12

---

Under the License Agreements, we generally own the intellectual property that we create or reduce to practice in the performance of the License Agreements or exercise of the licenses granted thereunder, except such inventions that relate primarily, in each instance, to the Chrysalis Technology (Chrysalis Technology Improvements). We are obligated to assign to Chrysalis and PMPSA all such Chrysalis Technology Improvements and all such inventions are then made subject to our rights under each License Agreement. The License Agreements also contain provisions related to the calculation and payment of royalties, record-keeping and audit rights, and prosecution of patents, and include customary representations, warranties and indemnities. Each License Agreement, unless terminated earlier will expire as follows as to each Licensed Product in each country in the respective territory, on a country-by-country basis, upon the latest of: (a) the tenth anniversary of the date of the first commercial sale of the Licensed Product; (b) the date on which the sale of such Licensed Product ceases to be covered by a claim of an issued and unexpired patent in such country, or (c) the date a generic form of the product is introduced in such country. The License Agreements may be terminated, by Chrysalis or PMPSA, as appropriate, in the event that we fail to make the payment of the minimum royalties, as provided therein, or by us, in whole or in part, in the early years following the effective date, upon payment of a termination fee. In addition, either party to each License Agreement may terminate upon a material breach by the other party (subject to a specified cure period).

PLAN OF OPERATIONS

We have incurred substantial losses since inception and expect to continue to make significant investments for product research, development, manufacturing, sales and marketing and general administrative activities. We will need to generate significant revenues from product sales, related royalties and transfer prices to achieve and maintain profitability.

Through September 30, 2008, we had no revenues from any product sales, and had not achieved profitability on a quarterly or annual basis. Our ability to achieve profitability depends upon, among other things, our ability to develop products, obtain regulatory approval for products under development and enter into collaboration and other agreements for product development, manufacturing and commercialization. In addition, our results are dependent upon the performance of our strategic partners and suppliers. Moreover, we may never achieve significant revenues or profitable operations from the sale of any of our products or technologies.

Through September 30, 2008, we had not generated taxable income. At December 31, 2007, net operating losses available to offset future taxable income for Federal tax purposes were approximately $258.7 million. In addition, we had a research and development tax credit carryforward of $6.1 million at December 31, 2007. The Tax Reform Act of 1986 (the “Act”) provides for a limitation on the annual use of net operating loss and research and development tax credit carry-forwards following certain “ownership changes” (as defined by the Act) that could limit our ability to utilize these carry-forwards. As a result of, among other things, past financings, we are considered to have experienced various such ownership changes. Accordingly, our ability to utilize the foregoing carry-forwards may be limited. Additionally, because tax laws limit the time periods during which these carry-forwards may be applied against future taxes, we may not be able to take full advantage of these carry-forwards for federal and state income tax purposes. The Federal net operating loss and research and development tax credit carryforwards expire beginning in 2008 through 2027. In 2008, $0.8 million of Federal net operating losses and $18,124 of research and development tax credit carryforwards expire.

Over the next 12 to 24 months, we plan to undertake a variety of initiatives that are discussed below.

Research and Development

13

---

Our major research and development projects include:

SRT for Neonatal and Pediatric Indications

In order to address the most prevalent respiratory disorders affecting infants in the NICU and PICU, we are conducting several therapeutic programs that target respiratory conditions that have been cited as some of the most significant unmet medical needs in the neonatal and pediatric community.

Surfaxin for the Prevention of RDS in Premature Infants

On May 1, 2008, the date under the Prescription Drug User Fee Act (PDUFA) on which the FDA was to complete its review of our NDA for Surfaxin for the prevention of RDS in premature infants, we received a third Approvable Letter for this NDA. Most notably, this Approvable Letter did not contain a requirement for additional clinical trials. On October 17, 2008, we submitted our Complete Response to this Approvable Letter. The FDA designated our Complete Response as a Class 2 resubmission and has established April 17, 2009 as its target action date under PDUFA to complete its review of our Surfaxin NDA.

Prior to receiving the May 2008 Approvable Letter, we believe that we had made significant progress towards gaining regulatory approval for Surfaxin. Specifically, (i) as of March 2008, we had submitted to the FDA 12-month stability data on our Surfaxin process validation batches, (ii) also in March 2008, the FDA completed a pre-approval inspection (PAI) of our manufacturing operations at Totowa, New Jersey, and thereafter issued an Establishment Inspection Report (EIR) indicating an approval recommendation, and (iii) on April 30, 2008, as part of our NDA review, we completed labeling discussions with the FDA and agreed to a proposed Surfaxin package insert setting forth prescribing information, although the package insert will not be considered final until the FDA approves our NDA.

The May 2008 Approvable Letter included, among other things, requests (i) to further tighten or justify one acceptance criterion for the biological activity test that we previously had implemented for Surfaxin release and stability testing (Biological Activity Test), (ii) to further tighten or justify acceptance criteria for lipid drug substance impurities, (iii) to further tighten or justify 2 of the 21 physical and chemical drug product acceptance criteria that we had proposed in our October 2007 Complete Response to the April 2006 Approvable Letter, and (iv) to submit certain specified equipment and aseptic process-related validation reports. To gain clarification of certain items identified in this Approvable Letter, on May 14, we submitted an information package to the FDA and requested a meeting, which occurred by teleconference on June 18, 2008.

Based on our assessment of the May 2008 Approvable Letter, after consulting with our regulatory experts, and the our June 2008 teleconference with the FDA, with the exception of two items, we believed that we could respond to the Approvable Letter using readily available data. With respect to the two remaining items, we agreed with the FDA to provide additional confirmatory data and related information as follows:

(i) Surfaxin Biological Activity Test

14

---

At the June 18, 2008 meeting, the FDA asked us to conduct an additional test with respect to the Biological Activity Test using a different dose level than historically employed for Surfaxin release and stability testing. In addition, in a side by side experiment, we conducted a study using the same RDS animal model and dose as was used in the 2007 Study. We believe that the data generated supports determination of final acceptance criteria for the Biological Activity Test, the proposed shelf life for Surfaxin and further confirms the comparability of Surfaxin drug product used in our Surfaxin Phase 3 clinical trials to the Surfaxin drug product to be manufactured for commercial use. This information was included in our recent Complete Response.

(ii) Specifications for Lipid-Related Impurities in Surfaxin Active Pharmaceutical Ingredients

Surfaxin is comprised of four active pharmaceutical ingredients (APIs); a novel peptide, a fatty acid and two phospholipids. To gain final marketing authorization by the FDA, the FDA indicated that our proposed specifications for lipid-related impurities in the two individual phospholipids must also satisfy guidance issued by the International Conference of Harmonization (ICH). The ICH generally designates threshold limits for impurities present in an API and also provides guidance for justifying specifications that exceed the designated threshold limits.

 

At the June 18 meeting with the FDA, we discussed justifying impurity levels for certain lipid-related impurities that exceeded the ICH designated threshold limits based upon their being present in the human lung at levels equal to or greater than those that exist in Surfaxin. The FDA requested information about the levels of these lipid-related impurities specific to the neonatal lung. In addition to reviewing the scientific literature to satisfy the FDA’s request, we also consulted with lipid-experts and our phospholipids suppliers to determine whether the lipid-related impurities in question can be reduced to the ICH threshold limit. As a consequence of these efforts, we included in the Complete Response data and other information demonstrating that the two phospholipids can be produced with lipid-related impurities at levels that satisfy ICH guidelines.

In October 2004, we filed a Marketing Authorization Application (MAA) with the European Medicines Agency (EMEA) for clearance to market in Europe Surfaxin for the prevention and rescue treatment of RDS in premature infants. In June 2006, following the April 2006 Surfaxin process validation stability failure, we determined that we could not resolve our manufacturing issues within the regulatory time frames mandated by the EMEA procedure. Consequently, in June 2006, we voluntarily withdrew the MAA without resolving with the EMEA certain outstanding clinical issues related to the Surfaxin Phase 3 clinical trials. We have also consulted with regulatory experts in Europe and, if we receive approval for Surfaxin in the United States, plan to have further discussions with the EMEA and potentially develop a strategy to gain approval for Surfaxin in Europe.

Surfaxin for BPD in Premature Infants

15

---

Surfaxin for Acute Respiratory Failure

In June 2007, we initiated a clinical trial to determine if restoration of surfactant with Surfaxin will improve lung function and result in a shorter duration of mechanical ventilation and NICU/PICU stay for children up to two years of age suffering with ARF. The Phase 2 clinical trial is a multicenter, randomized, masked, placebo-controlled trial that will compare Surfaxin to standard of care masked by a sham air control. Approximately 180 children (subject to sample size adjustment per protocol) under the age of two with ARF will receive standard of care and be randomized to receive either Surfaxin at 5.8 mL/kg of body weight (expected weight range up to 15 kg) or sham air control. The trial will be conducted at approximately 35-40 sites in both the Northern and Southern Hemispheres. The objective of the study is to evaluate the safety and tolerability of Surfaxin administration and to assess whether such treatment can decrease the duration of mechanical ventilation in young children with ARF. Following conclusion of the upcoming viral season in the Southern Hemisphere in the fourth quarter 2008 and initiation of enrollment in the Northern Hemisphere, we plan to assess the status of patient enrollment in this trial and determine at that time whether adjustments to our timeline, which is heavily dependent upon the strength of the viral seasons, are required. Currently, we believe that data from this trial may be available in the first half of 2009, although this timeline may be extended as we conserve our resources to focus on seeking approval of Surfaxin for the prevention of RDS in premature infants.

Aerosurf, Aerosolized SRT

 

Aerosurf is our first aerosolized SRT that is administered through less-invasive means and is being developed to potentially obviate the need for intubation and conventional mechanical ventilation. Aerosurf holds the promise to significantly expand the use of surfactants in respiratory medicine. We have demonstrated, through both research and feasibility studies that we can aerosolize our SRT and have completed a small Phase 2 clinical study of Aerosurf that concluded that it is feasible to administer Aerosurf through nasal continuous positive airway pressure (nCPAP) and that the treatment was generally safe and well tolerated. We are currently developing Aerosurf using the Chrysalis Technology.

Under our restructured strategic alliance with Chrysalis, we have assumed full responsibility for development of the initial prototype version of the novel capillary aerosolization system (see“Corporate Partnerships and Agreements”).  Our design engineers, together with our contract manufacturers and third-party medical device experts and consultants, are working to optimize the initial prototype version of this novel capillary aerosolization system.  Once specified development milestones have been achieved, we plan to file our regulatory package in support of our Phase 2 clinical program and manufacture capillary aerosolization devices and related components. In support of our regulatory package, we are executing a series of supportive pre-clinical studies. In that regard, we have also met with and received guidance from the FDA with respect to the design of our proposed Phase 2 clinical program.

We originally expected to initiate our Phase 2 clinical program utilizing this novel capillary aerosolization technology in 2008. However, as these activities require significant investments in research, engineering, device development and device manufacturing capabilities, we have found it necessary to delay certain of our planned activities as we have focused our efforts on gaining regulatory approval for Surfaxin while conserving our cash resources. As our resources permit, we expect to make judicious investments in the development of our capillary aerosolization technology, with a view to potentially finalizing our regulatory package and initiating our Phase 2a clinical program in 2009.

16

---

We have also engaged in preliminary activities to develop the next-generation capillary aerosolization system for use in potential Phase 2 and Phase 3 clinical trials for Aerosurf and, if approved, future commercial activities.  For this development phase, we have been working with a leading engineering and design firm that has a successful track record of developing innovative devices for major companies in the medical and pharmaceutical industries, both in the United States and other international markets.  As we have refocused our resources since receiving the May 2008 Approvable Letter on potentially gaining FDA approval for Surfaxin, we have temporarily put this effort on hold.

We believe that Aerosurf is a highly promising program because it has the potential to significantly expand the use of SRT in respiratory medicine. However, we are currently conserving our resources to focus on seeking approval of Surfaxin for the prevention of RDS in premature infants. Having recently filed our Complete Response to the May 2008 Approvable Letter and now that we have a date for the potential marketing approval for Surfaxin, we plan to develop a new timeline for this activity.

 

SRT for Critical Care and Hospital Indications

We are also evaluating the potential development of our proprietary synthetic peptide-containing SRT to address respiratory disorders such as CF, ALI, COPD, asthma, and other debilitating respiratory conditions.

Manufacturing

Our SRT, including Surfaxin, must be manufactured in compliance with cGMP established by the FDA and other international regulatory authorities. Surfaxin is a complex drug and, unlike many drugs, contains four active ingredients. It must be aseptically manufactured at our facility as a sterile, liquid suspension and requires ongoing monitoring of drug product stability and conformance to specifications.

We plan to invest in and support our manufacturing capabilities to produce sufficient quantities of our proprietary peptide-containing synthetic SRT to meet anticipated clinical needs and, if approved, commercial needs in the United States, Europe and other markets:

Current Manufacturing Capabilities

We have operated our own manufacturing operations at a leased facility in Totowa, New Jersey, since December 2005. We believe that this has provided us with improved control and economics for the production of clinical and commercial supply of our lead product, Surfaxin, if approved, and our SRT pipeline products.

 

Following the failure in April 2006 of Surfaxin process validation batches that had been manufactured for us in 2005 by our then-contract manufacturer to meet designated stability parameters, and after an investigation into the root cause of the failures and implementation of a corrective action and preventative action (CAPA) plan, we completed manufacture of three new Surfaxin process validation batches in February 2007. As of March 2008, we submitted to the FDA 12-month stability data on these new Surfaxin process validation batches. Also in March 2008, the FDA completed a pre-approval inspection (PAI) of this facility and thereafter issued an Establishment Inspection Report (EIR) indicating an approval recommendation for our Surfaxin NDA. (See“Management’s Discussion and Analysis of Financial Condition and Results of Operations – Plan of Operations – Research and Development – SRT for Neonatal Intensive Care Unit – Surfaxin for the Prevention of RDS in Premature Infants.”)

17

---

Our manufacturing strategy includes investing in our analytical and quality systems. In October 2007, we completed construction of a new analytical and development laboratory in our headquarters in Warrington, Pennsylvania and have consolidated at this location the analytical, quality and development activities previously located in Doylestown, Pennsylvania and Mountain View, California. The activities conducted in our new laboratory include release and stability testing of raw materials as well clinical and, if approved, commercial drug product supply. We also expect to perform development work with respect to our aerosolized SRT and novel formulations of our SRT technology. The laboratory has expanded our capabilities by providing additional capacity to conduct analytical testing as well as opportunities to leverage our newly-consolidated professional expertise across a broad range of projects, improving both operational efficiency and financial economics.

 

Long-Term Manufacturing Capabilities

 

We are planning to have manufacturing capabilities, primarily through our manufacturing operations in Totowa, New Jersey, that should allow for sufficient production of drug product to supply (i) the potential worldwide commercial demand for Surfaxin for our RDS program, if approved, (ii) the preclinical and clinical and, if approved, potential worldwide commercial demand for Surfaxin for our ARF and BPD programs, and (iii) the anticipated preclinical and clinical and, if approved, potential worldwide commercial demand for Aerosurf. We are also planning to use one or more contract manufacturers to support development of potential new formulations of our SRT technology.

Owning our own manufacturing operations in Totowa is an initial step in our manufacturing strategy to support the continued development of our SRT portfolio, including life cycle management of Surfaxin for new indications, optimization of our current SRT formulation as well as the development of new formulations and dosage forms, and expansion of our aerosol SRT products, beginning with Aerosurf. The lease for our Totowa facility expires in December 2014. In addition to customary terms and conditions, the lease is subject to a right of the landlord, first after December 2007 and upon two years’ prior notice, to terminate the lease early. This termination right is subject to certain conditions, including that the master tenant, a related party of the landlord, must have ceased all activities at the premises, and, in the earlier years, if we satisfy certain financial conditions, the landlord must make payments to us of significant early termination amounts. Currently, our long-term manufacturing strategy includes (i) potentially renegotiating our current lease to amend the termination and other provisions, (ii) building or acquiring additional manufacturing capabilities for the production of our SRT drug products, and (iii) potentially using contract manufacturers, for the production of our SRT drug products.

Aerosol Devices and Related Componentry

To manufacture capillary aerosolization devices and related components for our planned Phase 2 Aerosurf clinical trials, we expect to utilize third-party contract manufacturers, suppliers and integrators. The manufacturing process involves assembly of key device sub-components that comprise the aerosolization systems, including the aerosol-generating device, disposable dose delivery packets, which must be assembled in a clean room environment, and patient interface systems to administer our aerosolized SRT. Under our manufacturing plan, third-party vendors will manufacture customized parts for us and assemble the key device sub-components and ship them to one central location for final assembly and integration into the aerosolization system. Once assembled, the critical drug product-contact components and patient interface systems will be packaged and sterilized. The assembled aerosolization systems will be quality-control tested prior to release for use in our clinical trials. We have entered into a Master Services Agreement with Kloehn, Inc. to act as integrator of the prototype aerosol generating device sub-components and disposable dose delivery packets that we plan to use in our planned Phase 2 clinical trials.

See also, the applicable risks discussed herein and in the “Risk Factors” section contained in our most recent Annual Report on Form 10-K.

19

---

Research and Development Expenses

Research and development expenses for the three and nine months ended September 30, 2008 were $6.7 million and $21.4 million, respectively. Research and development expenses for the three and nine months ended September 30, 2007 were $6.2 million and $18.4 million, respectively. For a description of expenses and research and development activities, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Research and Development.” For a description of the clinical programs included in research and development, see“Management’s Discussion and Analysis of Financial Condition and Results of Operations – Plan of Operations.”

The increase in research and development expenses for the three and nine months ended September 30, 2008 compared to the same periods in 2007 primarily reflects:

(i)

Manufacturing development activities (included in research and development expenses) to support the production of clinical and potential commercial drug supply for our SRT programs, including Surfaxin, if approved, in conformance with cGMP. Expenses associated with manufacturing development activities for the three and nine months ended September 30, 2008 were $3.3 million and $12.7 million, respectively. Expenses associated with manufacturing development activities for the three and nine months ended September 30, 2007 were $3.5 million and $9.9 million, respectively. Manufacturing development expenses primarily consist of costs to: (a) maintain our manufacturing operations and quality assurance and analytical chemistry capabilities to assure adequate production of clinical and potential commercial drug supply for our SRT programs, including Surfaxin, if approved, in conformance with cGMP; (b) design, develop, manufacture and assemble aerosolization systems to administer Aerosurf, including the initial prototype version and the next-generation version of our novel capillary aerosolization system, and (c) develop new formulations of our SRT. Included in the expenses for the three and nine months ended September 30, 2007 were activities associated with obtaining data and other information included in our Complete Response to the April 2006 Approvable Letter. The increase in manufacturing development activities for the nine months ended September 30, 2008, as compared to the same period in 2007, is primarily due to: (i) investments in our quality assurance and analytical chemistry capabilities to support the production of clinical and anticipated commercial drug supply for our SRT programs in accordance with cGMP; and (ii) activities related to the development and optimization of the initial version of the capillary aerosolization system to administer Aerosurf.

(ii)

Research and development operations to manage the development and advancement of our SRT pipeline. Expenses related to these activities for the three and nine months ended September 30, 2008 were $1.9 million and $5.9 million, respectively. Expenses related to these activities for the three and nine months ended September 30, 2007 were $1.7 and $5.3 million, respectively. These costs are primarily associated with: (i) clinical, regulatory and biostatistics activities for the management of our clinical trial programs in accordance with current good clinical practices (cGCP) and (ii) medical affairs capabilities, including medical science liaisons, to provide scientific and medical education support in connection with the potential commercial launch of Surfaxin and other products in our SRT pipeline.

(iii)

Direct pre-clinical and clinical program activities related to the advancement of our SRT pipeline. Expenses related to these activities for the three and nine months ended September 30, 2008 were $1.5 million and $2.8 million, respectively. Expenses related to these activities for the three and nine months ended September 30, 2007 were $1.0 million and $3.2 million, respectively. These expenses in 2008 and 2007 primarily include: (a) activities associated with the ongoing Phase 2 clinical trial evaluating the use of Surfaxin for ARF in children up to two years of age; (b) pre-clinical and preparatory activities for anticipated Phase 2 clinical trials for Aerosurf for the prevention and treatment of RDS in premature infants; and (c) activities associated with obtaining data and other information included in our Complete Responses to the April 2006 Approvable Letter and the May 2008 Approvable Letter.

20

---

Research and development expenses for the three and nine months ended September 30, 2008, included charges of $0.4 million and $1.1 million, respectively, and for the three and nine months ended September 30, 2007, included charges of $0.3 million and $1.1 million, respectively, associated with stock-based employee compensation in accordance with the provisions of Statement No. 123(R).

 

General and Administrative Expenses

General and administrative expenses for the three and nine months ended September 30, 2008 were $3.7 million and $13.3 million, respectively. General and administrative expenses for the three and nine months ended September 30, 2007 were $3.1 million and $9.4 million, respectively. General and administrative costs primarily include costs associated with executive management, business development activities, financial and legal management, management information technologies, pre-launch commercialization activities and other administrative costs.

The increase in general and administrative expenses for the three and nine months ended September 30, 2008, compared to the same periods in 2007, primarily reflects pre-launch commercialization activities in 2008 in anticipation of the potential approval of Surfaxin related to building a U. S. commercial organization. Expenditures for these activities for the three and nine months ended September 30, 2008 were $1.1 million and $4.2 million, respectively. We did not incur significant pre-launch commercialization expenses for the three and nine months ended September 30, 2007.

General and administrative expenses for the three and nine months ended September 30, 2008, included charges of $0.8 million and $2.3 million, respectively, and for the three and nine months ended September 30, 2007, included charges of $0.7 million and $2.3 million, respectively, associated with stock-based employee compensation in accordance with the provisions of Statement No. 123(R).

Other Income and (Expense)

Other income and (expense) for the three and nine months ended September 30, 2008 were $(0.2) million and $(0.5) million, respectively. Other income and (expense) for the three and nine months ended September 30, 2007 were $0.0 million and $(0.3) million, respectively.

 

Interest and other income for the three and nine months ended September 30, 2008 were $0.1 million and $0.8 million, respectively. Interest and other income for the three and nine months ended September 30, 2007 were $0.5 million and $1.3 million, respectively. The decrease for the three and nine months ended September 30, 2008 as compared to the same period last year is primarily due to lower interest income resulting from a decrease in our average cash and marketable securities.

Interest, amortization and other expenses for the three and nine months ended September 30, 2008 were $0.4 million and $1.3 million, respectively. Interest, amortization and other expenses for the three and nine months ended September 30, 2007 were $0.5 million and $1.6 million, respectively. These expenses consist of: (i) interest on the outstanding balance under the PharmaBio loan; (ii) interest expense related to the amortization of deferred financing costs associated with warrants issued to PharmaBio in October 2006 in consideration for renegotiating the terms of the existing $8.5 million loan; and (iii) interest associated with our equipment loan obligations with GE Business Financial Services Inc. See“Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources.”

LIQUIDITY AND CAPITAL RESOURCES

 

Working Capital

We have incurred substantial losses since inception and expect to continue to make significant investments for continued product research, development, manufacturing and, in anticipation of potential marketing approval of our SRT products, commercialization activities. Historically, we have funded our operations primarily through the issuance of equity securities and the use of debt and our equipment financing facility.

21

---

We are subject to risks customarily associated with the biotechnology industry, which requires significant investment for research and development. There can be no assurance that our research and development projects will be successful, that our developed products, including Surfaxin for the prevention of RDS in premature infants, will obtain necessary regulatory approval, or that any approved product will be commercially viable.

We plan to fund our research, development, manufacturing and potential commercialization activities through:

·

the issuance of equity and debt financings;

·

payments from potential strategic collaborators, including license fees and sponsored research funding;

·

sales of Surfaxin and our other SRT, if approved;

·

equipment financings; and

·

interest earned on invested capital.

Our capital requirements will depend on many factors, including the success of the product development and, if approved, our commercialization plans. Even if we succeed in developing and subsequently commercializing product candidates, we may never achieve sufficient sales revenue to achieve or maintain profitability.

We have Committed Equity Financing Facilities (CEFFs) that we entered into on May 22, 2008 (2008 CEFF) and April 17, 2006 (2006 CEFF). Each of the 2008 CEFF and the 2006 CEFF allows us to raise capital for a period of three years ending June 19, 2011 and May 12, 2009, respectively, at the time and in amounts deemed suitable to us. Our shares of common stock are issued at a predefined discount based on the volume weighted-average price of our common stock (VWAP) on each trading day. Use of each CEFF is subject to certain conditions, including aggregate share and dollar limitations, draw down limitations and minimum daily price restrictions. As of September 30, 2008, under the 2008 CEFF, approximately 17.2 million shares (up to an aggregate purchase price of $56.9 million) were potentially available for issuance, provided that the VWAP on each trading day in a draw down period must be at least equal to the greater of $1.15 or 90% of the closing price of our common stock on the trading day immediately preceding the draw down period. As of September 30, 2008, under the 2006 CEFF, approximately 4.5 million shares (up to an aggregate purchase price of $34.3 million) were potentially available for issuance, provided that the VWAP on each trading day in a draw down period must be at least equal to the greater of $2.00 or 85% of the closing price of our common stock on the trading day immediately preceding the draw down period. We anticipate using our CEFFs, when available, to support our working capital needs and maintain cash availability in 2008. (For a discussion of the 2008 CEFF, see“Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Committed Equity Financing Facility”. For a discussion of the 2006 CEFF, see our most recent Annual Report on Form 10-K at “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Committed Equity Financing Facility”).

We continue to evaluate a variety of strategic transactions, including, but not limited to, potential business alliances, commercial and development partnerships, financings and other similar opportunities, although there can be no assurance that we will be able to obtain additional capital when needed and on acceptable terms, if at all.

Cash, Cash Equivalents and Marketable Securities

As of September 30, 2008, we had cash, cash equivalents and marketable securities of $31.5 million, as compared to $53.0 million as of December 31, 2007. The decrease is primarily due to $26.7 million used in operating activities, purchases of capital expenditures and principal payments on outstanding debt offset by $4.3 million of proceeds from financings pursuant to the CEFF and $0.9 million of proceeds from our equipment loans.

Committed Equity Financing Facility (CEFF)

2008 CEFF

22

---

The purchase price of shares sold to Kingsbridge under the 2008 CEFF is at a discount ranging from 6 to 12 percent of the volume-weighted average of the price of our common stock (VWAP) for each of the eight trading days following our initiation of a “draw down”. The discount on each of these eight trading days is determined as follows:

VWAP*		% of VWAP			(Applicable Discount)
Greater than $7.25 per share			94	%		(6	)%
Less than or equal to $7.25 but greater than $3.85 per share			92	%		(8	)%
Less than or equal to $3.85 but greater than $1.75 per share			90	%		(10	)%
Less than or equal to $1.75 but greater than or equal to $1.15 per share			88	%		(12	)%

 

---

* As such term is set forth in the Common Stock Purchase Agreement dated May 22, 2008 (2008 CEFF Agreement).

If on any trading day during the eight trading day pricing period for a draw down, the VWAP is less than the greater of (i) $1.15 or (ii) 90 percent of the closing price of our common stock for the trading day immediately preceding the beginning of the draw down period, no shares will be issued with respect to that trading day and the total amount of the draw down for that pricing period will be reduced for each such trading day by one-eighth of the draw down amount that we had initially specified.

Our ability to require Kingsbridge to purchase our common stock is subject to various limitations. Each draw down is limited to the lesser of 3.0 percent of the closing price market value of the outstanding shares of our common stock at the time of the draw down or $10 million. Unless Kingsbridge agrees otherwise, a minimum of three trading days must elapse between the expiration of any draw-down pricing period and the beginning of the next draw-down pricing period. In addition, Kingsbridge may terminate the CEFF under certain circumstances, including if a material adverse effect (as defined in the 2008 CEFF Agreement) relating to our business continues for 10 trading days after Kingsbridge provides notice of such material adverse effect.

The financings completed under the 2008 CEFF are as follows:

On July 11, 2008, we completed a financing pursuant to the 2008 CEFF resulting in gross proceeds of approximately $1.6 million from the issuance of 1,104,850 shares of our common stock at an average price per share, after the applicable discount, of $1.41.

On July 31, 2008, we completed a financing pursuant to the 2008 CEFF resulting in gross proceeds of $1.5 million from the issuance of 991,537 shares of our common stock at an average price per share, after the applicable discount, of $1.51.

On October 17, 2008, we completed a financing pursuant to the 2008 CEFF resulting in gross proceeds of approximately $1.3 million from the issuance of 913,827 shares of our common stock at an average price per share, after the applicable discount, of $1.44.

As of October 17, 2008, there were approximately 16.3 million shares available for issuance under the 2008 CEFF (up to an aggregate purchase price of $55.6 million) for future financings.

On May 22, 2008, in connection with the 2008 CEFF, we issued a warrant to Kingsbridge to purchase up to 825,000 shares of our common stock at an exercise price of $2.506 per share, which is fully exercisable for a five year period beginning November 22, 2008. The warrant is exercisable in whole or in part for cash, except in limited circumstances, with expected total proceeds to us, if exercised, of approximately $2.1 million.

23

---

2006 CEFF

In April 2006, we entered into the 2006 CEFF in which Kingsbridge committed to purchase the lesser of up to $50 million or up to 11,677,047 shares of our common stock. Use of the 2006 CEFF is subject to certain conditions, including that the VWAP on each trading day of the eight trading day pricing period must be at least equal to the greater of $2.00 or 85% of the closing price of our common stock for the trading day immediately preceding the beginning of the draw down period. (See our most recent Annual Report on Form 10-K at “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Committed Equity Financing Facility”.)

 

The financings completed under the 2006 CEFF in 2008 are as follows:

On September 9, 2008, we completed a financing pursuant to the 2006 CEFF resulting in gross proceeds of approximately $1.3 million from the issuance of 676,360 shares of our common stock at an average price per share, after the applicable discount, of $1.85.

As of September 30, 2008, there were approximately 4.5 million shares available for issuance under the 2006 CEFF (up to an aggregate purchase price of $34.3 million).

In 2006, in connection with the 2006 CEFF, we issued a Class C Investor Warrant to Kingsbridge to purchase up to 490,000 shares of our common stock at an exercise price of $5.6186 per share. The warrant, which expires in October 2011, is exercisable in whole or in part for cash, except in limited circumstances, with expected total proceeds, if exercised, of approximately $2.8 million. As of September 30, 2008, the Class C Investor Warrant had not been exercised.

In 2004, in connection with a prior Committed Equity Financing Facility with Kingsbridge (2004 CEFF) that was terminated in 2006, we issued a Class B Investor Warrant to Kingsbridge to purchase up to 375,000 shares of our common stock at an exercise price equal to $12.0744 per share. The warrant, which expires in January 2010, is exercisable in whole or in part for cash, except in limited circumstances, with expected total proceeds, if exercised, of approximately $4.5 million. As of September 30, 2008, the Class B Investor Warrant had not been exercised.

Universal Shelf Registration Statement

On June 13, 2008, we filed a universal shelf registration statement on Form S-3 (2008 Shelf Registration Statement) with the SEC for the proposed offering from time to time of up to $150 million of our securities. Under the 2008 Shelf Registration Statement, we have the flexibility to react to market opportunities as they arise and will be able to issue and sell a variety of securities, including common stock, preferred stock, varying forms of debt and warrant securities, or any combination of the foregoing, on terms and conditions that will be determined at that time. We currently have no immediate plans to sell securities under the 2008 Shelf Registration Statement.

In October 2005, we filed a universal shelf registration statement on Form S-3 (2005 Shelf Registration Statement) with the SEC for the proposed offering, from time to time, of up to $100 million of our debt or equity securities. In December 2005, we completed a registered direct offering of 3,030,304 shares of our common stock to select institutional investors resulting in gross proceeds to us of $20.0 million. In April 2007, we completed a registered direct offering of 14,050,000 shares of our common stock to select institutional investors resulting in gross proceeds of $30.2 million. In December 2007, we completed a registered direct offering of 10,000,000 shares of our common stock to select institutional investors resulting in gross proceeds of $25.0 million.

The 2005 Shelf Registration Statement may permit us, from time to time, to offer and sell up to an additional approximately $24.8 million of equity or debt securities. The 2008 Shelf Registration Statement may permit us, from time to time, to offer and sell up to $150.0 million of our securities. There can be no assurance, however, that we will be able to complete any such offerings. Factors influencing the availability of additional financing include the progress of our research and development activities, investor perception of our prospects and the general condition of the financial markets, among others.

24

---

Debt

Loan with PharmaBio

PharmaBio, the strategic investment group of Quintiles Transnational Corp., extended to us a secured, revolving credit facility of $8.5 to $10.0 million in 2001. Currently, the outstanding principal, $8.5 million, matures on April 30, 2010. Interest on the loan accrues at the prime rate, compounded annually, and from and after October 1, 2006, is payable together with the outstanding principal at maturity. We may repay the loan, in whole or in part, at any time without prepayment penalty or premium. Our obligations to PharmaBio under the loan documents are secured by an interest in substantially all of our assets, subject to limited exceptions set forth in the related Security Agreement.

In October 2006, in consideration of PharmaBio’s agreement to restructure the loan, we entered into a Warrant Agreement with PharmaBio, pursuant to which PharmaBio has the right to purchase 1.5 million shares of our common stock at an exercise price equal to $3.5813 per share. The warrants have a seven-year term and are exercisable, in whole or in part, for cash, cancellation of a portion of our indebtedness under the PharmaBio loan agreement, or a combination of the foregoing, in an amount equal to the aggregate purchase price for the shares being purchased upon any exercise. In connection with the Warrant Agreement, we filed a registration statement with the SEC with respect to the resale of the shares issuable upon exercise of the warrants. As of September 30, 2008, the warrants had not been exercised.

As of September 30, 2008, the outstanding balance under the loan was $10.0 million ($8.5 million of principal and $1.5 million of accrued interest) and was classified as a long-term loan payable on the Consolidated Balance Sheets.

Equipment Financing Facility with GE Business Financial Services Inc.

In May 2007, we entered into a Credit and Security Agreement (Credit Agreement) with GE Business Financial Services Inc. (formerly known as Merrill Lynch Business Financial Services Inc.) (GE), as Lender, pursuant to which GE agreed to provide us a $12.5 million facility (Facility) to fund our capital programs. Prior to May 2007, our capital financing arrangements had been primarily with the Life Science and Technology Finance Division of General Electric Capital Corporation under a Master Security Agreement dated December 20, 2002, as amended (Previous Facility). Upon execution of the Credit Agreement, we simultaneously drew down approximately $4.0 million of the Facility to prepay all of our then-outstanding indebtedness under the Previous Facility.

On May 30, 2008, we and GE amended the Credit Agreement to extend the term of the Facility for an additional period of six months for the purpose of funding our anticipated capital investments for that period, up to $300,000. In consideration of the extension, we agreed to pay GE $3,500 to cover legal fees and a non-refundable consent fee. All other terms and conditions under the Credit Agreement remain unchanged. (See our most recent Annual Report on Form 10-K at “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Debt – Equipment Financing Facility”.)

As of September 30, 2008, approximately $3.8 million was outstanding under the Facility ($2.9 million classified as current liabilities and $0.9 million as long-term liabilities) and $154,000 remained available for use, subject to the conditions of the Facility.

Pennsylvania Machinery and Equipment Loan Fund (MELF)

25

---

In addition to customary terms and conditions, the MELF Agreement provides that we must (i) retain seven current employees and create 25 new positions at our new laboratory within three years, and (ii) comply with certain state-contracting requirements in completing the laboratory project. In the event that we fail to comply with the new employee requirement within the three-year period, the interest rate on the Promissory Note, except in limited circumstances, will be increased to a fixed rate equal to two percentage points above the current prime rate for the remainder of the term.

As of September 30, 2008, approximately $0.5 million was outstanding under the Facility ($0.1 million classified as current liabilities and $0.4 million as long-term liabilities).

Lease Agreements

We maintain facility leases for our operations in Pennsylvania, New Jersey and California.

We maintain our headquarters in Warrington, Pennsylvania. The facility is 39,594 square feet and serves as the main operating facility for clinical development, regulatory, analytical technical services, research and development, sales and marketing, and administration. In April 2007, the lease, which originally expired in February 2010 with total aggregate payments of $4.6 million, was extended an additional three years through February 2013 with additional payments of $3.0 million over the extension period.

We lease 21,000 square feet of space for our manufacturing facility in Totowa, New Jersey, at an annual rent of $150,000. This space is specifically designed for the production of sterile pharmaceuticals in compliance with cGMP requirements and is our only manufacturing facility. The lease expires in December 2014, subject to a right of the landlord, first exercisable after December 2007 and upon two years’ prior notice, to terminate the lease early. This termination right is subject to certain conditions, including that the master tenant, a related party of the landlord, must have ceased all activities at the premises, and, in the earlier years, if we satisfy certain financial conditions, the landlord must make payments to us of significant early termination amounts. The total aggregate payments over the term of the lease are $1.4 million. For a discussion of our manufacturing strategy, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Plan of Operations – Research and Development – Manufacturing.”

We leased approximately 5,600 square feet office and analytical laboratory space in Doylestown, Pennsylvania, with an annual rent of approximately $93,800. The lease was terminated effective July 31, 2008 and all activities at this location have been consolidated into our new laboratory space in Warrington, Pennsylvania.

We leased 16,800 square feet of office and laboratory space at our facility in Mountain View, California, at an annual rent of approximately $275,000. In December 2007, we consolidated these activities into our new laboratory space in Warrington, Pennsylvania. The term of this lease expired without renewal or extension on June 30, 2008.

Future Capital Requirements

26

---

 

If a transaction involving the issuance of additional equity and debt securities is concluded, such a transaction may result in additional dilution to our shareholders. We cannot be certain that additional funding will be available when needed or on terms acceptable to us, if at all. If we fail to receive additional funding or enter into business alliances or other similar opportunities, we may have to reduce significantly the scope of or discontinue our planned research, development and manufacturing activities, which could significantly harm our financial condition and operating results.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk is confined to our cash, cash equivalents and available for sale securities. We place our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer. We currently do not hedge interest rate or currency exchange exposure. We classify highly liquid investments purchased with a maturity of three months or less as “cash equivalents” and commercial paper and fixed income mutual funds as “available for sale securities.” Fixed income securities may have their fair market value adversely affected due to a rise in interest rates and we may suffer losses in principal if forced to sell securities that have declined in market value due to a change in interest rates.

ITEM 4.  CONTROLS AND PROCEDURES

 

(a) Evaluation of disclosure controls and procedures

 

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls or our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

 

Our Chief Executive Officer and our Chief Financial Officer have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Exchange Act) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that as of the end of the period covered by this report our disclosure controls and procedures were effective in their design to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms.

27

---

(b) Changes in internal controls

There were no changes in internal controls over financial reporting or other factors that could materially affect those controls subsequent to the date of our evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II – OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

Reference is made to Item 3 of our most recent report on Form 10-K and Part II, Item 1 of our Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2008 and June 30, 2008 for information concerning the dismissal of securities class action proceedings involving us and certain of our officers and directors. Although we successfully defended these actions, similar actions, based upon similar allegations, or otherwise, may be filed in the future. The potential impact of such actions, if filed, which generally seek unquantified damages, attorneys’ fees and expenses, is uncertain.

In addition, we have from time to time been involved in disputes and proceedings arising in the ordinary course of business. Such claims, with or without merit, if not resolved, could be time-consuming and result in costly litigation. There can be no assurance that an adverse result in any such proceedings would not have a potentially material adverse effect on our business, results of operations and financial condition.

ITEM 1A. RISK FACTORS

In addition to the risks, uncertainties and other factors set forth below and elsewhere in this Form 10-Q, see the “Risk Factors” section contained in our most recent Annual Report on Form 10-K.

Receipt of the May 2008 Approvable Letter has caused us to refocus our efforts and conserve our financial resources, which may subject us to unanticipated risks and uncertainties.

As a result of the May 2008 Approvable Letter, and the delay with respect to the timing of potentially gaining approval for Surfaxin for the prevention of RDS in premature infants, we have adopted a strategy of focusing our efforts primarily on responding to the Approvable Letter and conserving our financial resources to potentially gain approval for Surfaxin in 2009. This has caused us to reassess the level of investment and the pace of our research and development programs, including programs for Aerosurf, BPD, ARF and new formulations of our SRT.  We presently anticipate that we will experience some delays in the progress of these programs. While we remain reasonably confident that we can achieve our goals, we will continue to reassess the business environment, the competitive landscape, our position within the biotechnology industry and the adequacy of our financial resources. As a consequence of our reassessment, at any time we may implement additional and potentially significant changes to our development plans and our operations as we seek to strengthen our financial and operational position. Such changes, if adopted, could prove to be disruptive and detrimental to our development programs. Moreover, consideration and planning of such strategic changes diverts management’s attention and other resources from day to day operations, which subjects us to further risks and uncertainties.

 

28

---

 

Within the anticipated timeline for gaining approval for Surfaxin, we will have to raise significant additional capital to continue our existing planned research and development activities.  Moreover, such additional financing could result in equity dilution.