UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549 FORM 10-K x Annual Report Pursuant
to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Fiscal
Year Ended December 31, 2006 o Transition Report Pursuant
to Section 13 or 15(d) of the Securities Exchange Act of 1934 Commission File No. 0-11550 Pharmos Corporation
 (Exact name of registrant as specified in its
charter)
  Nevada

36-3207413(State or other jurisdiction of

(IRS Employer Id. No.)incorporation or organization) 99 Wood Avenue South, Suite 311
Iselin, NJ 08830(Address of
principal executive offices) (zip code) Registrants telephone number, including area
code: (732) 452-9556 Securities registered pursuant to Section
12(b) of the Act: None
(Title of Class) Securities registered pursuant to Section
12(g) of the Act: Common
Stock, $.03 par value
(Title of Class) Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act. o Yes   
xNo Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. o Yes   
xNo Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 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. x Yes   
oNo Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not 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-K or any amendment to this Form 10-K.
x 1   Indicate
by check mark whether registrant is a large accelerated filer, an accelerated
filer or a non-accelerated filer (as defined in Rule 12b-2 of the Act).

Large accelerated fileroAccelerated
fileroNon-accelerated
filer x

Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act).oYes   
xNo

The
aggregate market value of the registrants Common Stock at June 30, 2006 held
by those persons deemed to be non-affiliates was approximately $39,778,482.

As
of March 13, 2007, the Registrant had outstanding 25,565,784 shares of its $.03
par value Common Stock.

2

PART
I

This report contains information that may
constitute forward-looking statements. The use of words such as believe, expect,
intend, estimate, anticipate, project, will and similar expressions
identify forward-looking statements, which generally are not historical in
nature. All statements that address operating performance, events or
developments that we expect or anticipate will occur in the future are
forward-looking statements. As and when made, we believe that these
forward-looking statements are reasonable. However, caution should be taken not
to place undue reliance on any such forward-looking statements because such
statements speak only as of the date when made. We undertake no obligation to
publicly update or revise any forward-looking statements, whether as a result
of new information, future events or otherwise. In addition, forward-looking
statements are subject to certain risks and uncertainties that could cause
actual results to differ materially from our companys historical experience
and our present expectations or projections. These risks and uncertainties
include, but are not limited to, those described in Part I, Item 1A. Risk
Factors and elsewhere in this report and those described from time to time in
our future reports filed with the Securities and Exchange Commission.

We do not undertake to discuss matters relating to our
ongoing clinical trials or our regulatory strategies beyond those which have
already been made public or discussed herein.

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Item 1. Business

RECENT DEVELOPMENTS

Appointment of New CEO

On February 26, 2007 Pharmos
Corporation (the Company or Pharmos) announced that Elkan Gamzu, Ph.D., had
been appointed by the Board of Directors to become Chief Executive Officer,
effective March 31, 2007. He will succeed Haim Aviv, Ph.D., who will be
retiring on that date. Dr. Aviv will continue as Chairman of the Board.

Dr. Gamzu, a Director of the
Company since February 2000, is currently a consultant to the biotechnology and
pharmaceutical industries and has held a number of senior executive positions
in those industries, including Vice President, Project Management Leadership,
of Millennium Pharmaceuticals, CEO of Cambridge Neuroscience and senior
positions with Warner-Lambert and Hoffmann-La Roche. Dr. Gamzu has worked in
the pharmaceutical industry since 1971. He is a graduate of Hebrew University
in Jerusalem, and has M.A. and Ph.D. degrees in experimental and physiological
psychology from the University of Pennsylvania.

Dr. Gamzu will be based in
the Companys corporate headquarters in Iselin, New Jersey. He also will spend
a significant amount of his time at the Companys Rehovot, Israel offices,
where its research and drug development activities are centered. As part of a
brief transition period, Dr. Gamzu started his employment immediately and,
after assuming the position of Chief Executive Officer on March 31, 2007, will
devote full time to Pharmos.

Acquisition of Vela Pharmaceuticals Inc.

In
March 2006, the Company announced an agreement to acquire Vela Pharmaceuticals,
Inc. (Vela), which had a Phase II product candidate, dextofisopam, in
development to treat irritable bowel syndrome. The Company intends to dedicate
substantial resources to complete clinical development of this product
candidate. The Vela acquisition also included additional compounds in
preclinical and/or clinical development for neuropathic pain, inflammation and
sexual dysfunction. The issuance of up to 20 million shares in connection with
the acquisition was approved by the Companys shareholders on October 25, 2006 and
the acquisition was consummated immediately thereafter.

Under the
amended Merger Agreement, the Company issued 6.5 million shares of common stock
and paid $6 million to Vela shareholders at closing. Pharmos also agreed to
reimburse Vela for $679,000 of operating expenses from July 1, 2006 through
closing. The amended Merger Agreement also includes additional
performance-based milestone payments to the Vela stockholders related to the development
of dextofisopam, aggregating up to an additional $8 million in cash and the
issuance of up to an additional 13,500,000 shares of Pharmos common stock. In
the event that such shares or payments are issued or funded in future periods,
a determination will then be made as to whether the values are to be written
off as in-process research and development and charged to results of
operations; any such future charge could be material. None of the conditions
requiring issuance of these contingent shares or funding these payments had
been met as of December 31, 2006.

OVERVIEW

Pharmos
Corporation is a biopharmaceutical company that discovers and develops novel
therapeutics to treat a range of indications with a focus on specific diseases
of the nervous system including disorders of the brain-gut axis (GI/IBS), pain/inflammation
and autoimmune disorders. We have a portfolio of drug candidates and compounds
in various development stages, including clinical, preclinical and discovery. The Companys lead product, Dextofisopam, has
completed Phase 2a testing in irritable bowel syndrome (IBS), with positive
effect on the primary efficacy endpoint (n=141, p=0.033). The Company has
initiated a Phase 2b study of Dextofisopam for the treatment of IBS. Dextofisopam,
a non-serotonergic agent, is the R-enantiomer of racemic tofisopam, a molecule
marketed and used safely outside the United States for over three decades for
multiple indications including IBS.

4

The
Companys core proprietary technology platform focuses on the discovery and
development of synthetic cannabinoid compounds. Collaborative research as well
as in-house research at Pharmos over the last decade has served as a
cornerstone of our scientific foundation, and through such efforts we have
extensively characterized many of the key variables involved in cannabinoid
receptor activation and modulation. In order to identify and optimize promising
drug candidates quickly and efficiently, we combine:


Our
  extensive knowledge of the cannabinoid pathways we believe are responsible
  for therapeutic effects, and strategies for minimizing potential adverse
  effects
Our
  comprehensive library of well-annotated cannabinoid potential drug candidates
Our
  interdisciplinary drug discovery and development approach
Manufacturing
  capability of clinical material, including a cGMP-compliant pilot plant
Pharmaceutical
  formulation expertise, which has provided additional opportunities for
  developing novel drug delivery systems which can be employed both for
  internal programs in pain and inflammation and which also provide partnering
  opportunities for areas outside of our therapeutic focusThe Companys
discovery efforts are focused primarily on CB2-selective compounds which are
small molecule cannabinoid receptor agonists that bind preferentially to CB2
receptors found primarily in peripheral immune cells and peripheral nervous
system. Cannabinor, formerly known as PRS211,375, the lead CB2-selective
receptor agonist candidate, has completed one of two proof-of-principle Phase
IIa test in pain indications with the intravenous (IV) formulation and is
scheduled to complete the second proof-of-principle Phase IIa test and initiate
a Phase I test with the oral formulation during 2007. Other compounds from
Pharmos proprietary synthetic cannabinoid library are in pre-clinical studies
targeting nociceptive, neuropathic and visceral pain, as well as autoimmune
diseases, including multiple sclerosis, rheumatoid arthritis and inflammatory
bowel disease.

The Company
also has a family of synthetic cannabinoid compounds that do not bind to
cannabinoid receptors. Unlike the CB2-selective agonists such as Cannabinor,
the pharmacologic activity of these compounds is mediated by processes other
than CB receptor signaling. The Company is seeking to partner Dexanabinol, its
lead compound from this family, as a preventive agent against cognitive
impairment following cardiac surgery.

The Companys
NanoEmulsion (NE) drug delivery system, a proprietary asset derived from our
formulation expertise, completed in 2006 the second Phase I trial that
confirmed the safety, and tolerability as well as low systemic exposure of a
more optimized NE diclofenac cream formulation. In 2007, the Company expects to
initiate a Phase IIa trial in Osteoarthritis patients with this delivery
technology for topical application of analgesic and anti-inflammatory agents.
The NanoEmulsion technology has demonstrated additional potential applications,
including vaccine formulation as well as targeted delivery of such molecules as
antibiotics. The Company is interested in partnering this technology in these
areas.

VPI-013 has
completed Phase IIa clinical development as a treatment for neuropathic pain
and female hypoactive sexual desire disorder. The company is seeking to out-license
this compound.

Tianeptine,
a potential follow-on product to Dextofisopam, has completed late-preclinical
development for the treatment of irritable bowel syndrome (IBS). Tianeptine, a
racemic molecule, has been marketed outside the United States since 1988 for
the treatment of depression. Preclinical studies support the potential utility
of Tianeptine for the treatment of functional gastrointestinal disorders and,
in particular, IBS. Pharmos has established patent rights for the use of Tianeptine
and its enantiomers for the treatment of IBS and functional dyspepsia.

The Company
continues to refine its commercialization and business development strategy,
with the intention of capitalizing on internal resources through strategic
alliances and scientific and academic collaborations, out-licensing and
co-development opportunities, as well as balancing the portfolio with strategic
acquisitions and in-licensing opportunities. The Company intends to acquire
later stage product candidates for treating diseases in line with its research
and development expertise and targeted areas of interest, including pain,
inflammation, autoimmunity and select CNS disorders.

In October
2006, Pharmos completed its acquisition of Vela Pharmaceuticals Inc. (Vela),
which specialized in the development of medicines related to diseases of the
nervous system including disorders of the brain-gut

5

axis. The
acquisition fulfilled Pharmos strategic objective to expand its pipeline with
later stage compounds, in particular Dextofisopam, a promising and innovative
new drug with positive Phase 2a data for the treatment of diarrhea-predominant
and alternatingtype irritable bowel syndrome (IBS). The Vela acquisition also
included additional compounds in preclinical and/or early clinical development
for neuropathic pain, inflammation and sexual dysfunction.

To date, our
principal sources of cash have been public and private financings, the sale of
our ophthalmic business, revenues from our ophthalmic product line prior to the
sale, research grants and the sale of a portion of our New Jersey State net
operating loss carryforwards. In December 2004, the Companys former marketing
partner, Bausch & Lomb Incorporated (Bausch & Lomb), received
approval from the FDA of its New Drug Application (NDA) for Zylet® as an
ophthalmic anti-inflammatory antibiotic combination drug with respect to which
the Company sold its rights subject to certain payment milestones. In
connection therewith, the Company received net proceeds of approximately $9.1
million from Bausch & Lomb during the first quarter of 2005. Management
believes that cash, cash equivalents, and short term investments of $26.0
million as of December 31, 2006, will be sufficient to support the Companys
continuing operations beyond December 31, 2007.

STRATEGY

Pharmos
business is the discovery and development of new drugs to treat a range of
indications including pain, inflammation, autoimmunity and select CNS
disorders, including disorders of the CNS-gut axis. Our discovery program is
focused on capitalizing on our expertise in the biology, chemistry and
manufacturing of cannabinoid-based therapeutics, with the goal of developing
increasingly potent, drugable and selective cannabinoid receptor agonists and
antagonists for the treatment of a variety of human diseases. Modulation of
these receptors in preclinical models of disease suggests that potential areas
for therapeutic intervention include the treatment of pain, autoimmune disease,
osteoporosis, asthma, allergy, atherosclerosis and obesity. Based on our
advanced preclinical testing of drug candidates, we are currently focused on
the use of CB2-selective compounds for the treatment of pain and autoimmunity.

We have a
portfolio of drug candidates and compounds in various development stages,
including clinical, preclinical and discovery. To complement our own drug
development platforms, the Company is looking to expand its portfolio of
internally developed products with either in-licensed products or acquisitions
in selected related therapeutic areas. Also, we seek to enter into targeted
strategic alliances/scientific collaborations with established pharmaceutical
companies to complete development and commercialization of selected products. The
Company also maintains a commitment to out-license proprietary technologies and
products not consistent with our primary corporate focus.

Pharmos lead
product, Dextofisopam, has completed a
double-blind, placebo-controlled diarrhea-predominant or alternating IBS Phase
2a study with positive effect on primary efficacy endpoint (n=141, p=0.033). In
this study, Dextofisopam was well-tolerated and demonstrated significant
improvement over placebo suggesting that Dextofisopam has the potential to
become a novel firstline treatment for IBS. The design of a larger, Phase 2b,
dose-ranging study was discussed at a 2005 meeting with FDA, and Pharmos initiated
a Phase 2b trial in February 2007. Dextofisopam is the R-enantiomer of racemic
tofisopam, a molecule marketed and used safely outside the United States for
over three decades for multiple indications including IBS that binds to
specific receptors in areas of the brain affecting autonomic function,
including gastrointestinal (GI) function. Unlike 5-HT3 or 5-HT4 IBS therapies
currently available, both of which have significant safety concerns,
Dextofisopams novel non-serotonergic, brain-gut mechanism offers a unique and
innovative approach to IBS treatment.

In research efforts over the
past decade, the Company has developed a significant expertise in cannabinoid
biology and chemistry, and has generated significant know-how and an
intellectual property estate pertaining to multiple areas of cannabinoid
biology. The Company is focusing its preclinical research efforts in
CB2-selective cannabinoids, and has generated both clinical-stage drugs and
late preclinical compounds which appear promising in preclinical testing. From
the CB2-selective portfolio of compounds, Cannabinor is the most advanced,
having begun its clinical development in 2005 and completed a Phase I safety
study in January of 2006 and a Phase IIa clinical study in subjects with capsaicin-induced
pain model of neuropathic pain with the IV formulation in January 2007. Although
the preliminary results didnt meet the primary endpoint defined by

6

analgesic
effects compared to placebo, the trial confirmed safety and tolerability
observed in previous studies. In December 2006, the Company announced the
completion of preclinical toxicology and safety pharmacology studies of an oral
formulation of cannabinor. The toxicology studies included maximum tolerated
dose (MTD) studies, a 28-day repeat-dose study, and a cardiovascular safety
study in animals. Results of the repeat-dose, 28-day dose-ranging trial
demonstrated that daily administration of oral cannabinor was safe and
well-tolerated with no serious adverse events or target organ or tissue
toxicity. The completion of these MTD, repeat-dose and cardiovascular safety
studies represents an important milestone for oral cannabinor and clears the
way for the initiation of a Phase 1 clinical trial in humans. In 2007, the
Company plans to complete the Phase IIa trial of Cannabinor in patients
experiencing nociceptive pain from 3rd molar extraction that was initiated in
2006, and to conduct a Phase I safety study with the Cannabinor oral
formulation and other CB2-selective compounds in preclinical development to
preferentially activate the CB2 cannabinoid receptor, which is expected to
minimize psychotropic and other potential adverse effects of cannabinoids which
are mediated by the CB1 (central nervous system) cannabinoid receptor.
Preclinical investigations of these CB2-selective compounds have demonstrated
pharmacological activity as analgesic, anti-inflammatory, and immunomodulatory
agents that may effectively treat multiple neuro-inflammatory and autoimmune
disorders, such as various types of pain, multiple sclerosis, and rheumatoid
arthritis.

Pharmos is
conducting a clinical program to develop its proprietary NanoEmulsion (NE) drug
delivery technology. Two Phase I studies in healthy volunteers have been
completed and confirmed the safety and tolerability as well as the low systemic
exposure of a diclofenac NE topical cream. The Company plans to initiate a
Phase IIa clinical trial in Osteoarthritis patients in early 2007. The study
will evaluate the analgesic effect of an approved non-steroidal
anti-inflammatory drug (NSAID) formulated using our NanoEmulsion technology.
Efforts are targeted for the development of a product for the treatment of
osteoarthritic pain.

DRUG DISCOVERY APPROACH

Pharmos is
developing families of compounds based on its scientific knowledge of the
medicinal activities of cannabinoids, compounds with chemical structures or
receptor-binding properties related to the main active component of cannabis.
The Company utilizes state-of-the-art technologies to synthesize, evaluate and
develop new cannabinoid molecules that appear to exhibit enhanced therapeutic
benefit. Pharmos has a library of hundreds of well-characterized cannabinoids,
and continues to expand its library of compounds through a hybrid methodology
combining the rational design of compounds based on knowledge of detailed
molecular requirements for drug activity (structure-activity relationships or
SAR) with combinatorial chemistry, a technique that utilizes chemical reactions
to synthesize large numbers of different molecules. In contrast to random
methods of combinatorial chemistry, this hybrid approach leads to a larger
percentage of synthesized compounds that demonstrate activity in screening
assays and increases the potential of developing potent and selective drug
candidates. Many of these inherently lipophylic compounds have been modified to
make them water soluble. Pharmos has developed screening paradigms to screen
compounds in its library for different properties, including binding to CB1 and
CB2 receptors and activation of their downstream pathways as well as inhibition
of LPS-stimulated macrophages, including detection of cytokine release and
expression of receptors implicated in immune cell migration and antigen
presentation. Additional anti-inflammatory potential is assessed by screening
compounds for their ability to affect the expression of genes involved in
inflammation as measured by a panel of stably transfected cell lines generated
at Pharmos. Compounds that show potent activity in one or more of the screening
assays are tested in early ADMET (Absorption, Distribution, Metabolism,
Excretion, Toxicology) screens. The most promising compounds are then tested in
validated animal models of human pain, including CFA-induced paw edema for
inflammatory pain, and the chronic sciatic nerve ligation (Bennett and Xie)
model for neuropathic pain. Promising molecules are further studied with
additional models for neuropathic and chronic pain. Selected molecules are also
tested in animal models of autoimmune disease (rheumatoid arthritis, multiple
sclerosis and inflammatory bowel disease).

Pharmos
chemical library consists of several chemically distinct classes of cannabinoid
compounds. The Companys primary focuses for development are the families of
CB2-selective compounds which are cannabinoid receptor agonists that bind
preferentially to CB2 receptors. These receptors are found primarily in
peripheral immune cells. Employing the selection criteria noted above, the lead
candidate of one of these families of compounds has been elevated to full
clinical development status, and clinical trials have been initiated. In
addition to the compounds from this family, new platforms of synthetic CB2
selective compounds

7

are being
developed. The new compounds possess advantages such as a simpler synthesis,
increased potency and improved drug ability. A number of novel lead scaffolds
have been identified, and potential lead compounds with improved
physicochemical properties and increasing potency in animal models are
undergoing late-stage feasibility testing prior to being advanced into full
preclinical development. Pharmos recognizes the potential therapeutic promise
of CB2 activation in such diverse disease entities as pain, inflammation,
autoimmunity, osteoporosis and atherosclerosis. Our present research focus
remains in the development of our compounds in the areas of pain, inflammation
and autoimmunity.

Pharmos has
also developed a class of compounds identified as tricyclic dextrocannabinoids.
Drugs of this class do not bind appreciably to cannabinoid receptors, and
mediate their effects by other mechanisms including NMDA antagonism. The
Company is concentrating its efforts on the CB2-selective cannabinoids, and is
looking to partner additional development efforts on the dextrocannabinoids.

8

COMPOUNDS IN CLINICAL DEVELOPMENT

Dextofisopam

A non-serotonergic agent currently being evaluated for the treatment of
irritable bowel syndrome (IBS), is the R-enantiomer of racemic tofisopam, a
molecule marketed and used safely outside the United States for over three
decades for multiple indications including IBS. Dextofisopam represents a
novel, first-in-class opportunity with a positive proof-of-concept study in an
arena where there are few compounds with unique approaches or positive efficacy
results. By structure, Dextofisopam is a member of the homophthalazine class;
Dextofisopam binds to specific receptors in areas of the brain affecting autonomic
function, including gastrointestinal (GI) function. Unlike 5-HT3 or 5-HT4 IBS
therapies currently available, both with significant safety concerns,
Dextofisopam novel non-serotonergic, brain-gut mechanism offers a unique and
innovative approach to IBS treatment.

A double-blind, placebo-controlled diarrhea-predominant or alternating
IBS Phase 2a study has been completed with positive effect on primary efficacy
endpoint (n=141, p=0.033). In this study, Dextofisopam was well-tolerated and
demonstrated significant improvement over placebo suggesting that Dextofisopam
has the potential to become a novel firstline treatment for IBS. The design of
a larger, Phase 2b, dose-ranging study was discussed at a 2005 meeting with
FDA, and Pharmos initiated a Phase 2b trial in February 2007.

An extensive patent estate is in place with Dextofisopam. This consists
of an issued composition-of-matter patent, an issued method-of-use patent, and
numerous additional pending patent applications in both the United States (including
use of Dextofisopam for inflammatory disorders and immunomodulation) and
foreign counterparts.

CB2-selective cannabinoids

Pharmos novel
CB2-selective cannabinoids are synthetic compounds which belong to the class of
nonclassical cannabinoids. Compounds in this class have been demonstrated to
possess immunomodulatory and analgesic activities. Importantly, the
CB2-selective cannabinoids display fewer of the undesired psychotropic and
cardiovascular side-effects seen with some natural cannabinoids because they
bind with high affinity to the peripheral cannabinoid type two (CB2) receptor
and with lower affinity to the cannabinoid type one (CB1) receptor, located in
the central nervous system. In contrast to CB1 receptors, CB2 receptors are
expressed mainly outside of the central nervous system, on immune and
inflammatory cells, including mast cells that are thought to play a role in
triggering pain. CB2 activation also inhibits the release of pro-nociceptive
peptide from the periphery which may prevent activation of primary afferent
neurons. CB2 activation also modulates T-cell activity, skewing the T-helper
cell type 1 (Th1) responses to the T-helper cell type 2 (Th2)
activity. Most autoimmune diseases and models of autoimmunity in which
susceptibility is associated with the expression of specific MHC class II
allotypes appear to be of the Th1 type. Thus considerable emphasis
has been placed on developing means of altering the course of the autoimmune Th1
response to become that of a Th2 response, with the goal of
downregulating the autoimmune pathogenesis

As noted
earlier, (SEE: DRUG DISCOVERY APPROACH), several candidates from Pharmos
CB2-selective cannabinoid library have demonstrated promise in animal models
for autoimmune inflammatory disorders, such as multiple sclerosis and
rheumatoid arthritis. These compounds have also demonstrated efficacy in animal
models of neuropathic, inflammatory and chronic nociceptive pain. In selected
preclinical models, these compounds have demonstrated analgesic activity
equivalent to morphine but without the unwanted opioid side effects such as
sedation and respiratory depression. The anti-inflammatory activity of these
compounds in selected models is equivalent or superior to that afforded by
non-steroidal anti-inflammatory drugs (NSAIDs). Cannabinor, the lead compound
from this library, demonstrates an optimized combination of CB2 specificity and
analgesic and anti-inflammatory potency. Cannabinor has been found to be
pharmacologically active in chronic, inflammatory, visceral and neuropathic
pain models in rodents. In animal model experiments, the drug candidate was as
potent as morphine in blocking noxious pain in the inflammatory pain in the
carrageenan-induced paw edema model, and neuropathic pain in the Bennett &
Xie model. Cannabinor also was effective in blocking acetic-acid induced
visceral pain. The analgesic efficacy of Cannabinor was also demonstrated in
large animals by a post-surgical pain model in pigs. Administration of the CB2
antagonist and not the CB1 antagonist prior to the administration of Cannabinor
reversed the analgesic effect of Cannabinor. These findings suggest

9

that the
analgesic mechanism of Cannabinor is most likely mediated by CB2 receptor
activity. Importantly, Cannabinor was effective in blocking inflammatory pain
when administered orally.

One of the
selection criteria for advancing this lead compound into clinical development
is water solubility; Cannabinor is water soluble, increasing the likelihood
that oral administration will be possible. A Phase I safety trial with the Oral
formulation is planned in 2007 for chronic administration in anticipation of
further trials in neuropathic pain. In the 2006, the Company initiated two
Phase IIa trials for different types of pain, including a model of nociceptive
pain (third molar extraction) and a model of neuropathic pain
(experimentally-induced capsaicin model). In December 2006, the Company
announced the completion of preclinical toxicology and safety pharmacology
studies of an oral formulation of Cannabinor required prior to initiation of
human studies. Pharmos recently issued a press release about the preliminary
results of an exploratory study of a single intravenous (iv) administration of
Cannabinor on capsaicin-induced pain in healthy normal volunteers.
Subsequent analysis of the data showed iv Cannabinor to be generally safe and
well tolerated. Evaluation of Cannabinors cardiovascular profile using digital
ECG holter monitors revealed no changes in QTc interval. Despite not meeting
the studys primary end point, a post hoc analysis of secondary end points
demonstrated evidence of a systemic analgesic effect of iv Cannabinor. The
Company expects to complete its separate, ongoing Phase IIa clinical trail of
Cannabinor as a treatment for nociceptive pain in the second quarter of 2007
and to conduct a Phase I safety trial with the Oral formulation in 2007 for
chronic administration.

Potential
pharmaceutical markets for Pharmos CB2-selective cannabinoids

The
development of novel CB2-selective diseasemodifying agents (DMA) that combine
anti-inflammatory, immunomodulatory and analgesics properties for the treatment
of inflammatory/autoimmune diseases is a major goal of Pharmos research and
discovery activity. Inflammation and
immunodysregulation play a pivotal role in a majority of chronic and
debilitating autoimmune diseases such as rheumatoid arthritis (RA),
inflammatory bowel disease (IBD) and multiple sclerosis (MS). Treatment and
healthcare costs associated with these diseases have been estimated to exceed
$500 billion annually. Recent products introduced in this market have been
limited due to lack of efficacy and/or severe side effect profile.

In preclinical
models, Pharmos novel CB2-selective cannabinoids have also demonstrated
anti-inflammatory and analgesic properties, suggesting that they may be useful
in the treatment of nociceptive, visceral and neuropathic pain.

The analgesic
market where unmet medical needs remain can be categorized into five major
syndromes: cancer pain, back pain, HIV pain, neuropathies, and
arthritic/osteoarthritic pain. The incidence and prevalence of the major pain
syndromes continues to increase with an estimated patient potential in 2009 of
over 368 million. In 2000, the global market for analgesics was about $16
billion. Global analgesic sales increased to more than $22 billion for 2002 and
are predicted to increase to $30 billion by 2009. In the US, spending for drugs
to treat neuropathic pain is anticipated to exceed $1 billion by 2009. At
present, there is no specific or satisfactory analgesic for neuropathic pain.
Opioids and NSAIDs are only marginally effective in a minority of patients.
Pfizers Lyrica® (pregabalin) was recently FDA-approved for the treatment of
various forms of neuropathic pain, In controlled clinical trials, however, only
35% of patients with neuropathic pain had a 50% reduction in pain score, and
the most common side effects of Lyrica® included dizziness, somnolence, dry
mouth, peripheral edema, blurred vision, weight gain and difficulty with
concentration/attention. Lyrica® is also designated as a controlled substance
by the FDA. In the first year after launch, the drug generated $291 million in
sales, with an additional $639 million in sales for Neurontin® (gabapentin), a
closely-related drug widely used for the treatment of neuropathic pain.
Neuropathic pain occurs most commonly in diabetes, cancer, multiple sclerosis,
stroke, amyotrophic lateral sclerosis, HIV, trigeminal and post-herpetic
neuralgia, and after trauma (traumatic neuralgia, phantom limb surgery). The
main symptoms are spontaneous (i.e. not triggered by noxious stimuli), severe
shooting pains, hyperalgesia and allodynia (painful sensations evoked by light
touch or small changes in temperature that do not normally elicit pain).

These
potential markets are extremely attractive for analgesics that can effectively
manage pain experienced by patients suffering from any of these syndromes. The
properties of our CB2-selective cannabinioids place them in a good position for
potential deployment in several of these major pain syndromes.

10

Cannabinor and
other CB-2 selective compounds in preclinical development demonstrate
significant immunomodulatory activity in autoimmune disease models of multiple
sclerosis, rheumatoid arthritis and inflammatory bowel disease. The total
global market for autoimmune disease therapeutics reached an estimated $11.3
billion in 2000. This was an increase of 23.6% over an estimated $4.8 billion
in 1996. Key market drivers at that time included products such as Celebrex®,
Vioxx®, Enbrel®, Avonex®, Betaseron®, Rebif®, and Synthroid®. In 2006, the
market is expected to generate estimated revenues of $21.1 billion, reflecting
a 15.9% increase from 2000 to 2006. The largest segment by disease area within
the global autoimmune disease market was the rheumatoid arthritis market, with
55.9% share in 2000.

More than two
million Americans suffer from Rheumatoid arthritis (RA), which causes
stiffness, swelling and limitation in the motion and function of multiple
joints. RA is a chronic, progressive disease, and if left untreated, patients
can become disabled from joint damage caused by the disease, limiting their
ability to function. RA is associated with substantial disability and economic
losses, and one study showed that one-third of patients in the United Kingdom
who were employed became work-disabled within two years of disease onset.
Rheumatologic disorders also account for 25 percent of Social Security
disability payments in the United States. Radiographic changes occur within two
years of disease onset in 50 percent to 70 percent of RA patients. The American
College of Rheumatology suggests control of disease progression should start
early to limit joint damage in RA. Therapy for patients with RA has improved
dramatically over the past 25 years. Current treatments offer most patients
good to excellent relief of symptoms and the ability to continue to function at
or near normal levels. Since there is no cure for RA, the goal of treatment is
to minimize patients symptoms and disability by introducing appropriate drug
therapy early in the course of the disease before permanent damage to the
joints has occurred. No one treatment is effective for all patients, and many
patients will need to change therapies during the course of their disease.
Successful management of RA requires early diagnosis and, at times, aggressive
treatment. Non-steroidal anti-inflammatory drugs (most commonly referred to as
NSAIDs, such as ibuprofen or naproxen) and/or corticosteroids (such as
prednisone) given orally at low doses or via injection into the joints may be
used first with the primary aim of quickly reducing joint inflammation. All RA
patients with persistent swelling in the joints are candidates for treatment
with disease-modifying anti-rheumatic drugs (called DMARDs for short) that are
typically used in conjunction with NSAIDs and/or low dose corticosteroids. The
DMARD class of drugs has greatly improved the symptoms and function as well as
the quality of life for the vast majority of patients with RA. DMARDs include:
methotrexate (Rheumatrex ® and Folex ®), hydroxychloroquine (Plaquenil ®),
sulfasalazine (Azulfidine ®), gold given orally (Auranofin ®) or
intramuscularly (Myochrisine ®), minocycline (Minocin ®, Dynacin ® and Vectrin
®), azothiaprine (Imuran ®), cyclosporine (Sandimmune ® and Neoral ®),
leflunomide (Arava ®). The benefits from these medications may take weeks or
months to be apparent. Because they are associated with toxic side effects,
frequent monitoring of blood tests while on these medications is imperative.
Another class of medications, referred to as biologic disease response
modifiers or biologic agents can specifically target parts of the immune
system that lead to joint and tissue damage in RA. FDA approved treatments
include agents etanercept (Enbrel ®), infliximab (Remicade ®), adalimumab
(Humira ®), and anakinra (Kineret ®). These drugs are associated with variable
degrees of immune suppression, and long-term use of anti-TNF-alpha agents can
lead to the development of autoantibodies. Anti-idiotype antibodies may develop
against the Fab portion of monoclonal antibodies. Antinuclear antibodies and,
less commonly, anti-double-stranded DNA antibodies have been noted with
anti-TNF-alpha therapy, but clinical lupus is rare. Demyelinating diseases such
as multiple sclerosis may also occur. With their unique mechanism of
immunomodulation, CB-2 agonists such as cannabinor could be viable therapeutic
candidates for study in patients with RA.

Multiple
sclerosis is a chronic and disabling disease, with healthcare costs
disproportionate to the numbers affected. In the US alone, costs are estimated
to exceed $10 billion per year. Estimates suggest that about 2.5 million people
worldwide have MS, an inflammatory disease of the nervous system characterized
by recurrent relapses followed by periods of remission. After trauma, it is the
second most common neurological disability to affect young and middle-aged
adults. It affects twice as many women as men, with the relapsing forms of MS
the most common. Patients with MS display a range of symptoms which arise from
demyelination in the central nervous system, including the brain, spinal cord
and optic nerves. While symptoms vary between patients, they commonly include
blurred vision, slurred speech, numbness or tingling in the limbs and problems
with balance and coordination, due to the loss of control over vital functions
such as seeing, walking and talking.

11

The
introduction of the first generation of disease-modifying drugs, which include
interferon beta-1a and 1b as well as glatiramer acetate, represented an
important advance in the treatment of MS when introduced into clinical
practice. Approved for the treatment of relapsing forms of MS, they reduce the
frequency and severity of exacerbations as well as the number of lesions seen
on magnetic resonance imaging (MRI). However, while these agents have an
immunomodulatory effect that alters the course of the disease they do not
reverse the neurological damage that occurs in MS. Currently, no marketed
treatments for MS can produce remyelination and so treatment aims to:


Reduce
  relapse rates
Prevent
  fixed disability directly associated to relapse
Provide
  symptomatic management of fixed neurological deficits
Prevent
  disability arising from disease progressionPotential
pharmaceutical market for Dextofisopam

The development of Dextofisopam
for the treatment of Irritable Bowel Syndrome (IBS) is a major goal of Pharmos
development activity. Annual direct medical costs associated with IBS has been
estimated at $8 billion annually in the U.S. It has been estimated that
indirect costs for IBS in the U.S. exceed $20 billion. The few recent products
introduced in this market have been limited by poor side effect profiles.

Irritable Bowel Syndrome: Disease Description
and Diagnosis

Irritable
bowel syndrome is defined by a constellation of symptoms that includes
abdominal pain or discomfort and is accompanied by diarrhea, constipation, or
an alternation between the two. IBS is classified as a functional disorder; it
is diagnosed by symptom-based criteria following exclusion of organic diseases
that may produce abdominal pain and altered bowel function.

Although the
etiology of IBS is not completely understood, five factors have been proposed
as playing a role in the development of IBS:

1.
Psychosocial
  factorsa.
impact of
  stress on motor function of the GI tractb.
approximately
  60% of patients seen at referral centers have psychiatric symptoms.2.
Visceral
  hypersensitivity - lower threshold for abdominal pain3.
Altered
  bowel motility - abnormal motility of the small intestine4.
Infection
  and inflammation5.
Autonomic
  nervous system dysfunctiona.
studies show
  that IBS patients have aberrant autonomic nervous system activityb.
altering
  autonomic nervous system activity in volunteers produces symptoms of IBS.This
perspective on the pathophysiology of IBS suggests that a drug that improves
altered bowel motility, decreases visceral hypersensitivity, reduces
stress-related impact on GI function, normalizes autonomic dysfunction, and
possesses anti-inflammatory properties may provide a superior, broad-spectrum
approach to the treatment of IBS. In preclinical studies, dextofisopam exhibits
all of these properties.

The diagnostic
criteria for IBS have evolved over the years. Today, diagnosis for clinical
trials and regulatory purposes is defined by the Rome III Criteria. Diagnosis
is based on the patient having recurrent abdominal pain or discomfort for at
least 6 months, and on at least 3 days/month over the past 3 months,
associated with at least two of the following three features:

1.
Improvement
  with defecation2.
Onset associated
  with a change in frequency of stool3.
Onset
  associated with a change in form (appearance) of stool12

Based on the
clustering of symptoms, IBS patients are usually categorized as either
diarrhea-predominant, constipation-predominant, or alternating (also
termed mixed). For a diagnosis of IBS, specific red flag symptoms are
usually excluded. These red flag symptoms may indicate the presence of
organic disease, such as colon cancer (especially if onset is rapid or occurs
over the age of 40), ulcerative colitis (rectal bleeding), or Crohns disease
(weight loss, fever). For the diagnosis of IBS to be made, normal results must
have been obtained for blood and stool tests, x-rays, endoscopy, and biopsies.

While not a
life-threatening disease, IBS can have a large negative impact on the quality
of life of patients. Even mild cases can be life-altering, and severe cases are
often debilitating, with the frequency and severity of episodes seriously
affecting work, school, and social schedules.

IBS is a
leading cause of physician visits, accounting for approximately 3,000,000
visits annually in the U.S., representing 4% of all visits to office-based
physicians and 49% of visits to office-based gastroenterologists. The need to
eliminate other possible diagnoses (colon cancer, inflammatory bowel disease,
other GI diseases) necessitates expensive in-office procedures. As noted
earlier, the annual direct medical costs for IBS in the U.S. have been
estimated at $8 billion.

Prevalence of IBS

IBS is a very
common disorder, with studies indicating prevalence in the range of 6-15% for
North America, Europe, and Japan. Based on a prevalence rate of 12.5%, approximately 36 million individuals
in the United States meet diagnostic criteria for IBS. Prevalence rates are
similar in the major European markets (France, Germany, Italy, Spain, and the
United Kingdom). While prevalence rates for other countries are not well
established, published studies support the existence and recognition of IBS
throughout the world, including China and India.

The prevalence
of IBS varies with gender and age. Higher prevalence rates are consistently
reported for women than men (two to three times greater). While IBS is observed
in all age groups, including pediatric and geriatric populations, it is more
common in the age range of 20 to 60 years for both genders

Current Market

Even with the
recent introduction of two new therapies - Lotronex®(alosetron),
a5-HT3 antagonist, and Zelnorm® (tegaserod), a 5-HT4
partial agonist - the IBS market is still largely served by older products,
with questionable efficacy and poor tolerability. These older products include
antispasmodics, laxatives, and antidiarrheal agents. While antispasmodics at
high doses may provide relief of specific symptoms, these drugs are poorly
tolerated at those doses. The estimated sales of IBS drugs in the U.S. market
totaled $353.7 M in 2003.

Lotronex®
was introduced into the U.S. IBS market in March 2000, and was withdrawn from
the market in November 2000 owing to safety issues. Lotronex® was
subsequently reintroduced in 2003 with a restricted marketing program
(Physician Prescribing Program). The utility of Lotronex® is
severely hampered both by its narrow indication (only for women with severe
diarrhea-predominant IBS who have failed to respond to conventional therapy)
and a major safety issue (the risk of potentially fatal ischemic colitis).
Since its reintroduction, Lotronex®has had minimal prescription
volume.

Zelnorm®
was introduced into the U.S. IBS market in July 2002 for short-term use in
women with constipation-predominant IBS. In April 2004, a precautionary
statement was added to Zelnorm® labeling regarding post-marketing
cases of ischemic colitis and a warning for severe diarrhea. Despite these
changes to the package insert, the strong marketing and educational efforts
supporting Zelnorm® appear to have increased awareness and expanded
utilization. Zelnorm® achieved U.S. sales of $26 M in 2002, $132 M
in 2003, $249 M in 2004, $357 M in 2005, and $488 M in 2006, with 2006
worldwide sales of $561 M. Sales over the next few years are projected to
grow markedly. Zelnorm® is currently approved in 30 countries,
though not yet in major EU markets or in Japan.

13

Market Potential (United States and Rest of
World)

The market
potential for IBS is very large. IBS is a prevalent disorder for which there
are currently no safe and broadly effective treatments. Investment research
analysts project a U.S. market worth $2.5 B by 2009. Market research reports
project that the current full worldwide (WW) market potential for IBS therapies
could be as high as $15 B (over $6 B in the United States alone). Based on its
current clinical profile, it may have the potential to capture a significant
portion of the IBS market.

Despite recent
advances in treatment, there remains a need for more efficacious drugs for MS
and especially for primary progressive MS, the most aggressive form of the
disease. Tysabri® (natalizumab) was recently introduced by Biogen-Idec as a
potential advance in the treatment of MS; however, cases of a neurological
disease called progressive multifocal leukoencephalopathy (PML) were reported
in users of natalizumab. The disease is most likely caused by a virus, and is
associated with being immunocompromised. The drug was withdrawn from the
market. Prior to market withdrawal, estimates of sales of up to $3 billion were
projected. Tysabri® has subsequently re-entered into the market, but is only
available through a special distribution program.

NanoEmulsion Drug Delivery
System

Topical
application of drugs directly to pathological sites offers potential advantages
over systemic delivery by producing high drug concentration in the affected
tissue while avoiding unwanted side-effects due to high systemic drug levels.
Topical preparations of NSAIDs are commonly used as analgesics and
anti-inflammatory agents to treat various disorders such as arthropathies and
myalgias. Many topical formulations employ chemical penetration enhancers to
improve dermal penetration of drugs. Chemical enhancers, which are usually
organic solvents, may cause skin irritation and sensitization. Pharmos invented
and owns a family of patents covering novel NanoEmulsion formulations as
vehicles for lipophilic drugs. NanoEmulsions are solvent-free, injection-free
topical vehicles based on drug entrapment in oil-in-water nanoemulsion
droplets. Such vehicles allow for high loading of water-insoluble drugs and
offer enhanced skin penetration over competing technologies. A topical
application of the nanotechnology has already demonstrated excellent targeted
delivery of lipophilic drugs to muscle and joints in animal models, and has
undergone two Phase I testing in humans, demonstrating excellent local safety
and tolerability with low systemic exposure. Pharmos has formulated several
NSAIDs into this platform technology, and plans to initiate a PIIa clinical
study in 2007 in Osteoarthritis patients. This platform technology also offers
the potential for topical delivery of a wide variety of water-insoluble
compounds in addition to NSAIDs, and the possibility of incorporating other
drug candidates into the delivery system continue to be evaluated, either for
internal development or for out-licensing.

Market for topical NSAIDs

Osteoarthritis
is the most common chronic disease in North America and afflicts an estimated
10% of the worlds population. The active ingredient of the Companys first
NanoEmulsion technology NSAID, diclofenac, has a long-standing and proven
clinical treatment record. With the Companys enhanced proprietary delivery
system, the Company believes its clinical effectiveness will be significantly
enhanced compared to other topical preparations. The Company believes that
NanoEmulsion NSAID delivery may circumvent the significant GI side-effects
commonly found with orally ingested NSAIDs and will help to fill the void
created by the withdrawal of products from the market or requiring restrictive
label indications based on safety concerns of the COX-2 inhibitors.

14

COMPETITION

The pharmaceutical
industry is highly competitive. Pharmos competes with a number of
pharmaceutical companies that have financial, technical and marketing resources
that are significantly greater than those of Pharmos. Some companies with
established positions in the pharmaceutical industry may be better equipped
than Pharmos to develop, market and distribute products in the global markets
Pharmos is seeking to enter. A significant amount of pharmaceutical research is
also being carried out at universities and other not-for-profit research
organizations. These institutions are becoming increasingly aware of the
commercial value of their findings and are becoming more active in seeking
patent protection and licensing arrangements to collect royalties for the use
of technology they have developed. They may also market competitive commercial
products on their own or through joint ventures and will compete with Pharmos
in recruiting highly qualified scientific personnel. Further, these
institutions will compete with Pharmos in recruiting qualified patients for
enrollment in their trials.

Pharmos is
pursuing areas of product development in which there is a potential for
extensive technological innovation. Pharmos competitors may succeed in
developing products that are more effective than those of Pharmos. Rapid
technological change or developments by others may result in Pharmos potential
products becoming obsolete or non-competitive.

We know of
various programs using cannabinoid research in various stages that compete in
analgesia.

Dr Alexandros
Makriyannis from the University of Connecticut has filed several patents
relating to CB2 cannabinoid ligands and mimetics. MakScientific, a company
founded by Dr. Makriyannis in 2003, is developing technologies originating from
AlexiPharma and the University of Connecticut. In 2004, MakScientific has
licensed its existing and future preclinical library of compounds with
selective CB2 agonist activity to Endo Pharmaceuticals, for use in the fields
of pain and selected CNS disorders. Other University labs are carrying out
academic research on CB2 agonists. According to recent reports presented at
scientific meetings, there are other companies pursuing the development of
synthetic cannabinoid derivatives with low psychotropic side effects for the
treatment of severe and chronic pain conditions. Indevus is developing IP 751,
an anti-inflammatory and analgesic compound, as a potential treatment for both
acute and chronic pain. A Phase II trial with IP 751, conducted by researchers
in Germany and published in the Journal of the American Medical Association
(JAMA 2003; 290(13): 1757-1762), showed that patients treated with this
compound experienced a significant reduction in neuropathic pain. In addition,
the drug was reported to be well tolerated, with no major adverse psychological
or physical effects observed. An IND has been filed with the FDA, and an
initial Phase I clinical trial designed to assess the safety of IP 751
demonstrated that it was well tolerated and showed no evidence of psychotropic
activity. Indevus is completing the scale-up and manufacturing of IP 751 in
anticipation of beginning additional Phase I trials starting in early 2005.
Indevus licensed exclusive worldwide rights to IP 751 from Manhattan
Pharmaceuticals, Inc.

We know of a number of
programs in various stages that compete in the area of IBS.

Dextofisopam
is currently targeted for the treatment of diarrhea-predominant IBS and/or
alternating-type IBS. To the best of our knowledge, there are no competing
compounds in development specifically for the treatment of alternating-type
IBS. Several compounds are reported to be in development for the potential
treatment of diarrhea-predominant IBS. These include DDP-225, a mixed 5-HT3
antagonist/norepinephrine reuptake blocker, reportedly in Phase 2 (Dynogen);
rifaximin, an antibiotic marketed for the treatment of travelers diarrhea
(Salix); arverapamil, a compound with 5-HT3 antagonist and calcium
channel blocking properties, reportedly in Phase 2 (AGI); and TRN-002, a
chloride channel blocker reportedly in Phase 2 (Trine). Several other compounds
are reported to be in development for the treatment of IBS, however, it is not
clear if these compounds are intended for a specific type of IBS, e.g.,
diarrhea-predominant, constipation-predominant, or alternating-type IBS. Such
compounds include a glucagon-like peptide-1 agonist (Gastrotech) and
asimadoline, a kappa opiate agonist (Tioga), both reportedly in Phase 2.
Several other compounds are reported to be in development for the treatment of
constipation-predominant IBS. While such compounds may not directly compete
with dextofisopam, it is possible that they may eventually be developed for
diarrhea-predominant or alternating-type IBS, or that dextofisopam may
eventually be developed for constipation-predominant IBS.

15

Such compounds
include DDP-733, a 5-HT3 partial agonist reportedly in Phase 2
(Dynogen) and MD-1100, a guanylate cyclase C agonist reportedly in Phase 2
(Microbia).

Collaborative Relationships

Pharmos
commercial strategy is to develop products independently and, where
appropriate, in collaboration with established pharmaceutical companies and
institutions. The Company also intends to supplement its product line with
additional compounds that serve to enhance the product portfolio. Collaborative
partners may provide financial resources, research and manufacturing
capabilities and marketing infrastructure to aid in the commercialization of
Pharmos products in development as well as potential future products. Depending
on the availability of financial, marketing and scientific resources, among
other factors, Pharmos may license its technology or products to others and
retain profit sharing, royalty, manufacturing, co-marketing, co-promotion or
similar rights. Any such arrangements could limit Pharmos flexibility in
pursuing alternatives for the commercialization of its products. Due to the
often unpredictable nature of the collaborative process, Pharmos cannot be
certain that it will be able to establish any additional collaborative
arrangements or that, if established, any of these relationships will be
successful.

Bausch & Lomb

In 2001,
Pharmos sold to Bausch & Lomb all of its rights in the U.S. and Europe to
manufacture and market Lotemax® and Alrex® and Zylet®, the third loteprednol
etabonate-based product, which was submitted to the FDA for marketing approval
in September 2003. In December 2004, Bausch & Lomb received approval from
the FDA of its NDA for Zylet® as an ophthalmic anti-inflammatory/antibiotic combination
product.

At the time of
the sale in 2001, Pharmos received gross proceeds of approximately $25 million
in cash in 2001. During January 2005, an amended agreement was signed in regard
to Zylet® and Pharmos received additional gross proceeds of approximately $12.2
million from Bausch & Lomb. Additionally, the Company may have received a
milestone payment of up to $10 million if actual sales during the first two
years following Bausch & Lombs commercialization were exceeding
agreed-upon forecasted amounts. The Company is not expecting to receive further
proceeds from Bausch & Lomb due to this sale. Pharmos agreed to pay up to
$3.75 million of the costs of developing Zylet®, of which $600,000 was deducted
from the purchase price paid by Bausch & Lomb in October 2001. In July
2003, another $1.57 million was paid to Bausch & Lomb. Pharmos paid the
remaining balance of $1.56 million as its share of these research and
development related Zylet® expenses in January 2005. Pharmos has no further
obligation for payments to Bausch & Lomb.

Pharmos paid
Dr. Nicholas Bodor, the loteprednol etabonate patent owner and licensor, who is
a former director of and consultant to Pharmos, a total of approximately $2.7
million from the initial proceeds of the sale of Lotemax® and Alrex® in return
for his consent to Pharmos assignment of its rights under the license
agreement to Bausch & Lomb. In January 2005, the Company paid Dr. Bodor
approximately $1.3 million per the agreement with respect to Zylet®. Pharmos
owes Dr. Bodor an additional 14.3% of any payments the Company may receive from
Bausch & Lomb in the event that certain sales levels are exceeded in the
first two years following commencement of sales in the U.S. In February 2005,
the Company paid the Israel-U.S. Binational Industrial Research and Development
Foundation $211,712, which represented the maximum amount the Company owed the
foundation for Zylet®.

Loteprednol Etabonate

Loteprednol
etabonate is a unique steroid that is designed to act in the eye and alleviate
inflammatory and allergic conditions. The drug is quickly and predictably
reduced into inactive particles before it reaches the inner eye or systemic
circulation. This action results in improved safety by avoiding the side
effects related to exposure to most ocular steroids. In the eye, the most
unwanted side effect of steroids is the elevation of intra-ocular pressure,
which can be sight-threatening. While steroids, for lack of an alternative, are
regularly used for severe inflammatory conditions of the eye, milder conditions
such as allergies are preferentially treated with less effective non-steroidal
agents.

16

For Bausch
& Lombs ophthalmic product, Zylet®, in which we have a financial interest
there are competing products currently on the market including Tobradex® from
Alcon, which is the largest-selling product in its category, as well as Vexol®
from Alcon and Pred Forte® from Allergan.

Patents and Proprietary Rights

Proprietary
protection generally has been important in the pharmaceutical industry, and the
commercial success of products incorporating Pharmos technologies may depend,
in part, upon the ability to obtain strong patent protection.

Some of the
technologies underlying Pharmos potential products were invented by or are
owned by various third parties, including the Hebrew University of Jerusalem.
Pharmos is the licensee of these technologies under patents held by the
applicable owner, through licenses that generally remain in effect for the life
of the applicable patent. Pharmos generally maintains, at its expense, U.S. and
foreign patent rights with respect to both the licensed technology and its own
technology and files and/or prosecutes the relevant patent applications in the
U.S. and foreign countries. Pharmos also relies upon trade secrets, know-how,
continuing technological innovations and licensing opportunities to develop its
competitive position. Pharmos policy is to protect its technology by, among
other things, filing, or requiring the applicable licensor to file, patent
applications for technology that it considers important to the development of
its business. Pharmos intends to file additional patent applications, when
appropriate, relating to its technology, improvements to its technology and to
specific products it develops.

The patent
positions of pharmaceutical firms, including Pharmos, are uncertain and involve
complex factual questions. In addition, the coverage claimed in a patent
application can be significantly reduced before or after the patent is issued.
Consequently, Pharmos does not know whether any of the pending patent
applications underlying the licensed technology will result in the issuance of
patents or, if any patents are issued, whether they will provide significant
proprietary protection or will be circumvented or invalidated. Since patent
applications in the U.S. and elsewhere publish only 18 months after priority
date, and since publication of discoveries in the scientific or patent
literature often lag behind actual discoveries, Pharmos cannot be certain that
it or its licensors, as the case may be, were the first creators of inventions
covered by pending and issued patents or that it or its licensors, as the case
may be, were the first to file patent applications for such inventions.
Moreover, it may be necessary for Pharmos to participate in interference
proceedings declared by the U.S. Patent and Trademark Office in order to
determine priority of invention. Involvement in these proceedings could result
in substantial cost to Pharmos, even if the eventual outcomes are favorable to
Pharmos. Because the results of the judicial process are often uncertain, we
cannot be certain that a court of competent jurisdiction will uphold the
patents, if issued, relating to the licensed technology, or that a competitors
product will be found to infringe those patents.

Other
pharmaceutical and drug delivery companies and research and academic
institutions may have filed patent applications or received patents in Pharmos
fields. If patents are issued to other companies that contain competitive or
conflicting claims and those claims are ultimately determined to be valid, it
is possible that Pharmos would not be able to obtain licenses to these patents
at a reasonable cost or be able to develop or obtain alternative technology.

Pharmos also
relies upon trade secret protection for its confidential and proprietary
information. It is always possible that others will independently develop
substantially equivalent proprietary information and techniques or otherwise
gain access to Pharmos trade secrets.

It is Pharmos policy to
require its employees, consultants, outside scientific collaborators, sponsored
researchers and other advisors to execute confidentiality agreements upon the
commencement of employment or consulting or advisory relationships with
Pharmos. These agreements generally provide that all confidential information
developed or made known to the individual during the course of the individuals
relationship with Pharmos is to be kept confidential and not disclosed to third
parties except in specific circumstances. Further, these agreements provide for
the maintenance of confidentiality following the termination of the
individuals relationship with Pharmos. In the case of employees and certain
consultants, the agreements provide that all

17

inventions
conceived by the individual in the course of their employment or consulting
relationship shall be the exclusive property of Pharmos. Due to the vital
nature of trade secrets and the often uncertain results of the judicial
process, we cannot be sure, however, that these agreements will provide
meaningful protection or adequate remedies for Pharmos trade secrets in the
event of unauthorized use or disclosure of such information. Pharmos patents
and licenses underlying its potential products described herein are summarized
below.

Neuroprotective Agents. Pharmos has licensed
from the Hebrew University of Jerusalem, which is the academic affiliation of
the inventor, Dr. Raphael Mechoulam, patents covering new cannabinoid compounds
that have demonstrated beneficial activity which may prevent damage or death to
nerve cells resulting from various diseases and disorders of the nervous system
while appearing to be devoid of most of the deleterious side effects usually
associated with this class of compounds. Several patents have been designed to
protect this family of compounds and their uses devised by inventors at Pharmos
and the inventors at the Hebrew University. The earliest patent applications
resulted in patents issued in 1989, and the most recent patents date from 2006.
These patents cover dexanabinol, which has been under development for the
treatment of post-operative cognitive impairment and other conditions, and new
molecules discovered by modifying the chemical structure of dexanabinol.

Anti-inflammatory and Analgesic Agents.
Pharmos has also licensed, from the Hebrew University of Jerusalem, patents for
inventions of Dr. Mechoulam covering new compounds that have demonstrated
beneficial activity, which may be effective in treating not only neurological
disorders, but also inflammatory diseases, and most importantly, pain. These
compounds are expected to cause less adverse deleterious side effects usually
associated with cannabinoids. Several patents have been designed to protect
this family of compounds and their uses by inventors at Pharmos and Hebrew
University. The earliest patent applications resulted in patents issued in
1995, and the most recent patent dates from 2006.

Emulsion-based Drug Delivery Systems. In the
general category of SubMicron Emulsion technology, Pharmos holds a license to
one family of patents from the Hebrew University of Jerusalem and has filed ten
independent patent families of applications including more than ninety patent
applications that are at different stages of prosecution. These patents and
patent applications have been devised to protect a group of formulation
technologies devised by Pharmos and the inventors as they relate to
pharmaceutical and medicinal products. The earliest patent filings for
SubMicron Emulsion technology date from 1992 and the most recent are dated from
1996. These patents cover a broad range of new formulations, which improve the
absorption of drugs that are poorly soluble in water.

Additional
Pharmos assets include dextofisopam (previously known as R-tofisopam) and
tianeptine for the treatment of irritable bowel syndrome and VPI-013
(previously known as OPC-14523) for the treatment of neuropathic pain.

Dextofisopam to Treat IBS. Irritable bowel syndrome, or IBS, is a
chronic, recurring condition with symptoms that affect up to 15% of American
adults, more often women than men. IBS is characterized by multiple symptoms
that include bowel dysmotilitydiarrhea, constipation, or alternating diarrhea
and constipationand abdominal discomfort. Studies have shown that
diarrhea-predominant IBS appears to be the most common subtype. For patients
with diarrhea-predominant and alternating-type IBS, there are no recently
approved treatments for any but the most severely affected women, and none for
men.

Dextofisopam
is a novel non-serotonergic agent in development for the treatment of IBS.
Dextofisopam is the R-enantiomer of racemic tofisopam. Pharmos holds an issued
composition-of-matter patent in the United States on dextofisopam which expires
in 2019. Pharmos owns certain counterpart foreign patents and patent
applications, as well. Pharmos has filed additional patent applications for the
treatment of IBS in the United States, and abroad.

Tianeptine to Treat IBS or Functional
Dyspepsia.Tianeptine is a racemic molecule
marketed and used outside the United States for the treatment of depression.
Pharmos patent protection for tianeptine consists of a United States
method-of-use patent covering tianeptine and its two enantiomers for the
treatment of IBS and non-ulcer

18

dyspepsia.
This patent expires in 2023. Additional foreign patents related to this United
States patent are pending.

VPI-013 to Treat Neuropathic Pain.
Neuropathic pain is caused by a primary lesion or dysfunction in the nervous
system. The injury can be to the central nervous system (brain and spinal cord)
or the peripheral nervous system (nerves outside the brain and spinal cord).
Neuropathic pain is a component of many disorders, including infections,
diabetes, and lumbar disc disease. The current therapeutic market for
neuropathic pain is underserved, primarily by the off-label use of
antidepressants and by the off-label use of anticonvulsants. The anticonvulsant
gabapentin (Neurontin®), while not
broadly approved for the treatment of neuropathic pain, is widely used
off-label for this indication. Treatment with gabapentin is limited by
significant side-effect issues, including high rates of dizziness and
somnolence.

Pharmos has
in-licensed North American and European rights (and rights in select additional
countries) to VPI-013 from Otsuka Pharmaceutical Co., Ltd. The VPI-013 patent
estate consists of a United States composition-of-matter patent (which expires
in 2014), a United States method-of-use patent, and foreign counterparts. The patents
are owned by Otsuka and are licensed exclusively to Pharmos in the geographic
areas noted above. Pharmos and Otsuka have jointly filed additional patent
applications covering the treatment of neuropathic pain.

Licenses

As discussed
above, Pharmos has licensed patents covering neuroprotective agents and certain
emulsion-based drug delivery systems from the Hebrew University of Jerusalem.

Pharmos
subsidiary, Pharmos Ltd., licensed its patents related to the oral delivery of
lipophilic substances in the limited field of use of nutraceuticals to
Herbamed, Ltd., a company in Israel controlled by the Chairman and Chief
Executive Officer of Pharmos. The terms of the license agreement are discussed
in Item 13. Certain Relationships and Related Transactions.

Site-Specific
Drugs. In the general category of site-specific drugs that are active mainly in
the eye and have limited systemic side effects, Pharmos licensed several
patents from Dr. Nicholas Bodor. It assigned its rights under the Bodor license
to Bausch & Lomb in connection with its sale of its ophthalmic business.
The earliest patents date from 1984 and the most recent from 1996. Some of
these patents cover loteprednol etabonate-based products and its formulations.

19

Government Regulation

FDA and Comparable Authorities in Other
Countries

Regulation by
governmental authorities in the U.S. and other countries is a significant
factor in our ongoing research and development activities and in the production
and marketing of our products. Pharmaceutical products intended for therapeutic
use in humans are governed in the U.S. by the Federal Food, Drug and Cosmetic
Act (21 U.S.C. § 321 et seq.) and
by FDA regulations and by comparable agency regulations in other countries.
Specifically, in order to undertake clinical tests, and to produce and market
products for human therapeutic or diagnostic use, mandatory procedures and
safety standards established by the FDA and Department of Health and Human
Services in the U.S. and comparable agencies in other countries must be
implemented and followed. These standards include protection of human research
subjects.

The following
is an overview of the steps that must be followed before a drug product may be
marketed lawfully in the U.S.:

(i)
Preclinical
  studies including pharmacology, laboratory evaluation and animal studies to
  test for initial safety and efficacy;(ii)
Submission
  to the FDA of an Investigational New Drug (IND) Application, which must
  become effective before human clinical trials may commence;(iii)
Adequate and
  well-controlled human clinical trials to establish the safety and efficacy of
  the drug in its intended application;(iv)
Submission
  to the FDA of a New Drug Application (NDA), which application is not
  automatically accepted by the FDA for consideration; and(v)
FDA approval
  of the New Drug Application prior to any commercial sale or shipment of the
  drug.In addition to
obtaining FDA approval for each product, each drug-manufacturing establishment
must be registered or licensed by the FDA for each product sold within the US
that is manufactured at that facility. Manufacturing establishments are subject
to inspections by the FDA and by other national and local agencies and must
comply with current Good Manufacturing Practices (cGMPs), requirements that are
applicable to the manufacture of pharmaceutical drug products and their
components.

Preclinical
studies include laboratory evaluation of product chemistry and animal studies
to assess the potential safety and efficacy of the product and its formulation.
The results of the preclinical studies are submitted to the FDA as part of an
IND, and unless the FDA objects, the application will become effective 30 days
following its receipt by the FDA. If the potential of addiction is found in the
animal tests, then additional regulatory requirements may be imposed by the FDA
and DEA.

Clinical
trials involve the administration of the drug to healthy volunteers as well as
to patients under the supervision of a qualified principal investigator, who
is a medical doctor. Clinical trials in humans are necessary because
effectiveness in humans may not always be gleaned from findings of
effectiveness in animals. They are conducted in accordance with protocols that
detail the objectives of the study, the parameters to be used to monitor safety
and the efficacy criteria to be evaluated. Each protocol is submitted to the
FDA as part of the application. Each clinical study is approved and monitored
by an independent Institutional Review Board (IRB) (Ethics Committee) at each
clinical site. The IRB must consider, among other things, the process of
obtaining the informed consents of each study subject, the safety of human
subjects, the possible liability of the institution conducting a clinical study,
as well as various ethical factors.

Clinical
trials typically are conducted in three sequential phases, although the phases
may overlap. In Phase I, the initial introduction of the drug to humans, the
drug is tested in a small group of healthy volunteers for safety and clinical
pharmacology such as metabolism and tolerance. Phase I trials may also yield
preliminary

20

information
about the products effectiveness and dosage levels. Phase II involves detailed
evaluation of safety and efficacy of the drug in patients with the disease or
condition being studied. It also involves a determination of optimal dosage and
identification of possible side effects in a larger patient group. Phase III
trials consist of larger scale evaluation of safety and efficacy and usually
require greater patient numbers and multiple clinical trial sites, depending on
the clinical indications for which marketing approval is sought.

The process of
completing clinical testing and obtaining FDA approval for a new product is
likely to take a number of years and requires the expenditure of substantial
resources. The FDA may grant an unconditional approval of a drug for a
particular indication or may grant approval conditioned on further
post-marketing testing. The FDA also may conclude that the submission is not
adequate to support an approval and may require further clinical and
preclinical testing, re-submission of the New Drug Application, and further
review. Even after initial FDA approval has been obtained, further studies may be
required to provide additional data on safety or to gain approval for the use
of a product for clinical indications other than those for which the product
was approved initially. This could delay the NDA approval process.

The 1962
amendments to the Federal Food, Drug and Cosmetic Act required for the first
time that drug effectiveness be proven by adequate and well-controlled clinical
trials. The FDA interpretation of that requirement is that at least two such
trials are necessary to demonstrate effectiveness for approval of an NDA. This
interpretation is based on the scientific need for independent substantiation
of study results. However, Section 115 of FDAMA revised Section 505 of the Act
to read, in pertinent part that based on relevant science, data from one
adequate and well-controlled clinical investigation and confirmatory evidence 
are sufficient to establish effectiveness. The FDA has not issued
comprehensive standards of testing conditions for pivotal trials. The FDA
maintains a preference for at least two adequate and well-controlled clinical
trials. Cannabinor and dexanabinol have been shown to be devoid of psychotropic
properties, and Pharmos believes that the potential of addictive properties is
remote. However, because cannabinor and dexanabinol are cannabinoids, the
Company will conduct a test to specifically evaluate any addictive potential.
If the test shows the possibility of addiction, additional regulatory
requirements would have to be met which could delay the NDA approval process.

Pharmos
products will be subject to foreign regulatory approval before they may be
marketed abroad. Marketing beyond the US is subject to regulatory requirements
that vary widely from country to country. In the European Union, the general
trend has been towards coordination of the common standards for clinical
testing of new drugs. Centralized approval in the European Union is coordinated
through the European Medicines Evaluation Agency (EMEA). The time required to
obtain regulatory approval from comparable regulatory agencies in each country
may be longer or shorter than that required for FDA or EMEA approval. Further,
in certain markets, reimbursement may be subject to governmentally mandated
prices.

Drug Enforcement Administration

In animal and
human testing, neither cannabinor nor dexanabinol have been shown to possess
clinically significant psychotropic properties at relevant therapeutic doses.
As part of the filing requirements with the FDA, Pharmos will study the
addiction potential of cannabinor concurrent with late-stage clinical trials.
If the potential of addiction is found in animal tests, additional regulatory
requirements may be imposed by the FDA and Drug Enforcement Agency (DEA). The
DEA regulates controlled substances as Schedule I, II, III, IV or V substances,
with Schedule I and II substances considered to present the highest risk of
substance abuse and Schedule V substances the lowest risk. Should one of the
Companys products be classified as a controlled substance, its manufacture,
shipment, storage, sale and use would be subject to a high degree of
regulation. To meet its responsibilities, the DEA conducts periodic inspections
of registered establishments that handle controlled substances. Facilities that
conduct research, manufacture or distribute controlled substances must be
registered to perform these activities and have the security, control and
accounting mechanisms required by the FDA to prevent loss and diversion.
Failure to maintain any required compliance might result in regulatory action
that could have a material adverse event on our business. The FDA could seek
civil penalties, refuse to renew necessary registrations or initiate
proceedings to revoke those registrations. In certain circumstances, violations
could give rise to criminal proceedings.

21

Corporate History

Pharmos
Corporation, (formerly known as Pharmatec, Inc.) a Nevada corporation, was
incorporated under the laws of the State of Nevada on December 20, 1982. On
October 29, 1992, Pharmatec, the Nevada Corporation, completed a merger with a
privately held New York corporation known as Pharmos Corporation founded by Dr.
Aviv (the name of the post-merger Nevada corporation was changed to Pharmos
Corporation).

Human Resources

As of December
31, 2006, Pharmos had 54 employees (51 full-time and 3 part-time), including 9
in the U.S. (0 part-time) and 45 in Israel (3 part-time). Of the 54 employees,
15 hold doctorate or medical degrees.

Pharmos
employees are not covered by a collective bargaining agreement. To date,
Pharmos has not experienced employment-related work stoppages and considers its
employee relations to be excellent.

Public Funding and Grants

Pharmos
subsidiary, Pharmos Ltd., has received certain funding from the Chief Scientist
of the Israel Ministry of Industry and Trade (the Chief Scientist) for: (1)
research and development of dexanabinol; (2) SubMicron Emulsion technology for
injection and nutrition; (3) research relating to pilocarpine, dexamethasone
and ophthalmic formulations for dry eyes; (4) research and development of CB2,
including cannabinor. As of December 31, 2006, the total amounts received under
such grants amounted to $17,015,457. Under the terms of the grant agreements,
aggregate future royalty payments related to sales of products developed, if
any, as a result of the grants are limited to $15,526,517 based on grants
received through December 31, 2006. Pharmos will be required to pay royalties
to the Chief Scientist ranging from 3% to 5% of product sales, if any, as a
result of the research activities conducted with such funds. Aggregate royalty
payments per product are limited to the amount of funding received to develop
that product and interest. Additionally, funding by the Chief Scientist places
certain legal restrictions on the transfer of know-how and the manufacture of
resulting products outside of Israel. See Conditions in Israel.

Pharmos
received funding of $925,780 from the Israel-U.S. Binational Industrial
Research and Development Foundation to develop Lotemax® and Zylet®. Bausch
& Lomb received approval from the FDA for Zylet® in December 2004. In
February 2005, the Company paid the foundation $211,712, which represented the
maximum amount the Company owed the foundation.

Pharmos signed
an agreement with the Consortium Magnet, operated by the Office of the Chief
Scientist, for developing generic technologies and for the design and
development of drug and diagnostic kits. Under such agreement, Pharmos was
entitled to a non-refundable grant amounting to approximately 60% of the actual
research and development and equipment expenditures on approved projects. No
royalty obligations were required within the framework. As of December 31, 2005
Pharmos had received grants totaling $1,659,549 for this program which was
completed and closed.

During 2004,
the Company signed an agreement with Consortium Magnet to develop a supply of
water-soluble products of lipophilic compounds that improve their
bioavailability and biopharmaceutical properties. Under such agreement the
Company is entitled to a non-refundable grant amounting to approximately 60% of
actual research and development and equipment expenditures on approved
projects. No royalty obligations are required within the framework. As of
December 31, 2006, the Company received grants totaling $546,609 from this
program which was completed and closed.

22

2005Reverse
Stock Split

On May 26, 2005, Pharmos
Corporation filed a Certificate of Change with the Nevada Secretary of State
which served to effect, as of May 31, 2005, a 1-for-5 reverse split of Pharmos
common stock. As a result of the reverse stock split, every five shares of
Pharmos common stock were combined into one share of common stock; any
fractional shares created by the reverse stock split were rounded up to whole
shares. The reverse stock split affected all of Pharmos common stock, stock
options and warrants outstanding immediately prior to the effective date of the
reverse stock split. The reverse split reduced the number of shares of Pharmos
common stock outstanding at that time from 95,137,076 shares to 19,027,809
shares, and the number of authorized shares of common stock was reduced from
150,000,000 shares to 30,000,000 shares. All references to common share and per
common share amounts for all periods presented have been retroactively restated
to reflect this reverse split. At the Annual Meeting in September 2005, the
shareholders voted to increase the number of authorized shares of common stock
to 60,000,000 shares.

Availability of SEC Filings

All reports
filed by the Company with the SEC are available free of charge via EDGAR
through the SEC website at www.sec.gov. In addition, the public may read
and copy materials filed by the Company with the SEC at the SECs public
reference room located at 100 F Street NE, Washington, D.C., 20549. The company
also provides copies of its Forms 8-K, 10-K, 10-Q, Proxy and Annual Report at
no charge available through its website at www.pharmoscorp.com/investors
as soon as reasonably practicable after filing electronically such material
with the SEC. Copies are also available, without charge, from Pharmos
Corporation, 99 Wood Avenue South, Suite 311, Iselin, NJ, 08830.

23

Item 1A. Risk Factors

We are a defendant in class action lawsuits which, if
determined adversely, could have a material adverse affect on us.

Several purported class
action securities lawsuits have been filed against us. We are defending against
these actions vigorously; however, we do not know what the outcome of these
proceedings will be and, if we do not prevail, we may be required to pay
substantial damages or settlement amounts. Furthermore, regardless of the
outcome, we may incur significant defense costs, and the time and attention of
our management may be diverted from normal business operations. If we are
ultimately required to pay significant defense costs, damages or settlement
amounts, such payments could materially and adversely affect our operations and
results. In any event, publicity surrounding the lawsuits and/or any outcome
unfavorable to us could adversely affect our reputation, profitability and
share price. The uncertainty associated with substantial unresolved lawsuits
could harm our business, financial condition and reputation.

We have certain obligations to indemnify our officers and
directors.

We have certain obligations
to indemnify our officers and directors and to advance expenses to such
officers and directors. Although we have purchased liability insurance for our
directors and officers, if our insurance carriers should deny coverage, or if
the indemnification costs exceed the insurance coverage, we may be forced to
bear some or all of these indemnification costs directly, which could be
substantial and may have an adverse effect on our business, financial
condition, results of operations and cash flows. If the cost of our liability
insurance increases significantly, or if this insurance becomes unavailable, we
may not be able to maintain or increase our levels of insurance coverage for
our directors and officers, which could make it difficult to attract or retain
qualified directors and officers.

We are at an early stage of development.

We are at an early stage of
development. Our lead product, dextofisopam, has completed Phase 2a testing for
irritable bowel syndrome (IBS), and we plan a Phase 2b study of dextofisopam
for the treatment of IBS in 2007. Our lead CB2-selective receptor agonist
candidate, cannabinor, is undergoing Phase 2a testing for the treatment of
nociceptive pain. Apart from an ophthalmic product that was sold to Bausch
& Lomb Incorporated in October 2001, most of our other potential products
are early in the research and development phase, and product revenues may not
be realized from the sale of any such products for at least the next several
years, if at all. Many of our proposed products will require significant
additional research and development efforts prior to any commercial use,
including extensive preclinical and clinical testing, as well as lengthy
regulatory approval. Because of the uncertain nature of the process, we cannot
be sure that our research and development efforts will be successful, that our
potential products will prove to be safe and effective in clinical trials or
that we will develop any other commercially successful products.

We have a history of operating losses and expect to sustain
losses in the future.

We have experienced
significant operating losses since our inception. As of December 31, 2006, we
had an accumulated deficit of approximately $181 million. We expect to incur
operating losses over the next several years as our research and development
efforts and preclinical and clinical testing activities continue. Our ability
to generate revenues and achieve profitability depends in part upon our
ability, alone or with others, to successfully complete development of our
proposed products, to obtain required regulatory approvals and to manufacture
and market our products.

We may not be able to obtain financing in the future.

As of December 31, 2006, we
had an accumulated deficit of approximately $181 million. The development of
our technology and potential products will require a commitment of substantial
funds to conduct the costly and time-consuming research necessary to develop
and optimize our technology, and ultimately, to
establish

24

manufacturing and marketing
capabilities. Our future capital requirements will depend on many factors,
including:


continued scientific
  progress in the research and development of our technology and drug programs;
our ability to establish
  and maintain collaborative arrangements with others for drug development;
progress with preclinical
  and clinical trials;
the time and costs
  involved in obtaining regulatory approvals;
the costs involved in
  preparing, filing, prosecuting, maintaining and enforcing patent claims;
competing technological
  and market developments;
changes in our existing
  research relationships; and
effective product
  commercialization activities and arrangements.We believe that our cash and
cash equivalents and short term investments as of December 31, 2006, combined
with research and development grants and investment income should be sufficient
to fund our continuing operations beyond December 31, 2007.

We are also continuing to
actively pursue various funding options, including equity offerings, strategic
corporate alliances, business combinations and product-related research and
development limited partnerships, to obtain the additional financing which we
require to continue developing our products and ultimately bring them to
market. We may not be able to obtain additional financing when needed, if at
all. If we are unable to raise adequate financing in the future, our long term
operations will need to be scaled-back or discontinued.

Our product candidates may not successfully complete clinical
trials required for commercialization, and as a result our business may never
achieve profitability.

To obtain regulatory
approvals needed for the sale of our drug candidates, we must demonstrate
through testing and clinical trials that each drug candidate is both safe and
effective for the human population that it was intended to treat. In general,
two successful Phase III clinical trials are required. The clinical trial
process is complex and the regulatory environment varies widely from country to
country. Positive results from testing and early clinical trials do not ensure
positive results in the Phase III human clinical trials. Many companies in our
industry have suffered significant setbacks in Phase III, potentially pivotal
clinical trials, even after promising results in earlier trials. The results
from our trials, if any, may show that our drug candidates produce undesirable
side effects in humans or that our drug candidates are not safe or effective or
not safe or effective enough to compete in the marketplace. Such results could
cause us or regulatory authorities to interrupt, delay or halt clinical trials
of a drug candidate. Moreover, we, the FDA, or foreign regulatory authorities
may suspend or terminate clinical trials at any time if we or they believe the
trial participants face unacceptable health risks or that our drug candidates
are not safe or effective enough. Clinical trials are lengthy and expensive. They require adequate supplies of drug
substance and sufficient patient enrollment. Patient enrollment is a function
of many factors, including:


the size of the patient
  population,
the nature of the protocol
  (i.e., how the drug is given, and the size and frequency of the dose and use
  of placebo control),
the proximity of patients
  to clinical sites, and
the eligibility criteria
  for the clinical trial (i.e., age group, level of symptoms, concomitant
  diseases or medications etc.).Delays in patient enrollment
or negative trial outcomes can result in increased costs and longer development
times. Even if we successfully complete clinical trials, we may not be able to
file any required regulatory submissions in a timely manner and we may not
receive regulatory approval for the particular drug candidate that was tested.

25

In addition, if the FDA or
foreign regulatory authorities require additional clinical trials, we could
face increased costs and significant development delays. Changes in regulatory
policy or additional regulations adopted during product development and
regulatory review of information we submit could also result in delays or
rejections.

Our clinical trials depend on third party investigators who
are outside our control.

We depend upon the personnel
of third party independent investigators to conduct our clinical trials. Such
personnel are not our employees, and we cannot control the amount of time or
resources that they devote to our programs. They may not assign as great a
priority to our programs or pursue them as diligently as we would if we were
undertaking such programs ourselves. If such third-party personnel fail to
devote sufficient time and resources to our clinical trials, or if their
performance is substandard, the approval of our FDA applications, if any, and
our introduction of new drugs, if any, will be delayed. Such third-party
investigators may also have relationships with other commercial entities that
compete with us. If they assist our competitors at our expense, our competitive
position would be harmed.

We face extensive governmental regulation and any failure to
adequately comply could prevent or delay product approval or cause the
disallowance of our products after approval.

The FDA and comparable
agencies in foreign countries impose many requirements on the introduction of
new drugs through lengthy and detailed clinical testing procedures, and other
costly and time consuming compliance procedures. These requirements make it
difficult to estimate when any of our products in development will be available
commercially, if at all. In addition, the FDA or other comparable agencies in
foreign countries may impose additional requirements in the future that could
further delay or even stop the commercialization of our products in
development.

Our proprietary compounds in
development require substantial clinical trials and FDA review as new drugs.
Even if we successfully enroll patients in our clinical trials, patients may
not respond to our potential drug products. We think it is prudent to expect setbacks
and possible product failures. Failure to comply with the regulations
applicable to such testing may delay, suspend or cancel our clinical trials, or
the FDA might not accept the test results. The FDA, or any comparable
regulatory agency in another country, may suspend clinical trials at any time
if it concludes that the trials expose subjects participating in such trials to
unacceptable health risks. Further, human clinical testing may not show any
current or future product candidate to be safe and effective to the
satisfaction of the FDA or comparable regulatory agencies or the data derived
there from may be unsuitable for submission to the FDA or other regulatory
agencies.

We cannot predict with
certainty when we might submit any of our proposed products currently under
development for regulatory review. Once we submit a proposed product for
review, the FDA or other regulatory agencies may not issue their approvals on a
timely basis, if at all. If we are delayed or fail to obtain such approvals, our
business may be damaged due to the resulting inability to generate revenues
from the sale of such product. If we fail to comply with regulatory
requirements, either prior to approval or in marketing our products after
approval, we could be subject to regulatory or judicial enforcement actions.
These actions could result in:


injunctions;
criminal prosecution;
refusals to approve new
  products and withdrawal of existing approvals; and
enhanced exposure to
  product liabilities.We may need to find collaborative partners.

Our strategy for the
development, clinical testing, manufacture, marketing and commercialization of
our products includes the use of collaborations with corporate partners,
licensors, licensees and others.

Due to the often
unpredictable nature of the collaboration process, we cannot be sure that any
present or future collaborative agreements will be successful. To the extent we
choose not to or are not able to establish such arrangements, we would
experience increased capital requirements. In addition, we may encounter
significant

26

delays in introducing our
products currently under development into certain markets or find that the
development, manufacture, or sale of those products is hindered by the absence of
collaborative agreements due to the relatively small size of our company as
compared with that of some of our potential competitors.

Our technologies are subject to a license and termination of
the license would seriously harm our business.

We are the licensee under a
license agreement with YISSUM Research Development Company of the Hebrew
University of Jerusalem relating to certain neuroprotective agents. Should we
default on the obligations to YISSUM, the license could terminate, which would
be detrimental to our operations and prospects due to our dependence on this
technology as a future source of revenue.

The value of our research could diminish if we cannot protect
or enforce our intellectual property rights adequately.

We actively pursue both
domestic and foreign patent protection for our proprietary products and
technologies. We have filed for patent protection for our technologies in all
markets we believe to be important for the development and commercialization of
our drug products; however, our patents may not protect us against our
competitors. We may have to file suit to protect our patents or to defend our
use of our patents against infringement claims brought by others. Because we
have limited cash resources, we may not be able to afford to pursue or defend
against litigation in order to protect our patent rights. As a result, while we
currently have no specific concerns about gaps in our intellectual property
portfolio, we recognize that for companies like ours, where intellectual
property constitutes a key asset, there is always a risk that a third party
could assert a patent infringement claim or commence a patent interference
action. Defending against any such claims or actions could be very costly to
us, even if they were without merit.

We also rely
on trade secret protection for our unpatented proprietary technology. However,
trade secrets are difficult to protect. While we enter into proprietary
information agreements with our employees and consultants, these agreements may
not successfully protect our trade secrets or other proprietary information.

We face large competitors and our limited financial and
research resources may limit our ability to develop and market new products.

The pharmaceutical industry
is highly competitive. We compete with a number of pharmaceutical companies
that have financial, technical and marketing resources that are significantly
greater than ours. Some companies with established positions in the
pharmaceutical industry may be better equipped than we are to develop, market
and distribute products in the global markets we seek to enter. A significant
amount of pharmaceutical research is also being carried out at universities and
other not-for-profit research organizations. These institutions are becoming
increasingly aware of the commercial value of their findings and are becoming
more active in seeking patent protection and licensing arrangements to collect
royalties for the use of technology they have developed. They may also market
competitive commercial products on their own or through joint ventures and may
compete with us in recruiting highly qualified scientific personnel. Further,
these institutions may compete with us in recruiting qualified patients for
enrollment in their trials.

We are pursuing areas of
product development in which there is a potential for extensive technological
innovation. Our competitors may succeed in developing products that are more
effective than those we develop. Rapid technological change or developments by
others may result in our potential products becoming obsolete or
non-competitive.

We lack manufacturing capability.

Other than for the
production of clinical trial material, we currently do not have manufacturing
facilities. Should any of our products receive approval for marketing, we would
likely need to find third party manufacturers to assist in their production. If
we should be unable to find such manufacturers with which to work on
commercially reasonable terms, it could delay or restrict any potential
revenues from such products.

27

We use hazardous materials in our research.

As with most other
pharmaceutical companies, our research and development involves the controlled
use of hazardous materials. Our laboratories store and/or produce carbon
monoxide, nitric acid and ammonia. Although we believe that our safety
procedures for handling and disposing of these hazardous materials comply in
all material respects with the standards prescribed by government regulations,
the risk of accidental contamination or injury from these materials cannot be
completely eliminated. In the event of an accident, we could be held liable for
any resulting damages which may or may not be covered by insurance.

We have certain anti-takeover provisions and are also subject
to certain Nevada anti-takeover provisions that may make it difficult for a
third party to acquire us or for stockholders to replace or remove current
management.

We have adopted a
stockholder rights plan that imposes a significant penalty upon any person or
group that acquires 15% or more of our outstanding common stock without the
approval of our board. In addition, our by-laws provide for the division of our
board into three classes serving staggered terms and our charter documents
authorize our board to issue up to 1,250,000 shares of preferred stock.
Moreover, certain provisions of the Nevada General Corporation Law that limit
our ability to enter into business combinations with certain interested
shareholders and limit the voting rights of those stockholders who obtain control
shares may also act to inhibit a hostile acquisition of our company. All of
these provisions described above are likely to discourage potential acquisition
proposals and delay or prevent a transaction resulting in a change in control.

In addition, the existence
of these provisions could prevent or frustrate stockholder attempts to replace
or remove current management, who serve at the pleasure of our board. Since the
staggered board provisions of our by-laws, as well as other by-law provisions
limiting the ability of our stockholders to call special meetings, make it
difficult to replace the majority of our board at once, stockholder efforts to
change the direction of our company, in the event of their dissatisfaction with
the boards or managements performance, could be hindered.

Conditions in Israel continue to be volatile.

A significant part of our
operations is conducted in Israel through our wholly owned subsidiary, Pharmos
Ltd., and we are directly affected by economic, political and military
conditions there.

Since the establishment of
the State of Israel in 1948, a number of armed conflicts have taken place
between Israel and its Arab neighbors, as well as incidents of civil unrest. In
addition, Israel has in the past been the subject of an economic boycott, as
have companies doing business with Israel. Although Israel has entered into
various agreements with certain Arab countries and the Palestinian Authority,
there has been an increase in the unrest and terrorist activity that began in September
2000 and has continued with varying levels of severity into 2007. We do not
believe that the political and security situation has had any material negative
impact on our business to date; however, the situation is volatile, and we
cannot be sure that security and political conditions will have no such effect
in the future.

Many of our employees in
Israel are obligated to perform military reserve duty. In the event of severe
unrest or other conflict, individuals could be required to serve in the military
for extended periods of time. Our operations could be disrupted by the absence
for a significant period of time of some of our employees due to military
service.

Pharmos Ltd. has received
funding from the Office of the Chief Scientist of the Israel Ministry of
Industry and Trade relating to various technologies for the design and
development of drugs and diagnostic kits. This funding prohibits the transfer
or license of know-how and the manufacture of resulting products outside of
Israel without the permission of the Chief Scientist. Although we believe that
the Chief Scientist does not unreasonably withhold this permission if the
request is based upon commercially justified circumstances and any royalty
obligations to the Chief Scientist are sufficiently assured, the matter is
solely within his discretion and we cannot be sure that such consent, if
requested, would be granted upon terms satisfactory to us or granted at

28

all. Without such consent,
we would be unable to manufacture any products developed by this research
outside of Israel, which may greatly restrict any potential revenues from such
products.

The price of our Common Stock may experience volatility

The trading price of our
Common Stock could be subject to wide fluctuations in response to variations in
our quarterly operating results, the failure of trial results, the failure to
bring products to market, conditions in the industry, and the outlook for the
industry as a whole or general market or economic conditions. In addition, in
recent years, the stock market has experienced extreme price and volume
fluctuations. These fluctuations have had a substantial effect on the market
prices for many companies, often unrelated to the operating performance of the
specific companies. Such market fluctuations could have a material adverse
effect on the market price for our securities.

29

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

Pharmos is
headquartered in Iselin, New Jersey, where it leases its executive offices and
maintains clinical, regulatory and business development staff. The New Jersey
lease expires in 2009. Pharmos also leases facilities used in the operation of
its research, development, pilot manufacturing and administrative activities in
Rehovot, Israel. The facility in Rehovot has been improved to meet the special
requirements necessary for the operation of Pharmos research and development
activities. In the opinion of the management, these facilities are sufficient
to meet the current and anticipated future requirements of Pharmos. In
addition, management believes that it has sufficient ability to renew its
present leases related to these facilities or obtain suitable replacement
facilities. The monthly lease obligations for our office space in 2006 are
$26,559 for Iselin, New Jersey and $27,650 for Rehovot, Israel. The approximate
square footage for Iselin, New Jersey and Rehovot, Israel are 10,403 and
21,600, respectively. A portion of the NJ offices are subleased; the net
monthly lease obligations and approximate square footage are $11,258 and 4,445
square feet, respectively.

In February
2007 Pharmos Ltd. signed a new four-year lease for its Rehovot facilities.
There are two early termination dates on January 31, 2008 and January 31, 2009
with no penalty to Pharmos if the company elects to notify an early termination
150 days prior to one of the early termination dates.

Item 3. Legal Proceedings

The Company and certain current officers have been named as defendants
in several purported shareholder class action lawsuits alleging violations of
federal securities laws. These lawsuits were filed beginning in January 2005
and are pending in the U.S. District Court for the District of New Jersey.
These lawsuits assert claims under Sections 10(b) and 20(a) of the Securities Exchange
Act of 1934 and Rule 10b-5 there under. The complaints allege generally that
the defendants knowingly or recklessly made false or misleading statements
regarding the effectiveness of dexanabinol in treating TBI which had the effect
of artificially inflating the price of our shares. The complaints seek
unspecified damages. These class actions have been consolidated by order of the
Court and lead plaintiffs and lead plaintiffs counsel have been appointed. An
amended complaint was filed in September 2005.

Management intends to defend these lawsuits vigorously. However, we
cannot assure you that we will prevail in these actions, and, if the outcome is
unfavorable to Pharmos, our reputation, profitability, financial condition,
cash flows and share price could be adversely affected.
In addition, two purported shareholders of Pharmos common stock
commenced derivative actions in 2005 against our directors and against certain
current and former officers. The first derivative lawsuit was commenced in
February 2005 in the U.S. District Court for the District of New Jersey, and
was consolidated for pretrial purposes with the class actions. An amended
complaint in the federal derivative lawsuit was filed in September 2005. The
second was filed in April 2005 in the Superior Court of New Jersey, County of
Middlesex. An amended complaint in the state court case was filed in November
2005. An agreement was subsequently reached to settle both of the
derivative cases. The settlement provides for the adoption by the Company of
certain changes to its corporate governance charters and Board of Directors
committee documents and for the payment by the Companys insurer of attorneys
fees and expenses to plaintiffs counsel not to exceed $265,000. The settlement
was approved by the federal court on February 8, 2007.

Item 4. Submission of Matters to a Vote of
Security Holders

At the Pharmos Annual
Meeting of Stockholders held on October 25, 2006, our stockholders elected the
following persons as Class III Directors to serve until the 2009 annual meeting
of stockholders and until their successors are duly elected and qualified: Haim
Aviv, Ph.D, Mony Ben Dor and Abraham Sartani, MD. The results of the voting
were as follows:

30

VOTES FOR
VOTES WITHHELDHaim Avi, Ph.D
14,254,713
805,070Mony Ben Dor
13,994,252
1,065,531Abraham Sartani, MD
14,029,870
1,029,913Also at the Annual Meeting,
the stockholders approved the issuance of up to 20,000,000 shares of common
stock in connection with the proposed acquisition of Vela Pharmaceuticals,
Inc., with 4,880,006 votes for approval, 910,651 votes against approval, 81,609
abstentions, and 9,187,516 broker non-votes.

Also at the Annual Meeting,
the stockholders approved grating discretionary authority to adjourn the
meeting if necessary to solicit additional proxies, with 4,741,103 votes cast
for approval, 1,050,736 votes cast against, 80,428 abstentions, and 9,187,515
broker non-votes.

Further, the stockholders
ratified the Boards selection of PricewaterhouseCoopers LLP as Pharmoss
independent registered public accounting firm for the fiscal year ended
December 31, 2006, with 14,803,471 votes for ratification, 135,210 votes
against ratification, 121,100 abstentions, and zero broker non-votes.

31

PART II

Item 5. Market for Registrants Common
Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The Companys
Common Stock is traded on the Nasdaq Capital Market under the symbol PARS.
The following table sets forth the range of high and low sales prices per share
for the Common Stock as reported on Nasdaq during the periods indicated.


Year ended December 31, 2006

HIGH

LOW4th Quarter

$
2.22

$
1.683rd Quarter


2.14


1.552nd Quarter


2.70


2.011st Quarter


2.93


2.00Year ended December 31, 2005

HIGH

LOW4th Quarter

$
2.29

$
1.943rd Quarter


2.63


2.032nd Quarter


3.80
*

2.35
*1st Quarter


7.45
*

3.05
**      Adjusted to
account for a 1-for-5 reverse stock split effective May 31, 2005.

The high and
low sales prices for the Common Stock during the first quarter of 2007 (through
March 5, 2007) were $1.88 and $1.36, respectively. The closing price on March
5, 2007 was $1.47.

On March 5,
2007, there were approximately 482 record holders of the Common Stock of the
Company and approximately 16,347 beneficial owners of the Common Stock of the
Company, based upon the number of shares of Common Stock held in street name.

The Company
has paid no dividends on its Common Stock and does not expect to pay cash
dividends in the foreseeable future. The Company is not under any contractual
restriction as to its present or future ability to pay dividends. The Company
currently intends to retain any future earnings to finance the growth and
development of its business.

PERFORMANCE
GRAPH

The following
graph compares the Companys cumulative stockholders return for the five year
period ended December 31, 2006 with the cumulative total return of the Nasdaq
Equity Market Index and the Nasdaq Pharmaceuticals Index over the same period.

(LINE GRAPH)

32

Item 6. Selected Financial Data


Year Ended December 31,2006

2005

2004

2003

2002Revenues














Operating
  expenses

($
37,542,519
)(1)
($
15,708,888
)
($
19,880,151
)
($
16,034,146
)
($
16,858,414
)Other income
  (expense), net


1,792,775


12,288,382
(2)

(2,532,390
)

(2,679,517
)

(426,409
)Loss before
  income taxes


(35,749,744
)

(3,420,506
)

(22,412,541
)

(18,713,663
)

(17,284,823
)Net loss


(35,136,969
)

(2,929,872
)

(21,967,767
)

(18,485,865
)

(17,069,600
)Net loss
  applicable to common shareholders

($
35,136,969
)(3)
($
2,929,872
)(3)
($
21,967,767
)(3)
($
18,485,865
)(3)
($
17,069,600
)(3)Net loss per
  share applicable to common shareholders  basic and diluted

($
1.74
)
($
0.15
)
($
1.22
)
($
1.37
)
($
1.51
)Total assets

$
28,393,338

$
48,990,772

$
57,664,842

$
69,622,482

$
25,250,146Long term
  obligations

$
1,388,306

$
1,125,551

$
1,236,451

$
5,772,344

$
878,031Cash
  dividends declared














Average
  shares outstanding - basic and diluted


20,249,714


18,974,175


18,033,358


13,479,435


11,304,0081.
The Company
  acquired in-process research and development in the Vela acquisition in
  October 2006. Vela results are consolidated from October 26, 2006 forward.2.
Includes a
  $10.7 million milestone payment received in 2005 related to the sale of the
  ophthalmic product line in October 2001.3.
Includes
  sales of Pharmos NJ Net Operating Loss in 2006, 2005, 2004, 2003 and 2002 of
  $612,775, $490,634, $444,744, $227,798 and $215,223, respectively.Item 7. Managements Discussion and Analysis
of Financial Condition and Results of Operations

This
discussion and analysis of our financial condition and results of operations
contains forward-looking statements that involve risks and uncertainties. We
have based these forward-looking statements on our current expectations and
projections of future events. Such statements reflect our current views with
respect to future events and are subject to unknown risks, uncertainty and
other factors that may cause results to differ materially from those
contemplated in such forward looking statements. In addition, the following
discussion should be read in conjunction with the audited consolidated
financial statements and the related notes thereto included elsewhere in this
report.

Executive Summary

The results
for the year ended December 31, 2006 and 2005 were a net loss of $35.1 million
and $2.9 million or a loss per share of $1.74 and $0.15, respectively.

The operating
expenses for 2006 were $37.5 million, primarily comprised of $20.6 million for in-process
acquired research and development relating to the Vela acquisition, ongoing
research and development expenses for $7.5 million and general and
administration expenses of $9.1 million.

The year 2006
was one of strategic repositioning of the Company. The Company sought to
acquire later stage clinical assets and this was accomplished by the
acquisition of Vela Pharmaceuticals which closed on October 25, 2006. In
connection with this, the Company expensed $20.6 million for in-process
research and development costs.

33

Research and
development efforts in 2006 were conducted out of the Companys Rehovot
facility in Israel. The most significant development efforts were the
completion of a Phase I trial and the conduct of two proof of principal Phase
IIa trials for its lead candidate for treating pain, Cannabinor. The Company
also completed a Phase 1 trial for its NanoEmulsion delivery technology.

During the
year the general and administrative expenses were higher than normal due to
legal and accounting work related to the acquisition of Vela along with the
costs associated with a shareholder proxy contest.

In 2005 the
Company received a payment from Bausch and Lomb of $10.7 million which
significantly reduced the loss for that year.

Critical Accounting Policies

The
preparation of our consolidated financial statements in conformity with
accounting principles generally accepted in the U.S. requires management to
make estimates and assumptions that affect the amounts reported in our
consolidated financial statements and accompanying notes. Future events and
their effects cannot be determined with absolute certainty. Therefore, the
determination of estimates requires the exercise of judgment. Actual results
inevitably will differ from those estimates, and such differences may be
material to the financial statements. The listing below is not intended to be a
comprehensive list of all of our accounting policies. The Company considers
certain accounting policies related to stock-based compensation, tax valuation
allowance and asset impairments to be critical policies due to the estimation
process involved in each.

Equity based compensation

Effective
January 1, 2006, the Company adopted the provisions of Statement of Financial
Accounting Standards No. 123R, Share-Based Payment (SFAS
123R), which establishes the financial accounting and reporting standards
for stock-based compensation plans. SFAS 123R requires the measurement and
recognition of compensation expense for all stock-based awards made to
employees and directors, including employee stock options and restricted stock
units, and employee stock purchases related to the ESPP. Under the provisions
of SFAS 123R, stock-based compensation cost is measured at the grant date,
based on the fair value of the award, and is recognized as an expense over the
requisite service period of the entire award (generally the vesting period of
the award). The Company has elected to expense these awards on a straight line
basis over the life of the awards. As a result of adopting SFAS 123R, the
Companys net loss before income taxes and net loss for the year ended December
31, 2006 was $939,500 more than if the Company had continued to account for
stock-based compensation under Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25) and its related
interpretations. Basic and diluted net loss per share for the year ended
December 31, 2006 of $(1.74) is $0.04 more as a result of adopting SFAS 123R.

The Company elected
to use the modified prospective transition method as permitted by SFAS 123R
and, therefore, financial results for prior periods have not been restated.
Under this transition method, stock-based compensation expense for the year
ended December 31, 2006 includes expense for all equity awards granted prior
to, but not yet vested as of January 1, 2006, based on the grant date fair
value estimated in accordance with the original provisions of
SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123,)
as amended by SFAS 148, Accounting for Stock-Based CompensationTransition and
Disclosure. Since the adoption of SFAS 123R, there have been no changes to the
Companys stock compensation plans or modifications to outstanding stock-based
awards which would increase the value of any awards outstanding other than the
acceleration and full vesting of options held by two senior executives who left
the Company and two board members who left the board. The financial impact of
these modifications has been reflected in our results. Compensation expense for
all stock-based compensation awards granted subsequent to January 1, 2006 was
based on the grant-date fair value determined in accordance with the provisions
of SFAS 123R. During the year ended December 31, 2006, the Company recognized
compensation expense of $939,500 for stock options which was recognized in the
Consolidated Statement of Operations. As of December 31, 2006, the
total compensation costs related to non-vested awards not yet recognized is
$1.7 million which will be recognized over the next three and one-half years.

34

Prior to
January 1, 2006, the Company accounted for stock-based compensation in
accordance with APB 25 and also followed the disclosure requirements of
SFAS 123. Under APB 25, the Company accounted for stock-based awards to
employees and directors using the intrinsic value method as allowed under SFAS
123.

The following
table illustrates the effect on net loss and loss per share if the Company had
applied the fair value recognition provisions of SFAS No. 123 to stock-based
employee compensation. The estimated fair value of each option is calculated
using the Black-Scholes option-pricing model.

Year Ended 
  December 31, 2005

Year Ended 
  December 31, 2004Net loss as reported

($
2,929,872
)
($
21,967,767
)Add: Stock-based employee
compensation
  expense included in reported net loss


1,171,728


439,540Deduct: Total stock-based
employee
  compensation expense determined under fair value based method for all awards


(4,578,359
)

(1,705,559
)Pro forma net loss

($
6,336,503
)
($
23,233,786
)Loss per share:Basic and diluted, as
reported

($
0.15
)
($
1.22
)Basic and diluted, pro
forma

($
0.33
)
($
1.29
)For disclosure
purposes under SFAS No. 123, the fair value of each option grant was estimated
on the date of grant using the Black-Scholes option valuation model with the
following weighted-average assumption:

2005

2004Risk-free
  interest rate


3.71-4.45%


2.89-3.69%Expected
  lives (in years)


5


5Dividend
  yield


0%


0%Expected
  volatility


99 -107%


88 -89%On June 28, 2005, the Company accelerated the vesting of unvested stock
options awarded under its stock option plans that had exercise prices greater
than $9.00; the closing price was $2.43 on June 28, 2005. Unvested options to
purchase approximately 200,000 shares became exercisable as a result of the
vesting acceleration. Typically, the Company grants stock options that vest
over a four-year period. The purpose of the accelerated vesting was to enable
the Company to avoid recognizing, in its consolidated statement of operations,
compensation expense associated with these options in future periods, upon
adoption of SFAS 123R (Share-Based Payment) in January 2006. The impact of this
acceleration resulted in a $2.6 million increase in proforma stock-based
compensation expense in 2005.

Options issued
to non-employees other than directors are accounted for under the fair value
method in accordance with SFAS 123 and EITF Issue No. 96-18, Accounting
for Equity Instruments that are Issued to Other than Employees for Acquiring,
or in Conjunction with Selling Goods or Services. Under the fair value method,
compensation cost is measured at the grant date of the option based on the
value of the award using the Black-Scholes method. Compensation cost is
periodically remeasured as the underlying options vest in accordance with EITF
Issue No. 96-18 and is recognized over the service period.

On September
6, 2004, the Board of Directors approved the Retention Award Agreements and
Pharmos entered into Retention Award Agreements with each of Dr. Haim Aviv,
Chairman and Chief Executive Officer, and Dr. Gad Riesenfeld, its then
President and Chief Operating Officer. The Company granted retention awards
consisting of cash and restricted stock units to Dr. Aviv. The Company granted
retention awards consisting of cash and restricted stock to Dr. Riesenfeld (the
Awards). Under the agreement, one-half of the Awards vested on December 31,
2005 and the balance shall vest and become non-forfeitable on June 30, 2007,
subject to certain accelerated vesting provisions. Under the terms of Dr.
Riesenfelds severance agreement, the balance of his Awards vested on his
departure from the Company on April 2, 2006 and the expense of those awards was

35

accelerated
through April 2, 2006. The fair value of the restricted shares was based on the
fair value of the stock on the issuance date. The aggregate fair value of the
restricted stock awards totaled $2 million. For financial reporting purposes,
the cash awards and the fair value of the restricted stock awards, which
totaled $2,500,000, will be expensed pro rata over the vesting periods. Per the
Awards, only Dr. Riesenfeld was issued the restricted stock; Dr. Aviv received
restricted stock units.

Impairment of Long-Lived Assets

We review
long-lived assets for impairment whenever events or changes in business
circumstances indicate that the carrying amount of the assets may not be fully
recoverable or that the useful lives of these assets are no longer appropriate.
Each impairment test is based on a comparison of the undiscounted cash flow to
the recorded value of the asset. Subsequent impairment assessments could result
in future impairment charges. Any impairment charge would result in the
reduction in the carrying value of long-lived assets and would increase our net
loss in the period in which the charge arose.

Tax Valuation Allowance

The Company
has assessed the likelihood of realizing future taxable income and has
determined that a 100% deferred tax valuation allowance is deemed necessary. In
the event the Company were to determine that it would be able to realize its
deferred tax asset, an adjustment to the deferred tax asset would increase
income or decrease the loss in the period such determination is made.

Results of Operations

Years Ended
December 31, 2006 and 2005

The Company
recorded no product sales revenue and cost of sales during 2006 and 2005.

Total
operating expenses increased by $21,833,631 or 139%, to $37,542,519 in 2006
from $15,708,888 in 2005. In 2006, the Company completed its acquisition of
Vela Pharmaceuticals, Inc. which included $20,608,000 of in-process research
and development costs. The Vela operations have been integrated into Pharmos
and the Company currently operates as one operating segment. From the Vela
acquisition, the Company expects to initiate a large Phase 2b study of
Dextofisopam for the treatment of IBS in the first half of 2007. During 2006,
the Company has completed the Phase I trial and one of two proof-of-principle
Phase IIa testing for its lead candidate for treating pain, a CB-2 selective
agonist, Cannabinor with the IV formulation and is scheduled to complete the
second proof-of-principle Phase IIa testing and for a Phase I testing with the
oral formulation during 2007. The Companys NanoEmulsion delivery technology
for topical application of analgesic and anti-inflammatory agents has completed
in 2006 the second Phase I trial with Diclofenac cream and is scheduled in 2007
for a Phase IIa clinical trial in Osteoarthritis patients. During 2006, the
Company incurred higher professional fees primarily in connection with legal
fees related to the proxy contest including the coverage of Lloyd Millers
legal costs, higher investor relation costs related to the acquisition and
proxy preparation, higher costs for the clinical trial activity for Cannabinor
and NanoEmulsion and higher salaries costs for severance for a number of
executives and the 2006 implementation of the equity based compensation of SFAS
123R.

During 2006,
Pharmos completed the Phase I trial and one of two proof-of-principle Phase IIa
testing for its lead candidate for treating pain from its proprietary platform
of CB2-selective synthetic cannabinoid compounds, Cannabinor with IV
formulation as well as the preclinical toxicology and safety pharmacology
studies of an oral formulation of Cannabinor. Cannabinor and other platform
compounds were designed to reduce the side effects caused by natural cannabinoids.
In a number of animal models, these compounds have demonstrated efficacy as
analgesics to treat moderate to severe pain, as anti-inflammatory agents, and
immunomodulation agents to treat diseases such as multiple sclerosis,
rheumatoid arthritis and inflammatory bowel disease. The preliminary results of
one of two proof-of-principle Phase IIa testing of Cannabinor in
capsaicin-induced pain model of neuropathic pain didnt meet the primary
endpoint defined by analgesic effects compared to placebo, but confirmed safety
and tolerability observed in previous studies. The Company expects in 2007 to
complete the analysis of the

36

Cannabinor
proof-of-principle Phase IIa testing in capsaicin-induced pain model of
neuropathic pain results, to complete the proof-of-principle Phase IIa testing
Cannabinor in patients experiencing nociceptive pain from 3rd molar extraction
and to conduct a Phase I safety study with the Cannabinor oral formulation.

During 2006,
Pharmos completed the second Phase I study with its proprietary NanoEmulsion
drug delivery technology in healthy volunteers that confirmed the safety and
tolerability as well as the low systemic exposure of a Diclofenac NE topical
cream. The Company plans to initiate a Phase IIa clinical trial in Osteoarthritis
patients in 2007.

The acquisition of Vela
resulted in the Company acquiring three potential drug candidates in various
stages of development. The Company is planning to initiate a large scale Phase
IIb trial involving approximately 480 patients with Dextofisopam for irritable
bowel syndrome (IBS). The second drug acquired through Vela VPI-013 for female
sexual dysfunction and neuropathic pain. This drug candidate has completed
Phase IIa testing and the Company intends to seek to license this to a partner.
The Company also intends to license out the third drug candidate, Tianeptine,
also for IBS, which has completed pre-clinical testing. Significant additional
clinical testing and related expenses will be needed before these drugs reach
the market, if at all. The additional expenses cannot be quantified at this
time.

The Company is
currently dependent upon external financing, interest income, and research and
development contracts to pursue its intended business activities. The Company
has not been profitable since its inception, except for 2001. During 2006, the
Company funded the majority of its expenses and other capital requirements with
$13 million of common stock issued in conjunction with the Vela acquisition,
utilization of cash and short term investments available from external
financing in earlier years, income from grants received from the Office of the
Chief Scientist of Israel and the sale of NJ Net Operating Losses. At December
31, 2006, the Company has an accumulated deficit of $181 million and expects to
continue to incur losses going forward. Losses have resulted principally from
costs incurred in research activities aimed at identifying and developing the
Companys product candidates, clinical research studies, the write-off of purchased
research and development, and general and administrative expenses. The Company
expects to incur additional losses over the next several years as the Companys
research and development and clinical trial programs continue. The Companys
ability to achieve profitability, if ever, is dependent on its ability to
develop and obtain regulatory approvals for its product candidates, to enter
into agreements for product development and commercialization with strategic
corporate partners and contract to develop or acquire the capacity to
manufacture and sell its products. See Managements Discussion and Analysis of
Financial Condition and Results of Operations  Liquidity and Capital
Resources.

Research
efforts in 2006 have been focused on the identification of new, potentially
more potent CB2 agonists, completion of preclinical toxicology and safety
pharmacology studies of an oral formulation of Cannabinor, scale-up
manufacturing, technology transfer to the active ingredient supplier, and
clinical trial finished material at Pharmos facility in Rehovot, Israel. The
major increase in year-to-date operating expenses yearover-year reflects the
shift from primarily in-house research & development activities in 2005 to
preclinical and clinical trials in 2006.

The Company
considers major research & development projects to be those projects that
have reached at least Phase II level of clinical development. The Companys
Phase II project is the development of Cannabinor. During 2006, the gross cost
of development and review was approximately $2.5 million. Total costs since the
Cannabinor project entered Phase II development in 2006 through December 31,
2006 were $2.5 million,

Gross expenses
for other research and development projects in early stages of development for
the year ended December 31, 2006 and 2005 were $6,477,805 and $ 6,257,498,
respectively: 75% in 2006 and 87% in 2005 of the spending was related to
cannabinor and other CB2 compounds. Research & development (R&D) gross
expenses decreased by $611,472 or 6% from $9,568,293 in 2005 to $8,956,821 in
2006 due to a reduction in clinical
activity that was related to Dexanabinol. The Company recorded research
and development grants received from the Office of the Chief Scientist of
Israels Ministry of Industry and Trade of $1,445,513 and $1,406,508 during
2006 and 2005, respectively, which reduced research and development expenses.
The increase in grants is directly related to the increase in the underlying
eligible activity for the grants for 2006 over 2005. Total research and
development expenses, net of grants, decreased by $650,477 or 8% from
$8,161,785 in 2005 to $7,511,308 in 2006.

37

In process
acquired research and development costs increased by $20,607,575 from $0 in
2005 to $20,607,575 in 2006. The in process acquired research and development
costs were acquired in conjunction with the acquisition of Vela.

General and
administrative expenses increased by $1,943,576 or 27%, from $7,165,291 in 2005
to $9,108,867 in 2006. The increase in general and administrative expenses is
due to higher compensation, professional fees, and investor relations by
$1,086,000, $695,000, and $304,000 respectively, in 2006 compared to 2005.
There were also decreases in general and administrative expenses related to
lower consultant expenses of $239,000. The increase in compensation is
attributed to severance costs, and the cost of stock based compensation awards
associated with the adoption of FAS 123R. The higher professional fees in 2006
are attributed to legal fees related to the proxy and the Vela acquisition. The
increase in investor relation costs is primarily related to costs associated
with the printing and distribution of the proxy.

Depreciation
and amortization expenses decreased by $67,043, or 18%, from $381,812 in 2005
to $314,769 in 2006. The decrease is due to fixed assets which have become
fully depreciated.

Other income
net, decreased by $10,495,607 from income of $12,288,382 in 2005 to income of
$1,792,775 in 2006. Income of $10,725,688 was recognized for the net payment
received from B&L in the first quarter of 2005. Interest expense decreased
by $166,322 from $166,322 in 2005 to $0 in 2006. The decrease in 2005 interest
expense is a result of the substantially reduced average outstanding balance
and maturity at March 31, 2005 of the September 2003 Convertible Debentures.
This debt was fully repaid as of March 31, 2005. Interest income increased by
$263,164, or 17%, from $1,514,878 in 2005 to $1,778,042 in 2006 as a result of
higher interest rates. During 2006. the Company recorded in other income
royalties of $5,177 compared with $24,670 in 2005 per the licensing agreement
with Herbamed Ltd, a company controlled by Dr. Haim Aviv, the Companys CEO.

No tax
provision is required at this time since the company is in a tax loss position
at year-end December 31, 2006 and has net operating losses from previous years.
The Company has established a 100% valuation allowance against the deferred tax
asset. The Company had an increase in income tax benefit by $122,141 from $490,634
in 2005 to $612,775. The income tax benefit represents funds derived from the
sale of Pharmos New Jersey State net operating losses.

Years Ended
December 31, 2005 and 2004

The Company
recorded no product sales revenue and cost of sales during 2005 and 2004.

Total
operating expenses decreased by $4,171,263 or 21%, to $15,708,888 in 2005 from
$19,880,151 in 2004. During 2005, the Company commenced a Phase I trial for its
lead candidate for treating pain, a CB-2 selective agonist, cannabinor. The
Company expects to enter Phase II testing in pain indications in 2006. The
Companys NanoEmulsion drug delivery system is in development for the topical
application of analgesic and anti-inflammatory agents and also has the
potential for the delivery of a wide variety of water-insoluble molecules.
Phase I (safety and tolerability) studies have been completed with a prototype
formulation of an NSAID, and revealed that it was well-tolerated. From the
dextrocannabinoid family, the neuroprotective drug candidate dexanabinol
completed a Phase IIa trial as a preventive agent against post-surgical
cognitive impairment in the fourth quarter of 2004. Results of the exploratory
Phase II trial of dexanabinol as a preventive agent for cognitive impairment
(CI) in coronary artery bypass graft (CABG) patients were reviewed internally
and with the FDA. During 2005, the Company incurred higher costs related to
legal services, amortization of deferred compensation from the Retention Award
Agreements to two executives, and severance costs related to the departure of
two executives. In 2005, the Company incurred a decrease in costs for the Phase
III clinical trial of dexanabinol for severe TBI over 2004 as a result of the
trial being completed and the results announced in December 2004.

During 2005,
Pharmos advanced the lead candidate from its proprietary platform of
CB2-selective synthetic cannabinoid compounds, cannabinor, through the initial
stages of development, including safety and toxicology

38

studies in
multiple species, kinetics, and clinical Phase I. Cannabinor and other platform
compounds were designed to reduce the side effects caused by natural
cannabinoids. In a number of animal models, these compounds have demonstrated
efficacy as analgesics to treat moderate to severe pain, as anti-inflammatory
agents, and immunomodulation agents to treat diseases such as multiple
sclerosis, rheumatoid arthritis and inflammatory bowel disease. The Company
commenced Phase I human testing of cannabinor during the third quarter of 2005,
and dosing in the Phase I study in healthy volunteers has been completed.
Pending full review of the Phase I data, Phase II studies will be conducted to
assess feasibility for treating indications such as post-operative pain and
neuropathic pain with cannabinor.

In December
2004, the Company completed and announced the results of a Phase 3 trial of
dexanabinol to treat severe traumatic brain injury (TBI) patients. Dexanabinol
did not demonstrate efficacy in the trial, and the program was discontinued. A
final report was submitted to the FDA, and a manuscript was published in a
peer-reviewed journal for publication. During 2005, the Company responded to
the unfavorable TBI results and the termination of the TBI project by reducing
its workforce by 20%, rebalancing its personnel to focus on advancing its
preclinical programs toward a clinical developmental stage and by reducing
costs without jeopardizing its strategic initiatives.

On May 26, 2005, Pharmos
Corporation filed a Certificate of Change with the Nevada Secretary of State
which served to effect, as of May 31, 2005, a 1-for-5 reverse split of Pharmos
common stock. As a result of the reverse stock split, every five shares of
Pharmos common stock were combined into one share of common stock; any
fractional shares created by the reverse stock split were rounded up to whole
shares. The reverse stock split affected all of Pharmos common stock, stock
options and warrants outstanding immediately prior to the effective date of the
reverse stock split. The reverse split reduced the number of shares of Pharmos
common stock outstanding from 95,137,076 shares to 19,027,809 shares on May 31,
2005, and the number of authorized shares of common stock was reduced from
150,000,000 shares to 30,000,000 shares. All references to common share and per
common share amounts for all periods presented have been retroactively restated
to reflect this reverse split. At the Annual Meeting in September 2005, the
shareholders voted to increase the number of authorized shares of common stock
to 60,000,000 shares.

Research
efforts in 2005 have been focused on the completion of cannabinor toxicology,
scale-up manufacturing, technology transfer to the active ingredient supplier,
and clinical trial finished material at Pharmos facility in Rehovot, Israel.
During the fourth quarter of 2005, the Company commenced its dose escalating
safety trial. The major decreases in year-to-date operating expenses
yearover-year reflects the shift from robust clinical trial spending for two
trials in 2004 vs. primarily in-house research & development activities in
2005.

The Company
considers major research & development projects to be those projects that
have reached at least Phase II level of clinical development. The Companys
Phase II project is the development of dexanabinol as a preventive agent
against the cognitive impairment that can follow CABG surgery. During 2005, the
gross cost of development and review was approximately $1.2 million. Total
costs since the CI-CABG project entered Phase II development in 2003 through
December 31, 2005 were $3.5 million. To bring this product to the FDA for
approval would require extensive additional testing in both Phase II and Phase
III trials and there is no assurance the product could achieve regulatory
approval and commercialization; therefore, the Company is seeking a partner for
the development of this product.

Gross expenses
for other research and development projects in early stages of development for
the year ended December 31, 2005 and 2004 were $6,257,498 and $ 3,696,477,
respectively. Over 85% of the spending in both 2005 and 2004 was related to
cannabinor and other CB2 compounds. Research & development (R&D) gross
expenses decreased by $6,767,041 or 41% from $16,335,334 in 2004 to $9,568,293
in 2005 due to a reduction in clinical
activity. The Company recorded research and development grant
receivables from the Office of the Chief Scientist of Israels Ministry of
Industry and Trade of $1,406,508 and $3,446,677 during 2005 and 2004, respectively,
which reduced research and development expenses. The decrease in grants is
directly related to the decrease in the underlying eligible activity for the
grants for 2005 over 2004. Total research and development expenses, net of
grants, decreased by 4,726,872 or 37% from $12,888,657 in 2004 to $8,161,785 in
2005.

39

General and
administrative expenses increased by $751,488 or 12%, from $6,413,803 in 2004
to $7,165,291 in 2005. The increase in general and administrative expenses is
due to higher compensation, professional fees, and insurance by $939,630,
$197,840, and $430,979 respectively, in 2005 compared to 2004. There were
decreases in general and administrative expenses related to lower consultant
expenses of $746,472 and savings from the Companys cost containment efforts in
2005 compared to 2004. The increase in compensation is attributed to the
amortization of deferred compensation related to General & Administration
from the Retention Award Agreements in the amount of $735,300 which commenced in
September of 2004. The higher professional fees in 2005 are attributed to legal
fees related to the class action suits offset by reduced accounting fees. The
decrease in consulting is attributed to a non-cash charge of approximately
$517,000 for extending the stock option exercise period to the Companys former
chief financial officer and stock options granted to a key consultant which
were incurred in 2004 but did not occur in 2005, coupled with reduced
pre-marketing consulting in 2005 vs. 2004. The increase in insurance is
attributable to higher insurance rates.

Depreciation
and amortization expenses decreased by $195,879, or 34%, from $577,691 in 2004
to $381,812 in 2005. The decrease is due to fixed assets which have become
fully depreciated.

Other income
(expense), net, increased by $14,820,772 from an expense of $2,532,390 in 2004
to income of $12,288,382 in 2005. Income of $10,725,688 was recognized for the
net payment received from B&L in the first quarter of 2005. Interest
expense decreased by $3,539,213 from $3,705,535 in 2004 to $166,322 in 2005.
The decrease in 2005 interest expense is a result of the substantially reduced
average outstanding balance and maturity at March 31, 2005 of the September
2003 Convertible Debentures. This debt was fully repaid as of March 31, 2005.
Interest income increased by $856,868, or 130%, from $658,010 in 2004 to
$1,514,878 in 2005 as a result of a higher average cash balances and higher
interest rates. During 2005. the Company recorded in other income royalties of
$24,670 compared with $9,008 in 2004 per the licensing agreement with Herbamed
Ltd, a company controlled by Dr. Haim Aviv, the Companys CEO.

No tax
provision is required at this time since the company is in a tax loss position
at year-end December 31, 2005 and has net operating losses from previous years.
The Company has established a 100% valuation allowance against the deferred tax
asset. The tax benefit in both years represents funds derived from the sale of
Pharmos New Jersey state net operating losses.

Liquidity and Capital Resources

The Company
was not profitable from 2004 through 2006. During 2006, the Company funded the
majority of its expenses and other capital requirements with the issuance of
6.5 million shares of common stock valued at $13.0 million and the payment of
$6.0 million in cash in conjunction with the Vela acquisition, utilization of
cash and short term investments available from external financing in earlier
years, income from grants received from the Office of the Chief Scientist of
Israel and the sale of NJ Net Operating Losses. At December 31, 2006, the
Company had an accumulated deficit of $181 million and expects to continue to
incur losses going forward. Such losses have resulted principally from costs
incurred in research and development and from general and administrative
expenses. The Company has financed its operations with public and private
offerings of securities, advances and other funding pursuant to a marketing
agreement with Bausch & Lomb, grants from the Office of the Chief Scientist
of Israel, research contracts, the sale of a portion of its New Jersey net
operating loss carryforwards, and interest income. Management believes that the
current cash, cash equivalents and short term investments, totaling of $25.9 million
as of December 31, 2006, will be sufficient to support the Companys continuing
operations beyond December 31, 2007.

The Company expects to incur
additional losses over the next several years as the Companys research and
development and clinical trial programs continue. The Company expects cash
expenditures in research and development to increase in 2007 due to the
acquisition of Vela in late 2006. Although the Company may receive a future
milestone payment from sales of Zylet® in future periods, it may not be
sufficient to allow the Company to operate profitably at any time in the
foreseeable future. The Companys ability to achieve profitability, if ever, is
dependent on its ability to develop and obtain regulatory approvals for its
product candidates, to enter into agreements for product development and
commercialization with strategic corporate partners and contract to develop or
acquire the capacity to manufacture and sell its products.

40

The following
table describes the Companys liquidity and financial position on December 31,
2006, and on December 31, 2005:

December 31, 2006

December 31, 2005Working
  capital


$
24,168,153



$
44,763,056Cash and
  cash equivalents


$
12,757,013



$
10,289,127Short term
  investments


$
13,172,673



$
35,748,343Total cash,
  cash equivalents and short term investments


$
25,929,686



$
46,037,470Current
working capital position

As of December
31, 2006, the Company had working capital of $24.2 million consisting of
current assets of $26.7 million and current liabilities of $2.5 million. This
represents a decrease of $20.6 million from its working capital of $44.8
million on current assets of $47.4 million and current liabilities of $2.6
million as of December 31, 2005.

Current and
future liquidity position

Management
believes that cash, cash equivalents and short term investments, totaling $25.9
million as of December 31, 2006 will be sufficient to support the Companys
continuing operations beyond December 31, 2007. The Company is continuing to
actively pursue various funding options, including additional equity offerings,
strategic corporate alliances, business combinations and the establishment of
product related research and development limited partnerships to obtain
additional financing to continue the development of its products and bring them
to commercial markets. Should the Company be unable to raise adequate financing
or generate revenue in the future, long-term operations will need to be scaled
back or discontinued.

Cash

At December
31, 2006, cash and cash equivalents totaled $12.8 million. At December 31, 2005
cash and cash equivalents totaled $10.3 million. This net increase in cash of
$2.5 million was attributable due to the utilization of cash from operating
activities offset by the sale of short term investments to meet cash needs.
During January 2005, the Company received net proceeds of approximately $9.1
million from Bausch & Lomb for the commercialization of Zylet®. The cash
and cash equivalents, in combination with the short term investments, will be
used to finance future growth.

The Company
has a lease agreement for the premises it occupies in New Jersey. The lease
agreement expires in 2009. The lease agreement is secured by a letter of credit
of $63,922. This amount is included in restricted cash at December 31, 2006.

In addition,
the Companys subsidiary, Pharmos Ltd., has a lease agreement for the premises
it occupies in Israel. The lease agreement expired in November 2006 and was
renewed for a four year term in February 2007 and is cancellable after one
year. The lease agreement is secured by a letter of guarantee in the amount of
$177,016 based on the Israeli consumer price index. A deposit of $82,926 is
included in restricted cash at December 31, 2006.

Operating
activities

Net cash used
in operating activities for 2006 was $19.7 million compared to $12.0 million
for 2005. The increase is primarily attributed to the $6 million cash portion of the
purchase of Vela and its related in process research and development costs.

41

Capital
expenditures

Our capital
expenditures for property, plant and equipment for 2006, 2005 and 2004 totaled
approximately $165,000, $137,000 and $310,000 respectively for normal
replacements and improvements.

Investing
activities

In 2006, the
Company purchased short term investments that were typically auction rate
securities and investments that mature between 90 days and one year. Short term
investments are reinvested upon maturity to the extent that the funds are not
needed to meet operating activity cash flow needs. In 2006, the Company
received $45.9 million in short term investment proceeds and reinvested $23.3
million in short term investments.

The Company
considers all investments that are not considered cash equivalents and with a
maturity of less than one year from the balance sheet date to be short-term
investments. The Company considers all investments with a maturity of greater
than one year to be long-term investments. All investments are considered as
held-to-maturity and are carried at amortized cost, as the Company has both the
positive intent and ability to hold them to maturity. The Company invests in a
variety of instruments such as commercial paper, US Government securities and
corporate securities with an effective maturity of less than one year. Some of
the Companys investments are in auction-rate securities (ARS) that are held as
investments available for sale. Auction rate securities are instruments with
long-term underlying maturities, but for which an auction is conducted
periodically, as specified, to reset the interest rate and allow investors to
buy or sell the instruments. Because auctions generally occur more often than
annually, and because the Company holds these instruments in order to meet
short-term liquidity needs, the auction rate securities are classified as
short-term investments in the Consolidated Balance Sheet. Interest income
includes interest, amortization of investment purchases premiums and discounts,
and realized gains and losses on sales of securities. Realized gains and losses
on sales of investment securities are determined based on the specific
identification method. The Consolidated Statement of Cash Flows reflects the
gross amount of the purchases of short term investments and the proceeds from
maturities of short term securities and sales of auction rate securities.

In 2005, the
Company implemented its Investment Policy; cash previously invested in money
market accounts has been invested in slightly longer term securities earning
higher interest rates. Approximately $41,748,000 was invested in short term
investments during 2005 of which $6,000,000 was reinvested in other short term
securities.

In January
2005, Pharmos received additional gross proceeds of approximately $12,275,000
from Bausch & Lomb in connection with their successful commercial launch of
the Zylet® product and income from the Office of the Chief Scientist of Israel.
In January 2005, Pharmos paid approximately $1,549,000 to B&L (included in
accounts payable on December 31, 2004) for costs of developing Zylet® and an
additional payment of approximately $1,533,000 to the former patent holder of
Zylet®. All payments due to B&L have been made.

Financing
activities

During 2005,
the financing activities were the repayment of the remainder of the September
2003 Convertible Debentures in the amount of $4,846,148.

During the
third quarter of 2004, the Company completed a private placement to sell common
shares to six investors generating net proceeds of $15.7 million. An aggregate
of 1,116,667 shares of common stock were issued.

During the
first quarter of 2004, one of the investors from the September 2003 Convertible
Debentures private placement converted a total of $2 million plus interest into
99,532 shares of common stock of the Company. As part of the escrow agreement,
$2 million of restricted cash was released to the Company during April 2004. As
of December 31, 2004, the Company had repaid or converted approximately $16.2
million of the September 2003 Convertible Debentures. The remaining Convertible
Debenture balance of $4.8 million was repaid in total by March 2005.

42

In January
2004, the underwriters of the December 2003 public offering exercised their
over-allotment option in full, generating net proceeds of approximately $4.04
million. An aggregate of 315,000 shares of Pharmos common stock were issued at
a purchase price of $13.75 per share.

During 2004,
the Company received proceeds of approximately $2.1 million from the exercise
of stock option and warrants by employees, former employees, consultants and
warrant holders.

Executive
stock trading program

During April
2004, Pharmos Corporations former President and Chief Operating Officer, Dr.
Gad Riesenfeld, and one of its directors, Dr. Elkan Gamzu, separately adopted
pre-arranged stock trading plans in accordance with guidelines specified by
Rule 10b5-1 under the Securities Exchange Act of 1934.

Rule 10b5-1
permits officers and directors of public companies to adopt pre-determined
plans for selling specified amounts of stock. The plans may be entered into
only when the director or officer is not in possession of material, non-public
information and may be used to gradually diversify investment portfolios over a
period of time.

During 2004,
pursuant to his 10b5-1 Plan, Dr. Riesenfeld sold an aggregate of 30,917 shares,
which he acquired upon the exercise of options and warrants covered by the
plan. Having depleted all plan-covered securities, Dr. Riesenfelds 10b5-1 Plan
terminated.

During 2004,
pursuant to his 10b5-1 Plan, Dr. Gamzu sold an aggregate of 4,500 shares, which
he acquired upon the exercise of options and warrants covered by the plan. The
plan expired in April 2005.

Bausch
& Lomb

In October
2001, Bausch & Lomb purchased all rights to the Companys loteprednol
etabonate (LE) ophthalmic product line for cash and assumption of certain
ongoing obligations. The Company received gross proceeds of approximately $25
million in cash for its rights to Lotemax® and Alrex®, prescription products
that are made and marketed by Bausch & Lomb under a 1995 Marketing
Agreement with the Company; in addition, Bausch & Lomb also acquired future
extensions of LE formulations including Zylet®, a product that was submitted to
the FDA for marketing approval in September 2003. In December 2004, Bausch
& Lomb received approval from the FDA of its New Drug Application for
Zylet® as an ophthalmic anti-inflammatory/antibiotic combination product. During
January 2005, the Company received gross proceeds of approximately $12.2
million from Bausch & Lomb. An additional milestone payment of up to $10
million could be paid to the Company to the extent sales of the new product
exceed an agreed-upon forecast in the first two years. The Company had a
passive role as a member of a joint committee overseeing the development of
Zylet® and had an obligation to Bausch & Lomb to fund up to a maximum of
$3.75 million of the LE-T development cost, of which $600,000 was deducted from
the purchase price paid by Bausch & Lomb to Pharmos in October 2001. In
July 2003, the Company paid Bausch & Lomb $1.57 million of its liability
for the development of Zylet®. As of December 31, 2004, Pharmos owed an
additional $1.56 million as its share of these research and development related
Zylet® expenses and represents the maximum amount Pharmos owes Bausch &
Lomb. Pharmos paid Bausch & Lomb the remaining research and development
related expenses in January 2005. The Company incurred transaction and royalty
costs of approximately $2 million. The Company also compensated the LE patent
owner approximately $2.7 million ($1.5 million paid upon closing and $1.2
million paid in October 2002) from the proceeds of the sale of Lotemax® and Alrex®
in return for his consent to the Companys assignment of its rights under the
license agreement to Bausch & Lomb. During January 2005, the Company paid
Dr. Bodor approximately $1.3 million per the agreement with respect to Zylet®.
Pharmos owes Dr. Bodor an additional 14.3% of the payment the Company will
receive from Bausch & Lomb in the event that certain sales levels are
exceeded in the first two years following commencement of sales in the U.S.

Private Placement of Convertible Debt

On September 26, 2003, the Company completed
a private placement of convertible debentures and warrants to

43

six institutional investors, generating total
gross proceeds of $21.0 million. Five million dollars of the proceeds was to be
used for working capital purposes, and $16.0 million was to be available to
fund acquisitions upon the approval of the investors. The convertible
debentures were convertible into common stock of the Company at a fixed price
of $20.20, 205% above the closing bid price of the stock for the five days
preceding the closing date. The debentures, which bore an interest rate of 4%,
were redeemed in 13 substantially equal monthly increments which began March
31, 2004. The debentures final payments were made in March 2005. Amounts
converted into shares of Pharmos common stock would have reduced the monthly
redemption amount in inverse order of maturity. The $16.0 million earmarked for
acquisition activity was held in escrow until it was repaid. In connection with
the financing, the Company also issued 1,102,941 three-year warrants (including
102,941 placement agent warrants) to purchase 1,102,941 shares of common stock
at an exercise price of $10.20 per share. The issuance costs related to the
convertible debentures of approximately $1,229,000 in cash and $434,000 for the
value of the placement agent warrants were capitalized and amortized over the
life of the debt. The Company calculated the value of the warrants at the date
of the transaction, including the placement agent warrants, being approximately
$4,652,877 under the Black-Scholes option-pricing method (assumption:
volatility 75%, risk free rate 1.59% and zero dividend yield). The Company
allocated the $21.0 million in gross proceeds between the convertible
debentures and the warrants based on their fair values. The Company is
reporting the debt discount as a direct reduction to the face amount of the
debt in accordance with APB 21. The discount will accrete over the life of the
outstanding debentures. The issuance costs allocated to the convertible
debentures are being deferred and amortized to interest expense over the life
of the debt. APB 21 also requires the Company to allocate the warrant costs
between the convertible debentures and the transaction warrants. The issuance
costs allocated to the warrants were recorded as a debit to additional paid in
capital. During the first quarter of 2004, one of the investors from the
September 2003 Convertible Debentures private placement converted a total of $2
million plus interest. The Company issued 99,532 shares of common stock. As
part of the escrow agreement, approximately $1,524,000 of restricted cash was
released to the Company.
The Company had no outstanding convertible debt at December 31, 2006.

Common
Stock Transactions

At the closing
of the Vela Pharmaceuticals Inc. acquisition on October 25, 2006, the Company
issued 6.5 million shares of common stock and paid $6 million to Vela
shareholders. Pharmos also agreed to reimburse Vela for $679,000 of operating
expenses from July 1, 2006 through closing. The amended Merger Agreement also
includes additional performance-based milestone payments to the Vela
stockholders related to the development of dextofisopam, aggregating up to an
additional $8 million in cash and the issuance of up to an additional 13,500,000
shares of Pharmos common stock. In the event that such shares or payments are
issued or funded in future periods, a determination will then be made as to
whether the values are to be written off as in-process research and development
and charged to results of operations; any such future charge could be material.
None of the conditions requiring issuance of these contingent shares or funding
these payments had been met as of December 31, 2006.

On September 6, 2004, the Board of Directors
approved, and Pharmos entered into, Retention Award Agreements with each of Dr.
Haim Aviv, Chairman and Chief Executive Officer, and Dr. Gad Riesenfeld, its
then President and Chief Operating Officer. The Company granted retention
awards of $300,000 cash and 75,950 restricted stock units to Dr. Aviv and
$200,000 cash and 50,633 shares of restricted stock to Dr. Riesenfeld (the
Awards). Under the agreements, one-half of the Awards vested on December 31, 2005 and the balance were scheduled
to vest and become non-forfeitable on June 30, 2007, subject to certain
accelerated vesting provisions. Under the terms of Dr. Riesenfelds severance
agreement, the balance of his Awards were vested on his departure from the
Company on April 2, 2006 and the expense of those awards was accelerated
through April 2, 2006. The fair value of
the restricted shares was based on the fair value of the stock on the issuance
date. The aggregate fair value of the restricted stock awards totaled $2
million. For financial reporting purposes, the cash awards and the fair value
of the restricted stock awards, which totaled $2,500,000, are being expensed
pro rata over the vesting periods.

On August 20, 2004, the Company completed a
private placement to sell common shares to six investors, generating total
gross proceeds of $16.75 million. An aggregate of 1,116,667 shares of common
stock were

44

issued utilizing a shelf registration of
Pharmos securities declared effective by the Securities and Exchange
Commission in December 2003 and was priced at $15.00 per share. Issuance costs
of approximately $1,067,000 were recorded as a reduction of additional paid in
capital.

Other

In 2006, 2005, and 2004, the Company sold
$7,781,267, $6,413,522, and $3,588,728, respectively, of its State Net
Operating Loss carryforwards under the State of New Jerseys Technology
Business Tax Certificate Transfer Program (the Program). The Program allows
qualified technology and biotechnology businesses in New Jersey to sell unused
amounts of net operating loss carryforwards and defined research and
development tax credits for cash. The proceeds from the sale in 2006, 2005, and
2004 were $612,775, $490,634 and $444,774, respectively and such amounts were
recorded as a tax benefit in the consolidated statements of operations. The
State renews the Program annually and limits the aggregate proceeds to
$10,000,000. We cannot be certain if we will be able to sell any of our
remaining or future carryforwards under the Program.

Commitments and Long
Term Obligations

Payments Due by PeriodTotal

Less than 
  1 Year

1  3
  Years

3  5
  Years

More 
  Than
  5 Years

Undetermined*Operating Leases

$
1,050,377

$
565,178

$
485,199

$


$


$
Other long-term liabilities
reflected on
  our balance sheet*


1,320,624














1,320,624Other Commitments**


26,000


26,000











Total

$
2,397,001

$
591,178

$
485,199

$


$


$
1,320,624*
Consists of
  severance benefits payable under Israeli law. Because these benefits are paid
  only upon termination of employment, it is not possible to allocate the
  liability across future years. The Company has funded $975,810.**
Represents
  cash retention bonus given to the CEO. Approximately $124,000 has been
  accrued through December 31, 2006. Final payment of $150,000 is due June
  2007. This may be accelerated upon the CEOs retirementThe Company
has entered into various employment agreements. The terms of these employment
agreements include one-year renewable terms and do not represent long term
commitments of the Company.

Management
believes that cash, cash equivalents, and short term investments of $25.9
million as of December 31, 2006, will be sufficient to support the Companys
continuing operations beyond December 31, 2007. The Company is continuing to
actively pursue various funding options, including additional equity offerings,
strategic corporate alliances, business combinations and the establishment of
product related research and development limited partnerships to obtain
additional financing to continue the development of its products and bring them
to commercial markets.

The Company
has assessed its vulnerability to certain market risks, including interest rate
risk associated with financial instruments included in cash and cash
equivalents, short term investments, restricted cash and the currency impact in
Israel. Due to the relatively short-term nature of these investments the
Company has determined that the risks associated with interest rate
fluctuations related to these financial instruments do not pose a material risk
to us. The value of the warrant liability is based upon the Companys stock
price, which has historically shown wide fluctuations.

45

New accounting pronouncements

In June 2006,
the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). This
Interpretation
clarifies the accounting for uncertainty in income taxes recognized in a
companys financial statements and prescribes a recognition threshold of
more-likely-than-not to be sustained upon examination. Measurement of the tax
uncertainty occurs if the recognition threshold has been met.
This Interpretation also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. FIN 48 will be effective in the Companys first quarter 2007 financial statements. The Companys adoption of FIN 48 is not expected
to have a material effect on our financial position, results of operations or
cash flows.

In September
2006, the FASB issued Statement No. 157, Fair Value Measurements (SFAS 157). SFAS
157 defines fair value, establishes a framework for measuring fair value in
generally accepted accounting principles and expands disclosures about fair
value measurements. SFAS 157 is effective for financial statements issued for
fiscal years beginning after November 15, 2007, with earlier application
encouraged. The Company is evaluating the impact of adopting SFAS 157.

Item 7A. Quantitative and Qualitative
Disclosures About Market Risk

We assessed
our vulnerability to certain market risks, including interest rate risk
associated with financial instruments included in cash and cash equivalents,
short term investments and restricted cash. Due to the short-term nature of the
cash and cash equivalents, short term investments and restricted cash, we have
determined that the risks associated with interest rate fluctuations related to
these financial instruments do not pose a material risk to us.

Item 8. Financial Statements and
Supplementary Data

The
information called for by this Item 8 is included following the Index to
Consolidated Financial Statements contained in this Annual Report on Form
10-K.

Item 9. Changes in and Disagreements with
Accountants on Accounting and Financial Disclosure

None.

Item 9A. Controls and Procedures

Evaluation of
Disclosure Controls and Procedures

Our
management, with the participation of our principal executive officer and principal
financial officer, has evaluated the effectiveness of the design and operation
of our disclosure controls and procedures (as defined in Rule 13a-15(e) under
the Securities Exchange Act of 1934, as amended (the Act)) as of the end of
the period covered by this annual Report on Form 10-K. Based on this
evaluation, our principal executive officer and principal financial officer
concluded that these disclosure controls and procedures were effective as of
such date, at a reasonable level of assurance, in ensuring that the information
required to be disclosed by our company in the reports we file or submit under
the Act is (i) accumulated and communicated to our management (including the
principal executive officer and principal financial officer) in a timely
manner, and (ii) recorded, processed, summarized and reported within the time
periods specified in the SECs rules and forms.

Changes in Internal
Control Over Financial Reporting

There was no
change in our internal control over financial reporting (as defined in Rule
13a-15(f) under the Securities Exchange Act of 1934, as amended) during our
last fiscal quarter that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.

46

Item
9B. Other Information

None.

47

PART III

Item 10. Directors, Executive Officers and
Corporate Governance

The directors,
officers and key employees of the Company are as follows:

Name

Age

PositionHaim Aviv,
  PhD***

67

Chairman, Chief Executive
Officer, Chief
  Scientist and DirectorAlan L.
  Rubino

52

President, Chief Operating
OfficerS. Colin Neill

60

Senior Vice
  President and Chief Financial Officer, Secretary and TreasurerDavid Schlachet **

61

DirectorMony Ben Dor*/**

61

DirectorSrinivas Akkaraju, MD, Ph.D

38

DirectorAnthony B. Evnin, Ph.D

66

DirectorLloyd Miller III**

52

DirectorElkan R. Gamzu, Ph.D***

64

DirectorCharles W.
  Newhall

61

DirectorAbraham
  Sartani, MD

60

Director*
Lead
  Director**
Members of
  the Audit Committee***
Haim Aviv
  will retire as CEO on March 31, 2007 and be succeeded by Elkan GamzuHaim Aviv,
Ph.D., is Chairman, Chief Executive Officer, Chief Scientist and a Director of
the Company. In 1990, he co-founded Pharmos Corporation, a New York corporation
(Old Pharmos), which merged into the Company in October 1992 (the Merger).
Dr. Aviv also served as Chairman, Chief Executive Officer, Chief Scientist and
a Director of Old Pharmos prior to the Merger. Dr. Aviv was the co-founder in
1980 of Savient Pharmaceuticals, Inc., a publicly-traded company engaged in the
development of products using recombinant DNA, its General Manager and Chief
Scientist from 1980 to 1985, and a Director and Senior Scientific Consultant
until August 1993. Dr. Aviv was also co-founder of Predix Pharmaceuticals Inc.
(Now Epix Pharmaceuticals Inc.) Prior to that time, Dr. Aviv was a professor of
molecular biology at the Weizmann Institute of Science. Dr. Aviv is an officer
and/or significant stockholder of several privately held Israeli
biopharmaceutical and venture capital companies. Dr. Aviv is a member of the
Board of Directors of Ben Gurion University at Beer-Sheva, Israel and Yeda
Ltd., the commercial arm of the Weizmann Institute, Rehovot, Israel. Dr. Aviv
holds a Ph.D. degree from the Weizmann Institute of Science. Dr. Aviv will
retire as CEO and Chief Scientist on March 31, 2007, but will remain as
Chairman and Director.

Elkan R.
Gamzu, Ph.D., a Director of the Company since February 2000, is a consultant to
the biotechnology and pharmaceutical industries a Principal of enERGetics
Biopharmaceutical Consultancy, LLC, and was a founding partner of the due
diligence company BioPharmAnalysis, LLC. From December 1, 2004 until February
24, 2005, Dr. Gamzu was the interim CEO of XTL Biopharmaceuticals, Ltd. Prior
to becoming a consultant, Dr. Gamzu held a number of senior executive positions
in the biotechnology and pharmaceutical companies, including President and
Chief Executive Officer of Cambridge Neuroscience, Inc. from 1994 until 1998.
Dr. Gamzu also served as President and Chief Operating Officer and Vice
President of Development for Cambridge Neuroscience, Inc. from 1989 to 1994.
Previously, Dr. Gamzu held a variety of senior positions with Warner-Lambert
and Hoffmann-La Roche, Inc. In 2001 and 2002, Dr. Gamzu was part-time Interim
VP, Product Management Leadership for Millennium Pharmaceuticals, Inc. Dr.
Gamzu is a member of the Board of Directors of three other biotechnology
companies: the privately held biotechnology companies Neurotech S.A. of Paris,
France, NeuroHealing Pharmaceuticals Inc. and AviTx Inc., for which he also
serves as President. Dr. Gamzu will succeed Dr. Aviv as CEO on March 31, 2007.

48

Alan L.
Rubino, became President and Chief Operating Officer, commencing November 14,
2005. Prior to joining Pharmos, Mr. Rubino had been Executive Vice President
and General Manager of PDI, Inc., a publicly traded outsourcing company focused
on the pharmaceutical and biotech industries, since January 2004. From 2001 through
December 2003, he served as Senior Vice President/Officer - PTS Marketing and
Business Unit Strategy in the Pharmaceutical and Technology Services Division
of Cardinal Health, Inc. Between 1977 and 2001, Mr. Rubino was with
Hoffmann-LaRoche where he rose to Senior Vice President and a member of the
U.S. Executive and Operating Committees. Currently, he is a member of the Board
of Directors of Rutgers Business School and Aastrom Biosciences, Inc. and
serves on the Advisory Board of SK Corp. Mr. Rubino holds a B.A. in Economics
from Rutgers University.

S. Colin Neill became Senior Vice President,
Chief Financial Officer, Secretary, and Treasurer of Pharmos in October 2006.
From September 2003 to October 2006, Mr. Neill served as Chief Financial
Officer, Treasurer and Secretary of Axonyx Inc., a biopharmaceutical company
that develops products and technologies to treat Alzheimers disease and other
central nervous system disorders, where he played an integral role in the
merger between Axonyx and TorreyPines Therapeutics Inc., a privately-held
biopharmaceutical company. Mr. Neill served as Senior Vice President, Chief
Financial Officer, Secretary and Treasurer of ClinTrials Research Inc., a $100
million publicly traded global contract research organization in the drug
development business, from 1998 to its successful sale in 2001. Following that
sale from April 2001 to September 2003 Mr. Neill served as an independent
consultant assisting small start-up and development stage companies in raising
capital. Earlier experience was gained as Vice President Finance and Chief
Financial Officer of BTR Inc., a $3.5 billion US subsidiary of BTR plc, a
British diversified manufacturing company, and Vice President Financial
Services of The BOC Group Inc., a $2.5 billion British owned industrial gas
company with substantial operations in the health care field. Mr. Neill served
four years with American Express Travel Related Services, first as chief
internal auditor for worldwide operations and then as head of business planning
and financial analysis. Mr. Neill began his career in public accounting with
Arthur Andersen LLP in Ireland and later with Price Waterhouse LLP as a senior
manager in New York City. He also served with Price Waterhouse for two years in
Paris, France. Mr. Neill graduated from Trinity College, Dublin with a first
class honors degree in Business/Economics and he holds a masters degree in
Accounting and Finance from the London School of Economics. He is a Certified
Public Accountant in New York State and a Chartered Accountant in Ireland. Mr.
Neill serves on the board of OXIS International, Inc.

David
Schlachet, a Director of the Company from December 1994, was named Chief
Executive Officer in November 2005 of Syneron Medical Ltd, a company that
develops, manufactures, and markets aesthetic medical products. As of July
2004, Mr. Schlachet had served as CFO of Syneron Medical Ltd. He had been a
managing partner of Biocom, a V.C Fund in the field of Life Science, from April
2000 until December 2004. Prior to that, he served as Chairman of Elite
Industries Ltd from July 1997 until June 2000. From January 1996 to June 1997,
Mr. Schlachet served as the Vice President of the Strauss Group and Chief
Executive Officer of Strauss Holdings Ltd, one of Israels largest privately
owned food manufacturers. He was Vice President of Finance and Administration
at the Weizmann Institute of Science in Rehovot, Israel from 1990 to December
1995, and was responsible for the Institutes administration and financial
activities, including personnel, budget and finance, funding, investments,
acquisitions and collaboration with the industrial and business communities.
From 1989 to 1990, Mr. Schlachet was President and Chief Executive Officer of
YEDA Research and Development Co. Ltd., a marketing and licensing company at
the Weizmann Institute of Science. He also serves as a Director of Harel
Investment House (Israeli broker, underwriter and asset management firm), Edgar
Ltd. (real estate company), Compugen Ltd. and Taya Investment Company Ltd.

Mony Ben Dor,
a director of the Company since September 1997, has been managing partner of
Biocom, a V.C Fund in the field of Life Science since April 2000 until December
2004. Prior to that he was Vice President of the Israel Corporation Ltd. from
May 1997, and Chairman of two publicly traded subsidiaries: H.L. Finance and
Leasing and Albany Bonded International Trade. He was also a Director of a
number of subsidiary companies such as Israel Chemicals Ltd., Zim Shipping
Lines, and Tower Semiconductors. From 1992-1997 Mr. Ben Dor was Vice President
of Business Development for Clal Industries Limited, which is one of the
leading investment groups in Israel. He was actively involved in the
acquisition of pharmaceutical companies, including Pharmaceutical Resources
Inc., Finetech Ltd. and BioDar Ltd. He served as a director representing Clal

49

Industries in
all of the acquired companies as well as other companies of Clal Industries.
Prior to his position at Clal Industries, Mr. Ben Dor served as Business
Executive at the Eisenberg Group of companies.

Srinivas
Akkaraju, M.D., Ph.D., a director since October 2006, is a Managing Director of
Panorama Capital, LLC, a private equity firm founded by the former venture
capital investment team of J.P. Morgan Partners, LLC, a private equity division
of JPMorgan Chase & Co. Panorama Capital is advising J.P. Morgan Partners
as to its investment in the Company. Prior to August 1, 2006, Dr. Akkaraju was
a Partner with J.P. Morgan Partners, LLC which he joined in April 2001. Prior
to JPMorgan Partners, LLC, from October 1998 to April 2001, Dr. Akkaraju was in
the Business and Corporate Development group at Genentech, Inc. where he served
in various capacities, most recently as Senior Manager and project team leader for
one of Genentechs clinical development products. Dr. Akkaraju is currently a
member of the Board of Directors of Barrier Therapeutics, Inc., Seattle
Genetics, Inc., and several private biotechnology companies. Dr. Akkaraju
received his undergraduate degrees in Biochemistry and Computer Science from
Rice University and his M.D. and Ph.D. in Immunology from Stanford University.

Anthony B.
Evnin, Ph.D., a director since October 2006, is a Managing General Partner of
Venrock Associates, a venture capital firm, where he has been a Partner since
1975. He is currently a member of the Board of Directors of Coley
Pharmaceutical Group, Inc., Icagen, Inc., Infinity Pharmaceuticals, Inc.,
Memory Pharmaceuticals Corp., Renovis, Inc., and Sunesis Pharmaceuticals, Inc.,
as well as being on the Board of Directors of a number of private companies. He
was formerly a director of IDEC Pharmaceuticals Corporation, Dianon Systems,
Inc., BioSurface Technologies, Inc., Sepracor, Inc., IDEXX Laboratories, Inc.,
Athena Neurosciences, Inc., Genetics Institute, Inc., SUGEN, Inc., Axys
Pharmaceuticals, Inc., Centocor, Inc., Ribozyme Pharmaceuticals, Inc., Triangle
Pharmaceuticals, Inc., Caliper Life Sciences, Inc., and Sonic Innovations, Inc.
Dr. Evnin received an A.B. in Chemistry from Princeton University and a Ph.D.
in Chemistry from the Massachusetts Institute of Technology.

Lloyd I.
Miller, III, a director since October 2006, is a registered investment advisor
and has been a member of the Chicago Board of Trade since 1978 and a member of
the Chicago Stock Exchange since 1996. Mr. Miller is currently a director of
Stamps.com, American BankNote Corporation, Synergy Brands Inc. and Aldila, Inc.
Mr. Miller previously served on the board of directors of several other
companies, including Anacomp, Dennys Corporation, Vulcan International,
Celeritek, Inc., Dynabazaar, Inc. (formerly FairMarket, Inc.) and American
Controlled Industries. Mr. Millers principal occupation is investing assets
held by Mr. Miller on his own behalf and on behalf of his family. Mr. Miller
graduated from Brown University in 1977 with a Bachelors Degree.

Charles W.
Newhall, III, a director since October 2006, co-founded New Enterprise
Associates (NEA) in 1978 and has been a General Partner of the firm since its
inception. While with NEA, his investment activities have focused on healthcare
services, healthcare information services and biopharmaceutical companies.
Prior to co-founding NEA, Mr. Newhall was a Vice President with T. Rowe Price
Associates and Vice President of its New Horizons Fund. His board memberships
include Vitae Pharmaceuticals, Inc., ElderHealth, Inc., Hospital Partners of
America, Inc., Sensors for Medicine & Science, Inc., TargetRx, Inc., and
Trine Pharmaceuticals, Inc.. Mr. Newhall is also a founder of the Mid-Atlantic
Venture Association. He received his M.B.A. from the Harvard University
Graduate School of Business and his B.A. in English Literature with honors from
the University of Pennsylvania.

Abraham
Sartani, M.D., a Director of the Company since June 2005, is currently
Vice-President and Director, Pharmaceutical Research and Development Division
of Recordati S.p.A. Dr. Sartani has been involved in pharmaceutical research
and development for 25 years, first at Farmitalia Carlo Erba and, since 1985,
at Recordati. Since 1988, he has reported directly to the chairman of the
company as the Vice President and Director of the Research and Development
Division. Since 1999, his responsibilities have included all licensing
activities. Dr. Sartani received his medical degree from the Sackler School of
Medicine, University of Tel Aviv, Israel in 1974, graduating cum laude. Between
1975 and 1978, he completed his internship and residency at the Jaffa
Government Hospital in Tel Aviv. From 1978 to 1980, he was a Specialist in
Endocrinology at the University of Pavia and a Ford Foundation Research Fellow
at the University of Milan.

50

Role of the Board; Corporate Governance
Matters

It is the
paramount duty of the Board of Directors to oversee the Chief Executive Officer
and other senior management in the competent and ethical operation of the
Company on a day-to-day basis and to assure that the long-term interests of the
shareholders are being served. To satisfy this duty, the directors set
standards to ensure that the Company is committed to business success through
maintenance of the highest standards of responsibility and ethics.

Members of the
Board bring to the Company a wide range of experience, knowledge and judgment.
The governance structure in the Company is designed to be a working structure
for principled actions, effective decision-making and appropriate monitoring of
both compliance and performance. The key practices and procedures of the Board
are outlined in the Companys Code of Ethics and Business Conduct, which is
available on the Companys website at www.pharmoscorp.com. Click
Investors, and then Corporate Governance.

Lead Director

In June 2004,
the Board created the position of lead director and adopted a Lead Independent
Director Charter, a copy of which is available on our website at
www.pharmos.com. The position of lead director was created for the purpose of
assisting the Chairman and the remainder of the Board in assuring effective
corporate governance in managing the affairs of the Board and the Company. The
Board, in accordance with the recommendation of the Governance and Nominating
Committee, designated Mony Ben Dor as lead director, to hold office until the
next Annual Meeting of Directors or until his successor is duly elected and
qualified.

Board Committees

The Board has
a standing Compensation Committee, Governance and Nominating Committee, Audit
Committee and Science & Technology Committee.

The
Compensation Committee is primarily responsible for reviewing the compensation
arrangements for the Companys executive officers, including the Chief
Executive Officer, and for administering the Companys stock option plans.
Members of the Compensation Committee are Messrs. Ben Dor, Gamzu and Evnin.

The Governance
and Nominating Committee, created by the Board in February 2004, assists the
Board in identifying qualified individuals to become directors, determines the
composition of the Board and its committees, monitors the process to assess
Board effectiveness and helps develop and implement the Companys corporate
governance guidelines. Members of the Governance and Nominating Committee are
Messrs. Miller, Ben Dor, and Evnin.

The Audit
Committee is primarily responsible for overseeing the services performed by the
Companys independent registered public accounting firm and evaluating the
Companys accounting policies and its system of internal controls. Consistent
with the Nasdaq audit committee structure and membership requirements, the
Audit Committee is comprised of three members: Messrs. Schlachet, Miller and
Ben Dor, all of whom are independent directors. While more than one member of
the Companys Audit Committee qualifies as an audit committee financial
expert under Item 407(d)(5) of Regulation S-K, Mr. David Schlachet, the
Committee chairperson, is the designated audit committee financial expert. Mr.
Schlachet is considered independent under applicable Nasdaq rules.

The Clinical
Development and Science Committee was formed in June, 2005 and assists the
Board of Directors by reviewing and evaluating the Companys clinical programs
and research and development efforts. Members of the Clinical Development and
Science Committee are Messrs. Gamzu, Akkaraju, and Sartani.

The Audit
Committee, Compensation Committee, Governance and Nominating Committee, and
Clinical Development and Science Committee each operate under written charters
adopted by the Board. These charters are available on the Companys website at
www.pharmoscorp.com. Click Investors, and then Corporate Governance.

51

Code of Ethics

As part of our
system of corporate governance, our Board of Directors has adopted a Code of
Ethics and Business Conduct that is applicable to all employees and
specifically applicable to our chief executive officer, president, chief
financial officer and controllers. The Code of Ethics and Business Conduct is
available on the Companys website at www.pharmoscorp.com. Click Investors,
and then Corporate Governance. We intend to disclose any changes in or
waivers from our Code of Ethics and Business Conduct by filing a Form 8-K or by
posting such information on our website.

Section 16(a) Beneficial Ownership Reporting
Compliance

No person who,
during the fiscal year ended December 31, 2006, was a Reporting Person
defined as a director, officer or beneficial owner of more than ten percent of
the Companys Common Stock which is the only class of securities of the Company
registered under Section 12 of the Securities Exchange Act of 1934 (the Act),
failed to file on a timely basis, reports required by Section 16 of the Act
during the most recent fiscal year. The foregoing is based solely upon a review
by the Company of Forms 3 and 4 during the most recent fiscal year as furnished
to the Company under Rule 16a-3(d) under the Act, and Forms 5 and amendments
thereto furnished to the Company with respect to its most recent fiscal year,
and any representation received by the Company from any reporting person that
no Form 5 is required.

52

Item 11. Executive Compensation

COMPENSATION DISCUSSION AND
ANALYSIS

General Executive Compensation Policy

The
Compensation and Stock Option Committee of the Board of Directors establishes
the general compensation policies of the Company, the compensation plans and
specific compensation levels for executive officers, and administers the
Companys 2001 Employee Stock Purchase Plan, as well as the 2000, 1997 and 1992
Incentive and Non-Qualified Stock Option Plans. The Compensation and Stock
Option Committee is composed of three independent, non-employee Directors who
have no interlocking relationships as defined by the Securities and Exchange
Commission.

The
Compensation and Stock Option Committee, being responsible for overseeing and
approving executive compensation and grants of stock options, is in a position
to appropriately balance the current cash compensation considerations with the
longer-range incentive-oriented growth outlook associated with stock options.
The main objectives of the Companys compensation structure include rewarding
individuals for their respective contributions to the Companys performance,
establishing executive officers with a stake in the long-term success of the
Company and providing compensation policies that will attract and retain
qualified executive personnel.

The Compensation
and Stock Option Committee uses no set formulas and may accord different weight
to different factors for each executive. The Committee looks toward the
progress of the Companys research and development programs and its clinical
programs, its ability to gain support for those programs, either internally or
externally, its ability to attract, motivate and retain talented employees and
its ability to secure capital sufficient for its product development to achieve
rapid and effective commercialization as may be practicable.

The
Compensation and Stock Option Committee believes that the chief executive
officers compensation should be heavily influenced by Company performance.
Although Dr. Avivs existing agreement with the Company (see Employment
Contracts) provides for a base level of compensation, the Committee determines
the appropriate level of bonuses and increases, if any, based in large part on
Company performance. The Committee also considers the salaries of CEOs of
comparably-sized companies and their performance. Stock options are granted to
the CEO, as to other executives, primarily based on the executives ability to
influence the Companys long-term growth.

The
Compensation and Stock Option Committee has adopted similar policies with
respect to compensation of other officers of the Company. The Committee
establishes base salaries that are within the range of salaries for persons
holding positions of similar responsibility at other companies. In addition,
the Committee considers factors such as relative Company performance, the
executives past performance and future potential in establishing the base
salaries of executive officers.

As with the
CEO, the number of options granted to the other officers is determined by the
subjective evaluation of the executives ability to influence the Companys
long-term growth. All options are granted at no less than the current market
price. Since the value of an option bears a direct relationship to the
Companys stock price, it is an effective incentive for managers to create
value for shareholders. The Committee therefore views stock options as an
important component of its long-term, performance-based compensation
philosophy.

Executive Officers Compensation
Paid in 2006

Cash Compensation.During 2005, the Company
redirected its
efforts to drug discovery activities, to the development of early stage drug
candidates and to business development activities involving potential strategic
alliances, product acquisitions and mergers and acquisitions. As a result, the
Company significantly reduced its operating expenses in 2005. Consistent with
this retrenchment and refocusing of efforts, and following the unfavorable
clinical trial results in December 2004 for dexanabinol which was tested as an
agent to treat severe traumatic brain injury, the Compensation and Stock Option
Committee determined in January 2006 not to award

53

any cash bonus to the
Companys Chief Executive Officer, Dr. Haim Aviv, for 2005 performance.
However, the Committee increased his annual base compensation, effective
January 1, 2006, from $308,497 for 2005 to $322,396 for 2006.

Under the terms of his
employment contract, Alan Rubino, the Companys President and Chief Operating
Officer, received a cash bonus of $12,500 in January 2006 for his performance
in 2005, and base compensation for 2006 of $315,000.

James Meer, the Companys
former Chief Financial Officer, received a cash bonus of $20,000 in January
2006 for his performance in 2005. The Committee also raised Mr. Meers annual
base rate of compensation by 3%, effective January 1, 2006, from $235,000 for
2005 to $242,050 for 2006. Mr. Meers employment contract was not renewed upon
its expiration in July 2006, and Mr. Meer continued to serve as Chief Financial
Officer until his successor was hired in October 2006. His salary paid from
January 1, 2006 through the date of his departure was $205,587. Pursuant to the
terms of his employment contract, Mr. Meer received severance-related payments
upon his departure totaling $254,291.

The Company did not renew
the employment agreement of Dr. Gad Riesenfeld, the former President and Chief
Operating Officer, when it expired in April 2006. Under the terms of his
employment agreement, this nonrenewal required several payments from the
Company including salary, benefits and the vesting of certain stock options and
restricted stock. These payments included salary through April 2006 of $62,266,
one years additional salary of $249,063, plus payments for benefits of
$60,756. The total cost of severance for Dr. Riesenfeld was approximately
$645,000.

Upon the completion of the
acquisition by the Company of Vela Pharmaceuticals in October 2006, the
Companys Board of Directors awarded special cash bonuses to Dr. Aviv of
$120,000, to Mr. Rubino of $60,000, and to Mr. Meer of $15,000, in recognition
of their performance during the negotiation and consummation of the
transaction, including the proxy fight and related settlement.

Pursuant to the terms of his
October 2006 employment agreement, S. Colin Neill, the Companys new Chief
Financial Officer, was paid $62,938 in salary from his hire date through
December 31, 2006. Mr. Neill also received a sign-on bonus of $20,000 in October 2006.

Stock Options.Seeking to base a significant
part of his
compensation on future performance, the Committee in January 2006 also awarded
Dr. Aviv 325,000 stock options under the Companys 2000 Stock Plan, with 25%
vesting on the first anniversary of the date of grant and the remainder vesting
in twelve equal quarterly installments over the next three years, and
exercisable at the fair market value of the Companys Common Stock as of the
date of grant. This amount awarded was greater than the number of stock options
awarded to him in 2005 and 2004 (190,000 options for each year, as calculated
at the time of the awards, currently equal to 38,000 options for each year
following the May 2005 one-for-five reverse share split). The size of the award
for Dr. Aviv was equal to the initial stock option grant awarded in November
2005 to the Companys then-new President and Chief Operating Officer, Mr.
Rubino. The Committee concluded that Dr. Avivs stock option incentive award,
designed to reward the Companys Chief Executive Officer in the event of
successful execution of the Companys revised strategy, should be no less than
the award to its President and Chief Operating Officer.

The Committee also awarded
25,000 stock options to James Meer in January 2006 under the Companys 2000
Stock Plan. Mr. Meers options originally had vesting terms identical to those
of Dr. Avivs. Under the terms of his employment agreement, all of Mr. Meers
options vested upon the termination of his employment in October 2006.

Upon joining the Company as
Chief Financial Officer in October 2006, Mr. Neill was awarded 90,000 stock
options under the Companys 2000 Stock Plan, exercisable at the fair market
value of the Companys Common Stock as of the date of grant, with 30,000 of
such options being immediately vested, and the remainder to vest in twelve
equal quarterly installments over a three-year period beginning on October 5,
2007.

54

Bonuses for 2006 and Compensation
Determinations for 2007

Cash Compensation.In January, 2007, the
Compensation and Stock
Option Committee decided, based on his performance in 2006, to award Dr. Aviv a
cash bonus of $50,000. For 2006, pursuant to the terms of their respective
employment agreements, in January 2007 Mr. Rubino received a cash bonus of
$100,000, and Mr. Neill received a cash bonus of $18,750. The Compensation and
Stock Option Committee also decided, based on their performance in 2006, to increase
each of the base salaries for Dr. Aviv and Mr. Rubino by three percent for
2007. Dr. Avivs base salary for 2007 will be $333,640, and Mr. Rubinos will
be $324,450. Pursuant to the terms of his employment agreement, Mr. Neills
base salary is $265,000.

Stock Options. Seeking to base a significant
part of their
respective compensation on future performance, the Committee in January 2007
also awarded Dr. Aviv 60,000 stock options, Mr. Rubino 50,000 stock options and
Mr. Neill 40,000 stock options, all under the Companys 2000 Stock Plan, with
25% vesting on the first anniversary of the date of grant and the remainder
vesting in twelve equal quarterly installments over the next three years, and
exercisable at the fair market value of the Companys Common Stock as of the
date of grant.

March 2007 Chief Executive Officer
Transition

On February 26, 2007, the
Company announced that Elkan Gamzu, Ph.D., has been appointed by the Board of
Directors to become Chief Executive Officer, effective March 31, 2007. Dr. Aviv
will retire as Chief Executive Officer and Chief Scientist on that date, but
will remain as Chairman of the Board. As part of a brief transition period, Dr.
Gamzus employment commenced immediately at a base salary of $300,000 per annum
and a potential annual bonus of up to 25% of base salary, to be determined
annually by the Board based upon the attainment of business, transactional,
clinical and stock performance milestones and the recommendation of the
Compensation and Stock Option Committee. On February 26, 2007, Dr. Gamzu was
granted options to purchase 150,000 shares of Pharmos Common Stock at an
exercise price of $1.55 per share (the fair market value of the Companys
Common Stock as of the date of grant), and will be granted options at the conclusion
of the transition period to purchase an additional 200,000 shares at an
exercise price to be determined. One-fourth of the options will become
exercisable on the first anniversary of the date of grant; the remaining
options will become exercisable thereafter in twelve equal quarterly
increments.

COMPENSATION
AND STOCK OPTION COMMITTEE REPORT

The Compensation and Stock
Option Committee of Pharmos Corporation has reviewed and discussed the
Compensation Discussion and Analysis required by Item 402(b) of Regulation S-K
with management and, based on such review and discussions, the Compensation and
Stock Option Committee has recommended to the Board that the Compensation
Discussion and Analysis be included in this Annual Report on Form 10-K.

THE COMPENSATION ANDSTOCK OPTION COMMITTEEMony
  Ben DorAnthony
  B. EvninElkan R.
  Gamzu55

SUMMARY COMPENSATION TABLE

The following
table summarizes the total compensation of the Chief Executive Officer of the
Company in 2006 and the two previous years, as well as all other executive
officers of the Company who received compensation in excess of $100,000 for
2006.

Name/Principal
  Position

Year

Salary

Bonus

Restricted
  Stock
  Awards


Option
  Awards

All
  Other
  Compensation


Total
  CompensationHaim Aviv, Ph.D. Chairman,


2006

$
322,396
(1)
$
170,000





$
78,379

$
34,692
(3)

$
605,467Chief Executive Officer, and


2005

$
308,497











$
37,412
(3)

$
345,909Chief Scientist


2004

$
298,284




$
1,200,000
(4)




$
333,244
(5)

$
1,831,528Alan L. Rubino


2006

$
315,000

$
160,000





$
136,800

$
24,454
(2)

$
636,254President & Chief Operating


2005

$
41,761
(6)
$
52,500








$
1,277
(2)

$
95,538Officer


2004S. Colin Neill


2006

$
62,938
(18)
$
38,750





$
40,199

$
2,800
(17)

$
144,687Senior Vice President,


2005Chief Financial Officer,


2004Secretary & TreasurerGad Riesenfeld, Ph.D.


2006

$
472,085
(13)







$
92,875

$
143,213
(14)

$
708,173Former President & Chief


2005

$
249,063
(7)










$
91,726
(8)

$
340,789Operating Officer


2004

$
249,063




$
800,000
(9)




$
284,557
(10)

$
1,333,620James A. Meer


2006

$
459,878
(15)
$
15,000





$
112,400

$
36,210
(16)

$
623,488Former Senior Vice


2005

$
235,000

$
20,000








$
13,300
(2)

$
268,300President, Financial Officer,


2004

$
110,320
(11)
$
50,000








$
5,890
(2)

$
166,210Secretary, TreasurerRobert W. Cook, Former


2006Executive Vice President,


2005Chief Financial Officer


2004

$
99,244
(12)
$
5,250








$
1,942
(2)

$
106,43656

(1)
Consists of
  compensation paid in the US and Israel.(2)
Consists of
  contributions to insurance premiums and/or car allowance and 401k employer
  contribution for 2006.(3)
In 2006,
  consists of deferred payment obligations of the Company equal to the cost of
  premiums that would otherwise have been payable to maintain a split dollar
  life insurance policy for $18,537, $10,782 in insurance premiums and/or car
  allowance and $5,373 in retirement benefits. In 2005, consists of deferred
  payment obligations of the Company equal to the cost of premiums that would
  otherwise have been payable to maintain a split dollar life insurance policy
  for $17,125 and $20,287 in insurance premiums and/or car allowance.(4)
Represents
  the value at the time of grant of 379,747 restricted stock units (which were
  converted to 75,950 restricted stock units as a result of the 1:5 stock split
  that was effective May 31, 2005) awarded to Dr. Aviv pursuant to a Retention
  Award Agreement dated September 6, 2004. Using the closing price of a share
  of Pharmos common stock on December 31, 2005, the aggregate value of Dr.
  Avivs restricted stock units would be approximately $152,660. Under the
  agreement, one-half of the restricted stock units vested and became
  non-forfeitable on December 31, 2005, and the balance are scheduled to vest
  and become non-forfeitable on June 30, 2007, subject to certain accelerated
  vesting provisions. The shares of common stock underlying the restricted
  stock units have the same dividend rights as our unrestricted common stock.(5)
Consists of
  (i) $300,000 awarded to Dr. Aviv pursuant to a Retention Award Agreement
  dated September 6, 2004 (one-half of the cash award vested and became
  non-forfeitable on December 31, 2005, and the balance is scheduled to vest
  and become non-forfeitable on June 30, 2007, subject to certain accelerated
  vesting provisions) and (ii) $15,821 in deferred payment obligations of the
  Company equal to the cost of premiums that would otherwise have been payable
  to maintain a split dollar life insurance policy and $17,423 in insurance
  premiums and/or car allowance.(6)
Mr. Rubino
  joined Pharmos Corporation in November 2005.(7)
Dr.
  Riesenfeld served as President and Chief Operating Officer through November
  2005.(8)
Consists of
  housing allowance, contributions to insurance premiums, car allowance and car
  expense of $75,294 and deferred payment obligations of the Company equal to
  the cost of premiums that would otherwise have been payable to maintain a
  split dollar life insurance policy for $16,432.(9)
Represents
  the value at the time of grant of 253,165 shares of restricted stock (which
  were converted to 50,633 shares of restricted stock as a result of the 1:5
  stock split that was effective May 31, 2005) awarded to Dr. Riesenfeld
  pursuant to a Retention Award Agreement dated September 6, 2004. Using the
  closing price of a share of Pharmos common stock on December 31, 2005, the
  aggregate value of Dr. Riesenfelds shares of restricted stock would be
  approximately $101,772. Under the agreement, one-half of the shares of
  restricted stock vested and became non-forfeitable on December 31, 2005.
  Under the terms of Dr. Riesenfelds severance agreement, the balance of his
  Awards will vest on his departure from the Company on April 2, 2006. The
  shares of common stock underlying the restricted stock units have the same
  dividend rights as our unrestricted common stock.(10)
Consists of
  (i) $200,000 awarded to Dr. Riesenfeld pursuant to a Retention Award
  Agreement dated September 6, 2004 (one-half of the cash award vested and
  became non-forfeitable on December 31, 2005, and the balance is scheduled to
  vest and become non-forfeitable on June 30,2007, subject to certain
  accelerated vesting provisions) and (ii) $15,181 in deferred payment
  obligations of the Company equal to the cost of premiums that would otherwise
  have been payable to maintain a split dollar life insurance policy. Under the
  terms of Dr. Riesenfelds severance agreement, the balance of his Awards will
  vest on his departure from the Company on April 2, 2006 and $69,376 for
  housing allowances, contributions to insurance premiums, car allowance and
  car expense.(11)
Mr. Meer
  joined Pharmos Corporation in July 2004.(12)
Mr. Cook
  resigned from Pharmos Corporation in March 2004.(13)
Consists of
  $62,266 in salary plus the following severance related payments: severance
  $249,063, retention grant $100,000, 401K match $6,600, life insurance $6,231,
  tax gross up on rent $13,561, Israeli health insurance $10,772, moving
  expenses $22,209 and other $1,383.(14)
Consists of
  payments for the cost of premiums for a split dollar life insurance policy
  for $136,613 and $6,600in 401k employer contribution.(15)
Consists of
  $205,587 in salary plus the following severance related payments: severance
  $242,050, benefits $1,868, 401K match $6,600 & interest $3,773.57

(16)
Consists of
  regular taxable auto plus a one time payout of $19,081 which includes an
  insurance policy of $8,500.(17)
Consists of
  $662 in 401k employer contribution and $2,138 in automobile allowance.(18)
Mr. Neill
  joined Pharmos Corporation in October 2006.GRANTS OF PLAN-BASED AWARDS IN 2006Name

Grant 
  Date

All other Option
  Awards: Number
  of Securities
  Underlying
  Options (#)

Exercise or Base Price of
  Option Awards ($/Sh)

Grant Date Fair
  Value of Stock
  and Option 
  Awards ($)Haim Aviv, PhD (1)

1/25/2006


325,000



$
2.15



$
542,720S. Colin Neill (2)

10/5/2006


90,000



$
1.75



$
120,600James A. Meer (3)

1/25/2006


25,000



$
2.15



$
41,750(1) 81,250 of
the options granted to Dr. Aviv vested on January 25, 2007; the remaining
243,750 are scheduled to vest in twelve equal quarterly increments beginning on
April 25, 2007.

(2) 30,000 of
the options granted to Mr. Neill were immediately exercisable; the remaining
60,000 options are scheduled to vest in twelve equal quarterly increments
beginning on October 5, 2007.

(3) Pursuant
to the terms of his employment agreement, all of the options granted to Mr.
Meer vested upon his departure from the Company in October 2006.

All option
grants in 2006 were made under the Companys 2000 Stock Option Plan. The
Company made no equity or non-equity incentive plan awards in 2006.

OPTION EXERCISES
  AND STOCK VESTED IN 2006Option Awards

Stock AwardsName

Number of
  Shares
  Acquired on 
  Exercise (#)

Value Realized
  on Exercise ($)

Number of
  Shares Acquired
  on Vesting (#)

Value 
  Realized on 
  Vesting($)Haim Aviv, PhD




$









$
Alan L. Rubino




$









$
S. Colin Neill




$









$
Gad Riesenfeld, PhD




$





25,317
(1)


$
141,177James A. Meer




$









$
(1) Dr.
Riesenfeld received an award of 50,633 shares of restricted stock in September
2004, 25,316 shares of which vested in December 2005. The remaining 25,317
shares vested upon his departure from the Company in April 2006.

58

OUTSTANDING
        EQUITY AWARDS AT 2006 FISCAL YEAR-ENDOption
        Awards
    
    Stock
        AwardsName
    
    Number
        of
        securities
        underlyiung 
        unexercised
        options (#) 
        Exercisable
    
    Number
        of
        securities
        underlyiung 
        unexercised
        options (#)
        Unexercisable
    
    Equity
        Incentive
        Plan 
        awards:
        Number of
        securities
        underlying
        unexercsied
        Unearned
        Options (#)
    
    Option
        Exercise
        Price ($)
    
    Option
        Expiration
        Date
    
    Number
        of Shares
        or Units
        of Stock
        That
        Have
        Not
        Vested
    
    Market
        Value of
        Shares or
        Units of
        Stock
        That
        have not
        vested ($)Haim
      Aviv, PhD
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    37,975
    (1)
    $
    69,8740
    
    
    325,000
    (2)
    
    325,000
    
    $
    2.15
    
    
    1/24/201616,625
    
    
    21,375
    (3)
    
    38,000
    
    $
    3.85
    
    
    2/15/201538,000
    
    
    0
    
    
    38,000
    
    $
    21.20
    
    
    2/12/201435,156
    
    
    2,344
    (4)
    
    37,500
    
    $
    5.10
    
    
    2/18/201330,000
    
    
    0
    
    
    30,000
    
    $
    9.50
    
    
    3/5/201220,000
    
    
    0
    
    
    20,000
    
    $
    9.38
    
    
    4/2/201120,001
    
    
    0
    
    
    20,001
    
    $
    20.15
    
    
    6/6/201013,000
    
    
    0
    
    
    13,000
    
    $
    6.25
    
    
    4/16/200920,000
    
    
    0
    
    
    20,000
    
    $
    13.91
    
    
    5/18/200850,000
    
    
    0
    
    
    50,000
    
    $
    7.95
    
    
    2/12/2007242,782
    
    
    348,719
    
    
    591,501Alan
        Rubino
    
    
    0
    
    
    225,000
    (5)
    
    225,000
    
    $
    2.18
    
    
    11/14/2015100,000
    
    
    0
    
    
    100,000
    
    $
    2.18
    
    
    11/14/2015100,000
    
    
    225,000
    
    
    325,000S.
        Colin Neill
    
    
    30,000
    
    
    60,000
    (6)
    
    90,000
    
    $
    1.75
    
    
    10/5/2016Gad
        Riesenfeld, PhD
    
    
    27,000
    
    
    0
    
    
    27,000
    
    $
    3.85
    
    
    2/15/201527,000
    
    
    0
    
    
    27,000
    
    $
    21.20
    
    
    2/12/201414,062
    
    
    0
    
    
    14,062
    
    $
    5.10
    
    
    2/18/20137,500
    
    
    0
    
    
    7,500
    
    $
    9.50
    
    
    3/5/20122,500
    
    
    0
    
    
    2,500
    
    $
    9.38
    
    
    4/2/201112,000
    
    
    0
    
    
    12,000
    
    $
    20.15
    
    
    6/6/201016,000
    
    
    0
    
    
    16,000
    
    $
    13.91
    
    
    5/18/2008106,062
    
    
    0
    
    
    106,062James
        A. Meer
    
    
    25,000
    
    
    0
    
    
    25,000
    
    $
    2.15
    
    
    1/23/201623,000
    
    
    0
    
    
    23,000
    
    $
    3.85
    
    
    2/14/201530,000
    
    
    0
    
    
    30,000
    
    $
    17.50
    
    
    7/11/201478,000
    
    
    0
    
    
    78,000

(1)  Scheduled to vest on June 30, 2007.



(2)  81,250 of these options vested on January 25, 2007; the remaining options are scheduled to vest in twelve equal increments on a quarterly basis beginning on April 25, 2007.



(3)  2,375 of these options vested on February 15, 2007; the remaining options are scheduled to vest in eight equal increments on a quarterly basis beginning on May 15, 2007.



(4)  Vested on February 18, 2007.



(5)  18,750 of these options vested on February 14, 2007; the remaining options are scheduled to vest in eleven equal increments on a quarterly basis beginning on May 14, 2007.



(6)  Scheduled to vest in twelve equal increments on a quarterly basis beginning on October 5, 2007.


The
Company made no equity plan incentive awards in 2006.

59

Stock Option Plans

It is
currently the Companys policy that all full time key employees are considered
annually for the possible grant of stock options, depending upon employee
performance. The criteria for the awards are experience, uniqueness of contribution
to the Company and level of performance shown during the year. Stock options
are intended to generate greater loyalty to the Company and help make each
employee aware of the importance of the business success of the Company.

As of December
31, 2006, 708,301 options to purchase shares of the Companys Common Stock were
outstanding under various option plans. During 2006, the Company granted 881
options to purchase shares of its Common Stock to employees, directors and
consultants.

A summary of
the various established stock option plans is as follows:

1992 Plan.
The maximum number of shares of the Companys Common Stock available for
issuance under the 1992 Plan is 150,000 shares, subject to adjustment in the
event of stock splits, stock dividends, mergers, consolidations and the like.
Common Stock subject to options granted under the 1992 Plan that expire or
terminate would again be available for options to be issued under the 1992
Plan. As of December 31, 2006, there were no options outstanding to purchase
the Companys Common Stock under this plan. The Company does not plan to issue
any additional options from the 1992 Plan.

1997 Plan and 2000
Plan. The 1997 Plan and the 2000 Plan are each
administered by a committee appointed by the Board of Directors (the
Compensation Committee). The Compensation Committee will designate the
persons to receive options, the number of shares subject to the options and the
terms of the options, including the option price and the duration of each
option, subject to certain limitations. All stock options grants during 2006
were made from the 2000 Plan. The Company does not plan to issue any additional
options from the 1997 Plan.

The maximum
number of shares of Common Stock available for issuance under the 1997 Plan is
300,000 shares, as amended, and under the 2000 Plan, as amended, is 2,700,000
shares. Each plan is subject to adjustment in the event of stock splits, stock
dividends, mergers, consolidations and the like. Common Stock subject to
options granted under the 1997 Plan and the 2000 Plan that expire or terminate
will again be available for options to be issued under each Plan.

The price at
which shares of Common Stock may be purchased upon exercise of an incentive
stock option must be at least 100% of the fair market value of Common Stock on
the date the option is granted (or at least 110% of fair market value in the
case of a person holding more than 10% of the outstanding shares of Common
Stock (a 10% Stockholder).

The aggregate
fair market value (determined at the time the option is granted) of Common
Stock with respect to which incentive stock options are exercisable for the
first time in any calendar year by an optionee under the 1997 Plan, the 2000
Plan or any other plan of the Company or a subsidiary, shall not exceed
$100,000. The Compensation Committee will fix the time or times when, and the
extent to which, an option is exercisable, provided that no option for annual
option grants will be exercisable earlier than one year or later than ten years
after the date of grant (or five years in the case of a 10% Stockholder). The
option price is payable in cash or by check to the Company. However, the Board
of Directors may grant a loan to an employee, other than an executive officer,
pursuant to the loan provision of the 1997 Plan or the 2000 Plan, for the
purpose of exercising an option or may permit the option price to be paid in
shares of Common Stock at the then current fair market value, as defined in the
1997 Plan or the 2000 Plan.

Under the 1997
Plan, upon termination of an optionees employment or consultancy, all options
held by such optionee will terminate, except that any option that was
exercisable on the date employment or consultancy terminated may, to the extent
then exercisable, be exercised within three months thereafter (or one year
thereafter if the termination is the result of permanent and total disability
of the holder), and except such three month period may be extended by the
Compensation Committee in its discretion. If an optionee dies while he

60

is an employee
or a consultant or during such three-month period, the option may be exercised
within one year after death by the decedents estate or his legatees or
distributees, but only to the extent exercisable at the time of death. The 2000
Plan provides that the Compensation Committee may in its discretion determine
when any particular stock option shall expire. A stock option agreement may
provide for expiration prior to the end of its term in the event of the
termination of the optionees service to the Company or death or any other
circumstances.

The 1997 Plan
and the 2000 Plan each provides that outstanding options shall vest and become
immediately exercisable in the event of a sale of the Company, including (i)
the sale of more than 75% of the voting power of the Company in a single
transaction or a series of transactions, (ii) the sale of substantially all
assets of the Company, (iii) approval by the stockholders of a reorganization,
merger or consolidation, as a result of which the stockholders of the Company
will own less than 50% of the voting power of the reorganized, merged or
consolidated company.

The Board of
Directors may amend, suspend or discontinue the 1997 Plan, but it must obtain
stockholder approval to (i) increase the number of shares subject to the 1997
Plan, (ii) change the designation of the class of persons eligible to receive
options, (iii) decrease the price at which options may be granted, except that
the Board may, without stockholder approval accept the surrender of outstanding
options and authorize the granting of new options in substitution therefore
specifying a lower exercise price that is not less than the fair market value
of Common Stock on the date the new option is granted, (iv) remove the
administration of the 1997 Plan from the Compensation Committee, (v) render any
member of the Compensation Committee eligible to receive an option under the
1997 Plan while serving thereon, or (vi) amend the 1997 Plan in such a manner
that options issued under it intend to be incentive stock options, fail to meet
the requirements of Incentive Stock Options as defined in Section 422 of the
Code.

The Board of
Directors may amend, suspend or discontinue the 2000 Plan, but it must obtain
stockholder approval to (i) increase the number of shares subject to the 2000
Plan or (ii) change the designation of the class of persons eligible to receive
options.

Under current
federal income tax law, the grant of incentive stock options under the 1997
Plan or the 2000 Plan will not result in any taxable income to the optionee or
any deduction for the Company at the time the options are granted. The optionee
recognizes no gain upon the exercise of an option. However the amount by which
the fair market value of Common Stock at the time the option is exercised
exceeds the option price is an item of tax preference of the optionee, which
may cause the optionee to be subject to the alternative minimum tax. If the
optionee holds the shares of Common Stock received on exercise of the option at
least one year from the date of exercise and two years from the date of grant,
he will be taxed at the time of sale at long-term capital gains rates, if any,
on the amount by which the proceeds of the sale exceed the option price. If the
optionee disposes of the Common Stock before the required holding period is
satisfied, ordinary income will generally be recognized in an amount equal to
the excess of the fair market value of the shares of Common Stock at the date
of exercise over the option price, or, if the disposition is a taxable sale or
exchange, the amount of gain realized on such sale or exchange if that is less.
If, as permitted by the 1997 Plan or the 2000 Plan, the Board of Directors
permits an optionee to exercise an option by delivering already owned shares of
Common Stock valued at fair market value) the optionee will not recognize gain
as a result of the payment of the option price with such already owned shares.
However, if such shares were acquired pursuant to the previous exercise of an
option, and were held less than one year after acquisition or less than two
years from the date of grant, the exchange will constitute a disqualifying
disposition resulting in immediate taxation of the gain on the already owned
shares as ordinary income. It is not clear how the gain will be computed on the
disposition of shares acquired by payment with already owned shares.

2001 Employee Stock
Purchase Plan. The 2001 Plan is intended to
qualify as an employee stock purchase plan under Section 423 of the Code. All employees
of the Company, its Pharmos Ltd. subsidiary or any other subsidiaries or
affiliated entities who have completed 180 consecutive days of employment and
who customarily work at least 20 hours per week will be eligible to participate
in the 2001 Plan, except for any employee who owns five percent or more of the
total combined voting power or value of all classes of stock of the Company or
any subsidiary on the date a grant of a right to purchase shares under the 2001
Plan (Right) is

61

made. There
currently are no such employees with such large holdings. Participation by
officers in the 2001 Plan will be on the same basis as that of any other
employee. No employee will be granted a Right which permits such employee to
purchase shares under the 2001 Plan at a rate which exceeds $25,000 of fair
market value of such shares (determined at the time such Right is granted) for
each calendar year in which such Right is outstanding. Each Right will expire
if not exercised by the date specified in the grant, which date will not exceed
27 months from the date of the grant. Rights will not be assignable or
transferable by a participating employee, other than in accordance with certain
qualified domestic relations orders, as defined in the Code, or by will or the
laws of descent and distribution.

The total
number of shares reserved for issuance under the 2001 Plan is 100,000 shares.
Under the 2001 Plan, for any given calendar year, a participating employee can
only be granted Rights to purchase that number of shares which, when multiplied
by the exercise price of the Rights, does not exceed more than 10% of the
employees base pay. To date, the Company has issued 12,560 shares of its
common stock under the 2001 Plan. The Company did not issue any shares under
the 2001 Plan in 2006.

From time to
time, the Board of Directors may fix a date or a series of dates on which the
Company will grant Rights to purchase shares of Common Stock under the 2001
Plan at prices not less than 85% of the lesser of (i) the fair market value of
the shares on the date of grant of such Right or (ii) the fair market value of
the shares on the date such Right is exercised.

The 2001 Plan
also provides that any shares of Common Stock purchased upon the exercise of
Rights cannot be sold for at least six months following exercise, to avoid
potential violations of the short swing trading provisions of Section 16 of
the Securities Exchange Act of 1934, as amended.

The Board of
Directors or a committee to which it delegates its authority under the 2001
Plan will administer, interpret and apply all provisions of the 2001 Plan. The
Board has delegated such authority to the Compensation and Stock Option
Committee.

The Board of
Directors may amend, modify or terminate the 2001 Plan at any time without notice,
provided that no such amendment, modification or termination may adversely
affect any existing Rights of any participating employee, except that in the
case of a participating employee of a foreign subsidiary of the Company, the
2001 Plan may be varied to conform with local laws. In addition, subject to
certain appropriate adjustments to give effect to relevant changes in the
Companys capital stock, no amendments to the 2001 Plan may be made without
stockholder approval if such amendment would increase the total number of
shares offered under the 2001 Plan or would render Rights unqualified for
special tax treatment under the Code.

No taxable
income will be recognized by a participant either at the time a Right is
granted under the 2001 Plan or at the time the shares are purchased. Instead,
tax consequences are generally deferred until a participant disposes of the
shares (e.g., by sale or gift). The federal income tax consequences of a sale
of shares purchased under the 2001 Plan will depend on the length of time the
shares are held after the relevant date of grant and date of exercise, as
described below.

If shares
purchased under the 2001 Plan are held for more than one year after the date of
purchase and more than two years from the date of grant, the participant
generally will have taxable ordinary income on a sale or gift of the shares to
the extent of the lesser of: (i) the amount (if any) by which the fair market
value of the stock at the date of grant exceeds the exercise price paid by the
participant; or (ii) the amount by which the fair market value of the shares on
the date of sale or gift exceeds the exercise price paid by the participant for
the shares. In the case of a sale, any additional gain will be treated as
long-term capital gain. If the shares are sold for less than the purchase
price, there will be no ordinary income, and the participant will have a
long-term capital loss for the difference between the purchase price and the
sale price.

If the stock
is sold or gifted within either one year after the date of purchase or two
years after the date of grant (a disqualifying disposition), the participant
generally will have taxable ordinary income at the time of the sale or gift to
the extent that the fair market value of the stock at the date of exercise was
greater than the exercise price. This amount will be taxable in the year of
sale or disposition even if no gain is realized on the

62

sale, and the
Company would be entitled to a corresponding deduction. A capital gain would be
realized upon the sale of the shares to the extent the sale proceeds exceed the
fair market value of those shares on the date of purchase. A capital loss would
be realized to the extent the sales price of the shares disposed of is less
than the fair market value of such shares on the date of purchase. Special tax
consequences may follow from dispositions other than a sale or gift.

1997 Employees and Directors Warrants Plan

The 1997
Employees and Directors Warrants Plan was approved by the Stock Option Committee
as of February 12, 1997 and March 19, 1997. 206,000 Warrants to purchase
206,000 shares of Common Stock were granted to certain employees of the
Company. Of such warrants, 191,000 were granted at an exercise price of $7.95
per share and 15,000 were granted and an exercise price of $8.30 per share
(together, the 1997 Employees Warrants). The 1997 Employees Warrants become
exercisable in increments of 25% each on their first, second, third and fourth
anniversaries, respectively, and shall expire in the year 2007. 20,000 Warrants
to purchase 20,000 shares of Common Stock were granted to directors of the
Company at an exercise price of $7.95 per share (the 1997 Directors Warrants)
on February 12, 1997. The 1997 Directors Warrants become exercisable in increments
of 25% each on the first, second, third and fourth anniversaries of February
12, 1997 and shall expire on February 12, 2007. At December 31, 2006, there
were 63,000 1997 Employees Warrants at $7.95, no 1997 Employees Warrants at
$8.30 and 500 1997 Directors Warrants at $7.95 outstanding.

Upon
termination of a Warrant Holders employment, consultancy or affiliation with
the Company, all Warrants held by such Warrant Holder will terminate, except
that any Warrant that was exercisable on the date which the employment,
consultancy or affiliation terminated may, to the extent then exercisable, be
exercised within three months thereafter (or one year thereafter if the
termination is the result of permanent and total disability of the holder). If
a Warrant Holder dies while he or she is an employee, consultant or affiliate
of the Company, or during such three month period, the Warrant may be exercised
within one year after death by the decedents estate or his legatees or
distributees, but only to the extent exercisable at the time of death.

63

Employment Contracts

Haim Aviv, Ph.D. In
April 2001, the Compensation and Stock Option Committee of the Board of
Directors recommended, and the Board approved, a one-year employment/consulting
agreement for Dr. Aviv, as Chairman of the Board and Chief Executive Officer of
the Company. Dr. Aviv has agreed to devote a majority of his business time to
the Company and to Pharmos Ltd. The agreement provides for automatic one year
renewals unless either the Company terminates the agreement at least 180 days
prior to the scheduled expiration date during the initial one year term (and 90
days for subsequent terms) or Dr. Aviv terminates the agreement at least 60
days in advance of termination. Dr. Avivs base compensation for 2005 was
$308,497 and for 2006 was $322,396, and is allocated between the Company and is
paid in US dollars and Pharmos Ltd which is paid in shekels and may result in
exchange rate differences. The Company also agreed to make available for Dr.
Avivs benefit following his death, termination of employment for disability or
retirement at the age of at least 62 an amount equal to the cost of insurance
premiums the Company would otherwise have incurred to obtain and maintain a
split-dollar life insurance policy on his life (approximately $10,000 per
year, accruing interest at 8% per year). In addition, the Company agreed to
pay, in lieu of contributing to other benefits plans on his behalf, an amount
equal to an aggregate of approximately 21% of his base compensation toward the
Management Insurance Scheme managed by the government of Israel for members
of management of Israeli companies.

Dr. Avivs
employment agreement also provides that if his employment is terminated within
one year following a change of control, he will receive severance pay of 18
months of base salary for the then-current year, accelerated vesting of all
unvested stock options and extended exercisability of all stock options until
their respective expiration dates. A change of control involves an
acquisition of at least 50% of the voting power of the Companys securities, a
change in at least 51% of the composition of the current Board of Directors, or
approval by the Board of Directors or stockholders of the Company of a
transaction where such change of voting control or composition of the Board
would occur, where the Company would be liquidated or where all or
substantially all of its assets would be sold.

If Dr. Avivs
employment is terminated by the Company, after notice, other than for a change
in control, death, disability or for cause, as defined in his employment
agreement, or if he terminates his employment within one year of a change in
control or otherwise for good reason, as defined in his employment agreement,
he will receive severance pay of 12 months of base salary for the then-current
year, accelerated vesting of all unvested stock options and extended
exercisability of all stock options until their respective expiration dates.

The Board of Directors of
the Company also agreed at its January 25, 2006 meeting, based upon the
recommendation of the Compensation Committee, to clarify the Employment
Agreement of the Companys Chairman and CEO, Dr. Haim Aviv, dated as of April
2, 2001, to confirm that the calculation of any severance payments to be
received by him upon a termination of employment in certain circumstances shall
be based on the aggregate annual compensation he had been receiving at the time
of termination, both in the form of base salary as an employee of the Companys
Pharmos Ltd. subsidiary and in the form of an annual consulting fee paid
directly by the Company to an entity owned by Dr. Aviv.

The employment
agreement also contains customary confidentiality and non-competition
undertakings by Dr. Aviv.

64

Gad Riesenfeld, Ph.D.
In April 2001, the Compensation and Stock Option Committee of the Board of
Directors recommended, and the Board approved, a one-year employment agreement
for Dr. Riesenfeld, as full-time President and Chief Operating Officer of the
Company. Dr. Riesenfelds base compensation for 2005 was $249,063. The Company
did not renew Dr. Riesenfelds employment agreement when it expired in April
2006. Under the terms of his employment agreement, this nonrenewal required
several payments from the Company including salary, benefits and the vesting of
certain stock options and restricted stock. These payments included salary
through April 2006 of $62,266, one years additional salary of $249,063, plus
payments for benefits of $60,756. In addition, his restricted stock and other
stock options vested. The total cost of severance for Dr. Riesenfeld was
approximately $645,000.

On September
6, 2004, the Board of Directors approved, and Pharmos entered into, Retention
Award Agreements with each of Drs. Aviv and Riesenfeld. The Company granted
retention awards of $300,000 cash and 75,950 restricted stock units to Dr. Aviv
and $200,000 cash and 50,633 shares of restricted stock to Dr. Riesenfeld (the
Awards). Under the agreements, one-half of the Awards vested on December 31,
2005 and the balance were scheduled to vest and become non-forfeitable on June
30, 2007, subject to certain accelerated vesting provisions. Under the terms of
Dr. Riesenfelds severance agreement, the balance of his Awards vested on his departure
from the Company on April 2, 2006 and the expense of those awards was
accelerated through April 2, 2006. The fair value of the restricted shares was
based on the fair value of the stock on the issuance date. The fair value of
the restricted stock awards was based on the fair value of the underlying stock
on the issuance date. The aggregate fair value of the restricted stock awards
totaled $2 million.

Alan L. Rubino.In
November 2005, the Compensation and Stock Option Committees of the Board of
Directors recommended, and the Board approved, a three-year employment
agreement for Mr. Rubino as full time President and Chief Operating Officer of
the Company. Mr. Rubinos base compensation for 2005, effective November 14,
was $315,000 and was $315,000 for 2006. Mr. Rubino received a sign-on bonus of
$40,000 in November 2005. Mr. Rubino received a performance bonus for 2005 (pro
rated) of $12,500 and received a performance bonus for fiscal year 2006 of
$160,000 (including a special bonus of $60,000 in recognition of his
performance during the negotiation and consummation of the Vela acquisition,
including the proxy fight and related settlement). In subsequent years, the
bonus is to range from minimum of 25% of base salary to target of 50% of base
salary, with no maximum limit, based on milestones and determined by the CEO
and Compensation Committee. The other provisions of Mr. Rubinos employment
agreement relating to benefits, severance arrangements, automatic renewal and
confidentiality and non-competition obligations are substantially similar to
the those included in Dr. Avivs employment agreement, as described above,
except that Mr. Rubino does not participate in the Management Insurance
Scheme of Pharmos Ltd. Mr. Neill received a sign-on bonus of $20,000 in October 2006, and a performance bonus for 2006 (pro rated) of $18,750 in January 2007.

S. Colin Neill. In
October 2006, the Compensation and Stock Option Committees of the Board of
Directors recommended, and the Board approved, a one year employment agreement
for Mr. Neill as full time Senior Vice President, Chief Financial Officer,
Secretary and Treasurer of the Company. Mr. Neills initial base compensation
is $265,000. The other provisions of Mr. Neills employment agreement relating
to benefits, severance arrangements, automatic renewal and confidentiality and
non-competition obligations are substantially similar to the those included in
Dr. Avivs employment agreement, as described above, except that Mr. Neill does
not participate in the Management Insurance Scheme of Pharmos Ltd. Mr. Neill received a sign-on bonus of $20,000 in October 2006, and a
      performance bonus for 2006 (pro rated) of $18,750 in January
      2007.

James A. Meer. In
July 2004, the Compensation and Stock Option Committees of the Board of Directors
recommended, and the Board approved, a one year employment agreement for Mr.
Meer as full time Vice President, Chief Financial Officer, Secretary and
Treasurer of the Company. In January 2005, Mr. Meer was promoted to Senior Vice
President, Chief Financial Officer, Secretary and Treasurer. Mr. Meers base
compensation for 2005 was $235,000. Mr. Meer left the Company in October 2006.
His salary paid from January 1, 2006 through the date of his departure was
$205,587. Pursuant to the terms of his employment contract, Mr. Meer received
severance-related payments upon his departure totaling $254,291.

Compensation of
Directors

On January 25,
2006, the Board of Directors of Pharmos and its Compensation and Stock Option
Committee approved a change in the compensation arrangements for its
independent directors. In lieu of paying fees for each meeting attended, the
Board authorized the payment of an annual fee of $30,000 for service on the
Board.

65

Also, in
consideration of the additional work they perform for the Company, the Board
authorized payment of additional compensation in the amount of $5,000 to each
of the Chairmen of the Boards Audit Committee, Compensation Committee,
Governance and Nominating and Committee and Clinical Development and Scientific
Committee, and $15,000 to the Lead Director (the Lead Director does not receive
any additional fees for also serving as committee chair). Payment of such fees
to any director is subject to attendance by such director at a minimum of least
70% of the combined number of meetings of the full Board and any Committees on
which such director sits. Any director attending fewer than 70% of the meetings
in a given year will have his or her aggregate annual fees reduced on a
percentage basis by the same percentage of that years meetings not attended by
such director (e.g., a director who did not attend 45% of the meetings in a
given year would have his or her aggregate fees reduced by 45% for such year).

Also, on
January 25, 2006, the Board approved the annual grant to each of the
non-employee directors of 20,000 ten-year stock options, with 25% vesting on
the first anniversary of the date of grant and the remainder vesting in twelve
equal quarterly installments over the next three years, and exercisable at the
fair market value of the Companys Common Stock as of the date of grant.

On October 18,
2006, the Board of Directors approved payment of a fee of $50,000 to Mony Ben
Dor for his service as chair of the Boards Proxy Contest Steering Committee.

No fees or
stock option awards were paid in 2006 to the four directors (Akkaraju, Evnin,
Miller and Newhall) who joined the Board upon completion of the Companys
acquisition of Vela Pharmaceuticals on October 25, 2006.

66

DIRECTOR COMPENSATION
FOR 2006

The table
below summarizes the compensation paid by the Company to non-employee Directors
for the fiscal year ended December 31, 2006:

Name


Fees
  Earned
  or Paid in Cash ($)

Option
  Awards ($)(1)

Total ($)Srinivas
  Akkaraju, M.D., Ph.D. (2)


0


0


0Mony Ben Dor


95,000
(4)

9,247


104,247Anthony B.
  Evnin, Ph.D. (2)


0


0


0Elkan R.
  Gamzu, Ph.D.


35,000
(5)

9,564


44,564Georges
  Anthony Marcel, M.D., Ph.D. (3)


30,000


43,218


73,218Lawrence F.
  Marshall, M. D. (3)


30,000


45,791


75,791Lloyd I.
  Miller, III (2)


0


0


0Charles W.
  Newhall, III (2)


0


0


0Abraham
  Sartani, M.D.


30,000


7,125


37,125David
  Schlachet


35,000
(6)

9,247


44,247(1)
Reflects the
  dollar amount recognized for financial statement reporting purposes for the
  fiscal year ended December 31, 2006 in accordance with FAS 123(R), and thus
  includes amounts from awards granted in and prior to 2006. All options
  awarded to Directors in 2006 remained outstanding at fiscal year-end.(2)
Became a
  Director on October 25, 2006.(3)
Resigned as
  Director on October 17, 2006.(4)
Includes
  $15,000 fee as Lead Director and $50,000 fee as chair of the Proxy Contest
  Steering Committee.(5)
Includes
  $5,000 fee as chair of the Clinical Development and Scientific Committee.(6)
Includes
  $5,000 fee as chair of the Audit Committee.Director Resignations
in 2006

On October 17,
2006, Dr. Georges Anthony Marcel and Dr. Lawrence F. Marshall each resigned
from the Companys Board in order to enable three former directors of Vela
Pharmaceuticals to join the Companys Board following the closing of the
Companys then-pending acquisition of Vela. Dr. Marcel and Dr. Marshall each
agreed to serve as a consultant to the Boards Clinical Development and
Scientific Committee and the Companys senior management, for the period from
November 1, 2006 through May 1, 2008, on matters relating to drug discovery,
pre-clinical and clinical development and general business development in their
areas of scientific and medical expertise. In consideration for such consulting
services, the Company agreed to pay each of these former directors a fee of
$45,000, payable in three equal installments of $15,000 on November 1, 2006,
May 1, 2007 and November 1, 2007. In addition, all stock options held by Dr.
Marcel and Dr. Marshall became fully vested as of October 17, 2006; the
respective exercise prices and expiration dates of such stock options remained
unchanged.

Change in Lead
Director Fee for 2007

Beginning in 2007, at the
request of the Lead Director, the Board has reduced the annual fee for serving
as Lead Director from $15,000 to $10,000.

67

Compensation
Committee Interlocks and Insider Participation

The members of the Compensation and Stock Option
Committee in 2006 were Mony Ben Dor, Lawrence Marshall (through October 2006),
Anthony B. Evnin (beginning in October 2006) and Elkan Gamzu. There were no
interlocks on the Compensation and Stock Option Committee in 2006.

Item 12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters

EQUITY
COMPENSATION PLAN INFORMATION

The table below provides certain information
concerning our equity compensation plans as of December 31, 2006.

Plan Category
  
  Number of
  securities to be 
  issued upon exercise of 
  outstanding options, 
  warrants and rights
  
  Weighted
  average exercise price of outstanding 
  options, warrants and rights
  
  Number of
  securities remaining available for 
  future issuance under equity 
  compensation plans (excluding securities
  reflected in column (a)(a)
  
  (b)
  
  (c)Equity compensation plans   approved by security
  holders
  
  1,962,597
  
  
  
  $
  5.82
  
  
  708,301Equity compensation plans not approved by security
  holders
  
  N/A
  
  
  
  
  N/A
  
  
  N/ATotal
  
  1,962,597
  
  
  
  $
  5.82
  
  
  708,301SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS

The following table sets forth certain information
with respect to the beneficial ownership of the Companys Common Stock as of March
13, 2007, except as set forth in the footnotes, by (i) each person who was
known by the Company to own beneficially more than 5% of any class of the
Companys Stock, (ii) each of the Companys executive officers who served
during 2006 and Directors, and (iii) all current Directors and executive
officers of the Company as a group. Except as otherwise noted, each person
listed below has sole voting and dispositive power with respect to the shares
listed next to such persons name.

Name and Address of Beneficial Owner
  
  Amount of
  Beneficial
  Ownership
  
  Percentage
  of Total (1)Haim Aviv, Ph.D. (2)
  
  585,737
  
  2.3
  %c/o Pharmos
Ltd,
  Kiryat WeizmannRehovot
76326,
  IsraelSrinivas Akkaraju, M.D., Ph.D. (3)
  
  2,845,160
  
  11.1
  %c/o Panorama
  Management, LLC2440 Sand
Hill
  Road, Suite 302Menlo Park,
CA
  94025Mony Ben Dor (4)
  
  30,937
  
  *40 Hakukia
St.Rishon Le
Zion
  75548, Israel68

Anthony B. Evnin (5)
  
  1,283,212
  
  5.0
  %c/o Venrock
  Associates30
Rockefeller
  Plaza, Room 5508New York, NY
  10112Elkan R. Gamzu, Ph.D. (6)
  
  34,500
  
  *enERGetics99 Wells
Avenue,
  Suite 302Newton, MA
02459Lloyd I. Miller, III (7)
  
  1,965,275
  
  7.7
  %4550 Gordon
  DriveNaples, FL
34102Charles W. Newhall, III (8)
  
  1,880,824
  
  7.4
  %1119 St.
Paul
  StreetBaltimore,
MD 21202Abraham Sartani. M.D. (9)
  
  8,750
  
  *c/o
Recordati SpA, Via Civitali, 120148
Milano,
  ItalyDavid Schlachet (9)
  
  38,937
  
  *Syneron
Medical
  Ltd.Industrial
Zone,
  Tavor BuildingP.O.B. 550
  Yokneam Illit,20692
IsraelAlan L. Rubino (10)
  
  41,000
  
  *c/o Pharmos
Corporation99 Wood
Avenue
  South, Suite 311Iselin, NJ
08830S. Colin Neill (9)
  
  30,000
  
  *c/o Pharmos
Corporation99 Wood
Avenue
  South, Suite 311Iselin, NJ
08830All Current Directors
  and
  
  8,744,332
  
  33.5
  %Executive
  Officers as a group(eleven
persons)
  (11)James A. Meer (12)
  
  47,750
  
  *c/o Columbia
  Laboratories Inc.354
Eisenhower
  ParkwayPlaza 1,
2nd
  FloorLivingston,
NJ 07039JP Morgan Partners BHCA LLP (13)
  
  2,845,160
  
  11.1
  %c/o JP
Morgan
  Partners, LLC270 Park
Avenue,
  39th FloorNew York, NY
  1001769

New Enterprise Associates 10, LP (14)
  
  1,880,824
  
  7.4
  %1119 St.
Paul
  StreetBaltimore,
MD
  21202Venrock Associates (15)
  
  1,283,212
  
  5.0
  %Venrock Associates III LPVenrock Entrepreneurs Fund III LP30
Rockefeller
  Plaza, Room 5508New York,
NY 10112*
  Less than 1%.(1) Based on 25,565,784 shares of common stock
outstanding, plus each individuals warrants or options which are either
currently exercisable or will be exercisable within 60 days of the date set
forth above. Assumes that no other individual will exercise any warrants and/or
options.

(2) Consists of 202,423 outstanding shares and 383,314
shares issuable upon exercise of currently exercisable warrants and/or options.

(3) Consists of shares beneficially owned by JP Morgan
Partners BHCA LLP.

(4) Consists of 1,000 outstanding shares and 29,937
shares issuable upon exercise of currently exercisable warrants and/or options.

(5) Consists of shares beneficially owned by Venrock
Associates, Venrock Associates III LP and Venrock Entrepreneurs Fund III LP.

(6) Consists of 2,000 outstanding shares and 32,500
shares issuable upon exercise of currently exercisable warrants and/or options.

(7) Of such shares beneficially owned by Mr. Miller,
1,603,097 shares are held by Milfam II, LP, 352,178 shares are held by Trust
A-4, and 10,000 shares are held directly by Mr. Miller.

(8) Consists of shares beneficially owned by New
Enterprise Associates 10, LP.

(9) Consists entirely of shares issuable upon exercise
of currently exercisable warrants and/or options.

(10) Consists
of 1,000 outstanding shares and 40,000 shares issuable upon exercise of
currently exercisable options.

(11) Consists of 8,180,894 outstanding shares and
563,438 shares issuable upon exercise of currently exercisable warrants and/or
options.

(12) As of October 4, 2006. Mr. Meer served as Chief
Financial Officer through October 4, 2006.

(13) As of January 17, 2007, based on a Form 4 filed
with the SEC.

(14) As of October 25, 2006, based on a Schedule 13D
filed with the SEC.

(15) As of October 25, 2006, based on a Form 4 filed with the SEC.

70

Item 13. Certain Relationships, Related
Transactions and Director Independence

Herbamed
License Agreement. The Companys subsidiary,
Pharmos Ltd., is party to a License Agreement with Herbamed, Ltd., a company
controlled by Dr. Haim Aviv, the Companys Chairman and Chief Executive
Officer. The License Agreement licenses to Herbamed the Companys patent rights
for the oral delivery of lipophilic substances in the limited field of
nutraceuticals, which include food and dietary supplements, food additives, vitamins
and herbs. Under the terms of the revised License Agreement, Herbamed will pay
to Pharmos Ltd. royalties of 3% on net sales. During 2006 and 2005, the Company
recognized royalties of $5,177 and $24,670, respectively.

Neither the
Company nor its Pharmos Ltd. subsidiary is involved in the field of
nutraceuticals generally, and specifically in developing improved oral delivery
of nutraceuticals. Pharmos Ltd., therefore, licensed its technology in this
narrow non-pharmaceutical field of use to Dr. Avivs company as a way of
seeking to benefit from a potential stream of royalty payments without having
to devote any resources to the development of an application it otherwise would
not have pursued. In addition, if the technology proves to be successful for the
delivery of nutraceuticals, Pharmos hopes that it could be able to interest
potential strategic partners in licensing the technology for pharmaceuticals
applications.

Dr. Aviv was
not involved with either party in negotiating the terms of the License Agreement
with Herbamed. Pharmos Ltd. concluded that the royalty rates and other terms of
the License Agreement are commercially reasonable to it, and the Board of the
Company ratified the License Agreement.

The Herbamed
License Agreement was approved by Pharmos Board of Directors and subsequently
ratified by the Audit Committee.

Director
Independence. The Company has determined that eight of
the nine Directors serving at December 31, 2006 (Srinivas Akkaraju, Mony Ben
Dor, Anthony B. Evnin, Elkan R. Gamzu, Lloyd I. Miller, III, Charles W.
Newhall, III, Abraham Sartani and David Schlachet), as well as the two
Directors who resigned in October 2006 (Georges Anthony Marcel and Lawrence F.
Marshall), were independent under applicable Nasdaq rules.

Item 14. Principal Accounting Fees and Services

Audit fees

Aggregate fees
for professional services rendered by PricewaterhouseCoopers LLP in connection
with its audit of the Companys consolidated financial statements as of and for
the years ended December 31, 2006 and 2005, its reviews of the Companys
unaudited consolidated interim financial statements, and for SEC filings were
$441,000 and $370,000, respectively.

Audit-related fees

Aggregate fees
for professional services rendered by PricewaterhouseCoopers LLP in connection
with Vela acquisition due diligence services in 2006 were $43,000.

Tax fees

Aggregate fees
for professional services rendered by PricewaterhouseCoopers LLP in connection
with its income tax compliance and related tax services for the years ended December
31, 2006, and 2005 were $35,000 and $0, respectively.

71

All other fees

Aggregate fees
for professional services rendered by PricewaterhouseCoopers LLP in connection
with its executive compensation analysis for the years ended December 31, 2006,
and 2005 were $0 and $20,000, respectively. An additional fee of $1,500 was
incurred in 2006 and 2005 in relation to subscription services for accounting
related topics. The Company also licenses Automated Disclosure Checklist -
Client Assist from PricewaterhouseCoopers LLP at no cost.

Policy on Audit Committee Pre-Approval of
Audit and Non-Audit Services of Independent Auditor

The charter of
the Audit Committee requires that the Committee review and pre-approve all
audit, review or attest engagements of, and non-audit services to be provided
by, the independent registered public accounting firm (other than with respect
to the de minimis exception permitted by the Sarbanes-Oxley Act of 2002 and the
SEC rules promulgated thereunder). The Audit Committee pre-approved all
auditing services and permitted non-audit services rendered by
PricewaterhouseCoopers LLP in 2006.

The
pre-approval duty may be delegated to one or more designated members of the
Audit Committee, with any such pre-approval reported to the Committee at its
next regularly scheduled meeting. Any such designated member(s) of the
Committee shall also have the authority to approve non-audit services already
commenced by the independent registered public accounting firm if (i) the
aggregate amount of all such services provided constitutes no more than five
percent (5%) of the total amount of revenues paid by the Company to the
independent registered public accounting firm during the fiscal year in which
the services are provided, (ii) such services were not recognized by the
Company at the time of the engagement to be non-audit services, and (iii) such
services are promptly brought to the attention of the Committee and approved by
such designated member(s) prior to the completion of the audit.

72

PART IV

Item 15. Exhibits and Financial Statement
Schedules

(a) Financial
Statements and Exhibits

(1) FINANCIAL
STATEMENTS

Report of
Independent Registered Public Accounting Firm

Consolidated
balance sheets as of December 31, 2006 and 2005

Consolidated
statements of operations for the years ended December 31, 2006, 2005 and 2004

Consolidated
statements of changes in shareholders equity for the years ended December 31,
2006, 2005 and 2004

Consolidated
statements of cash flows for the years ended December 31, 2006, 2005, and 2004

Notes to
consolidated financial statements

(2) FINANCIAL
STATEMENT SCHEDULES

All schedules
have been omitted because the information required to be set forth therein is
not applicable or is shown in the financial statements or notes thereto.

(3) EXHIBITS

2 Plan of
purchase, sale, reorganization, arrangement, liquidation, or succession

2(a)
Agreement
  and Plan of Merger by and among Pharmos Corporation, Vela Acquisition
  Corporation and Vela Pharmaceuticals Inc. dated March 14, 2006 (Incorporated
  by reference to Exhibit 2.1 to the Companys Current Report on Form 8-K filed
  March 15, 2006).2(b)
Amendment to
  Agreement and Plan of Merger by and among Pharmos Corporation, Vela
  Acquisition Corporation and Vela Pharmaceuticals Inc. dated August 31, 2006
  (incorporated by reference to Exhibit 2.1 of the registrants Current Report
  on Form 8-K filed September 5, 2006).2(c)
Amendment
  No.2 to Agreement and Plan of Merger by and among Pharmos Corporation, Vela
  Acquisition Corporation, Vela Acquisition No.2 Corporation and Vela
  Pharmaceuticals Inc. dated September 29, 2006 (incorporated by reference to
  Exhibit 2.1 of the registrants Current Report on Form 8-K filed October 5,
  2006).3 Articles
  of Incorporation and By-Laws3(a)
Restated
  Articles of Incorporation (Incorporated by reference to Appendix E to the
  Joint Proxy Statement/Prospectus included in the Form S-4 Registration
  Statement of the Company dated September 28, 1992 (No. 33-52398)3(b)
Certificate
  of Amendment of Restated Articles of Incorporation dated January 30, 1995
  (Incorporated by reference to Annual Report on Form 10-K for the year ended
  December 31, 1994).3(c)
Certificate
  of Amendment of Restated Articles of Incorporation dated January 16, 1998
  (Incorporated by reference to the Companys Current Report on Form 8-K, dated
  February 6, 1998).3(d)
Certificate
  of Amendment of Restated Articles of Incorporation dated October 21, 1999
  (Incorporated by reference to exhibit 4(e) to the Form S-3 Registration
  Statement of the Company filed September 28, 2000 (No. 333-46818)).73

3(e)
Certificate
  of Amendment of Restated Articles of Incorporation dated July 19, 2002
  (Incorporated by reference to Exhibit 3 to the Companys Report on Form 10-Q
  for the quarter ended June 30, 2002).3(f)
Certificate
  of Amendment of Restated Articles of Incorporation dated July 7, 2004
  (Incorporated by reference to Exhibit 3.1 to the Companys Report on Form
  10-Q for the quarter ended June 30, 2004).3(g)
Certificate
  of Amendment to Articles of Incorporation dated September 23, 2005
  (Incorporated by reference to exhibit 3.1 to the Companys Quarterly Report
  on Form 10-Q for the quarter ended September 30, 2005).3(h)
Amended and
  Restated By-Laws (Incorporated by reference to Exhibit 99.4 to the Companys
  Current Report on Form 8-K filed on October 24, 2002).4
  Instruments defining the rights of security holders, including indentures4(a)
Form of
  Employee Warrant Agreement, dated April 11, 1995, between the Company and
  Oculon Corporation (Incorporated by reference to the Companys Current Report
  on Form 8-K, dated April 11, 1995, as amended).4(b)
Form of
  Warrant Agreement dated as of April 30, 1995 between the Company and Charles
  Stolper (Incorporated by reference to Form S-3 Registration Statement of the
  Company dated November 14, 1995, as amended [No. 33-64289]).4 (c)
Form of
  Stock Purchase Warrant dated as of March 31, 1997 between the Company and the
  Investor (Incorporated by reference to Form S-3 Registration Statement of the
  Company dated March 5, 1998 [No. 333-47359]).4(d)
Form of
  Common Stock Purchase Warrant exercisable until September 1, 2005
  (Incorporated by reference to Exhibit 4.4 to the Companys Current Report on
  Form 8-K filed on September 11, 2000).4(e)
Form of
  placement agent warrant with Ladenburg Thalmann & Co. Inc. (Incorporated
  by reference to Form S-3 Registration Statement of the Company dated
  September 28, 2000 (No. 333-46818).4(f)
Form of placement
  agent warrant with SmallCaps OnLine LLC (Incorporated by reference to Form
  S-3 Registration Statement of the Company dated September 28, 2000 (No.
  333-46818).4(g)
Form of consulting warrant with SmallCaps OnLine LLC (Incorporated by
  reference to Form S-3 Registration Statement of the Company dated September
  28, 2000 (No. 333-46818).4(h)
Certificate
  of Designation, Rights Preferences and Privileges of Series D Preferred Stock
  of the Company (Incorporated by reference to Exhibit 99.3 to the Companys
  Current Report on Form 8-K filed on October 24, 2002).4(i)
Rights
  Agreement dated as of October 23, 2002 between the Company and American Stock
  Transfer & Trust Company, as Rights Agent (Incorporated by reference to
  Exhibit 99.2 to the Companys Current Report on Form 8-K filed on October 24,
  2002).4(j)
Form of
  Investor Warrant dated March 4, 2003 (Incorporated by reference to Exhibit
  99.2 to the Companys Current Report on Form 8-K filed on March 4, 2003).4(k)
Form of Placement
  Agents Warrant dated March 4, 2003 (Incorporated by reference to Exhibit
  99.1 to the Companys Current Report on Form 8-K filed on March 4, 2003).4(l)
Registration
  Rights Agreement dated as of May 30, 2003 between the Company and the purchasers.
  (Incorporated by reference to Exhibit 4.2 to the Companys Current Report on
  Form 8-K filed on June 3, 2003).4(m)
Form of
  Investor Warrant dated June 2, 2003 (Incorporated by reference to Exhibit 4.3
  to the Companys Current Report on Form 8-K filed on June 3, 2003).4(n)
Securities
  Purchase Agreement dated as of September 26, 2003 between the Company and the
  purchasers identified on the signature pages thereto 2003 (Incorporated by
  reference to Exhibit 4.1 to the Companys Current Report on Form 8-K filed on
  September 30, 2003).74

4(o)
Form of 4%
  convertible debenture due March 31, 2005 (Incorporated by reference to
  Exhibit 4.2 to the Companys Current Report on Form 8-K filed on September
  30, 2003).4(p)
Registration
  Rights Agreement dated as of September 26, 2003 between the Company and the
  purchasers signatory thereto (Incorporated by reference to Exhibit 4.3 to the
  Companys Current Report on Form 8-K filed on September 30, 2003).4(q)
Form of
  Common Stock Purchase Warrant (Incorporated by reference to Exhibit 4.4 to
  the Companys Current Report on Form 8-K filed on September 30, 2003).4(r)
Escrow
  Agreement dated as of September 26, 2003 between the Company, the purchasers
  signatory thereto and Feldman Weinstein LLP (Incorporated by reference to
  Exhibit 4.5 to the Companys Current Report on Form 8-K filed on September
  30, 2003).4(s)
Form of
  Placement Agent Common Stock Purchase Warrant (Incorporated by reference to
  Exhibit 4.6 to the Companys Current Report on Form 8-K filed on September
  30, 2003).4(t)
Rights
  Agreement Amendment, dated October 23, 2006, between Pharmos Corporation and
  American Stock Transfer & Trust Co. (Incorporated by reference to Exhibit
  4.1 to the Companys Current Report on Form 8-K filed on October 27, 2006).4(u)
Registration
  Rights Agreement, dated as of October 25, 2006, by and among Pharmos
  Corporation and the Representatives named therein (Incorporated by reference
  to Exhibit 4.1 to the Companys Current Report on Form 8-K filed on October
  31, 2006).10 Material
  Contracts10(a)
Employment
  Agreement dated as of April 2, 2001, between Pharmos Corporation and Haim
  Aviv (Incorporated by reference to Exhibit 10(n) to the Companys Annual
  Report on Form 10-K for the year ended December 31, 2001).**10(b)
Amendment of
  Employment Agreement with Haim Aviv, dated as of January 25, 2006
  (Incorporated by reference to Exhibit 10.1 to the Companys Quarterly Report
  on Form 10-Q for the quarter ended March 31, 2006).**10(c)
Employment
  Agreement dated as of April 2, 2001, between Pharmos Corporation and Gad
  Riesenfeld (Incorporated by reference to Exhibit 10(o) to the Companys
  Annual Report on Form 10-K for the year ended December 31, 2001).**10(d)
Amendment of
  Employment Agreement dated as of April 23, 2001, between Pharmos Corporation
  and Gad Riesenfeld (Incorporated by reference to Exhibit 10(p) to the
  Companys Annual Report on Form 10-K for the year ended December 31, 2001).**10(e)
Amendment of
  Employment Agreement dated as of February 16, 2005 between Pharmos
  Corporation and Gad Riesenfeld (Incorporated by reference to Exhibit 10(w) to
  the Companys Annual Report on Form 10-K for the year ended December 31,
  2004).**10(f)
Employment Agreement
  dated as of July 19, 2004 between Pharmos Corporation and James A. Meer
  (Incorporated by reference to Exhibit 10.1 to the Companys Quarterly Report
  on Form 10-Q for the quarter ended September 30, 2004).**10(g)
Employment
  Agreement dated as of November 7, 2005, between Pharmos Corporation and Alan
  L. Rubino (Incorporated by reference to exhibit 10.1 to the Companys
  Quarterly Report on Form 10-Q for the quarter ended September 30, 2005).**10(h)
Employment
  Agreement between Pharmos Corporation and S. Colin Neill, dated as of October
  5, 2006 (Incorporated by reference to Exhibit 10.1 to the Companys Current
  Report on Form 8-K filed on October 6, 2006).**10(i)
Retention
  Award Agreement dated as of September 6, 2004 between Pharmos Corporation and
  Dr. Haim Aviv (Incorporated by reference to Exhibit 10.1 to the Companys
  Current Report on Form 8-K filed on September 10, 2004).**10(j)
Retention
  Award Agreement dated as of September 6, 2004 between Pharmos Corporation and
  Dr. Gad Riesenfeld (Incorporated by reference to Exhibit 10.2 to the
  Companys Current Report on Form 8-K filed on September 10, 2004).**75

10(k)
Consulting
  Agreement between Pharmos Corporation and Dr. Georges Anthony Marcel, dated
  October 17, 2006 (Incorporated by reference to Exhibit 10.1 to the Companys
  Current Report on Form 8-K filed on October 20, 2006).**10(l)
Consulting
  Agreement between Pharmos Corporation and Dr. Lawrence F. Marshall, dated
  October 17, 2006 (Incorporated by reference to Exhibit 10.2 to the Companys
  Current Report on Form 8-K filed on October 20, 2006).**10(m)
1997
  Incentive and Non-Qualified Stock Option Plan (Annexed as Appendix B to the
  Proxy Statement on Form 14A filed November 5, 1997).**10(n)
Amended and
  Restated 2000 Incentive and Non-Qualified Stock Option Plan.**10(o)
Amendment to
  the 2000 Stock Option Plan (incorporated by reference to Appendix D to the
  Companys Definitive Proxy Statement on Schedule 14A filed on August 8,
  2005).**10(p)
2001
  Employee Stock Purchase Plan (Incorporated by reference to Exhibit B to the
  Companys Definitive Proxy Statement on Form 14A filed on June 6, 2001).**10(q)(1)
Agreement
  between Avitek Ltd. (Avitek) and Yissum Research Development Company of the
  Hebrew University of Jerusalem (Yissum) dated November 20, 1986
  (Incorporated by reference to Annual Report on Form 10-K, as amended by
  Form10-K/A, for year ended December 31, 1992). (1)10(q)(2)
Supplement
  to Agreement (Incorporated by reference to Annual Report on Form 10-K, as
  amended by Form 10-K/A, for year ended December 31, 1992). (1)10(q)(3)
Hebrew
  language original executed version of Agreement (Incorporated by reference to
  Annual Report on Form 10-K, as amended by Form 10-K/A, for year ended
  December 31, 1992). (1)10(r)(1)
Agreement
  between Avitek and Yissum dated January 25, 1987 (Incorporated by reference
  to Annual Report on Form 10-K, as amended by Form 10-K/A, for year ended
  December 31, 1992). (1)10(r)(2)
Schedules
  and Appendixes to Agreement (Incorporated by reference to Annual Report on
  Form 10-K, as amended by Form 10-K/A, for year ended December 31, 1992). (1)10(r)(3)
Hebrew
  language original executed version of Agreement (Incorporated by reference to
  Annual Report on Form 10-K, as amended by Form 10-K/A, for year ended
  December 31, 1992). (1)10(s)(1)
Research,
  Development and License Agreement between Pharmos Ltd., Pharmos Corporation
  (Old Pharmos) and Yissum dated February 5, 1991 (Incorporated by reference
  to Annual Report on Form 10-K, as amended by Form 10-K/A, for year ended
  December 31, 1992). (1)10(s)(2)
Schedules
  and Appendixes to Agreement (Incorporated by reference to Annual Report on
  Form 10-K, as amended by Form 10-K/A, for year ended December 31, 1992). (1)10(s)(3)
Amendment
  No.1 to Research, Development and License Agreement between Pharmos
  Corporation, Pharmos Ltd. and Yissum Research Development Company of the
  Hebrew University of Jerusalem, dated May 31, 2006 (incorporated by reference
  to exhibit 99.1 to the registrants Current Report on Form 8-K filed June 6,
  2006).10(t)
License
  Assignment and Amendment Agreement dated as of October 9, 2001 by and among
  Dr. Nicholas S. Bodor, Pharmos Corporation and Bausch & Lomb Incorporated
  (Incorporated by reference to Exhibit 2.2 to the Companys Current Report on
  Form 8-K filed on October 16, 2001).10(u)
Asset
  Purchase Agreement between Bausch & Lomb Incorporated and Pharmos
  Corporation dated October 9, 2001 (Incorporated by reference to Exhibit 2.1
  to the Companys Current Report on Form 8-K filed on October 16, 2001).10(v)
Amendment
  No. 1 to Asset Purchase Agreement dated as of December 28, 2001 between
  Bausch & Lomb Incorporated and Pharmos Corporation (Incorporated by
  reference to Exhibit 10(v) to the Companys Annual Report on Form 10-K for
  the year ended December 31, 2001).76

10(w)
Amendment
  No. 2 to Asset Purchase Agreement dated as of December 30, 2004 between
  Bausch & Lomb Incorporated and Pharmos Corporation (Incorporated by
  reference to Exhibit 10(v) to the Companys Annual Report on Form 10-K for
  the year ended December 31, 2004).10(x)
License
  Agreement dated as of December 18, 2001 between Pharmos Ltd. and Herbamed
  Ltd. (Incorporated by reference to Exhibit 10(p) to the Annual Report on Form
  10-K for year ended December 31, 2002).10(y)
Amendment
  No. 1, dated as of June 30, 2005, to the License Agreement by and between
  Pharmos Ltd. and Herbamed Ltd., dated as of December 18, 2001 (Incorporated
  by reference to exhibit 99.1 to the Companys Quarterly Report on Form 10-Q
  for the quarter ended June 30, 2005).10(z)
Settlement
  Agreement between the Company and Lloyd I. Miller, III dated August 31, 2006
  (incorporated by reference to Exhibit 10.1 of the registrants Current Report
  on Form 8-K filed September 5, 2006).10(aa)
Voting
  Agreement and Waiver by and among the Company, Lloyd I. Miller, III, Trust
  A-4 - Lloyd I. Miller, Milfam II L.P. and Milfam LLC dated August 31, 2006
  (incorporated by reference to Exhibit 10.2 of the registrants Current Report
  on Form 8-K filed September 5, 2006).21
  Subsidiaries of the Registrant21(a)
Subsidiaries
  of the Registrant (Incorporated by reference to Annual Report on Form 10-K,
  as amended by Form 10-K/A, for year ended December 31, 1992).23 Consents
  of Experts and Counsel23(a) ***
Consent of
  PricewaterhouseCoopers LLP31 Rule
  13a-14(a)/15d-14(a) Certifications31(a)***
Certification
  of Chief Executive Officer31(b)***
Certification
  of Chief Financial Officer32 Section
  1350 Certifications32(a)***
Section 1350
  Certification of Chief Executive Officer and Chief Financial
  Officer(1)
Confidential
  information is omitted and identified by a * and filed separately with the
  SEC.(**)
This
  document is a management contract or compensatory plan or arrangement.(***)
Filed
  herewith77

SIGNATURES

Pursuant
to the requirements of 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.

PHARMOS
  CORPORATIONBy: /s/ Haim
  AvivDr. Haim
  Aviv, Chairman of the Board and ChiefExecutive
  Officer (Principal Executive Officer)Date: March
15, 2007

Pursuant to
the requirements of 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:

Signature

Title

Date/s/ S. Colin Neill

Chief
  Financial Officer (PrincipalFinancial and Accounting Officer),S. Colin Neill

and Secretary

March 15, 2007/s/ David Schlachet

Director

March 15, 2007David Schlachet/s/ Mony Ben
  Dor

Director

March 15,
  2007Mony Ben Dor/s/ Srinivas
  Akkaraju

Director

March 15, 2007Srinivas
  Akkaraju, MD, Ph.D/s/ Elkan R. Gamzu

Director

March 15,
  2007Elkan R. Gamzu, Ph.D/s/ Anthony
  B. Evnin

Director

March 15,
  2007Anthony B.
  Evnin, Ph.D/s/Lloyd I. Miller, III

Director

March 15,
  2007Lloyd I.
  Miller, III/s/Charles W. Newhall, III

Director

March 15,
  2007Charles W.
  Newhall, III/s/ Abraham
  Sartani

Director

March 15,
  2007Abraham Sartani, M.D.78

Pharmos
Corporation
Index to Consolidated Financial Statements

Report
  of Independent Registered Public Accounting Firm

F-2Consolidated
  balance sheets as of December 31, 2006 and 2005

F-3Consolidated
  statements of operations for the years ended December 31, 2006, 2005 and 2004

F-4Consolidated
  statements of changes in shareholders equity for the years ended December
  31, 2006, 2005 and 2004

F-5Consolidated
  statements of cash flows for the years ended December 31, 2006, 2005, and
  2004

F-6Notes
  to consolidated financial statements

F-7F-1

Report
of Independent Registered Public Accounting Firm

To the Board of Directors and
Shareholders of Pharmos Corporation:

In our opinion, the consolidated financial statements
listed in the index appearing under Item 15(a)(1) present fairly, in all
material respects, the financial position of Pharmos Corporation and its
subsidiaries at December 31, 2006 and December 31, 2005, and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2006 in conformity with accounting principles generally
accepted in the United States of America.
These financial statements are the responsibility of the Companys
management.  Our responsibility is to
express an opinion on these financial statements based on our audits.  We conducted our audits of these statements
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 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, and evaluating the overall financial statement presentation.  We believe that our audits provide a
reasonable basis for our opinion.

As discussed in Note 3 to the consolidated financial
statements, the Company changed the manner in which it accounts for share-based
compensation in 2006.

/s/ PricewaterhouseCoopers LLP

PricewaterhouseCoopers LLP
New York, NY
March 13, 2007

F-2

PHARMOS CORPORATIONConsolidated Balance Sheets

December 31,2006

2005AssetsCurrent AssetsCash and cash
  equivalents

$
12,757,013

$
10,289,127Short-term
  investments


13,172,673


35,748,343Restricted cash


82,926


79,527Research and
  development grants receivable


297,865


734,237Prepaid expenses
  and other current assets


424,658


543,109Total current
assets


26,735,135


47,394,343Fixed assets,
  net


593,457


742,860Restricted cash


63,922


62,874Severance pay
  funded


975,810


772,199Other assets


25,014


18,496Total assets

$
28,393,338

$
48,990,772Liabilities and Shareholders
  EquityCurrent
  liabilitiesAccounts payable

$
663,192

$
519,404Accrued expenses


889,783


575,222Warrant
  liability


11,435


38,880Accrued wages
  and other compensation


1,002,572


1,497,781Total current
liabilities


2,566,982


2,631,287Other liability


77,682


110,904Severance pay


1,320,624


1,014,647Total
liabilities


3,965,288


3,756,838Commitments and
  contingenciesShareholders
EquityPreferred stock,
  $.03 par value, 1,250,000 shares authorized, none issued and outstanding





Common stock,
  $.03 par value; 60,000,000 shares authorized, 25,565,784 and 19,065,784  issued in 2006 and 2005, respectively


766,973


571,973Deferred
  compensation





(529,393
)Paid-in capital
  in excess of par


204,700,030


191,093,338Accumulated
  deficit


(181,038,527
)

(145,901,558
)Treasury stock,
  at cost, 2,838 shares


(426
)

(426
)Total shareholders
equity


24,428,050


45,233,934Total liabilities and
shareholders
  equity

$
28,393,338

$
48,990,772The accompanying
notes are an integral part of these consolidated financial statements.

F-3

PHARMOS CORPORATIONConsolidated Statements of Operations

Year ended
  December 31,2006

2005

2004ExpensesResearch and
  development, gross

$
8,956,821

$
9,568,293

$
16,335,334Grants


(1,445,513
)

(1,406,508
)

(3,446,677
)Research and
  development, net of grants


7,511,308


8,161,785


12,888,657In-process
  acquired research and development


20,607,575





General and
administrative


9,108,867


7,165,291


6,413,803Depreciation
and
  amortization


314,769


381,812


577,691Total
operating expenses


37,542,519


15,708,888


19,880,151Loss from
operations


(37,542,519
)

(15,708,888
)

(19,880,151
)Other income
(expense)Bausch &
  Lomb payment, net





10,725,688


Interest
income


1,778,042


1,514,878


658,010Interest
expense





(166,322
)

(3,705,535
)Change in value
  of warrants


27,445


259,075


525,074Other (expense)
  income


(12,712
)

(44,937
)

(9,939
)Other income
(expense), net


1,792,775


12,288,382


(2,532,390
)Loss before income
taxes

$
(35,749,744
)
$
(3,420,506
)
$
(22,412,541
)Income tax
  benefit


(612,775
)

(490,634
)

(444,774
)Net loss

$
(35,136,969
)
($
2,929,872
)
$
(21,967,767
)Net loss per
share- basic and
  diluted

($
1.74
)
($
0.15
)
($
1.22
)Weighted average shares
outstanding- basic and
  diluted


20,249,714


18,974,175


18,033,358The accompanying
notes are an integral part of these consolidated financial statements.

F-4

Pharmos
CorporationConsolidated Statements of Changes in Shareholders Equity 
For the Years ended December 31, 2006, 2005 and 2004


|                                                                                        |  |              |             |        |   |                         |   |                                        |            |                       |   |             |   |        |              |                            |  |         |   |   |      |   |   |             |  
|--------------------------------------------------------------------------------------- |  | ------------ | ----------- | ------ | - | ----------------------- | - | -------------------------------------- | ---------- | --------------------- | - | ----------- | - | ------ | ------------ | -------------------------- |  | ------- | - | - | ---- | - | - | ----------- | -
|                                                                                        |  | Common Stock |             |        |   |                         |   |                                        |            | Treasury Stock        |   |             |  
|                                                                                        |  | Shares       |             | Amount |   | Deferred
  Compensation |   | Paid-in
  Capital in
  Excess of
  Par |            | Accumulated
  Deficit |   | Shares      |   | Amount |              | Total Stockholders Equity | 
|                                                                                        |  |             
|December 31, 2003                                                                       |  |              | 85,568,205  |        | $ | 2,567,047               |   | $                                      | (66,660    | )                     | $ | 161,960,059 |   | $      | (121,003,919 | )                          |  | 14,189  |   | $ | (426 | ) | $ | 43,456,101  |  
|                                                                                        |  |              |             |        |   |                         |   |                                        |            |                       |   |             |   |        |              |                            |  |         |   |   |      |   |   |             |  
|Warrant and option
exercises                                                            |  |              | 1,200,217   |        |   | 36,006                  |   |                                        |            |                       |   | 2,030,703   |   |        |              |                            |  |         |   |   |      |   |   | 2,066,709   |  
|Option issuance for consultant
compensation                                             |  |              |             |        |   |                         |   |                                        |            |                       |   | 578,238     |   |        |              |                            |  |         |   |   |      |   |   | 578,238     |  
|Issuance of and amortization of
stock option issuance below fair
  market value         |  |              |             |        |   |                         |   |                                        | (2,112     | )                     |   | 74,000      |   |        |              |                            |  |         |   |   |      |   |   | 71,888      |  
|Issuance of Common Stock 
Employee Stock Purchase Plan                                 |  |              | 9,493       |        |   | 285                     |   |                                        |            |                       |   | 28,714      |   |        |              |                            |  |         |   |   |      |   |   | 28,999      |  
|Issuance of Common Stock 
public offering sales, net of fees of
  $286,000             |  |              | 1,575,000   |        |   | 47,250                  |   |                                        |            |                       |   | 3,997,623   |   |        |              |                            |  |         |   |   |      |   |   | 4,044,873   |  
|Conversion of convertible debt
and interest and exercise of warrants                    |  |              | 947,662     |        |   | 28,429                  |   |                                        |            |                       |   | 2,632,213   |   |        |              |                            |  |         |   |   |      |   |   | 2,660,642   |  
|Issuance of Common Stock 
private equity sales, net of fees of
  $1.110,000            |  |              | 5,583,334   |        |   | 167,500                 |   |                                        |            |                       |   | 15,515,998  |   |        |              |                            |  |         |   |   |      |   |   | 15,683,498  |  
|Issuance of Retention Award
Agreements                                                  |  |              | 253,165     |        |   | 7,595                   |   |                                        | (1,632,350 | )                     |   | 1,992,407   |   |        |              |                            |  |         |   |   |      |   |   | 367,652     |  
|Net Loss                                                                                |  |              |             |        |   |                         |   |                                        |            |                       |   |             |   |        | (21,967,767  | )                          |  |         |   |   |      |   |   | (21,967,767 | )
|                                                                                        |  |              |             |        |   |                         |   |                                        |            |                       |   |             |   |        |              |                            |  |         |   |   |      |   |   |             |  
|December 31, 2004                                                                       |  |              | 95,137,076  |        |   | 2,854,112               |   |                                        | (1,701,122 | )                     |   | 188,809,955 |   |        | (142,971,686 | )                          |  | 14,189  |   |   | (426 | ) |   | 46,990,833  |  
|                                                                                        |  |              |             |        |   |                         |   |                                        |            |                       |   |             |   |        |              |                            |  |         |   |   |      |   |   |             |  
|Option issuance for consultant
compensation                                             |  |              |             |        |   |                         |   |                                        |            |                       |   | 1,244       |   |        |              |                            |  |         |   |   |      |   |   | 1,244       |  
|Amortization of stock option
issuance below fair market value                           |  |              |             |        |   |                         |   |                                        | 68,772     |                       |   |             |   |        |              |                            |  |         |   |   |      |   |   | 68,772      |  
|Amortization of Retention Award
Agreements                                              |  |              |             |        |   |                         |   |                                        | 1,102,957  |                       |   |             |   |        |              |                            |  |         |   |   |      |   |   | 1,102,957   |  
|Effect of Stock Split
(1:5)                                                             |  |              | (76,109,267 | )      |   | (2,283,278              | ) |                                        |            |                       |   | 2,283,278   |   |        |              |                            |  | (11,351 | ) |   |      |   |   |            |  
|Issuance of Retention Award
Shares                                                      |  |              | 37,975      |        |   | 1,139                   |   |                                        |            |                       |   | (1,139      | ) |        |              |                            |  |         |   |   |      |   |   |             |  
|Net Loss                                                                                |  |              |             |        |   |                         |   |                                        |            |                       |   |             |   |        | (2,929,872   | )                          |  |         |   |   |      |   |   | (2,929,872  | )
|                                                                                        |  |              |             |        |   |                         |   |                                        |            |                       |   |             |   |        |              |                            |  |         |   |   |      |   |   |             |  
|December 31, 2005                                                                       |  |              | 19,065,784  |        |   | 571,973                 |   |                                        | (529,393   | )                     |   | 191,093,338 |   |        | (145,901,558 | )                          |  | 2,838   |   |   | (426 | ) |   | 45,233,934  |  
|                                                                                       
|Stock and option issuance for
employee compensation and amortization of retention award |  |              |             |        |   |                         |   |                                        |            |                       |   | 1,363,092   |   |        |              |                            |  |         |   |   |      |   |   | 1,363,092   |  
|Issuance of Common Stock for
Vela Acquisition, net of direct costs of
  $32,007         |  |              | 6,500,000   |        |   | 195,000                 |   |                                        |            |                       |   | 12,772,993  |   |        |              |                            |  |         |   |   |      |   |   | 12,967,993  |  
|Reclassify deferred
Compensation to Paid in Capital                                     |  |              |             |        |   |                         |   |                                        | 529,393    |                       |   | (529,393    | ) |        |              |                            |  |         |   |   |      |   |   |             |  
|                                                                                        |  |              |             |        |   |                         |   |                                        |            |                       |   |             |   |        |              |                            |  |         |   |   |      |   |   |             |  
|Net loss                                                                                |  |              |             |        |   |                         |   |                                        |            |                       |   |             |   |        | (35,136,969  | )                          |  |         |   |   |      |   |   | (35,136,969 | )
|                                                                                        |  |              |             |        |   |                         |   |                                        |            |                       |   |             |   |        |              |                            |  |         |   |   |      |   |   |             |  
|December 31, 2006                                                                       |  |              | 25,565,784  |        | $ | 766,973                 |   | $                                      | 0          |                       | $ | 204,700,030 |   | ($     | 181,038,527  | )                          |  | 2,838   |   |   | (426 | ) | $ | 24,428,050  |  
|                                                                                        |  |              |             |        |   |                         |   |                                        |            |                       |   |             |   |        |              |                            |  |         |   |   |      |   |   |             |  

The accompanying notes
are an integral part of these consolidated financial statements. F-5   Pharmos CorporationConsolidated Statements of Cash Flows

Year Ended
  December 31,2006

2005

2004Cash flows from operating
activitiesNet loss

$
(35,136,969
)
$
(2,929,872
)
$
(21,967,767
)Adjustments to
reconcile net loss to net cash used in operating
  activities:Depreciation
and amortization


314,769


381,812


577,691Interest
expense on convertible debentures converted into common stock








10,555Provision for
severance pay


305,977


(182,392
)

208,034Change in the
value of warrants


(27,445
)

(259,074
)

(525,074
)Amortization
of debt discount and issuance costs





126,256


3,126,954Share-based
compensation


1,363,092


1,172,973


1,017,778Non cash
portion of in-process research and development charge


13,000,000Income from
Bausch & Lomb milestone payment, net





(10,725,688
)

Changes in operating assets and
liabilities:Research and
development grants receivable


436,372


803,545


(856,537
)Prepaid
expenses and other current assets


118,451


(280,299
)

322,210Other
assets


3,482


450


1,643Accounts
payable


143,788


(410,230
)

(543,299
)Accrued
expenses


314,561


(580,191
)

(595,787
)Accrued wages
and other compensation


(495,209
)

741,293


(355,447
)Other
liabilities


(43,222
)

71,492


29,412Net cash used in operating
activities


(19,702,353
)

(12,069,925
)

(19,549,634
)Cash flows from investing
activitiesPurchases of
fixed assets


(165,366
)

(137,222
)

(310,046
)Proceeds from
Bausch & Lomb milestone payment





12,275,000


Payment to
Bausch & Lomb related to sale of ophthalmic business





(1,532,528
)

Royalty
payment and grant reimbursement related to Bausch & Lomb milestone
  payment





(1,549,312
)

Purchase of
short-term investments


(23,312,980
)

(41,748,343
)

Proceeds from
sale of short-term investments


45,888,650


6,000,000


Severance pay
funding


(203,611
)

39,727


(197,515
)Decrease
(increase) in restricted cash


(4,447
)

4,843,348


11,190,858Net cash provided by (used in)
investing activities


22,202,246


(21,809,330
)

10,683,297Cash flows from financing
activitiesProceeds from
issuance of common stock and exercise of options and
  warrants, net of issuance costs








22,742,078Costs from
registration of common stock issued with Vela Acquisition


(32,007
)




Repayment of
convertible debentures





(4,846,148
)

(14,153,852
)Net cash (used in) provided by
financing activities


(32,007
)

(4,846,148
)

8,588,226Net increase (decrease) in cash
and cash equivalents


2,467,886


(38,725,403
)

(278,111
)Cash and cash equivalents at
beginning of year


10,289,127


49,014,530


49,292,641Cash and cash equivalents at
end of year

$
12,757,013

$
10,289,127

$
49,014,530Supplemental
information:Interest
paid




$
32,086

$
560,544Supplemental disclosure of
non-cash investing and financing
  activities:Common stock
issued with Vela acquisition

$
13,000,000Conversion of
convertible debt







$
2,000,000The accompanying
notes are an integral part of these consolidated financial statements.

F-6

Pharmos
CorporationNotes
to Consolidated Financial Statements

1.
The CompanyPharmos Corporation
  (the Company or Pharmos) is a specialty pharmaceutical company that
  discovers and develops new novel therapeutic drugs to treat a range of
  indicators including pain, inflammatory, auto-immune and select CNS
  disorders. The Company has executive offices in Iselin, New Jersey and
  conducts research, development and pilot manufacturing through its wholly
  owned subsidiary, Pharmos, Ltd., in Rehovot, Israel.2.
Liquidity
  and Business RisksExcept for 2001, the
  Company has experienced operating losses every year since inception in
  funding the research, development and clinical testing of our drug
  candidates. As of December 31, 2006, the Companys accumulated deficit was
  approximately $181 million. The Company expects to incur additional losses
  over the next several years as the Companys research and development and
  clinical trial programs continue. The Company has funded its operations
  through the use of cash obtained principally from third party financing,
  milestone payments from Bausch and Lomb, and government grants. Management
  believes that the cash, cash equivalents and short term investments of $26.0million as of December 31, 2006, will be
  sufficient to support the Companys continuing operations beyond December 31,
  2007.The Company regularly
  pursues various funding options, including additional equity offerings,
  strategic corporate alliances, business combinations and the establishment of
  product related research and development limited partnerships to obtain
  additional financing to continue the development of its products and bring
  them to commercial markets. Should the Company be unable to raise adequate
  financing in the future, long-term projects will need to be scaled back or
  discontinued.3.
Significant
  Accounting PoliciesBasis
  of consolidationThe accompanying
  consolidated financial statements include the accounts of the Company and its
  wholly owned subsidiaries: Pharmos Ltd. and Vela Pharmaceuticals. All
  significant intercompany balances and transactions are eliminated in
  consolidation. The functional currency for Pharmos Ltd is the US dollar.Use
  of estimatesThe preparation of the
  consolidated financial statements in conformity with generally accepted
  accounting principles requires the Company to make estimates and assumptions
  that affect the reported amounts of assets and liabilities, disclosure of
  contingent assets and liabilities at the date of the financial statements and
  the reported amounts of revenues, costs and expenses during the reporting
  period. The most significant estimates and assumptions related to stock based
  compensation asset impairments, including estimates of commitments and
  contingencies, and the tax valuation allowance. Actual results could differ
  from those estimates.Net
  loss per common shareBasic and diluted net
  loss per common share was computed by dividing the net loss for the period by
  the weighted average number of shares of common stock issued and outstanding.
  In accordance with the requirements of Statement of Financial Accounting
  Standards No. 128, potential shares of common stock have been excluded from
  the calculation of diluted net loss per common share, as their inclusion
  would be antidilutive.The following table
  summarized the equivalent number of potential common shares assuming the
  related securities that were outstanding as of December 31, 2006 and 2005 had
  been converted.F-7

Pharmos
CorporationNotes
to Consolidated Financial Statements

2006


2005Stock
  options


1,924,622


1,198,299Warrants


424,769


1,176,310Shares
  issuable upon exercise of convertible debt





Restricted
  stock  non vested


37,975


63,292Total
  potential dilutive securities not included in loss per share


2,387,366


2,437,901Cash
  and cash equivalentsThe
Company considers all highly liquid instruments
  purchased with an original maturity of three months or less to be cash
  equivalents. Cash equivalents primarily consist of commercial paper and money
  market accounts at December 31, 2006 and 2005.InvestmentsThe
Company considers all investments that are not
  considered cash equivalents and with a maturity of less than one year from
  the balance sheet date to be short-term investments. The Company considers
  all investments with a maturity of greater than one year to be long-term
  investments except for auction-rate securities as discussed below. All
  investments are considered as held-to-maturity and are carried at amortized
  cost, as the Company has both the positive intent and ability to hold them to
  maturity. The Company invests in a variety of instruments such as commercial
  paper, US Government securities and corporate securities with an effective
  maturity of less than one year. Some of the Companys investments are in
  auction-rate securities (ARS) that are held as investments available for
  sale. Auction rate securities are instruments with long-term underlying
  maturities, but for which an auction is conducted periodically, as specified,
  to reset the interest rate and allow investors to buy or sell the
  instruments. Because auctions generally occur more often than annually, and
  because the Company holds these instruments in order to meet short-term
  liquidity needs, the auction rate securities are classified as short-term
  investments in the Consolidated Balance Sheet. Interest income includes
  interest, amortization of investment purchases premiums and discounts, and
  realized gains and losses on sales of securities. Realized gains and losses
  on sales of investment securities are determined based on the specific
  identification method. The Consolidated Statement of Cash Flows reflects the
  gross amount of the purchases of short term investments and the proceeds from
  maturities of short term securities and sales of auction rate securities.Realized gains and losses on sales of investment
  securities are determined based on the specific identification method.2006

2005Securities greater than 90
  days

$
5,172,673

$
22,598,343Auction Rate Securities


8,000,000


13,150,000Total Short Term
  Investments

$
13,172,673

$
35,748,343

Revenue
  recognitionThe Companys
policy
  with respect to license fees is to recognize revenue when all performance
  obligations are completed. The Company had no product sales revenue during
  2006, 2005, or 2004 and does not expect product sale revenues for the next
  few years and may never have such sales if products currently under
  development fail to be commercialized.Research
  and development costsAll research and
  development costs are expensed when incurred. The Company accounts for
  reimbursements of research and development costs as a reduction of research
  and development expenses as the underlying expenses are incurred.F-8

Pharmos Corporation

Notes
to Consolidated Financial
Statements

Research
  and development grants receivableAs of December 31,
2006
  and 2005, research and development grant receivables consist of grants for
  research and development relating to certain projects. Research and
  development grants are recognized as a reduction of research and development
  expenses.Restricted cashThe Company has a
lease
  agreement for the premises it occupies in New Jersey. The lease agreement
  expires in 2009. The lease agreement is secured by a letter of credit of
  $63,922. This amount is included in restricted cash at December 31, 2006.In addition, the
Companys
  subsidiary, Pharmos Ltd., has a lease agreement for the premises it occupies
  in Israel. The lease agreement expired in January 2007. In February 2007 the
  Company renewed the lease for a four year term cancellable by Pharmos after
  one year. The lease agreement is secured by a letter of guarantee in the
  amount of $177,016 based on the Israeli consumer price index. A deposit of
  $82,926 is included in restricted cash (current) at December 31, 2006.Fixed
  assetsFixed assets are
  recorded at cost and are depreciated on a straight-line basis over their
  estimated useful lives. The Company uses the following estimated useful
  lives:Laboratory,
  pilot plant and other equipment

7 years to
  14 yearsLeasehold
  improvements

5 years to
  14 yearsOffice
  furniture and fixtures

3 years to
  17 yearsComputer
  equipment

3 years to 4
  yearsVehicles

5 years to 7
  yearsLeasehold improvements
  are amortized on a straight-line basis over the shorter of the lease term or
  the estimated lives of the related assets. Maintenance and repairs are
  expensed as incurred.Long-lived
  assetsThe Company periodically evaluates potential impairments of its
  long-lived assets. When the Company determines that the carrying value of
  long-lived assets may not be recoverable based upon the existence of one or
  more indicators of impairment, the Company evaluates the projected
  undiscounted cash flows related to the assets and other factors. If these
  cash flows are less than the carrying value of the assets, the Company
  measures the impairment using discounted cash flows or other methods of
  determining fair value.F-9

Pharmos
Corporation
Notes to Consolidated Financial Statements

Severance
  payThe Companys liability for severance pay is
  calculated pursuant to Israels Severance Pay Law on the most recent salary
  of the employees multiplied by the number of years of employment, as of the
  balance sheet date. Employees are entitled to one months salary for each
  year of employment or a portion thereof. The Companys liability for all of
  its Israeli employees is fully provided by monthly deposits with insurance
  policies and by an accrual. The value of these policies is recorded as an
  asset in the Companys balance sheet.The deposited funds may be withdrawn only upon the
  fulfillment of the obligation pursuant to Israels Severance Pay Law or labor
  agreements. The value of the deposited funds is based on the cash surrender
  value of these policies, and includes immaterial profits accumulated up to
  the balance sheet date.Severance expenses in Israel for the years ended
  December 31, 2006, 2005 and 2004 amounted to $396,826, $102,962, and $254,929,
  respectively and have been included in the appropriate R&D and G&A
  expense categories.Income
  taxesThe Company accounts for income taxes in accordance
  with the provisions of Statement of Financial Accounting Standards No. 109, Accounting
  for Income Taxes (SFAS 109). Under the asset and liability method of SFAS
  109, deferred tax assets and liabilities are recognized for the future tax
  consequences attributable to differences between the financial statement
  carrying amounts of existing assets and liabilities and their respective tax
  bases and operating loss and tax credit carryforwards. Deferred tax assets
  and liabilities, if any, are measured using enacted tax rates expected to
  apply to taxable income in the years in which those temporary differences are
  expected to be recovered or settled. Under SFAS 109, the effect on deferred
  tax assets and liabilities of a change in tax rates is recognized in income
  in the period that includes the enactment date.Foreign
  exchangeThe Companys foreign operations are principally
  conducted in U.S. dollars. Any transactions or balances in currencies other
  than U.S. dollars are remeasured and any resultant gains and losses are
  included in other income (expense). To date, such gains and losses have been
  insignificant.Concentration
  of credit riskFinancial instruments that potentially expose the
  Company to concentrations of credit risk consist primarily of cash, cash
  equivalents and short term investments. The Company maintains most of its
  cash balances in accounts that exceed federally insured limits. The Company
  has not experienced any losses to date resulting from this practice.Fair
  value of financial instrumentsThe carrying amounts of
  the Companys financial instruments, including cash and cash equivalents, investments,
  other receivables, other assets, accounts payable and accrued liabilities which
  approximate fair value due to their short term maturities.F-10

Pharmos
Corporation
Notes to Consolidated Financial Statements

Share
  based compensationThe Company has stock-based compensation plans under
  which employees and outside directors receive stock options and other
  equity-based awards. The plans provide for the granting of stock options,
  restricted stock awards, and other stock unit awards. The maximum number of
  shares of Common Stock available for issuance under the 2000 Plan, as
  amended, is 2,700,000 shares. At December 31, 2006, awards relating to 1,924,622
  shares were outstanding. Pharmos stock options are granted with an exercise
  price equal to 100% of the market value of a share of common stock on the
  date of the grant, generally have 10 year terms, and vest no later than four
  years from the date of grant.Under the terms of the Pharmos Employee Stock
  Purchase Plan (ESPP), all full-time and part-time employees of the Company
  who have completed a minimum of 6 months of employment are eligible to
  participate. The price of the Common Stock is calculated at 85% of the lower
  of either the mean between the highest and lowest prices at which Pharmos
  common stock trades on the first business day of the month, or the mean
  between the highest and lowest trading prices on the day of exercise (the
  last day of the month). A participant can purchase shares not to exceed 10%
  of ones annualized base pay; $25,000; or 5% or more of shares outstanding.
  The total number of shares reserved for issuance under the 2001 Plan is
  100,000 shares. During the year ended December 31, 2006, no shares were
  purchased under the ESPP and 87,440 shares remain for issuance under the 2001
  Plan.Effective January 1, 2006, the Company adopted the
  provisions of Statement of Financial Accounting Standards No. 123R, Share-Based
  Payment (SFAS 123R), which establishes the financial accounting and
  reporting standards for stock-based compensation plans. SFAS 123R requires
  the measurement and recognition of compensation expense for all stock-based
  awards made to employees and directors, including employee stock options and
  restricted stock units, and employee stock purchases related to the ESPP.
  Under the provisions of SFAS 123R, stock-based compensation cost is
  measured at the grant date, based on the fair value of the award, and is
  recognized as an expense over the requisite service period of the entire
  award (generally the vesting period of the award). The Company has elected to
  expense these awards on a straight line basis over the life of the awards. As
  a result of adopting SFAS 123R, the Companys net loss before income taxes
  and net loss for the year ended December 31, 2006 was $939,500 more than if
  the Company had continued to account for stock-based compensation under
  Accounting Principles Board Opinion No. 25, Accounting for Stock Issued
  to Employees (APB 25) and its related interpretations. Basic and diluted
  net loss per share for the year ended December 31, 2006 of $(1.74) is $0.05
  more as a result of adopting SFAS 123R.The Company elected to use the modified prospective
  transition method as permitted by SFAS 123R and, therefore, financial results
  for prior periods have not been restated. Under this transition method,
  stock-based compensation expense for the year ended December 31, 2006
  includes expense for all equity awards granted prior to, but not yet vested
  as of January 1, 2006, based on the grant date fair value estimated in
  accordance with the original provisions of SFAS No. 123, Accounting
  for Stock-Based Compensation (SFAS 123,) as amended by SFAS 148, Accounting
  for Stock-Based CompensationTransition and Disclosure. Since the adoption
  of SFAS 123R, there have been no changes to the Companys stock compensation
  plans or modifications to outstanding stock-based awards which would increase
  the value of any awards outstanding other than the acceleration and full
  vesting of options held by two senior executives who left the Company and two
  board members who left the board. The financial impact of these modifications
  has been reflected in our results. Compensation expense for all stock-based
  compensation awards granted subsequent to January 1, 2006 was based on the
  grant-date fair value determined in accordance with the provisions of SFAS
  123R. During the year ended December 31, 2006, the Company recognized
  compensation expense of $939,500 for stock options which was recognized in
  the Consolidated Statement of Operations. As of December 31, 2006,
  the total compensation costs related to non-vested awards not yet recognized
  is $1.7 million which will be recognized over the next three and one-half
  years.Prior to January 1, 2006, the Company accounted for
  stock-based compensation in accordance with APB 25 and also followed the
  disclosure requirements of SFAS 123. Under APB 25, the Company accountedF-11

Pharmos
Corporation
Notes to Consolidated Financial Statements

for stock-based awards to employees and directors
  using the intrinsic value method as allowed under SFAS 123. The following
  table sets forth the computation of basic and diluted loss per share for the years
  ended December 31, 2005 and 2004 and illustrates the effect on net loss and
  loss per share as if the Company had applied the fair value recognition
  provisions of SFAS 123 to its stock plans. The estimated fair value of each
  option is calculated using the Black-Scholes option-pricing model:Year Ended
  December 31, 2005

Year Ended
  December 31, 2004Net loss as
  reported

($
2,929,872
)
($
21,967,767
)Add:
Stock-based
  employee compensation expense included in reported net loss


1,171,728


439,540Deduct:
Total
  stock-based employee compensation expense determined under fair value based
  method for all awards


(4,578,359
)

(1,705,559
)Pro forma
net
  loss

($
6,336,503
)
($
23,233,786
)Loss per
share:As reported
-
  basic and diluted

($
0.15
)
($
1.22
)Pro forma -
basic
  and diluted

($
0.33
)
($
1.29
)For disclosure purposes under SFAS No. 123, the fair
  value of each option grant was estimated on the date of grant using the
  Black-Scholes option valuation model with the following weighted-average
  assumption:2005

2004Risk-free interest rate


3.71-4.45%


2.89-3.69%Expected lives (in years)


5%


5%Dividend yield


0%


0%Expected volatility


99 -107%


88 -89%Recently Issued Accounting
  PronouncementsIn June 2006, the FASB issued FASB Interpretation
  No. 48, Accounting for Uncertainty in
  Income Taxes(FIN
  48). This Interpretation clarifies the accounting for uncertainty in income
  taxes recognized in a companys financial statements and prescribes a
  recognition threshold of more-likely-than-not to be sustained upon
  examination. Measurement of the tax uncertainty occurs if the recognition
  threshold has been met. This Interpretation also provides guidance on
  derecognition, classification, interest and penalties, accounting in interim
  periods, disclosure, and transition. FIN 48 will be effective in the Companys
  first quarter 2007 financial statements. The Companys adoption of FIN 48 is not
  expected to have a material effect on our financial position, results of
  operations or cash flows.In September 2006, the FASB issued Statement No.
  157, Fair
  Value Measurements (SFAS 157). SFAS 157 defines fair value,
  establishes a framework for measuring fair value in generally accepted
  accounting principles and expands disclosures about fair value measurements.
  SFAS 157 is effective for financial statements issued for fiscal years
  beginning after November 15, 2007, with earlier application encouraged. The
  Company is evaluating the impact of adopting SFAS 157.F-12

Pharmos
Corporation
Notes to Consolidated Financial Statements

4.      Acquisition of Vela Pharmaceuticals, Inc.


In March 2006, the Company announced an agreement to
acquire Vela Pharmaceuticals, Inc. (Vela), which has a Phase II product
candidate, dextofisopam, in development to treat irritable bowel syndrome. The
Company intends to dedicate substantial resources to complete clinical
development of this product candidate. The Vela acquisition also includes
additional compounds in preclinical and/or clinical development for neuropathic
pain, inflammation and sexual dysfunction. The final merger agreement, as
amended, was announced on September 5, 2006 and approved by the Companys
shareholders on October 25, 2006.

Under the amended Merger Agreement, the Company issued
6.5 million shares of common stock and paid $6 million to Vela shareholders at
closing. Pharmos also agreed to reimburse Vela for $679,000 of operating
expenses from July 1, 2006 through closing. The amended Merger Agreement also
includes additional performance-based milestone payments to the Vela
stockholders related to the development of dextofisopam, aggregating up to an
additional $8 million in cash and the issuance of up to an additional
13,500,000 shares of Pharmos common stock. In the event that such shares or
payments are issued or funded in future periods, a determination will then be
made as to whether the values are to be written off as in - process research
and development and charged to results of operations; such future charge could
be material. None of the conditions requiring issuance of these contingent
shares or funding these payments were met at December 31, 2006. In addition, the
Companys additional paid in capital was reduced by $32,007 for registration
costs related to the issuance of the common shares issued to Velas
shareholders.

The combined value of the acquisition purchase price
was approximately $19.7 million, plus direct expenses. The fair value ascribed
to the 6.5 million shares of Company common stock ($13 million) was determined
using the closing price of Pharmos common stock on October 25, 2006, which was
the shareholder approval date of the acquisition.

The purchase price is as follows (in thousands):

Fair value of Pharmos shares issued at closing

$
13,000Cash and advances paid


6,67919,679Transaction costs incurred by Pharmos


1,422Purchase price

$
21,101The purchase price has been allocated based on a
  valuation of Velas tangible and intangible assets and liabilities and their
  following fair values (in thousands):Proceeds receivable from sale of New Jersey State
  net operating losses

$
493In-process research and development


20,608Total

$
21,101A substantial portion of the purchase price was
considered to represent in-process research and development (IPR&D) costs
as the products have not, at the acquisition date, reached technological
feasibility and may not have an alternate future use. Accordingly, such value
was written off as a charge to operations for the quarter and year ended
December 31, 2006. The value of the IPR&D charge was determined based on a
discounted forecast of the estimated net future cash flows for each project,
adjusted for the estimated probability of technical success and regulatory
approvals. The discount rate applied was 23%.

The Companys 2006 consolidated statement of
operations includes the results of operations from Vela from October 26, 2006
forward. The following table presents unaudited pro forma consolidated results
of operations for Pharmos for the years ended December 31, 2005 and 2006,
as though the Vela acquisition was completed as of the beginning of each period.

F-13

Pharmos
Corporation
Notes to Consolidated Financial Statements

December
        31, 2006
    
    December
        31, 2005Net
        loss attributable to common shareholders
    
    $
    (37,760,577
    )
    $
    (11,545,665
    )Net
        loss per share attributable to common shareholders:Basic
        and diluted
    
    $
    (1.48
    )
    $
    (0.45
    )Weighted
        average shares outstanding
    
    
    25,565,783
    
    
    25,474,1755.
Bausch & Lomb Collaborative AgreementPharmos sold to Bausch & Lomb all of its rights
  in the U.S. and Europe to manufacture and market Lotemax® and Alrex® and
  Zylet®, the third loteprednol etabonate-based product, which was submitted to
  the FDA for marketing approval in September 2003. In December 2004, Bausch
  & Lomb received approval from the FDA of its New Drug Application for
  Zylet as an ophthalmic anti-inflammatory/antibiotic combination product.During January 2005, an amended agreement was signed
  in regard to Zylet and the Company received gross proceeds of approximately
  $12.2 million from Bausch & Lomb. Additionally, the Company may receive a
  milestone payment of up to $10 million if actual sales during the first two
  years following Bausch & Lombs commercialization exceed agreed-upon
  forecasted amounts. Pharmos agreed to pay up to $3.75 million of Bausch &
  Lombs costs of developing Zylet, of which $600,000 was deducted from the
  purchase price paid by Bausch & Lomb in October 2001. In July 2003,
  another $1.57 million was paid to Bausch & Lomb. As of December 31, 2004,
 Pharmos owed an additional $1.56 million as its share of these research and
  development related Zylet expenses, which was included in accounts payable
  and represents the final amount Pharmos owes Bausch & Lomb for their
  project development under the terms of the agreement. This amount was paid to
  Bausch & Lomb in January 2005.Pharmos paid Dr. Nicholas Bodor, the loteprednol
  etabonate patent owner and licensor, who is also a former director of and
  consultant to Pharmos, a total of approximately $2.7 million from the initial
  proceeds of the sale of Lotemax® and Alrex® in return for his consent to
  Pharmos assignment of its rights under the license agreement to Bausch &
  Lomb ($1.5 million paid at closing and $1.2 million paid in October 2002).
  During January 2005, the Company paid Dr. Bodor approximately $1.3 million
  per the agreement with respect to Zylet. Pharmos owes Dr. Bodor an additional
  14.3% of any payments the Company may receive from Bausch & Lomb in the
  event that certain sales levels are exceeded in the first two years following
  commencement of sales in the U.S. Pharmos has no further obligations for
  payments to Bausch & Lomb.6.
Fixed AssetsFixed assets consist of the following:December 31,2006

2005Laboratory, pilot plant and other equipment

$
3,053,556

$
3,018,246Leasehold improvements


812,070


812,069Office furniture and fixtures


299,759


309,053Computer equipment


1,192,439


1,174,525Vehicles


49,489


50,3255,407,313


5,364,218Less - Accumulated depreciation


(4,813,856
)

(4,621,358
)Total Fixed Assets

$
593,457

$
742,860Depreciation of fixed assets was
$314,769, $381,812, and $577,691 in 2006, 2005 and 2004, respectively.F-14

Pharmos Corporation
Notes to Consolidated Financial Statements


7.       Grants for Research and DevelopmentDuring 2006,
  2005 and 2004, gross research and development costs amounted to $8,956,821,
  $9,568,293, and $16,335,334 respectively.The Company
  has entered into agreements with the State of Israel, which provide for
  grants for research and development relating to certain projects. Amounts
  received pursuant to these agreements have been reflected as a reduction of
  research and development expense. Such reductions amounted to $1,445,513, $1,406,508
  and $3,446,677 during 2006, 2005 and 2004, respectively. The agreements with
  agencies of the State of Israel place certain legal restrictions on the
  transfer of the technology and manufacture of resulting products outside
  Israel. The Company will be required to pay royalties, at rates ranging from
  3% to 5%, to such agencies from the sale of products, if any, developed as a
  result of the research activities carried out with the grant funds up to the
  amount received and interest.As of
  December 31, 2006, the total amounts received under such grants amounted to
  $17,015,457. Aggregate future royalty payments related to sales of products
  developed, if any, as a result of these grants are limited to $15,526,517,
  exclusive of interest, based on grants received through December 31, 2006.The Company
  signed an agreement with Consortium Magnet for developing generic
  technologies for design and development of drugs and diagnostic kits which
  consortium is operated by the Office of the Chief Scientist (OCS) of Israel.
  Under such agreements the Company is entitled to a non-refundable grant
  amounting to approximately 60% of actual research and development and
  equipment expenditures on approved projects. No royalty obligations are
  required within the framework. As of December 31, 2005, the Company received
  cumulative grants totaling $1,659,549 for this program which was completed
  and closed.The Company
  signed an agreement with Consortium Magnet to develop a supply of
  water-soluble prodrugs of lipophilic compounds that improve their
  bioavailability and biopharmaceutical properties. Under such agreement the
  Company is entitled to a non-refundable grant amounting to approximately 60%
  of actual research and development and equipment expenditures on approved
  projects. No royalty obligations are required within the framework. As of
  December 31, 2006, the Company received cumulative grants totaling $546,609
  for this program. On December 31, 2006, the OCS closed the magnet program.8.
Private
  Placement of Convertible DebtOn September
  26, 2003, the Company completed a private placement of convertible debentures
  and warrants to six institutional investors, generating total gross proceeds
  of $21.0 million. Five million dollars of the proceeds was to be used for
  working capital purposes, and $16.0 million would be available to fund
  acquisitions upon the approval of the investors. The convertible debentures
  were convertible into common stock of the Company at a fixed price of $20.20,
  205% above the closing bid price of the stock for the five days preceding the
  closing date. The debentures, which bore an interest rate of 4%, were
  redeemed in 13 substantially equal monthly increments beginning March 31,
  2004. In general, amounts converted into shares of Pharmos common stock
  reduced the monthly redemption amount proportionately. The $16.0 million
  earmarked for acquisition activity was held in escrow until repaid. The
  debentures were fully repaid during March 2005; As of December 31, 2005,
  there are no remaining funds in the escrow account. In connection with the
  financing, the Company also issued 1,102,941 three-year warrants (including
  102,941 placement agent warrants) to purchase 1,102,941 shares of common
  stock at an exercise price of $10.20 per share. Total issuance costs related
  to the financing were approximately $1,229,000 in cash and $434,000 for the
  value of the placement agent warrants. The issuance costs allocated to the
  warrants were recorded as a reduction to additional paid in capital. The
  placement agent warrants were capitalized and were amortized over the life of
  the debt. The Company calculated the value of the warrants at the date of the
  transaction, including the placement agent warrants, being approximately
  $4,652,877 under the Black-Scholes option-pricing method (assumption:
  volatility 75%, risk free rate 1.59% and zero dividend yield). The Company
  allocated the $19.34 million in net proceeds between the convertible
  debentures and the warrants based on their relative fair values. The Company has
  reported the debt discount of approximately $3.5 million as a direct
  reduction to the face amount of the debt in accordance with APB 21. The
  discount accreted over the life of the outstanding debentures. Total accretion of the debt
  discount from inception through December 31, 2005 was $3,284,041. The
  issuance costs allocated to the convertible debentures of approximately $1.4
  million had been being deferred and amortized to interest expense over the
  life of the debt. Total amortization of theF-15

Pharmos Corporation
Notes to Consolidated Financial Statements

debt issuance costs from
  inception through December 31, 2005 was $1,309,075. During the first quarter
  of 2004, one of the investors converted a total of $2 million plus interest
  into 99,533 shares of common stock. In conjunction with this conversion, the
  relating unamortized debt discount and issuance costs totaling $267,912 was
  reclassified to additional paid in capital. As of December 31, 2005, all the
  debentures had been either repaid or converted into common stock of the
  Company. As of December 31, 2005, 351,400 of the total warrants issued were
  exercised totaling approximately $3,584,280. There were no warrants exercised
  during 2005 or 2006.9.
Shareholders
  Equity Transactions2006 TransactionsOn October
  25, 2006 Pharmos issued 6,500,000 shares of its common stock to Velas
  shareholders in conjunction with the acquisition of Vela.During 2006,
  2005 and 2004, there were no shares of common stock issued pursuant to the Pharmos
  Corporation 2001 Employee Stock Purchase Plan. All full-time and part-time
  employees of the Company who have completed a minimum of 6 months of
  employment are eligible to participate. The price of the Common Stock is
  calculated at 85% of the lower of either the mean between the highest and
  lowest prices at which Pharmos common stock trades on the first business day
  of the month, or the mean between the highest and lowest trading prices on
  the day of exercise (the last day of the month). A participant can purchase
  shares not to exceed 10% of ones annualized base pay; $25,000; or 5% or more
  of shares outstanding. The total number of shares reserved for issuance under
  the 2001 Plan is 100,000 shares. As of December 31, 2006, there were 87,440
  shares remaining for issuance under the 2001 Plan.For the year
  ended December 31, 2006, there were no options exercised under the Companys
  Stock Option Plans. For the year ended December 31, 2006, the Company
  incurred a non-cash charge of $939,500 for issuing stock options to
  employees.As of
  December 31, 2006, the Company had reserved 1,987,914 for outstanding stock
  options and 424,769 for outstanding warrants.2005 TransactionsFor the year
  ended December 31, 2005, there were no options exercised under the Companys
  Stock Option Plans. For the year ended December 31, 2005, the Company
  incurred a non-cash charge of $1,244 for issuing stock options to consultants
  who have since become employees. In addition, the amortization of the
  remaining balance for options which had been issued below fair market value
  in 2004 and charged to deferred compensation has been expensed in the amount
  of $48,000 during 2005 as a result of the acceleration of vested options
  above $9.00 which included these shares. The total amortization for all
  shares issued below fair market value recognized during 2005 was $68,772.During 2005,
  the Company recorded an expense of approximately $1,103,000 in connection
  with the Retention Awards granted to Dr Aviv and Dr. Riesenfeld. Per the
  Awards, only Dr. Riesenfeld was issued shares of restricted stock. Dr. Aviv
  received restricted stock units and will be issued shares of stock when
  vested. On December 31, 2005, 37,975 shares were issued to Haim Aviv for
  shares which vested, according the terms of his Retention Award Agreement.
  Dr. Riesenfelds shares had already been issued at the time of the approval
  of the Retention Award Agreement.F-16

Pharmos Corporation
Notes to Consolidated Financial Statements

In September 2005, the shareholders of the Company approved the
  increase in the number of authorized shares of the Companys Common Stock to
  60,000,000 from 30,000,000.On May 26,
  2005, Pharmos Corporation filed a Certificate of Change with the Nevada
  Secretary of State which served to effect, as of May 31, 2005, a 1-for-5
  reverse split of Pharmos common stock. As a result of the reverse stock
  split, every five shares of Pharmos common stock were combined into one share
  of common stock; any fractional shares created by the reverse stock split
  were rounded up to whole shares. The reverse stock split affected all of
  Pharmos common stock, stock options, restricted shares and warrants
  outstanding immediately prior to the effective date of the reverse stock
  split. The reverse split reduced the number of shares of Pharmos common
  stock outstanding from 95,137,076 shares to 19,027,809 shares, and the number
  of authorized shares of common stock was reduced from 150,000,000 shares to
  30,000,000 shares. All references to common share and per common share
  amounts for all periods presented have been retroactively restated to reflect
  this reverse split. At the Annual Meeting in September 2005, the shareholders
  voted to increase the number of authorized shares of common stock to 60,000,000
  shares.As of
  December 31, 2005, the Company had reserved 1,261,591 for outstanding stock
  options and 1,176,310 for outstanding warrants.2004 TransactionsThe Company
  issued 190,632 shares of its common stock with gross proceeds of $1,720,826
  from the exercise of options and warrants by employees, former employees,
  board of directors and consultants. During 2004, the Company incurred
  non-cash charges of approximately $133,000, excluding those provided to the
  former CFO, in return for consulting services associated with former
  employees and certain other consultants.During,
  2004, the Company issued 1,899 shares of common stock with gross proceeds of
  $28,999 pursuant to the Pharmos Corporation 2001 Employee Stock Purchase
  Plan. All full-time and part-time employees of the Company who have completed
  a minimum of 6 months of employment are eligible to participate. The price of
  the Common Stock is calculated at 85% of the lower of either the mean between
  the highest and lowest prices at which Pharmos common stock trades on the
  first business day of the month, or the mean between the highest and lowest
  trading prices on the day of exercise (the last day of the month). A
  participant can purchase shares not to exceed 10% of ones annualized base
  pay; $25,000; or 5% or more of shares outstanding. The total number of shares
  reserved for issuance under the 2001 Plan is 100,000 shares. As of December
  31, 2004, there were 87,440 shares remaining for issuance under the 2001
  Plan.On September
  6, 2004, the Board of Directors approved the Retention Award Agreements and
  Pharmos entered into Retention Award Agreements with each of Dr. Haim Aviv,
  Chairman and Chief Executive Officer, and Dr. Gad Riesenfeld, its then
  President and Chief Operating Officer. The Company granted retention awards
  of $300,000 cash and 75,949 restricted stock units to Dr. Aviv and $200,000
  cash and 50,633 shares of restricted stock to Dr. Riesenfeld (the Awards).
  Under the agreement, one-half of the Awards vested on December 31, 2005 and
  the balance shall vest and become non-forfeitable on June 30, 2007, subject
  to certain accelerated vesting provisions. Under the terms of Dr.
  Riesenfelds severance agreement, the balance of his Awards will vest on his
  departure from the Company on April 2, 2006 and the expense of those awards
  is being accelerated through April 2, 2006. The fair value of the restricted
  shares was based on the fair value of the stock on the issuance date. The
  aggregate fair value of the restricted stock awards totaled $2 million. For
  financial reporting purposes, the cash awards and the fair value of the
  restricted stock awards, which totaled $2,500,000, will be expensed pro rata
  over the vesting periods. During 2004, the Company recorded an expense of
  approximately $460,000 in connection with the Awards. Per the Awards, only
  Dr. Riesenfeld was issued shares of restricted stock. Dr. Aviv received
  restricted stock units and will be issued shares of stock when vested.On August
  20, 2004, the Company completed a private placement to sell common shares to
  six investors, generating total gross proceeds of $16.75 million. An
  aggregate of 1,116,667 shares of common stock wereF-17

Pharmos Corporation
Notes to Consolidated Financial Statements

issued
  utilizing a shelf registration of Pharmos securities declared effective by
  the Securities and Exchange Commission in December 2003 and was priced at
  $15.00 per share. Issuance costs of approximately $1,067,000 were recorded as
  a reduction of additional paid in capital.In June 2004, the shareholders of the Company approved the increase
  in the number of authorized shares of the Companys Common Stock to
  30,000,000 from 22,000,000.In May 2004,
  the Companys Chief Financial Officer resigned and became a non-paid
  consultant through the end of the year. In accordance with the incentive
  option plan, all terminated employees who are extended a consulting contract
  may continue to vest their options. Since the former chief financial officer
  became a consultant on a prospective basis, the options outstanding on the
  date of termination are marked to market each quarter until the options vest.
  The Company recorded the value of the services being received based on the
  fair market value of the options using the Black Scholes option-pricing
  model. The fair value of these options has been estimated based on the
  following assumptions: volatility of 89%, risk free rate of 2.82% - 3.69%,
  and a zero dividend yield. For the year ended December 31, 2004, the Company
  recorded general and administrative expenses of approximately $445,000 in
  conjunction with these options.In January
  2004, the underwriters of the December 2003 public offering exercised their
  over-allotment option in full to purchase an aggregate of 315,000 shares of
  Pharmos common stock at a purchase price of $13.75 per share, less the
  underwriting discount. Total net proceeds from the offering, including $4.04
  million from the exercise of the over-allotment option, were approximately
  $31.0 million.10.
WarrantsSome of the
  warrants issued in connection with various equity financing and related
  transactions contain anti-dilution provisions requiring adjustment. The
  following table summarizes the common shares issuable upon exercise of
  warrants outstanding at December 31, 2006 as adjusted for the events which
  have triggered anti-dilution provisions contained in the respective warrant
  agreements:Warrants

Weighted
  Average
  Exercise PriceWarrants
  Outstanding at 12/31/03


1,544,599

$
10.60Exercised


(161,411
)
$
8.90Warrants
  Outstanding at 12/31/04


1,383,188

$
10.35Cancelled


(206,878
)
$
8.90Warrants
  Outstanding at 12/31/05


1,176,310

$
9.05Cancelled


(751,541
)
$
2.04Warrants
  Outstanding at 12/31/06


424,769

$
7.02Warrants
  Exercisable at 12/31/06


424,769

$
7.02Warrants
  Exercisable at 12/31/05


1,176,310

$
9.05Warrants
  Exercisable at 12/31/04


1,383,188

$
10.35F-18

Pharmos
Corporation
Notes to Consolidated Financial Statements

Schedule of warrants expiration:

Expiration 
  Date

Common Shares 
  Issuable Upon Exercise2007



127,0302008



297,739Total



424,76911.
Stock Option
  PlansThe Companys
  shareholders have approved incentive stock option plans for officers and
  employees.  The Companys shareholders
  have approved nonqualified stock options for key employees, directors and
  certain non-employee consultants. Options granted are generally exercisable
  over a specified period, not less than one year from the date of grant,
  generally expire ten years from the date of grant and vest evenly over four
  years.A summary of
  the various established stock options plans are as follows:1997 Plan
  and 2000 Plan.  The 1997 Plan was and
  the 2000 Plan is administered by a committee appointed by the Board of
  Directors (the Compensation Committee).
  The Compensation Committee will designate the persons to receive
  options, the number of shares subject to the options and the terms of the
  options, including the option price and the duration of each option, subject
  to certain limitations.The maximum
  number of shares of Common Stock available for issuance under the 1997 Plan
  was 300,000 shares, as amended, and under the 2000 Plan is 2,700,000 shares,
  as amended. Each plan is subject to adjustment in the event of stock splits,
  stock dividends, mergers, consolidations and the like.  Common Stock subject to options granted
  under the 1997 Plan and the 2000 Plan that expire or terminate will again be
  available for options to be issued under each Plan.All stock
  option grants during 2006 were made from the Pharmos Corporation 2000
  Incentive and Non-Qualified Stock Option Plan.The
  following table summarizes activity in stock options approved by the
  Companys Board of Directors:WeightedAverageOption

Exercise
  PriceOptions Outstanding at
  12/31/03


758,289

$
10.35Granted


277,415

$
20.10Exercised


(171,270
)
$
9.20Cancelled


(72,442
)
$
14.35Options Outstanding at
  12/31/04


791,992

$
13.65Granted


575,310

$
2.88Cancelled


(169,003
)
$
12.21Options Outstanding at
  12/31/05


1,198,299

$
8.63Granted


881,000

$
2.09Cancelled


(154,677
)
$
8.82Options Outstanding at
  12/31/06


1,924,622

$
5.62Options exercisable at
  12/31/06


879,467

$
9.62Options exercisable at
  12/31/05


622,333

$
13.81Options
  exercisable at 12/31/04


419,824

$
12.65F-19

Pharmos Corporation
Notes to Consolidated Financial Statements

Additional information with
respect to the outstanding stock options as of December 31, 2006 is as follows:

Options Outstanding

Options ExercisableWeightedAverage

Weighted




WeightedRange of
  Exercise

Options

Remaining

Average

Options

AveragePrices

Outstanding

Contractual
  Life

Exercise
  Price

Exercisable

Exercise
  Price$1.75 -
  $2.01

205,000


9.8 years



$
1.90


63,332



$
1.89$2.15 -
  $3.95

1,158,903


8.4 years



$
2.43


260,760



$
2.90$5.10 -
  $8.75

127,944


4.9 years



$
5.38


122,600



$
5.40$9.38 -
  $21.20

432,775


4.7 years



$
15.99


432,775



$
15.991,924,622


7.50 years



$
5.62


879,467



$
9.62On September
  6, 2004, the Board of Directors approved the Retention Award Agreements and
  Pharmos entered into Retention Award Agreements with each of Dr. Haim Aviv,
  Chairman and Chief Executive Officer, and Dr. Gad Riesenfeld, its then
  President and Chief Operating Officer. The Company granted retention awards
  of 75,949 restricted stock units to Dr. Aviv and 50,633 shares of restricted
  stock to Dr. Riesenfeld (the Awards). Under the agreement, one-half of the
  Awards vested on December 31, 2005 and the balance shall vest and become
  non-forfeitable on June 30, 2007, subject to certain accelerated vesting
  provisions.  Under the terms of Dr.
  Riesenfelds severance agreement, the balance of his Awards will vest on his
  departure from the Company on April 2, 2006 and the expense of those awards
  is being accelerated through April 2, 2006. The fair value of the restricted shares was based on the fair value of
  the stock on the issuance date. The Awards of restricted stock are not
  included in the above stock option table.Fair value of options:The fair
  value of each option grant was estimated on the date of grant using the
  Black-Scholes option valuation model with the following weighted-average
  assumptions:2006Risk-free
  interest rate
4.35-4.69%Expected
  lives (in years)
5Dividend
  yield
0%Expected
  volatility
80 -84%Fair value
$1.60Expected Volatility.The Company calculates the expected volatility of its stock options using historical volatility of weekly stock prices.

Expected Term.The expected term is based on historical observations of employee exercise patterns during the Companys history.

Risk-Free Interest Rate. The interest rate used in valuing awards is based on the yield at the time of grant of a U.S. Treasury security with an equivalent remaining term.

Dividend Yield. The Company has never paid cash dividends, and does not currently intend to pay cash dividends, and thus has assumed a 0% dividend yield.

Pre-Vesting Forfeitures. Estimates of pre-vesting option forfeitures are based on Company experience. The Company will adjust its estimate of forfeitures over the requisite service period based on the extent to which actual forfeitures differ, or are expected to differ, from such estimates. Changes in estimated forfeitures will be recognized through a cumulative catch-up adjustment in the period of change and will also impact the amount of compensation expense to be recognized in future periods.

During the years ended December 31, 2006 and 2005, employees and outside
directors of the Company were granted stock options under the Pharmos 2000 Stock
Option Plan in the amount of 881,000 options, or a fair value of $1,412,443, and
575,310 options, or a fair value of $949,900, respectively. The fair value of
options that vested during the years ended December 31, 2006 and 2005, without
considering forfeitures, was $1,046,956 and $4,939,943, respectively.

12.
Related
  PartiesThe
  Companys Pharmos Ltd. subsidiary renewed a License Agreement with Herbamed,
  Ltd., a company controlled by the Companys Chairman and Chief Executive
  Officer. The License Agreement licenses to Herbamed the Companys patent
  rights for the oral delivery of lipophilic substances in the limited field of
  nutraceuticals, which include food and dietary supplements, food additives, vitamins
  and herbs. Under theF-20

Pharmos Corporation
Notes to Consolidated Financial Statements

terms of the
  revised License Agreement, Herbamed will pay to Pharmos Ltd. royalties of 3%
  on net sales. During 2006, 2005 and 2004, the Company recognized other income
  of $5,177, $24,670, and $9,008, respectively, under terms of the licensing
  agreement with Herbamed.13.
Income TaxesFor 2006,
  2005 and 2004, the Company has not recorded a tax benefit on the operating
  losses generated by U.S and Israeli operations. After an assessment of all
  available evidence, including historical and forecasted operating results,
  management has concluded that realization of the Companys net operating loss
  carryforwards (NOLs), which includes Velas historical NOLs and research
  tax credits generated through the acquisition date, and other deferred tax
  assets could not be considered more likely than not. Based on this
  assessment, the Company has increased the valuation allowance established on
  deferred tax assets by approximately $40,510,000, $1,617,000 and $8,080,000
  in 2006, 2005 and 2004, respectively. A substantial portion of the increase
  in the December 31, 2006 valuation allowance relates to the acquired NOLs and
  tax credits of Vela.In 2006, 2005, and 2004, the Company sold
  $7,781,267, $6,413,522 and $3,588,728, respectively, of its State Net
  Operating Loss carryforwards under the State of New Jerseys Technology
  Business Tax Certificate Transfer Program (the Program). The Program allows
  qualified technology and biotechnology businesses in New Jersey to sell
  unused amounts of net operating loss carryforwards and defined research and
  development tax credits for cash. The proceeds from the sale in 2006, 2005,
  and 2004, net of commissions, were $612,775, $490,634 and $444,774,
  respectively, and such amounts were recorded as a tax benefit in the
  accompanying statements of operations. In December 2006, the Company received
  $493,000 related to the sale of Vela net operating losses. In accounting for
  the Vela acquisition, such amount was allocated to the purchase price and,
  accordingly, is not reflected in the accompanying 2006 statement of
  operations. The State renews the Program annually and currently limits the aggregate
  proceeds to $60,000,000. We cannot be certain if we will be able to
  sell any of our remaining or future New Jersey loss carryforwards or tax
  credits under the Program.For 2006,
  2005 and 2004, the Companys recorded tax benefit differs from the benefit
  calculated by applying the statutory U.S. federal income tax rate due to the
  valuation allowances established on deferred tax assets in those periods and
  non-deductible charges, including the in - process research and development
  charge, offset by the aforementioned tax benefits from the sale of New Jersey
  NOLs.At December
  31, 2006 and 2005, the Companys deferred tax assets are comprised of the
  following:2006

2005Domestic NOLs

$
72,838,000

$
44,034,000Israeli NOLs


818,000


942,000Research and Development Credit
Carryforwards


7,080,000


3,771,000In Process Research and
Development


8,231,000


Accrued expenses, compensation
and other


860,000


615,000Net Deferred Tax
Assets


89,801,000


49,362,000Valuation allowance


(89,801,000
)

(49,362,000
)$


$
At December
  31, 2006 the Company had net operating losses of approximately $196 million
  and $103 million for U.S and New Jersey tax return purposes, respectively. Of
  these amounts, approximately $60 million and $42 million, respectively,
  relate to Velas results of operations prior to the acquisition. Net
  operating losses for Israel tax return purposes approximated $2.6 million at
  December 31, 2006. As aF-21

Pharmos
Corporation
Notes to Consolidated Financial Statements

result of
  previous business combinations and changes in its ownership, there is a
  substantial amount of U.S. NOLs that are subject to annual limitations on
  utilization. The remaining U.S. NOLs begin to expire in 2007 and continue to
  expire through 2026.The Vela
  acquisition is expected to qualify as a tax free reorganization, although no
  assurances can be given to this treatment, within the meaning of Section
  368(a) of the Internal Revenue Code.14.
Commitments
  and ContingenciesLeasesThe Company
  leases research and office facilities in Israel and New Jersey. The
  facilities in Israel are used in the operation of the Companys research and
  development activities.All of the
  leases described above call for base rentals, payment of certain building
  maintenance costs (where applicable) and future increases based on the
  consumer price indices.At December
  31, 2006, the future gross minimum lease commitments with respect to
  non-cancelable operating leases (including office and equipment leases) with
  initial terms in excess of one year are as follows:Lease
  Commitments2007

$
565,1782008


255,0072009


227,4472010


2,7452011


$
1,050,377Rent expense
  during 2006, 2005 and 2004 amounted to $623,165, $544,013, and $556,308,
  respectively. In 2006, 2005 and 2004, rent expense is net of sublease income
  of $128,850, $97,630, and $97,630, respectively. A sublease agreement expires
  on March 31, 2007 and is at an annual rate of $97,630. A second sublease
  entered into March 2006 is for $37,466 annually and expires on December 2009.Consulting contracts and employment
  agreementsIn the
  normal course of business, the Company enters into annual employment and
  consulting contracts with various employees and consultants.Dividend restrictionsDividends
  may be paid by the Companys subsidiary, Pharmos Limited, only out of
  retained earnings as determined for Israeli statutory purposes. There are no
  retained earnings in Israel available for distribution as dividends as of
  December 31, 2006, 2005 or 2004.LitigationThe Company
  and certain current officers have been named as defendants in several
  purported shareholder class action lawsuits alleging violations of federal
  securities laws. These lawsuits were filed beginning in January 2005 and are
  pending in the U.S. District Court for the District of New Jersey. These
  lawsuits assert claims under Sections 10(b) and 20(a) of the Securities
  Exchange Act of 1934 and Rule 10b-5 thereunder. The complaints allege
  generally that the defendants knowingly or recklessly made false or
  misleading statements regarding the effectiveness of dexanabinol in treating
  TBI which had the effect of artificially inflating the price of our shares.
  The complaints seek unspecified damages. These class actionsF-22

Pharmos
Corporation
Notes to Consolidated Financial Statements

have been
  consolidated by order of the Court and lead plaintiffs and lead plaintiffs
  counsel have been appointed. An amended complaint was filed in September
  2005.Management
  intends to defend these lawsuits vigorously. However, we cannot assure you
  that we will prevail in these actions, and, if the outcome is unfavorable to
  Pharmos, our reputation, profitability, financial condition, cash flows and
  share price could be adversely affected.In addition, two purported shareholders of Pharmos common stock commenced
      derivative actions in 2005 against our directors and against certain
      current and former officers. The first derivative lawsuit was commenced in
      February 2005 in the U.S. District Court for the District of New Jersey,
      and was consolidated for pretrial purposes with the class actions. An
      amended complaint in the federal derivative lawsuit was filed in September
      2005. The second was filed in April 2005 in the Superior Court of New
      Jersey, County of Middlesex. An amended complaint in the state court case
      was filed in November 2005. An agreement was subsequently reached to
      settle both of the derivative cases. The settlement provides for the
      adoption by the Company of certain changes to its corporate governance
      charters and Board of Directors committee documents and for the payment by
      the Company's insurer of attorneys' fees and expenses to plaintiffs'
      counsel not to exceed $265,000. The settlement was approved by the federal
      court on February 8, 2007.15.
Employee
  Benefit PlansThe Company
  has a 401-K defined contribution profit-sharing plan covering its U.S.
  employees. Contributions to the plan are based on employer contributions as
  determined by the Company and allowable discretionary contributions, as determined
  by the Companys Board of Directors, subject to certain limitations.
  Contributions by the Company to this plan amounted to $46,080, $49,132, and
  $58,926 in 2006, 2005 and 2004, respectively.Pharmos Ltd.
  participates in various contribution severance plans and makes regular
  deposits with pension funds or insurance companies to allow some severance
  rights to most of its employees. The custody and management of the amounts so
  deposited are independent of the Company. The Company is required by Israeli
  labor laws to pay upon dismissal or retirement each employee one month of
  salary for each year of service. The Company generally funds this liability
  by purchasing insurance policies directly in the name of each employee.16.
Segment and
  Geographic InformationThe Company
  is active in one business segment: designing, developing, selling and
  marketing pharmaceutical products. The Company maintains development
  operations in the United States and Israel. The Companys administration
  operations are maintained in the United States. The Companys chief operating
  decision makers use measurements aggregated at the entity-wide level to
  manage the business. Reflected in the amounts below are intercompany billings
  from Israel to the United States for research and development activity.Geographic
  information for the years ended December 31, 2006, 2005 and 2004 are as
  follows:2006

2005

2004Net lossUnited
States

$
(34,848,770
)
$
(2,709,593
)
$
(21,545,126
)Israel


(288,199
)

(220,279
)

(422,641
)$
(35,136,969
)
$
(2,929,872
)
$
(21,967,767
)Total assetsUnited
States

$
25,245,098

$
45,752,574

$
53,352,426Israel


3,148,240


3,238,198


4,312,416$
28,393,338

$
48,990,772

$
57,664,842Long lived
  assets, netUnited
States

$
38,368

$
86,505

$
120,931Israel


555,089


656,355


849,647$
593,457

$
742,860

$
987,451Capital
  expenditures, netUnited
States

$
1,155

$
8,401

$
124,860Israel


164,211


128,821


185,186$
165,366

$
137,222

$
310,046F-23

Pharmos
Corporation
Notes to Consolidated Financial Statements

17.
Quarterly
  Information (Unaudited)Year ended 
  December 31, 2006

1st
  Quarter

2nd
  Quarter

3rd
  Quarter

4th
  QuarterOperating
Expenses1

$
3,458,184

$
4,596,064

$
4,730,287

$
24,757,984Loss from Operations


(3,458,184
)

(4,596,064
)

(4,730,287
)

(24,757,984
)Other income


455,498


497,688


488,734


350,855Net loss 3

$
(3,002,686
)
$
(4,098,376
)
$
(4,241,553
)
$
(23,794,354
)Net loss 
  per share  basic and diluted*

$
(.16
)
$
(.21
)
$
(.22
)
$
(1.00
)Year ended
  
  December 31, 2005

1st Quarter

2nd Quarter

3rd Quarter

4th QuarterOperating Expenses

$
4,394,699

$
3,663,505

$
3,718,286

$
3,932,398Loss from Operations


(4,394,699
)

(3,663,505
)

(3,718,286
)

(3,932,398
)Other
income2


11,072,226


325,067


425,610


465,479Net income
(loss)3

$
6,677,527

$
(3,338,438
)
$
(3,292,675
)
$
(2,976,286
)Net income (loss)
  per share  basic and diluted*

$
.35

$
(.18
)
$
(.17
)
$
(.16
)*
The addition
of earnings (loss) per share by quarter may not equal total earnings (loss) per
share for the year.1.
Fluctuations
  within operating expenses are primarily related to expenses with clinical
  trials and the timing of the receipt of grants and the acquisition of Vela in
  process research and development expenses in the fourth quarter of 2006.2.
Includes a
  $10.7 million milestone payment (net) related to the sale of the ophthalmic
  product line in first quarter 2005.3.
Includes the
  sale of the NJ Net Operating Losses in the fourth quarters of 2006 and 2005
  of $612,775, and $490,634, respectively.F-24