Exhibit 10.2

 
SENIOR CONVERTIBLE NOTE
 
NEITHER THE ISSUANCE AND SALE OF THE SECURITIES REPRESENTED BY THIS CERTIFICATE
NOR THE SECURITIES INTO WHICH THESE SECURITIES ARE CONVERTIBLE HAVE BEEN
REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR APPLICABLE STATE
SECURITIES LAWS.  THE SECURITIES MAY NOT BE OFFERED FOR SALE, SOLD, TRANSFERRED
OR ASSIGNED (I) IN THE ABSENCE OF (A) AN EFFECTIVE REGISTRATION STATEMENT FOR
THE SECURITIES UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR (B) AN OPINION
OF COUNSEL, IN A FORM REASONABLY ACCEPTABLE TO THE COMPANY, THAT REGISTRATION IS
NOT REQUIRED UNDER SAID ACT OR (II) UNLESS SOLD PURSUANT TO RULE 144 OR RULE
144A UNDER SAID ACT.  NOTWITHSTANDING THE FOREGOING, THE SECURITIES MAY BE
PLEDGED IN CONNECTION WITH A BONA FIDE MARGIN ACCOUNT OR OTHER LOAN OR FINANCING
ARRANGEMENT SECURED BY THE SECURITIES.  ANY TRANSFEREE OF THIS NOTE SHOULD
CAREFULLY REVIEW THE TERMS OF THIS NOTE.  THE PRINCIPAL AMOUNT REPRESENTED BY
THIS NOTE AND, ACCORDINGLY, THE SECURITIES ISSUABLE UPON CONVERSION HEREOF MAY
BE LESS THAN THE AMOUNTS SET FORTH ON THE FACE HEREOF PURSUANT TO
SECTION 3(c)(iii) OF THIS NOTE.
 
Aeolus Pharmaceuticals, Inc.
 
Senior Convertible Note
 
Issuance Date:  August 1, 2008
Original Principal Amount:  U.S. [               ]

FOR VALUE RECEIVED, Aeolus Pharmaceuticals, Inc., a Delaware corporation (the
“Company”), hereby promises to pay to [*] or its registered assigns (“Holder”)
the amount set out above as the Original Principal Amount (as reduced pursuant
to the terms hereof due to conversion or otherwise, the “Principal”) when due,
whether upon the Maturity Date (as defined below), acceleration,  or otherwise
(in each case in accordance with the terms hereof), and to pay interest
(“Interest”) on any outstanding Principal at the rate of seven percent (7%) per
annum (the “Interest Rate”), from the date set out above as the Issuance Date
(the “Issuance Date”) until the same becomes due and payable, whether upon an
Interest Date (as defined below) or the Maturity Date, acceleration, conversion
or otherwise (in each case in accordance with the terms hereof), in lawful money
of the United States.  This Senior Convertible Note (including all Senior
Convertible Notes issued in exchange, transfer or replacement hereof, this
“Note”) is one of an issue of Senior Convertible Notes issued pursuant to
Section 1 of the Securities Purchase Agreement (as defined below) (collectively,
the “Notes” and such other Senior Convertible Notes, the “Other
Notes”).  Certain capitalized terms used herein are defined in Section 26.
 
(1)           PAYMENTS OF PRINCIPAL.  On the Maturity Date, the Company shall
pay to the Holder an amount in cash representing all outstanding Principal,
accrued and unpaid Interest, and accrued and unpaid Late Charges (as defined in
Section 22 below), if any, on such
 

 
 
 

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Principal and Interest.  The “Maturity Date” shall be January 31, 2011, as may
be extended at the option of the Holder (i) in the event that, and for so long
as, an Event of Default (as defined in Section 4(a)) shall have occurred and be
continuing on the Maturity Date (as may be extended pursuant to this Section 1)
or any event that shall have occurred and be continuing that with the passage of
time and the failure to cure would result in an Event of Default, and
(ii) through the date that is ten (10) Business Days after the consummation of a
Change of Control in the event that a Change of Control is publicly announced or
a Change of Control Notice (as defined in Section 5(b)) is delivered prior to
the Maturity Date.  Other than as specifically permitted by this Note or as
agreed to in writing by the Holder, the Company may not prepay any portion of
the outstanding Principal amount of this Note prior to the Maturity Date.
 
(2)           INTEREST; INTEREST RATE.  Interest on the outstanding Principal
amount of this Note shall commence accruing on the Issuance Date and shall be
computed on the basis of a 365-day year and actual days elapsed and shall be
payable semi-annually, in arrears, on  January 31 and July 31 of each year
(each, an “Interest Date”), with the first Interest Date being  January 31,
2009.  Interest shall be payable on each Interest Date, to the record holder of
this Note, as set forth in the Register (as defined in Section 3(c)(iii)) on
each January 15 and July 15 immediately preceding the applicable Interest Date
(each, a “Record Date”), in cash or shares of the Company’s common stock, par
value $0.01 per share (“Common Stock”), at the sole option of the Company;
provided that to elect the option to pay Interest in shares of Common Stock, the
Company will have to notify the Holder in writing of such election within three
(3) Business Days after the applicable Record Date.  In the event the Company
elects to pay Interest in shares of Common Stock, the number of shares of Common
Stock to be issued shall equal the quotient (rounded down to the nearest whole
share with cash paid for fractional shares) of (i) the amount of Interest then
due and payable divided by (ii)  the Weighted Average Price for the Common Stock
over the fifteen (15) consecutive Trading Day period ending on the fifth (5th)
Trading Day immediately preceding the applicable Interest Date.  Prior to the
payment of Interest on an Interest Date, Interest on this Note shall accrue at
the Interest Rate.  From and after the occurrence and during the continuance of
an Event of Default, the Interest Rate shall be increased to twelve percent
(12%) (the “Default Rate”).  In the event that such Event of Default is
subsequently cured, the adjustment referred to in the preceding sentence shall
cease to be effective as of the date of such cure; provided that the Interest as
calculated and unpaid at such increased rate during the continuance of such
Event of Default shall continue to apply to the extent relating to the days
after the occurrence of such Event of Default through but not including the date
of cure of such Event of Default.
 
(3)           CONVERSION OF NOTES.  This Note shall be convertible into shares
of the Common Stock (as converted, the “Conversion Shares”) on the terms and
conditions set forth in this Section 3.
 
(a)           Conversion Right.  Subject to the provisions of Section 3(d), at
any time or times on or after the Issuance Date, the Holder shall be entitled to
convert any portion of the outstanding and unpaid Conversion Amount (as defined
below) into fully paid and nonassessable shares of Common Stock in accordance
with Section 3(c), at the Conversion Rate (as defined below).  The Company shall
not issue any fraction of a share of Common Stock upon any conversion.  If the
issuance would result in the issuance of a fraction of a share of Common
 

 
 
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Stock, the Company shall round such fraction of a share of Common Stock down to
the nearest whole share.  The Company shall pay any and all taxes that may be
payable with respect to the issuance and delivery of Common Stock upon
conversion of any Conversion Amount; provided that the Company shall not be
required to pay any tax that may be payable in respect of any issuance of Common
Stock to any Person other than the converting Holder or with respect to any
income tax due by the Holder with respect to such Common Stock.
 
(b)           Conversion Rate.  The number of shares of Common Stock issuable
upon conversion of any Conversion Amount pursuant to Section 3(a) shall be
determined by dividing (x) such Conversion Amount by (y) the Conversion Price
(the “Conversion Rate”).
 
(i)           “Conversion Amount” means the portion of the Principal to be
converted or otherwise with respect to which this determination is being made,
plus, in each case, accrued and unpaid Interest and Late Charges, if any,
thereon to, but not including, the applicable Conversion Date.
 
(ii)           “Conversion Price” means, as of any Conversion Date (as defined
below) or other date of determination, $0.35, subject to adjustment as provided
herein.
 
(c)           Mechanics of Conversion.
 
(i)           Optional Conversion.  To convert any Conversion Amount into shares
of Common Stock on any date (a “Conversion Date”), the Holder shall (A) transmit
by email or facsimile (or otherwise deliver), for receipt on or prior to 8:00
p.m., New York time, on such date, a copy of an executed notice of conversion in
the form attached hereto as Exhibit I (the “Conversion Notice”) to the Company
and (B) if required by Section 3(c)(iii), surrender this Note to a common
carrier for delivery to the Company as soon as practicable on or following such
date (or an indemnification undertaking with respect to this Note in the case of
its loss, theft or destruction).  On or before the second (2nd) Trading Day
following the date of receipt of a Conversion Notice, the Company shall transmit
by email or facsimile a confirmation of receipt of such Conversion Notice to the
Holder and the Company’s transfer agent (the “Transfer Agent”).  On or before
the fourth (4th) Trading Day following the date of receipt of a Conversion
Notice (the “Share Delivery Date”), the Company shall (X) provided that the
Transfer Agent is participating in the Depository Trust Company (“DTC”) Fast
Automated Securities Transfer Program, credit such aggregate number of shares of
Common Stock to which the Holder shall be entitled to the Holder’s or its
designee’s balance account with DTC through its Deposit Withdrawal Agent
Commission system or (Y) if the Transfer Agent is not participating in the DTC
Fast Automated Securities Transfer Program, issue and deliver to the address as
specified in the Conversion Notice, a certificate, registered in the name of the
Holder or its designee, for the number of shares of Common Stock to which the
Holder shall be entitled.  If this Note is physically surrendered for conversion
as required by Section 3(c)(iii) and the outstanding Principal of this Note is
greater than the Principal portion of the Conversion Amount being converted,
then the Company shall as soon as practicable and in no event later than
five (5) Business Days after receipt of this Note and at its own expense, issue
and deliver to the holder a new Note (in accordance with Section 16(d))
representing the outstanding Principal not converted.  Provided the Holder
complies with the terms for conversion set forth herein, the
 

 
 
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Person or Persons entitled to receive the shares of Common Stock issuable upon a
conversion of this Note shall be treated for all purposes as the record holder
or holders of such shares of Common Stock as of such time the Company actually
receives the Conversion Notice and this Note on the Conversion Date.
 
(ii)           Company’s Failure to Timely Convert.   If within five (5) Trading
Days after the Company’s receipt of the facsimile copy of a Conversion Notice
and the Note the Company shall fail to issue and deliver a certificate to the
Holder or credit the Holder’s balance account with DTC for the number of shares
of Common Stock to which the Holder is entitled upon such Holder’s conversion of
any Conversion Amount (a “Conversion Failure”), and if on or after such Trading
Day the Holder purchases (in an open market transaction or otherwise) Common
Stock in a good faith transaction with an unaffiliated third party (a “Good
Faith Purchase”) to deliver in satisfaction of a sale by the Holder of Common
Stock issuable upon such conversion that the Holder is actually entitled to
receive from the Company (a “Buy-In”), then the Company shall, within five (5)
Business Days after the Holder’s request and in the Holder’s discretion, and
after Holder provides the Company with written evidence of such Good Faith
Purchase either (i) pay cash to the Holder in an amount equal to the Holder’s
total purchase price (including documented brokerage commissions and other
out-of-pocket expenses, if any) for the shares of Common Stock so purchased (the
“Buy-In Price”), at which point the Company’s obligation to deliver such
certificate (and to issue such Common Stock) shall terminate, or (ii) promptly
honor its obligation to deliver to the Holder a certificate or certificates
representing such Common Stock and pay cash to the Holder in an amount equal to
the excess (if any) of the Buy-In Price over the product of (A) such number of
shares of Common Stock, times (B) the Weighted Average Price on the Conversion
Date.
 
(iii)           Registration; Book-Entry.  The Company shall maintain a register
(the “Register”) for the recordation of the names and addresses of the holders
of each Note and the principal amount of the Notes held by such holders (the
“Registered Notes”).  The entries in the Register shall be conclusive and
binding for all purposes absent manifest error.  The Company and the holders of
the Notes shall treat each Person whose name is recorded in the Register as the
owner of a Note for all purposes, including, without limitation, the right to
receive payments of Principal and Interest hereunder, notwithstanding notice to
the contrary.  A Registered Note may be assigned or sold in whole or in part
only by registration of such assignment or sale on the Register.  Upon its
receipt of a request to assign or sell all or part of any Registered Note by a
Holder, the Company shall record the information contained therein in the
Register and issue one or more new Registered Notes in the same aggregate
principal amount as the principal amount of the surrendered Registered Note to
the designated assignee or transferee pursuant to Section 16.  Notwithstanding
anything to the contrary set forth herein, upon conversion of any portion of
this Note in accordance with the terms hereof, the Holder shall not be required
to physically surrender this Note to the Company unless (A) the full Conversion
Amount represented by this Note is being converted or (B) the Holder has
provided the Company with prior written notice (which notice may be included in
a Conversion Notice) requesting reissuance of this Note upon physical surrender
of this Note.  The Holder and the Company shall maintain records showing the
Principal, Interest and Late Charges, if any, converted and the dates of such
conversions or shall use such other method, reasonably satisfactory to the
Holder and the Company, so as not to require physical surrender of this Note
upon conversion.
 

 
 
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(iv)           Disputes.  In the event of a dispute as to the number of shares
of Common Stock issuable to the Holder in connection with a conversion of this
Note, the Company shall issue to the Holder the number of shares of Common Stock
not in dispute and resolve such dispute in accordance with Section 21.
 
(d)           Limitations on Conversions.  Notwithstanding anything herein to
the contrary, the Company shall not effect any conversion of this Note, and the
Holder of this Note shall not have the right to convert any portion of this Note
pursuant to Section 3(a), to the extent that after giving effect to such
conversion, the Holder (together with the Holder’s Affiliates) would
beneficially own in excess of 9.99% (the “Maximum Percentage”) of the number of
shares of Common Stock outstanding immediately after giving effect to such
conversion, provided that such limitation shall not affect, limit or otherwise
impair the Company's ability to satisfy any of its obligations under this Note
by delivering Common Stock to the Holder.  For purposes of the foregoing
sentence, the number of shares of Common Stock beneficially owned by the Holder
and its Affiliates shall include the number of shares of Common Stock issuable
upon conversion of this Note with respect to which the determination of such
sentence is being made, but shall exclude the number of shares of Common Stock
which would be issuable upon (A) conversion of the remaining, nonconverted
portion of this Note beneficially owned by the Holder or any of its Affiliates
and (B) exercise or conversion of the unexercised or nonconverted portion of any
other securities of the Company (including, without limitation, any Other Notes
or warrants) subject to a limitation on conversion or exercise analogous to the
limitation contained herein beneficially owned by the Holder or any of its
Affiliates.  Except as set forth in the preceding sentence, for purposes of this
Section 3(d), beneficial ownership shall be calculated in accordance with
Section 13(d) of the Securities Exchange Act of 1934, as amended (the “Exchange
Act”).  For purposes of this Section 3(d), in determining the number of
outstanding shares of Common Stock, the Holder may rely on the number of
outstanding shares of Common Stock as reflected in (x) the Company’s most recent
Form 10-K, Form 10-Q or Form 8-K or other public filing with the SEC, as the
case may be, (y) a more recent public announcement by the Company or (z) any
other notice by the Company or the Transfer Agent setting forth the number of
shares of Common Stock outstanding.  For any reason at any time, upon the
written request of the Holder, the Company shall within two (2) Business Days
confirm in writing to the Holder the number of shares of Common Stock then
outstanding.  In any case, the number of outstanding shares of Common Stock
shall be determined after giving effect to the conversion or exercise of
securities of the Company, including this Note, by the Holder or its Affiliates
since the date as of which such number of outstanding shares of Common Stock was
reported.  By written notice to the Company, the Holder may increase or decrease
the Maximum Percentage to any other percentage specified in such notice;
provided that (i) any such increase will not be effective until the sixty-first
(61st) day after such notice is delivered to the Company, and (ii) any such
increase or decrease will apply only to the Holder and not to any other holder
of Notes.
 

 
 
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(4)           RIGHTS UPON EVENT OF DEFAULT.
 
(a)           Event of Default.  Each of the following events shall constitute
an “Event of Default”:
 
(i)           the suspension from trading or failure of the Common Stock to be
listed on an Eligible Market for a period of five (5) consecutive Trading Days
or for more than an aggregate of twenty (20) Trading Days in any 365-day period;
 
(ii)           the Company’s (A) failure to cure a Conversion Failure by
delivery of the required number of shares of Common Stock within ten (10)
Business Days after the applicable Conversion Date or (B) notice, written or
oral, to any holder of the Notes, including by way of public announcement or
through any of its agents, at any time, of its intention not to comply with a
request for conversion of any Notes into shares of Common Stock that is tendered
in accordance with the provisions of the Notes;
 
(iii)           at any time following the twentieth (20th) consecutive Business
Day that the Holder’s Authorized Share Allocation (as defined in
Section 10(a) below) is less than the number of shares of Common Stock that the
Holder would be entitled to receive upon a conversion of the full Conversion
Amount of this Note (without regard to any limitations on conversion set forth
in Section 3(d) or otherwise);
 
(iv)           the Company’s failure to satisfy any amount of Principal,
Interest, Late Charges or other amounts when and as due under this Note (after
giving effect to any grace period therefore agreed to by the Holder in writing),
except, in the case of a failure to pay Interest and Late Charges when and as
due, in which case only if such failure continues for a period of at least
five (5) Business Days;
 
(v)           the Company or any of its Subsidiaries shall (i) fail to pay, when
due, or within any applicable grace period, any payment with respect to any
Indebtedness in excess of $100,000, individually or in the aggregate, due to any
third party, other than payments contested by the Company in good faith by
proper proceedings and with respect to which adequate reserves have been set
aside for the payment thereof in accordance with GAAP, or otherwise be in breach
or violation of any agreement for monies owed or owing in an amount in excess of
$100,000, individually or in the aggregate, which breach or violation permits
the other party thereto to accelerate amounts due thereunder.
 
(vi)           the Company or any of its Subsidiaries, pursuant to or within the
meaning of Title 11, U.S. Code, or any similar Federal, foreign or state law for
the relief of debtors (collectively, “Bankruptcy Law”), (A) commences a
voluntary case, (B) consents to the entry of an order for relief against it in
an involuntary case, (C) consents to the appointment of a receiver, trustee,
assignee, liquidator or similar official (a “Custodian”), (D) makes a general
assignment for the benefit of its creditors or (E) admits in writing that it is
generally unable to pay its debts as they become due;
 
(vii)           a court of competent jurisdiction enters an order or decree
under any Bankruptcy Law that (A) is for relief against the Company or any of
its Subsidiaries in
 

 
 
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an involuntary case, (B) appoints a Custodian of the Company or any of its
Subsidiaries or (C) orders the liquidation of the Company or any of its
Subsidiaries;
 
(viii)                      a final judgment or judgments for the payment of
money aggregating in excess of $100,000 are rendered against the Company or any
of its Subsidiaries and which judgments are not, within sixty (60) days after
the entry thereof, bonded, discharged or stayed pending appeal, or are not
discharged within sixty (60) days after the expiration of such stay, provided,
however, that any judgment which is covered by insurance or an indemnity from a
credit worthy party shall not be included in calculating the $100,000 amount set
forth above;
 
(ix)           the Company breaches any material covenant or any material
representation or warranty under this Note or the Securities Purchase Agreement,
except, in the case of a breach of a covenant which is curable, only if such
breach continues for a period of at least ten (10) consecutive Business Days;
provided, however, that the foregoing cure period shall not apply with respect
to the breach or failure to comply with clause (a), (c), (d), (e) or (f) of
Section 12 of this Note; or
 
(x)           any Event of Default (as defined in the Other Notes) occurs with
respect to any Other Notes.
 
(b)           Remedies upon an Event of Default.  Upon the occurrence of an
Event of Default of the type specified in Section 4(a)(vi) or 4(a)(vii) above
(each, a “Bankruptcy Event of Default”), this Note shall immediately become due
and payable without notice, and the Company shall as promptly as practicable,
but in any event within one (1) Business Day after the Company has written
notice or actual knowledge of the occurrence of such Event of Default, deliver
written notice thereof via facsimile or e-mail and overnight courier (an “Event
of Default Notice”) to the Holder.  In connection with a Bankruptcy Event of
Default, the Company shall pay to the Holder in cash the sum of (i) all
outstanding Principal of this Note, plus (ii) accrued and unpaid Interest
thereon, plus (iii) accrued and unpaid Late Charges, if any.  Upon the
occurrence of any Event Default other than a Bankruptcy Event of Default, the
Company shall within two (2) Business Days deliver an Event of Default Notice
via facsimile or e-mail and overnight courier to the Holder.  At any time after
the earlier of the Holder’s receipt of an Event of Default Notice for other than
a Bankruptcy Event of Default and the Holder gives written notice to the Company
of an Event of Default, the Holder, in its sole discretion, may by written
notice to the Company declare this Note to be immediately due and payable (the
“Acceleration Notice”).  Provided such an Event of Default has occurred,
immediately following the Company’s receipt an Acceleration Notice, the Company
shall pay to the Holder in cash the sum of (i) the product of all outstanding
Principal multiplied by 115% (the “Default Premium”), plus (ii) accrued and
unpaid Interest thereon, plus (iii) accrued and unpaid Late Charges, if
any.  The parties hereto agree that in the event of the Company’s acceleration
of the Principal of this Note under this Section 4(b), the Holder’s damages
would be uncertain and difficult to estimate because of the parties’ inability
to predict future interest rates and the uncertainty of the availability of a
suitable substitute investment opportunity for the Holder.  Accordingly, any
Default Premium due under this Section 4(b) is intended by the parties to be,
and shall be deemed, a reasonable estimate of the Holder’s actual loss of its
investment opportunity and not as a penalty.
 

 
 
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(5)           RIGHTS UPON FUNDAMENTAL TRANSACTION AND CHANGE OF CONTROL.
 
(a)           Assumption.  The Company shall not enter into or be party to a
Fundamental Transaction unless (i) the Successor Entity assumes in writing all
of the obligations of the Company under this Note and the other Transaction
Documents (as defined in the Securities Purchase Agreement) in accordance with
the provisions of this Section 5(a) pursuant to written agreements in form and
substance reasonably satisfactory to the Required Holders and approved by the
Required Holders prior to such Fundamental Transaction, including agreements to
deliver to each holder of Notes in exchange for such Notes a security of the
Successor Entity evidenced by a written instrument substantially similar in form
and substance to the Notes, including, without limitation, having a principal
amount and interest rate equal to the principal amounts then outstanding and the
interest rates of the Notes held by such holder, having similar conversion
rights as the Notes and having similar ranking to the Notes, and reasonably
satisfactory to the Required Holders and (ii) the Successor Entity (including
its Parent Entity) is a publicly traded corporation whose common stock is quoted
on or listed for trading on an Eligible Market.  Upon the occurrence of any
Fundamental Transaction, the Successor Entity shall succeed to, and be
substituted for (so that from and after the date of such Fundamental
Transaction, the provisions of this Note referring to the “Company” shall refer
instead to the Successor Entity), and may exercise every right and power of the
Company and shall assume all of the obligations of the Company under this Note
with the same effect as if such Successor Entity had been named as the Company
herein.  Upon consummation of the Fundamental Transaction, the Successor Entity
shall deliver to the Holder confirmation that there shall be issued upon
conversion of this Note at any time after the consummation of the Fundamental
Transaction, in lieu of the shares of the Company’s Common Stock (or other
securities, cash, assets or other property) issuable upon the conversion of the
Notes prior to such Fundamental Transaction, such shares of the publicly traded
common stock (or their equivalent) of the Successor Entity (including its Parent
Entity), as adjusted in accordance with the provisions of this Note.  The
provisions of this Section shall apply similarly and equally to successive
Fundamental Transactions and shall be applied without regard to any limitations
on the conversion of this Note.
 
(b)           Notice.  No sooner than twenty (20) days nor later than fifteen
(15) days prior to the consummation of a Change of Control, but not prior to the
public announcement of such Change of Control, the Company shall deliver written
notice thereof via facsimile and overnight courier to the Holder (a “Change of
Control Notice”).
 
(6)           RIGHTS UPON ISSUANCE OF CORPORATE EVENTS.  In addition to and not
in substitution for any other rights hereunder, prior to the consummation of any
Fundamental Transaction pursuant to which holders of shares of Common Stock are
entitled to receive securities or other assets with respect to or in exchange
for shares of Common Stock (a “Corporate Event”), the Company shall make
appropriate provision to insure that the Holder will thereafter have the right
to receive upon a conversion of this Note, (i) in addition to the shares of
Common Stock receivable upon such conversion, such securities or other assets to
which the Holder would have been entitled with respect to such shares of Common
Stock had such shares of Common Stock been held by the Holder upon the
consummation of such Corporate Event (without taking into account any
limitations or restrictions on the convertibility
 

 
 
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of this Note) or (ii) in lieu of the shares of Common Stock otherwise receivable
upon such conversion, such securities or other assets received by the holders of
shares of Common Stock in connection with the consummation of such Corporate
Event in such amounts as the Holder would have been entitled to receive had this
Note initially been issued with conversion rights for the form of such
consideration (as opposed to shares of Common Stock) at a conversion rate for
such consideration commensurate with the Conversion Rate.  Provision made
pursuant to the preceding sentence shall be in a form and substance reasonably
satisfactory to the Required Holders.  The provisions of this Section shall
apply similarly and equally to successive Corporate Events and shall be applied
without regard to any limitations on the conversion of this Note.
 
(7)           RIGHTS UPON ISSUANCE OF OTHER SECURITIES.
 
(a)           Adjustment of Conversion Price upon Subdivision or Combination of
Common Stock.  If the Company at any time on or after the Subscription Date
subdivides (by any stock split, stock dividend, recapitalization or otherwise)
one or more classes of its outstanding shares of Common Stock into a greater
number of shares, the Conversion Price in effect immediately prior to such
subdivision will be proportionately reduced.  If the Company at any time on or
after the Subscription Date combines (by combination, reverse stock split or
otherwise) one or more classes of its outstanding shares of Common Stock into a
smaller number of shares, the Conversion Price in effect immediately prior to
such combination will be proportionately increased. Any adjustment under this
Section 7(a) shall become effective at the close of business on the date the
subdivision or combination becomes effective.
 
(b)           Other Events.  If any event occurs of the type contemplated by the
provisions of Section 7(a) but not expressly provided for by such provisions
(including, without limitation, the granting of stock appreciation rights,
phantom stock rights or other rights with equity features, excluding Excluded
Securities), then the Company’s board of directors will make an appropriate
adjustment in the Conversion Price so as to protect the rights of the Holder
under this Note; provided that no such adjustment will increase the Conversion
Price except as otherwise determined pursuant to this Note.
 
(c)           De Minimis Adjustments.  No adjustment in the Conversion Price
shall be required unless such adjustment would require an increase or decrease
of at least $0.01 in such price; provided, however, that any adjustment which by
reason of this Section 7(c) is not required to be made shall be carried forward
and taken into account in any subsequent adjustments under this Section 7.  All
calculations under this Section 7 shall be made by the Company in good faith and
shall be made to the nearest cent or to the nearest one hundredth of a share, as
applicable, provided that the Company shall not be required to issue any
fractional shares pursuant to this Note.  No adjustment need be made for a
change in the par value or no par value of the Company’s Common Stock.
 
(8)           UNSECURED OBLIGATION; NO SINKING FUND.  This Note and the Other
Notes are unsecured obligations of the Company and no sinking fund or reserve
has been established to pay the Principal of this Note or the principal amount
of the Other Notes.
 

 
 
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(9)           NONCIRCUMVENTION.  The Company hereby covenants and agrees that
the Company will not, by amendment of its Certificate of Incorporation, Bylaws
or through any reorganization, transfer of assets, consolidation, merger, scheme
of arrangement, dissolution, issue or sale of securities, or any other voluntary
action, avoid or seek to avoid the observance or performance of any of the terms
of this Note, and will at all times in good faith carry out all of the
provisions of this Note and take all action as it reasonably believes may be
required to protect the rights of the Holder of this Note in accordance with the
terms of this Note.
 
(10)           RESERVATION OF AUTHORIZED SHARES.
 
(a)           Reservation.  The Company shall initially reserve out of its
authorized and unissued Common Stock a number of shares of Common Stock for the
Notes equal to 105% of the Conversion Rate with respect to the Conversion Amount
of each all such Notes as of the Issuance Date.  So long as any of the Notes are
outstanding, the Company shall take all action necessary to reserve and keep
available out of its authorized and unissued Common Stock, solely for the
purpose of effecting the conversion of the Notes, 105% of the number of shares
of Common Stock as shall from time to time be necessary to effect the conversion
of all of the Notes then outstanding; provided that at no time shall the number
of shares of Common Stock so reserved be less than the number of shares required
to be reserved by the previous sentence (without regard to any limitations on
conversions) (the “Required Reserve Amount”).  The initial number of shares of
Common Stock reserved for conversions of the Notes and each increase in the
number of shares so reserved shall be allocated pro rata among the holders of
the Notes based on the principal amount of the Notes held by each holder thereof
at the Initial Closing (as defined in the Securities Purchase Agreement) or
increase in the number of reserved shares, as the case may be (the “Authorized
Share Allocation”).  In the event that a holder shall sell or otherwise transfer
any of such holder’s Notes, each transferee shall be allocated a pro rata
portion of such holder’s Authorized Share Allocation.  Any shares of Common
Stock reserved and allocated to any Person which ceases to hold any Notes shall
be allocated to the remaining holders of Notes, pro rata based on the principal
amount of the Notes then held by such holders.
 
(b)           Insufficient Authorized Shares.  If at any time while any of the
Notes remain outstanding the Company does not have a sufficient number of
authorized and unreserved shares of Common Stock to satisfy its obligation to
reserve for issuance upon conversion of the Notes at least a number of shares of
Common Stock equal to the Required Reserve Amount (an “Authorized Share
Failure”), then the Company shall immediately take all action necessary to
increase the Company’s authorized shares of Common Stock to an amount sufficient
to allow the Company to reserve the Required Reserve Amount for the Notes then
outstanding.  Without limiting the generality of the foregoing sentence, as soon
as practicable after the date of the occurrence of an Authorized Share Failure,
but in no event later than seventy-five (75) days after the occurrence of such
Authorized Share Failure, the Company shall hold a meeting of its stockholders
or otherwise obtain written consent from its stockholders without a meeting for
the approval of an increase in the number of authorized shares of Common
Stock.  In connection with such meeting or written consent, the Company shall
provide each stockholder with a proxy statement or written information statement
(which such proxy or information statement shall include all of the information
specified in Schedule 14C in accordance with Rule 14c-2 promulgated under the
Exchange Act), in each case as may be
 

 
 
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amended or restated from time to time, and shall use its best efforts to solicit
its stockholders’ approval of such increase in authorized shares of Common Stock
and to cause its board of directors to recommend to the stockholders that they
approve such proposal.
 
(11)           NOTE HOLDER NOT DEEMED A STOCKHOLDER .  Except as otherwise
specifically provided herein, the Holder, solely in such Person’s capacity as a
holder of this Note, shall not be entitled to vote or receive dividends or be
deemed the holder of share capital of the Company for any purpose, nor shall
anything contained in this Note be construed to confer upon the Holder, solely
in such Person’s capacity as the Holder of this Note, any of the rights of a
stockholder of the Company or any right to vote, give or withhold consent to any
corporate action (whether any reorganization, issue of stock, reclassification
of stock, consolidation, merger, conveyance or otherwise), receive notice of
meetings, receive dividends or subscription rights, or otherwise, prior to the
issuance to the Holder of the Conversion Shares which such Person is then
entitled to receive upon the due conversion of this Note.  In addition, nothing
contained in this Note shall be construed as imposing any liabilities on the
Holder to purchase any securities (upon conversion of this Note or otherwise) or
as a stockholder of the Company, whether such liabilities are asserted by the
Company or by creditors of the Company.
 
(12)           COVENANTS.
 
(a)           Rank.                      This Note is an unsubordinated
obligation of the Company and all payments due under this Note (A) shall rank
pari passu with all Other Notes and the Convertible Promissory Note issued on
February 8, 2007 by the Company to Elan Pharma International Limited, and
(B) shall not be subordinated to any other Indebtedness of the Company.
 
(b)           Disclosure of Operating Results.  Commencing with the Fiscal
Quarter ending June 30, 2008, the Company shall use commercially reasonable
efforts to publicly disclose and disseminate its operating results (the
“Operating Results”) (x) for each of the first three Fiscal Quarters of each
fiscal year no later than the forty-fifth (45th) day after the end of such
Fiscal Quarter and (y) for the fourth Fiscal Quarter of each fiscal year, no
later than the ninetieth (90th) day after the end of such Fiscal Quarter, and
shall file its Operating Results with SEC for the first three Fiscal Quarters of
each fiscal year a part of a Quarterly Report on Form 10-Q or Form 10-QSB, as
applicable, and for the fiscal year as  part of an Annual Report on Form 10-K or
Form 10-KSB, as applicable (provided that such deadlines shall be subject to
extension as permitted under the Exchange Act and the rules and regulations of
the SEC promulgated thereunder).
 
(c)           Equity Issuances.  The Company shall not, and shall cause its
subsidiaries not to, issue any Convertible Securities, Options, Common Stock,
shares of preferred stock of the Company, shares of any class of capital stock
of its subsidiaries, any securities, warrants, options, rights or other
instruments exchangeable, exercisable or convertible for or into shares of any
class of capital stock of any of the Company’s subsidiaries, or any other
security or instrument representing an ownership interest in the Company or any
of its subsidiaries, in each case other than Excluded Securities, without
obtaining the prior written consent of the Required Holders.
 

 
 
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(d)           Incurrence of Indebtedness.  So long as this Note is outstanding,
the Company shall not, and the Company shall not permit any of its Subsidiaries
to, directly or indirectly, incur or guarantee, assume or suffer to exist any
Indebtedness, other than (i) the Indebtedness evidenced by this Note and the
Other Notes and (ii) other Permitted Indebtedness, in each case without
obtaining the prior written consent of the Required Holders.
 
(e)           Existence of Liens.  So long as this Note is outstanding, the
Company shall not, and the Company shall not permit any of its Subsidiaries to,
directly or indirectly, allow or suffer to exist any mortgage, lien, pledge,
charge, security interest or other encumbrance upon or in any property or assets
(including accounts and contract rights) owned by the Company or any of its
Subsidiaries (collectively, “Liens”) other than Permitted Liens.
 
(f)           Restricted Payments.  The Company shall not, and the Company shall
not permit any of its Subsidiaries to, directly or indirectly, (i) redeem,
defease, repurchase, repay or make any payments in respect of, by the payment of
cash or cash equivalents (in whole or in part, whether by way of open market
purchases, tender offers, private transactions or otherwise), all or any portion
of any Indebtedness of the Company or any of its Subsidiaries, other than
(x) this Note and the Other Notes, (y) the payment of interest and  late
penalties on Permitted Indebtedness in accordance with the terms thereof and
(z) the payment of principal on Permitted Indebtedness on or after the scheduled
maturity date thereof, (ii) make any distributions or pay any dividends with
respect to any equity security of or any other equity interest in the Company or
any of its subsidiaries, provided that any subsidiary of the Company may make
distributions or pay dividends to the Company, and provided further that the
Company may repurchase equity of the Company issued to or held by employees,
officers, directors and consultants of the Company upon termination of their
employment or service with the Company, and (iii) make investments in any Person
other than the Company or a Subsidiary of the Company, provided that any
investment made by the Company in any of its Subsidiaries, other than a Wholly
Owned Subsidiary, shall be evidenced by an unsubordinated promissory note issued
by such Subsidiary to the Company for a principal amount not less than the
amount of such investment or such Subsidiary receiving such investment shall
execute and deliver a guaranty of this Note and the Other Notes in form and
substance reasonably acceptable to the Holder and the holders of the Other
Notes.
 
(13)           PARTICIPATION.  The Holder, as the holder of this Note, shall not
be entitled to receive such dividends paid and distributions made to the holders
of Common Stock with respect to any unconverted portion of the Principal of this
Note.
 
(14)           VOTE TO ISSUE, OR CHANGE THE TERMS OF, NOTES.  The affirmative
vote at a meeting duly called for such purpose or the written consent without a
meeting of the Required Holders shall be required for any change or amendment to
this Note or the Other Notes.  No consideration shall be offered or paid to any
holder of Notes to amend or consent to a waiver or modification of the Notes
unless the same consideration also is offered to all of the holders of
Notes.  Notwithstanding the foregoing, without the prior written consent of the
Holder, (i) the Maturity Date of this Note shall not be extended, (ii) the
Interest Rate shall not be decreased, (iii) the right to receive any payment
hereunder that is then due and owing shall not be reduced or waived, (iv) the
Principal shall not be reduced other than in accordance with the
 

 
 
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terms hereof and (v) the Conversion Price shall not be increased other than in
accordance with Section 6, 7(b) or 7(c) hereof.
 
(15)           TRANSFER.  This Note may be offered, sold, assigned or
transferred by the Holder without the consent of the Company, subject only to
the provisions of Section 2(f) of the Securities Purchase Agreement.
 
(16)           REISSUANCE OF THIS NOTE.
 
(a)           Transfer.  If this Note is to be transferred, the Holder shall
surrender this Note to the Company, whereupon the Company will forthwith issue
and deliver upon the order of the Holder a new Note (in accordance with
Section 16(d)), registered as the Holder may request, representing the
outstanding Principal being transferred by the Holder and, if less then the
entire outstanding Principal is being transferred, a new Note (in accordance
with Section 16(d)) to the Holder representing the outstanding Principal not
being transferred.  The Holder and any assignee, by acceptance of this Note,
acknowledge and agree that, by reason of the provisions of
Section 3(c)(iii) following conversion of any portion of this Note, the
outstanding Principal represented by this Note may be less than the Principal
stated on the face of this Note.
 
(b)           Lost, Stolen or Mutilated Note.  Upon receipt by the Company of
evidence reasonably satisfactory to the Company of the loss, theft, destruction
or mutilation of this Note, and, in the case of loss, theft or destruction, of
any indemnification undertaking by the Holder to the Company in customary form
and, in the case of mutilation, upon surrender and cancellation of this Note,
the Company shall execute and deliver to the Holder a new Note (in accordance
with Section 16(d)) representing the outstanding Principal.
 
(c)           Note Exchangeable for Different Denominations.  This Note is
exchangeable, upon the surrender hereof by the Holder at the principal office of
the Company, for a new Note or Notes (in accordance with Section 16(d) and in
principal amounts of at least $250,000) representing in the aggregate the
outstanding Principal of this Note, and each such new Note will represent such
portion of such outstanding Principal as is designated by the Holder at the time
of such surrender.
 
(d)           Issuance of New Notes.  Whenever the Company is required to issue
a new Note pursuant to the terms of this Note, such new Note (i) shall be of
like tenor with this Note, (ii) shall represent, as indicated on the face of
such new Note, the Principal remaining outstanding (or in the case of a new Note
being issued pursuant to Section 16(a) or Section 16(c), the Principal
designated by the Holder which, when added to the principal represented by the
other new Notes issued in connection with such issuance, does not exceed the
Principal remaining outstanding under this Note immediately prior to such
issuance of new Notes), (iii) shall have an issuance date, as indicated on the
face of such new Note, which is the same as the Issuance Date of this Note,
(iv) shall have the same rights and conditions as this Note, and (v) shall
represent accrued and unpaid Interest and Late Charges on the Principal and
Interest of this Note, if any, from the Issuance Date.
 

 
 
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(17)           REMEDIES, CHARACTERIZATIONS, OTHER OBLIGATIONS, BREACHES AND
INJUNCTIVE RELIEF.  The remedies provided in this Note shall be cumulative and
in addition to all other remedies available under this Note and any of the other
Transaction Documents at law or in equity (including a decree of specific
performance and/or other injunctive relief), and nothing herein shall limit the
Holder’s right to pursue any actual damages for any failure by the Company to
comply with the terms of this Note.  Amounts set forth or provided for herein
with respect to payments, conversion and the like (and the computation thereof)
shall be the amounts to be received by the Holder and shall not, except as
expressly provided herein, be subject to any other obligation of the Company (or
the performance thereof).  The Company acknowledges that a breach by it of its
obligations hereunder may cause irreparable harm to the Holder and that the
remedy at law for any such breach may be inadequate.  The Company therefore
agrees that, in the event of any such breach or threatened breach, the Holder
shall be entitled, in addition to all other available remedies, to an injunction
restraining any breach, without the necessity of showing economic loss and
without any bond or other security being required.
 
(18)           PAYMENT OF COLLECTION, ENFORCEMENT AND OTHER COSTS.  If (a) this
Note is placed in the hands of an attorney for collection or enforcement or is
collected or enforced through any legal proceeding or the Holder otherwise takes
action to collect amounts due under this Note or to enforce the provisions of
this Note or (b) there occurs any bankruptcy, reorganization, receivership of
the Company or other proceedings affecting Company creditors’ rights and
involving a claim under this Note, then the Company shall pay the reasonable
costs incurred by the Holder for such collection, enforcement or action or in
connection with such bankruptcy, reorganization, receivership or other
proceeding, including, but not limited to, reasonable financial advisory fees
and attorneys’ fees and disbursements.
 
(19)           CONSTRUCTION; HEADINGS.  This Note shall be deemed to be jointly
drafted by the Company and all the initial holders of the Notes and shall not be
construed against any person as the drafter hereof.  The headings of this Note
are for convenience of reference and shall not form part of, or affect the
interpretation of, this Note.
 
(20)           FAILURE OR INDULGENCE NOT WAIVER.  No failure or delay on the
part of the Holder in the exercise of any power, right or privilege hereunder
shall operate as a waiver thereof, nor shall any single or partial exercise of
any such power, right or privilege preclude other or further exercise thereof or
of any other right, power or privilege.
 
(21)           DISPUTE RESOLUTION.  In the case of a dispute as to the
determination of the Weighted Average Price or the arithmetic calculation of the
Conversion Rate, the Company shall submit the disputed determinations or
arithmetic calculations via facsimile within two (2) Business Days of receipt,
or deemed receipt, of the Conversion Notice or other event giving rise to such
dispute, as the case may be, to the Holder.  If the Holder and the Company are
unable to agree upon such determination or calculation within five (5) Business
Days of such disputed determination or arithmetic calculation being submitted to
the Holder, then the Company shall, within one (1) Business Day submit via
facsimile (a) the disputed determination of the Weighted Average Price to an
independent, reputable investment bank selected by the Company and approved by
the Holder, which approval shall not be unreasonably withheld, conditioned or
delayed, or (b) the disputed arithmetic calculation of the Conversion Rate to
the
 

 
 
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Company’s independent, outside accountant.  The Company, at the Company’s
expense, shall use its best efforts to cause the investment bank or the
accountant, as the case may be, to perform the determinations or calculations
and notify the Company and the Holder of the results no later than ten
(10)  Business Days from the time it receives the disputed determinations or
calculations.  Such investment bank’s or accountant’s determination or
calculation, as the case may be, shall be binding upon all parties absent
demonstrable error.
 
(22)           NOTICES; PAYMENTS.
 
(a)           Notices.  Whenever notice is required to be given under this Note,
unless otherwise provided herein, such notice shall be given in accordance with
Section 9(f) of the Securities Purchase Agreement.  The Company shall provide
the Holder with prompt written notice of all actions taken pursuant to this
Note, including in reasonable detail a description of such action and the reason
therefore.  Without limiting the generality of the foregoing, the Company will
give written notice to the Holder (i) immediately upon any adjustment of the
Conversion Price, setting forth in reasonable detail, and certifying, the
calculation of such adjustment and (ii) at least ten (10) days prior to the date
on which the Company closes its books or takes a record (A) with respect to any
dividend or distribution upon the Common Stock, (B) with respect to any pro rata
subscription offer to all holders of Common Stock or (C) for determining rights
to vote with respect to any Fundamental Transaction, dissolution or liquidation,
provided in each case that such information has been made known to the public
prior to or in conjunction with such notice being provided to the Holder.
 
(b)           Payments.  Whenever any payment of cash is to be made by the
Company to any Person pursuant to this Note, such payment shall be made in
lawful money of the United States of America by a check drawn on the account of
the Company and sent via overnight courier service to such Person at such
address as previously provided to the Company in writing (which address, in the
case of each of the initial holders of the Notes, shall initially be as set
forth on the Schedule of Buyers attached to the Securities Purchase Agreement);
provided that the Holder may elect to receive a payment of cash via wire
transfer of immediately available funds by providing the Company with prior
written notice setting out such request and the Holder’s wire transfer
instructions, provided that the Holder shall be required to bear any related
wire transfer fees.  Whenever any amount expressed to be due by the terms of
this Note is due on any day which is not a Business Day, the same shall instead
be due on the next succeeding day which is a Business Day and, in the case of
any Interest Date which is not the date on which this Note is paid in full, the
extension of the due date thereof shall not be taken into account for purposes
of determining the amount of Interest due on such date.  Any amount of Principal
or other amounts due under this Note which is not paid when due shall result in
a late charge being incurred and payable by the Company in an amount equal to
interest on such amount at the Default Rate from the date such amount was due
until the same is paid in full (“Late Charge”).
 
(23)           CANCELLATION.  After all Principal, accrued Interest and any Late
Charges owed on this Note have been paid in full, this Note shall automatically
be deemed canceled, shall be promptly surrendered to the Company by the Holder
for cancellation and shall not be reissued.
 

 
 
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(24)           WAIVER OF NOTICE.  To the extent permitted by law, the Company
hereby waives demand, notice, protest and all other demands and notices in
connection with the delivery, acceptance, performance, default or enforcement of
this Note and the Securities Purchase Agreement.
 
(25)           GOVERNING LAW; JURISDICTION; SEVERABILITY; JURY TRIAL.  This Note
shall be construed and enforced in accor­dance with, and all questions
concerning the construction, validity, interpretation and performance of this
Note shall be governed by, the internal laws of the State of New York, without
giving effect to any choice of law or conflict of law provision or rule (whether
of the State of New York or any other jurisdictions) that would cause the
application of the laws of any jurisdictions other than the State of New
York.  The Company hereby irrevocably submits to the exclusive jurisdiction of
the state and federal courts sitting in The City of New York, Borough of
Manhattan, for the adjudication of any dispute hereunder or in connection
herewith or with any transaction contemplated hereby or discussed herein, and
hereby irrevocably waives, and agrees not to assert in any suit, action or
proceeding, any claim that it is not personally subject to the jurisdiction of
any such court, that such suit, action or proceeding is brought in an
inconvenient forum or that the venue of such suit, action or proceeding is
improper.  Nothing contained herein shall be deemed to limit in any way any
right to serve process in any manner permitted by law.  In the event that any
provision of this Note is invalid or unenforceable under any applicable statute
or rule of law, then such provision shall be deemed inoperative to the extent
that it may conflict therewith and shall be deemed modified to conform with such
statute or rule of law.  Any such provision which may prove invalid or
unenforceable under any law shall not affect the validity or enforceability of
any other provision of this Note.  Nothing contained herein shall be deemed or
operate to preclude the Holder from bringing suit or taking other legal action
against the Company in any other jurisdiction to collect on the Company’s
obligations to the Holder, to realize on any collateral or any other security
for such obligations, or to enforce a judgment or other court ruling in favor of
the Holder.  THE COMPANY HEREBY IRREVOCABLY WAIVES ANY RIGHT IT MAY HAVE, AND
AGREES NOT TO REQUEST, A JURY TRIAL FOR THE ADJUDICATION OF ANY DISPUTE
HEREUNDER OR IN CONNECTION WITH OR ARISING OUT OF THIS NOTE OR ANY TRANSACTION
CONTEMPLATED HEREBY.
 
(26)           CERTAIN DEFINITIONS.  For purposes of this Note, the following
terms shall have the following meanings:
 
(a)           “Affiliate" means with respect to a specified Person, any other
Person who or which is (a) directly or indirectly controlling, controlled by or
under common control with the specified Person, or (b) any member, stockholder,
director, officer, manager, or comparable principal of, or relative or spouse
of, the specified Person. For purposes of this definition, “control”,
“controlling”, and “controlled” mean the right to exercise, directly or
indirectly, more than fifty percent of the voting power of the stockholders,
members or owners and, with respect to any individual, partnership, trust or
other entity or association, the possession, directly or indirectly, of the
power to direct or cause the direction of the management or policies of the
controlled entity.
 
(b)           “Approved Stock Plan” means any employee benefit plan which has
been or hereafter is approved by the board of directors of the Company, pursuant
to which
 

 
 
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the Company’s securities may be issued to any employee, consultant, officer or
director for services provided to the Company.
 
(c)           “Bloomberg” means Bloomberg Financial Markets.
 
(d)           “Business Day” means any day other than Saturday, Sunday or other
day on which commercial banks in The City of New York are authorized or required
by law to remain closed.
 
(e)           “Change of Control” means any Fundamental Transaction other than
(A) any reorganization, recapitalization or reclassification of Common Stock, in
which holders of the Company’s voting power immediately prior to such
reorganization, recapitalization or reclassification continue after such
reorganization, recapitalization or reclassification to hold publicly traded
securities and, directly or indirectly, the voting power of the surviving entity
or entities necessary to elect a majority of the members of the board of
directors (or their equivalent if other than a corporation) of such entity or
entities, or (B) pursuant to a migratory merger effected solely for the purpose
of changing the jurisdiction of incorporation of the Company.
 
(f)           “Contingent Obligation” means, as to any Person, any direct or
indirect liability, contingent or otherwise, of that Person with respect to any
indebtedness, lease, dividend or other obligation of another Person if the
primary purpose or intent of the Person incurring such liability, or the primary
effect thereof, is to provide assurance to the obligee of such liability that
such liability will be paid or discharged, or that any agreements relating
thereto will be complied with, or that the holders of such liability will be
protected (in whole or in part) against loss with respect thereto.
 
(g)           “Convertible Securities” means any stock or securities (other than
Options) directly or indirectly convertible into or exercisable or exchangeable
for Common Stock.
 
(h)           “Eligible Market” means the OTC Bulletin Board, The New York Stock
Exchange, Inc., the American Stock Exchange, The NASDAQ Global Market, The
NASDAQ Global Select Market or The NASDAQ Capital Market.
 
(i)           “Excluded Securities” means any (I) Common Stock issued or
issuable, directly or indirectly:  (i) in connection with any Approved Stock
Plan or with respect to any shares of Common Stock reserved as employee shares
(or for consultants, officers or directors of the Company and its Subsidiaries)
as of the date immediately preceding the Subscription Date; (ii) upon conversion
of this Note or any Other Note or the exercise of the Warrants; (iii) pursuant
to a bona fide firm commitment underwritten public offering with a nationally
recognized underwriter which generates gross proceeds to the Company in excess
of $10,000,000 (other than an “at-the-market offering” as defined in Rule
415(a)(4) under the Securities Act of 1933, as amended, and “equity lines”);
(iv) upon conversion of any Options or Convertible Securities which are
outstanding on the day immediately preceding the Subscription Date, provided
that the exercise or conversion price of such Options or Convertible Securities
are not reduced on or after the Subscription Date (except in connection with
recapitalizations,
 

 
 
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reclassifications, stock dividends, stock splits and the like); (v) in
connection with any merger, consolidation, acquisition, or similar business
combination approved by the board of directors of the Company; (vi) pursuant to
any equipment loan or leasing arrangement, real property leasing arrangement or
debt financing from a bank or similar financial institution approved by the
board of directors of the Company; (vii) to any Buyer pursuant to Section 4(m)
of the Securities Purchase Agreement; (viii) in connection with the payment of
interest, penalties, premiums or other liquidated damages on the Notes or under
any registration rights agreement of the Company in effect prior to the
Subscription Date (provided that such registration rights agreement was
disclosed to the Buyers on or prior to the Subscription Date or an exhibit to a
Current Report, Quarterly Report or Annual Report of the Company filed with the
SEC at least two (2) Business Days prior to the Subscription Date); or (ix) upon
conversion of any Series B nonredeemable convertible preferred stock, par value
$0.01 per share, of the Company (“Series B Preferred”), outstanding as of the
Subscription Date; (II) any Series B preferred issued or issuable upon
conversion of the convertible promissory note originally issued on February 8,
2007 by the Company to Elan Pharma International Limited and any replacements
thereof (the “Elan Note”) (provided, however, that the terms relating to the
conversion of such note shall not be materially modified and the principal
amount of such note, after deducting for amounts converted, repaid, redeemed or
prepaid, shall not have been increased) (the “Elan Note Series B Preferred”);
(III) any Common Stock issued or issuable upon conversion of any Elan Note
Series B Preferred; (IV) any warrant issued or issuable pursuant to the terms of
the Elan Note (an “Elan Warrant”); (V) any Series B Preferred issued or issuable
upon exercise of any Elan Warrant (the “Elan Warrant Series B”), (VI) any Common
Stock issued or issuable upon conversion of any Elan Warrant Series B and
(VII) this Note, any Other Note and any Warrant.
 
(j)           “Fiscal Quarter” means each of the fiscal quarters adopted by the
Company for financial reporting purposes that correspond to the Company’s fiscal
year as of the date hereof that ends on September 30 of each year, or such other
fiscal year-end date adopted by the Company.
 
(k)           “Fundamental Transaction” means any of the following transactions,
in which the Company shall, directly or indirectly, in one or more related
transactions, (i) consolidate or merge with or into (whether or not the Company
is the surviving corporation) another Person or Persons, and the holders of the
Voting Stock (not including any shares of Voting Stock held by the Person or
Persons making or party to, or associated or affiliated with the Persons making
or party to, such consolidation or merger) immediately prior to such
consolidation or merger hold or have the right to direct the voting of less than
50% of the Voting Stock or such voting securities of such other surviving Person
immediately following such transaction, or (ii) sell, assign, transfer, convey
or otherwise dispose of all or substantially all of the properties or assets of
the Company to another Person, or (iii) be the subject of a purchase, tender or
exchange offer that is accepted by the holders of more than 50% of the
outstanding shares of Voting Stock (not including any shares of Voting Stock
held by the Person or Persons making or party to, or associated or affiliated
with the Persons making or party to, such purchase, tender or exchange offer),
or (iv) consummate a stock purchase agreement or other business combination
(including, without limitation, a reorganization, recapitalization, spin-off or
scheme of arrangement) with another Person other than Goodnow Capital, L.L.C.,
Xmark Opportunity Partners, LLC or an Affiliate of either of the foregoing,
whereby such other
 

 
 
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Person acquires more than 50% of the outstanding shares of Voting Stock (not
including any shares of Voting Stock held by the other Person or other Persons
making or party to, or associated or affiliated with the other Persons making or
party to, such stock purchase agreement or other business combination), or
(v) be the subject of a change in ownership such that any “person” or “group”
(as these terms are used for purposes of Sections 13(d) and 14(d) of the
Exchange Act) other than Goodnow Capital, L.L.C., Xmark Opportunity Partners,
LLC or an Affiliate of either of the foregoing, is or shall become the
“beneficial owner” (as defined in Rule 13d-3 under the Exchange Act), directly
or indirectly, of 50% of the aggregate ordinary voting power represented by
issued and outstanding Common Stock.
 
(l)           “GAAP” means United States generally accepted accounting
principles, consistently applied.
 
(m)           “Indebtedness” of any Person means, without duplication (i) all
indebtedness for borrowed money, (ii) all obligations issued, undertaken or
assumed as the deferred purchase price of property or services, including
(without limitation) “capital leases” in accordance with generally accepted
accounting principles (other than trade payables entered into in the ordinary
course of business), (iii) all reimbursement or payment obligations with respect
to letters of credit, surety bonds and other similar instruments, (iv) all
obligations evidenced by notes, bonds, debentures or similar instruments,
including obligations so evidenced incurred in connection with the acquisition
of property, assets or businesses, (v) all indebtedness created or arising under
any conditional sale or other title retention agreement, or incurred as
financing, in either case with respect to any property or assets acquired with
the proceeds of such indebtedness (even though the rights and remedies of the
seller or bank under such agreement in the event of default are limited to
repossession or sale of such property), (vi) all monetary obligations under any
leasing or similar arrangement which, in connection with GAAP for the periods
covered thereby, is classified as a capital lease, (vii) all indebtedness
referred to in clauses (i) through (vi) above secured by (or for which the
holder of such Indebtedness has an existing right, contingent or otherwise, to
be secured by) any mortgage, lien, pledge, charge, security interest or other
encumbrance upon or in any property or assets (including accounts and contract
rights) owned by any Person, even though the Person which owns such assets or
property has not assumed or become liable for the payment of such indebtedness,
and (viii) all Contingent Obligations in respect of indebtedness or obligations
of others of the kinds referred to in clauses (i) through (vii) above.
 
(n)           “Options” means any rights, warrants or options to subscribe for
or purchase shares of Common Stock or securities convertible into or exercisable
or exchangeable for Common Stock.
 
(o)           “Parent Entity” of a Person means an entity that, directly or
indirectly, controls the applicable Person and whose common stock or equivalent
equity security is quoted or listed on an Eligible Market, or, if there is more
than one such Person or Parent Entity, the Person or Parent Entity with the
largest public market capitalization as of the date of consummation of the
Fundamental Transaction.
 

 
 
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(p)           “Permitted Indebtedness” means (i) Indebtedness under this Note
and the Other Notes, (ii) Indebtedness secured by Permitted Liens,
(iii) Indebtedness existing on the Subscription Date, as set forth on
Schedule 3(s) to the Securities Purchase Agreement and Indebtedness incurred
thereon, and (iv) extensions, refinancings and renewals of any items in clauses
(ii) and (iii) above (“Refinancing Debt”), provided that (x) the principal
amount is not increased, (y) the terms of such Indebtedness are not more
burdensome upon the Company or its Subsidiaries than the terms of the
Indebtedness being extended, refinanced or renewed (the “Existing Debt”),
including, without limitation, any increase in the interest rate, any
acceleration of the amortization schedule or any decrease in the time to
scheduled maturity, and (z) to the extent the Existing Debt was not guaranteed,
issued or co-issued by one or more Subsidiaries of the Company or secured, that
the related Refinancing Debt may not be guaranteed, issued or co-issued by any
such Subsidiary of the Company  or secured.
 
(q)            “Permitted Liens” means (i) any Lien for taxes not yet due or
delinquent or being contested in good faith by appropriate proceedings for which
adequate reserves have been established in accordance with GAAP, (ii) any
statutory Lien arising in the ordinary course of business by operation of law
with respect to a liability that is not yet due or delinquent, (iii) any Lien
created by operation of law, such as materialmen’s liens, mechanics’ liens and
other similar liens, arising in the ordinary course of business with respect to
a liability that is not yet due or delinquent or that are being contested in
good faith by appropriate proceedings, (iv) Liens upon or in any equipment
acquired or held by the Company or any of its Subsidiaries to secure the
purchase price of such equipment or indebtedness incurred solely for the purpose
of financing the acquisition or lease of such equipment, provided that the Lien
is confined solely to the property so acquired and improvements thereon,
(v) Liens existing on the Subscription Date, as set forth on Schedule 3(w) to
the Securities Purchase Agreement, (vi) Liens incurred in connection with the
extension, renewal or refinancing of the indebtedness secured by Liens of the
type described in clauses (i), (iv) and (v) above, provided that any extension,
renewal or replacement Lien shall be limited to the property encumbered by the
existing Lien and the principal amount of the Indebtedness being extended,
renewed or refinanced does not increase and terms of such Indebtedness complies
with the requirements for incurring “Refinancing Debt” as described in the
definition of “Permitted Indebtedness” above, (vii) Liens securing the Company’s
obligations under the Notes, (viii) leases or subleases and licenses and
sublicenses granted to others in the ordinary course of the Company’s and its
Subsidiaries’ businesses, not interfering in any material respect with the
business of the Company and its Subsidiaries taken as a whole, (ix) Liens in
favor of customs and revenue authorities arising as a matter of law to secure
payments of custom duties in connection with the importation of goods,
(ix) Liens arising from judgments, decrees or attachments in circumstances not
constituting an Event of Default under Section 4(a)(viii), (x) Liens in favor of
the Company, and (xi) Liens incurred in connection with acquiring inventory in
the ordinary course of business.
 
(r)            “Person” means an individual, a limited liability company, a
partnership, a joint venture, a corporation, a trust, an unincorporated
organization, any other entity and a government or any department or agency
thereof.
 
(s)           “Principal Market” means the Eligible Market the Common Stock is
then listed on.
 

 
 
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(t)           “Required Holders” means the holders of Notes representing at
least fifty and one-tenth percent (50.1%) of the aggregate principal amount of
the Notes then outstanding.
 
(u)           “SEC” means the United States Securities and Exchange Commission.
 
(v)           “Securities Purchase Agreement” means that certain Securities
Purchase Agreement, dated as of the Subscription Date, by and among the Company
and the investors listed on the Schedule of Buyers attached thereto, pursuant to
which the Company issued the Notes and warrants to the initial holders, as may
be amended or restated from time to time.
 
(w)           “Subscription Date” means August 1, 2008.
 
(x)           “Subsidiary” means each “Significant Subsidiary” (as such term is
defined in Rule 1-02 of Regulation S-X of the Securities Act of 1933, as amended
) of the Company.
 
(y)           “Successor Entity” means the Person, which may be the Company,
formed by, resulting from or surviving any Fundamental Transaction or the Person
with which such Fundamental Transaction shall have been made, provided that if
such Person is not a publicly traded entity whose common stock or equivalent
equity security is quoted or listed for trading on an Eligible Market, Successor
Entity shall mean such Person’s Parent Entity.
 
(z)           “Trading Day” means any day on which the Common Stock is traded on
the Principal Market, or, if the Principal Market is not the principal trading
market for the Common Stock, then on the principal securities exchange or
securities market on which the Common Stock is then traded; provided that
“Trading Day” shall not include any day on which the Common Stock is scheduled
to trade on such exchange or market for less than 4.5 hours or any day that the
Common Stock is suspended from trading during the final hour of trading on such
exchange or market (or if such exchange or market does not designate in advance
the closing time of trading on such exchange or market, then during the hour
ending at 4:00:00 p.m., New York time).
 
(aa)           “Voting Stock” of a Person means capital stock of such Person of
the class or classes pursuant to which the holders thereof have the general
voting power to elect, or the general power to appoint, at least a majority of
the board of directors, managers or trustees of such Person (irrespective of
whether or not at the time capital stock of any other class or classes shall
have or might have voting power by reason of the happening of any contingency).
 
(bb)           “Warrants” has the meaning ascribed to such term in the
Securities Purchase Agreement, and shall include all warrants issued in exchange
therefor or replacement thereof.
 
(cc)           “Weighted Average Price” means, for any security as of any date,
the dollar volume-weighted average price for such security on the Principal
Market during the period beginning at 9:30:01 a.m., New York time (or such other
time as the Principal Market
 

 
 
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publicly announces is the official open of trading), and ending at 4:00:00 p.m.,
New York time (or such other time as the Principal Market publicly announces is
the official close of trading) as reported by Bloomberg through its “Volume at
Price” functions, or, if the foregoing does not apply, the dollar
volume-weighted average price of such security in the over-the-counter market on
the electronic bulletin board for such security during the period beginning at
9:30:01 a.m., New York time (or such other time as such market publicly
announces is the official open of trading), and ending at 4:00:00 p.m., New York
time (or such other time as such market publicly announces is the official close
of trading) as reported by Bloomberg, or, if no dollar volume-weighted average
price is reported for such security by Bloomberg for such hours, the average of
the highest closing bid price and the lowest closing ask price of any of the
market makers for such security as reported in the “pink sheets”.  If the
Weighted Average Price cannot be calculated for a security on a particular date
on any of the foregoing bases, the Weighted Average Price of such security on
such date shall be the fair market value as mutually determined in good faith by
the Company and the Holder.  If the Company and the Holder are unable to agree
upon the fair market value of such security, then such dispute shall be resolved
pursuant to Section 21.  All such determinations to be appropriately adjusted
for any stock dividend, stock split, stock combination or other similar
transaction during the applicable calculation period.
 
(dd)           “Wholly Owned Subsidiary” means any Subsidiary of which all of
the outstanding equity securities and other equity interests, and any options,
warrants, rights or other securities convertible, exercisable or exchangeable
into or for equity securities or other equity interests of such Subsidiary
(collectively, “Equity Equivalents”), are owned beneficially and of record by
the Company, other than an immaterial amount of equity securities, other equity
interests or Equity Equivalents which may be held or owned by employees,
consultants, officers or directors of such Subsidiary.
 
(27)           DISCLOSURE.  Upon receipt or delivery by the Company of any
notice in accordance with the terms of this Note, unless the Company has in good
faith determined that the matters relating to such notice do not constitute
material, nonpublic information relating to the Company or its subsidiaries on a
consolidated basis, the Company shall within two (2) Business Days after any
such receipt or delivery publicly disclose such material, nonpublic information
on a Current Report on Form 8-K or otherwise.  In the event that the Company
believes that a notice it is delivering to the Holder contains material,
nonpublic information, relating to the Company or its subsidiaries on a
consolidated basis, the Company shall indicate such to the Holder
contemporaneously with delivery of such notice, and in the absence of any such
indication, the Holder shall be allowed to presume that all matters relating to
such notice do not constitute material, nonpublic information relating to the
Company or its subsidiaries on a consolidated basis.  With respect to any such
notice the Company receives from the Holder, the Company shall indicate to the
Holder in writing within one (1) Business Day after the Company’s receipt of
such notice whether the Company believes such notice contains material,
nonpublic information, relating to the Company or its subsidiaries on a
consolidated basis, and in the absence of any such indication, the Holder shall
be allowed to presume that all matters relating to such notice do not constitute
material, nonpublic information relating to the Company or its subsidiaries on a
consolidated basis.
 
[Signature Page Follows]
 

 
 
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IN WITNESS WHEREOF, the Company has caused this Note to be duly executed as of
the Issuance Date set out above.
 

 
AEOLUS PHARMACEUTICALS, INC.

 

 
 
By:
/s/ Michael P. McManus
 

 
 
Name:
Michael P. McManus

 
 
Title:
Chief Financial Officer

 

Signature Page to 7% Senior Convertible Note due 2011
 
 

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EXHIBIT I
 

AEOLUS PHARMACEUTICALS, INC.
 
CONVERSION NOTICE
 
Reference is made to the Senior Convertible Note (the “Note”) issued to the
undersigned by Aeolus Pharmaceuticals, Inc. (the “Company”).  In accordance with
and pursuant to the Note, the undersigned hereby elects to convert the
Conversion Amount (as defined in the Note) of the Note indicated below into
shares of Common Stock par value $0.01 per share (the “Common Stock”) of the
Company, as of the date specified below.  Capitalized terms used herein and not
otherwise defined shall have the respective meanings set forth in the Note.
 
Date of Conversion:
 
Aggregate Principal to be converted:
 
Please confirm the following information:
Conversion Amount:
 
Conversion Price:
 
Number of shares of Common Stock to be issued (which shall equal the Conversion
Amount divided by the Conversion Price rounded down to the nearest whole share):
 
Please issue the Common Stock into which the Note is being converted in the
following name and to the following address:
Issue to:
         
Facsimile Number:
 
The Holder represents and warrants to the Company that the Holder, together with
the Holder’s affiliates, will not beneficially own in excess of 9.99% of the
shares of Common Stock of the Company outstanding immediately after giving
effect to the exercise of the Note for the number of shares of Common Stock of
the Company to be issued pursuant to this Conversion Notice.
Authorization:
 
By:
 
Title:
 
Dated:
 
Account Number:
 
  (if electronic book entry transfer)
 
Transaction Code Number:
 
  (if electronic book entry transfer)
 

 
 

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ACKNOWLEDGMENT
 
The Company hereby acknowledges this Conversion Notice and hereby directs
American Stock Transfer and Trust Company to issue the above indicated number of
shares of Common Stock in accordance with the Irrevocable Transfer Agent
Instructions dated August 1, 2008 from the Company and acknowledged and agreed
to by American Stock Transfer and Trust Company.
 

 
AEOLUS PHARMACEUTICALS, INC.
 
By:                ___________________      
Name:    ___________________
Title:     ___________________