SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                   FORM 10-KSB

(Mark One)

      |X| ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934

                  For the fiscal year ended December 31, 2005

      |_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

          For the transition period from ___________ to _____________

                         Commission file number: 1-6787

                             HEALTH-CHEM CORPORATION
                 (Name of small business issuer in its charter)

           Delaware                                    13-2682801
(State or other jurisdiction of             (I.R.S. Employer Identification No.)
incorporation or organization)

101 Sinking Springs Lane, Emigsville, PA                 17318
----------------------------------------                 -----
(Address of principal executive offices)               (Zip code)

Issuer's telephone number, including area code: 717-764-1191

Securities registered under Section 12(b) of the Exchange Act: None

Securities registered under Section 12(g) of the Exchange Act:

                          Common Stock, $.01 Par Value
                          ----------------------------

         10.375% Convertible Subordinated Debentures due April 15, 1999
         --------------------------------------------------------------
                                (Title of class)

Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. |_| Yes |X| No

Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained in this form, and no disclosure will be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB. |X|

State the issuer's revenues for its most recent fiscal year: $7,586,000

State the aggregate market value of the voting and non-voting common equity held
by non-affiliates computed by reference to the price at which the common equity
was sold, or the average bid and asked price of such common equity, as of a
specified date within the past 60 days. (See definition of affiliate in Rule
12b-2 of the Exchange Act.): $784,229 as of January 1, 2007.

Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes |X| No |_|

State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 11,443,424 as of February 13, 2007.

                       DOCUMENTS INCORPORATED BY REFERENCE

None.

Transitional Small Business Disclosure Format (Check one): |_| Yes |X| No

<PAGE>

<TABLE>
<S>                                                                                                    <C>
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS ..................................................    3
PART I .............................................................................................    5
   ITEM 1.  DESCRIPTION OF BUSINESS ................................................................    5
   ITEM 2.  DESCRIPTION OF PROPERTIES ..............................................................   29
   ITEM 3.  LEGAL PROCEEDINGS ......................................................................   29
   ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ....................................   30
PART II ............................................................................................   30
   ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ...............................   30
   ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ..   31
   ITEM 7.  FINANCIAL STATEMENTS ...................................................................   43
   ITEM 8.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE ...   43
   ITEM 8A. CONTROLS AND PROCEDURES ................................................................   43
   ITEM 8B. OTHER INFORMATION ......................................................................   43
PART III ...........................................................................................   43
   ITEM 9.  DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH
            SECTION 16(A) OF THE EXCHANGE ACT ......................................................   43
   ITEM 10. EXECUTIVE COMPENSATION .................................................................   46
   ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
            STOCKHOLDER MATTERS ....................................................................   49
   ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS .........................................   50
   ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K .......................................................   51
   ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES .................................................   58
SIGNATURES .........................................................................................   59
</TABLE>


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<PAGE>

                SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

      This Annual Report on Form 10-KSB for the year ended December 31, 2005
("Annual Report") contains forward-looking statements. We have based these
forward-looking statements on our current expectations and projections about
future events. These statements include, but are not limited to:

o     statements relating to our ability to restructure our outstanding past due
      liabilities;

o     statements as to the development of new products and the commercialization
      of products;

o     statements as to the anticipated timing of clinical tests and other
      business developments;

o     expectations as to the adequacy of our cash balances to support our
      operations for specified periods of time and as to the nature and level of
      cash expenditures; and

o     expectations as to the market opportunities for our products, as well as
      our ability to take advantage of those opportunities.

      These statements may be found in the sections of this Annual Report
entitled "Description of Business", "Risk Factors", and "Management's Discussion
and Analysis of Financial Condition and Results of Operations," as well as in
this Annual Report generally. Actual results could differ materially from those
anticipated in these forward-looking statements as a result of various factors,
including all the risks discussed in "Risk Factors" and elsewhere in this Annual
Report.

      In addition, statements that use the terms "can," "continue," "could,"
"may," "potential," "predicts," "should," "will," "believe," "expect," "plan,"
"intend," "estimate," "anticipate," "scheduled" and similar expressions are
intended to identify forward-looking statements. All forward-looking statements
in this Annual Report reflect our current views about future events and are
based on assumptions and are subject to risks and uncertainties that could cause
our actual results to differ materially from future results expressed or implied
by the forward-looking statements. Many of these factors are beyond our ability
to control or predict. Forward-looking statements do not guarantee future
performance and involve risks and uncertainties. Actual results will differ, and
may differ materially, from projected results as a result of certain risks and
uncertainties. The risks and uncertainties include, without limitation, those
described under "Risk Factors" and those detailed from time to time in our
filings with the Securities and Exchange Commission, and include, among others,
the following:

o     our ability to restructure outstanding liabilities and continue as a going
      concern;

o     our ability to successfully develop and commercialize new products;

o     a lengthy approval process and the uncertainty of the Food and Drug
      Administration and other government regulatory requirements;

o     the degree and nature of our competition;

o     our continued ability to obtain certain raw materials from which we
      manufacture our products;

o     our ability to employ and retain qualified employees; and


                                     - 3 -
<PAGE>

o     the other factors referenced in this Annual Report, including, without
      limitation, under the section entitled "Risk Factors", "Management's
      Discussion and Analysis of Financial Condition and Results of Operations,"
      and "Description of Business."

      These risks are not exhaustive. Other sections of this Annual Report may
include additional factors that could adversely impact our business and
financial performance. Moreover, we operate in a very competitive and rapidly
changing environment. New risk factors emerge from time to time, and it is not
possible for our management to predict all risk factors, nor can we assess the
impact of all factors on our business or to the extent to which any factor, or
combination of factors, may cause actual results to differ materially from those
contained in any forward-looking statements. Given these risks and
uncertainties, investors should not place undue reliance on forward-looking
statements as a prediction of actual results. These forward-looking statements
are made only as of the date of this Annual Report. Except for our ongoing
obligation to disclose material information as required by federal securities
laws, we do not intend to update you concerning any future revisions to any
forward-looking statements to reflect events or circumstances occurring after
the date of this Annual Report.


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<PAGE>

                                INTRODUCTORY NOTE

      In July 2006, Health-Chem Corporation filed an Annual Report on Form
10-KSB for the years ended December 31, 2003 and 2004 (the "2004 Annual
Report"). Prior to filing the 2004 Annual Report, Health-Chem had not filed any
annual or quarterly reports with the Securities and Exchange Commission since it
filed an annual report for the year ended December 31, 1998 and quarterly
reports for the first three quarters of 1999 in November 1999. This annual
report covers the year ended December 31, 2005 and includes audited financial
statements for the year then ended but includes information through a recent
practicable date with respect to certain topics we believe are of particular
importance to readers, such as information with respect to the business of
Health-Chem and its directors, executive officers and principal stockholders. To
the extent this Annual Report references financial information relating to 2006,
said information is drawn from internally prepared financial statements and has
not been audited, as noted in each case where reference to that information is
made.

                                     PART I

ITEM 1. DESCRIPTION OF BUSINESS.

Overview.

      Health-Chem Corporation ("Health-Chem") and its subsidiaries (Health-Chem
and its subsidiaries collectively may be referred to as "we", "us", the
"Company" or by like terms) manufacture controlled release products to deliver
drugs topically or transdermally (transdermal patches). Currently, our sole
product is a prescription transdermal patch which delivers nitroglycerin for use
in the relief of the vascular and cardiovascular symptoms related to angina
pectoris (chest pain); however, we have the manufacturing capability to produce
transdermal patches which deliver other medications. We manufacture our
nitroglycerin patch both on a contract basis for specific clients and for sale
to distributors and wholesalers for distribution in the United States. We
manufacture our products in accordance with Good Manufacturing Practices, or
GMP's, prescribed by the United States Food and Drug Administration, or FDA, at
our facility in Emigsville, Pennsylvania. We conduct the majority of our
business through Transderm Laboratories Corporation ("Transderm"), of which
Health-Chem owns 90% of the outstanding common stock.

Current Financial Condition of Health Chem.

      As of December 31, 2005, the Company had total current liabilities of
approximately $19.7 million which includes (i) $10.8 million of principal and
interest due under certain convertible subordinated debentures due April 15,
1999 ("Debentures"), under which we are in default, (ii) $6.1 million of
royalties due under a license with Key Pharmaceuticals, Inc., or Key, under
which we are in breach (the "Key License"), and (iii) $2.8 million of million of
trade payables and other miscellaneous liabilities. The notes to our financial
statements for the year ended December 31, 2005 and the auditor's report
accompanying said financial statements indicate that these liabilities and our
working capital deficiency raise substantial doubt about our ability to continue
as a going concern, as more fully described in "Item 6. Management's Discussion
and Analysis or Plan of Operation." The following is a description of our
obligations under the Debentures and the Key License.

      The Debentures

      On April 15, 1981, Health Chem sold and issued 10.375% convertible
subordinated Debentures due April 15, 1999 in the principal amount of $20
million under the terms of an Indenture between the Company and Bankers Trust
Company (now Deutsche Bank Trust Company Americas), as trustee (the "Trustee").
Interest on the Debentures was payable semi-annually on April 15 and October 15
in each year. The Debentures:


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<PAGE>

o     were convertible into shares of the Company's common stock at a conversion
      price of $19.52 per share (as adjusted), through April 15, 1999;

o     were redeemable (i) in whole or in part at any time after October 15, 1982
      at the option of the Company at 108.82% of the principal amount thereof
      decreasing to 100% of the principal amount if redeemed after April 15,
      1991 and (ii) by operation of a sinking fund whereby the Company was
      required to redeem Debentures in the aggregate principal amount of $1.5
      million on April 15 of each year commencing in 1991 to and including 1998;

o     were subordinated in right of payment to the prior payment of all "senior
      indebtedness" (as defined in the Indenture governing the Debentures);

o     restricted the Company, in certain cases, from (i) declaring or making any
      distribution on its capital stock or to its stockholders (other than
      dividends payable in its capital stock) or (ii) purchasing, redeeming or
      otherwise acquiring or retiring for value any of its capital stock or
      permit any subsidiary to do so;

o     were subject to certain default provisions typical of debt instruments and
      which provide that upon an event of default, the Trustee or the holders of
      at least 25% in aggregate principal amount of all Debentures may declare
      the outstanding principal of the Debentures plus all accrued and unpaid
      interest immediately due and payable.

      Since the date we issued the Debentures:

o     From 1981 through 1998, we paid interest on the Debentures as it became
      due from cash flow from operations.

o     We satisfied our obligations under the sinking fund provisions of the
      Indenture by redeeming or repurchasing Debentures in the principal amount
      of $1.5 million per year from 1991 through 1998.

o     We made a $1.9 million payment on our debt obligations in respect of the
      Debentures out of the proceeds of the sale of certain assets in August
      1999 but have not made any principal or interest payments with respect to
      the Debentures since that date.

o     No Debentures have been converted into common stock.

      In April 1999, the Company defaulted on its obligations to repay the $8.0
million in principal then outstanding as well as the accrued interest of $.4
million due on the Debentures at maturity. The Company has remained in sporadic
contact with the Trustee for the Debentures since it defaulted but has not had
the funds to make any payments or principal or interest since August 1999.

      As of December 31, 2005 and 2006, the Company owed $10,830,000 and
$11,463,000 (unaudited), respectively, of principal and interest on the
Debentures.

      The Company periodically has entered into agreements with the Trustee,
including:


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<PAGE>

o     tolling agreements which provide, among other things, that the Company
      would not use the statute of limitations as a defense in any claim against
      the Company under the Debentures or the Indenture, the latest of which
      agreements extends through the earlier of April 15, 2007 or 120 days after
      the Trustee shall have received from the Company or the Company shall have
      received from the Trustee or a majority of the holders of Debentures then
      outstanding, a notice stating that the agreement shall be terminated 120
      days after receipt thereof; and

o     an agreement whereby the Company agreed: (i) to use its best efforts to
      adopt a plan to repay the Debentures at the earliest practical date; (ii)
      that pending a repayment plan, it will not make any payments to insiders
      except for salaries and benefits due and becoming due to them and that
      insiders can receive pari passu payments on Debentures they hold; and
      (iii) to give the Trustee not less than two business days' notice before
      engaging in any extraordinary transactions

      We recently have been communicating with the Trustee as to repaying the
debt represented by such instruments but have not entered into formal
negotiations with respect to any plan to repay or restructure this debt. Any
failure to enter into an agreement with the Trustee to restructure the repayment
provisions of the Debenture on terms favorable to us could have a material
negative impact on our Company, as more fully described under the heading "Risk
Factors."

      Key License

      Our second generation transdermal patch technology developed during the
mid 1990's incorporates certain technology which, unbeknownst to us at the time
of development, was the subject of a patent held by Key, a subsidiary of
Schering-Plough Corporation. In December 1997, Key obtained a court order
enjoining us from manufacturing or selling any transdermal nitroglycerin patches
that have been found to infringe Key's patent, before the expiration of Key's
patent on February 16, 2010. In March 2000, we acquired a non-exclusive license
from Key to manufacture and sell any drug-in-adhesive transdermal nitroglycerin
patch product developed by the Company either before or during the term of the
license and provided for the payment of a royalty per unit sold in amounts
ranging from $2 to $3, based upon the dosage delivered (the "Key License"). The
Key License extends through the expiration of Key's patent. We have never made
royalty payments under the Key License and are in breach thereof. As of December
31, 2005 and 2006, we owed aggregate royalties to Key of approximately $6.1
million and $7.3 million (unaudited), respectively. We currently are discussing
a payment plan with Key with respect to payment of past due royalties. Any
failure to negotiate a repayment agreement with Key on terms favorable to us
could have a material negative impact on our Company, as more fully described
under the headings "Risk Factors" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations."

Transdermal Delivery Systems.

      Transdermal systems deliver drugs through the skin into the bloodstream.
These systems utilize a special membrane to control the rate at which the liquid
drug contained in the patch can pass through the skin and into the bloodstream
(plasma). Transdermal drug delivery involves the inherent challenge of
overcoming the skin barrier. Skin protects the body from the environment very
effectively and generally is only permeable to small molecule, lipophilic (oil
soluble) drugs which require only limited dose sizes. Transdermal delivery
systems, therefore, not only have to provide drug to the skin under stable
conditions in controlled dosages and in a format convenient to the patient, but
also serve to locally increase the permeability of skin to larger, charged, or
hydrophilic (easily dissolved in water) drug molecules while minimizing
irritation.


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<PAGE>

      The first transdermal patch was approved by the FDA in 1979. It contained
the drug scopolamine used to prevent the nausea and vomiting associated with
motion sickness. In 1981, the FDA approved a patch for nitroglycerin and as of
2003 transdermal patches have been approved to deliver 15 molecules spanning 35
different drugs, including combination patches utilized for, among other
purposes, contraception and hormone replacement. Developments and improvements
to transdermal systems are being made rapidly.

      Transdermal drug delivery has numerous advantages over conventional drug
delivery methods. In contrast to orally delivered drugs, compounds entering the
body through the skin escape first-pass metabolism in the liver (which may
destroy the drug), often resulting in higher bioavailability of the drug.
Transdermal delivery is effective for use in patients who experience nausea from
the medication because there are few or no gastrointestinal effects from the
drug itself and is useful for those drugs that have poor oral uptake, need
frequent administration or that interact with stomach acid and allows effective
use of drugs with short half-lives that otherwise require large initial doses
(bolus dosing) to achieve desired drug levels, such as nitroglycerin. As a
result, the side effects, or variability in therapeutic effect due to peaks and
troughs in plasma concentration, that are seen with bolus administration are
minimized. In contrast to intravenous drug delivery, transdermal administration
is noninvasive and poses little risk of infection. It is also relatively easy
for patients to apply and remove a transdermal system.

Our Nitroglycerin Transdermal Patch.

      In 1986, we introduced the first FDA-approved generic transdermal
nitroglycerin patch into the United States market. Nitroglycerin, also known as
glycerin trinitrate, provides relief from the vascular and cardiovascular
symptoms related to angina pectoris or angina. Angina pectoris, or "heart pain,"
is the chest discomfort that occurs when the blood oxygen supply to an area of
the heart muscle does not meet the demand. Nitroglycerin corrects the imbalance
between the flow of blood and oxygen to the heart and relieves the work that the
heart must do by dilating the arteries and veins in the body. Dilation of the
veins reduces the amount of blood that returns to the heart that must be pumped.
Dilation of the arteries lowers the pressure in the arteries against which the
heart must pump. As a consequence, the heart works less and requires less blood
and oxygen. Additionally, nitroglycerin preferentially dilates blood vessels
that supply the areas of the heart where there is not enough oxygen, thereby
delivering oxygen to the heart tissue that needs it most.

      Since no one holds a valid patent covering nitroglycerin, which would
grant to the patent holder the exclusive right to sell the drug while the patent
is in effect and which is intended to protect the holder's development
investment, others can seek to obtain FDA approval to sell nitroglycerin based
products, assuming the proposed product meets certain specific criteria, by
submitting an Abbreviated New Drug Application, or ANDA. The ANDA approval
process can be substantially quicker and significantly less expensive than the
new drug approval process because the applicant can rely on results collected
from clinical trials conducted by the original drug developer.

      Our nitroglycerin transdermal patch comprises a multi-layer
drug-in-adhesive system wherein the medication and all the excipients (the inert
substances used as diluents or vehicles for a drug) are incorporated into a
membrane between two distinct drug-in-adhesive layers under a single backing
film. Our patch is comprised of three layers; a transparent outer backing layer
composed of a composition plastic film and printed with the name of the drug and
strength; nitroglycerin in a acrylic-based polymer adhesive with a cross-linking
agent; and a protective, translucent peelable liner which covers the second
layer and must be removed prior to use. Our nitroglycerin transdermal patch is
AB2 rated, which means it is considered bioequivalent to Novartis' NitroDerm(TM)
product based on clinical trial data. Our patch is a one-day use patch and is
sold in shelf cartons, with each shelf carton containing thirty patches. Our
patch is produced in three different dosage sizes, with each size delivering
different milligrams per hour (mg/hr) amounts of nitroglycerin to the patient.
The three sizes are: 0.2mg/hr, 0.4mg/hr and 0.6mg/hr.


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<PAGE>

      As described above under the heading "Current Financial Condition of
Health Chem" we have acquired a license which allows us to incorporate certain
technology into our current generation transdermal patches which is the subject
of a patent owned by Key. We currently are in default under the Key License for
failure to pay royalties due, aggregating $6,108,000 and $7,315,000 (unaudited)
as of December 31, 2005 and 2006, respectively, and if we are prevented from
utilizing the Key technology, we would have to discontinue selling our
transdermal patches unless we could develop our own technology to replace that
covered by the Key License or otherwise locate and obtain a license for similar
technology which can be incorporated into our manufacturing process, of which we
can give no assurance. See "BUSINESS-Risk Factors" and "Management's Discussion
and Analysis of Financial Statements and Results of Operations."

Research and Development.

      Our research and development efforts are severely constrained by our lack
of cash, as described elsewhere in this Annual Report, and other than activities
currently being undertaken for third parties as described below, we are not
engaging in any research and development on our own behalf.

      If and when we possess cash sufficient to resume our research and
development activities, we expect that our strategy will be to identify generic
drugs which can be delivered transdermally, which are suitable for transdermal
delivery, which correspond with our technical and manufacturing capabilities and
which we believe have substantial market potential or for which a product niche
may exist. We may also explore developing transdermal products that use
FDA-approved drugs that currently are being delivered to patients through means
other than transdermal delivery. In addition, we may seek to supplement our
research and development efforts by entering into research and development
agreements, joint ventures and other collaborative arrangements with other
companies.

      By focusing on bringing new products to market based upon unprotected,
generic drugs that are then being delivered transdermally, we will not have to
bear the same level of research and development and other expenses associated
with bringing a new drug formulation to market. Thus, we believe that we would
be able to charge significantly less for a product, a decided competitive
advantage in our industry, given that managed care organizations typically favor
generic products over brand name drugs, and governments encourage, or under some
circumstances, mandate generic drugs.

      We currently are developing transdermal products for two companies, one of
which has engaged us to assist in the development of two drug formulations to be
delivered transdermally. In all cases, we act as an independent contractor for
the party that engaged us and said party owns all intellectual property which
may emanate from the projects we are retained to complete or the services which
we render.

      In February 2001, we entered into a series of agreements with Ranbaxy
Pharmaceuticals Inc., or Ranbaxy, namely a Product Purchase Agreement,
Development Assistance Agreement and Finished Goods Supply Agreement. Under
these agreements, we:

      o     granted a worldwide, non-exclusive, royalty-free license to Ranbaxy
            to use certain intellectual property we developed relating to the
            transdermal delivery of a certain generic pharmaceutical compound;

      o     acquired a license from Ranbaxy to use certain intellectual property
            it had developed in connection with the pharmaceutical compound and
            were retained by Ranbaxy to assist in the development of commercial
            products to deliver the pharmaceutical compound transdermally; and


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      o     agreed to supply the products which may be developed and approved by
            the FDA exclusively to Ranbaxy which agreed to purchase from us all
            of its requirements for such products from us on an exclusive basis.

      We recently completed certain milestones under these agreements, including
producing a supply of the pharmaceutical compound which permitted Ranbaxy to
complete pilot bioequivalence study results which were filed by Ranbaxy with the
FDA as part of the ANDA filed in connection with this compound.

      Under our Development Assistance Agreement with Ranbaxy, we have
undertaken to provide certain services, including, completing the development of
the initial formulation of the pharmaceutical compound for transdermal delivery,
demonstrating that our production techniques can be scaled-up to meet
anticipated production runs of the transdermal patch, providing all laboratory
data relating to the utilization of our patch technology for this pharmaceutical
compound, completing documentation necessary for GMP production of the product,
providing dosage forms for the pilot and bioequivalence studies, conducting the
pilot and other studies and providing underlying documentation required for
Ranbaxy to gain regulatory approval for the product and support Ranbaxy's ANDA
filing. We are performing under this agreement as requested by Ranbaxy

      Under our Finished Goods Supply Agreement, Ranbaxy granted us a license to
utilize certain intellectual property we will require for the manufacture of the
products which are the subject of the agreement and we have agreed to supply
Ranbaxy with such product in the strengths and amounts as Ranbaxy may require
for its bioequivalence studies. Thereafter, assuming Ranbaxy's ANDA for this
product is approved by the FDA, of which neither we nor Ranbaxy can be certain,
we will manufacture and supply Ranbaxy with all of its commercial requirements
of the product, subject to its right to acquire the product elsewhere if we are
unable to furnish the supplies it requires, under the circumstances provided in
the agreement. We have agreed to sell the product exclusively to Ranbaxy. We
also have agreed to conform to GMP's in connection with the manufacture of the
product and otherwise supply product in conformity with Ranbaxy's specifications
as enumerated in the agreement which relate to quality control, packaging and
labeling, among other things. Ranbaxy will pay us fixed prices for the products
of various dosages and a royalty in excess of the per product price in the event
it achieves certain net sales milestones. The agreement has a ten-year term from
the date of the first commercial sale of the products. We have agreed to
indemnify Ranbaxy for damages resulting from, among other things, our
formulation or manufacturing of the product and Ranbaxy has agreed to indemnify
us for damages relating to regulatory improprieties.

      In June 2004, we entered into a Development, Manufacturing and Supply
Agreement with Ranbaxy relating to a generic pharmaceutical compound subject to
transdermal delivery. Under the agreement, we have been engaged to manufacture
and supply products for use both in connection with Ranbaxy's regulatory
approval requirements and ANDA application and thereafter, if FDA approval is
granted, of which neither we nor Ranbaxy can be certain, on an ongoing basis to
meet its requirements. In furtherance of our efforts, Ranbaxy extended a loan to
us in the amount of $166,664 to purchase certain equipment required in
connection with our obligations under the agreement which is repayable by
offsetting amounts payable for product which may eventually be purchased from
us, agreed to pay for the active pharmaceutical ingredient incorporated into the
product during the trial phases and to pay for a contract research organization
to conduct bioequivalence studies of the proposed product. Our obligations under
this agreement are similar to those in our agreement with Ranbaxy described
above. For example, we have agreed to conform to GMP's in connection with the
manufacture of the product and otherwise supply product in conformity with
Ranbaxy's specifications as enumerated in the agreement which relate to quality
control, packaging and labeling, among other things, and in accordance with all
applicable laws. The successful completion of the development portion of the
agreement could yield us an aggregate of $678,800 of gross revenues, payable in
tranches upon achieving certain milestones. Ranbaxy will purchase products from
us calculated in relation to the price we pay for the underlying pharmaceutical
ingredient and in the event that the price for said ingredient exceeds the
maximum amount set forth in the agreement, Ranbaxy may terminate the agreement
as to that specific product. We have agreed to indemnify Ranbaxy for damages
resulting from, among other things, our development and related obligations
under the agreement and Ranbaxy has agreed to indemnify us for damages relating
to regulatory improprieties.


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<PAGE>

      In April 2006, we entered into a Development, Manufacturing and Supply
Agreement with Cure Therapeutics, Inc., or CTI, relating to the development of a
transdermal patch which delivers two generic pharmaceutical compounds which will
be utilized for new indications (that is, the treatment of conditions not
covered by the original FDA approval) for such drugs. Under the agreement, CTI
engaged us to undertake all processing of the pharmaceutical compound for the
purpose of filing a new drug application, or NDA, with the FDA and to
manufacture and supply sufficient quantities of the compound required for
obtaining approval of the NDA. Our engagement is divided into three stages:
technology transfer, formulation optimization, and scale-up; FDA phase 2
clinical trial batch manufacturing; and FDA phase 3 clinical trial batch
manufacturing. Our obligations under the agreement include all manner of
analyzing, testing, optimizing the formulation of or process by which clinical
trial products are made, creation of dedicated tooling, scaling-up our
manufacturing facility to produce commercial quantities of product, finishing,
packaging, inspecting, labeling and preparing product for shipment, all as
required under applicable law. In addition, we are required to maintain data and
records with respect to all aspects of the foregoing for the specific purpose of
filing same with the FDA with respect to the NDA and to report to CTI with
respect to each phase of the process. CTI pays us fees upon our successful
completion of milestones enumerated in the agreement. We are currently working
on the second stage under the agreement. CTI has agreed, at its own cost and
expense, to engage a contract research organization to conduct safety and
efficacy studies of the clinical trial products we manufacture and, in the event
that such studies fail to demonstrate the safety or efficacy of such products,
CTI may terminate the agreement. We have agreed to conform to GMP's in
connection with the manufacture of the product and otherwise supply product in
conformity with CTI's specifications as enumerated in the agreement which relate
to quality control, packaging and labeling, among other things, and in
accordance with all applicable laws. We have agreed to indemnify CTI for damages
resulting from, among other things, our performance of or failure to perform our
obligations under the agreement and CTI has agreed to indemnify us for damages
relating to regulatory improprieties. Each party has agreed to maintain the
confidentiality of the other's confidential information. The agreement has a
term of two years but is subject to prior termination by either party in the
event of a material breach by the other party and by CTI for any reason at any
time upon written notice. The parties recognize the possibility that no
commercial product may arise from their efforts.

      We are also conducting a number of feasibility studies on transdermal
products which we may develop independently or on behalf of client companies and
are pursuing additional contract manufacturing opportunities. We do not
undertake clinical studies. As a contract manufacturer for developing products,
it would be the responsibility of our client to undertake and bear the cost of
these clinical studies, including preparing and filing all documents required by
the FDA. We would, however, perform routine chemical analysis of these products
to determine if they meet proposed product specifications.

      For the years ended December 31, 2005, 2004 and 2003, we spent $438,000,
$414,000 and $418,000, respectively, for research and development activities.
Our research and development expense may vary significantly from quarter to
quarter and year to year depending on product development cycles, the timing of
clinical studies and whether we or a third party are funding development. These
variations in research and development spending may not be accurately
anticipated and may have a material effect on our results of operations.
Currently, research and development personnel engage in assisting with technical
transfers of existing formulation and test methodology to our production
facility. In addition, our personnel perform small scale development work on
behalf of clients, including producing hand cut transdermal patches on a
research laminator for analytical testing or performing permeation studies to
demonstrate how drug formulations penetrate a skin layer. Our personnel also
work on improving test methods that may impact day to day testing requirements
for commercial products. We periodically outsource analytical testing because we
do not possess the appropriate equipment or outsourcing is more economically
efficient if the test is not of a routine nature.


                                     - 11 -
<PAGE>

      The time necessary to complete clinical trials and the regulatory process
to obtain marketing approval varies significantly. We cannot assure that we will
have the financial resources necessary to complete products which we propose to
develop, that those projects to which we dedicate resources will be successfully
completed, that we will be able to obtain regulatory approval for any such
product, or that any approved product may be produced in commercial quantities,
at reasonable costs, and be successfully marketed. Similarly, we cannot assure
that our competitors, most of which have greater resources than we do, will not
develop and introduce products that will adversely affect our business and
results of operations.

Manufacturing.

      We conduct our manufacturing operations in a single facility comprised of
an approximately 61,000 square foot building located on approximately 3.5 acres
in Emigsville, Pennsylvania. Our products are manufactured in accordance with
GMP's prescribed by the FDA. The FDA visited our facility in November 2003 and
June 2006 and issued establishment inspection reports. The reports indicated
that there were no objectionable conditions or practices noted during their
reviews. The FDA did not issue a Form FDA 483 (Inspectional Observations) report
during either of these two visits. The FDA uses the Form FDA 483 report to
communicate all observations of objectionable conditions noted during their
inspection process. This facility has also been licensed by the United States
Drug Enforcement Administration ("DEA") to conduct research and manufacture
products containing Schedule II controlled substances. To bring new products to
market as quickly as possible, we will seek to have the manufacturing capacity
to produce the new product prior to obtaining FDA approval.

      Our products are manufactured according to current GMP's as specified by
federal regulations which require us to maintain and update procedures and
specifications as provided under federal law. We must maintain records that
demonstrate the application of raw materials from receipt to use in a finished
product. In addition, any complaints received must be documented and
investigated. We are obligated to submit to the FDA reports covering our
marketed products that include both chemistry information and adverse event
information on an annual basis. If we do not adhere to current GMP's, the FDA
could seek an injunction barring commercial distribution of our products, among
other things.

      The manufacture of advanced transdermal drug delivery systems requires
specialized skills in several areas, as well as specialized manufacturing
equipment. The Company's process development and design engineers work closely
with the research and development department starting early in the product
design stage, which renders the manufacturing development process more
efficient. All scale up work (spanning the gamut of initial research on a
potential product to large-scale manufacturing for clinical and stability work),
commencing with initial product development trials, is conducted on full-size,
completely functional manufacturing equipment, reducing delays in the
development and approval process and smoothing the transition to commercial
production. Some of this equipment is manufactured in-house; the balance is
fabricated by outside manufacturers to the Company's specifications. The Company
believes that this equipment provides a decided advantage in the manufacture of
the complex multi-layer systems necessary for successful transdermal drug
delivery. The Company currently has assembly packaging equipment in place having
a single shift capacity of over 24 million patches annually. The Company
believes that its current manufacturing facility is adequate for its intended
purpose and will be sufficient for product expansion for the foreseeable future.


                                     - 12 -
<PAGE>

      As part of the manufacturing process, the Company has developed and
performs appropriate quality control procedures including testing of all raw
materials and finished product. Quality control procedures are specific checks
and balances performed on raw materials and finished product to ensure materials
adhere to the predetermined specifications.

      Several raw materials used in the manufacture of the Company's products
are only available from single sources, all of which are domestic companies.
These materials have generally been available to the Company and the
pharmaceutical industry on commercially reasonable terms. To date, the Company
has not experienced difficulty acquiring necessary materials. The Company will
seek to negotiate supply agreements, as appropriate, for certain components.

      Any curtailment in the availability of such raw materials could result in
production or other delays, and, in the case of products for which only one raw
material supplier exists, could result in a material loss of sales, with
consequent adverse effects on our business and results of operations. In
addition, because most raw material sources for transdermal patches must
generally be approved by regulatory authorities, changes in raw material
suppliers may result in production delays, higher raw material costs and loss of
sales, customers and market share.

      We do not believe that compliance with federal, state or local laws and
regulations which have been enacted or adopted regulating the discharge of
materials into the environment or otherwise relating to the protection of the
environment has had or will have any material effect upon our capital
expenditures, earnings or competitive position. There can be no assurance,
however, (i) that changes in federal, state or local laws or regulations,
changes in regulatory policy or the discovery of unknown problems or conditions
will not in the future require substantial expenditures, or (ii) as to the
extent of the Company's liabilities, if any, for past failures, if any, to
comply with laws, regulations and permits applicable to its operations. Any
interruption of supply could have a material adverse effect on the Company's
ability to manufacture its products.

Marketing and Sales.

      We have contracted with a full-service sales and marketing outsourcing
company that focuses on generic and branded pharmaceutical companies to handle
the majority of the sales and marketing efforts for our transdermal
nitroglycerin product. This company monitors client sales, as well as examines
our competition in order to anticipate and recommend changes to our sales,
marketing and promotional strategy. This company also assists in providing the
industry contacts to reach all distribution channels.

      We have engaged Cardinal Health, Inc. as a non-exclusive distributor of
our transdermal patches pursuant to an agreement dated October 1, 2001. We sell
product to Cardinal at our list price and Cardinal is entitled to receive
certain discounts and rebates as stipulated in the agreement. During the years
ended December 31, 2003, 2004 and 2005, Cardinal purchased products representing
in excess of 10% of our total sales.

      We market our products directly to wholesalers, distributors, retail
pharmacy chains, mail order pharmacies and group purchasing organizations. We
also market our products indirectly to independent pharmacies, managed care
organizations, hospitals, nursing homes and pharmacy benefit management
companies, collectively referred to as "indirect customers." We may enter into
agreements with our indirect customers to establish contract pricing for certain
products. The indirect customers then independently select a wholesaler from
which they actually purchase the products at these contracted prices.
Alternatively, certain wholesalers may enter into agreements with indirect
customers which establish contract pricing for certain products which the
wholesalers provide.


                                     - 13 -
<PAGE>

Competition.

      The market for our nitroglycerin transdermal patches is highly
competitive. Because nitroglycerin is a generic drug, companies willing and able
to comply with FDA and other applicable regulations can produce nitroglycerin
based products. Moreover, nitroglycerin can be administered utilizing a wide
array of conventional and alternate forms of drug delivery. Accordingly, our
product faces intense competition from a diverse group of domestic and
multinational companies most of which possess significantly greater financial
and personnel resources than we do and that includes:

o     large conglomerates of which pharmaceutical nitroglycerin formulations,
      including nitroglycerin based products, represent only a portion of the
      products they offer;

o     pharmaceutical companies of all sizes which focus on the development of
      advanced transdermal systems which deliver nitroglycerin;

o     pharmaceutical companies which offer nitroglycerin based products
      delivered other than transdermally or other formulations which relieve
      angina; and

o     companies that offer alternate non-drug therapies.

      In addition, medical science is constantly evolving and the entities
against which compete may change in the future. As developments in medicine are
made, drugs and delivery methods may become obsolete or fall out of favor with
physicians.

      Most of our competitors have substantially greater financial resources and
larger research and development staffs than we do and may have substantially
greater experience in developing products, in obtaining regulatory approvals and
in manufacturing and marketing pharmaceutical products. Many other
pharmaceutical companies have the financial resources to acquire the skills
necessary to develop transdermal systems.

      Advances in transdermal patch technology have intensified over the last
several years. As new materials have been developed which allow for more
efficient delivery of drugs through the patch membrane and adhesive,
manufacturers have been able to develop smaller patches which are more
comfortable for the user. New adhesive technologies have recently been
incorporated into patches which have selective adhesive properties once in
contact with the skin, exhibit substantial strength of initial adhesion and
duration of adhesion and are compatible with skin and various drug molecules.
Other advances in patch technology include the development of chemical
penetration enhancers, substances that make the skin more permeable and allow
drug molecules to cross the skin at a faster rate, and the development of
micro-needles to enlarge the skin pores through which drugs flow. In addition,
active transdermal patches which use energy, such as electricity and ultrasound,
to enhance the extent and rate at which pharmaceutical compounds cross the skin
and which will allow for larger drug molecules to be delivered transdermally,
are being developed at a rapid rate. All of these new transdermal technologies
could supplant our technology and render our product obsolete.

      Since we manufacture a generic drug product and are not subject to the
myriad of factors which impact drug developers, such as high development costs
and establishing name and brand recognition, we believe that the principal
factors that bear upon our competitive position are price, consistency and
quality of product, our ability to deliver product on a timely basis,
reliability and patient convenience. We have been manufacturing nitroglycerin
patches for nearly twenty years and believe that we have gained significant
experience that contributes to our ability to compete effectively in the market.
The Company's competitive position will also depend on its ability to attract
and retain qualified scientific and other personnel, develop effective
proprietary products, implement production and marketing plans, effect
distribution of its products, obtain patent protection and secure adequate
capital resources.


                                     - 14 -
<PAGE>

Patents and Proprietary Rights.

      We seek to obtain patent protection on our delivery systems and
manufacturing processes whenever possible. We have obtained eleven United States
and foreign patents and trademarks relating to our transdermal delivery systems
and manufacturing processes. While we view our patents and trademarks as a
valuable asset, we do not consider any single patent or trademark to be of
material importance to our business as a whole.

      As a result of changes in United States patent law under the General
Agreement on Tariffs and Trade and the accompanying agreement on Trade-Related
Aspects of Intellectual Property Law, which took effect in their entirety on
January 1, 1996, the terms of some of our existing patents have been extended
beyond the original term of seventeen years from the date of grant. Our patents
filed after June 7, 1995 will have a term of twenty years computed from the
effective filing date.

      We are unaware of any challenge to the validity of our patents or of any
third party claim of patent infringement with respect to any of our products, in
either case that could have a material adverse effect on our business or
prospects.

      Although there is a statutory presumption as to a patent's validity, the
issuance of a patent is not conclusive as to such validity, or as to the
enforceable scope of the claims of the patent. We cannot assure that our patents
or any future patents will prevent other companies from developing similar or
functionally equivalent products. We cannot assure that we would have the
resources to prosecute an action to enforce our patent rights against an alleged
infringer or that we would be successful in any infringement action that we
elect to bring. Likewise, we cannot assure that we would have the resources to
defend an infringement action or that we would be successful in any such
defense. Furthermore, we cannot assure that any of our future processes or
products will be patentable, that any pending or additional patents will be
issued in any or all appropriate jurisdictions or that our processes or products
will not infringe upon the patents of third parties. In addition, since our
patents typically cover our product formulation rather than the compound being
delivered, competitors may seek to create functionally equivalent products
(i.e., patches delivering the same compound over the same time period to treat
the same indication) that avoid our patents. In those cases, we may face
competition from functionally equivalent products even before our patents
expire.

      We also attempt to protect our proprietary information under trade secret
and confidentiality agreements. Generally, our agreements with each employee,
client, consultant and agent contain provisions designed to protect the
confidentiality of our proprietary information. There can be no assurance that
these agreements will not be breached, that we will have adequate legal remedies
as a result thereof, or that our trade secrets will not otherwise become known
or be independently developed by others.

Government Regulation.

      Our operations are subject to extensive regulation by governmental
authorities in the United States and in other countries in which we or our
distributors may sell products which we manufacture in the future with respect
to the testing, approval, manufacture, labeling, marketing and sale of
pharmaceutical products and the possession and use of controlled substances. We
devote significant time, effort and expense to address the extensive government
regulations applicable to our business.


                                     - 15 -
<PAGE>

      The marketing of pharmaceutical products requires the approval of the FDA
in the United States. The process for obtaining such approval varies depending
upon the nature of the product we are seeking to manufacture and sell. The FDA
has established regulations, guidelines and safety standards, which apply to the
pre-clinical evaluation, clinical testing, manufacturing and marketing of
pharmaceutical products. New drugs or drugs to be delivered by a new route of
administration are subject to a more lengthy approval process. Typically, drugs
that, among other factors, have been previously approved by the FDA are subject
to a less stringent, less time consuming and less expensive approval process.

      The process of obtaining FDA approval for a new product may take several
years or more and is likely to involve the expenditure of substantial resources.
The steps required before a product can be produced and marketed for human use
typically include: (i) pre-clinical studies; (ii) submission to the FDA of an
Investigational New Drug Exemption ("IND"), which must become effective before
human clinical trials may commence in the United States; (iii) adequate and well
controlled human clinical trials; (iv) submission to the FDA of a New Drug
Application ("NDA"); and (v) review and approval of the NDA by the FDA. Approval
of a product by the FDA does not serve as a guaranty of the product's safety or
efficacy.

      Generally, products with new active ingredients, new indications, new
routes of administration, new dosage forms or new strengths require an NDA to be
filed with the FDA. An NDA requires that complete clinical studies of a
product's safety and efficacy be submitted to the FDA, the cost of which is
substantial. These costs can be reduced, however, for delivery systems that
utilize approved drugs. In these cases, the company seeking approval may refer
to safety and toxicity data reviewed by the FDA in its approval process for the
innovator product. In addition, a supplemental NDA may be filed to add an
indication to an already approved product.

      Since we expect that any new products we may bring to market will contain
drugs previously approved by the FDA for transdermal delivery, an abbreviated
approval process may be available. Such products must have, among other
requirements, the same active ingredient(s), indication, route of
administration, dosage form and dosage strength as an existing FDA-approved
product covered by an NDA, if clinical studies have demonstrated bio-equivalence
of the new product to the FDA-approved product covered by an NDA. For this
abbreviated process, we would submit an ANDA to the FDA instead of an NDA. Under
FDA ANDA regulations, companies that seek to introduce an ANDA product must also
certify that the product does not infringe on any approved product's patent
listed with the FDA or that such patent has expired. If the applicant certifies
that its product does not infringe on the approved product's patent or that such
patent is invalid, the patent holder may institute legal action to determine the
relative rights of the parties and the application of the patent. Under the Drug
Price Competition and Patent Term Restoration Act of 1984 (the "Hatch-Waxman
Act"), the FDA may not finally approve the ANDA until the later of thirty months
from the date of the legal action or a final determination by a court that the
applicable patent is invalid or would not be infringed by the applicant's
product.

      With respect to any new products we may seek to develop, the results of
our product development and pre-clinical and clinical studies (if necessary)
will be submitted to the FDA as an NDA or ANDA for approval. If an application
is submitted, there can be no assurance that the FDA will review and approve the
NDA or ANDA in a timely manner. The FDA may deny an NDA or ANDA if applicable
regulatory criteria are not satisfied or it may require additional clinical
testing. Even if such data is submitted, the FDA may ultimately deny approval of
the product. Further, if there are modifications to the drug, including changes
in indication, manufacturing process, labeling, or a change in manufacturing
facility, an NDA or ANDA notification may be required to be submitted to the FDA
and FDA approval required prior to implementation of the change. Product
approvals may be withdrawn after the product reaches the market if compliance
with regulatory standards is not maintained or if problems occur regarding the
safety or efficacy of the product. The FDA may require testing and surveillance
programs to monitor the effect of products that have been commercialized, and
has the power to prevent or limit further marketing of these products based on
the results of these post-marketing programs.


                                     - 16 -
<PAGE>

      Manufacturing facilities are subject to periodic inspections for
compliance with the FDA's good manufacturing practices regulations and each
domestic drug manufacturing facility must be registered with the FDA. In
addition, our manufacturing operations must be registered with the Pennsylvania
Department of Health. In complying with standards set forth in these
regulations, we must expend significant time, money and effort in the area of
quality assurance to ensure full technical compliance. Facilities handling
controlled substances, such as ours, also must be licensed by the DEA, and are
subject to more extensive regulatory requirements than those facilities not
licensed to handle controlled substances. We also require approval of the DEA to
obtain and possess controlled substances. We produce transdermal drug delivery
products in accordance with United States regulations for manufacturing process
validation studies and commercial sale. FDA approval to manufacture a drug
product is site specific. In the event our approved manufacturing facility
becomes inoperable, obtaining the required FDA approval to manufacture such drug
at a different manufacturing site could result in production delays, which could
adversely affect our business and results of operations.

      Failure to comply with governmental regulations may result in fines,
warning letters, unanticipated compliance expenditures, interruptions or
suspension of production and resulting loss of sales, product seizures or
recalls, injunctions prohibiting further sales, withdrawal of previously
approved marketing applications and criminal prosecution.

      Our activities are subject to various federal, state and local laws and
regulations regarding occupational safety, sales practices, laboratory
practices, environmental protection and hazardous substance control, and may be
subject to other present and possible future local, state, federal and foreign
regulations. Under certain of these laws, we could be liable for substantial
costs and penalties in the event that waste is disposed of improperly. While it
is impossible to accurately predict the future costs associated with
environmental compliance and potential remediation activities, compliance with
environmental laws is not expected to require significant capital expenditures
and has not had, and is not presently expected to have, a material adverse
effect on our earnings or competitive position.

Employees.

      We employ approximately fifty two employees, of whom seventeen are covered
by a collective bargaining agreement with a local unit of the Retail Wholesale
and Department Store Union, AFL-CIO ("R.W.D.S.U."). The R.W.D.S.U. agreement is
for a three year period ending December 10, 2007. The contract is subject to
annual renewal thereafter and acknowledges that the R.W.D.S.U. is the exclusive
bargaining agent for the Company's regular production employees, excluding all
other employees including but not limited to supervisors, foremen, clerical
employees, time-keepers, watchmen, guards, maintenance personnel and part-time
employees. We believe our employee relations are good.

Risk Factors.

      The following is a summary of certain risk factors that may cause our
results to differ from the "forward-looking statements" made in this report. The
risks and uncertainties described below are not listed in order of priority and
are not the only ones we face. Additional risks not presently known to us or
other factors not perceived by us to present significant risks to our business
at this time also may impair our business operations. If any of these risks
actually occur, our business, financial condition, and/or results of operations
would likely suffer significantly. We do not undertake to update any of these
forward-looking statements or to announce the results of any revisions to these
forward-looking statements except as required by law.


                                     - 17 -
<PAGE>

Risks Relating to Our Financial Condition.

      We believe that our financial condition as of December 31, 2005 and our
continuing default under the Debentures and breach of the Key License give rise
to several risks and uncertainties. We believe that the financial information
and other factors set forth below are relevant in this regard:

o     As of December 31, 2005, the Company had aggregate debts and liabilities
      of nearly $22 million, which includes $10.8 million due under the
      Debentures and $6.1 million due under the Key License; had current assets
      of $5.0 million; and had a negative working capital of approximately $14.7
      million.

o     As of December 31, 2006, we estimate that the Company had aggregate debts
      and liabilities of approximately $22.3 million (unaudited), which includes
      $11.5 million due under the Debentures and $7.3 million due under the Key
      License.

o     We have not made any payments under the Debentures since 1999 and are in
      default thereunder and the Trustee or the holders of the Debentures could
      demand immediate payment of all amounts due under such instruments.

o     We are in breach of the Key License for failing to pay royalties since the
      execution thereof and Key could terminate the license and our right to use
      the intellectual property covered thereby in which case we may have to
      discontinue manufacturing and selling our sole transdermal patch product
      and we would have no source of continuing meaningful revenues.

In view of the foregoing, investors should consider the following risks:

Our financial condition, including our capital deficiency and our continuing
default under the Debentures and breach of the Key License, creates substantial
doubt as to whether we can continue to operate as a going concern. If we can not
continue to operate as a going concern, we may have to cease all operations and
investors will lose their entire investment in our company.

      The Company's audited consolidated financial statements for the year ended
December 31, 2005 have been prepared assuming that we will continue as a going
concern. However, Note 3 of the Notes to Consolidated Financial Statements
details certain conditions and other factors which are referenced in the
auditor's report to the December 31, 2005 financial statements that raise
substantial doubt about our ability to continue to operate as a going concern,
including:

o     the aggregate amount of the Company's outstanding debts and liabilities at
      December 31, 2005 and specifically the amounts due under the Debentures
      and the Key License;

o     the fact that we currently are in default under the Debentures and breach
      of the Key License and do not have the cash on hand or credit or financing
      facilities available to cure such default and breach and make the payments
      owed to the Debenture holders or Key;

o     the fact that if the Debenture holders or Key were to take legal action
      against the Company, we would not be able to continue as a going concern
      unless there was an increase in profitability and/or an infusion of
      additional funds in order to meet our obligations to these entities for
      both the past amounts due and ongoing amounts as they became due; and


                                     - 18 -
<PAGE>

o     the fact that we have a working capital deficiency of $14.7 million which
      casts doubt on our ability to pay our obligations as they become due or
      pay extraordinary obligations if any should arise.

      With the exception of 2004 in which we generated income of $9,000, the
Company has experienced net losses from operations in every year since 1995. At
December 31, 2005, the Company had an accumulated deficit of approximately $26
million and a working capital deficit of approximately $14.7 million. We have
been able to continue operating over the last several years because we have not
paid the holders of the Debentures or Key. We do not have the means to satisfy
the amounts due to these parties but we have been paying our other debts and
liabilities on a current basis from cash flow generated from operations. Our
financial condition has prevented us from securing financing or obtaining loans
from which we could repay all or a portion of the amounts due to holders of the
Debentures and Key.

      We have had limited discussions with the Trustee and Key with respect to
repaying the amount due under the Debentures and the royalties under the Key
License, though we cannot be certain we will be successful in our efforts in
reaching an agreement with either or both of these parties that allows us to
continue our operations.

      While management has formulated a plan to address the conditions cited by
the auditor in its report, as described under the heading "Management's
Discussion and Analysis of Financial Condition and Results of Operation" and in
Note 3 of the Notes to Consolidated Financial Statements, we cannot be certain
that we will be successful in executing this plan or that if we are successful
that we will achieve profitability. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.

      If we are unable to address successfully the conditions that raise doubt
about our ability to continue to operate as a going concern, particularly our
efforts to negotiate favorable payment terms of the amounts due to the holders
of the Debentures and Key, we may have to wind-up our operations and possibly
seek protection under bankruptcy laws, which likely would result in the loss of
all value which our stock now or at such time may have and result in investors
losing the entire amount of their investment.

Even if we are successful in negotiating payment terms for our debts and
liabilities, our cash flow and ability to operate may be adversely affected.

      If we successfully negotiate payment plans with respect to the amounts due
under the Debentures and the Key License, it is likely that a significant
portion of our revenues, if we earn any, will be allocated to making payments to
our creditors. Given our working capital deficiency, any agreements under which
are obligated to make to payments to the Debenture holders and Key likely will
cause us to face liquidity issues that could:

o     impair our ability to remain current in the payment of other liabilities
      and current accounts payable;

o     limit our ability to obtain additional financing for working capital,
      capital expenditures, new product development, marketing, acquisitions and
      general corporate or other purposes;

o     limit our ability to retain qualified management and other personnel;

o     increase our vulnerability to general economic and industry conditions;
      and


                                     - 19 -
<PAGE>

o     place us at a disadvantage compared to our competitors who have less debt.

Even if we are able to negotiate favorable payment terms under the Debentures
and the Key License in a way allows us to continue normal operations, we may not
be able to generate sufficient cash from operations to abide by the terms of
these agreements and we may be forced to take other actions to satisfy our
obligations and liabilities which may not be successful.

      Even if we successfully negotiate favorable agreements with respect to
paying the amounts due to the Debenture holders and Key, our ability to make
scheduled payments on these obligations and remain current with respect to our
other financial obligations will depend on our operating performance, which is
subject to prevailing economic and competitive conditions and to certain
financial, business and other factors, many of which are beyond our control. We
cannot assure you that we will maintain a level of cash flows from operating
activities sufficient to permit us to pay the Debenture holders and Key under
any agreement we may enter with them or remain current with respect to our other
outstanding liabilities. In such case, we might be required to wind-up our
operations and possibly seek protection under bankruptcy laws, which likely
would result in the loss of all value which our stock now or at such time may
have and result in investors losing the entire amount of their investment.

In light of our continuing default under the Key License, if Key terminates the
license or we lose our right to utilize the technology subject to such license
for any other reason, we will have to discontinue manufacturing our sole
product.

      Our second generation transdermal patch technology developed during the
mid 1990's incorporates certain technology which, unbeknownst to us at the time
of development, was the subject of a patent held by Key. In December 1997, Key
obtained a court order enjoining us from manufacturing or selling any
transdermal nitroglycerin patches that have been found to infringe Key's patent,
before the expiration of Key's patent on February 16, 2010. In March 2000, we
acquired a license from Key to use the patent covering that technology in our
transdermal patch which provided for the payment of a royalty per unit sold. We
have not made any royalty payments under our license with Key and as of December
31, 2005 we owed aggregate royalties to Key of approximately $6,108,000.

      We have entered into discussions with Key with respect to payment of past
due royalties which we hope will not impede our ability to operate and or not
otherwise materially impact our cash flow but we cannot be certain that we will
enter into an agreement favorable to us, if at all. If we are not able to
negotiate an agreement for the payment of past due royalties on terms that allow
us to continue our operations and we lose the license for the technology for
this or any other reason, we will not be able to sell our nitroglycerin
transdermal patch, our sole product, unless we could develop our own technology
to replace that covered by the Key License or otherwise locate and obtain a
license for similar technology which can be incorporated into our manufacturing
process, of which we can give no assurance, and will have no source of
continuing meaningful revenues. Given our current liabilities and debts, it is
unlikely we would be able to continue operating under such circumstances and
investors could lose the entire amount of their investment in the Company.

Risks Relating to Our Failure to File Reports under Federal Securities Laws.

Our failure to abide by our reporting requirements under federal securities laws
could subject us to enforcement proceedings by the SEC, including the
de-registration of our securities, which could materially adversely affect our
business and your ability to obtain information about our company and could also
subject the Company's management to civil liabilities from private shareholder
actions.


                                     - 20 -
<PAGE>

      Prior to filing an Annual Report on Form 10-KSB for the years ended
December 31, 2003 and 2004 (the "2004 Annual Report") in July 2006, we had not
filed any annual or quarterly reports with the SEC since we filed an annual
report for the year ended December 31, 1998 and quarterly reports for the first
three quarters of 1999 in November 1999. We have not filed and do not expect to
file annual or quarterly reports for the years 1999 through 2002 because we do
not have the financial information necessary to prepare such reports, as
detailed in the 2004 Annual Report. We do not expect to file any quarterly
reports for the years 1999 through 2006, though we expect to file an annual
report for 2006 as soon as practicable after the preparation of audited
financial information for the period. Our failure to file any of the reports we
were required to file under federal securities laws could give rise to action by
the SEC or private litigation by our current and former shareholders. The SEC's
action against us could take the form of penalties, fines, sanctions,
enforcement or other actions or proceedings, including revocation of
registration of our common stock under the Securities Exchange Act which could
result in less public information available to our security holders and
negatively impact any opportunity which we might otherwise have to raise capital
in the future. Moreover, private suits by our current and former security
holders for failing to make available current information about our company
could subject us as well as our officers and directors to civil liabilities. We
cannot predict what, if any, actions the SEC may impose upon or take against our
company or suits shareholders may bring against us for our failure to file
required reports; however, any such actions could cause us to incur significant
additional compliance expenditures and divert management's attention from our
core business activities.

Risks Relating to Our Business.

We are subject to all of the risks associated with being a single product
company, including special risks relating to the fact that we manufacture and
sell such product pursuant to a license. If we are unable to develop and bring
to market other products, our current and future operations and financial
condition may be adversely affected.

      We manufacture and sell only one product, our nitroglycerin transdermal
patch. We are subject to all of the risks associated with being a single product
company, including

      o     the inordinate effect of competition on our business which could
            cause us to reduce the price we charge for the product or erode
            total sales, and the corresponding reduction in earnings we generate
            from such product as result of competition;

      o     the loss of the license pursuant to which we manufacture and sell
            the product described in the foregoing risk factor; and

      o     our inability to obtain critical raw materials from which we
            manufacture the product.

      If we experience any of the foregoing or other difficulties or impediments
with respect to sales of such product, our business, financial condition and
results of operations would be materially adversely affected.

      We are seeking to develop and bring to market other products to broaden
our revenue base and reduce reliance on revenues generated from sales of our
nitroglycerin patch. We cannot be certain that our efforts to develop and market
other products will be successful. To the extent that we are unable to expand
our product offerings, our business and results of operation could be negatively
impacted and shareholders in our company may lose all or part of their
investment.


                                     - 21 -
<PAGE>

The development and manufacturing agreements to which we currently are a party
allow our clients to terminate these agreements at will. The termination of
these agreements for any reason would have a negative impact on our operations.

      We are party to contracts with two clients under which we have agreed to
develop and manufacture three potential pharmaceutical compounds. We currently
generate revenues from these agreements in connection with our product
development efforts and may generate revenues under these agreements in the
future from the manufacture of products which ultimately are approved by the FDA
for sale in the United States, of which we can offer no assurance. In some
cases, our clients are permitted to terminate these agreements at will for any
reason. If our clients elect to terminate these agreements our current and
future operations would be adversely impacted.

We are subject to extensive regulation by the FDA and other federal and state
agencies. If we fail to maintain satisfactory compliance with FDA regulations
and other governmental agencies, we may be forced to suspend or terminate our
operations and we could be subject to civil or criminal penalties.

      Our operations are subject to extensive regulation by governmental
authorities in the United States with respect to the testing, approval,
manufacture, labeling, marketing and sale of pharmaceutical products. These
regulations are wide-ranging and govern, among other things: adverse drug
experience reporting, product promotion, product pricing and discounting, drug
sample accountability, drug product stability, product manufacturing, including
good manufacturing practices, and product changes or modifications. Our
facilities handle controlled substances, resulting in additional extensive
regulatory requirements and oversight. Compliance with the extensive government
regulations applicable to our business requires the allocation of significant
time, effort and expense. Even if a product is approved by a regulatory
authority, product approvals may be withdrawn after the product reaches the
market if compliance with regulatory standards is not maintained or if problems
occur regarding the safety or efficacy of the product. If we fail to comply with
the regulatory requirements of the FDA and other applicable U.S. regulatory
authorities or previously unknown problems with our products or manufacturing
processes are discovered, we could be subject to administrative or judicially
imposed sanctions, including: restrictions on the products, manufacturers or
manufacturing processes; warning letters; civil or criminal penalties; fines;
injunctions; product seizures or detentions; voluntary or mandatory product
recalls and publicity requirements; unanticipated compliance expenditures;
suspension or withdrawal of previously approved marketing applications; total or
partial suspension of production; and criminal prosecution.

Our product sales are concentrated among a few customers and a substantial
decrease in revenues generated from sales to these customers would have an
adverse effect on our business unless we were able to identify other customers.

      During each of fiscal years ended December 31, 2005 and 2004, a
significant portion of our revenues were derived from a small number of
customers. In 2005, two customers accounted for approximately 55% of our
revenues and these customers accounted for approximately 53% of our revenues
during fiscal 2004. During 2005, orders from one of our principal customers
decreased by 44% and our revenues for the year declined commensurately. If we
are unable to identify other customers to replace the revenues lost from the
decline in sales to this customer or this customer does not place order for
products from us at its prior levels, our business, financial condition and
results of operations will continue to be negatively impacted.

      Because our sales tend to be concentrated among a small number of
customers during any period, our operating results may be subject to substantial
fluctuations. Moreover, we tend to receive relatively large orders for products
from a relatively small number of customers. Consequently, a single order from
one customer may represent a substantial portion of our sales in any one period
and significant orders by any customer during one period may not be followed by
further orders from the same customer in subsequent periods. These and other
factors may cause our sales and operating results to be subject to very
substantial periodic variations. Since quarterly performance is likely to vary
significantly, our results of operations for any quarter are not necessarily
indicative of the results that we might achieve for any subsequent period.
Accordingly, quarter-to-quarter comparisons of our operating results may not be
meaningful.


                                     - 22 -
<PAGE>

We rely on a single supplier or a limited number of suppliers for certain raw
materials used in our products.

      Certain raw materials and components used in the manufacture of our
products are available from limited sources, and, in some cases, a single
source. Generally, regulatory authorities must approve raw material sources for
transdermal products, and in the case of controlled substances, the DEA sets
quotas for controlled substances and we must receive authorization from the DEA
to purchase and handle these substances. We cannot be certain that we will be
granted sufficient DEA quota to meet production requirements for controlled
substances. Without adequate approved supplies of raw materials or packaging
supplies, our manufacturing operations could be interrupted until another
supplier is identified, our products approved and trading terms with it
negotiated. We may not be able to identify an alternative supplier and any
supplier that we do identify may not be able to obtain the requisite regulatory
approvals in a timely manner, or at all. Furthermore, we may not be able to
negotiate favorable terms with an alternative supplier. Any disruptions in our
manufacturing operations from the loss of an approved supplier may cause us to
incur increased costs and lose revenues and may have an adverse effect on our
relationships with our partners and customers, any of which could have adverse
effects on our business and results of operations. Our business also faces the
risk that third party suppliers may supply us with raw materials that do not
meet required specifications, which, if undetected by us, could cause our
products to test out of specification and require us to recall the affected
product.

We rely on the services of a single agent to market our product and if we were
to lose the services of such entity or it was not as successful in its sales
efforts, our business and results of operations would be adversely affected.

      We market all of our products through a single marketing representative.
If we were to lose the services of such marketing agent for any reason or said
entity does not maintain a steady demand for our product and we are unable to
identify an adequate replacement, our business, results of operations and
financial condition would be materially adversely affected.

We may expend significant cash and personnel resources in the development of any
new products and if we do not generate the anticipated level of revenues from
sales of such products, our business will be negatively and adversely affected.

      Our efforts to commercialize new products will require significant
expenditures of resources, including cash and time, in the research,
development, testing, preparation and execution of applications with
governmental authorities to manufacture and sell such product,. If we do not
generate revenues from sales of any such product at levels anticipated prior to
embarking on such development, our business, financial condition and results of
operations would be materially adversely affected.

We may lose out to larger and better-established competitors.

      The drug delivery industry is intensely competitive. We face competition
from a number of companies that develop, market and sell transdermal patches
that deliver generic drugs, and competition is expected to intensify as more
companies enter the field. Most of our competitors have significantly greater
financial, technical, manufacturing, marketing and distribution resources as
well as greater experience in the drug delivery industry than we have. The
particular medical conditions our product addresses can also be addressed by
other drugs and other delivery modalities. Many of these alternatives are widely
accepted by physicians and have a long history of use. Physicians may use our
competitors' products and/or our products may not be competitive with other
technologies. If these things happen, our sales and revenues will decline.
Competition may result in price reductions, reduced gross margins and loss of
market share.


                                     - 23 -
<PAGE>

      We cannot assure that our products will compete successfully against
competitive products or that developments by others will not render our products
obsolete or uncompetitive. If we cannot maintain competitive products and
technologies, our current and potential strategic partners may choose to adopt
the drug delivery technologies of our competitors or their own internally
developed technologies.

Our product may be displaced by more effective medications or newer
technologies.

      The drug delivery industry is undergoing rapid and significant
technological change. Others may succeed in developing or marketing technologies
and products that are more effective than those developed or marketed by us, or
that would make our technology and product obsolete or non-competitive.
Additionally, researchers could develop new delivery devices and medications
that replace or reduce the importance of our products. Accordingly, our success
will depend, in part, on our ability to respond quickly to medical and
technological changes through the development and introduction of new products.
We do not currently have the resources to do this. If our products become
obsolete and our efforts to develop new products do not result in any
commercially successful products, our sales and revenues will decline.

Competitors may use legal, regulatory and legislative strategies to prevent or
delay our launch of generic products.

      The Hatch-Waxman Act provides for a period of 180 days of generic
marketing exclusivity for each ANDA applicant that is first to file an ANDA
containing a certification of invalidity, non-infringement or unenforceability
related to a patent listed with respect to a reference drug product, commonly
referred to as a Paragraph IV certification. During this exclusivity period, the
FDA cannot grant final approval to any other Paragraph IV filer. If an ANDA
containing a Paragraph IV certification is successful, it generally results in
higher market share, net revenues and gross margin for that applicant for a
period of time. Even if we obtain FDA approval for generic drug products, we may
lose significant advantages to a competitor who was first to file an ANDA
containing a Paragraph IV certification.

      Competitors may also pursue legislative and other regulatory or litigation
strategies to prevent or delay our launch of a generic product. These strategies
include, but are not limited to: seeking to obtain new patents on drugs for
which patent protection is about to expire, changing the labeling for the
branded product, filing a citizen petition with the FDA, pursuing state
legislative efforts to limit the substitution of generic versions of brand
pharmaceuticals, filing patent infringement lawsuits that automatically delay
FDA approval of many generic products, introducing a second generation product
prior to the expiration of market exclusivity for the first generation product
which may reduce demand for a generic first generation product, and obtaining
market exclusivity extensions by conducting pediatric trials of brand drugs.

Unfavorable pricing regulations, third-party reimbursement practices or
healthcare reform initiatives applicable to our product and product candidates
could limit our potential product revenue.

      The healthcare industry is undergoing fundamental changes resulting from
political, economic and regulatory influences. In the United States,
comprehensive programs have been proposed that seek to increase access to
healthcare for the uninsured, control the escalation of healthcare expenditures
within the economy and use healthcare reimbursement policies to balance the
federal budget.


                                     - 24 -
<PAGE>

      We expect that Congress and state legislatures will continue to review and
assess healthcare proposals, and public debate of these issues will likely
continue. We cannot predict which, if any, of such reform proposals will be
adopted and when they might be adopted. Significant changes in the healthcare
system could have a substantial impact on the manner in which we conduct our
business and could require us to revise our strategies and negatively affect our
business, prospects and results of operations.

We may experience reductions in the levels of reimbursement for pharmaceutical
products by governmental authorities, HMOs or other third-party payers.

      Various governmental authorities and private health insurers and other
organizations, such as HMOs, provide reimbursement to consumers for the cost of
certain pharmaceutical products. Demand for our product depends in part on the
extent to which such reimbursement is available. Third-party payers increasingly
challenge the pricing of pharmaceutical products. This trend and other trends
toward the growth of HMOs, managed health care and legislative health care
reform create significant uncertainties regarding the future levels of
reimbursement for pharmaceutical products. Further, any reimbursement may be
reduced in the future, perhaps to the point that market demand for our product
declines. Such a decline could have a material adverse effect on our business,
financial position and results of operations.

Legislative or regulatory programs that may influence prices of prescription
drugs could have a material adverse effect on our business, financial position
and results of operations.

      Current or future federal or state laws and regulations may influence the
prices of drugs and, therefore, could adversely affect the price that we receive
for our product. Programs in existence in certain states seek to set prices of
all drugs sold within those states through the regulation and administration of
the sale of prescription drugs. Expansion of these programs, in particular,
state Medicaid programs, or changes required in the way in which Medicaid
rebates are calculated under such programs, could adversely affect the price we
receive for our product and could have a material adverse effect on our
business, financial position and results of operations.

We cannot be certain of the protection or confidentiality of our patents and
proprietary rights.

      Our success will depend, in part, on our ability to obtain patents for our
products, processes and technologies. If we do not do so, our competitors may
exploit our innovations and deprive us of the ability to realize revenues from
those innovations. There is no assurance that we will be issued patents for any
of our patent applications, that any existing or future patents that we receive
or license will provide competitive advantages for our products, or that we will
be able to enforce successfully our patent rights. Additionally, there can be no
assurance that our patents or any future patents will prevent other companies
from developing similar or functionally equivalent products, or challenging,
invalidating or avoiding our patent applications or any existing or future
patents that we receive or license.

      We also rely on trade secrets, unpatented proprietary know-how and
continuing technological innovation. We use confidentiality agreements with
purchasers, suppliers, employees and consultants to protect our trade secrets,
unpatented proprietary know-how and continuing technological innovation, but
there can be no assurance that these parties will not breach their agreements
with us or that we will be able to effectively enforce our rights under those
agreements. We also cannot be certain that we will have adequate remedies for
any breach. Disputes may arise concerning the ownership of intellectual property
or the applicability of confidentiality agreements. Furthermore, we cannot be
sure that our trade secrets and proprietary technology will not otherwise become
known or that our competitors will not independently develop our trade secrets
and proprietary technology.


                                     - 25 -
<PAGE>

Third parties may claim that we infringe their proprietary rights, forcing us to
expend substantial resources in resulting litigation, the outcome of which is
uncertain. Any unfavorable outcome could negatively affect our financial
position and results of operations.

      Our success will depend, in part, on our ability to operate without
infringing the proprietary rights of others, and there can be no assurance that
our products and processes will not infringe upon the patents of others. Third
parties may also institute patent litigation against us for competitive reasons
unrelated to any infringement by us. If a third party asserts a claim of
infringement, we may have to seek licenses, defend infringement actions or
challenge the validity of those third-party patents in court. If we cannot
obtain the required licenses, or are found liable for infringement or are not
able to have these patents declared invalid, we may be liable for significant
monetary damages, encounter significant delays in bringing products to market or
be precluded from participating in the manufacture, use or sale of products or
methods of drug delivery covered by the patents of others. There can be no
assurance that we have identified, or that in the future we will be able to
identify, all U.S. and foreign patents that may pose a risk of potential
infringement claims.

We may not be able to manufacture new products in commercial quantities
efficiently.

      We may seek to bring to market new products that we have never
manufactured on a commercial scale. Accordingly, inefficiencies and other
scale-up problems may occur in the process of manufacturing new products in
commercial quantities. If we experience manufacturing difficulties, our overall
manufacturing costs may be higher than we had anticipated.

We may be subject to product liability claims and we cannot be certain that we
will have adequate insurance coverage.

      The testing, manufacturing and marketing of our products may expose us to
potential product liability and other claims resulting from their use. If any
such claims against us are successful, we may be required to make significant
compensation payments and suffer adverse publicity. Even unsuccessful claims
could result in the expenditure of funds in litigation and the diversion of
management time and resources. We maintain product liability insurance, but
there can be no assurance that our insurance will cover all future claims or
that we will be able to maintain existing coverage or obtain additional coverage
at reasonable rates. If a claim is not covered or if our coverage is
insufficient, we may incur significant liability payments that would negatively
affect our business, financial position or results of operations.

All of our products are manufactured at one location and any interruption of
production at this facility could negatively affect our business, financial
position and results of operations.

      All of our products are manufactured at a single facility located in
Emigsville, Pennsylvania. An interruption of manufacturing resulting from
regulatory issues, technical problems, casualty loss or other factors could
result in our inability to meet production requirements, which may cause us to
lose revenues and which could have an adverse effect on our relationships with
our partners and customers, any of which could have a material adverse effect on
our business, financial position or results of operations. We maintain business
interruption insurance, but there can be no assurance that our insurance will
cover all future claims or that we will be able to maintain existing coverage or
obtain additional coverage at reasonable rates. Without our existing production
facility, we would have no other means of manufacturing our products until we
were able to restore the manufacturing capability at our facility or develop an
alternative manufacturing facility.

Our insurance coverage may not be adequate and rising insurance premiums could
negatively affect our profitability.


                                     - 26 -
<PAGE>

      We rely on insurance to protect us from many business risks, including
product liability, business interruption, property and casualty loss and
employment practices liability. The cost of insurance has risen significantly in
recent years. In response, we may increase deductibles and/or decrease certain
coverages to mitigate these costs. There can be no assurance that the insurance
that we maintain and intend to maintain will be adequate, or that the cost of
insurance and limitations in coverage will not adversely affect our business,
financial position or results of operations. Furthermore, it is possible that,
in some cases, coverage may not be available at any price.

We enter into agreements that include provisions that require us to indemnify
the other party under certain circumstances. If we are required to perform under
these indemnification provisions, our financial condition and results of
operations could be negatively affected.

      Many of the license, development, supply, employment and other agreements
we enter into include indemnification provisions. The various indemnification
provisions in these agreements are not uniform and may be subject to differing
legal interpretations. Accordingly, it may be difficult for us to determine or
accurately predict in advance what indemnification obligations we may owe under
these provisions or, alternatively, what obligations may be owed to us by these
parties, including as it relates to potential damages, settlement amounts and
defense costs associated with the product liability lawsuits that claim the use
of products manufactured by us and distributed by third parties. Our insurance
coverage may mitigate the costs of some of our obligations under these
indemnification provisions but our business, financial position and results of
operations could be harmed if we are required to perform under these
indemnification provisions and there is no or insufficient insurance coverage.

We may have difficulty raising capital, which could deprive us of necessary
resources.

      We expect to require capital for many purposes, including developing new
products, retaining qualified personnel, funding research and development and
maintaining existing manufacturing capacity. In order to support the initiatives
envisioned in our business plan, we may need to raise additional funds through
the sale of assets, public or private debt or equity financing, collaborative
relationships or other arrangements. Our ability to raise financing depends on
many factors beyond our control, including the state of capital markets and the
development or prospects for development of competitive technology by others.
Because our common stock is not listed on a major stock market, many investors
may not be willing or allowed to purchase it or may demand steep discounts. Our
current financial condition and our default under the Debentures and the Key
license have prevented us from borrowing money from third parties or raising
capital from the sale of equity. Sufficient additional financing may not be
available to us or may be available only on terms that would result in further
dilution to the current owners of our common stock. If we are unable to raise
additional funds when we need them, we may have to severely curtail our
operations.

Our success depends on attracting and retaining our key employees.

      Our success depends on our ability to attract and retain qualified,
experienced personnel. We face significant competition in recruiting talented
personnel. The loss of key personnel, or the inability to attract and retain
additional, competent employees, could adversely affect our business, financial
position or results of operations.

Limitations on liability and indemnification matters.

      As permitted by the corporate laws of the State of Delaware, we have
included in our Certificate of Incorporation a provision to eliminate the
personal liability of our directors for monetary damages for breach or alleged
breach of their fiduciary duties as directors, subject to certain exceptions. In
addition, our By-Laws provide that we are required to indemnify our officers and
directors under certain circumstances, including those circumstances in which
indemnification would otherwise be discretionary, and we will be required to
advance expenses to our officers and directors as incurred in connection with
proceedings against them for which they may be indemnified.


                                     - 27 -
<PAGE>

We have no intention of paying dividends on our common stock in the near future
and holders of our common stock will have to rely on the appreciation thereof to
realize any monies from holding these securities.

      We have not paid any dividends on our common stock and do not anticipate
paying cash dividends in the foreseeable future. Management intends to retain
any earnings to finance the growth of the Company's business. Management cannot
assure you that the Company will ever pay cash dividends. Accordingly, holders
of our common stock will have to rely on the appreciation thereof to realize any
monies from holding these securities.

Our common stock is not traded or admitted to quotation on any market, so you
may not be able to sell your shares of common stock and thus you may never
realize any monies from holding these securities.

      Our common stock is not listed on any stock market or admitted to
quotation on the over-the-counter bulletin board, accordingly, there is no
public trading market for our common stock. From time to time, quotations for
our stock are published by market makers in the Pink Sheets, which provides an
extremely limited market for our stock. Therefore, you may only be able to
dispose of our common stock in a private transaction. If no active trading
market develops for our common stock, holders of our common stock will have to
rely on the appreciation thereof to realize any monies from holding these
securities.

We must maintain adequate internal controls and in the future be able, on an
annual basis, to provide an assertion as to the effectiveness of such controls.

      Effective internal controls are necessary for the Company to provide
reasonable assurance with respect to its financial reports. We may be required
to spend a substantial amount of management time and resources to comply with
changing laws, regulations and standards relating to corporate governance and
public disclosure, including the Sarbanes-Oxley Act of 2002 and new SEC
regulations. In particular, Section 404 of the Sarbanes-Oxley Act of 2002
requires management's annual review and evaluation of our internal control
systems, and attestations as to the effectiveness of these systems by our
independent public accounting firm. If we fail to maintain the adequacy of our
internal controls, we may not be able to ensure that we can conclude on an
ongoing basis that we have effective internal control over financial reporting.
Additionally, internal control over financial reporting may not prevent or
detect misstatements because of its inherent limitations, including the
possibility of human error, the circumvention or overriding of controls, or
fraud. Therefore, even effective internal controls can provide only reasonable
assurance with respect to the preparation and fair presentation of financial
statements. In addition, projections of any evaluation of effectiveness of
internal control over financial reporting to future periods are subject to the
risk that the control may become inadequate because of changes in conditions, or
that the degree of compliance with the policies or procedures may deteriorate.
If the Company fails to maintain the adequacy of its internal controls,
including any failure to implement required new or improved controls, this could
have a material adverse effect on our business, financial position and results
of operations.

There are inherent uncertainties involved in estimates, judgments and
assumptions used in the preparation of financial statements in accordance with
GAAP.


                                     - 28 -
<PAGE>

      The consolidated and condensed consolidated financial statements included
in the periodic reports we are required to file with the SEC are prepared in
accordance with accounting principles generally accepted in the United States of
America ("GAAP"). The preparation of financial statements in accordance with
GAAP involves making estimates, judgments and assumptions that affect reported
amounts of assets (including intangible assets), liabilities, revenues, expenses
and income. Estimates, judgments and assumptions are inherently subject to
change in the future and any necessary revisions to prior estimates, judgments
or assumptions could lead to a restatement. Any such changes could result in
corresponding changes to the amounts of assets (including goodwill and other
intangible assets), liabilities, revenues, expenses and income. Any such changes
could have a material adverse effect on our business, financial position and
results of operations.

ITEM 2. DESCRIPTION OF PROPERTIES.

      We lease an approximately 61,000 square foot building, from a related
party, located on approximately 3.5 acres in Emigsville, Pennsylvania which is
used for manufacturing, laboratory, engineering, quality control, research and
development, warehousing, administrative and office purposes. Our manufacturing
facility complies with GMP standards and is operating under registration from
both the FDA and DEA and pursuant to registration with the Pennsylvania
Department of Health. The lease, which expires December 6, 2019, has an annual
rental of $212,400, payable in equal monthly installments of $17,700. We
currently lease approximately 600 square feet of office space in Suffern, New
York under a lease that expires December 31, 2007. The annual rental, inclusive
of utilities, will be $7,416 and $7,691 for 2006 and 2007, respectively.

      We believe that our present facilities are in good condition and are
adequate for our current and immediate future requirements.

ITEM 3. LEGAL PROCEEDINGS.

      In June 2004, Plaintiffs Jack Aronowitz and his companies, Health-Chem
Diagnostics, LLC ("Diagnostics") and Leon Services, LLC ("Leon"), filed a
Complaint and subsequently, an Amended Complaint in the United States District
Court Southern District of Florida (the "Court") for breach of contract and
foreclosure of a security interest against the Company. The contracts at issue
were a Master Agreement along with an associated License Agreement and Security
Agreement, executed jointly and dated February 15, 2002 (the "2002 Agreements"),
and a November 6, 2003 Outline Agreement (the "2003 Agreement") terminating the
Company's obligations under the 2002 Agreements and effectuating a purchase of
certain assets by the Company in exchange for monies and a 25% equity stake in
Diagnostics. The Company filed a counterclaim for breach of the 2003 Agreement,
based on Plaintiffs' failure to render payment for the assets which were
transferred to Plaintiffs, as well as a claim for trademark infringement. The
Company also asserted a claim for a declaratory judgment determining that the
2003 Agreement superseded the 2002 Agreements, consistent with the conclusions
in the Order. The jury rendered its verdict on November 21, 2005, finding in
favor of Plaintiffs on the counts for breach of the 2002 and 2003 Agreements.
The jury found that Plaintiffs were guilty of copyright infringement, but did
not find a breach of the 2003 Agreement on the part of Plaintiffs. On December
2, 2005, the Court entered a Final Judgment and Order Closing Case, and ordered
judgment on the jury verdict in the amount of $2,931,000 in favor of Plaintiffs
and against the Company. The Court also entered judgment for the Company in the
amount of $25,000 for trademark infringement. The Company filed a Motion for
Judgment As A Matter Of Law, and alternatively, Motion for New Trial. On
February 14, 2006, the Court issued an Amended Final Judgment, vacating the
Court's December 2, 2005 Final Judgment and Order Closing Case. The February 14,
2006 judgment reduced the award to the Plaintiffs Jack Aronowitz, Health-Chem
Diagnostics, LLC and Leon Services, LLC and against the Company to the amount of
$1.00. The February 14, 2006 judgment also awarded $25,000 to the Company and
against the Plaintiffs Jack Aronowitz, Health-Chem Diagnostics, LLC and Leon
Services, LLC for trademark infringement. The February 14, 2006 judgment also
included a permanent injunction in favor of the Company and against the
Plaintiffs Jack Aronowitz, Health-Chem Diagnostics, LLC and Leon Services, LLC
to cease and desist any present or future use of the "Health-Chem" trademark or
any other marks similar to the Company's trademark. On February 27, 2006, the
Plaintiffs filed an appeal from the Court's February 14, 2006 Amended Final
Judgment. The ultimate outcome of this litigation can not be ascertained at this
time.


                                     - 29 -
<PAGE>

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

      None

                                     PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

      Our common stock is not listed or admitted to quotation on any established
trading market. From time to time, quotes for our stock are reported on the Pink
Sheets which is a centralized quotation service that collects and publishes
market maker quotes for over-the-counter securities in real time. Unlike
companies the stock of which trades on a stock exchange, companies quoted on the
Pink Sheets system do not need to meet quantitative and qualitative listing and
maintenance standards or be registered or file reports with the SEC. Investors
may obtain quotes for our common stock by entering our symbol, HCLC, in the
input box of the Web site pinksheets.com. Such quotations reflect inter-dealer
prices, without retail markup, markdown or commission, and may not represent
actual transactions.

      The high and low sales prices for our common stock, as reported by the
Pink Sheets, have been as follows during the three years ended December 31,
2006:

--------------------------------------------------------------------------------
Quarter                       2006                2005                2004
--------------------------------------------------------------------------------
                         High       Low      High      Low       High      Low
--------------------------------------------------------------------------------
1st                     $ 0.08    $ 0.08    $0.100    $0.090    $0.090    $0.060
--------------------------------------------------------------------------------
2nd                      0.085      0.08     0.120     0.090     0.080     0.060
--------------------------------------------------------------------------------
3rd                       0.09      0.05     0.100     0.100     0.070     0.070
--------------------------------------------------------------------------------
4th                       0.10      0.03     0.100     0.080     0.100     0.070
--------------------------------------------------------------------------------

      There were approximately 1,201 holders of record of our common stock as of
February 13, 2007. This number of holders of record does not include beneficial
owners of our common stock whose shares are held in the names of various
security holders, dealers and clearing agencies.

      We have not paid any cash dividends on our common stock during the five
years ended December 31, 2006 and we do not anticipate paying cash dividends in
the foreseeable future. Under the terms of the Debentures, we are restricted
from paying cash dividends by a formula based upon the consolidated net income
of the Company and other factors. Under the formula, at December 31, 2005 and
2006, no amount was available for the payment of dividends.


                                     - 30 -
<PAGE>

Recent Sales of Unregistered Securities.

      Set forth below is information relating to securities issued by
Health-Chem since January 1, 2005 which were not registered under the Securities
Act of 1933, as amended.

2006

      During the year ended December 31, 2006, the Company issued an aggregate
of 20,000 options to purchase a like number of shares of common stock to each of
Andrew Levinson and Manfred Mayerfeld as compensation for serving as directors
of the Company during the period (5,000 shares on the first day of each quarter)
pursuant to the exemption from the registration requirements of the Securities
Act of 1933, as amended, afforded by Section 4(2) thereof. These options are
exercisable for a period of five years from the date of grant at an exercise
price equal to the closing sale price (or average of the closing bid and asked
price if no sale price is quoted) on the last trading day of the preceding
quarter. These options have the following exercise prices:

o     Options issued during the first quarter are exercisable at $0.08 per
      share.

o     Options issued during the second quarter are exercisable at $0.08 per
      share.

o     Options issued during the third quarter are exercisable at $0.085 per
      share.

o     Options issued during the fourth quarter are exercisable at $0.06 per
      share.

2005

      Health-Chem did not issue any securities during fiscal 2005.

ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.

      The following discussion and analysis, as well as other sections in this
Annual Report, should be read in conjunction with the Consolidated Financial
Statements and related Notes to Consolidated Financial Statements included
elsewhere in this report.

      This discussion and analysis may contain "forward-looking statements".
These statements are made pursuant to the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. Such forward-looking statements may
include, without limitation, statements about the Company's market
opportunities, strategies, competition and expected activities and expenditures,
and at times may be identified by the use of words such as "may", "will",
"could", "should", "would", "project", "believe", "anticipate", "expect",
"plan", "estimate", "forecast", "potential", "intend", "continue" and variations
of these words or comparable words. Forward-looking statements inherently
involve risks and uncertainties. Accordingly, actual results may differ
materially from those expressed or implied by these forward-looking statements.
Factors that could cause or contribute to such differences include, but are not
limited to, the risks described under "Risk Factors" in Item 1. The Company
undertakes no obligation to update any forward-looking statements for revisions
or changes after the date of this Annual Report.

Company Overview.

      We manufacture controlled release products to deliver drugs topically or
transdermally (transdermal patches) and undertake research and development
activities for third parties on a contract basis. Currently, our sole product
and source of continuing revenue is a prescription transdermal patch which
delivers nitroglycerin for use in the relief of the vascular and cardiovascular
symptoms related to angina pectoris (chest pain); however, we have the
manufacturing capability to produce transdermal patches which deliver other
medications. We manufacture our nitroglycerin patch both on a contract basis for
specific clients and for sale to distributors and wholesalers for distribution
in the United States. We manufacture our products in accordance with GMP's
prescribed by the FDA at our facility in Emigsville, Pennsylvania. We utilize
the services of an independent sales organization to identify customers and
market and sell our transdermal patches. We also derive limited revenues from
development work. We currently conduct the majority of our business through our
90%-owned subsidiary, Transderm.


                                     - 31 -
<PAGE>

      We generate revenues principally from sales of transdermal patches and
secondarily from research and development projects we undertake for third
parties on a contract basis.

      Our business faces certain important risks, including that:

o     as of December 31, 2005, we had debts and liabilities to third parties of
      approximately $22 million;

o     we have a working capital deficiency of $14.7 million which casts doubt
      upon our ability to pay our debts and liabilities as they become due and
      renders us vulnerable in the event we are subject to extraordinary
      expenditures;

o     we generate the vast majority of our revenue from sales of a single
      product;

o     we are in default under the Debentures which became due in 1999 and under
      which we owed an aggregate of $10,830,000 of principal and interest at
      December 31, 2005 and $11,463,000 at December 31, 2006 (unaudited);

o     we are in breach of the terms of a technology license agreement (the Key
      License) upon which we rely to manufacture our sole product because we
      have never made royalty payments thereunder, which totaled $6.1 million at
      December 31, 2005 and $7.3 million at December 31, 2006 (unaudited);

o     we have no borrowing capacity to expand our product lines and reduce our
      reliance on sales from our nitroglycerin patches, to take advantage of
      other business opportunities as they arise or to retain additional
      qualified personnel; and

o     the pharmaceutical industry is highly regulated and intensely competitive.

      During the year ended December 31, 2005, our operating results declined
over the prior year. When comparing 2005 to 2004, net sales decreased by 17%
from nearly $9.2 million to $7.6 million, which reduced our gross profit from
$2.9 million to $1.1 million. In addition, total operating expenses increased by
34% to $4.0 million from $3.0 million, primarily due to an increase of 60% in
selling, general and administrative ("SG&A") expenses from $1.6 million to $2.6
million. As a result, we experienced a net loss of $2.5 million during 2005
compared to net income of $9,000 in 2004. Management attributes the decrease in
net sales for the years 2004 to 2005 to a decline in orders from our largest
customer and the increase in SG&A expenses primarily to funds expended in
connection with the preparation of disclosure documents to be filed with the SEC
for the years ended December 31, 2003 and 2004 and the defense of the Aronowitz
litigation described under "ITEM 3. LEGAL PROCEEDINGS."

      Prior to filing an Annual Report on Form 10-KSB for the years ended
December 31, 2003 and 2004 in July 2006 (the "2004 Annual Report"), Health-Chem
had not filed any annual or quarterly reports with the Securities and Exchange
Commission since it filed an annual report for the year ended December 31, 1998
and quarterly reports for the first three quarters of 1999 in November 1999. As
more fully described in the 2004 Annual Report, commencing in 1998 the Company
encountered acute economic difficulties which caused it to restructure its
business and discontinue reporting under federal securities laws. Management
suggests that investors refer to the 2004 Annual Report and Transderm
Laboratories Corporation's Annual Report on Form 10-KSB for the year ended
December 31, 2004 for a more complete understanding of the Company's economic
travails during this period, the restructuring of its operations, intercompany
relationships and the reasons it suspended reporting.


                                     - 32 -
<PAGE>

Factors Which We Believe Affect Our Current Operations and May Materially Impact
Our Future Operations.

      Certain existing conditions and known material uncertainties could impact
our business in the short- and long- term. Investors should analyze our business
in light of the issues and uncertainties described in the following discussion
and elsewhere herein, such as under the section titled "ITEM 1-BUSINESS- Risk
Factors," which are intended to highlight and amplify the numerical and other
information contained throughout this Annual Report.

      Our company faces several challenges as we continue our efforts to emerge
from the financial and operating crises of the late 1990's (as more fully
described in the 2004 Annual Report and Transderm Laboratories Corporation's
Annual Report on Form 10-KSB for the year ended December 31, 2004). Management
has identified the following factors as those most likely to materially impact
our operations:

o     the resolution of our obligations under the Debentures and the Key
      License;

o     short- and long- term liquidity issues;

o     issues relating to reliance on a single product for the majority of our
      revenues;

o     the need to identify and retain senior management who have experience in
      the pharmaceutical industry or in any business in which we may become
      involved in the future;

o     the impact of competition on our business; and

o     issues relating to concentration of our customer base.

      We defaulted on our obligations under the Debentures by not repaying the
principal and accrued interest on their due date in April 1999 and are in breach
of the Key License for failing to make any payments thereunder since we entered
into the agreement in March 2000. As described elsewhere in this Annual Report,
as of December 31, 2006, our obligations under both the Debentures and the Key
License were considerable and we currently do not have the financial resources
to make significant payments to reduce our debt under the Debentures or to pay
past due royalties under the Key License. Moreover, we are not generating
sufficient cash from operations which will allow us to make material payments to
reduce these obligations in the near future.

      As we have rebuilt sales over the last few years, we have been able to
forestall taking action with respect to resolving our obligations under the
Debentures and the Key License. Over the last several years, we have been in
sporadic contact with the Trustee of the Debentures which has proposed opening
negotiations with respect to our satisfying our obligations under these
instruments, but have not yet begun negotiations. We have executed tolling
agreements with the Trustee extending the time in which the Trustee is permitted
to seek legal redress for our default under the Debentures. We have commenced
negotiating with representatives of Key to develop a plan to pay the royalties
due under the Key License but have not reached a definitive agreement with Key
as of the date hereof. The nature of the agreements with these creditors, if we
are able to negotiate them at all, and the manner in which we will be required
to repay our obligations under the Debentures and the Key License represent a
material uncertainty and will bear significantly on how, or if we are able to,
do business in the future.


                                     - 33 -
<PAGE>

      Given that we are in default under the Debentures and the Key License,
either party could initiate legal action against us seeking to recover the
entire amount due to them. If we were to lose one or both such actions, as of
the date hereof, we would be unable to satisfy the amount due under either such
obligation, in which case, we might be required to liquidate all of our assets
and wind-up or dissolve our company to satisfy these obligations or seek
protection from our creditors under federal bankruptcy laws. Management hopes to
enter, but can offer no assurance that it will be successful, into agreements
with both the Trustee and Key which will allow us to continue operating and
repay them over time in a manner that does not interfere with our normal
operations. Ideally, we would negotiate agreements with these parties which
would allow us, if and when we achieve profitable operations, of which we cannot
be certain, to retain some cash from operations to permit us to develop new
products and take the other actions necessary to strengthen our company.
Accordingly, there is substantial uncertainty as to our future which will become
clearer only when we complete agreements with the Trustee and Key. The terms of
our agreements with these entities, if we are successful in our efforts to
negotiate such agreements, will bear materially on our business and financial
condition and likely will significantly impact our liquidity and cash resources.

      Accordingly, short - and long - term liquidity issues represent a
significant challenge as we seek to balance rebuilding and restructuring our
business with repayment of amounts due under the Debentures and royalties due
under the Key License. Our lack of liquidity impacts our business in many ways,
some of which are inextricably intertwined and affect all aspects of our
operations, as more fully described below.

      While net sales have increased in 4 of the last 5 years, the Company has
reported a net loss in all but one of those years (2004). Moreover, at December
31, 2005 the Company had a capital deficit of $14.9 million and has experienced
a capital deficit in every year since 1998. The Company has no credit facilities
upon which to draw and no assets to utilize as collateral for borrowings. The
Company's lack of liquidity and its obligations to the Debenture holders and Key
currently and in the future will affect our ability to:

      o     diversify our operations by developing new products and reduce our
            reliance on revenues generated from sales of a single product;

      o     obtain financing for operations;

      o     endure business cycles resulting from general economic conditions or
            the effects of competition, among other things, as they occur; and

      o     take advantage of business opportunities as they may arise.

      Assuming we are successful in our efforts to reach favorable agreements
with both the Trustee and Key, we are severely constrained by financial and
personnel resources from taking the steps to diversify our operations to reduce
our reliance on revenues generated solely from the sale of our transdermal
nitroglycerin patches. Management believes it is critical to the Company's
future to develop other products to offset potential adverse business
developments which may impact sales of our transdermal nitroglycerin patch,
including:

      o     any decrease in orders from our major customers, as was the case
            during 2005;


                                     - 34 -
<PAGE>

      o     the potential negative impact of competition, which could require us
            to reduce the price we charge for our product or which would result
            in diminished sales, either of which would reduce our revenues;

      o     the introduction by others of new products, such as new drugs or
            delivery methods which render our nitroglycerin transdermal patches
            obsolete; or

      o     other events or general economic conditions which result in
            diminished demand for our patch.

      Our efforts to diversify our operations may entail developing a new
product that is compatible with our manufacturing and personnel capabilities or
merging with or acquiring (perhaps in exchange for capital stock) an entity that
already is selling or proposes to market a product within the same general
industry as our transdermal patch. Developing or otherwise acquiring a new
product or entering into a new business, particularly in a highly regulated
industry such as the pharmaceutical business, entails significant risks
including that it will be expensive, time consuming and will divert the
attention of management from a company's core operations. Moreover, at this
time, we do not employ the personnel we likely will require, such as a chief
operating officer who has experience in the pharmaceutical or other industry we
enter, to attempt to add new products or otherwise diversify our operations.
Further, we can not be certain that we would derive any material revenues from
any diversification and may suffer significant losses from any such venture.

      At this time, we do not have capital on-hand nor do we have access to
capital to fund product development or complete an acquisition. Given our
current financial and business condition, it is unlikely that we will be able to
obtain outside financing from any source for any purpose, including introducing
new products. We have no material assets to use as collateral given that we sold
our real property and equipment in 2004 (though we are able to carry these items
on our financial statements because York Realty Leasing LLC, the entity that
purchased the real property and equipment, is considered a "variable interest
entity" and according to GAAP our consolidated balance sheet must include the
assets and liabilities of York Realty Leasing LLC) and the risks and
uncertainties attached to our operations would present significant impediments
to locating a source of financing. We expect that any available cash from
operations we may have in the foreseeable future will be utilized to satisfy our
existing obligations. Our inability to obtain outside financing, among other
things:

      o     will restrict our ability to develop or add new products;

      o     restrain our ability to add new personnel;

      o     limit our ability to take advantage of other business opportunities
            as they arise; and

      o     puts us at risk to period-to-period operating fluctuations resulting
            from general economic conditions or the effects of competition.

      Accordingly, we expect that available cash is and will be limited to net
income generated from continuing operations, if any, without giving effect to
how the terms of any agreements we may enter with the Debenture holders or Key
will impact on our cash position. We are uncertain as to whether we will post
net profits in any future years and the extent to which any such profits would
be subject to remittance to the Debenture holders or Key under our obligations
to these entities.

      We have contracted with a full-service sales and marketing outsourcing
company that focuses on generic and branded pharmaceutical companies to handle
the majority of the sales and marketing efforts for our transdermal
nitroglycerin product. This company monitors client sales, as well as
scrutinizes the competition in order to anticipate and recommend changes to our
sales, marketing and promotional strategy. This company also assists in
providing the industry contacts to reach all distribution channels. Two
customers accounted for approximately 55% of the sales volume of our patch
during 2005. Management recognizes the need to expand distribution channels to
reduce our reliance on sales to a few customers and will seek to take the steps
necessary to address this situation and alleviate this risk.


                                     - 35 -
<PAGE>

Results of Operations.

      Overview.

      The consolidated financial statements of the Company have been
reclassified to reflect the results of operations and net assets of the
diagnostic product division of the Company as discontinued operations in
accordance with generally accepted accounting principles.

      Year ended December 31, 2005 versus December 31, 2004

      For the year ended December 31, 2005, our net sales with respect to
continuing operations were $7.6 million consisting solely of transdermal
nitroglycerin patches. For the 2004 year, our net sales with respect to
continuing operations were $9.2 million, comprised solely of net sales of
transdermal nitroglycerin patches. Net sales of transdermal nitroglycerin
patches decreased 17% during the 2005 period. This decrease is due primarily to
a single customer who purchased approximately 44% less transdermal nitroglycerin
patches in 2005 as compared to the amount purchased in 2004.

      Product development income increased $.1 million for the twelve months
ended December 31, 2005 as compared to the same period in 2004, due primarily to
additional development work income associated with a new project that commenced
in 2005.

      Gross profit with respect to continuing operations decreased $1.8 million,
or 61%, to $1.1 million for the twelve months ended December 31, 2005 as
compared to $2.9 million for the same period in 2004. Gross profit as a percent
of sales decreased from 32% during 2004 to 15% during 2005. The decrease in
gross profit was due primarily to decreased sales volumes of lower margin
products.

      Selling, general and administrative expenses increased $1.0 million for
the twelve months ended December 31, 2005 as compared to the corresponding
period in 2004. The increase is due primarily to increases in wages,
professional/consulting fees and legal fees of $216,000, $342,000 and $542,000,
respectively, partially offset by a decrease in commission expense of $190,000.
A significant portion of the legal and accounting fees are attributable to the
preparation of disclosure documents filed with the SEC and the defense of the
Aronowitz litigation described under "ITEM 3. LEGAL PROCEEDINGS."

      Research and development expenses increased $24,000, or 6%, to $438,000
for the twelve months ended December 31, 2005 as compared to $414,000 for the
same period in 2004. The increase is due primarily to higher expenditures for
lab supplies.

      Net interest expense was essentially the same for the twelve months ended
December 31, 2005 as compared to the same period in 2004. Outstanding debt
during these periods was relatively constant.

      The Company did not experience a loss from discontinued operations during
2005 but suffered a loss from discontinued operations of $260,000 for the twelve
months ended December 31, 2004. The loss from discontinued operations in 2004 of
$260,000 represents a write-off of the recorded values of the assets related to
the elimination of the diagnostic division.


                                     - 36 -
<PAGE>

      Year ended December 31, 2004 versus December 31, 2003

      For the year ended December 31, 2004, our net sales with respect to
continuing operations were $9.2 million consisting solely of transdermal
nitroglycerin patches. For the 2003 year, our net sales with respect to
continuing operations were $7.9 million, comprised solely of net sales of
transdermal nitroglycerin patches. Net sales of transdermal nitroglycerin
patches increased 16% during the 2004 period. This increase is due primarily to
a single customer who purchased approximately 84% more transdermal nitroglycerin
patches in 2004 as compared to the quantity purchased in 2003.

      Product development income increased $.2 million for the twelve months
ended December 31, 2004 as compared to the same period in 2003, due primarily to
additional development work income associated with a contract signed in June
2004.

      Gross profit with respect to continuing operations increased $1.0 million,
or 54%, to $2.9 million for the twelve months ended December 31, 2004 as
compared to $1.9 million for the same period in 2003. Gross profit as a percent
of sales increased from 24% during 2003 to 32% during 2004. The increase in
gross profit was due primarily to increased sales volumes of higher margin
products.

      Selling, general and administrative expenses decreased $.2 million for the
twelve months ended December 31, 2004 as compared to the corresponding period in
2003. The decrease is due primarily to lower factor expenses.

      Research and development expenses were essentially the same for the twelve
months ended December 31, 2004 as compared to the same period in 2003.

      Net interest expense decreased $.1 million for the twelve months ended
December 31, 2004 as compared to the same period in 2003 because interest rates
on the debt outstanding were marginally lower in 2004, due to the Company
refinancing existing debt with new parties at lower interest rates.

      Loss from discontinued operations decreased $.4 million for the twelve
months ended December 31, 2004 as compared to the corresponding period in 2003.
The loss from discontinued operations in 2004 of $260,000 represents a write-off
of the recorded values of the assets related to the elimination of the
diagnostic division. The loss from discontinued operations in 2003 of $658,000
consists of $659,000 in losses generated by the diagnostic division, partially
offset by $1,000 in collections on the accounts receivable of the Pacific
Combining Corporation subsidiary that was closed on November 20, 1998.

Liquidity and Capital Resources.

      In addition to the discussion relating to our liquidity and capital
resources below, we refer readers to the section titled "Factors Which We
Believe Affect Our Current Operations and May Materially Impact Our Future
Operations" appearing above, for more analysis as to the impact our lack of
liquidity may have on our current and future operations.

      We incurred a net loss during 2005 of $2,480,000 as compared to the
receipt of net income of $9,000 for the 2004 fiscal year. Our total capital
deficiency was $14.9 million at December 31, 2005, compared to $12.5 million at
December 31, 2004. As of December 31, 2005, we had an accumulated deficit of
approximately $26,402,000. Our principal sources of liquidity have been cash
provided by loans from management and cash generated by operations. Our
principal uses of cash have been for working capital and research and
development.


                                     - 37 -
<PAGE>

      Our working capital deficit increased $2.3 million to $14.7 million from
December 31, 2004 to December 31, 2005 due to an increase of $1.9 million in
current liabilities and a decrease of $.4 million in current assets. The current
liabilities increase consists primarily of increases in royalties payable,
accrued interest on the Debentures and other liabilities of $1.6 million, $.6
million and $.5 million, respectively, partially offset by a decrease in
accounts payable of $.9 million. The current assets decrease consists primarily
of decreases in each of cash, accounts receivable, amount due from financing
agency and inventory of $.1 million, $.1 million, $.1 million and $.1 million,
respectively. The royalties payable and accrued interest on the Debentures
increases are attributable to the Company's not making payments to the Debenture
holders or Key during the year. The increases in the other liabilities are due
primarily to increases in accrued chargebacks. The decrease in accounts
receivable resulted from a decrease in sales in the month of December 2005 as
compared to the month of December 2004 and also reflects the timing of customer
payments. The decrease in due from financing agency is due to the Company
terminating its relationship with the financing agency in April 2005. The
decrease in inventory reflects lower transdermal nitroglycerin product sales and
the timing of raw material purchases.

      Cash used for operating activities of continuing operations for the twelve
months ended December 31, 2005 was $213,000, as compared to cash provided by
operating activities of continuing operations of $614,000 for the same period in
2004. The decrease is due primarily to the $2.5 million net loss in 2005 and to
decreasing accounts receivable, amount due from financing agency, inventory and
accounts payable of $.1 million, $.1 million, $.1 million and $.9 million,
respectively, and increasing royalties payable, accrued interest on the
Debentures, other liabilities and mortgage escrow deposit of $1.6 million, $.6
million, $.5 million and $.2 million, respectively, in 2005 as compared to
increasing accounts receivable, inventory, royalties payable, accrued interest
on the Debentures and other liabilities of $2.1 million, $.5 million, $1.6
million, $.6 million and $.2 million, respectively, in 2004. Investing
activities of continuing operations for the twelve months ended December 31,
2005 used cash of $87,000 as compared to the same period in 2004 which used cash
of $128,000. This increase in use of cash is due to additions made to property,
plant and equipment during 2005. Financing activities of continuing operations
for the twelve months ended December 31, 2005 provided $211,000 of cash as
compared to the same period in 2004 which provided $26,000 of cash.

      As of December 31, 2005, we owed an aggregate of $10.8 million under the
Debentures, comprising $6.1 of principal and $4.7 of accrued interest.
Management expects to enter into discussions in the near future with respect to
structuring a plan to satisfy the amount due under the Debentures but cannot
predict the nature of the agreement, if one is reached at all, the parties will
enter or the terms of any such agreement. Any failure to enter into an agreement
to satisfy its obligations under the Debentures would have a material adverse
effect on the financial condition and operations of the Company.

      Management has initiated discussions with Key with respect to repaying
past royalties due under the Key License. To date, no agreement has been
reached.

      Expenditures in 2006 such as capital expenditures, research and
development costs and other operating expenses have been financed by cash
generated from operating activities of continuing operations. The Company
anticipates that it will not be required to make any material capital
expenditures for property, plant or equipment in 2007. At December 31, 2006, the
Company estimates that it had expended approximately $125,000 for capital
expenditures for property, plant and equipment in 2006.

Contractual Obligations.

      The following table summarizes our contractual obligations at December 31,
2005 (in thousands):


                                     - 38 -
<PAGE>

--------------------------------------------------------------------------------
                                    Payments due by Period (in thousands)
--------------------------------------------------------------------------------
                                      Less than     1-3        3-5    More than
                              Total     1 Year     Years      Years    5 Years
--------------------------------------------------------------------------------
Debentures                  $10,830    $10,830
--------------------------------------------------------------------------------
Other Long-term Debt            167                          $   167
--------------------------------------------------------------------------------
Royalties                     6,108      6,108
--------------------------------------------------------------------------------
Sale/Leaseback
(Operating Lease)             2,974        212    $   425        425    $1,912
--------------------------------------------------------------------------------
Operating Lease                  15          7          8
--------------------------------------------------------------------------------
          Total             $20,094    $17,157    $   433    $   592    $1,912
--------------------------------------------------------------------------------

      Debentures consist of $6.1 million of convertible subordinated debentures
that became due April 15, 1999 and $4,730,000 of accrued interest associated
with these Debentures.

      Other long-term debt consists of a $167,000 note related to the purchase
of certain fixed assets. The purchase of these fixed assets was pursuant to a
development, manufacturing and supply agreement that the Company entered into
with a client company. Payment terms of the note are contingent upon certain
performance criteria under the agreement. One such performance criteria
applicable to the client company may result in the note being forgiven. We
estimate the earliest that the note may need to be repaid is in 2008.

      Royalties consist of the amount due to Key for royalties under the Key
License. We are uncertain as to what arrangements we can make for the payment of
these royalties. Because the Key License provides for payments based upon
products sold, we have excluded future royalty payments from the above table.

      The sale/leaseback (operating lease) consists solely of the December 2004
sale/leaseback agreement with York Realty Leasing LLC, the terms of which are
described in Item 12, below.

      In December 2004 we entered into a lease for office space in Suffern, New
York for a one year period commencing January 1, 2005, and renewed the lease for
additional one year periods commencing January 1, 2006 and January 1, 2007. The
annual rental was $7,200, inclusive of utilities, for 2005 and will be $7,416
and $7,691 for 2006 and 2007, respectively.

Liquidity and Operations Going Forward.

      The Company intends to continue its efforts to (i) take the steps
necessary to meet its future cash flow requirements, (ii) develop new products
and (iii) take advantage of contract manufacturing opportunities. Management's
plans in this regard include, but are not limited to, the following:

o     continue negotiating with Key with respect to devising a plan to pay the
      royalties due under the Key License and possibly negotiate a new license
      agreement;

o     approach the Trustee of the Debentures to negotiate a payment plan which
      will allow for the normal operation of the Company;


                                     - 39 -
<PAGE>

o     continue with existing projects whereby the Company is developing other
      transdermal products for client companies and where the Company will be
      the contract manufacturer of these products, if FDA approval is obtained;

o     form business alliances with other pharmaceutical companies in connection
      with the development and/or manufacture of new products;

o     raise additional working capital through borrowing or by issuing equity;
      and

o     evaluate new directions for the Company's operations.

      Management believes that actions presently being taken will need to be
further realigned or otherwise amended so that the Company will be in a position
to generate sufficient revenues to provide positive cash flows from operations
and meet its obligations as they become due. However, there can be no assurance
that this will occur.

      Given our current financial condition and outstanding obligations, we are
uncertain as to our future sources of cash as we expect to encounter difficulty
either accessing capital markets or obtaining financing from traditional
lenders. We expect that our liquidity position and ability to obtain cash from
outside sources will be materially impacted by the terms of the agreements we
may enter into with the holders of the Debentures and Key and the other factors
enumerated above under the heading "Factors which Affect or May Impact Our
Current and Future Operations."

Off-Balance Sheet Arrangements.

      We have not entered into any off-balance sheet arrangements.

Critical Accounting Policies.

      Our significant accounting policies are described in Note 2 of the Notes
to Consolidated Financial Statements, which were prepared in accordance with
accounting principles generally accepted in the United States of America.
Included within these policies are certain policies which contain critical
accounting estimates and, therefore, have been deemed to be "critical accounting
policies." Critical accounting estimates are those which require management to
make assumptions about matters that were uncertain at the time the estimate was
made and for which the use of different estimates, which reasonably could have
been used, or changes in the accounting estimates that are reasonably likely to
occur from period to period, could have a material impact on the presentation of
our financial condition, changes in financial condition or results of
operations. The Company has identified revenue recognition and legal matters as
its critical accounting policies.

Revenue Recognition.

      Revenue is recognized for product sales upon shipment when title and risk
of loss have transferred to the customer and when provisions for estimates,
including discounts, rebates, promotional adjustments, price adjustments,
returns, chargebacks, and other potential adjustments are reasonably
determinable. Accruals for these provisions are presented in the Consolidated
Financial Statements as reductions to net revenues and within other current
liabilities. Other current liabilities include $1,745,000 and $1,267,000 at
December 31, 2005 and 2004, respectively, for certain rebates and other
adjustments that are paid to customers.


                                     - 40 -
<PAGE>

      Provisions for estimated discounts, rebates, promotional and other credits
are estimated based on historical payment experience, historical relationship to
revenues and contract terms. Such provisions are determinable due to the limited
number of assumptions and consistency of historical experience. Others, such as
price adjustments, returns and chargebacks, require management to make more
subjective judgments and evaluate current market conditions. These provisions
are discussed in further detail below.

      Price Adjustments -- Price adjustments, which include shelf stock
adjustments, are credits issued to reflect decreases in the selling prices of
our products. Shelf stock adjustments are based upon the amount of product that
our customers have remaining in their inventories at the time of the price
reduction. Decreases in our selling prices are discretionary decisions made by
us to reflect market conditions. Amounts recorded for estimated price
adjustments are based upon specified terms with direct customers, and in the
case of shelf stock adjustments, estimates of inventory held by the customer.

      Returns -- Consistent with industry practice, we maintain a return policy
that allows our customers to return product within a specified period prior to
and subsequent to the expiration date. Our estimate of the provision for returns
is based upon our historical experience with actual returns, which is applied to
the level of sales for the period that corresponds to the period during which
our customers may return product. This period is known by us based on the shelf
lives of our products at the time of shipment.

      Chargebacks -- The provision for chargebacks is the most significant
estimate used in the recognition of revenue. The Company markets products
directly to wholesalers, distributors, retail pharmacy chains, mail order
pharmacies and group purchasing organizations. The Company also markets products
indirectly to independent pharmacies, managed care organizations, hospitals,
nursing homes and pharmacy benefit management companies, collectively referred
to as "indirect customers." The Company enters into agreements with its indirect
customers to establish contract pricing for certain products. The indirect
customers then independently select a wholesaler whom they actually purchase the
products at these contracted prices. Alternatively, certain wholesalers may
enter into agreements with indirect customers which establish contract pricing
for certain products which the wholesalers provide. Under either arrangement,
the Company will provide credit to the wholesaler for any difference between the
contracted price with the indirect party and the wholesaler's invoice price.
Such credit is called a chargeback, while the difference between the contracted
price and the wholesaler's invoice price is referred to as the chargeback rate.
The provision for chargebacks is based on expected sell-through levels by our
wholesaler customers to indirect customers. Additionally, internal estimates are
prepared based upon historical buying patterns and estimated end user demand.
Such information allows us to estimate the potential chargeback that we may
ultimately owe to our customers given the quantity of inventory on hand. We
continually monitor our provision for chargebacks and evaluate our reserve and
estimates as additional information becomes available.

Legal Matters.

      The Company is involved in various legal proceedings, one of which
involves claims for substantial amounts. An estimate is made to accrue for a
loss contingency relating to any of these legal proceedings if it is probable
that a liability was incurred as of the date of the financial statements and the
amount of loss can be reasonably estimated. Because of the subjective nature
inherent in assessing the outcome of litigation and because of the potential
that an adverse outcome in a legal proceeding could have a material impact on
the Company's financial position or results of operations, such estimates are
considered to be critical accounting estimates. After review, it was determined
at December 31, 2005 that for each of the various legal proceedings in which we
are involved, the conditions mentioned above were not met. The Company will
continue to evaluate all legal matters as additional information becomes
available.


                                     - 41 -
<PAGE>

Recent Accounting Pronouncements.

      In January 2003, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable
Interest Entities ("FIN 46(R)"). FIN 46(R) addresses the consolidation of
business enterprises to which the usual condition (ownership of a majority
voting interest) of consolidation does not apply. FIN 46(R) focuses on
controlling financial interests that may be achieved through arrangements that
do not involve voting interests. It concludes that in the absence of clear
control through voting interests, a company's exposure (variable interest) to
the economic risks and potential rewards from the variable interest entity's
assets and activities are the best evidence of control. If an enterprise holds a
majority of the variable interests of an entity, it would be considered the
primary beneficiary. Upon consolidation, the primary beneficiary is generally
required to include assets, liabilities and non-controlling interests at fair
value and subsequently account for the variable interest as if it were
consolidated based on majority voting interest. As a result of FIN 46(R),
effective as of December 31, 2004, the Company's consolidated balance sheet
includes the assets and liabilities of York Realty Leasing LLC.

      In May 2004, the FASB issued FASB Staff Position No. 106-2, Accounting and
Disclosure Requirements Related to the Medicare Prescription Drug, Improvement
and Modernization Act of 2003 (FSP 106-2)in response to a new law regarding
prescription drug benefits under Medicare as well as a federal subsidy to
sponsors of retiree healthcare benefit plans. We expect that the impact of this
act will not be material.

      In November 2004, the FASB issued Statement of Financial Accounting
Standards ("SFAS") No. 151, Inventory Costs - an Amendment of ARB No. 43,
Chapter 4. SFAS 151 clarifies the accounting for abnormal amounts of idle
facility expense, freight, handling costs and spoilage. SFAS 151 also requires
that allocation of fixed production overhead costs be based on normal production
activity. The provisions of SFAS 151 are effective for inventory costs incurred
beginning in January 2006, with adoption permitted for inventory costs incurred
beginning in January 2005. Adoption of this Statement is not expected to have a
material effect on the Company's Consolidated Financial Statements.

      In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment.
SFAS 123(R) establishes standards for the accounting for transactions in which
an entity exchanges its equity instruments for goods and services. Under SFAS
123(R), companies will no longer be able to account for share-based compensation
transactions using the intrinsic method in accordance with APB No. 25,
Accounting for Stock Issued to Employees. Instead, companies will be required to
account for such transactions using a fair-value method and to recognize
compensation expense over the period during which an employee is required to
provide services in exchange for the award. In April 2005, the SEC delayed the
effective date of SFAS 123(R) to fiscal years beginning after June 15, 2005.
Management is currently assessing the impact that adoption of this Statement
will have on the Company's Consolidated Financial Statements.

      In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
Corrections - a Replacement of APB Opinion No. 20 and SFAS No. 3. SFAS 154
changes the requirements for the accounting for and reporting of a change in
accounting principle. This Statement applies to all voluntary changes in
accounting principle. SFAS 154 also applies to changes required by an accounting
pronouncement in the usual instance that the pronouncement does not include
specific transition provisions. The provisions of SFAS 154 are effective for
accounting changes and corrections of errors made in fiscal years beginning
after December 15, 2005. Adoption of this Statement is not expected to have a
material effect on the Company's Consolidated Financial Statements.


                                     - 42 -
<PAGE>

Inflation.

      We believe that our results of operations are not dependent upon moderate
changes in inflation rates.

ITEM 7. FINANCIAL STATEMENTS.

      Health-Chem submits with this report the financial statements and related
information listed in the Index to Consolidated Financial Statements on page F-1
following this report's signature page.

ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.

      On February 4, 2005, we retained the services of Demetrius & Company,
L.L.C. to serve as our independent accountant to audit our financial statements.
We had not retained an independent auditor since 2000. The engagement of
Demetrius & Company was approved by our Board of Directors.

      Prior to its engagement, we had not consulted with Demetrius & Company,
L.L.C. regarding the application of accounting principles to a specific
completed or contemplated transaction, or the type of audit opinion that would
be rendered on our financial statements. Moreover, we did not seek, and
Demetrius & Company, L.L.C. did not furnish, written or oral advice on any
matter that we considered an important factor in reaching a decision as to an
accounting, auditing or financial reporting issue.

      Demetrius & Company's offices are located at Wayne Interchange Plaza II,
155 Route 46, Wayne, New Jersey 07470.

ITEM 8A. CONTROLS AND PROCEDURES.

      We maintain disclosure controls and procedures designed to ensure that
information required to be disclosed in our reports filed or submitted under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in the SEC's rules and forms. As of the end of
the period covered by this Annual Report, we carried out an evaluation, under
the supervision and with the participation of management, including our Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures pursuant to
Exchange Act Rule 13a-15. Based upon that evaluation, management and our Chief
Executive Officer and Chief Financial Officer concluded that our disclosure
controls and procedures are effective. During the periods covered by this Annual
Report, there was no change in our internal control over financial reporting (as
defined in Rule 13a-15(f) under the Exchange Act) that materially effected, or
is reasonably likely to materially effect, our internal control over financial
reporting.

ITEM 8B. OTHER INFORMATION.

None

                                    PART III

ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE
WITH SECTION 16(A) OF THE EXCHANGE ACT.


                                     - 43 -
<PAGE>

Directors and Executive Officers.

      The following table sets forth certain information about our directors and
executive officers as of February 1, 2007:

--------------------------------------------------------------------------------
                                                                          Year
                                                                         First
                                                                         Became
       Name             Age                  Position                   Director
       ----             ---                  --------                   --------
--------------------------------------------------------------------------------
Andy E. Yurowitz         71     Chairman of the Board, President,         2000
                                Chief Executive Officer and Director
--------------------------------------------------------------------------------
Ronald J. Burghauser     46     Chief Financial Officer, Treasurer
                                and Secretary
--------------------------------------------------------------------------------
Andrew J. Levinson       58     Director                                  2000
--------------------------------------------------------------------------------
Manfred Mayerfeld        75     Director                                  2000
--------------------------------------------------------------------------------

      The Company's directors are elected to hold office until the next annual
meeting of shareholders and until their respective successors have been elected
and qualified. The Company's officers serve at the pleasure of the Board of
Directors.

      Set forth below is biographical information concerning our directors and
executive officers for at least the past five years. All of the following
persons who are executive officers are also full-time employees.

      Andy E. Yurowitz has served as Chairman of the Board of Directors of the
Company since February 2000. Mr. Yurowitz has also served as Chairman of the
Board of Directors of Transderm Laboratories Corporation since February 2000.

      Ronald J. Burghauser, a certified public accountant, has served as Chief
Financial Officer, Treasurer and Secretary of the Company since November 2003.
From May 2002 through October 2003, Mr. Burghauser was Controller of the
Company. From April 1999 through September 2001, Mr. Burghauser was Chief
Financial Officer for Oakworks, Inc., a manufacturer of therapeutic equipment.

      Andrew J. Levinson has been a practicing attorney for more than
twenty-nine years. From September 2002 to the present, Mr. Levinson has been
counsel to Greenberg & Kahr in New York City. Previously he was a partner in
Phillips Nizer, LLP from March 2001 to August 2002.

      Manfred Mayerfeld retired from teaching in 1991. Since then he has been
active in real estate investing and property management.

Section 16(a) Beneficial Ownership Reporting Compliance

      Section 16(a) of the Securities Act of 1934 requires the Company's
officers and directors, and greater than 10% stockholders, to file reports of
ownership and changes in ownership of its securities with the SEC. Copies of the
reports are required by SEC regulation to be furnished to the Company. Based on
management's review of these reports during the year ended December 31, 2005,
none of the reports required to be filed were filed on a timely basis.


                                     - 44 -
<PAGE>

Code of Ethics

      Our Board of Directors has adopted a Code of Ethics that applies to our
Chief Executive Officer, our Chief Financial Officer and to the other senior
management and senior financial staff of our company. Our Code of Ethics
complies with the requirements imposed by the Sarbanes-Oxley Act of 2002 and the
rules and regulations issued thereunder for codes of ethics applicable to such
officers. Our Board of Directors has reviewed and will continue to evaluate its
role and responsibilities with respect to the new legislative and other
requirements of the SEC. Interested persons can obtain a copy of our Code of
Ethics, without charge and upon request, by writing to the Company's Secretary
at: Health-Chem Corporation, 101 Sinking Springs Lane, Emigsville, PA 17318.

Corporate Governance

      General

      We believe that good corporate governance is important to ensure that
Health-Chem is managed for the long-term benefit of our stockholders. This
section describes key corporate governance practices.

      Board Determination of Independence

      As of the date hereof, the Company has no policy with respect to
independence requirements for its Board members or that a majority of its board
be comprised of "independent directors." In determining whether a Board member
is "independent," the Company applies the standards of "independence" prescribed
by rules set forth by the American Stock Exchange ("AMEX"). Accordingly, a
director will only qualify as an "independent director" if, in the opinion of
our Board of Directors, that person does not have a relationship with our
company which would interfere with the exercise of independent judgment in
carrying out the responsibilities of a director. A director who is, or at any
time during the past three years, was employed by the Company or by any parent
or subsidiary of the Company, shall not be considered independent. Accordingly,
Manfred Mayerfeld and Andrew Levinson meet the definition of "independent
director" under Section 121 of the American Stock Exchange Company Guide; Andy
Yurowitz does not.

      Board of Directors Meetings and Attendance

      The Board of Directors has responsibility for establishing broad corporate
policies and reviewing our overall performance rather than day-to-day
operations. The primary responsibility of our Board of Directors is to oversee
the management of our company and, in doing so, serve the best interests of the
Company and our stockholders. The Board of Directors selects, evaluates and
provides for the succession of executive officers and, subject to stockholder
election, directors. It reviews and approves corporate objectives and
strategies, and evaluates significant policies and proposed major commitments of
corporate resources. Our Board of Directors also participates in decisions that
have a potential major economic impact on our Company. Management keeps the
directors informed of Company activity through regular communication.

      We have no formal policy regarding director attendance at the annual
meeting of stockholders, although all directors are expected to attend the
annual meeting of stockholders if they are able to do so. The Board of Directors
did not meet or otherwise take action by written consent during 2005.


                                     - 45 -
<PAGE>

      Board of Directors Committees

      We do not currently have a standing audit, nominating or compensation
committee of the Board of Directors, or any committee performing similar
functions. Our Chairman of the Board, Andy Yurowitz, and our remaining
directors, Manfred Mayerfeld and Andrew Levinson, perform the functions of
audit, nominating and compensation committees. As of the date of this report, no
member of our Board of Directors qualifies as an "audit committee financial
expert" as defined in Item 401(e) of Regulation S-B promulgated under the
Securities Act of 1933, as amended. Since the Board of Directors currently
consists of three members, it does not believe that establishing a separate
nominating committee is necessary for effective governance. When additional
members of the Board of Directors are appointed or elected, we will consider
creating a nominating committee. Given the Company's financial condition,
management does not anticipate hiring any additional executives in the
foreseeable future and for this reason it does not believe that establishing a
separate compensation committee is necessary for effective governance. The Board
will consider establishing a compensation committee if and when it becomes
necessary or required.

      Shareholder Communications

      The Company does not presently provide a process for security holders to
send communications to the Board of Directors. The Company does not provide such
process because it has not held a shareholders meeting at which directors were
elected since 1999, as it has not had the funds to cover the cost of preparing
and filing a proxy statement in connection with such meeting. All of the current
members of the Board of Directors have served as directors since 2000. The Board
of Directors expects to hold a shareholders meeting at which directors will be
elected after it files its annual report for the year ended December 31, 2006
and to adopt a process for security holders to send communications to the Board
of Directors prior to the annual shareholders meeting after the 2007 fiscal year
which it will make available to shareholders in a report it will file with the
SEC after the adoption of such process.

ITEM 10. EXECUTIVE COMPENSATION

Directors' Compensation

      The Company does not compensate its employee directors for services
rendered as directors. The Company reimburses non-employee directors for travel
and related expenses for attending board meetings. Effective January 1, 2006,
non-employee directors receive $1,250 per month, an additional fee of $1,000 for
each board meeting attended in person and $500 for each board meeting attended
telephonically. Effective January 1, 2006, the Company's outside directors
receive an annual award of 20,000 stock options under the Company's equity
incentive plan. These awards are granted quarterly on the first business day of
each calendar quarter, with an exercise price equal to the market price on such
date. During the period January 2000 through December 2005, non-employee
directors received no fees and only were reimbursed for travel and related
expenses for attending board meetings.

Executive Compensation

      The following Summary Compensation Table sets forth certain information
concerning the annual and long-term compensation of the person serving as the
Company's chief executive officer and each other executive officer who received
annual compensation in excess of $100,000 during the last two fiscal years
(collectively, the "Named Executives").


                                     - 46 -
<PAGE>

<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------------------------------------------
                                                     SUMMARY COMPENSATION TABLE
------------------------------------------------------------------------------------------------------------------------------------
                                                                                      Long Term Compensation
------------------------------------------------------------------------------------------------------------------------------------
                                              Annual Compensation                      Awards              Payouts
------------------------------------------------------------------------------------------------------------------------------------
                                                                                            Securities
                                                               Other Annual   Restricted    Underlying                  All Other
Name and                                                       Compensation   Stock         Options/SARs   LTIP         Compensation
Principle Position           Year      Salary($)    Bonus($)   ($)            Award(s)($)   (#)            Payouts($)   ($)(1)
------------------------------------------------------------------------------------------------------------------------------------
<S>                          <C>       <C>           <C>       <C>            <C>           <C>            <C>          <C>
Andy Yurowitz,
President, Chief
Executive Officer and        2005      $180,000                                                                         $    606
Chairman                     2004      $145,974
------------------------------------------------------------------------------------------------------------------------------------
Ronald J. Burghauser,        2005      $133,827                                                                         $  1,994
Chief Financial Officer      2004      $117,036      $4,600                                                             $  1,583
------------------------------------------------------------------------------------------------------------------------------------
Kenneth Brody, Former
Chief Financial
Officer and Former
Manager - Sales,
Marketing & Business         2005      $130,769                                                                         $  2,659
Development
------------------------------------------------------------------------------------------------------------------------------------
Donald E. Kauffman,
Former Vice President
Transderm Laboratories
Corp. and Hercon             2004      $112,800                                                                         $  1,613
Laboratories Corp.
------------------------------------------------------------------------------------------------------------------------------------
Richard L. Bulwicz,
Manager - Quality            2005      $101,600                                                                         $  1,503
Operations                   2004      $ 97,575      $3,900                                                             $  1,412
------------------------------------------------------------------------------------------------------------------------------------
</TABLE>

(1)   Consists of the Company matching contributions under our 401(K) plan and
      the term cost value of all excess group life insurance policies on behalf
      of the Named Executives.

Option Grants during the 2005 and 2006 Fiscal Year.

      The Company did not grant any options during the years ended December 31,
2005.

      During fiscal 2006, the Company issued an aggregate of 20,000 options to
purchase a like number of shares of common stock to each of Andrew Levinson and
Manfred Mayerfeld as compensation for serving as directors during directors of
the Company during the period (5,000 shares on the first day of each quarter).
These options are exercisable for a period of five years from the date of grant
at an exercise price equal to the closing sale price (or average of the closing
bid and asked price if no sale price is quoted) on the last trading day of the
preceding quarter. These options have the following exercise prices:

o     Options issued during the first quarter are exercisable at $0.08 per
      share.


                                     - 47 -
<PAGE>

o     Options issued during the second quarter are exercisable at $0.08 per
      share.

o     Options issued during the third quarter are exercisable at $0.085 per
      share.

o     Options issued during the fourth quarter are exercisable at $0.06 per
      share.

Fiscal Year-End Option Numbers and Values.

      The following table sets forth additional information as of December 31,
2005, concerning shares of our common stock that may be issued upon the exercise
of options under our existing equity compensation plans held by the Named
Executives, divided between plans approved by our stockholders and plans or
arrangements not submitted to our stockholders for approval. The information
includes the number of shares covered by, and the weighted average exercise
price of, outstanding options and the number of shares remaining available for
future grants excluding the shares to be issued upon exercise of outstanding
options, warrants, and other rights.

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------------
                                                                Number of Securities      Value of Unexercised
                                                                Underlying Unexercised    In-the-Money Options
                                                                Options at 12/31/05       at 12/31/05 (2)
                        Shares Acquired on    Value Realized    Exercisable/              Exercisable/
Name                    Exercises (#) (1)     ($) (1)           Unexercisable (#)         Unexercisable ($)
----                    -----------------     -------           -----------------         -----------------

--------------------------------------------------------------------------------------------------------------
<S>                     <C>                   <C>               <C>                       <C>
Andy E. Yurowitz        ---                   ---               837,500/0                 0/0
--------------------------------------------------------------------------------------------------------------
Kenneth E. Brody        ---                   ---               50,000/0                  0/0
--------------------------------------------------------------------------------------------------------------
</TABLE>

(1)   None of the Named Executives exercised any stock options during 2005.

(2)   Based upon the last sales price of the Company's common stock reported as
      traded in 2005 on the Pink Sheets minus the respective option exercise
      price.

Equity Compensation Plan Information.

      The following table sets forth additional information as of December 31,
2005 concerning shares of our common stock that may be issued upon the exercise
of options and other rights under our existing equity compensation plans,
divided between plans approved by our stockholders and plans not submitted to
our stockholders for approval. The information includes the number of shares
covered by, and the weighted average exercise price of, outstanding options and
the number of shares remaining available for future grants excluding the shares
to be issued upon exercise of outstanding options, warrants, and other rights.

                                     - 48 -
<PAGE>
<TABLE>
<CAPTION>
                                           Equity Compensation Plan Information

--------------------------------------------------------------------------------------------------------------------------------
Plan Category                               (a)                           (b)                              (c)
                              Number of securities to be           Weighted-average         Number of securities available
                              issued upon exercise of              exercise price of        for future issuance under equity
                              outstanding options, warrants        outstanding              compensation plans (excluding
                              and rights                           options, warrants        securities reflected in column (a))
                                                                   and rights
--------------------------------------------------------------------------------------------------------------------------------
<S>                           <C>                                  <C>                                       <C>
Equity compensation
plans approved
by security holders
--------------------------------------------------------------------------------------------------------------------------------
Equity compensation
plans not approved
by security holders           3,395,500 (1)                        $0.11
--------------------------------------------------------------------------------------------------------------------------------

Total                         3,395,500                            $0.11                                     0
--------------------------------------------------------------------------------------------------------------------------------
</TABLE>

(1)   At certain times, the Board of Directors deemed it beneficial to the
      Company to issue specific amounts of stock options to selected option
      holders. These option grants were for specific purposes, as follows: (i)
      1,845,500 options granted to persons who loaned funds to the Company; (ii)
      1,100,000 options granted to persons who provided consulting services to
      the Company; (iii) 250,000 options granted to non-employee directors in
      lieu of their receiving compensation for attending board meetings; (iv)
      100,000 options granted to a former employee upon his separation from the
      Company; and (v) 100,000 options granted to a director as an incentive.

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.

      The following table sets forth information, as of February 13, 2007 with
respect to the beneficial ownership of our common stock by each person known by
us to be the beneficial owner of more than 5% of the outstanding common stock,
by each of our officers and directors, and by all of our officers and directors
as a group.

      For the purpose of this table, the beneficial ownership of a person
includes shares as to which that person has sole or shared voting or investment
power as well as shares that the person has the right to acquire within 60 days
(such as upon conversion of convertible securities or exercise of warrants or
options) as of February 13, 2007. For the purpose of calculating the ownership
percentages for each person listed, we have considered to be outstanding both
the total number shares actually outstanding on February 13, 2007 and the total
number of shares that the persons named in the following table then had the
right to acquire within 60 days of said date.

--------------------------------------------------------------------------------
                                      Number of Shares
     Name and Address             Beneficially Owned as of            Percent of
 of Beneficial Owner (1)             January 1, 2007 (2)               Class (3)
--------------------------------------------------------------------------------
Andy E. Yurowitz                         2,444,700(4)                   19.91%
--------------------------------------------------------------------------------
Manfred Mayerfeld                        1,829,789(5)                   14.73%
--------------------------------------------------------------------------------
Andrew J. Levinson                         225,000(6)                    1.96%
--------------------------------------------------------------------------------
Ronald J. Burghauser                        75,780(7)                       *
--------------------------------------------------------------------------------
Marvin Speiser (8)                       2,304,674(8)                   20.14%
--------------------------------------------------------------------------------
   All directors and
   executive officers as a
   group (4 persons)                     4,575,269(9)                   34.43%
--------------------------------------------------------------------------------


                                     - 49 -
<PAGE>

*     Indicates ownership of less than one percent (1%) of class.

(1)   Address is c/o Health-Chem Corporation, 101 Sinking Springs Lane,
      Emigsville, PA 17318.

(2)   The information concerning security holders is based upon information
      furnished to the Company by such security holder. Except as otherwise
      indicated, all of the shares are owned of record and beneficially and the
      persons identified have sole voting and dispositive power with respect
      thereto.

(3)   Based upon 11,443,424 shares of common stock outstanding on February 13,
      2007.

(4)   Includes (i) 1,607,100 shares of common stock, (ii) 837,500 shares of
      common stock issuable upon the exercise of all stock options which are or
      exercisable within 60 days of the date hereof; and (iii) 100 shares where
      voting and/or dispositive power is shared with another individual.

(5)   Includes the following shares of common stock: (i) 755,600 shares: (ii)
      983,000 shares issuable upon the exercise of all stock options which are
      exercisable within 60 days of the date hereof; and (iii) 91,189 shares
      where voting and/or dispositive power is shared with another individual.

(6)   Includes the following shares of common stock: (i) 200,000 shares and (ii)
      25,000 shares issuable upon the exercise of all stock options exercisable
      within 60 days of the date hereof.

(7)   Includes 780 shares where voting and/or dispositive power is shared with
      another individual.

(8)   Includes the following shares of common stock: (i) 1,516,593 shares
      registered in the name of Laura Speiser; (ii) 512,763 shares registered in
      the name of Marvin Speiser; (iii) 266,664 shares registered in the name of
      Lauralei Investors, Inc., of which Marvin Speiser and his wife, Laura
      Speiser, are the sole stockholders; and (iv) 8,654 registered in the name
      of Robert Speiser, Marvin and Laura Speiser's son. The Company has not
      been in contact with the Speisers since 1999 but is aware of the demise of
      Marvin and Laura Speiser.

(9)   Includes 1,845,500 shares of common stock issuable upon the exercise of
      options which are exercisable within 60 days of the date hereof.

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
INDEPENDENCE.

Transactions with Related Persons, Promoters and Certain Control Persons.

      In December 2004, the Company sold its real property, buildings,
improvements and equipment located in Emigsville, Pennsylvania to York Realty
Leasing LLC for a sale price of $1.9 million. Concurrent with the sale, the
Company entered into a 15-year lease for the property expiring in December 2019,
which can be extended by the Company for an additional five years. The agreement
provides for a Company repurchase option at a price of $1,995,000. The annual
lease cost during the initial 15 year term is $212,400. In December 2002, the
Company had received an appraisal for the real property, including the
structures and appurtenances, by Weinstein Realty Advisors, an independent real
estate agent located in York, Pennsylvania, which appraised the market value of
the real property and structures at $1,850,000. The proceeds from the sale were
used to satisfy a $1.6 million first mortgage associated with the property and
to substantially pay off a $367,500 Second Mortgage (the "Second Mortgage"). Mr.
Andy E. Yurowitz, the Company's Chairman of the Board, President, Chief
Executive Officer and a member of the Board of Directors, is a 50% owner of York
Realty Leasing LLC. The Company entered into the sale/leaseback arrangement with
York Realty Leasing LLC because it required cash and was unable to obtain a loan
or any other financing from an unaffiliated party on any basis. In December
2005, York Realty Leasing LLC obtained a $1.4 million mortgage from Fulton Bank.
Proceeds from the mortgage were used to pay down York Realty Leasing LLC member
loans.

Director Independence.

      See the discussion of director independence included under Item 9.
Directors, Executive Officers, Promoters And Control Persons; Compliance With
Section 16(A) Of The Exchange Act-Corporate Governance.


                                     - 50 -
<PAGE>

ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K

(a) EXHIBITS

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------------------
Exhibit
No.          Description                                                       Location Reference
---          -----------                                                       ------------------
-----------------------------------------------------------------------------------------------------------------------------
<S>          <C>                                                               <C>
2            Plan of Reorganization and Asset Exchange Agreement  dated as     Previously filed as Exhibit 2 to
             of June 30, 1995, by and among the Registrant,  Herculite         Registration Statement on  Form S-1 (Reg.
             Products, Inc. and Transderm Laboratories Corporation.            No. 33-95080) for Transderm, as filed
                                                                               with the Commission on July 28, 1995.
-----------------------------------------------------------------------------------------------------------------------------
3.1          Restated Certificate of Incorporation and amendments  of the      Previously filed as  Exhibit No. 3 to the
             Registrant.                                                       Registrant's Annual Report on Form 10-K
                                                                               for the year ended December 31, 1985.
-----------------------------------------------------------------------------------------------------------------------------
3.2          Certificate of Amendment of the Restated Certificate of           Previously filed as Exhibit No. 3.2 to
             Incorporation of the Registrant dated May 8, 1987.                the Registrant's Annual Report on Form
                                                                               10-K for the year ended December 31, 1987.
-----------------------------------------------------------------------------------------------------------------------------
3.3          By-Laws of the Registrant.                                        Previously filed as Exhibit 3.3 to the
                                                                               Registrant's Annual Report on Form 10-K
                                                                               for the year ended December 31, 1991.
-----------------------------------------------------------------------------------------------------------------------------
4.1          Indenture between the Registrant and Bankers Trust Company        Previously filed as Exhibit No. 4.2 to
             dated as of April 15, 1981 relating to the Registrant's 10 3/8%   the Registrant's Registration Statement
             Convertible Subordinated Debentures due 1999.                     on Form S-7 (Reg. No. 2-71341) as filed
                                                                               with the Commission on April 15, 1981.
-----------------------------------------------------------------------------------------------------------------------------
4.2          Form of 10?% Convertible Subordinated Debenture due April 15,     Previously filed as an exhibit  to the
             1999.                                                             Registrant's Registration Statement on
                                                                               Form S-7 (Reg. No. 2-71341) as filed with
                                                                               the Commission on April 15, 1981.
-----------------------------------------------------------------------------------------------------------------------------
4.3          Common Stock Purchase Warrant for the purchase of up to 712,500   Previously filed as Exhibit 4.3 to the
             shares of common stock issued by the Registrant in favor of       Registrant's Annual Report on Form 10-KSB
             Lazar & Company IG LLC.                                           for the year ended December 31, 2004 as
                                                                               filed with the SEC on July 31, 2006 (the
                                                                               "HC 2004 10-KSB").
-----------------------------------------------------------------------------------------------------------------------------
</TABLE>


                                     - 51 -
<PAGE>

<TABLE>
-----------------------------------------------------------------------------------------------------------------------------
<S>          <C>                                                               <C>
4.4          Common Stock Purchase Warrant for the purchase of up to 237,500   Previously filed as Exhibit 4.4 to the HC
             shares of common stock issued by the Registrant in favor of       2004 10-KSB.
             Hillel Zakai.
-----------------------------------------------------------------------------------------------------------------------------
4.5          Common Stock Purchase Warrant for the purchase of up to 50,000    Previously filed as Exhibit 4.5 to the HC
             shares of common stock issued by the Registrant in favor of       2004 10-KSB.
             Adam Epner.
-----------------------------------------------------------------------------------------------------------------------------
4.6          Registration Rights Agreement between the Registrant and Lazar    Previously filed as Exhibit 4.6 to the HC
             & Company IG LLC dated December 2003.                             2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
10.1         The 1986 Stock Option Plan as approved by the Registrant's        Previously filed as Exhibit No. 10.7 to
             Stockholders on April 26, 1986 and as amended by the              the Registrant's Annual Report on Form
             Registrant's Board of Directors on December 30, 1987.             10-K for the year ended December 31, 1987.
-----------------------------------------------------------------------------------------------------------------------------
10.2         Second Amendment to the 1986 Stock Option Plan as  approved by    Previously filed as Exhibit 10.4 to the
             the Registrant's Board of Directors on May 6,  1993.              Registrant's Annual Report on Form 10-K
                                                                               for the year ended December 31, 1993.
-----------------------------------------------------------------------------------------------------------------------------
10.3         The 1995 Performance Equity Plan.                                 Previously filed as Exhibit A to the
                                                                               Registrant's definitive Proxy Statement
                                                                               dated March 1, 1995 in connection with
                                                                               the Registrant's 1995 Annual Meeting of
                                                                               Stockholders.
-----------------------------------------------------------------------------------------------------------------------------
10.4         Asset Acquisition Agreement dated April 28, 1995 between Hercon   Previously filed as Exhibit 10.7 to
             Environmental Corporation and Hercon Laboratories Corporation.    Transderm Laboratories Corporation's
                                                                               Registration Statement on Form S-1  as
                                                                               filed with the Commission on July 28,
                                                                               1995.
-----------------------------------------------------------------------------------------------------------------------------
10.5         Modification Agreement dated August 31, 1995 by and between The   Previously filed as Exhibit 10.6(b) to
             First National Bank of Maryland, the Registrant, Hercon           Amendment No. 1 to Transderm Laboratories
             Laboratories Corporation, Herculite Products, Inc., Pacific       Corporation's Registration Statement on
             Combining Corporation, Hercon Environmental Corporation and       Form S-1 filed with the Commission on
             Transderm Laboratories Corporation.                               September 6, 1995.
-----------------------------------------------------------------------------------------------------------------------------
</TABLE>


                                     - 52 -
<PAGE>

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------------------
Exhibit
No.          Description                                                       Location Reference
---          -----------                                                       ------------------
-----------------------------------------------------------------------------------------------------------------------------
<S>          <C>                                                               <C>
10.6         $7,000,000 principal amount Subordinated Promissory Note of       Previously filed as Exhibit 10.8 to
             Hercon Laboratories Corporation.                                  Amendment No. 1 to Transderm Laboratories
                                                                               Corporation's Registration Statement on
                                                                               Form S-1 filed with the Commission on
                                                                               September 6, 1995.
-----------------------------------------------------------------------------------------------------------------------------
10.7         Corporate Services Agreement dated as of August 31, 1995          Previously filed as Exhibit 10.9 to
             between the Registrant and Transderm Laboratories Corporation.    Amendment No. 1 to Transderm Laboratories
                                                                               Corporation's Registration Statement on
                                                                               Form S-1 filed with the Commission on
                                                                               September 6, 1995 .
-----------------------------------------------------------------------------------------------------------------------------
10.8         Tax Sharing Agreement dated as of August 31, 1995 between the     Previously filed as Exhibit 10.10 to
             Registrant and Transderm.                                         Amendment No. 1 to Transderm Laboratories
                                                                               Corporation's Registration Statement on
                                                                               Form S-1 filed with the Commission on
                                                                               September 6, 1995.
-----------------------------------------------------------------------------------------------------------------------------
10.9         Second Modification Agreement dated as of October 11, 1995 by     Previously filed as Exhibit 10.5 to the
             and among the Registrant, Hercon Laboratories Corporation,        Registrant's Quarterly Report for the for
             Herculite Products, Inc., Pacific Combining Corporation, Hercon   the Quarter ended September 30, 1995
             Environmental Corporation and Transderm Laboratories
             Corporation.
-----------------------------------------------------------------------------------------------------------------------------
10.10        Loan and Security Agreement dated as of October 11, 1995 by and   Previously filed as Exhibit 1 to the
             among the Registrant, Hercon Laboratories Corporation,            Registrant's Current Report on Form 8-K
             Herculite Products, Inc., Pacific Combining Corporation, Hercon   filed with the Commission on October 11,
             Environmental Corporation and Transderm Laboratories              1995.
             Corporation and The First National Bank of Maryland.
-----------------------------------------------------------------------------------------------------------------------------
10.11        Revolving Credit, Term Loan and Security Agreement dated as of    Previously filed as Exhibit 1 to the
             January 9, 1997 by and among the Registrant, Hercon               Registrant's Current Report on Form 8-K
             Laboratories Corporation, Herculite Products, Inc., Pacific       dated January 22, 1997.
             Combining Corporation, Hercon Environmental Corporation,
             Transderm Laboratories Corporation and IBJ Schroder Bank &
             Trust Company.
-----------------------------------------------------------------------------------------------------------------------------
</TABLE>


                                     - 53 -
<PAGE>

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------------------
Exhibit
No.          Description                                                       Location Reference
---          -----------                                                       ------------------
-----------------------------------------------------------------------------------------------------------------------------
<S>          <C>                                                               <C>
10.12        First Amendment to Revolving Credit, Term Loan and Security       Previously filed as Exhibit 10.18(b) to
             Agreement dated as of January 21, 1998 by and among the           the Registrant's Form 10-K for the year
             Registrant, Hercon Laboratories Corporation, Herculite            ended December 31, 1997.
             Products, Inc., Pacific Combining Corporation, Hercon
             Environmental Corporation, Transderm Laboratories Corporation
             and IBJ Schroder Business Credit Corporation (as successor in
             interest to IBJ Schroder & Trust Company).
-----------------------------------------------------------------------------------------------------------------------------
10.13        Second Amendment to Revolving Credit, Term Loan and  Security     Previously filed as Exhibit 6.(a) to the
             Agreement dated as of July 31, 1998 by and among the              Registrant's Form 10-Q for the quarter
             Registrant, Hercon Laboratories Corporation, Herculite Products   ended September 30, 1998.
             Inc., Pacific Combining Corporation,  Hercon Environmental
             Corporation, Transderm Laboratories Corporation and IBJ
             Schroder Business Credit Corporation.
-----------------------------------------------------------------------------------------------------------------------------
10.14        Waiver and Third Amendment to Revolving Credit, Term  Loan and    Previously filed as Exhibit 10.18(d) to
             Security Agreement dated as of January 11, 1999 by and among      the Registrant's Form 10-K for the year
             the Registrant, Hercon Laboratories Corporation, Herculite        ended December 31, 1998.
             Products Inc., Pacific Combining Corporation,  Hercon
             Environmental Corporation, Transderm Laboratories Corporation
             and IBJ Whitehall Business Credit Corporation.
-----------------------------------------------------------------------------------------------------------------------------
10.15        Consent and Fourth Amendment to Revolving Credit, Term Loan and   Previously filed as Exhibit 10.18(e) to
             Security Agreement dated as of March 24, 1999 by and among the    the Registrant's Form 10-K for the year
             Registrant, Hercon Laboratories Corporation, Herculite Products   ended December 31, 1998.
             Inc., Pacific Combining Corporation,  Hercon Environmental
             Corporation, Transderm Laboratories Corporation and IBJ
             Whitehall Business Credit Corporation.
-----------------------------------------------------------------------------------------------------------------------------
10.16        Amendment and Forbearance Agreements to Revolving Credit, Term    Previously filed as Exhibit 10.18(f) to
             Loan and Security Agreement dated as of April 14, 1999, May 14,   the Registrant's Form 10-K for the year
             1999, June 21, 1999, July 15, 1999 and August 15, 1999 by and     ended December 31, 1998.
             between the Registrant, Hercon Laboratories Corporation,
             Herculite Products Inc., Pacific Combining Corporation,  Hercon
             Environmental Corporation, Transderm Laboratories Corporation
             and IBJ Whitehall Business Credit Corporation.
-----------------------------------------------------------------------------------------------------------------------------
10.17        Asset Purchase Agreement dated as of July 20, 1999 by and among   Previously filed as Exhibit 2.1 to the
             Herculite Products Inc., Hercon Environmental Corporation and     Company's Current Report on Form 8-K
             Aberdeen Road Company.                                            dated September 2, 1999.
-----------------------------------------------------------------------------------------------------------------------------
</TABLE>


                                     - 54 -
<PAGE>

<TABLE>
-----------------------------------------------------------------------------------------------------------------------------
<S>          <C>                                                               <C>
10.18        License Agreement dated March 13, 2000 between Hercon             Previously filed as Exhibit 10.18 to the
             Laboratories Corporation and Key Pharmaceuticals, Inc.            HC 2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
10.19        Mortgage and Security Agreement dated May 23, 2000 between        Previously filed as Exhibit 10.19 to the
             Transderm Laboratories Corporation and Mercury Capital Corp.      HC 2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
10.20        Mortgage Note dated May 23, 2000 made by Transderm Laboratories   Previously filed as Exhibit 10.20 to the
             Corporation in favor of Mercury Capital Corp.                     HC 2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
10.21        Guaranty of Registrant in favor of Mercury Capital Corp. dated    Previously filed as Exhibit 10.21 to the
             May 23, 2000.                                                     HC 2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
10.22        Assignment of Leases and Rents from Transderm Laboratories        Previously filed as Exhibit 10.22 to the
             Corporation to Mercury Capital Corp. dated May 23, 2000.          HC 2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
10.23        Mortgage Modification Agreement dated June 30, 2000 between       Previously filed as Exhibit 10.23 to the
             Transderm Laboratories Corporation and Mercury Capital Corp.      HC 2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
10.24        Mortgage Modification Agreement dated July 10, 2000 between       Previously filed as Exhibit 10.24 to the
             Transderm Laboratories Corporation and Mercury Capital Corp.      HC 2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
10.25        Assignment of Leases and Rents from Transderm Laboratories        Previously filed as Exhibit 10.25 to the
             Corporation to Mercury Capital Corp. dated July 13, 2000.         HC 2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
10.26        Guaranty of Registrant in favor of Mercury Capital Corp. dated    Previously filed as Exhibit 10.26 to the
             July 13, 2000.                                                    HC 2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
10.27        Sales Representative Agreement dated July 25, 2000 between        Previously filed as Exhibit 10.27 to the
             Hercon Laboratories Corporation and Granard Pharmaceutical, LLP.  HC 2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
10.28        Product Purchase Agreement dated February 28, 2001 between        Previously filed as Exhibit 10.28 to the
             Hercon Laboratories Corporation and Ranbaxy Pharmaceuticals       HC 2004 10-KSB.
             Inc. (portions of this Exhibit have been omitted pursuant to a
             request for confidential treatment and have been filed
             separately with the Commission).
-----------------------------------------------------------------------------------------------------------------------------
</TABLE>


                                     - 55 -
<PAGE>

<TABLE>
-----------------------------------------------------------------------------------------------------------------------------
<S>          <C>                                                               <C>
10.29        Development Assistance Agreement dated February 28, 2001          Previously filed as Exhibit 10.29 to the
             between Hercon Laboratories Corporation and Ranbaxy               HC 2004 10-KSB.
             Pharmaceuticals Inc. (portions of this Exhibit have been
             omitted pursuant to a request for confidential treatment and
             have been filed separately with the Commission).
-----------------------------------------------------------------------------------------------------------------------------
10.30        Finished Goods Supply Agreement dated February 28, 2001 between   Previously filed as Exhibit 10.30 to the
             Hercon Laboratories Corporation and Ranbaxy Pharmaceuticals       HC 2004 10-KSB.
             Inc. (portions of this Exhibit have been omitted pursuant to a
             request for confidential treatment and have been filed
             separately with the Commission).
-----------------------------------------------------------------------------------------------------------------------------
10.31        Amendment No. 1 to Sales Representative Agreement between         Previously filed as Exhibit 10.31 to the
             Hercon Laboratories Corporation and Granard Pharmaceutical, LLP   HC 2004 10-KSB.
             dated July 24, 2001.
-----------------------------------------------------------------------------------------------------------------------------
10.32        Mortgage Note in the principal amount of $367,500 dated August    Previously filed as Exhibit 10.32 to the
             7, 2001 among Transderm Laboratories Corporation and certain      HC 2004 10-KSB.
             creditors, including affiliates of the Registrant and Transderm
             Laboratories Corporation.
-----------------------------------------------------------------------------------------------------------------------------
10.33        Master Agreement dated as of February 15, 2002 among the          Previously filed as Exhibit 10.33 to the
             Registrant, Leon Services, LLC, Jack Aronowitz and MA Associates  HC 2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
10.34        Agreement dated May 22, 2002 among Zackfoot Investments, LLC,     Previously filed as Exhibit 10.34 to the
             the holders of the Mortgage Note dated August 7, 2001 and         HC 2004 10-KSB.
             Transderm Laboratories Corporation.
-----------------------------------------------------------------------------------------------------------------------------
10.35        Promissory Note in the principal amount of $164,692.50  dated     Previously filed as Exhibit 10.35 to the
             May 22, 2002 among Transderm Laboratories Corporation and         HC 2004 10-KSB.
             Zackfoot Investments, LLC and certain other lenders to
             Transderm Laboratories Corporation.
-----------------------------------------------------------------------------------------------------------------------------
10.36        Mortgage Note in the principal amount of $150,000 dated June      Previously filed as Exhibit 10.36 to the
             22, 2002 made by Transderm Laboratories Corporation in favor of   HC 2004 10-KSB.
             Albert David.
-----------------------------------------------------------------------------------------------------------------------------
</TABLE>


                                     - 56 -
<PAGE>

<TABLE>
-----------------------------------------------------------------------------------------------------------------------------
<S>          <C>                                                               <C>
10.37        Outline of Agreement between the Registrant and Jack Aronowitz,   Previously filed as Exhibit 10.37 to the
             Leon Services LLC and Health-Chem Diagnostics, LLC, effective     HC 2004 10-KSB.
             October 31, 2003
-----------------------------------------------------------------------------------------------------------------------------
10.38        Development, Manufacturing and Supply Agreement dated June 10,    Previously filed as Exhibit 10.38 to the
             2004 between Hercon Laboratories Corporation and Ranbaxy          HC 2004 10-KSB.
             Pharmaceuticals Inc. (portions of this Exhibit have been
             omitted pursuant to a request for confidential treatment and
             have been filed separately with the Commission).
-----------------------------------------------------------------------------------------------------------------------------
10.39        Deed dated December 7, 2004 selling and transferring ownership    Previously filed as Exhibit 10.39 to the
             of the land and building owned by Transderm Laboratories          HC 2004 10-KSB.
             Corporation to York Realty Leasing LLC.
-----------------------------------------------------------------------------------------------------------------------------
10.40        Warranty Bill of Sale dated December 7, 2004 selling and          Previously filed as Exhibit 10.40 to the
             transferring ownership of machinery and equipment owned by        HC 2004 10-KSB.
             Hercon Laboratories Corporation to York Realty Leasing LLC.
-----------------------------------------------------------------------------------------------------------------------------
10.41        Commercial Lease Agreement dated December 7, 2004 by  and         Previously filed as Exhibit 10.41 to the
             between York Realty Leasing LLC and Transderm  Laboratories       HC 2004 10-KSB.
             Corporation.
-----------------------------------------------------------------------------------------------------------------------------
10.42        Development, Manufacturing and Supply Agreement dated April 28,   Previously filed as Exhibit 10.42 to the
             2006 between Hercon and Cure Therapeutics, Inc. (portions of      HC 2004 10-KSB.
             this Exhibit have been omitted pursuant to a request for
             confidential treatment and have been filed separately with the
             Commission).
-----------------------------------------------------------------------------------------------------------------------------
14           Code of Ethics.                                                   Previously filed as Exhibit 14 to the HC
                                                                               2004 10-KSB.
-----------------------------------------------------------------------------------------------------------------------------
21           Subsidiaries of the Registrant.                                   Filed herewith.
-----------------------------------------------------------------------------------------------------------------------------
31.1         Certification of Chief Executive Officer pursuant to Rule         Filed herewith.
             13a-14(a) or Rule 15d-14(a) as adopted pursuant to Section 302
             of the Sarbanes-Oxley Act of 2002.
-----------------------------------------------------------------------------------------------------------------------------
31.2         Certification of Chief Financial Officer pursuant to Rule         Filed herewith.
             13a-14(a) or Rule 15d-14(a) as adopted pursuant to Section 302
             of the Sarbanes-Oxley Act of 2002.
-----------------------------------------------------------------------------------------------------------------------------
</TABLE>


                                     - 57 -
<PAGE>

<TABLE>
-----------------------------------------------------------------------------------------------------------------------------
<S>          <C>                                                               <C>
32.1         Certification of Chief Executive Officer pursuant to 18 U.S.C.    Filed herewith.
             Section 1350, as adopted pursuant to Section 906 of the
             Sarbanes-Oxley Act of 2002.
-----------------------------------------------------------------------------------------------------------------------------
32.2         Certification of Chief Financial Officer pursuant to 18 U.S.C.    Filed herewith.
             Section 1350, as adopted pursuant to Section 906 of the
             Sarbanes-Oxley Act of 2002.
-----------------------------------------------------------------------------------------------------------------------------
</TABLE>

(b) REPORTS ON FORM 8-K

During the quarter ended December 31, 2005 the Company did not file any reports
on Form 8-K.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

Audit Fees

The aggregate fees billed by Demetrius & Company, L.L.C. for professional
services related to the audit of the Company's consolidated financial statements
for the fiscal years ended December 31, 2004 and 2005 were $201,000.

Audit-Related Fees

There were no fees billed by Demetrius & Company, L.L.C. for audit-related
services for the fiscal years ended December 31, 2004 or 2005.

Tax Fees

There were no fees billed by Demetrius & Company, L.L.C. for tax services during
the fiscal years ended December 31, 2004 or 2005.

All Other Fees

There were no fees billed by Demetrius & Company, L.L.C. for any other
professional services during the fiscal years ended December 31, 2004 or 2005.


                                     - 58 -
<PAGE>

                                   SIGNATURES

In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.

                                HEALTH-CHEM CORPORATION

--------------------------------------------------------------------------------
Name and Capacity                              Date
-----------------                              ----
--------------------------------------------------------------------------------

/s/ Andy E. Yurowitz                           March 2, 2007
--------------------
By: Andy E. Yurowitz
Chairman of the Board,
President and Chief Executive
Officer (Principal Executive Officer)

--------------------------------------------------------------------------------

/s/ Ronald J. Burghauser                       March 2, 2007
------------------------
By: Ronald J. Burghauser
Chief Financial Officer,
Treasurer and Secretary
(Principal Financial Officer)
(Principal Accounting Officer)
--------------------------------------------------------------------------------

In accordance with the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------
        Person                                  Capacity                            Date
        ------                                  --------                            ----
--------------------------------------------------------------------------------------------
<S>                                 <C>                                        <C>
/s/ Andy E. Yurowitz                Chairman of the Board, President           March 2, 2007
--------------------                and Chief Executive Officer
Andy E. Yurowitz                    (Principal Executive Officer) and
                                    Director

--------------------------------------------------------------------------------------------
/s/ Ronald J. Burghauser            Chief Financial Officer,                   March 2, 2007
------------------------            Treasurer and Secretary
Ronald J. Burghauser                (Principal Financial Officer)
                                    (Principal Accounting Officer)

--------------------------------------------------------------------------------------------
/s/ Andrew J. Levinson                Director                                 March 2, 2007
----------------------
Andrew J. Levinson

--------------------------------------------------------------------------------------------
/s/ Manfred Mayerfeld                 Director                                 March 2, 2007
---------------------
Manfred Mayerfeld
--------------------------------------------------------------------------------------------
</TABLE>


                                     - 59 -
<PAGE>

                       SECURITIES AND EXCHANGE COMMISSION

                              Washington, DC 20549

                             HEALTH-CHEM CORPORATION

                            FORM 10-KSB ANNUAL REPORT

                            FOR THE FISCAL YEAR ENDED

                                DECEMBER 31, 2005

                              FINANCIAL STATEMENTS


                                     - 60 -
<PAGE>

ITEM 7. FINANCIAL STATEMENTS

Index to Consolidated Financial Statements.

                                                                            PAGE
                                                                            ----

Report of Independent Registered Public Accounting Firm                      F-2

Consolidated Balance Sheets - December 31, 2005 and 2004               F-3 & F-4

Consolidated Statements of Operations
  Years Ended December 31, 2005, 2004 and 2003                               F-5

Consolidated Cash Flow Statements
  Years Ended December 31, 2005, 2004 and 2003                         F-6 & F-7

Consolidated Statements of Stockholders' Deficiency
  Years Ended December 31, 2005, 2004 and 2003                               F-8

Notes to Consolidated Financial Statements                           F-9 to F-27


                                     - 1 -
<PAGE>


             REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders
Health-Chem Corporation

We have audited the  accompanying  consolidated  balance  sheets of  Health-Chem
Corporation and Subsidiaries ("Health-Chem" or the "Company") as of December 31,
2005 and 2004 and the related consolidated statements of operations, cash flows,
and  stockholders'  deficiency  for each of the years in the three  year  period
ended December 31, 2005. These financial  statements are the  responsibility  of
Health-Chem's  management.  Our responsibility is to express an opinion on these
financial statements based on our audits.

We conducted our audits in accordance  with the standards of the Public  Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes consideration of
internal  control  over  financial  reporting  as a basis  for  designing  audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the  effectiveness  of the Company's  internal  control
over financial reporting. Accordingly, we express no such opinion. An audit also
includes  examining,  on a test  basis,  evidence  supporting  the  amounts  and
disclosures in the financial  statements,  assessing the  accounting  principles
used and  significant  estimates made by  management,  as well as evaluating the
overall financial statement  presentation.  We believe that our audits provide a
reasonable basis for our opinion.

In our opinion,  the financial  statements  referred to above present fairly, in
all  material  respects,  the  consolidated  financial  position of  Health-Chem
Corporation and Subsidiaries at December 31, 2005 and 2004, and the consolidated
results  of their  operations  and their cash flows for each of the years in the
three year period  ended  December  31,  2005,  in  conformity  with  accounting
principles generally accepted in the United States of America.

The  accompanying  financial  statements  have been  prepared  assuming that the
Company will continue as a going concern. As more fully described in Note 3, the
Company is in default of  payments to its  bondholders  and  licensors,  and has
working capital  deficiencies  that raise substantial doubt about its ability to
continue as a going concern.  Management's  plans  concerning  these matters are
also  described  in  Note  3.  The  financial  statements  do  not  include  any
adjustments that might result from the outcome of this uncertainty.


s/s DEMETRIUS & COMPANY, L.L.C.
Wayne, New Jersey
March 2, 2007


                                     - 2 -
<PAGE>

                             HEALTH-CHEM CORPORATION
                           CONSOLIDATED BALANCE SHEETS
                      (In thousands, except share amounts)

                         ASSETS                                December 31,
                                                            2005            2004
                                                          ------          ------
CURRENT ASSETS
   Cash                                                   $  839          $  928
   Accounts receivable                                     2,908           2,985
   Due from financing agency                                   0             110
   Inventories                                             1,168           1,302
   Other current assets                                      132             125
                                                          ------          ------
     Total Current Assets                                  5,047           5,450
                                                          ------          ------

PROPERTY, PLANT and EQUIPMENT, net                         1,718           1,947

MORTGAGE ESCROW DEPOSIT                                      200               0

OTHER NON-CURRENT ASSETS                                       1              46
                                                          ------          ------

TOTAL ASSETS                                              $6,966          $7,443
                                                          ======          ======

Consolidated Balance Sheets are continued on the next page.

See Notes to Consolidated Financial Statements.


                                     - 3 -
<PAGE>

                             HEALTH-CHEM CORPORATION
                     CONSOLIDATED BALANCE SHEETS, CONTINUED
                      (In thousands, except share amounts)

           LIABILITIES AND STOCKHOLDERS' DEFICIENCY           December 31,
                                                              2005         2004
                                                          --------     --------

CURRENT LIABILITIES
   Accounts payable                                       $    508     $  1,411
   Royalties payable                                         6,108        4,522
   Current portion of 10.375% convertible subordinated
    debentures                                               6,100        6,100
   Accrued interest on convertible subordinated
    debentures                                               4,730        4,097
   Other liabilities                                         2,144        1,657
   Current portion of long-term debt                            42            0
   State income taxes payable                                   75           75
                                                          --------     --------
     Total Current Liabilities                              19,707       17,862
                                                          --------     --------

LONG-TERM LIABILITIES
   Mortgage payable                                          1,358            0
   Payable to affiliate                                        666        1,736
   Note payable                                                167          167
                                                          --------     --------
     Total Long-Term Liabilities                             2,191        1,903
                                                          --------     --------

COMMITMENTS

MINORITY INTEREST                                                3          133

STOCKHOLDERS' DEFICIENCY
   Preferred stock, par value $.01 per share;
     1,000,000 shares authorized, none issued                    0            0
   Convertible special stock, nonvoting, par value
     $.01 per share; 750,000 shares authorized;
     738,667 shares issued, all of which are
     held in treasury                                            7            7
   Common stock, par value $.01 per share;
     50,000,000 shares authorized; 17,934,056
     shares issued; 11,443,424 shares outstanding
     in 2005 and 2004                                          179          179
   Additional paid-in capital                               18,915       18,915
   Accumulated deficit                                     (26,402)     (23,922)
                                                          --------     --------
     Subtotal                                               (7,301)      (4,821)
   Less treasury stock, at cost                             (7,634)      (7,634)
                                                          --------     --------
     Total Stockholders' Deficiency                        (14,935)     (12,455)
                                                          --------     --------

TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIENCY            $  6,966     $  7,443
                                                          ========     ========

See Notes to Consolidated Financial Statements.


                                     - 4 -
<PAGE>

                             HEALTH-CHEM CORPORATION
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                    (In thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                            Years Ended December 31,
                                                           2005         2004         2003
                                                       --------     --------     --------
<S>                                                    <C>          <C>          <C>
REVENUE:
  Net sales                                            $  7,586     $  9,192     $  7,896
                                                       --------     --------     --------
  Cost of goods sold - royalties                          1,586        1,594        1,518
  Cost of goods sold - other                              4,861        4,654        4,469
                                                       --------     --------     --------
    Total cost of goods sold                              6,447        6,248        5,987
                                                       --------     --------     --------
  Gross profit                                            1,139        2,944        1,909
                                                       --------     --------     --------

OPERATING EXPENSES:
  Selling, general and administrative                     2,633        1,646        1,821
  Research and development                                  438          414          418
  Interest, net                                             908          909        1,016
                                                       --------     --------     --------
    Total operating expenses                              3,979        2,969        3,255
                                                       --------     --------     --------

LOSS FROM OPERATIONS                                     (2,840)         (25)      (1,346)
  Product development income                                349          239           31
  Other income (expense) - net                                0           55            0
                                                       --------     --------     --------

(LOSS) INCOME FROM CONTINUING OPERATIONS BEFORE
 TAXES, MINORITY INTEREST AND DISCONTINUED
 OPERATIONS                                              (2,491)         269       (1,315)
  Minority interest                                          11            0            0
  Income tax benefit                                          0            0            0
                                                       --------     --------     --------

(LOSS) INCOME FROM CONTINUING OPERATIONS BEFORE
  DISCONTINUED OPERATIONS                                (2,480)         269       (1,315)
  Loss from discontinued operations, net of tax               0         (260)        (658)
                                                       --------     --------     --------

NET (LOSS) INCOME                                      $ (2,480)    $      9     $ (1,973)
                                                       ========     ========     ========

(Loss) earnings per common share (basic & diluted):
  Continuing operations                                $   (.22)    $    .02     $   (.11)
  Discontinued operations                                   .00         (.02)        (.06)
                                                       --------     --------     --------
NET (LOSS) EARNINGS PER SHARE                          $   (.22)    $    .00     $   (.17)
                                                       ========     ========     ========

Average number of common shares
 outstanding: (in thousands)
  Basic                                                  11,443       11,443       11,443
  Diluted                                                11,443       11,443       11,443
</TABLE>

See Notes to Consolidated Financial Statements.


                                     - 5 -
<PAGE>

                             HEALTH-CHEM CORPORATION
                        CONSOLIDATED CASH FLOW STATEMENTS
                                 (In thousands)

<TABLE>
<CAPTION>
                                                         Years Ended December 31,
                                                        2005        2004        2003
                                                     -------     -------     -------
<S>                                                  <C>         <C>         <C>
CASH FLOWS FROM OPERATING ACTIVITIES OF
 CONTINUING OPERATIONS:
Net (loss) income                                    $(2,480)    $     9     $(1,973)
 Add: Loss from discontinued operations,
  net of taxes                                             0         260         658
                                                     -------     -------     -------
(Loss) income from continuing operations              (2,480)        269      (1,315)
Adjustments to reconcile (loss) income from
 continuing operations to net cash provided by
 operating activities of continuing operations:
  Depreciation and amortization                          316         326         381
  Loss on disposal of property, plant & equipment          0           0           5
  Minority interest                                      (11)          0           0
Changes in:
  Accounts receivable                                     77      (2,099)       (552)
  Due from financing agency                              110          59         (36)
  Inventories                                            134        (536)       (159)
  Other current assets                                    (7)         19         (31)
  Mortgage escrow deposit                               (200)          0           0
  Other non-current assets                                45          58         (31)
  Accounts payable                                      (903)         45         385
  Royalties payable                                    1,586       1,594       1,518
  Accrued interest on convertible debentures             633         633         633
  Other liabilities                                      487         246         583
                                                     -------     -------     -------
Net cash (used for) provided by operating
 activities of continuing operations                    (213)        614       1,381
                                                     -------     -------     -------

CASH FLOWS FROM INVESTING ACTIVITIES OF
 CONTINUING OPERATIONS:
Additions to property, plant and equipment               (87)       (128)       (181)
                                                     -------     -------     -------
Net cash used for investing activities of
 continuing operations                                   (87)       (128)       (181)
                                                     -------     -------     -------

CASH FLOWS FROM FINANCING ACTIVITIES OF
 CONTINUING OPERATIONS:
Long-term debt proceeds                                1,400       1,903           0
Long-term debt payments                               (1,200)     (2,007)       (522)
Minority interest contributions                           11         130           0
                                                     -------     -------     -------
Net cash provided by (used for) financing
 activities of continuing operations                     211          26        (522)
                                                     -------     -------     -------
</TABLE>

Consolidated Cash Flow Statements are continued on the next page.


                                     - 6 -
<PAGE>

                                             HEALTH-CHEM CORPORATION
                                  CONSOLIDATED CASH FLOW STATEMENTS, CONTINUED
                                                (In thousands)

                                                       Years Ended December 31,
                                                       2005      2004      2003
                                                      -----     -----     -----

DISCONTINUED OPERATIONS:
Net cash provided by Pacific Combining operating
 activities                                               0         0         1
                                                      -----     -----     -----

Cash used for Health-Chem Diagnostics operating
 activities                                               0      (278)     (668)
Adjustment to reconcile cash used for
 Health-Chem Diagnostics operating activities to
 net cash used for Health-Chem Diagnostics
 operating activities:
  Depreciation and amortization                           0        18         9
                                                      -----     -----     -----
Net cash used for Health-Chem Diagnostics
 operating activities                                     0      (260)     (659)
                                                      -----     -----     -----
Net cash used for discontinued operations                 0      (260)     (658)
                                                      -----     -----     -----

NET (DECREASE) INCREASE IN CASH                         (89)      252        20
Cash at beginning of year                               928       676       656
                                                      -----     -----     -----
Cash at end of year                                   $ 839     $ 928     $ 676
                                                      =====     =====     =====

Supplemental Disclosures of Cash Flow Information:
 Cash paid during the year for:
  Interest                                            $ 251     $ 359     $ 263
  Income taxes                                            0         0         0

Supplemental Disclosures of Non-Cash Financing
 Activities:
  Conversion of members' capital to long-term
   debt                                               $ 130     $   0     $   0

See Notes to Consolidated Financial Statements.


                                     - 7 -
<PAGE>

                             HEALTH-CHEM CORPORATION
               CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIENCY
                  YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003
                                 (In thousands)

<TABLE>
<CAPTION>
                             Conver-             Addi-
                              tible              tional    (Accumu-
                             Special   Common    Paid-In   lated      Treasury
                              Stock    Stock     Capital   Deficit)    Stock     Total
                             -------   -------   -------   --------   --------  --------
<S>                          <C>       <C>       <C>       <C>        <C>       <C>
Balance, January 1, 2003     $     7   $   179   $18,915   $(21,958)  $(7,634)  $(10,491)

Net loss                                                     (1,973)              (1,973)
                             -------   -------   -------   --------   -------   --------

Balance, December 31, 2003   $     7   $   179   $18,915   $(23,931)  $(7,634)  $(12,464)

Net income                                                        9                    9
                             -------   -------   -------   --------   -------   --------

Balance, December 31, 2004   $     7   $   179   $18,915   $(23,922)  $(7,634)  $(12,455)

Net loss                                                     (2,480)              (2,480)
                             -------   -------   -------   --------   -------   --------

Balance, December 31, 2005   $     7   $   179   $18,915   $(26,402)  $(7,634)  $(14,935)
                             =======   =======   =======   ========   =======   ========
</TABLE>

See Notes to Consolidated Financial Statements.


                                     - 8 -
<PAGE>

                             HEALTH-CHEM CORPORATION
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003

1. Nature of Operations

Health-Chem Corporation  ("Health-Chem") and its subsidiaries  (collectively the
"Company")  are  engaged  in  the  development,  manufacture  and  marketing  of
transdermal  drug delivery  systems.  Since 1986, the Company has manufactured a
transdermal  nitroglycerin patch which was the first such product introduced for
the generic  market in the United States.  This product is used for  transdermal
relief of vascular and cardiovascular  symptoms related to angina pectoris.  The
Company  sells  the  transdermal   nitroglycerin   patch  to  distributors   and
wholesalers who distribute it in the United States.

In addition to its transdermal nitroglycerin products, the Company is developing
other  transdermal  products  for  client  companies  and  will be the  contract
manufacturer  of these  products if United  States Food and Drug  Administration
("FDA")  approval  is  obtained.  The  Company  is also  conducting  a number of
feasibility  studies  on  drugs  to be  developed  independently  or for  client
companies and pursuing additional contract  manufacturing  opportunities.  There
can be no assurance that FDA filings for  additional  products will be submitted
or that FDA approval for any additional products will be obtained.

2. Summary of Significant Accounting Policies

a. Principles of Consolidation

The  accompanying  consolidated  financial  statements  include the  accounts of
Health-Chem  Corporation  and  those  of  its  wholly-owned  and  majority-owned
subsidiaries.  As of December 31, 2004, the  consolidated  financial  statements
also include a Variable  Interest  Entity  ("VIE"),  York Realty Leasing LLC, of
which Health-Chem Corporation is the primary beneficiary as further described in
Note 5. All significant intercompany accounts and transactions,  including those
involving the VIE, have been eliminated in consolidation.

b. Cash Equivalents

Money market funds and investment instruments with original maturities of ninety
days or less are considered cash equivalents.

c. Fair Value of Financial Instruments and Concentrations of Credit Risk

Management  believes  that  the  carrying  amounts  of the  Company's  financial
instruments,  including cash and cash equivalents, accounts receivable, accounts
payable,  and accrued  liabilities  approximate fair value due to the short-term
nature of these instruments. The carrying amount of the Company's long-term debt
also approximates fair value.

Financial  instruments that potentially subject the Company to concentrations of
credit risk consist primarily of cash, cash equivalents and accounts receivable.
Periodically, the Company has cash balances at certain financial institutions in
excess of federally insured limits.  However,  the Company does not believe that
it is subject to unusual  credit risk beyond the normal  credit risk  associated
with  commercial  banking  relationships.  The  Company  mitigates  this risk by
depositing  its cash in high quality  financial  institutions.  To reduce credit
risk  related to  accounts  receivable,  the  Company  performs  ongoing  credit
evaluations of its customers' financial condition but does not generally require
collateral.  Approximately  80%  and  78% of the  accounts  receivable  balances
represent  amounts  due  from two  customers  at  December  31,  2005 and  2004,
respectively.


                                     - 9 -
<PAGE>

The  percentage of sales to each major customer who was  responsible  for 10% or
more of the total revenues is as follows:

                                                    Years Ended December 31,
                                                 2005         2004         2003
                                                -----        -----        -----
Customer A ..............................          13%          23%          15%
Customer B ..............................          42%          30%          34%

At December 31, 2005 and 2004, accounts  receivable of approximately  $2,340,000
and $2,333,000, respectively, were from such customers.

d. Revenue Recognition and Accounts Receivable

The Company  recognizes  revenue for product  sales upon shipment when title and
risk of loss pass to its customers and when provisions for estimates,  including
trade discounts, rebates, promotional adjustments,  price adjustments,  returns,
chargebacks,  and other potential  adjustments are reasonably  determinable.  No
revisions  were made to the  methodology  used in determining  these  provisions
during the years ended December 31, 2005, 2004 and 2003.

The Company has historically provided financial terms to customers in accordance
with  what  management   views  as  industry   norms.   Financial   terms,   for
credit-approved  customers,  are generally on a net 30-61 day basis, though most
customers are entitled to a prompt payment discount. Management periodically and
regularly  reviews  customer account activity in order to assess the adequacy of
allowances  for  doubtful  accounts,   considering   factors  such  as  economic
conditions and each  customer's  payment  history and  creditworthiness.  If the
financial  condition  of our  customers  were to  deteriorate,  or if they  were
otherwise unable to make payments in accordance with management's  expectations,
we might have to increase  our  allowance  for doubtful  accounts,  modify their
financial  terms and/or pursue  alternative  collection  methods.  When accounts
receivable are considered uncollectible, they are charged against the allowance.

The  following  briefly  describes  the  nature of each  provision  and how such
provisions are estimated.

Trade discounts are charged to operations when taken by customers.

Rebates are offered to key customers to promote  customer  loyalty and encourage
greater product sales. These rebate programs provide that upon the attainment of
pre-established  volumes or the attainment of revenue milestones for a specified
period,  the customer  receives  credit  against  purchases.  Other  promotional
programs are  incentive  programs  periodically  offered to our  customers.  The
Company  is able to  estimate  provisions  for  rebates  and  other  promotional
programs based on the specific terms in each agreement at the time of shipment.


                                     - 10 -
<PAGE>

Consistent with industry practices,  customers may return short-dated or expired
product  within a specified  period prior to and  subsequent  to the  expiration
date.  The  Company's  estimate  of the  provision  for  returns  is based  upon
historical experience with actual returns.

Price adjustments,  which include shelf stock adjustments, are credits issued to
reflect decreases in the selling prices of products. Shelf stock adjustments are
based  upon the  amount of  product  which the  customer  has  remaining  in its
inventory at the time of the price  reduction.  Decreases in selling  prices are
discretionary  decisions  made by the  Company  to  reflect  market  conditions.
Amounts recorded for estimated price  adjustments are based upon specified terms
with direct customers, and in the case of shelf stock adjustments,  estimates of
inventory held by the customer.

The Company has agreements with certain indirect customers,  such as independent
pharmacies,  managed care organizations,  hospitals, nursing homes, governmental
agencies and pharmacy benefit  management  companies,  which establish  contract
prices for certain products.  The indirect customers then independently select a
wholesaler from whom they purchase the products at these contracted  prices. The
Company will provide credit to the  wholesaler  for any  difference  between the
contracted  price with the indirect  party and the  wholesaler's  invoice price.
Such credit is called a chargeback.  The provision for  chargebacks  is based on
expected sell-through levels by our wholesaler customers to indirect customers.

Costs incurred for shipping and handling are recorded in cost of sales.

e. Inventories

Inventories are stated at lower of cost (first-in, first-out basis) or market.

f. Property, Plant and Equipment

Property,  plant and equipment are recorded at cost. Maintenance and repairs are
charged to expense  as  incurred,  and costs of  improvements  are  capitalized.
Depreciation  and amortization  are provided using the  straight-line  method by
charges to operations over estimated useful lives of five to twenty-five  years.
The cost and related  accumulated  depreciation  of disposed  assets are removed
from the  applicable  accounts and any gain or loss is included in income in the
period of disposal.

g. Impairment of Long-Lived Assets

The Company  reviews  long-lived  assets,  such as property and  equipment,  and
purchased intangibles subject to amortization, for impairment whenever events or
changes in  circumstances  indicate that the carrying amount of an asset may not
be recoverable,  in accordance with Statement of Financial  Accounting Standards
("SFAS")  No. 144,  Accounting  for the  Impairment  or  Disposal of  Long-Lived
Assets. Recoverability of assets to be held and used is measured by a comparison
of the carrying amount of an asset to estimated  undiscounted  future cash flows
expected  to be  generated  by the  asset.  If the  carrying  amount of an asset
exceeds its estimated  future cash flows, an impairment  charge is recognized by
the amount by which the carrying  amount of the asset  exceeds the fair value of
the asset. There were no impairment charges in 2005, 2004 and 2003.


                                     - 11 -
<PAGE>

h. Accounts Receivable Financing

In January  2001,  the Company  entered into an agreement to sell certain of its
accounts  receivable  with full  recourse  to a factor,  Bay View  Funding.  The
agreement,  as amended,  provided for a maximum amount of financing availability
of $1.5 million.  Under this agreement,  the Company sold, on a revolving basis,
an undivided percentage  ownership in certain accounts  receivable.  As existing
receivables were collected, undivided interests in new eligible receivables were
sold.  The Company sold  accounts  receivable  of $0 and  $3,091,000 to Bay View
Funding  during 2005,  and 2004,  respectively.  The amounts due from the factor
were $ 0 and $110,000 at December 31, 2005 and 2004, respectively. Accounts that
became 90 days past due were no longer  eligible  to be sold and the Company had
to repurchase the receivable.  The Company addresses the risk of loss associated
with these  repurchased  receivables  in its  allowance  for doubtful  accounts.
Expenses incurred under this factoring  program totaling  $43,000,  $132,000 and
$243,000 for 2005,  2004, and 2003,  respectively,  are included on the selling,
general  and  administrative  expense  line in the  Consolidated  Statements  of
Operations.  The Company terminated its agreement with Bay View Funding in April
2005 because management  believed that the Company no longer needed the services
of a factor.

i. Research and Development

Research and development costs are charged to operations as incurred.

j. Income Taxes

Deferred tax assets and  liabilities  are provided for  differences  between the
financial  statement and tax bases of assets and liabilities that will result in
future taxable or deductible  amounts.  The deferred tax assets and  liabilities
are measured  using the enacted tax laws and rates  applicable to the periods in
which the differences are expected to affect taxable income.  Income tax expense
is computed as the tax  payable or  refundable  for the period plus or minus the
change  during the period in deferred tax assets and  liabilities.  Deferred tax
assets are reduced by a valuation  allowance when, in the opinion of management,
it is more likely than not that some  portion or all of the  deferred tax assets
will not be realized.

k. Per Share Information

Basic and  diluted  earnings  per share are  computed  based  upon the  weighted
average number of common shares  outstanding  during each year after  adjustment
for any dilutive effect of the Company's stock options.

A reconciliation of the basic and diluted earnings per common share computations
for income for continuing operations for the years ended December 31, 2005, 2004
and 2003 is presented below (in thousands, except per share amounts):


                                     - 12 -
<PAGE>

<TABLE>
<CAPTION>
                                   2005                                 2004                                 2003
                    ---------------------------------     -------------------------------     ---------------------------------
                    Income         Shares      Per        Income        Shares     Per        Income         Shares      Per
                    (Numer-        (Denom-     Share      (Numer-       (Denom-    Share      (Numer-        (Denom-     Share
                    ator)          inator)     Amount     ator)         inator)    Amount     ator)          inator)     Amount
                    -------        -------     ------     -------       -------    ------     -------        -------     ------
<S>                 <C>            <C>         <C>        <C>           <C>         <C>       <C>            <C>         <C>
Net (loss)
income              $(2,480)                              $     9                             $(1,973)
                    -------                               -------                             -------

Basic Earnings
Per Common
Share
 Net (loss)
 income
 applicable to
 common stock-
 holders             (2,480)       11,443      $(.22)           9       11,443      $.00       (1,973)       11,443      $(.17)
                                               =====                                ====                                 =====

Effect of
Dilutive
Securities
 Stock options            0             0                       0            0                      0             0
                    -------        ------                 -------       ------                -------        ------

Diluted
Earnings
Per Common
Share
 Net (loss)
 income
 applicable to
 common stock-
 holders            $(2,480)       11,443      $(.22)     $     9       11,443      $.00      $(1,973)       11,443      $(.17)
                    =======        ======      =====      =======       ======      ====      =======        ======      =====
</TABLE>

l. Stock Options

In accordance  with SFAS No. 123,  Accounting for Stock-Based  Compensation  and
SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure,
the Company accounts for its stock option plans under the  intrinsic-value-based
method as defined in APB No. 25,  Accounting for Stock Issued to Employees.  The
following table illustrates the effect on net earnings and earnings per share if
the Company had applied the fair value recognition provisions of SFAS No. 123 to
stock-based employee compensation (in thousands, except per share amounts):


                                     - 13 -
<PAGE>

<TABLE>
<CAPTION>
                                                        Years Ended December 31,
                                                         2005       2004      2003
                                                      -------    -------   -------
<S>                                                   <C>        <C>       <C>
Net (loss) income, as reported: ...................   $(2,480)   $     9   $(1,973)
Add: Stock-based compensation expense recognized
  under the intrinsic value method ................         0          0         0
Deduct: Stock-based compensation expense
  determined under fair value based method ........         0          0        (9)
                                                      -------    -------   -------
Pro forma net (loss) income .......................   $(2,480)   $     9   $(1,982)
                                                      =======    =======   =======

Net (loss) income per share:
  Basic - as reported .............................   $  (.22)   $   .00   $  (.17)
                                                      =======    =======   =======
  Basic - pro forma ...............................   $  (.22)   $   .00   $  (.17)
                                                      =======    =======   =======
  Diluted - as reported ...........................   $  (.22)   $   .00   $  (.17)
                                                      =======    =======   =======
  Diluted - pro forma .............................   $  (.22)   $   .00   $  (.17)
                                                      =======    =======   =======
</TABLE>

m. Use of Estimates in the Preparation of Financial Statements

The preparation of financial  statements in conformity  with generally  accepted
accounting principles requires management to make estimates and assumptions that
affect  the  reported  amounts  of assets  and  liabilities  and  disclosure  of
contingent  assets and  liabilities at the date of the financial  statements and
the  reported  amounts of revenues  and expenses  during the  reporting  period.
Actual results could differ from those estimates.

n. Recent Accounting Pronouncements

In January 2003, the Financial  Accounting  Standards Board ("FASB") issued FASB
Interpretation  No.  46  (revised  December  2003),  Consolidation  of  Variable
Interest  Entities  ("FIN  46(R)").  FIN 46(R)  addresses the  consolidation  of
business  enterprises  to which the usual  condition  (ownership  of a  majority
voting  interest)  of  consolidation  does  not  apply.  FIN  46(R)  focuses  on
controlling  financial interests that may be achieved through  arrangements that
do not  involve  voting  interests.  It  concludes  that in the absence of clear
control through voting interests,  a company's exposure  (variable  interest) to
the economic  risks and potential  rewards from the variable  interest  entity's
assets and activities are the best evidence of control. If an enterprise holds a
majority of the variable  interests  of an entity,  it would be  considered  the
primary  beneficiary.  Upon consolidation,  the primary beneficiary is generally
required to include  assets,  liabilities and  noncontrolling  interests at fair
value  and  subsequently  account  for  the  variable  interest  as if  it  were
consolidated  based on  majority  voting  interest.  As a result  of FIN  46(R),
effective as of December 31, 2004,  the  Company's  consolidated  balance  sheet
includes the assets and liabilities of York Realty Leasing LLC.

In May 2004,  the FASB issued FASB Staff  Position  No.  106-2,  Accounting  and
Disclosure  Requirements Related to the Medicare Prescription Drug,  Improvement
and  Modernization  Act of 2003 (FSP  106-2)in  response to a new law  regarding
prescription  drug  benefits  under  Medicare  as well as a federal  subsidy  to
sponsors of retiree  healthcare benefit plans. We expect that the impact of this
act will not be material.

In November 2004, the FASB issued SFAS No. 151,  Inventory  Costs - an Amendment
of ARB No. 43, Chapter 4. SFAS 151 clarifies the accounting for abnormal amounts
of idle facility expense,  freight,  handling costs and spoilage.  SFAS 151 also
requires that allocation of fixed  production  overhead costs be based on normal
production  activity.  The  provisions  of SFAS 151 are  effective for inventory
costs incurred  beginning in January 2006, with adoption permitted for inventory
costs  incurred  beginning in January  2005.  Adoption of this  Statement is not
expected  to have a  material  effect on the  Company's  Consolidated  Financial
Statements.


                                     - 14 -
<PAGE>

In December  2004, the FASB issued SFAS No. 123(R),  Share-Based  Payment.  SFAS
123(R)  establishes  standards for the accounting for  transactions  in which an
entity  exchanges  its equity  instruments  for goods and  services.  Under SFAS
123(R), companies will no longer be able to account for share-based compensation
transactions  using  the  intrinsic  method  in  accordance  with  APB  No.  25,
Accounting for Stock Issued to Employees. Instead, companies will be required to
account  for  such  transactions  using a  fair-value  method  and to  recognize
compensation  expense  over the period  during  which an employee is required to
provide  services in exchange for the award.  In April 2005, the SEC delayed the
effective  date of SFAS 123(R) to fiscal  years  beginning  after June 15, 2005.
Management is currently  assessing  the impact that  adoption of this  Statement
will have on the Company's Consolidated Financial Statements.

In May  2005,  the FASB  issued  SFAS No.  154,  Accounting  Changes  and  Error
Corrections  - a  Replacement  of APB  Opinion  No.  20 and SFAS No. 3. SFAS 154
changes the  requirements  for the  accounting  for and reporting of a change in
accounting  principle.  This  Statement  applies  to all  voluntary  changes  in
accounting principle. SFAS 154 also applies to changes required by an accounting
pronouncement  in the usual  instance  that the  pronouncement  does not include
specific  transition  provisions.  The  provisions of SFAS 154 are effective for
accounting  changes and  corrections  of errors made in fiscal  years  beginning
after  December 15, 2005.  Adoption of this  Statement is not expected to have a
material effect on the Company's Consolidated Financial Statements.

o. Reclassifications

The Company  reclassified  certain prior period financial  statement balances to
conform to current presentations.

3. Going Concern

As of December 31, 2005,  the Company had  aggregate  debts and  liabilities  of
$21,898,000 and had a working capital deficiency of $14,660,000. These debts and
liabilities  include  $10,830,000 due under outstanding  debentures which became
due in 1999 and under which the Company is currently in default.  Also  included
in these debts and  liabilities  is  $6,108,000 of royalties due under a license
agreement  with Key  Pharmaceuticals,  Inc.  ("Key") which allows the Company to
utilize certain technology incorporated into our current transdermal patch which
has been accumulating  since 2000. The Consolidated  Statement of Operations for
the year ended December 31, 2005 includes $633,000 of debenture interest expense
and $1,586,000 of Key royalty expense.  The Company has been able to continue to
operate by not having  paid these  creditors.  The  Company  has been paying its
debts and  liabilities not related to the debentures or the license on a current
basis from cash flow generated from  operations.  The Company does not have cash
on hand to repay the amount due under the debentures or the royalty payment owed
under the license agreement.  The Company's financial condition has prevented it
from  securing  financing or obtaining  loans from which it could repay all or a
portion of the amounts due.


                                     - 15 -
<PAGE>

The Company is in default under several provisions of the debentures as a result
of its failure to have paid interest and principal when they became due in April
1999. Upon an event of default,  the trustee of the debentures or the holders of
at least 25% in aggregate  principal  amount of all  debentures  may declare the
outstanding  principal of the  debentures  plus all accrued and unpaid  interest
which shall become immediately due and payable. The Company is also in breach of
the Key license  agreement  for failing to pay royalties as they became due. The
Company's  default  under and  breach of this  license  agreement  entitles  the
licensor to  terminate  the  agreement.  If these  creditors  took legal  action
against  the  Company,  the  Company  would not be able to  continue  as a going
concern  unless  there was an  increase in  profitability  and/or an infusion of
additional  funds in order to meet these  obligations  for both the past amounts
due and ongoing amounts as they became due.

The Company  intends to continue its efforts to complete the necessary  steps in
order to meet its future cash flow  requirements  and to continue its pursuit of
new products and contract  manufacturing  opportunities.  Management's  plans in
this regard include, but are not limited to, the following:

      o     Continue  with the  preliminary  negotiations  entered into with Key
            with respect to devising a plan to pay the royalties due,  including
            possibly negotiating a new royalty agreement.

      o     Approach the trustee of the  debentures  to negotiate a payment plan
            which  will  allow  for  the  normal   operation  of  the  Company's
            operations.  Such a payment plan may include forgiveness of interest
            and converting the debentures into equity.

      o     Continue  with  existing  projects  where the Company is  developing
            other  transdermal  products  for  client  companies  and  where the
            Company will be the contract  manufacturer  of these products if FDA
            approval is obtained.

      o     Form business alliances with other  pharmaceutical  companies on the
            development and/or manufacturing of new products.

      o     Raise  additional  working  capital  through  borrowing  or  through
            issuing equity.

      o     Evaluate new directions for the Company.

Management  believes that actions  presently being taken will need to be further
realigned  or  otherwise  amended so that the  Company  will be in a position to
generate  sufficient revenues to provide positive cash flows from operations and
meet its obligations as they become due. However, there can be no assurance that
this will occur.  The  accompanying  consolidated  financial  statements  do not
include  any   adjustments   that  might   result  from  the  outcome  of  these
uncertainties.

4. Inventories (In thousands)

                                                       December 31,
                                                      2005       2004
                                                    ------     ------
             Raw materials                          $  630     $  525
             Finished goods and work in process        538        777
                                                    ------     ------
                                                    $1,168     $1,302
                                                    ======     ======


                                     - 16 -
<PAGE>

5. Property, Plant and Equipment

In December 2004, the Company sold its real  property,  buildings,  improvements
and equipment located in Emigsville, Pennsylvania to York Realty Leasing LLC, an
affiliated company, for a sale price of $1.9 million.  Concurrent with the sale,
the  Company  entered  into a 15-year  net lease for the  property  expiring  in
December  2019,  which can be extended by the  Company  for an  additional  five
years.  The  agreement  provides for a Company  repurchase  option at a price of
$1,995,000.  The base  annual  lease  cost  during  the  initial 15 year term is
$212,400,  and the base lease expense for the remaining  term of the lease is as
follows:  2006 - $212,400;  2007 - $212,400;  2008 - $212,400;  2009 - $212,400;
2010 - $212,400;  and 2011 and  thereafter - $1,911,600.  In December  2002, the
Company  had  received  an  appraisal  for  the  real  property,  including  the
structures and  appurtenances,  which appraised the market value of the property
at  $1,850,000.  The proceeds  from the sale were used to satisfy a $1.6 million
first  mortgage  associated  with the  property and to  substantially  pay off a
$367,500 second mortgage,  a portion of which was held by related parties.  Andy
Yurowitz,  the  Company's  Chairman  of the Board,  President,  Chief  Executive
Officer  and a member of the Board of  Directors,  is a 50% owner of York Realty
Leasing  LLC. As a result of  Financial  Interpretation  46(R),  effective as of
December 31, 2004, the Company's  consolidated balance sheet includes the assets
and  liabilities  of York Realty  Leasing  LLC. In  December  2005,  York Realty
Leasing LLC obtained a $1.4 million  mortgage on this  property with a financial
institution.

The  Company's  property,  plant  and  equipment  balances  are as  follows  (in
thousands):

                                                            December 31,
                                                           2005        2004
                                                        -------     -------
     Land                                               $   120     $   120
     Buildings                                            2,734       2,734
     Equipment and leasehold improvements                 8,572       8,323
     Construction-in-progress                                92         254
                                                        -------     -------
       Total Property, Plant and Equipment               11,518      11,431
     Less accumulated depreciation and amortization       9,800       9,484
                                                        -------     -------
       Net Property, Plant and Equipment                $ 1,718     $ 1,947
                                                        =======     =======

Depreciation  expense for the years ended  December 31, 2005,  2004 and 2003 was
$316,000, $326,000 and $381,000, respectively.

6. Other Liabilities (In thousands)

                                                                December 31,
                                                               2005         2004
                                                             ------       ------
Accrued chargebacks                                          $1,067       $  682
Accrued rebates & allowances                                    367          454
Accrued trade show discounts                                    196           73
Allowance for returns                                           115           59
Accrued audit fees                                              254          184
Accrued interest on the second mortgage                           0           32
Accrued interest on other related party debt                     35          117
Accrued interest on other debt                                    5            2
Financed insurance premiums                                      49            0
Other                                                            56           54
                                                             ------       ------
                                                             $2,144       $1,657
                                                             ======       ======


                                     - 17 -
<PAGE>

7. Long-Term Debt

The Company's long-term debt balances are as follows (in thousands):

                                                                 December 31,
                                                                2005        2004
                                                              ------      ------
10.375% convertible subordinated debentures,
  due April 15, 1999                                          $6,100      $6,100
Less debentures purchased to meet
  sinking fund requirements                                        0           0
                                                              ------      ------
Subtotal 10.375% convertible subordinated debentures           6,100       6,100
Less current portion                                           6,100       6,100
                                                              ------      ------
Total 10.375% convertible subordinated debentures             $    0      $    0
                                                              ======      ======

Mortgage payable                                              $1,400      $    0
Payable to York Realty Leasing LLC members - affiliate           666       1,736
Note payable                                                     167         167
                                                              ------      ------
Subtotal other long-term debt                                  2,233       1,903
Less current portion                                              42           0
                                                              ------      ------
Total Long-Term Debt                                          $2,191      $1,903
                                                              ======      ======

Interest on the debentures is payable semi-annually. The debentures were subject
to redemption  through a sinking fund whereby the Company was required to redeem
at face value $1.5  million of the  debentures  each April 15, from 1991 through
1998. The balance of $8 million was due on April 15, 1999.  The debentures  were
convertible  into  shares of the  Company's  common  stock at  $19.52  per share
through April 15, 1999 and were  redeemable in whole or in part at par. In April
1999, the Company defaulted on its obligations to repay the remaining $8 million
in principal as well as the accrued  interest due on the debentures at maturity.
The Company made a $1.9 million  partial  repayment of its debt  obligations  in
respect  of the  debentures  out of the  proceeds  of the sale of the  assets of
Herculite Products, Inc. and Hercon Environmental Corporation,  two subsidiaries
of the Company,  in August 1999.  No additional  principal or interest  payments
with respect to the  debentures  have been made since April 1999. As of December
31,  2005 and 2004,  the  Company had  accrued  interest  on the  debentures  of
$4,730,000 and $4,097,000, respectively.

The terms of the  indenture  relating to the  debentures  restrict the Company's
ability to pay cash dividends and/or  repurchase its capital stock pursuant to a
formula based upon the consolidated net income of the Company and other factors.
Under the formula, at December 31, 2005, no amount was available for the payment
of dividends and/or the repurchase of capital stock.

In the spring of 2000,  the Company  obtained a $1.6  million  loan from Mercury
Capital  Corporation  at 15%  interest  per annum  secured by a mortgage  on the
Company's  Pennsylvania  facility. In December 2003, Mercury Capital Corporation
assigned this mortgage to William  Robbins.  In December  2004, the Company sold
its real property, buildings,  improvements and equipment located in Emigsville,
Pennsylvania  to York Realty  Leasing LLC for a sale price of $1.9 million.  The
proceeds  from the sale were used to satisfy  the $1.6  million  first  mortgage
noted above and to substantially pay off a $367,500 second mortgage. The Company
entered into the sale/leaseback arrangement with York Realty Leasing LLC because
it was unable to negotiate a like  transaction  with an  unaffiliated  party. In
December  2005,  York Realty  Leasing LLC obtained a $1.4 million  mortgage from
Fulton Bank.  Proceeds  from the mortgage were used to pay down the $1.2 million
of member loans from William Robbins.  Andy Yurowitz,  the Company's Chairman of
the  Board,  President,  Chief  Executive  Officer  and a member of the Board of
Directors,  is a 50% owner of York Realty Leasing LLC. William Robbins is also a
50% owner of York Realty Leasing LLC. In addition to capital  contributions that
Messrs. Yurowitz and Robbins made to York Realty Leasing LLC, as of December 31,
2005 each had loans outstanding to York Realty Leasing LLC totaling $201,000 and
$465,000,  respectively. York Realty Leasing LLC has classified these two member
loans of $666,000 as long-term and is accruing interest of 15% per annum on both
loans.  The members of York Realty  Leasing LLC have  provided  the Company with
documentation  indicating  that these  loans  would not have to be repaid  until
January 15, 2007. As a result of Financial Interpretation 46(R), effective as of
December 31, 2004, the Company's  consolidated balance sheet includes the assets
and liabilities of York Realty Leasing LLC, including the $666,000 member loans.


                                     - 18 -
<PAGE>

The York Realty  Leasing  LLC  mortgage  with  Fulton Bank has payment  terms of
eighty three (83) consecutive monthly  installments of principal and interest of
$13,065  commencing  January  1,  2006,  with one final  payment  of all  unpaid
principal and interest payable on December 1, 2012. The interest rate associated
with this mortgage is one-half  (1/2) percent over Fulton Bank's prime rate. The
average   interest  rate  charged  during  2006  was  8.36%.   The  mortgage  is
collateralized  by the building owned by York Realty Leasing LLC. As of December
31, 2005, the approximate  aggregate annual maturities of long-term debt for the
next five years,  which consists solely of the York Realty Leasing LLC mortgage,
were: 2006 - $42,000;  2007 - $40,000; 2008 - $43,000; 2009 - $47,000 and 2010 -
$51,000.  Terms of the mortgage  require York Realty  Leasing LLC to maintain an
escrow  account at Fulton Bank. The balance in this account at December 31, 2005
was $200,000. Additionally, Fulton Bank does not have recourse to the Company in
the event of a default on this mortgage.

The $167,000 note relates to the purchase of certain fixed assets.  The purchase
of these fixed assets was pursuant to a  development,  manufacturing  and supply
agreement that the Company entered into with a client company.  Payment terms of
the note are contingent upon certain  performance  criteria under the agreement.
One such performance criteria applicable to the client company may result in the
note being  forgiven.  We  estimate  the  earliest  that the note may need to be
repaid is in 2008.

8. Employee Benefit Plan

All  permanent,  full-time  non-union  employees  of the Company are eligible to
participate in  Health-Chem's  401(k) Plan (the "Plan")  following six months of
employment.  The  Plan  allows  eligible  employees  to defer up to 20% of their
income on a pre-tax basis  through  contributions  to the Plan.  The Company may
contribute for each participant a matching contribution equal to a percentage of
the  elective  contributions  made by the  participants.  The  decision  to make
matching  contributions and the amount of such  contributions  will be made each
year by the Company. These Company matching contributions were $14,000,  $13,000
and $16,000 in 2005, 2004 and 2003, respectively.

9. Commitments & Contingencies

In December 2004, the Company entered into a sale/leaseback  agreement with York
Realty Leasing LLC for the land,  buildings,  improvements  and equipment at the
Company's previously-owned  manufacturing facility in Emigsville,  Pennsylvania.
The term of the lease is for fifteen  years,  expiring in December  2019, can be
extended an additional five years and contains a repurchase  option. The selling
price was $1.9 million and annual lease payments are $212,400. The proceeds from
the sale were used to satisfy a $1.6 million first mortgage  associated with the
property and to substantially pay off a $367,000 second mortgage. The effects of
this sale/leaseback  agreement have been eliminated in consolidation as a result
of York Realty Leasing LLC being considered a Variable Interest Entity.


                                     - 19 -
<PAGE>

In December 2004, the Company  entered into a lease for office space in Suffern,
New York for a one year period commencing January 1, 2005, and renewed the lease
for additional one year periods  commencing January 1, 2006 and January 1, 2007.
The annual  rental was  $7,200,  inclusive  of  utilities,  for 2005 and will be
$7,416 and $7,691 for 2006 and 2007, respectively.

Approximately  thirty-two  percent of the  Company's  employees are covered by a
collective  bargaining  agreement with a local unit of the Retail  Wholesale and
Department Store Union, AFL-CIO ("R.W.D.S.U.").  The R.W.D.S.U. agreement is for
a three year period ending  December 10, 2007. The contract is subject to annual
renewal  thereafter  and  acknowledges  that  the  R.W.D.S.U.  is the  exclusive
bargaining agent for the Company's regular production  employees,  excluding all
other  employees  including but not limited to  supervisors,  foremen,  clerical
employees,  time-keepers,  watchmen, guards, maintenance personnel and part-time
employees.

Certain raw materials and components used in the manufacture of our products are
available from limited sources, and, in some cases, a single source.  Generally,
regulatory  authorities  must  approve  raw  material  sources  for  transdermal
products.  Without  adequate  approved  supplies of raw  materials  or packaging
supplies,  our  manufacturing  operations  could be  interrupted  until  another
supplier  is  identified,  our  products  approved  and  trading  terms  with it
negotiated.  We may not be able to  identify  an  alternative  supplier  and any
supplier that we do identify may not be able to obtain the requisite  regulatory
approvals  in a timely  manner,  or at all.  Furthermore,  we may not be able to
negotiate favorable terms with an alternative  supplier.  Any disruptions in our
manufacturing  operations from the loss of an approved  supplier may cause us to
incur  increased  costs and lose revenues and may have an adverse  effect on our
relationships  with our partners and customers,  any of which could have adverse
effects on our business and results of  operations.  Our business also faces the
risk that third party  suppliers  may supply us with raw  materials  that do not
meet  required  specifications,  which,  if  undetected  by us,  could cause our
products  to test out of  specification  and  require us to recall the  affected
product.

We market all of our products through a single marketing  representative.  If we
were to lose the services of such marketing  agent for any reason or said entity
does not maintain a steady demand for our product, and we are unable to identify
an adequate  replacement,  our  business,  results of  operations  and financial
condition would be materially adversely affected.

We rely on insurance to protect us from many business risks,  including  product
liability,  business  interruption,  property and casualty  loss and  employment
practices  liability.  The cost of insurance has risen  significantly  in recent
years.  In  response,  we  may  increase  deductibles  and/or  decrease  certain
coverages to mitigate these costs.  There can be no assurance that the insurance
that we maintain and intend to maintain  will be  adequate,  or that the cost of
insurance and  limitations  in coverage will not adversely  affect our business,
financial position or results of operations.  Furthermore,  it is possible that,
in some cases, coverage may not be available at any price.


                                     - 20 -
<PAGE>

10. Litigation

In  June  2004,  Plaintiffs  Jack  Aronowitz  and  his  companies,   Health-Chem
Diagnostics,  LLC  ("Diagnostics")  and  Leon  Services,  LLC  ("Leon")  filed a
Complaint and  subsequently,  an Amended Complaint in the United States District
Court  Southern  District of Florida  (the  "Court")  for breach of contract and
foreclosure of a security  interest against the Company.  The contracts at issue
were a Master Agreement along with an associated  License Agreement and Security
Agreement, executed jointly and dated February 15, 2002 (the "2002 Agreements"),
and a November 6, 2003 Outline Agreement (the "2003 Agreement")  terminating the
Company's  obligations  under the 2002 Agreements and effectuating a purchase of
certain  assets by the Company in exchange  for monies and a 25% equity stake in
Diagnostics.  The Company filed a counterclaim for breach of the 2003 Agreement,
based on  Plaintiffs'  failure  to render  payment  for the  assets  which  were
transferred to Plaintiffs,  as well as a claim for trademark  infringement.  The
Company also asserted a claim for a declaratory  judgment  determining  that the
2003 Agreement  superseded the 2002 Agreements,  consistent with the conclusions
in the Order.  The jury  rendered its verdict on November  21, 2005,  finding in
favor of  Plaintiffs  on the counts for breach of the 2002 and 2003  Agreements.
The jury found that  Plaintiffs were guilty of copyright  infringement,  but did
not find a breach of the 2003 Agreement on the part of  Plaintiffs.  On December
2, 2005,  the Court entered a Final Judgment and Order Closing Case, and ordered
judgment  on the  jury  verdict  in the  amount  of  $2,931,000.00  in  favor of
Plaintiffs  and against the  Company.  The Court also  entered  judgment for the
Company in the amount of  $25,000.00  for  trademark  infringement.  The Company
filed a Motion for  Judgment As A Matter Of Law, and  alternatively,  Motion for
New Trial.  On February  14, 2006 the Court  issued an Amended  Final  Judgment,
vacating the Court's December 2, 2005 Final Judgment and Order Closing Case. The
February 14, 2006 judgment  reduced the award to the Plaintiffs  Jack Aronowitz,
Health-Chem  Diagnostics,  LLC and Leon Services, LLC and against the Company to
the amount of $1.00.  The February 14, 2006 judgment also awarded  $25,000.00 to
the Company and against the Plaintiffs Jack Aronowitz,  Health-Chem Diagnostics,
LLC and Leon  Services,  LLC for trademark  infringement.  The February 14, 2006
judgment  also  included a  permanent  injunction  in favor of the  Company  and
against the Plaintiffs Jack  Aronowitz,  Health-Chem  Diagnostics,  LLC and Leon
Services, LLC to cease and desist any present or future use of the "Health-Chem"
trademark or any other marks similar to the Company's trademark. On February 27,
2006 the Plaintiffs  filed an appeal from the Court's  February 14, 2006 Amended
Final Judgment. The ultimate outcome of this litigation cannot be ascertained at
this time.

11. Stockholders' Equity

A summary of the shares of common and treasury stock is as follows:


                                     - 21 -
<PAGE>

                                                     Treasury Stock
                                              --------------------------
                                  Common       Convertible       Common
                                  Stock       Special Stock      Stock
                                ----------    -------------   ----------

        Balance at 12/31/04     11,443,424        738,667      6,490,632
        Balance at 12/31/05     11,443,424        738,667      6,490,632

a. Convertible special stock

The convertible special stock has the same rights as common stock except that it
is  nonvoting.  Each share is  convertible  into 1 1/3  shares of the  Company's
common  stock.   The  conversion   rate  is  subject  to  change  under  certain
circumstances. No shares of convertible special stock are outstanding.

b. Reserved shares (as of December 31, 2005)

                                                                 Number of
      Purpose of Reservation                                      Shares
      ----------------------                                     ---------

      Conversion of convertible special stock                      984,889
      Stock option plans                                         3,395,500
                                                                 ---------
      Total reserved shares                                      4,380,389
                                                                 =========

12. Stock Options

Options  granted under the Company's  various stock option plans are exercisable
for up to five  years  from the  grant  date.  A  summary  of the  status of the
Company's  plans as of December 31, 2005,  2004 and 2003 and changes  during the
years ended on those dates is presented below:

<TABLE>
<CAPTION>
                                  2005                     2004                     2003
                         ---------------------     --------------------     --------------------
                                      Weighted                 Weighted                 Weighted
                                       Average                  Average                  Average
                                      Exercise                 Exercise                 Exercise
                           Shares       Price        Shares      Price        Shares      Price
                         ---------    --------     ---------   --------     ---------   --------
<S>                      <C>            <C>        <C>           <C>        <C>           <C>
Outstanding at
 beginning of year       4,086,587      $ .18      4,086,587     $ .18      3,986,587     $ .18

Granted                          0                         0                  100,000     $ .12

Exercised                        0                         0                        0

Forfeited                 (691,087)     $ .50              0                        0
                         ---------                 ---------                ---------

Outstanding at end
 of year                 3,395,500      $ .11      4,086,587     $ .18      4,086,587     $ .18
                         =========                 =========                =========

Options exercisable
 at year-end             3,395,500                 4,086,587                4,086,587
                         =========                 =========                =========

Weighted-average
 fair value of
 options granted
 during the year                        $ .00                    $ .00                    $.092
                                        =====                    =====                    =====
</TABLE>


                                     - 22 -
<PAGE>

The fair value of each option  grant is estimated on the date of grant using the
Black-Scholes   option-pricing   model  with  the   following   weighted-average
assumptions used for grants in 2003; no dividend yield;  expected  volatility of
134.97%; risk-free interest rate of 2.06%; and expected lives of three years for
the 2003 option grants.

The  following  table  summarizes  information  about the Plan's  stock  options
outstanding at December 31, 2005:

                     Options Outstanding              Options Exercisable
            -------------------------------------  ------------------------

                           Weighted-
                            Average     Weighted-                 Weighted-
 Range of      Number      Remaining     Average      Number       Average
 Exercise   Outstanding   Contractual   Exercise    Exercisable   Exercise
  Prices    at 12/31/05      Life         Price     at 12/31/05     Price
----------  -----------   -----------   ---------   -----------   ---------

$.10          1,845,500    0.30 years      $.10       1,845,500      $.10
$.12-$.125    1,550,000    1.16 years      $.12       1,550,000      $.12
              ---------    ----------      ----       ---------      ----
$.10-$.125    3,395,500    0.69 years      $.11       3,395,500      $.11
              =========    ==========      ====       =========      ====

13. Taxes on Income (In thousands)

                                                        Years Ended December 31,
                                                         2005     2004     2003
                                                         ----     ----     ----
Taxes on income include provision (benefit) for:
  Federal income taxes                                   $  0     $  0     $  0
  State and local income taxes                              0        0        0
                                                         ----     ----     ----
   Total                                                 $  0     $  0     $  0
                                                         ====     ====     ====

Taxes on income are comprised of:
  Current                                                $  0     $  0     $  0
  Deferred                                                  0        0        0
                                                         ----     ----     ----
   Total                                                 $  0     $  0     $  0
                                                         ====     ====     ====

A reconciliation of taxes on income to the federal statutory rate is as follows:

                                                   Years Ended December 31,
                                                   2005        2004        2003
                                                -------     -------     -------

(Benefit) tax at statutory rate                 $  (607)    $     3     $  (671)
Increase (decrease) resulting from:
 Net operating and other tax loss
   carryforwards that expired                     3,734           0           0
 State and local taxes, net of federal
   tax benefit                                     (179)          0         (99)
 Other                                              167           0           0
 Change in valuation allowance                   (3,115)         (3)        770
                                                -------     -------     -------
Tax provision (benefit)                         $     0     $     0     $     0
                                                =======     =======     =======

At December 31, 2005 and 2004,  the deferred tax assets and  liabilities  result
from the following temporary differences and carryforwards:


                                     - 23 -
<PAGE>

                                                           2005            2004
                                                       --------        --------
Deferred tax assets:
  Net operating and other tax loss
   carryforwards                                       $  8,955        $ 11,980
  Accumulated depreciation                                    0              90
                                                       --------        --------
     Total deferred tax assets                            8,955          12,070
                                                       --------        --------

Deferred tax liabilities:
  Accelerated depreciation                                    1               0
                                                       --------        --------
     Total deferred tax liabilities                           1               0
                                                       --------        --------
Net deferred tax asset before valuation
 allowance                                                8,954          12,070
Valuation Allowance                                      (8,955)        (12,070)
                                                       --------        --------

Net deferred tax liability                             $      1        $      0
                                                       ========        ========

At December 31, 2005, the Company had approximately $22 million of net operating
loss carryforwards for federal income tax purposes which expire in various years
through 2025 and tax credit  carryforwards  that expire in various years through
2025. The Company also had net operating loss carryforwards in various states in
which the Company and its  subsidiaries  operate  which are  available to absorb
allocated  portions of future taxable  income for state tax purposes.  The state
operating loss  carryforwards  expire in various years through 2025. At December
31, 2005, valuation allowance relating to tax loss carryforwards was $8,955,000.

14. Interest, Net (In thousands)

                                       Years Ended December 31,
                                         2005      2004      2003
                                      -------   -------   -------

     Interest expense                 $   908   $   912   $ 1,017
     Interest income                        0        (3)       (1)
                                      -------   -------   -------
                                      $   908   $   909   $ 1,016
                                      =======   =======   =======

15. Related Party Transactions

The consolidated  financial statements include the following items applicable to
related parties (in thousands):

                                                              December 31,
   Balance Sheets:                                           2005        2004
                                                           ------      ------

   Property, plant and equipment, net                      $1,610      $1,693

   10.375% convertible subordinated debentures
     held by directors and executive officers                 159         159

   Payable to York Realty Leasing LLC members
     (See Note 7)                                             666       1,736

   Accrued interest on the second mortgage                      0          32

   Accrued interest on other related party debt                35         117


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<PAGE>

                                                 Years Ended December 31,
   Income Statements:                            2005        2004        2003
                                              -------     -------     -------

   Interest, net                              $   267     $    53     $   115

Accrued interest on the second mortgage

In August 2001, the Company obtained a $367,500 loan from Zackfoot  Investments,
LLC at 12.5%  interest  secured  by a  mortgage  on the  Company's  Pennsylvania
facility.  This loan was repaid during 2004. At December 31, 2005 and 2004,  the
following related parties were owed interest with respect to this loan:

                                                         2005            2004
                                                      -------         -------

   Manfred Mayerfeld (Director)                       $     0         $21,000
   Andrew Levinson (Director)                               0          11,000
                                                      -------         -------
                                                      $     0         $32,000
                                                      =======         =======

Accrued interest on other related party debt

During 2000 and 2001,  Manfred Mayerfeld  provided the Company with an aggregate
of $191,600 at various times and for various purposes including working capital,
to pay creditors and to meet payroll.  These loans accrued  interest at the rate
of 18% per annum.  The Company  repaid the principal  amount of the loans during
2001 and 2003 along with aggregate  interest of $91,783 during 2004. In addition
to  receiving  interest on these  loans,  the Company  granted to Mr.  Mayerfeld
five-year options to purchase up to 958,000 shares of the Company's common stock
(five options for each dollar loaned) at an exercise price of $0.10 which expire
in April 2007. In 1999,  Mr.  Mayerfeld  expended  $40,000 in connection  with a
successful  proxy contest brought against  Health-Chem in 1999 by a group led by
Mr.  Yurowitz.  The Company repaid the principal amount of this loan during 2004
with interest of $25,700 (equal to 18% per annum).

In December 2004, the Company sold its real  property,  buildings,  improvements
and equipment located in Emigsville, Pennsylvania to York Realty Leasing LLC for
a sale  price of $1.9  million.  The  Company  entered  into the  sale/leaseback
arrangement  with York Realty  Leasing LLC because it was unable to  negotiate a
like  transaction  with an  unaffiliated  party.  Andy  Yurowitz,  the Company's
Chairman of the Board,  President,  Chief Executive  Officer and a member of the
Board of Directors,  is a 50% owner of York Realty Leasing LLC.  William Robbins
is also a 50%  owner  of  York  Realty  Leasing  LLC.  In  addition  to  capital
contributions that Messrs. Yurowitz and Robbins made to York Realty Leasing LLC,
as of December 31, 2005 each had loans  outstanding  to York Realty  Leasing LLC
totaling  $201,000  and  $465,000,  respectively.  York  Realty  Leasing LLC has
classified  these two member  loans of  $666,000  as  long-term  and is accruing
interest of 15% per annum on both loans.

At December 31, 2005 and 2004, the following  related parties were owed interest
with respect to these loans:


                                     - 25 -
<PAGE>

                                                         2005            2004
                                                     --------        --------

   Manfred Mayerfeld (Director)                      $      0        $117,000
   York Realty Leasing LLC members                     35,000               0
                                                     --------        --------
                                                     $ 35,000        $117,000
                                                     ========        ========

Interest, net

Interest  expense with respect to related  parties for the years ended  December
31, 2005, 2004 and 2003 is presented below:

                                                     Years Ended December 31,
                                                      2005       2004       2003
                                                  --------   --------   --------

Manfred Mayerfeld - Other related party debt      $      0   $  3,000   $ 37,000
Andy Yurowitz - Other related party debt                 0          0     32,000
Second mortgage                                          0     36,000     46,000
York Realty Leasing LLC members                    267,000     14,000          0
                                                  --------   --------   --------
                                                  $267,000   $ 53,000   $115,000
                                                  ========   ========   ========

16. Minority Interest

A former president of Hercon Laboratories  Corporation maintains a 1.5% interest
in Hercon Laboratories Corporation and Hercon Environmental Corporation.  Equity
in Hercon Environmental Corporation has generated a $3,000 minority interest.

As a result of  Financial  Interpretation  46(R),  effective  as of December 31,
2004,  the  Company's   consolidated  balance  sheet  includes  the  assets  and
liabilities  of York Realty  Leasing LLC. Andy Yurowitz and William  Robbins are
each 50% owners of York Realty  Leasing LLC. As of December  31, 2005,  each had
contributed  $5,500 in capital to York Realty Leasing LLC. In 2005,  York Realty
Leasing LLC  sustained a loss of $147,000 of which  $11,000 was allocated to the
stockholders  of the LLC. This  eliminated  their cash investment as of December
31, 2005.

17. Discontinued Operations

In June 2001,  management  sought to diversify the Company's  business to reduce
its  reliance  on  its  single  nitroglycerin   transdermal  patch  product  and
investigated  a variety of  strategies  which  could  initiate a new and ongoing
product  pipeline.  Toward that end, the Company purchased the key machinery and
equipment of TCPI,  Inc., a  Florida-based  manufacturer  of medical  diagnostic
products,  out of bankruptcy in December  2001.  In February  2002,  the Company
organized a division which entered into a series of agreements pursuant to which
(i) it  licensed  thirty  diagnostic  products  derived  from a common  platform
technology,  (ii) it  retained  the  inventor  of  these  products  to  continue
development  work and (iii)  arranged to  manufacture  the  products at a leased
premises  located  in  Pompano  Beach,  Florida.  The  new  diagnostic  division
purchased  pregnancy  test wands  manufactured  under the  licenses and launched
shipment of these  products to European  customers.  However,  the  division was
unable to  manufacture  the  pregnancy  test wands  utilizing  the  equipment it
purchased.   Moreover,  the  Company  brought  to  market  only  two  additional
diagnostic  products of the thirty it licensed and  generated  minimal  revenues
from  sales of  these  products.  After  sales of the  pregnancy  test  products
declined dramatically due to patent issues, and with continuing operating losses
and cash flow drains, the Company divested itself of this division in 2004.


                                     - 26 -
<PAGE>

The consolidated  financial  statements of the Company have been reclassified to
reflect the results of operations and net assets of this diagnostic  division of
the Company as  discontinued  operations in accordance  with generally  accepted
accounting principles.

18. Subsequent Events

During  December  2006,  the Company  merged  several of its  subsidiaries  into
Health-Chem or other  subsidiaries  of  Health-Chem.  These mergers will have no
impact on the financial statements of the Company.

During January 2007, the Company was notified verbally by representatives of the
State of Pennsylvania that there was approximately  $300,000 due in state income
taxes dating back as far as 1972.  The Company  believes it is not obligated for
such taxes and is pursuing the cancellation of such Notices.

19. Quarterly Results of Operations (Unaudited)

                                  First      Second       Third      Fourth
                                 Quarter     Quarter     Quarter     Quarter
                                 -------     -------     -------     -------
                                    (in thousands, except per share data)

2005
Net sales                        $ 1,474     $ 2,224     $ 1,893     $ 1,995

Net loss applicable
 to common stockholders          $  (140)    $  (318)    $  (377)    $(1,645)

Net loss per
 common share                    $ (.012)    $ (.028)    $ (.033)    $ (.144)

Diluted net loss per
 common share                    $ (.012)    $ (.028)    $ (.033)    $ (.144)

2004
Net sales                        $ 1,975     $ 2,128     $ 2,290     $ 2,798

Net income (loss) applicable
 to common stockholders          $  (167)    $   147     $   356     $  (328)

Net income (loss) per
 common share                    $ (.015)    $  .013     $  .031     $ (.029)

Diluted net income (loss) per
 common share                    $ (.015)    $  .013     $  .031     $ (.029)

The above financial data may not total to the results indicated on the Company's
financial statements.


                                     - 27 -