA, clinicians, patients, the drug company's, et cetera, about the under reporting of failed studies, and also about the under reporting of suicides associated with antidepressants, specifically in off label adolescent use. So, there is, and there are bipartisan activity going on in congress today focused on that very issue. So, the answer to your question is, I don't know. One thing I do know is 3 of the 4 deputized members, that FDA deputized, were from the drug advisory panel and 2 of those 3 voted in favor of the approval. So, if there is undue influence, it must have come, as you said, after the panel meeting, because, the panel recommended the approval, and it was a specifically chosen panel of experts with expertise in psychiatry and with experience on the FDA antidepressant drug panel.


After reading the [inaudible] article, and connecting the dots, one would seem to think that in reading that [inaudible] and Kraemer, the street.com and some of the, what I'll call action in the prices of stock, brought on perhaps by the hedge fund communities, you have the confluence of a lot of factors that are going on here, and I would hope, as a long investors, a long time investor in Cyberonics, you would you exhaust whatever remedies there are to be able to uncover, if there is any undue influence, no matter what the source?


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Well, the other thing I can tell you is this, is that you don't have to have a great imagination to imagine the significant interest that would be potentially aligned against approval of this device. We have some very powerful data that shows nothing works in this patient population.

***

89. Defendant Cummins’ apparent validation of a conspiracy against the Company’s

TRD treatment option was without any objectively reasonable basis in fact and, arguably,

demonstrates a masterful skill, expertise and creativeness at “spin doctoring” in his efforts to

mislead the investment community regarding the data-driven problems underlying acceptance of

the VNS Device for TRD-related treatment. Defendants continued:


Hi, you talked a lot about suicides in the severely depressed population and the implication of the FDAs action. But, I don't recall see any data suggesting that VNS has any impact on suicide. Can you comment on that?


Again, if you check on our website we provided the slide that was presented to the panel that compared suicide and suicide attempts in the VNS cohort versus a con study of the FDA joint database. What that showed was no increase in suicide in our extreme TRD population relative to the nonresistant populations that are typically studied in those drug studies. Now, while there is no data, what I can tell you is the patients I've met that were part of the studies, virtually every one of them had attempted suicide prior to entering our study. And the ones I've met have said they no longer even remotely consider suicide. So, the data confirms that there's no elevated suicide risk, and anecdotes would suggest that, perhaps, the opposite might be true.


Okay, but anecdotes is a little different than making statements about suicide that would have been prevented had this device been approved by the FDA, don't you think?


We are not saying that they would have been prevented. We are just saying that that is the nature of this illness, and with no treatment options there will continue to be suicides.

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But with the treatment option, as well, that statement is also true.


Correct. It's undefined what impact approval of VNS could have on suicide rates.

90. The Company’s dialogue regarding “suicidality” was false and misleading on the

basis of what defendants stated at the panel meeting. According to the FDA Chief Medical

Officer, defendants told the panelists that,“[t]he sponsor admitted that a prospective, randomized,

long-term trial was now feasible. They however attempted to persuade the panel by claiming that

36,000 patients would die as a result, during the three years that it would take to complete

such a trial. The data provided in the PMA do not support a decreased rate of suicide in the

treated patients compared to the control population (D04).”

91. Thus, while defendants found it useful to state that their unapproved treatment

option might prevent suicides, their comments are false and misleading, in that they vigorously

fought FDA’s advice regarding the level and quality of the scientific evidence required for

approval purposes, resulting in studies and data that didn’t accomplish good science, including

the impact of the device on the rate of suicide.

92. Amidst the shocking news and defendants’ continued concealment, those truly

abused by the Company’s false, misleading and antagonistic statements and representations

were, in fact, the Company’s own investors. On August 12, 2004, defendants’ concealed,

bellicose relationship with FDA reared its ugly head, causing the value of the Company’s shares

to plunge over 40 percent, losing $9.59 from the previous closing price of $23.95 on August 11,

2004, to close on August 12, 2004 at $14.36, on heavy volume of over 27 million shares.

93. On September 15, 2004, defendants conducted a conference call. Defendants

stated in part:

- 63 -

Skip Cummins - Cyberonics, Inc. - Chairman, President, CEO, Director

Thanks, Pam. Yes, indeed, I am in a remote location again. It happens to be the same location -- actually, the same hotel room where I was when we last spoke, and that happens to be in Washington, D.C. The first topic I will discuss is our progress in gaining clarity and certainty on our US depression regulatory process, and that's what brings me to Washington.

We are now about five weeks out from the very surprising, out-of-the-blue FDA not-approvable letter for our expedited review depression PMA supplement. And in those five weeks, we have had numerous meetings, conversations and communications, in writing and verbally, with senior management of CDRH, including Dr. Dan Shultz, who is the Director, and Dr. Donna Bea Tillman, who is the Acting Director of the Office of Device Evaluation. One of those meetings did occur today. What was discussed at that meeting was the Treatment IDE submission, and also we discussed the additional information that might be available for us to submit to FDA from the existing studies to address the effectiveness concerns expressed by FDA in their not-approvable letter.

***

So that's the update on FDA. Obviously, we are making very good progress towards gaining clarity and certainty on the revised depression regulatory timeline and, probably most importantly, we're making very good progress towards the accomplishment of our mission to improve the lives of people touched by treatment-resistant depression, who today desperately need an informatively labeled, FDA-approved, safe and effective long-term treatment for their lifelong and life-threatening illness.

***

David Kim Analyst

If during this "informal process" the FDA reviews this new analysis you are providing and determines that the evidence is still inadequate, do you still go through a "formal appeal process" with the PMA amendment? Or at that point in time, do you initiate a new randomized control trial?


Well, basically we have the informal appeal process, which would lead to the submission of the PMA amendment. Once that goes in, now we are really not in an informal appeal. But that will basically be sort of it, in terms of additional information that we have to submit. Now, if that's not good enough, then we go into the formal appeal. We have formal appeal options which would include a dispute revenue resolution panel, an evidentiary hearing, et cetera, et cetera. So those would be in addition to, if we have already exhausted this last of the additional information options.

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We anticipate that by the end of this calendar year, we will know whether or not we have exhausted the additional information informal appeal and formal appeal options, and at that point we are left with nothing but the last resort, which would be a new pivotal trial.

David Kim Analyst

So the year-end timeframe also includes a so-called formal appeal process?


Correct, although, depending how long the review time would take for a PMA amendment, it may be extended. But obviously, we will let you know at the time.

***

Lavina Telectar Analyst

The additional information, the two-year data -- does that data specifically answer all the questions that were raised in the not-approvable letter?


That, of course, is a matter of opinion. But if the opinion of the pre-eminent psychiatric thought leaders that were involved in these studies, who were considered the worldwide experts in TRD and ECT, the answer to that question would be yes. And their opinion is what was already submitted addressed those potential and theoretical concerns. So anything in addition to that, their answer would be yes, it does.

Lavina Telectar Analyst

And the FDA is only basing their decision on what was originally submitted, which lacks this two-year data?


That's correct.

***

94. During its press release and conference call of September 15, 2004, defendants

make a key material omission concealing the fact that earlier that day FDA had closed out its

inspection of Cyberonics. This inspection was well known within the Company, according to

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another confidential witness (“CW3”), as was also the fact that it was not proceeding well. CW3

worked directly with defendant Rudolph during the Class Period, as well as closely with

Engineers, Regulatory Affairs and the Clinical and Marketing Departments. The result was a

long and blistering FDA Form 483, which documented the observation of numerous violations,

including inadequate investigation of the reasons for thousands of device reimplants, numerous

medical “adverse events” and unaddressed injury, death and malfunction reports arising from

“unapproved use” of the device.23

95. The inspection had, in fact, occurred despite the fact that, during a January 7,

2004 conference call, defendant Totah had told investors that “no inspection of Cyberonics

manufacturing facility will be required by the FDA.”24 As a result, investors did not expect one

and, as a result, investors would have been reasonably concerned if FDA had decided to change

its mind.

96. Defendants concealed this important information, although it is clear that they

could not reasonably do so. Coupled with the fact that the Company had received a “Not-

Approvable Letter,” the outcome of the inspection was material and would have to be disclosed

to investors because defendant Totah undertook a duty to make that disclosure. As defendant

Totah himself explained during the Company’s January 4, 2004 conference call, the need to

“cure” FDA inspectional observations was an administrative regulatory step in the submission

review and approval process. As he defined it, the need to cure inspectional observations was no

less material to the Company’s progress in its submission review and approval process than

the definition and submission of a PMA-S Amendment following a “Not Approvable Letter”

would be.

23 Neither FDA nor the Company can prevent off-label use of medical devices. However, since many of the Company’s “unaddressed” complaints of injuries and deaths arising from “unapproved uses” of the VNS System, this logically raised a question of serious safety-related concerns.

24 During the Company’s January 7, 2004 conference call, defendant Totah stated, “Finally, after the meeting we were advised by the FDA that although normally a manufacturing facility inspection is required for panel track application, such as the one we submitted, based upon our current quality compliance record and the fact that our VNS device platform has not changed, no inspection of Cyberonics manufacturing facility will be required by the FDA. This is a real plus to Cyberonics, as this removes another administrative regulatory step from the submission review and approval process.”

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97. Additionally, defendant Cummins knew that his continued comments regarding

the “positive progress” being made with FDA based on “new” data and information was false

and misleading. At no time did defendant Cummins reveal the basis for FDA’s decision, that the

agency had, in fact, reiterated again and again the type and quality of the scientific evidence it

sought for TRD safety and efficacy and that the Company had refused to provide it, as

documented in the FDA memo of March 1, 2002, the FDA letter of October 4, 2002, the minutes

of the PMA-S meeting of February 4, 2004, the “Major Deficiency Letter” of March 1, 2004 and

finally in the “Not Approvable Letter” of August 11, 2004.

98. Moreover, Cummins knew or was in conscious and reckless disregard of the fact

that, most importantly, these adverse developments clearly demonstrated that defendants would

be unable to provide adequate science-based information to the Payers for positive insurance

coverage determinations in the broad TRD patient population. As a result, Cummins knew or

was in conscious and reckless disregard of the fact that the Company faced potentially ruinous

consequences in the marketplace, once the Payers evaluated the Company’s data and discovered

these science-based deficiencies.

99. In view of defendants’ positive conference call statements regarding “good

progress” with FDA for salvaging the PMA-S application, the positive nature of defendants’

disclosure of their positive efforts to file a PMA-S amendment, while choosing to actively

conceal the negative implications of an extremely unsuccessful and problematic FDA

inspection, the price of the Company’s stock posted another substantial increase. On the news of

September 15, 2004, the price of the Company’s stock gained $4.32, or 22.8%, closing on

September 15, 2004 at $23.23, on volume of over 12 million shares.

100. Internal FDA documents show that, following the Company’s submission of its

Amendment to the PMA-S on September 23, 2004, subsequent review by the PMA-S reviewing

team on November 10, 2004 resulted in a nearly unanimous “Not-Approvable” decision.25 25 FDA staff noted the contemptuous nature of the Company’s subsequent communications to convince FDA to approve the Company’s PMA-S. During these subsequent deliberations, FDA staff noted the Company’s “terrible” behavior, leaving the reviewing staff to state that they felt “abused” in meetings with the sponsor. At one point, FDA management requested that defendant Cummins “refrain from yelling” at the review team.

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101. On November 10, 2004, defendants conducted their Q2 2005 earnings conference

call. Defendants stated in part:

Skip Cummins - Cyberonics, Inc. - Chairman, President and CEO

***

We also made excellent progress in obtaining clarity and certainty in our U.S. depression regulatory process.

In September, Cyberonics submitted an amendment to its expedited review PMA supplement to address the safety and effectiveness concerns expressed in FDA's August 11, 2004, not-approvable letter, and obtain approval to market the VNS Therapy System as an adjunctive long-term treatment of chronic or recurrent depression for patients who are experiencing a major depressive episode that has not had an adequate response to 4 or more antidepressant treatments, as recommended by FDA's specially chosen Advisory Panel on June 15, 2004.

That amendment included compelling 2-year data showing a sustained and improving long-term benefit-to-risk ratio for patients treated with VNS; a point by point response to the concerns expressed in FDA's not-approvable letter; and fully informative and transparent labeling as recommended by the Advisory Panel in conjunction with their approval recommendation.

We continue to expect to receive FDA's decision on the approvability of our depression PMA-S, including the amendment, by January 31, 2005.

***

Pam Westbrook - Cyberonics, Inc. - VP Finance & Administration and CFO

Thank you, Skip. Good afternoon, everyone. Today we reported the financial results for the second quarter ended October 29, 2004. Net sales were 25.4 million, slightly ahead of guidance of 25 million and below net sales of 29.3 million for the quarter ended October 24, 2003.

U.S. net sales for the second quarter were $22.3 million compared to U.S. net sales of $26.9 million for the same quarter last year. International sales for the second quarter were $3.1 million compared to $2.4 million for the same quarter last year.

Net sales for the 6 months ended October 29, 2004, were $50.6 million, compared to net sales of $56 million for the 6 months ended October 24, 2003. Net sales for the 6 months ended October 29 included $44.9 million from the U.S. market and $5.7 million from international markets, as compared to net sales of

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$51.9 million from the U.S. market and $4.1 million from international markets for the same period last year.

***

Proceeds from employee stock options and stock purchase plans continue to be a sizable source of cash for the Company, contributing $5.4 million for the 6 months.

As compared to fiscal year-end, accounts receivable days decreased slightly from 63 to 58 at the end of this quarter, and inventory turnover decreased slightly from 1.9 to 1.8 times.

Regarding guidance for the next quarter, we expect sales for the third quarter to be essentially flat versus Q2 at approximately $25 million, and that gross margin will be at least 84 percent. We expect that net loss for the quarter will be $3.3 million or 13 cents per share.

This is consistent with our guidance for Q2 and assumes no increases in depression spending. Obviously should we receive a final depression decision from the FDA prior to the end of the quarter, we will properly scale our organization to support a revised depression plan, and revise our guidance accordingly.

***

Alex Arrow - Lazard Freres - Analyst

Is the regulatory process in the U.S. having any impact on the ability to sell in the depression market in Europe? I guess that could be either a positive or a negative, since they are waiting to see what the U.S. FDA says. Is that helping or hurting the depression sales in Europe or Canada?


It will neither help nor hurt until we get the final decision. Basically the psychiatrists who are using the product today in Europe really look at the data more than they look at the United States Food and Drug Administration.

The panel's recommendation carries a lot more weight with them, as does their own experience, their data being if anything even better than the long-term D-02 data, than does FDA's not-approvable decision.

Alex Arrow - Lazard Freres - Analyst

Of that 3.1 million is perhaps, ballpark, about half of it depression and half epilepsy?


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We cannot give you those numbers. We just don't know what they are.

***

Tom Gunderson - US Bancorp Piper Jaffray - Analyst

I had 3 more questions on that and I won't ask those. But since the meeting with FDA, back in August, September, there was speculation that you might bring political pressure on the FDA, since it does report to Congress.

Can you comment, Skip? Have any communications between Congressman and FDA taken place?


It would be totally inappropriate for me to comment on that. All I can assure you is that FDA's unusual decision was of great interest to a variety of Americans who have a significant stake in this terrible lifelong and life-threatening illness.

102. Defendants’ conference call of November 10, 2004 was false and misleading.

First, defendant Westbrook’s statement of quarterly financial guidance was erroneous, false and

misleading, as a result of the flawed and defective internal controls over accounting and GAAP

violations in existence at the Company as evidenced by improper accounting involving stock

option grants, including those awarded on June 15, 2004.

103. Second, defendant Cummins made false and misleading statements regarding the

nature and quality of the review the PMA-S received at FDA. Cummins falsely stated that the

PMA-S Amendment contained “compelling” two-year data when, in fact, the data fell far short

of that sufficient Payer standards. Indeed, Cummins concealed the fact that, on the basis of the

objective review the PMA-S had received, the “marketability” of the VNS Device as a treatment

option for TRD was a “highly impaired” opportunity, since it relied on a level and quality of

scientific evidence for adequate assurance of safety and effectiveness that was far below what the

FDA reviewing team had initially recommended and advised. As a result, it did not matter

whether the Company actually achieved FDA approval, defendants knew that they faced

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potentially ruinous consequences in the marketplace, once the Payers evaluated the Company’s

data and discovered these science-based deficiencies.

104. In the aftermath of the Company’s submission of its PMA-S Amendment

submission, FDA staff duly noted the contemptuous nature of the Company’s communications

with them, as Company staff sought to convince FDA to approve the Company’s PMA-S.

During these deliberations, FDA staff noted that they felt “abused” in meetings and, at one point,

FDA management requested that defendant Cummins “refrain from yelling” at the review

team.26

105. Internal FDA documents also show that following the Company’s submission of

its Amendment to the PMA-S on September 23, 2004, subsequent review by the PMA-S

reviewing team on November 10, 2004 resulted in a nearly unanimous “Not-Approvable”

decision.27

106. On December 1, 2004, the Company met again with FDA and it was explained

why clinical data from the Company’s existing studies could not be used to address the

deficiencies listed in the not approvable letter. Internal FDA documents also show that when

Cyberonics was approached to do an extraordinarily simple “randomized withdrawal” study, in

which “responders” from its D-02 study would be randomly selected to have their device

“lowered” or “turned off,” to observe any relapse and presumably to dispel concerns about a

persistent “placebo effect,” the Company “pushed back” on the proposal. In an FDA memo

dated January 6, 2005, the FDA reviewing team and concurring levels of FDA management once

again reiterated the appropriateness of the “not-approvable letter.”28

26 See Senate Report at p21.

27 See Senate Report at p214.

28 See Senate Report at p204-217.

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107. On January 3, 2005, defendants issued a press release entitled, “CYBERONICS

RECEIVES FDA WARNING LETTER REGARDING THE GOOD MANUFACTURING

PRACTICE REQUIREMENTS OF THE QUALITY SYSTEM REGULATION FOR

MEDICAL DEVICES - FDA Considers Cyberonics’ Initial Responses to be Incomplete -

Revised Response to be Submitted by January 19, 2005.” The press release finally revealed to

investors the fact that an FDA inspection of Cyberonics facilities and records was initiated on

July 12, 2004, and that objectionable observations persisted for weeks after the close-out of the

inspection on September 15, 2004, resulting in the receipt of an FDA “Warning Letter,” dated

December 22, 2004. This letter, which contained essentially the same objectionable observations

as were received in FDA Form 483 on September 15, 200429 provided a shocking confirmation

of the inadequacy of Cyberonics’ TRD-related data and research during the Class Period,

including issues related to the efficacy of the VNS Device for TRD treatment, and stated, in part:

Dear Mr. Cummins:

During an inspection of your firm’s manufacturing operations located in Houston, Texas, on July 12 through September 15, 2004, United States Food and Drug Administration (FDA) Investigator, Ellen J. Tave, determined that your firm manufactures the Vagus Nerve Stimulator (VNS), an implanted generator that is indicated for use as an adjunctive therapy in reducing the frequency of seizures in adults and adolescents over 12 years of age with medically intractable partial seizures. The VNS system includes a pulse generator, programming wand, programming software. electrode leads, tunneling tool, and accessory pack. This product is a device as defined in Section 201(h) of the Federal Food, Drug, and Cosmetic Act (the Act).

The above-stated inspection revealed that these devices are adulterated within the meaning of Section 501(h) of the Act, in that the methods used in, or the facilities or controls used for their manufacturing, packing, storage, or installation are not in conformance with the Current Good Manufacturing Practice (CGMP) requirements of the Quality System (QS) Regulation for medical devices, as specified in Title 21, Code of Federal Regulation (CFR). Part 820.

29 According to the press release, “FDA’s Dallas District Office found Cyberonics’ initial responses to their Form-483 CGMP inspectional observations to be incomplete and chose to issue a Warning Letter containing the majority of the original observations.”

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Quality System Regulation

At the close of the inspection, your firm was issued a list of inspectional observations, Form FDA-483 (copy enclosed), which identified a number of significant QS regulation violations including, but not limited to, the following:

1. Failure to completely investigate and evaluate the cause of each medical adverse event as required by 21 CFR 803.50(b)(2) and failure to maintain complete deliberation results as required by 21 CFR 803.18(b)(1)(i) [FDA-483, Item 1]. For example, your firm has not provided adequate documentation of deliberations to support your firm’s decision making process for explaining why your firm could not reach a conclusion about the cause of (a) device migration reported in complaint file # 200306-0477 (reference MDR report # 2003-00402); and (b) high lead impedance, device migration, increase in seizures, and subsequent patient death reported in complaint file # 200312-0567 (reference MDR report # 2004-00030).

2. Failure to establish and maintain adequate procedures for validating the device design to ensure that the device conforms to user needs and intended uses and include design testing under actual or simulated use conditions as required by 21 CFR 820.30(g) [FDA 483, item 2]. Evidence of your firm’s design validation with regard to Model 102 is inadequate. For example:

a) Evidence of design validation lacked supporting documentation to demonstrate how your simulated testing of the generator and the lead connecting to a [redacted] load actually simulated use conditions. For example, in an [redacted] chamber [redacted] maintained at [redacted] evidence was not provided which demonstrated the equivalence to the actual implanted generator and electrode connecting to the vagus nerve which resides in a fluidal or wet condition in the chest cavity (actual implant environment); and

b) There was a lack of supporting documentation explaining why real time testing is not needed to verify the actual device longevity and a lack of evidence confirming the accuracy of your theoretical device life expectancy across patient programming ranges at the end of service voltage (actual use condition).

c) The design validation does not appear to address the impact of possible increase in lead impedance of the electrode and vagus nerve interface during the course of patient therapy on battery life. Therefore, the accuracy of your theoretical estimate of device longevity is called into question; and

d) The theoretical calculation of battery hours of operation does not appear to include or discuss the effect of the total number of patient magnet wipes (activations) on actual device longevity at nominal conditions in clinical settings (actual use condition); and

e) The design validation does not discuss or reference testing results of the ERI (Elective Replacement Indicator) flag under the various fault diagnostics

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conditions listed in the Physician’s Manual (Section High Lead Impedance on a Diagnostic Test at Follow-up Visit).

3. Failure to investigate the cause of nonconformities relating to product, processes, and the quality system as required by 21 CFR 820.100(a)(2) [FDA-483, Items 3, 9, and 10]. For example:

a) Complaints of suspected end of service (EOS) were not considered as a product complaint, and there were no attempts to collect patient’s programming data’ to evaluate if the devices reached normal/expected EOS; and

b) Your firm has not documented the death data by age categories to support data analysis required in CAPA Investigation Report INV 01-0006, dated January 8, 2002 and February 19, 2003. Your firm then concluded that there was no relationship seen in seizure changes among the 81 patients but reported that the patients responses to the VNS therapy were unknown or there was no information for 28 of 81 patients. Your firm also had not collected programming history data to assess the relationship of the amount of stimulation therapy at the time of death: and

c) CAPA investigation to verify a physician’s observations that the devices delivered less current therapy than what were programmed during the last 6 to 12 months of device life had incomplete explanation of the results of Phase II and III testing; and

d) Product analysis (PA) of explanted generators did not show testing of the devices using the patients programming history to confirm or duplicate the patient complaints or non-complaints. For example, PA #5243, 4935, and 5600; and

e) Incident # 200310-1077 reported that a pediatric patient was implanted on December 18, 2002 and explanted on October 8, 2003 due to suspected end of service (EOS). The generator was implanted for almost 10 months. Your firm has not explained why the implanted generator did not set the ERI flag as it was approaching EOS. The user reported that the ERI flag did not set in spite of a high lead impedance reading. Your firm did not conduct duplicate testing of the explanted generator using the user’s actual programming parameters to confirm the user’s complaint of EOS. Your firm’s product analysts documented that the explanted generator met its electrical specifications but did not explain (a) how your firm’s electrical testing results are related to the user’s complaint, and (b) your firm’s evaluation of the user report of normal diagnostics test results of high lead impedance in your product analysis report.

4. Failure to analyze processes, work operations, and other sources of quality data to identify existing and potential causes of non-conforming product as required by 21 CFR 820.100(a)(1) [FDA-483. Item 4, 6, and 11]. For example:

a) Your firm has not documented, analyzed, and evaluated the reasons for both implants/reimplants and product returns to identify existing and potential

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causes of non-conforming product. Your firm does not know or explain how many reimplants were due to broken leads, suspected end of service (EOS), actual EOS, and high lead impedance; and

b) User reports (non-complaints) of suspected EOS and confirmed EOS, and collected data on adverse events of asystole and bradycardia were omitted from [redacted] CAPA meetings; and

c) Your firm has not analyzed complaints of high lead impedance, lead discontinuity, confirmed EOS, and suspected EOS to identify how many complaints were confirmed with an ERI (Elective Replacement Indicator) flag being set; and

d) Your firm has not described the possible meaning of complaint conclusion code 40 in order to explain how complaints or adverse events were resolved with this conclusion code. It was found that conclusion code 40 was often used when the adverse events were resolved by device explants and reimplants. Review of complaint data queried by conclusion code 40 showed that your firm had classified 1081 complaints and 524 MDR reports using this code; and

e) Your firm has neither collected nor analyzed patient programming history since 1997 in order to provide a theoretical estimate of actual device longevity over the entire implant population.

5. Failure to implement and record changes in methods and procedures needed to prevent and correct identified quality problems as required by 21 CFR 620.100(a)(5) [FDA-483, item 6]. For example, although your firm has listed several potential causes of high lead impedance, your firm has not implemented the necessary solutions and verified their effectiveness in order to address numerous complaints of high lead impedance. A complaint log entitled “Lead Discontinuity, Suspected Lead Discontinuity, or High Lead Impedance Incoming Complaints with Conclusions” for the period of January 1, 2002 through May 31, 2004 documented that 89 complaints were identified as a “design” issue.

6. Failure to establish and maintain procedures for implementing corrective and preventive action as required by 21 CFR 820.100(a) [FDA-483 Items 7 and 11]. For example, your firm (a) has not documented, analyzed, and evaluated the reasons for thousands of reimplants since 1997; (b) has not analyzed patient programming history data over the entire implant population; and (c) does not know how many reimplants were due to broken leads, suspected EOS, confirmed EOS, and high lead impedance, in order to validate input data used to calculate your firm’s cumulative survival probability for the implanted generators. In addition, your firm has not explained how your device’s survival probability curve matches the actual device longevity in clinical settings.

7. Failure to establish and maintain procedures for receiving, reviewing, and evaluating complaints by a formally designated unit as required by

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21 CFR 820.198(a). For example, your firm has not defined how your firm differentiates user complaints of suspected EOS from complaints of confirmed EOS, or high lead impedance.

Cyberonics’ Response

We acknowledge receiving your letters with attachments, dated September 17, October 7, and December 8, 2004, responding to the Form FDA-483, Inspectional Observations, issued to your firm at the conclusion of our inspection on September 15, 2004. We have completed our review and determined that your response is incomplete. Your December 8th response was incomplete and did not provide any supporting information or evidence relating to the longevity verification. Your responses have not satisfactorily addressed the underlying issues. For example:

1. Your response did not clearly explain whether or not your firm considers user reports of suspected end of service (EOS) as a product complaint to be treated in accordance with 21 CFR 820.198(a). Your firm has not been able to determine the causes associated with many user reports of suspected EOS or high lead impedance or that your firm has not determined and documented how many reimplants were due to normal/actual EOS, suspected EOS. or high lead impedance. See your firm’s investigation reports INV 02-0014, 02-0024, and 03-0016. Your firm also has not (a) explained whether your firm will attempt to collect patient programming history to aid your firm’s investigation of complaints of suspected EOS or high lead impedance; and (b) established procedures to indicate how your firm differentiates user complaints of suspected EOS from user complaints of actual EOS or high lead impedance to determine if in fact the devices were approaching or at their normal end of service based on the actual patient programming parameters. Your firm’s investigation report 02-0014 was initiated in October, 2002 which recommended corrective actions to address user reports of high lead impedance. However, the completion dates for the proposed corrective actions were still classified "TBD" (To be Determined) at the time of the inspection.

2. Your firm has not been able to determine or explain how many reimplant cases were due to high lead impedance or other potential quality problems. Although you firm has identified several theoretical causes of high lead impedance complaints (user training, lead manufacturing defects, and design robustness), your firm has not completed the following proposed corrective actions. The effectiveness of these proposed corrective actions cannot be determined until you provide the results of your firm’s monitoring of the high lead impedance complaints.

(a) Corrective Action Plan CAR 03-0003 addressing user training a potential cause of high lead impedance are in process without establishing an expected completion date; and

(b) Your response reported that Corrective Action Plan CAR 03-0004 addresses the handling of the Model 300 and Model 302 leads during

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manufacturing as a potential cause of high lead impedance was completed on July 16, 2004 during our inspection. You indicated manufacturing defects related to coil damage was not a significant cause of high lead impedance events. However, you have not explained what types of lead defects you found, specific steps your firm has taken or will take (a) to reduce incidents of lead manufacturing defects; (b) establish complaint investigation methods to differentiate user complaints of high lead impedance caused by a lack of user training from user complaints of high lead impedance caused by manufacturing lead defects; and

(c) [redacted] design project (DHF 0044) was initiated in [redacted] and is not expected to be completed until [redacted]

3. Your response implied that FDA’s approval of your original PMA or subsequent PMA supplements means that FDA approves your firm’s design controls. This is not true. Your firm’s design control steps must be continuously maintained throughout the device design life cycle to ensure compliance with 21 CFR 820.30. Your response further stated that the investigator attempted to inspect the safety and effectiveness of your devices. We disagree. The investigator explained that she did not inspect the safety and effectiveness of your devices epilepsy indication but rather she questioned the adequacy of your firm’s design validation process concerning simulated testing of actual device implant conditions and device longevity.

4. Regarding simulated testing of actual implant environment, as part of your device failure investigation process, some of the explanted generators were actually tested in a [redacted] solution in order to investigate the complaint issues of suspected end of service, high lead impedance, or generators not delivering enough therapeutic currents as programmed. See your investigation reports INV 03-0016 and 02-0024. These two investigation reports documented that the explanted devices were placed in a [redacted] solution to simulate the actual implant environment. Your firm failed to explain how this type of testing is appropriately related to the original design validation testing of Model 100 in 1997, 101, and 102 in 2002.

5. Regarding real time testing to confirm device longevity, your response explained that performing the real time testing is inappropriate because it would require [redacted] to complete, and your mathematical equation for device longevity was based on "proven laws of math.” First, your response has not explained why it takes [redacted] to conduct real time testing across all programming parameters. Second, you have not explained if your firm has (a) trended and/or documented the actual implant times of the clinical patients enrolled in the prior E01 - E05 studies using Model 100, the patients enrolled in the current Depression clinical study, or current non-clinical patients implanted with model 101 and 102, in order to compare their projected (theoretical) implant times to their actual implant times. Third, in your firm’s Table 20 [Nominal Longevity Estimates Begin of Life (BOL) to End of Service (EOS)] listed in the electrical characterization report, your firm's longevity equation calculated that the device longevity would last [redacted] at a heavy stimulation setting of [redacted] and [redacted]% duty cycle. Real time testing at this rapid simulation

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setting would take about [redacted] not [redacted] to verify the accuracy of your theoretical device longevity equation.

6. Magnet Activations by Patients, you responded that the occurrence of manual magnet activations by patients would not cause any significant reduction of device longevity when compared to normal device stimulation. However, you acknowledged that your firm’s extrapolation of energy consumption and rationales were not explained and documented in the design validation documents, e.g., electrical characterization report.

7. Your firm’s current complaint handling procedure requires that a reply letter be sent to the complainant (physician) if your firm’s complaint investigation resulted in “user error,” and the user has not been notified of the error. The use of the VNS device for pediatric patients younger than 12 years of age is an unapproved use (off-label use), and therefore, adverse events related to this use are considered user error. See 21 CFR 803.3(d). In this situation, your firm did not follow its complaint handling procedures in that your firm had not sent reply letters to the complainants to notify them of user error concerning medical adverse events occurring in pediatric patients younger than 12 years of age. Our inspection documented that your firm had received 197 serious injury reports, 53 death reports, and 99 malfunction reports that were coded 212 (unapproved use of device) from January 1, 2002 through May 14, 2004. Many of these medical adverse events were associated with the users using the VNS devices in pediatric patients younger than 12 years of age. We believe your firm should send a reply to each complainant in order to prevent further misuse, injury or other adverse situations from recurring. When the problem was caused by misuse, it is very important to advise the user to help prevent further misuse. If your firm, believes there may be cases where a reply is not necessary, the record should state that no reply was made and the reason for not replying. Finally, although not sending a reply letter to the complainant is not a deviation of 21 CFR 820.198(e)(8), when a reply is sent it must be kept as part of the complaint file.

In summary of our review, your firm should implement a comprehensive QS action plan and provide FDA with status update reports outlining specific steps addressing the specific FDA-483 observations and issues identified in this letter and a global approach to correct and prevent any potential systemic problems.

Responding to This Letter

This letter is not intended to be an all-inclusive list of deficiencies at your facility. It is your responsibility to ensure adherence to each requirement of the Act and the regulations. The specific violations noted in this letter and in the Form FDA-483 issued at the close of the inspection may be symptomatic of serious underlying problems in your firm’s manufacturing and quality assurance systems. Federal agencies are advised of the issuance of all Warning Letters about devices so that they may take this information into account when considering the award of contracts.

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You should take prompt action to correct these violations. Failure to promptly correct these violations may result in regulatory action being initiated by the Food and Drug Administration without further notice. These actions include, but are not limited to, seizure, injunction, and/or civil penalties.

108. On February 2, 2005, the Company reported that FDA found the VNS Device for

TRD-related treatment approvable, “conditional on final labeling, final protocols for a post-

approval dosing optimization study and patient registry, satisfactory compliance with Quality

System Regulations (QSR) and satisfactory resolution of any outstanding bioresearch monitoring

issues.” The “Approvable Letter” was the result of a highly unusual director-level override of

unanimous “not-approvable” recommendations as formed by the FDA PMA-S reviewing team

and a number of concurring director-level staff.30 While the Company was well-aware of the

facts and circumstances leading up to the “Approvable Letter,” it took full advantage of the fact

that investors were totally in the dark regarding the internal dissent and turmoil at FDA since the

issuance of the “Not Approvable Letter.”31

109. Nowhere in Company’s communications of February 2, 2005 was it discussed

that while an approvable decision was reached at FDA, serious issues of safety and effectiveness

of importance to patients, healthcare providers and medical insurance Payers remained. Nor did

these communications touch upon the ruinous consequences the Company would likely suffer in

the marketplace, once Payers learned of the unanimous findings of the FDA PMA-S reviewing

team and of the inadequate nature of the scientific evidence existing in purported support of a

finding of “medical necessity” of the device. Following the news of the February 2, 2005

“approvable letter,” the price of Cyberonics stock the price of Cyberonics stock again rocketed

30 The controversial nature of the override decision is underscored by the fact that the decisonmaker, FDA CDRH Director Dr. Dan Schultz noted the scientific insufficiency of the available data in his override memo, when he stated that, “I think that one has to conclude that, based on that data; either the device has no effect, or, if it does have an effect that in order to measure that effect a longer period of followup is required.”

31 Further evidence of the controversial nature of Dr. Schultz’s decision can be found in e-mail correspondence of the FDA Chief Medical Officer where, as late as January 12, 2005, he stated, “As an M.D. with an interest in science, it seems to me that such an approval would be akin to approving an experimental product and is this what FDA does?”

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upward, achieving a gain of $11.53 or 41.9 percent, on volume of over 14.2 million shares,

closing on February 3, 2005 at $39.01 per share.

110. Company executives quickly cashed in on their highly controversial “Approvable

Letter,” including Skip Cummins, the CEO, who personally reaped over $14.7 million dollars in

stock sales within 2 weeks of the announcement. In all, Company executives sold more than

$17.4 million dollars within 2 weeks of the receipt of the “Approvable Letter.” Company

executives did so while in active concealment of the fact that the “marketability” of the VNS

Device as a treatment option for TRD was a “highly impaired” opportunity, since it relied on a

level and quality of scientific evidence for adequate assurance of safety and effectiveness that

was far below what the FDA reviewing team had recommended and advised. As a result,

Company executives knew that they faced potentially ruinous consequences in the marketplace,

regardless of whether or not the PMA-S was ultimately approved, once the Payers evaluated the

data and discovered these science-based deficiencies.

111. On May 18, 2005, the Company issued a press release, entitled, “CYBERONICS

CONFIRMS SENATE FINANCE COMMITTEE REQUEST FOR INFORMATION.” The press

release stated in part:

HOUSTON, Texas, May 18, 2005 – Cyberonics, Inc. (NASDAQ:CYBX) today confirmed in response to numerous inquiries by investors, that Cyberonics recently received a letter from the Senate Finance Committee (SFC) stating that SFC is “examining the FDA’s handling of Cyberonics’ Panel Track PMA-Supplement for the VNS Therapy to address treatment-resistant depression (TRD) in adults,” and that the “FDA issued an approvable letter to Cyberonics on February 2, 2005, despite the strong objections from FDA scientists involved in evaluating the safety and efficacy of VNS Therapy.” The letter from the SFC alleges no wrongdoing on Cyberonics’ part and requests that Cyberonics provide certain information to SFC.

“Cyberonics and its advisors believe that SFC’s ’examination’ will produce no new information and that SFC’s ’examination’ will have no bearing on FDA’s final TRD approval decision,” commented Robert P. (“Skip”) Cummins, Cyberonics Chairman of the Board and Chief Executive Officer. “All of the ’strong objections’ referred to in SFC’s letter were fully

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considered by a specially chosen FDA Advisory Panel of depression experts that recommended approval in June 2004 and by FDA’s Center for Devices and Radiological Health (CDRH) during its rigorous review of the Expedited Review PMA-S and PMA-S Amendment that resulted in the recent approvable decision.

“The TRD status quo that a few FDA personnel involved in the original not-approvable decision are apparently attempting to preserve has miserably failed millions of Americans with TRD, their families, psychiatrists and payers,” continued Mr. Cummins. “The status quo facing people living and working in TRD is represented by many expensive, ineffective, often unsafe treatments evaluated in 8 to 10 week studies of non-resistant patients, used by physicians and consumers without informative labeling. There are no FDA-approved treatments for TRD, and none other than VNS has ever been studied or deemed approvable for TRD. According to most patients with TRD, the only real way out of the TRD status quo is suicide. Clearly, the TRD status quo for millions of Americans, their families, psychiatrists and payers is neither safe nor effective.

***

“Cyberonics is prepared for a successful TRD launch and to accomplish its mission of improving the lives of people touched by treatment-resistant depression, regardless of whether we receive FDA’s decision before, during or after the annual American Psychiatric Association meeting which runs from May 22 – 26, 2005,” concluded Mr. Cummins. “We continue to make good progress towards favorable TRD coverage policy and approval of existing VNS reimbursement codes for use by VNS TRD service providers. We have also received significant interest from psychiatrists in post-market studies including the dosing study, TRD registry and TRD mechanism of action research. Last but not least, we have successfully scaled our demand creation and customer support organization, and we expect that a total of 330 highly-qualified and well-trained personnel will satisfy the needs of our epilepsy and depression customers going forward.”

112. Defendants’ press release of May 18, 2005 regarding the “SFC ‘examination’”

was false and misleading. First, defendant Cummins’ statement that the ‘examination’ would

yield no new information to investors, patients, Payers or other members of the public was false

and misleading. In fact, defendants knew and concealed the turmoil and scientific dissent

resulting from the review of the application at FDA, as well as the ruinous consequences the

Company would likely suffer in the marketplace if it ever managed to receive approval for the

TRD indication on the basis of its inadequate scientific evidence.

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113. Since FDA was obligated to hold in confidence the entire record of its

confidential communications with the Company, the press release was false and misleading,

since Cummins knew or was in conscious and reckless disregard of the fact that the SFC would

disclose for reasons of public health and safety the record of the unanimous scientific dissent of

the “more than 20 FDA scientists who tried to do the right thing”32 Rather than admit to this,

Cummins again relied on scare tactics, “[a]ccording to most patients with TRD, the only real

way out of the TRD status quo is suicide. Clearly, the TRD status quo for millions of Americans,

their families, psychiatrists and payers is neither safe nor effective.” Finally, while well aware

of his own deception regarding adequate scientific evidence for Payer purposes, Cummins

falsely stated that “[w]e continue to make good progress towards favorable TRD coverage policy

and approval of existing VNS reimbursement codes for use by VNS TRD service providers.”

114. On July 15, 2005, following defendant’s resolution of issues and clearance in

connection with the Warning Letter,33 defendants reported that FDA had approved the VNS

Device for sale in the treatment of TRD.34 Following this, on July 19, 2005, the Company issued

a second press release regarding the approval decision, entitled, “FDA SUMMARY OF

SAFETY AND EFFECTIVENESS (SSE) FOR CYBERONICS’ VNS THERAPY™ SYSTEM

FOR TRD NOW ON FDA’S WEBSITE - SSE Summarizes the Rationale for FDA Approval of

First Treatment for TRD.” The press release stated in part:

32 Congressional Record – Senate, 109th Congress, Vol. 152 No.20, S1388-1389, February 16, 2006.

33 See defendants’ press release of April 7, 2005, entitled “FDA NOTIFIES CYBERONICS THAT ITS WARNING LETTER RESPONSE IS COMPLETE AND ADEQUATE” at http://www.cyberonics.com/PressRelease_detail.asp?ID=ABBC1ED2-B9F9-4460-BE2E-71C00A0B97D4 , last accessed on November 20, 2005.

34 See defendant’s press release of July 15, 2005 entitled “FDA APPROVES CYBERONICS’ VNS THERAPY™ SYSTEM FOR TREATMENT-RESISTANT DEPRESSION (TRD),” at http://www.cyberonics.com/PressRelease_detail.asp?ID=F5FBFBC8-1998-46D3-A234-53A960853081 , last accessed on November 20, 2005.

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HOUSTON, Texas, July 19, 2005 -- Cyberonics, Inc. (NASDAQ:CYBX) today announced that the United States Food and Drug Administration’s (FDA) Summary of Safety and Effectiveness for FDA’s approval of Cyberonics’ Vagus Nerve Stimulation (VNS) Therapy System for the adjunctive long-term treatment of chronic or recurrent depression for patients 18 years of age or older who are experiencing a major depressive episode and have not had an adequate response to four or more adequate antidepressant treatments, is now available on FDA’s website (http://www.fda.gov/cdrh/PDF/P970003S050.html). VNS Therapy is delivered from a small pacemaker-like generator implanted in the chest that sends preprogrammed, intermittent, mild electrical pulses through the vagus nerve in the neck to the brain. The VNS Therapy System is the first FDA-approved implantable device-based treatment for depression and the first treatment developed, studied, approved and labeled specifically for patients with treatment-resistant depression (TRD). The VNS Therapy System was approved as a treatment for medically refractory epilepsy in Europe in 1994 and in the United States and Canada in 1997 and as a treatment for TRD in Europe and Canada in 2001. Over 32,000 patients worldwide have accumulated over 94,000 patient years of experience with the VNS Therapy System. The VNS Therapy System is now commercially available for the treatment-resistant depression and refractory epilepsy approved uses in the United States, European Union and Canada. For more information on VNS Therapy for treatment-resistant depression, including the contraindications, warnings and precautions, see the Physician’s and Patient’s Manuals and other information at www.cyberonics.com or www.vnstherapy.com or call 1-877-NOW 4 VNS.

***

“FDA’s Summary of Safety and Effectiveness provides the rationale for FDA’s approval of the VNS Therapy System for TRD,” commented Robert P. (“Skip”) Cummins, Cyberonics’ Chairman of the Board and Chief Executive Officer. “The SSE on FDA’s website and the TRD Physician’s and Patient’s Manuals available on the Cyberonics (www.cyberonics.com) and VNS Therapy (www.vnstherapy.com) websites, provide all the data and scientific evidence to facilitate fully-informed treatment decisions by psychiatrists, patients and their families, payers, hospitals and surgeons. Unprecedented-in-antidepressants post- market surveillance, including a 460-patient dosing study and the first and only long-term patient outcome registry in TRD, will ensure that the VNS labeling remains fully-informative and that Cyberonics accomplishes its mission of improving the lives of people touched by epilepsy and TRD going forward.”

***

115. Defendants’ press release of July 19, 2005 was false and misleading. First,

defendants were well aware that the FDA SSE was “sanitized,” in that it contained no details of

the nearly unanimous scientific dissent of the “more than 20 FDA scientists who tried to do the

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right thing…” that comprised the FDA PMA-S reviewing team.35 As a result, the SSE did not

provide “all the data and scientific evidence to facilitate fully-informed treatment decisions…,”

regardless of the fact that FDA had issued its approval decision.

116. In knowing and active concealment of these facts, defendants purposefully

published a second press release for the approval, pointing to the FDA SSE. Since FDA was

obligated to hold in confidence the entire record of its confidential communications with the

Company, the press release mislead investors in that the material omission of the record of

scientific dissent within the SSE that FDA was obligated to make served to falsely enhance the

credibility of the “scientific evidence” behind the Company’s TRD treatment option and the

validity of the Company’s marketability claims in the eyes of investors.

117. On July 24, 2005, Ronald A. Matricaria, Cyberonics Board Director and

Chairman of the Board’s Compensation Committee resigned from the Company, as documented

in the Company’s July 28, 2005 SEC Form 8-K, which stated in part:

From: Ron Matricaria

Sent: Sunday, July 24, 2005 12:35 PM

To: David Wise

Cc: Skip Cummins; Alan Olsen; Kevin Moore; Tony Coelho; Stanley Appel; Guy Jackson; ‘Michael J Strauss, MD’; Reese Terry

Subject: Letter of resignation

David:

Per our conversation, please accept this letter as my formal resignation from the Cyberonics Board of Directors and Chairman of its Compensation committee, effective Saturday July 23, 2005.

I unfortunately cannot support the direction of the governance practices of the Cyberonics board, in particular its practices regarding CEO compensation and succession.

35 Congressional Record – Senate, 109th Congress, Vol. 152 No.20, S1388-1389, February 16, 2006.

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I would appreciate your acknowledging receipt of this e-mail.

Sincerely,

Ronald A Matricaria

118. Director Matricaria chose to document his resignation to David Wise, as opposed

to defendant Cummins, the Chairman of the Board, in a move that clearly expressed his break

with Cummins on corporate governance issues within the Company, as they related to Cummins’

compensation and how Cummins would be succeeded. Up to this point, neither of these issues

had been publicly raised. Although the curious resignation appeared to be linked to Cummins’

compensation “issues,” clearly his $14.7 million dollars in stock sales within 2 weeks of the

announcement of the “Approvable Letter” of February 2, 2004, and advance knowledge of the

ethically questionable award of “in-the-money” stock options to Company executives, would

have been known to Mr. Matricaria.

119. In August of 2005, the time had come for Payers to begin to address coverage

determinations on the basis of the available scientific evidence supporting the Company’s

“treatment option” for TRD. On the basis of the scientific evidence available up to the time of

the FDA advisory committee meeting on June 15, 2004, and absent any knowledge of

confidential communications between FDA and the Company, including the “content” of the

September 23, 2004 Amendment to the PMA-S, the Technical Evaluation Center of Blue Cross

Blue Shield Association (“TEC”) issued its assessment.36

120. The assessment pointed to the very issues of effectiveness concealed by

defendants from a time prior to the beginning of the Class Period. The assessment rejected the

Company’s data and results, finding no objective support for concluding any improvement of

health outcomes, stating in part:

36 See http://www.bcbs.com/tec/vol20/20_08.html , last accessed on November 18, 2005.

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Vagus Nerve Stimulation for Treatment-Resistant Depression

Assessment Program

Volume 20, No. 8

August 2005

Executive Summary

Depression is a serious psychiatric condition that sometimes does not respond to standard treatments such as medication and/or psychotherapy. Vagus nerve stimulation (VNS) therapy is a type of treatment administered through an implanted pulse generator and bipolar lead that has been studied in patients with treatment-resistant depression. This Assessment will review the available evidence to determine if VNS therapy is effective for treatment-resistant depression.

Based on the available evidence, the Blue Cross and Blue Shield Association Medical Advisory Panel made the following judgments about whether vagal nerve stimulation for the indication of treatment-resistant depression meets the Blue Cross and Blue Shield Association Technology Evaluation Center (TEC) criteria.


The NeuroCybernetic Prosthesis System (NCP®, Cyberonics, Inc.) received approval of its Premarket Application (PMA) to market from the U.S. Food and Drug Administration (FDA) on July 16, 1997, for treatment-refractory seizures. The device was approved for use in conjunction with drugs or surgery “as an adjunctive treatment of adults and adolescents over 12 years of age with medically refractory partial onset seizures.”

On July 15, 2005, the VNS Therapy System received final PMA approval by the FDA for “adjunctive long-term treatment of chronic or recurrent depression for patients 18 years of age or older who are experiencing a major depressive episode and have not had an adequate response to 4 or more adequate antidepressant treatments.”


The available evidence is not sufficient to permit conclusions of the effect of VNS therapy on health outcomes. The available evidence consists of a case series of 60 patients receiving VNS, a short-term (i.e., 3-month) randomized, sham-controlled clinical trial of 221 patients, and an observational study comparing 205 patients on VNS therapy compared to 124 patients receiving ongoing treatment for depression. Patients who responded to sham treatment in

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the short-term randomized, controlled trial (approximately 10%) were excluded from the long-term observational study.

Patient selection was a concern for all studies. VNS is intended for treatment-refractory depression, but the entry criteria of failure of 2 drugs and a 6-week trial of therapy may not be a strict enough definition of treatment resistance. Treatment-refractory depression should be defined by thorough state-of-the-art psychiatric evaluation and management.

The case series data show rates of improvement, as measured by a 50% improvement in depression score of 31% at 10 weeks to greater than 40% at 1 to 2 years, but there are some losses to follow-up. Natural history, placebo effects, and patient and provider expectations make it difficult to infer efficacy from case series data.

The randomized study that compared VNS therapy to a sham control (implanted but inactivated VNS) showed a nonstatistically significant result for the principal outcome. Fifteen percent of VNS subjects responded, versus 10% of control subjects (p=0.31). There was a statistically significant result for a secondary outcome.

An observational study comparing patients participating in the randomized clinical trial and a separately recruited control group evaluated VNS therapy out to 1 year. This observational study showed a statistically significant difference in the rate of change of depression score. However, issues such as unmeasured differences between patients and nonconcurrent controls, differences in sites of care between VNS therapy patients and controls, and differences on concomitant therapy changes raise concern about this observational study. Analyses performed on subsets of patients cared for in the same sites, and censoring observations after treatment changes, generally showed diminished differences in apparent treatment effectiveness of VNS and almost no statistically significant differences. Given these concerns about the quality of the observational data, these results do not provide strong evidence for the effectiveness of VNS therapy.

Adverse effects of VNS therapy include voice alteration, headache, neck pain, and cough, which are known from prior experience with VNS therapy for seizures. Regarding specific concerns for depressed patients such as mania, hypomania, suicide, and worsening depression, there does not appear to be a greater risk of these events during VNS therapy.

3. The technology must improve the net health outcome; and


The available evidence does not permit conclusions regarding the effect of VNS therapy on health outcomes or compared with alternatives.


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It has not yet been demonstrated whether VNS therapy improves health outcomes in the investigational setting. Therefore, it cannot be demonstrated whether improvement is attainable outside the investigational settings.

For the above reasons, VNS therapy for the indication of treatment-resistant depression does not meet the TEC criteria.

121. Continuing to mislead the market in light of TEC’s assessment, defendants

addressed the issue of whether or not the TEC assessment was fair, reasonable and what could

be done about it was put to defendants during the Company’s conference call on November 21,

2005. Addressing both the Company’s financial forecasts and the TEC assessment, defendants

stated in part:

Pam Westbrook - Cyberonics, Inc. - VP Finance and Administration, CFO

Thanks, Skip.

Throughout fiscal 2006, our efforts have been focused on gaining and preparing for FDA approval in TRD, maintaining our core epilepsy business and launching VNS therapy in treatment-resistant depression. As reported in our press release issued in afternoon, net sales were $29.1 million compared to net sales of $25.4 million for the quarter ended October 29, 2004 and are in line with revised sales guidance of 29 million.

This represents annual growth of 14% and sequential growth over last quarter of 8%.

U.S. net sales for the second quarter were $24.8 million compared to U.S. net sales of $22.3 million for the second quarter last year. U.S. net sales annual growth of 11% and sequential growth of 5% is due to increases in new patient unit growth and improved pricing relating to product mix.

International sales for the second quarter were $4.2 million compared to $3.1 million for the second quarter last year and represents a record quarter for rest of world sales. International annual sales growth was 36% driven by an increase in sales volumes and average system prices relating to product and country mix.

Net sales for the six months ending October 28th were $56.1 million compared to $50.6 million for the six months last year, increasing by 11%. Net sales included $48.5 million from the U.S. market and $7.6 million from international markets compared to net sales of last year $44.9 million from the U.S. market and $5.7 million from international markets.

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Gross profit margin for the quarter was 87%, yet another record, and improved by 160 basis points over the same quarter last year and by 88 basis points over the previous quarter. Gross profit margin for the six months was 86.5% compared to 83.2% for the same period last year.

The continuing improvement in gross profit margins is the result of improved manufacturing efficiencies relating to increased production levels as well as a slight increase in average system prices.

Operating expenses were $47.7 million for the quarter and $89.9 million for the six months, and have doubled over the same quarter last year and increased by 91% over the first six months of last year. Fiscal 2006 spending reflects the expanded organization and business philosophies across all functions to support the U.S. TRD launch on August 1st.

This quarter not only includes a full quarter's impact of the expanded staffing levels, but also includes the expanded marketing post approval launch program costs. As expected, the primary area of growth was in SG&A which increased by 111% over the same quarter last year.

R&D increased by 58% over last year largely due expanded clinical study activities in post approval study programs.

Net loss for the quarter was $22.1 million, or $0.88 per fully diluted share compared to net loss of $2 million, or $0.08 per fully diluted share for the quarter ended October 29, 2004, and is in line with our revised guidance of no more than $22.5 million. Net loss for the six months was 40.9 million, or $1.64 per fully diluted share compared to net loss of $4.9 million last share, or $0.21 per fully diluted share.

Now let's briefly review the balance sheet components.

Cash and marketable securities at the end of the quarter were $118.9 million compared to $61.5 million in cash and marketable securities at the end of the fiscal year and $43.2 million last quarter. In addition to our increased spending levels to support the U.S. TRD launch, we are continuing to increase accounts receivable and inventory to support growth of the business.

Accounts receivables are in line with revenue growth and inventory had been increased to support anticipated sales demands. In September, we elected not to renew our line of credit of $20 million and issued notes payable totaling $125 million [which] provided net proceeding of approximately 98 million.

With this additional funding, the Company's current capital structure is currently adequate to fund the TRD launch and our long-term strategic plans.

On the slide before you is a summary of the terms of the notes that we issued this quarter. The notes payable were issued for $125 million and are senior subordinated notes with a 3% coupon rate that is payable biannually.

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The notes have a no call feature and mature in seven years in September, 2012. They carry a conversion premium of 25%, which is the equivalent of a conversion price of $41.50 at which time the bottoms can be converted into Cyberonics stock at the holder's option.

We also implemented a simultaneous share buy back program and purchased $10 million of Cyberonics stock on the open market. We further executed a separate bond hedge that minimizes potential conversion dilution at the bond conversion price up to market price of $50.

Looking on to the rest of this year, fiscal 2006 financial performance will continue to be largely determined by U.S. sales. Fiscal 2006 sales are highly dependent upon continued progress in obtaining TRD case-by-case approval and favorable national and regional coverage policies.

Until such time as we gain clarify and certainty on TRD conversion rates and cycle times, we will limit our guidance to annual guidance.

To that end, our fiscal 2006 worldwide sales goal is now $140 million. And our fiscal 2006 bottom line objective is now a maximum net loss of $50 million.

We expect to see solid progress towards quarterly profitably throughout the remainder of fiscal 2006.

Quarterly operating expenses will decline from Q2 consistent with the original TRD launch plan to a fourth quarter breakeven point at approximately $47 million in quarterly sales. Our profitability objective to return to corporate profitability by the second quarter of fiscal 2007 remains unchanged.

***

Keay Nakae - C.E. Unterberg, Towbin - Analyst

Yes, specific to the, your appeal of the Blue Cross/Blue Shield tech evaluation, have you resubmitted that?

Skip Cummins - Cyberonics, Inc. - Chairman, CEO

Basically yes to the extent that you ever submit anything there. But, yes, we have presented to the Blue Cross/Blue Shield tech and at a conference call with them going through in detail all of the incomplete and inaccurate information upon which their original assessment was based, and we have presented to them in detail all of the, quote, new information, the new publicly available information which was not available in June, 2005 when they did their original assessment.

And of course, Keay, that includes our complete PMA supplement, our complete PMA supplement amendment. It includes FDA summary of safety and effectiveness, which obviously comes to conclusions completely different than the

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FDA summary of the panel meeting minutes, et cetera. It also includes five peer-reviewed journal articles, et cetera.

So there is a significant amount of new publicly available information that was not available at the time of their original assessment which clearly demonstrates that VNS in TRD satisfies all of the tech criteria as well, if not better, than VNS in epilepsy did.

***

Bill Plovanic - First Albany Capital - Analyst

Hi. You've talked about when you gave us the list of the PMA supplement, the amendment, the FDA panel, but a question in regards to the data that you're supplying to the tech assessment committees for the different payors.

Were they or did they have access to the data prior to publication? So did they see any of this data prior to it was published or were they missing just a significant amount of data and only had basically one or two studies to kind of look at to make their decisions on post the first rejection from the FDA?


Yeah. First of all, Bill, most of the payors don't have technology assessment groups. I mean, there are three or four major ones in the U.S., Medicare would be one and Blue Cross/Blue Shield are the two large ones. But in essence, all of those technology assessments and most of the medical directors, when they're deciding on even case-by-case coverage, rely on publicly available information.

For instance, if you look at the Blue Cross/Blue Shield tech assessment which was a June, 2005 assessment, actually published and made publicly available in August of 2005, what you'll see is in their references their only data references are what are the limited publicly available information that FDA chose to put on their Web site as of the June, 2004 panel meeting.

So you'll see FDA's panel minutes. You'll see FDA's statistical summary. You'll see FDA's clinical summary. And you'll see Cyberonics' executive summary that went with the PMA supplement.

That was basically the only publicly available information upon which the Blue Cross/Blue Shield tech assessment was based. It did not include, again, all the data and analyses from the PMA supplement amendment, it did not include, or from the PMA supplement. It did not include any of the data analysis from the PMA supplement amendment because it had not yet been submitted.

It did not include FDA summary of safety and effectiveness, which supersedes FDA's other prior positions and analyses, and it didn't include all the peer-reviewed journal articles which basically reiterated in a peer-reviewed format all of the data upon which FDA was compelled to approve VNS therapy

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which has the most weight with almost all the payors. That is the peer-reviewed publications.

So in essence, all of the decisions that are out there today and the technology assessments were relying on out of date information that compelled FDA not to approve VNS but to deem it not approvable.

***

Nathan Sedagy - Kilkenny Capital Management - Analyst

Hi, guys. Thanks for taking the question.

Can you just, I just want to make sure I understand something here. You said that there are 200 TRD implants since launch as of last week. Correct?


Approximately. That's correct.


Roughly. So if I assume, let's say, that 175 of them were implanted in the quarter, would I be correct at estimating the sales at somewhere around 2.6 million in TRD leaving us with about 22.2 million in epilepsy?


I would have to say that I can't really provide you that information because Pam Westbrook is vigorously shaking her head.


Well --


Can you help us out with maybe like what the average sort of price per unit that you guys get?


Again, here's what I would say. Number one is it would be inappropriate for us to provide you with the details of what happened in Q1 or Q2 versus what we've seen so far in Q3 other than to say we're gaining momentum.

But the other thing I would have to say is that, again, these are implants that we've received cards on. There are likely a similar number of implants that we're not aware of because they haven't either sent in the implant card yet or they

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have no intention of sending in the implant card and they did not need our help with any sort of reimbursement.

***


And then just as a quick follow-up, the sort of average selling price or the average price that you guys receive per implant sale, is that about 15,000 still or is that higher?


That's correct.

122. Defendants’ conference call of November 21, 2005 was false and misleading.

First, defendant Westbrook’s statement of quarterly financial guidance was erroneous, false and

misleading, as a result of the flawed and defective internal controls over accounting and GAAP

violations in existence at the Company, as evidenced by improper accounting involving the stock

option grants awarded on June 15, 2004.

123. Second, defendants sparred with the analysts regarding “hard numbers” for

implants being performed on TRD patients. No matter how hard the analysts tried, defendants

refused to provide any data, arguing that there was no way for them to know the details of this.

In fact, this absurd “inability” either argued for the erroneous, flawed and defective nature of the

Company’s accounting practices, impacting the Company’s inventory controls, forecasting and

business planning activities, or it was simply a false and misleading statement designed to

prevent analysts from learning that there was no basis for optimism regarding the marketability

of the Company’s TRD treatment option.

124. Finally, when defendant Cummins was asked about the appeal of the BC/BS TEC

assessment, he falsely claimed that the initial TEC assessment was negative because TEC didn’t

have all the required information. He further stated that the appeal detailed to TEC “all of the

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incomplete and inaccurate information upon which their original assessment was based,” while

referring them to purported “new” information not previously available to them.

125. If this statement is to be believed, the Company not only concealed from investors

all knowledge of the scientific dissent at FDA surrounding the Company’s efforts subsequent to

the receipt of the “Not Approvable Letter,” but had also concealed that same information from

BC/BS TEC, as well. The PMA-S Amendment of September 23, 2004 and the SSE posted by

FDA did not contain FDA minutes, memos or opinions regarding the unanimous decision of the

FDA PMA-S reviewing team to uphold the “Not Approvable Letter.” Moreover, the “peer-

reviewed articles Cummins pointed to was nothing more than “new analysis of the same data,

new ways of dicing the data, new ways of cutting the data.”37 As a result, investors continued to

be deceived in the process.

126. On February 16, 2006, the Company issued a press release entitled “Cyberonics

Responds to Senate Finance Committee Staff Report.” The press release stated in part:

HOUSTON, Texas, February 16, 2006 -- Cyberonics, Inc. (NASDAQ:CYBX) today provided the following response to the Senate Finance Committee staff report on the FDA’s approval process for the Vagus Nerve Stimulation Therapy System for treatment-resistant depression.

“VNS Therapy is the only safe and effective treatment option ever specifically developed, studied, FDA-approved and fully-informatively labeled for the treatment of chronic or recurrent treatment-resistant depression (TRD), the most unrelenting, disabling, life-threatening and expensive form of depression,” commented Robert P. (“Skip”) Cummins, Cyberonics’ Chairman of the Board and Chief Executive Officer. “Unfortunately for the large number of Americans and their families who are trying to live with TRD and their psychiatrists who are trying to help them, the Senate Finance Committee today issued a report without having interviewed world renowned experts on TRD, widely published biostatisticians, patients and families living with TRD, patient advocacy organizations like NAMI, VNS Therapy TRD study investigators and all the FDA statisticians and clinicians involved in the review of the submissions, that ultimately led to the approval of the only FDA-approved treatment option for TRD.

37 This, in the judgment of Naomi Aronson, Director of BC/BS TEC. See the Reuters article of August 8, 2006 entitled, “Blue Cross to again reject Cyberonics device” discussed herein.

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“Unfortunately, no treatment, including VNS Therapy, works for everyone, especially for patients whose TRD has failed everything,” continued Mr. Cummins. “Cyberonics has an eight-year commercial track record in 35,000 epilepsy patients with over 100,000 years of experience and a nine-month track record since approval in TRD that confirms we are very sensitive to this issue. Not only do the epilepsy and TRD VNS Physician’s and Patient’s Manuals contain ALL the data from ALL the studies, but the VNS manuals are by far the most complete and informative of all the FDA-approved anticonvulsant and antidepressant treatments manuals. We believe that all the data from all the studies is considerably more important than the details of FDA’s internal debate about the data. In addition to complete, fully-informative manuals with all the data, Cyberonics’ track record confirms that we are fully committed to rigorous post-market study programs and registries to update the VNS Therapy manuals and to facilitate fully informed decisions going forward. That’s exactly what we did in epilepsy and exactly what we are doing in TRD. Consistent with our mission to improve the lives of people touched by refractory epilepsy and TRD, we believe that fully-informed treatment decisions should be made by qualified physicians who specialize in, and patients and families who are living with refractory epilepsy and TRD, as opposed to politicians and their staffs, ill-informed payers, etc.

127. Defendants’ press release was false and misleading for the following reasons.

First, it dismissed the conclusions of the Senate Report, to falsely portray the report as politically

motivated. In truth, defendants lacked a reasonable basis for doing so in that they lacked any

creditable evidence of political chicanery. Second, defendant Cummins dismissed the validity of

the science-based issues underlying the Report in that the SFC did not check with the “FDA

statisticians and clinicians involved in the review.” In fact, the SFC had access to the best and

brightest minds at FDA and at CMS, sparing no reasonable efforts to gain an objective view of

the matter. Finally, defendant Cummins knew, just as he did during the Company’s conference

call in November of 2005 that he still had no new substantive data or other “adequate evidence”

to reverse the negative coverage determinations of the Payers.

128. The Company continued in its cat-and-mouse game with investors by conducting

a conference call on May 2, 2006 entitled, “Cyberonics Announces 1,100th Patient Treated With

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VNS Therapy(tm) for Treatment-Resistant Depression (TRD) Since FDA Approval.” Defendants

stated in part:

Amit Hazan - SunTrust - Analyst

Okay, and then just kind of thinking about that in the context of -- Pam, some of the comments you were making about sales perhaps being not exactly linear. What kind of visibility do you guys have into the fiscal first quarter? Do you see some strength there? Should we see some sequential growth, or are you able to comment on that?

Skip Cummins - Cyberonics Inc. - Chairman, CEO, President

Well, Pam is shaking her head, and the guidance we’ve provided is basically what we will provide going forward, which is our goal, our annual growth goal for the fourth quarter, our profitability goal for the second quarter. And all we can tell you is that given that our business continues in TRD to be case-by-case, it continues to be a bit choppy and more problematic to predict.

Although, I will tell you that Q4 was also very encouraging because of the consistent above-planned performance of a significant portion of our territories and regions in the U.S. sales force from week one all the way through week 13, I guess it is. And the other thing, I’ll just tell you, is we’re off to a very strong start in Q1.

***

Steven Lichtman - Banc of America Securities - Analyst

Thank you. Good morning, guys. Skip, you mentioned some regional payers moving toward favorable coverage policies; can you describe that a little bit more? Where are they in the process? Are they at different points in the process? Can you characterize that maybe a little bit more.


Of course, they are all at very different points of the process, despite our best efforts to get them all across the finish line much more quickly then they are willing to go. But, yes, basically it’s all across the board. And in most cases, payers don’t publicize their -- contrary to what you all might like or we might like -- payers don’t publicize their coverage policies.

Now, as I mentioned, there are several regional payers when we’ve called regarding prior authorization who tell us VNS is a covered in TRD. Well, they haven’t made any fanfare about it, they don’t make any announcements. They’ve just amended their coverage policy and already put into their systems the diagnosis code of TRD matches to the service codes for VNS therapy.

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There is one that I think most of you are aware of, one major regional carrier that has written draft policy and is through now the public comment period. Hopefully, you all [are] calling them on an hourly basis to see where they are. And then, there are probably some 20 that are behind that that we’re actively working with that appear to be working towards favorable regional coverage policy.

And again, as I mentioned in the formal part of the presentation, this is an [integral] process where with each and every individual payer, you work with them to provide them with adequate evidence for them to implement coverage policy, with or without a public announcement. So, we’re working with every payer that covers a meaningful number of lives, and we’re making reasonable progress, especially when you consider our guidance throughout FY ‘07, just like the reality of Q4 where we posted record annual growth is that no coverage – we’re assuming no coverage policy whatsoever and no favorable technology assessments.

Steven Lichtman - Banc of America Securities - Analyst

Okay, great. Just building on that, Skip; you talked about the [integral] process, you talked about Aetna earlier. What’s the type of new evidence that you believe that will be needed, is it the peer review studies coming up or is some of the post-market data, or is unclear at this point?


Well, we have the next round of evidence basically is complete, the peer review publication of the study data upon which FDA base their approval, and its supplements that with some additional information on the ineffectiveness of treatments as usual, such as the two-year outcomes of the patients treated in our D04 study only with treatments as usual, which has already been accepted for publication. It also supplements it with a comprehensive analysis of the VNS mechanism of action, which provides the scientific basis for the unique long-term sustained and improving outcomes produced by VNS in patients with TRD.

It includes things like the international study that really wasn’t in our PMA submission, but the publication for which is now being drafted and will soon be submitted which shows the best one-year response in remission rates of any of the VNS studies, and I eluded to it, one-year response rates in excess of 50%, one-year remission rates in excess of 35%. And these are a group of patients very similar to the D01 and D02 patients, but in this case were treated with much higher doses of VNS from the start than were the D02 treatment group patients.

And the other thing that we expect to see in the next several months are position statements from experts on appropriate use of VNS. All of that, we think, is going to compel a number of payers to issue favorable coverage policy consistent with our guidance in fiscal 2008.

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Ryan Rauch - Jeffries & Co. - Analyst

Got you.


But the good news is ultimately if the patient and the psychiatrist can persevere, we will help them make sure they get the therapy they want and deserve as evidenced by the fact that over 80% of third-party appeals boards have ruled in favor of VNS therapy once it reaches the third party.

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129. Defendants’ conference call of May 2, 2006, was false and misleading. First, the

Company’s quarterly financial guidance was erroneous, false and misleading, as a result of the

flawed and defective internal controls over accounting and GAAP violations in existence at the

Company, as evidenced by improper accounting involving the stock option grants awarded on

June 15, 2004.

130. Second, defendant Cummins made clear that the Company was capable of

providing “adequate evidence” to insurance Payers for its TRD treatment option. This

statement was objectively baseless, false and misleading, even on the basis of “the peer review

publication of the study data upon which FDA base their approval, and its supplements…” or

any of the other data defendant Cummins claimed the Company possessed, since this data and

information was nothing more than “new analysis of the same data, new ways of dicing the data,

new ways of cutting the data as recognized by BC/BS TEC Director Naomi Aronson.”

131. Finally, the Company continued to conceal the fact that thousands of patients had

been rejected in their attempts for reimbursement, making the 80% success rate in the appeal

process so meaningless as to be false and misleading. Defendants made these statements to

purport the existence of momentum and traction in their “TRD franchise” and that the Company

was well on its way to implement positive coverage determinations. But, in fact, defendants

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already knew that they lacked any new data or studies of a substantive nature to provide the

Payers..

132. Then, on June 8, 2006, revelations of improprieties related to the Company’s

grant of 170,000 stock options on the night of June 15, 2004, had finally come to light. On June

12, 2004, SunTrust Robinson Humphrey (“STRH”) analyst Amit Hazan expanded his reporting

into the matter, noting that the SEC had launched an informal investigation, as he stated in

part:

SEC Contacts CYBX. According to a report in the Wall Street Journal, the SEC has now launched an informal probe into CYBX stock option practices. The move highlights a concern we raised last week (see note dated 6/8/06: “Moving to Neutral on Option Grant Concerns & Reimbursement Delays”) regarding stock option grants to three executives on June 15, 2004. Specifically, 170,000 options were granted that night, just a few hours after a very controversial FDA Panel voted to approve VNS therapy for depression. With a full understanding of the materiality of the event (this was undoubtedly the single greatest event in the company's history), this management and board of directors granted the options with a prior day’s (June 14th) exercise price of $19.58. The stock rose 78% on June 16, yielding the executives a combined overnight paper profit of ~$2.5M.

• We Fully Stand by Our Claim. To further clarify our claim, it breaks down into two issues: (1) the timing of the option grants, and (2) their exercise price. As to the first issue, we understand the very spirit of stock option grants to be an alignment of managers’ interests more closely with those of its shareholders (sharing alike in events that unfold). But by granting the options on the evening in question, this management knowingly abused that principle, acting in their own self interest with material information at a time when their shareholders and investors could not do so. Secondly, management's response to this issue in an 8-K filing last week claims the June 14th exercise price of $19.58 was "fair market value," because the rules do allow using the most recent day's closing price.

We don’t agree. While the exact letter of the law may very well have been followed, it seems clear to us that the very intent of the regulation was manipulated. Fully aware of the positive FDA Panel decision, this management team and its directors surely realized the "fair" value of its equity was worth much more than the mere $19.58 share price prior to when this very controversial event took place? If so, then we believe they improperly took advantage of this definition for their own benefit, as the intent of the regulation is to come as close as possible to capturing the "true" value of the stock. If management had wanted to properly “align” themselves with shareholders for the 60 month vesting period (as they claimed last week), they should have allowed the event to be factored into the share price. Incidentally, investors who bought shares on the morning after the FDA Panel have now lost 35% of their investment value to date (two

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years on), but the three executives acting on the same information are still "in the money" by over 10%.

• Credibility is the Real Issue. Whether the facts above (which have not been disputed) results in regulatory violations or not, these actions appear unethical to us, and are akin "in effect" to the broader stock option incentive compensation abuses currently unfolding at a number of other companies. While Cyberonics' abuse does not appear to be a regular systemic pattern, it unfortunately takes on a much larger significance when put into a historical context of credibility issues with this management team. Simply put, it has become increasingly evident to us that the value of CYBX common continues to be meaningfully discounted due to the presence of the current CEO, in our opinion, and we believe that stock appreciation will continue to be limited by this factor. At the end of the day, shareholders will have to decide whether this management team and its board of directors have fulfilled their fiduciary duty. We are currently hard pressed to reach such a conclusion.

133. Thus, Hazan raised ethical concerns regarding the Company’s claim that it had

priced the options at the “fair market price” of $19.58 reached at the close of trading on June 14,

2004, while it was clear that the grants were priced on the evening of June 15, 2004, following

the outcome of a highly material event, the news of the Company’s positive result before the

FDA advisory committee. The Company’s response to Hazan’s accusations, in its SEC Form 8-

K of June 9, 2006, was to state that “[t]he assertions and claims made in the STRH report are

inaccurate and without merit.”

134. On June 24, 2006, the BC/BS TEC reported on its website that its Medical

Advisory Panel (MAP) had recently revisited and updated its evaluation of the VNS Device for

TRD,38 as noticed by the following bare-bones statement:


The MAP concluded that vagus nerve stimulation for the indication of treatment-resistant depression does not meet the TEC criteria.

38 See http://www.bcbs.com/tec/tec_initial_findings.html , last accessed on August 13, 2006.

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THE TRUTH IS REVEALED

135. Finally, on August 1, 2006, the Company issued a shocking press release entitled,

“Cyberonics Revises Guidance For FY07 And Confirms Receipt Of Nasdaq Staff Determination

Letter.” The press release stated in part:

HOUSTON, Texas, August 1, 2006 -- Cyberonics, Inc. (NASDAQ:CYBX) today announced revised guidance for FY07. Sales for the first quarter ended July 28, 2006 are expected to be approximately $33.5 million, compared to fiscal year 2006 first quarter sales of $27.0 million, reflecting annual growth of 24% from the same period last year. U.S. sales for the first quarter ended July 28, 2006 are expected to be approximately $29.4 million, and international sales for the first quarter ended July 28, 2006 are expected to be approximately $4.1 million. Cash and marketable securities are expected to increase from $92.3 million at April 28, 2006 to approximately $94.0 million at July 28, 2006 and borrowings under the Company’s $40 million line of credit are expected to increase from $2.5 million as of April 28, 2006 to approximately $5.0 million on July 28, 2006. Financial results and the Form 10-Q for the quarter ended July 28, 2006 as well as the Annual Report on Form 10-K for the year ended April 28, 2006 will be issued and filed upon completion of the previously announced internal review being conducted by the Audit Committee of the Company’s Board of Directors regarding option grants and resolution of any disclosure and accounting issues that may arise from the results of the review. The Audit Committee is working diligently to complete its internal review, and the Company intends to release its results and file its Forms 10-Q and 10-K as expeditiously as possible.

“Cyberonics’ highest priorities are to (1) improve TRD patients’ access to VNS Therapy, and (2) complete the Audit Committee’s internal review and resolve any issues regarding option grants as quickly as possible,” commented Pamela B. Westbrook, Vice President, Finance and Administration and Chief Financial Officer. “Our accomplishment of these objectives will have a material affect on Cyberonics’ financial performance throughout FY07. In the first quarter, TRD patients’ case-by-case access to VNS Therapy, the only treatment proven safe and effective and FDA-approved for TRD, was more difficult than in previous quarters and as a result, we now do not anticipate any meaningful sequential sales growth from Q1 until such time as we obtain favorable coverage policies for VNS Therapy in TRD. In the first quarter, Cyberonics also expended considerable human and financial resources on the stock option matters, for which the total FY07 legal and accounting fees will likely exceed $3.0 million. Cyberonics is not likely to return to corporate profitability (excluding non-cash stock options expenses required under FAS123R) until such time as TRD coverage policies facilitate sequential quarterly growth in U.S. Sales and the various stock option grant matters are behind us.”

“Cyberonics remains committed to its objective of providing Americans with TRD universal access to VNS Therapy through national and regional

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coverage policies more quickly than the almost three years it took us to create broad-based national and regional coverage policies for VNS Therapy in refractory epilepsy,” commented Robert P. (“Skip”) Cummins, Cyberonics’ Chairman of the Board and Chief Executive Officer. “A year into our TRD launch, approximately 1,600 TRD patients have received VNS Therapy and more than 4,000 patients with TRD have been denied access to VNS Therapy by their payers. Approximately 213 payers have to date provided case-by-case access to between one and 50 TRD patients, 68 payers have had 104 case-by-case denials overturned, 39 payers have had 59 case-by-case denials overturned by third party appeals boards, 36 payer plans have informed patients that VNS for TRD is a covered benefit under the patient’s plan, 13 State Medicaid programs provided coverage of VNS Therapy for TRD by extending existing policy or on case-by-case approvals, four payers have issued formal written coverage policy for VNS Therapy in TRD (VNSTherapy.com “Insurance and Reimbursement”) and five Medicare Regional Financial Intermediaries have issued negative local coverage policies for VNS in TRD.

“In terms of national and regional coverage policies, Cyberonics recently began formally requesting that payers’ existing VNS Therapy coverage policies be amended to include patients with TRDEH defined as TRD patients that were either previously (1) treated with or refused treatment with ECT, or (2) hospitalized for depression,” continued Mr. Cummins. “TRDEH is the most chronic, resistant, disabling, life-threatening and expensive form of major depressive disorder. Studies show that TRDEH patients are a relatively small subset of depressed patients that consume enormous and disproportionate resources. TRDEH patients represent less than 0.3% of Medicare and private payers’ beneficiaries and approximately 10% of patients that have failed to respond to at least one antidepressant medication. TRDEH patients cost payers over $40,000 per patient per year in healthcare costs, most of which is for depression-related hospitalizations. None of the treatments currently used to treat TRDEH or covered by payers for that use have been proven safe and effective or FDA-approved for TRD or TRDEH. VNS Therapy is not only the only treatment proven safe and effective and FDA-approved for use in TRDEH, but it is also the only treatment that has been proven to produce the accumulating and durable long-term safety and effectiveness needed by TRDEH patients and their payers. Standard pharmaco-economics analyses suggest that VNS Therapy will provide TRDEH payers with 1.8 times the value and savings on hospitalization costs alone produced by VNS Therapy in epilepsy, for which VNS Therapy has been a widely covered benefit among regional and national payers since 2000. In TRDEH, data and evidence confirm that payers have considerably more exposure for continuing to cover only ineffective, unproven treatments that result in frequent hospitalizations and extraordinary annual costs, than they do for extending their coverage policies for less than 0.3% of their beneficiaries to include the only treatment that has been proven to produce accumulating and durable long-term safety and effectiveness and decreases in healthcare utilization and costs in refractory epilepsy and TRD.”

As anticipated in the Company’s Form 8-K filed with the Securities and Exchange Commission on July 27, 2006, Cyberonics received a Nasdaq Staff

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Determination Letter on July 31, 2006 indicating that the Company fails to comply with the filing requirement for continued listing set forth in Marketplace Rule 4310(c)(14), and that its securities are, therefore, subject to delisting from The Nasdaq Global Market. The Company will request a hearing before a Nasdaq Listing Qualifications Panel to review the Staff Determination. There can be no assurance the Panel will grant the Company’s request for continued listing.

136. Investors finally learned what the Company always understood and attempted to

conceal – that the effectiveness of its VNS device was so seriously suspect in the broad

treatment-resistant depression population it had defined that it would now focus on attaining

positive coverage determinations for its unproven therapy in a small but extraordinarily desperate

subset of those patients.

137. Shockingly, the Company was prepared to abandon its broadly defined TRD

patient population, as it now re-defined the target population as “patients with TRDEH defined

as TRD patients that were either previously (1) treated with or refused treatment with ECT, or

(2) hospitalized for depression.” Amazingly, along with its newly defined TRDEH disease, the

Company availed itself of an opportunity to “guide down” its previous marketability claims,

stating that, “[s]tudies show that TRDEH patients are a relatively small subset of depressed

patients that consume enormous and disproportionate resources.” As a result, investors finally

learned the true dimensions of the hollow, false and misleading nature of defendants’ Class

Period claims.

138. As if these admissions were not enough, the Company also reported that it had

received a Nasdaq Staff Determination Letter on July 31, 2006 in connection with its stock

option award improprieties, GAAP violations and inability to timely file its financial reports. The

Company put investors on notice “that its securities are, therefore, subject to delisting from The

Nasdaq Global Market.”

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139. As a result of the shocking news regarding the severely limited marketability of

the VNS Device for TRD and the issues leading to the SEC informal investigation and a possible

delisting of the Company’s stock, on August 1, 2006, nearly two years after the Company’s

receipt of its “Not Approvable Letter,” the value of the Company’s shares plummeted again,

falling $5.54 from the previous closing price of $21.43 on July 31, 2006, for a loss of over

25.8%, to close at $15.89, on heavy volume of over 5.4 million shares.

LOSS CAUSATION

140. Founded upon FDA’s meticulous and objectively sound review process, the

impact of the August 11, 2004 “Not Approvable Letter” was immediate in its corrective effect on

the market, inflicting severe losses on investors. As a result of the shocking news of the “Not

Approvable Letter,” on August 12, 2004, the value of the Company’s shares plunged over 40

percent, losing $9.59 from the previous closing price of $23.95 on August 11, 2004, to close on

August 12, 2004 at $14.36, on heavy volume of over 27 million shares.

141. Nevertheless, the Company immediately went to work to reverse the deservedly

devastating effect that the “Not Approvable Letter” had on market sentiment. Defendants’ efforts

to again artificially inflate the price of the Company’s stock succeeded, the result of unfounded

and objectively unreasonable claims directed towards “confirmation” of a lucrative marketing

opportunity for the Company’s TRD treatment option.

142. In addition to this, during the Class Period, defendants concealed violations of

Generally Accepted Accounting Principles (“GAAP”), as well as the maintenance of flawed and

defective internal controls over accounting, resulting in the issuance of erroneous, false and

misleading financial statements and forward guidance. Defendants’ concealment of these

problems also served to inflate the value of the Company’s stock, as well as unjustly enrich

defendants at the expense of the members of the Class.

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143. As a result of the shocking news regarding the severely limited marketability of

the VNS Device for TRD and the issues leading to the SEC informal investigation and a possible

delisting of the Company’s stock, on August 1, 2006, the value of the Company’s shares

plummeted again, falling $5.54 from the previous closing price of $21.43 on July 31, 2006, for a

loss of over 25.8%, to close at $15.89, on heavy volume of over 5.4 million shares.

144. The almost 40.0% decline in Cyberonics stock on August 12, 2004, and the

25.8% decline in Cyberonics’ stock price on August 1, 2006, at the end of the Class Period were

the direct result of the unraveling of the nature and extent of defendants’ fraud finally being

revealed to investors and the market. The timing and magnitude of Cyberonics stock price

decline negate any inference that the loss suffered by plaintiff and other Class members was

caused by changed market conditions, macroeconomic or industry factors or Company-specific

facts unrelated to the defendants’ fraudulent conduct.

145. On the days in which Cyberonics stock price fell almost 40.0% and 25.8% as a

result of aspects of defendants’ fraud being revealed, the Standard & Poor’s 500 securities index

was flat. The economic loss, i.e., damages, suffered by plaintiff and other members of the Class

was a direct result of defendants’ fraudulent scheme to artificially inflate Cyberonics stock price

and the subsequent significant decline in the value of Cyberonics stock when defendants’ prior

misrepresentations and other fraudulent conduct was revealed.

POST-CLASS PERIOD REVELATIONS

146. On August 2, 2006, TEC issued its summary of the reassessment the Company’s

“treatment option.”39 Once again, and in spite of the Company’s representations of a necessary

and corrective appeal, the updated assessment pointed to the very same issues of effectiveness

concealed by defendants from a time prior to the beginning of the Class Period. The re-

39 See http://www.bluecares.com/tec/tecinpress/8206f.html , last accessed on August 13, 2006.

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assessment once again rejected the Company’s data and results, finding no objective support for

concluding any improvement of health outcomes, stating in part:


EXECUTIVE SUMMARY

Background: Depression is a serious psychiatric condition that sometimes does not respond to standard treatments such as medication and/or psychotherapy. Vagus nerve stimulation (VNS) therapy is administered through an implanted pulse generator and bipolar lead and has been studied in patients with treatment-resistant depression. VNS was previously evaluated by the Technology Evaluation Center (TEC) for this indication in 2005 and did not meet TEC criteria. Since the last TEC Assessment, the same studies evaluated in the prior Assessment have now been published in peer-reviewed journals, and there have been some reanalyses of the same data also published.

Objective: This Assessment will review the available evidence to determine if VNS therapy is effective for treatment-resistant depression. This Assessment updates the prior TEC Assessment of VNS for the same indication.

Search strategy: A search of the MEDLINE® database was completed for the period up through June 2006. The search strategy used the terms “depression” and “vagus [or “vagal”] nerve stimulator/stimulation” as text words or subject terms. Articles were limited to those published in English language and enrolling human subjects. The MEDLINE® search was supplemented by an examination of article bibliographies and relevant review articles, which were searched for citations.

Selection criteria: Articles were case series, randomized trials, or observational studies evaluating clinical outcomes of VNS therapy. In the prior TEC Assessment, results were available only from documents posted to the U.S. Food and Drug Administration (FDA) website. At this time, the same studies have now been published in peer-reviewed journals, almost unchanged from the FDA documents. New publications analyze the same data in various ways examining duration of benefit.

Main results: The relevant clinical evidence evaluating VNS consists of a case series of 60 patients receiving VNS, a short-term (i.e., 3-month) randomized, sham-controlled clinical trial (RCT) of 221 patients, and an observational study comparing 205 of the RCT patients on VNS therapy to 124 patients receiving usual treatment for depression. Patients who responded to sham treatment in the short-term randomized, controlled trial (approximately 10%) were excluded from the long-term observational study.

Patient selection was a concern for all studies. VNS is intended for treatment-refractory depression, but the entry criteria of failure of 2 drugs and a 6-week trial of therapy may not be a strict enough definition of treatment resistance.

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Treatment-refractory depression should be defined by thorough state-of-the-art psychiatric evaluation and management. Patients with clinically significant suicide risk were excluded from all VNS studies.

The case series data show rates of improvement, as measured by a 50% improvement in depression score of 31% at 10 weeks to greater than 40% at 1 to 2 years, but there are some losses to follow-up. Natural history, placebo effects, and patient and provider expectations make it difficult to infer efficacy from case series data.

The randomized study that compared VNS therapy to a sham control (implanted but inactivated VNS) did not show a statistically significant result for the principal outcome at 3 months. Fifteen percent of VNS subjects responded, versus 10% of control subjects (p=0.31). There was a statistically significant result for a secondary outcome.

An observational study comparing patients participating in the randomized clinical trial and a separately recruited control group evaluated VNS therapy out to 1 year. This observational study showed a statistically significant difference in the rate of change of depression score. However, issues such as unmeasured differences between patients and nonconcurrent controls, differences in sites of care between VNS therapy patients and controls, and differences on concomitant therapy changes raise concern about this observational study. Analyses performed on subsets of patients cared for in the same sites, and censoring observations after treatment changes, generally showed diminished differences in apparent treatment effectiveness of VNS and almost no statistically significant differences. Given these concerns about the quality of the observational data, these results do not provide strong evidence for the effectiveness of VNS therapy.

Additional reanalyses of these same data to evaluate persistence of response show that among those who achieve a response at 3 or 12 months, 60–75% of such patients are judged to remain a responder at 1 year later. In the context of relatively low overall response rates, these data do not provide evidence of efficacy.

Adverse effects of VNS therapy include voice alteration, headache, neck pain, and cough, which are known from prior experience with VNS therapy for seizures. Regarding specific concerns for depressed patients such as mania, hypomania, suicide, and worsening depression, there does not appear to be a greater risk of these events during VNS therapy.

Author’s conclusions and comments: Since the last TEC Assessment, there have been no studies reporting clinical outcomes on any new or different patients. Data from the case series and clinical trials have been reanalyzed to show what proportions of patients who respond at one time are still responders at a subsequent time point. However, this information by itself does not provide evidence of the efficacy of VNS beyond that provided by the original observational comparison of VNS versus treatment as usual.

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Based on the available evidence, the Blue Cross and Blue Shield Association Medical Advisory Panel made the following judgments about whether vagus nerve stimulation (VNS) for the indication of treatment-resistant depression meets the Blue Cross and Blue Shield Association Technology Evaluation Center (TEC) criteria.


The NeuroCybernetic Prosthesis System (NCP®, Cyberonics, Inc.) received approval of its Premarket Application (PMA) to market from the U.S. Food and Drug Administration (FDA) on July 16, 1997, for treatment-refractory seizures. The device was approved for use in conjunction with drugs or surgery “as an adjunctive treatment of adults and adolescents over 12 years of age with medically refractory partial onset seizures.”

On July 15, 2005, the VNS Therapy System received final PMA approval by the FDA for “adjunctive long-term treatment of chronic or recurrent depression for patients 18 years of age or older who are experiencing a major depressive episode and have not had an adequate response to 4 or more adequate antidepressant treatments.”


The clinical trials reviewed above report weak evidence that does not demonstrate efficacy.

3. The technology must improve the net health outcome; and


The available evidence does not permit conclusions regarding the effect of VNS therapy on health outcomes or its effect compared with alternative therapies.


Whether VNS therapy for treatment-related depression improves health outcomes has not yet been determined in the investigational setting.

For the above reasons, VNS therapy for the indication of treatment-resistant depression does not meet the TEC criteria.

147. Following this, on August 4, 2006, defendants provided investors with the

potentially dire consequences of its GAAP violations, as it issued SEC Form 8-K, which stated

in part:

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Item 2.04 Triggering Events That Accelerate or Increase a Direct Financial Obligation or an Obligation Under an Off-Balance Sheet Arrangement.

Pursuant to the Indenture dated September 27, 2005 ("Indenture"), between Cyberonics, Inc. ("Company"), as issuer, and Wells Fargo Bank, National Association (the "Trustee"), as trustee, with respect to the Company's $125 million of 3.0% Senior Subordinated Convertible Notes due 2012 ("Notes"), the Company is required to deliver to the Trustee "within 15 days after it files them" with the Securities and Exchange Commission ("SEC") copies of all annual reports and other information, documents and other reports that the Company is required to file with the SEC pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended.

On July 31, 2006, the Company received a notice of default and demand letter dated July 28, 2006 from the Trustee, pursuant to which the Trustee asserts that the Company is in default under the Indenture as a result of its failure (a) to timely file with the SEC its Annual Report on Form 10-K for the fiscal year ended April 28, 2006 ("2006 Form 10-K") by July 12, 2006 and (b) to deliver a copy of the 2006 Form 10-K to the Trustee by July 27, 2006.

The Company does not believe that a default has occurred under the Indenture. As discussed above, the Indenture provision referenced in the letter specifically requires the Company to deliver a copy of its 2006 Form 10-K within 15 days after the date it is filed with the SEC. The Indenture provision does not require the Company to file the 2006 Form 10-K by any particular date. The Company will furnish to the Trustee copies of its 2006 Form 10-K within 15 days after it files such report with the SEC. The Company believes that this action will comply fully with the Indenture.

If the Company's interpretation of the Indenture provision is not correct such that a default under the Indenture has occurred, and if the Company does not cure the default by filing with the SEC and delivering to the Trustee a copy of the 2006 Form 10-K by September 27, 2006, then an "event of default" occurs under the Indenture. If an event of default occurs under the Indenture, the Trustee or the holders of at least 25% in aggregate principal amount of the Notes could declare all unpaid principal and accrued interest on the Notes then outstanding to be immediately due and payable. Moreover, any event of default under the Indenture constitutes an event of default under the Company's Credit Agreement dated January 13, 2006 with Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc. ("Administrative Agent") and the lenders who are party thereto ("Lenders"). As disclosed in the Company's Current Report on Form 8-K filed with the SEC on July 27, 2006, the Company entered into a Consent and Amendment Agreement ("Consent") that same date with the Administrative Agent and Lenders providing that certain events will not constitute a default under the Credit Agreement prior to October 31, 2006, including the Company's failure to timely file with the SEC its 2006 Form 10-K. If a default has occurred under the Indenture and the Company is unable to negotiate an appropriate amendment to the Consent to include such default under the Indenture, then the lenders may accelerate the due date of all loans then

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outstanding under the Credit Agreement. As of August 4, 2006, loans aggregating $5 million in principal amount, representing the minimum for which the Company must pay interest, were outstanding under the Credit Agreement.

Item 3.01 Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing.

On August 1, 2006, the Company issued a press release and filed a Current Report on Form 8-K disclosing that, as a result of the delay in filing its 2006 Form 10-K, it had received a Staff Determination Letter from the NASDAQ Stock Market, Inc. ("NASDAQ") dated July 31, 2006 indicating that the Company fails to comply with the filing requirement for continued listing set forth in Marketplace Rule 4310(c)(14), and that its securities are, therefore, subject to delisting from The NASDAQ Global Market. The July 31, 2006 Staff Determination Letter was superseded by a Staff Determination Letter dated August 1, 2006 that differed only insofar as necessary to account for NASDAQ's operation as an exchange effective on that date.

On August 3, 2006, the Company requested a hearing before a NASDAQ Listing Qualifications Panel ("NASDAQ Panel") to review the NASDAQ Staff's Determination Letter. On August 4, 2006, the Company received formal notice from NASDAQ that the delisting action has been stayed pending a written decision from the NASDAQ Panel and that the NASDAQ Panel will review the NASDAQ Staff's determination at a hearing on September 14, 2006. The NASDAQ Panel's written decision is expected to be issued on a date subsequent to the date of the hearing. As previously advised, however, there can be no assurance that the NASDAQ Panel will grant the Company's request for continued listing.

148. Finally, on August 8, 2006, Reuters was able to get TEC “on the record”

regarding the science-based deficiencies facing the Company’s TRD treatment option, in an

article entitled, “Blue Cross to again reject Cyberonics device,” which stated in part:

BOSTON, Aug 8 (Reuters) - The Blue Cross Blue Shield Association has rejected an appeal by Cyberonics Inc. <CYBX.O> to pay for its electronic device to treat depression, a senior Blue Cross executive said on Tuesday.

Information presented by Cyberonics contained "nothing new" said Naomi Aronson, executive director of the technology evaluation center at Blue Cross Blue Shield, the trade association for 38 independently owned Blue Cross health insurance plans.

Blue Cross, like many other health insurance plans, have balked at paying for the stop-watch-like Vagus Nerve Stimulator, which is implanted in a patient's chest and sends electrical pulses to the brain.

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Aronson said the association will post its decision on its web site within the next few weeks.

Last week shares of Cyberonics fell roughly 25 percent after it said insurers were not reimbursing for the product as fast as it had hoped.

Cyberonics, which also sells the device as a treatment for epilepsy, is counting on selling expanding its sales in other indications, including depression.

An initial trial of the device in more than 200 depressed people, half of whom had the device turned on and half who didn't, showed no statistically significant benefit, for those whose devices were turned on, after three months.

"This was a well-designed trial that deserves credit," Aronson said. "The result showed there was no difference between the two groups.”

A second trial showed there was an improvement but that study was criticized for lacking an adequate control group. The FDA approved the device for depression last year after a top agency official overruled opposition by more than 20 staff members. Most insurance companies remain skeptical.

Aronson said Cyberonics had presented Blue Cross with "several binders" of information in a bid to get the organization to reconsider its decision not to recommend paying for the treatment.

"We saw new publications from the same trial, new analysis of the same data, new ways of dicing the data, new ways of cutting the data," she said. "There are many ways you can slice it but the bottom line is that it is weak.”

Aronson said it is far less likely that insurers will reimburse for the product in depression than in epilepsy, where she said the data was more robust.

"The data for epilepsy was fairly clear. You had a clearly defined refractory group and a tangible and significant reduction in seizures.”

DEFENDANTS’ CLASS PERIOD STOCK SALES

149. During the Class Period, defendants sold their shares of Cyberonics stock in

accordance with the following schedule:

Date Insider Shares Price Proceeds 6/1/2006 CHENEY MICHAEL A 1000 $24.38 $24,384 2/14/2005 CHENEY MICHAEL A 22947 $41.13 $943,877 2/10/2005 CHENEY MICHAEL A 1461 $42.38 $61,918 6/28/2004 CHENEY MICHAEL A 1000 $35.00 $35,000 6/25/2004 CHENEY MICHAEL A 1000 $34.53 $34,526 6/25/2004 CHENEY MICHAEL A 1000 $34.53 $34,526

2/11/2005 CUMMINS ROBERT P 18000 $44.25 $796,453 2/10/2005 CUMMINS ROBERT P 32200 $44.24 $1,424,638

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2/10/2005 CUMMINS ROBERT P 180449 $40.67 $7,338,699 2/10/2005 CUMMINS ROBERT P 119351 $43.08 $5,141,402

6/2/2006 JENNINGS WILLIAM 1000 $25.31 $25,312 6/1/2006 JENNINGS WILLIAM 20000 $25.16 $503,200 6/23/2004 JENNINGS WILLIAM 5000 $33.60 $168,000

7/24/2006 RUDOLPH RICHARD 11933 $20.36 $242,909 6/1/2006 RUDOLPH RICHARD 2500 $24.62 $61,551 6/18/2004 RUDOLPH RICHARD 2905 $37.00 $107,485

9/16/2004 TOTAH ALAN D 1000 $22.58 $22,585 6/28/2004 TOTAH ALAN D 1410 $36.20 $51,042

Totals 424156 $17,017,506

APPLICABILITY OF PRESUMPTION OF RELIANCE

FRAUD-ON-THE-MARKET DOCTRINE

150. At all relevant times, the market for Cyberonics securities was an efficient market

for the following reasons, among others:

(a) Cyberonics’s stock met the requirements for listing, and was listed and

actively traded on the NASDAQ, a highly efficient and automated market;

(b) As a regulated issuer, Cyberonics filed periodic public reports with the

SEC; and

(c) Cyberonics regularly communicated with public investors via established

market communication mechanisms, including through regular disseminations of press releases

on the national circuits of major newswire services and through other wide-ranging public

disclosures, such as communications with the financial press and other similar reporting services.

151. As a result of the foregoing, the market for Cyberonics’s securities promptly

digested current information regarding Cyberonics from all publicly available sources and

reflected such information in Cyberonics’s stock price. Under these circumstances, all persons

who purchased or acquired Cyberonics’s securities during the Class Period suffered similar

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injury through their purchase of the aforementioned securities at artificially inflated prices and a

presumption of reliance applies.

NO SAFE HARBOR

152. The statutory safe harbor provided for forward-looking statements under certain

circumstances does not apply to any of the allegedly false statements pleaded in this complaint.

Many of the specific statements pleaded herein were not identified as “forward-looking

statements” when made. To the extent there were any forward-looking statements, there were no

meaningful cautionary statements identifying important factors that could cause actual results to

differ materially from those in the purportedly forward-looking statements. Alternatively, to the

extent that the statutory safe harbor does apply to any forward-looking statements pleaded

herein, defendants are liable for those false forward-looking statements because at the time each

of those forward-looking statements was made, the particular speaker knew that the particular

forward-looking statement was false, and/or the forward-looking statement was authorized

and/or approved by an executive officer of Cyberonics who knew that those statements were

false when made.

CLASS ACTION ALLEGATIONS

153. Plaintiffs bring this action as a class action under Federal Rule of Civil Procedure

23, on behalf of all persons who purchased or acquired the securities of Cyberonics between

February 5, 2004 and August 1, 2006, inclusive (the “Class Period”), and were damaged thereby.

Excluded from the Class are defendants, any entity in which a defendant has or had a controlling

interest, and members of defendants’ families.

154. The members of the Class are so numerous that joinder of all members is

impracticable. The disposition of their claims in a class action will provide substantial benefits

to the parties and the Court. During the Class Period, Cyberonics had more than 25 million

shares of stock outstanding, owned by thousands of persons. Record owners and other class

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members may be identified from records maintained by Cyberonics and/or its transfer agents and

may be notified of the pendency of the action by mail, using a form customarily used in

securities class actions.

155. There is a well-defined community of interest in the questions of law and fact

involved in this case. There are no conflicts between plaintiffs and the Class, and plaintiffs’

claims are typical of those of other Class members. The questions of law and fact common to

the members of the Class which predominate over questions which may affect individual Class

members include the following:

(a) Whether §§10(b) and 20(a) of the Exchange Act were violated by

Cyberonics and the Individual Defendants.

(b) Whether defendants misrepresented material facts;

(c) Whether defendants’ statements omitted material facts necessary to make

the statements made, in light of the circumstances under which they were made, not misleading;

(d) Whether the defendants knew or should have known that their statements

were false and misleading;

(e) Whether the prices of Cyberonics securities were artificially inflated

during the Class Period; and

(f) The extent of damage sustained by Class members and the appropriate

measure of damages.

156. A class action is superior to all other available methods for the fair and efficient

adjudication of this controversy since joinder of all class members is impracticable.

Furthermore, the damages suffered by individual Class members may be relatively small, and the

expense and burden of litigation make it impossible for members of the Class to individually

redress the wrongs done to them. There will be no difficulty in the management of this action as

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a class action. Plaintiffs will fairly and adequately protect the interests of the Class and have

retained counsel competent and experienced in class and securities litigation.

COUNT 1

For Violation of §10(b) of the Exchange Act and Rule 10b-5 Against Cyberonics and the Individual Defendants

157. Plaintiffs incorporate paragraphs 1-156 by reference.

158. During the Class Period, defendants disseminated or approved the false

statements specified above, which they knew or recklessly disregarded were materially false and

misleading in that they contained material misrepresentations and failed to disclose material facts

necessary in order to make the statements made, in light of the circumstances under which they

were made, not misleading.

159. Defendants violated §10(b) of the Exchange Act and Rule 10b-5 in that they:

(a) Employed devices, schemes, and artifices to defraud;

(b) Made untrue statements of material facts or omitted to state material facts

necessary in order to make statements made, in light of the circumstances under which they were

made, not misleading; or

(c) Engaged in acts, practices, and a course of business that operated as a

fraud or deceit upon plaintiffs and others similarly situated in connection with their purchases or

acquisitions of Cyberonics securities during the Class Period.

160. Plaintiffs and the Class have suffered damages in that, in reliance on the integrity

of the market, they paid artificially inflated prices for Cyberonics securities during the Class

Period. Plaintiffs and the Class would not have purchased, acquired or exchanged Cyberonics

securities at the prices they paid, or at all, if they had been aware that the market prices had been

artificially and falsely inflated by defendants’ misleading statements.

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161. As a direct and proximate result of defendants’ wrongful conduct, plaintiffs and

the other members of the Class suffered damages in connection with their purchases and

acquisitions of Cyberonics securities during the Class Period.

COUNT II For Violation of §20(a) of the Exchange Act

Against Cyberonics and the Individual Defendants

162. Plaintiffs incorporate paragraphs 1-161by reference.

163. The Individual Defendants prepared, or were responsible for preparing, the

Company’s press releases and SEC filings. By reason of their positions as directors and/or

officers of Cyberonics they had the power and authority to cause Cyberonics to engage in the

wrongful conduct complained of herein. Cyberonics controlled each of the Individual

Defendants and all of its employees. By reason of such wrongful conduct, the Individual

Defendants and Cyberonics are liable pursuant to §20(a) of the Exchange Act.

PRAYER FOR RELIEF

164. WHEREFORE, plaintiffs on behalf of themselves and the Class, pray for

judgment as follows:

A. Declaring this action to be a class action properly maintained pursuant to

Rule 23 of the Federal Rules of Civil Procedure;

B. Awarding plaintiffs and other members of the Class compensatory

damages;

C. Awarding plaintiffs and members of the Class pre-judgment and post-

judgment interest, as well as reasonable attorneys’ fees, expert witness fees, and other costs and

disbursements;

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D. Awarding extraordinary, equitable and/or injunctive relief as permitted by

law, equity and the federal statutory provisions sued hereunder, pursuant to Rules 64 and 65 and

any appropriate state law remedies to assure that the Class has an effective remedy; and

E. Awarding plaintiffs and other members of the Class such other relief as

this Court may deem just and proper under the circumstances.

DATED: August 17, 2006

SCOTT + SCOTT LLC /s/ Arthur L. Shingler III ARTHUR L SHINGLER III SCOTT + SCOTT, LLC ARTHUR L. SHINGLER III NICHOLAS J. LICATO 600 B Street, Suite 1500 San Diego, CA 92101 Telephone: 619/233-4565 Facsimile: 619/233-0508 SCOTT + SCOTT, LLC DAVID R. SCOTT DENISE ZAMORE 108 Norwich Avenue P.O. Box 192 Colchester, CT 06415 Telephone: 860/537-5537 Facsimile: 860/537/4432 FINKELSTEIN & KRINSK, LLP JEFFREY R. KRINSK MARK L. KNUTSON 501 W. Broadway Suite 1250 San Diego, CA 92101 Telephone: 619/238-1333 Facsimile: 619/238-5425 Lead Counsel for Plaintiffs JOHN G. EMERSON EMERSON POYNTER LLP Federal I.D. No. 5309 State Bar No. 06602600 830 Apollo Lane

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Houston, TX 77058 Telephone: 281/488-8854 Facsimile: 281/488-8867 SCOTT E. POYNTER EMERSON POYNTER LLP 2228 Cottondale Lane, Suite 100 Little Rock, AR 72202 Telephone: 501/907-2555 Facsimile: 501/907-2556 Local Attorney for Plaintiff

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CERTIFICATE OF SERVICE I hereby certify that on the 17th day of August, 2006, I electronically filed the foregoing with the Clerk of the Court using the CM/ECF system which sent notification of such filing to the following: David R. Scott [email protected] Arthur L Shingler, III [email protected] Geoffrey M. Johnson [email protected] Jeffrey R Krinsk [email protected] Mark A Golovach [email protected] Mark L Knutson [email protected] N Scott Fletcher [email protected]

/s/ Arthur L. Shingler . ARTHUR L. SHINGLER III

Documents

UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF … · landscape and processes applicable to payer third-party reimbursement issues in its SEC Form 10-K filed on July 18, 2003,